Tuesday, March 31, 2009

Stocks, Bonds, Pensions and Guarantees

On Monday the Boston Globe had an article, "Pension insurer shifted to stocks" that reminded me of my reaction when the Pension Benefit Guaranty Corp. announced the policy shift in February 2008:

Yikes! In Policy Shift, PBGC Turns to Stock Market

Hey, what could possibly go wrong?
Ya know how retail investment types always point to Ibbotson and say something to the effect "There's never been a ten year period...blah, blah blah"? Ask 'em about the Cowles extension and the longest period the index value showed a net decline (I seem to remember 42 years, I'll dig out the book). When they come back at you that you aren't including reinvested dividends, throw a right, left, right combination:

1) What was the average dividend yield in Cowles 1871-1937?

2) What was the payout ratio?

3) What was the equity risk premium?

I usually get the cow eyes.
Even simpler is to ask the question Zvi Bodie did, back in the '90's:
(he seems to have overcome his MIT doctorate)

"If the risk of negative returns decreases over time, why does the cost of long term puts increase?"
(now I know the arguments against Bodie's implication, here's a decent one, here's a counter to the counter, we've got links, baby.)

What I'm wondering is if an entity like the PBGC, with its implicit call on the U.S. Treasury, should be increasing its exposure to equities. Especially when you consider that most busted pensions got that way through a combination of underfunding and lousy investments....
I forgot to post the Boston.com piece but it worked out because Pension Pulse picked up on it and used it in a post that touched on equity vs. fixed income returns, including a chart I had seen in another context (and forgot) and tying it all together:
A Giant Experiment?

(Click on chart to enlarge)

Toward the end of the post he uses the Globe piece to pivot to this:

...And the article above brings me to another excellent post by Ian Williams that appeared on the Barricade blog over the weekend, Who Killed U.S. Public Pension System?

Ian was kind enough to email me and share his insights with me. The charts above are from his post and I quote the following:

Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, “I have students of mine - PhDs - going around the country telling people it’s a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe.”

When someone tells you that stocks always beat bonds, or that stocks go up in the long run, they have not done their homework. At best, they are parroting bad research that makes their case, or they are simply trying to sell you something.

Which leads nicely into our 2nd bullet point - politically connected pension systems promising benefits and COLA’s assuming and I am likely being conservative a 7.5% investment return assumption on their portfolio which is now skewed heavily into stocks over bonds..MORE
Very good stuff and helpful in estimating returns going forward.