by Brian Pretti CFA, Contrary Investor. June 12, 2009
In the midst of the current economic cycle, corporations have been meaningfully pulling back on their financial engineering activities (stock buybacks) that have positively influenced both reported earnings per share as well as acted as a demand support for equity prices in relatively cyclical fashion over time. The fact is that the S&P has experienced its best performance periods really over the last thirty years whenever corporate retirement of equities has been the strongest at any point in time. Not surprising. But as we look over the truly long term, another meaningful secular support for equity prices has been demand from pension funds, with very much special emphasis on the public pension funds of this world. What have been massive demographic tailwinds for US financial assets of really all types over the prior three-plus decades are set to become modest headwinds as we move forward. It’s already starting. This is not some huge negative that these rhythmic headwinds are now starting to blow. What this set of circumstances suggests is that investment selection, asset allocation and individual investment decision making need to be thoughtful and focused. After all, one need only look at the ten year performance of the S&P to know change is already upon us and broad exposure to equities as an asset class being an investment strategy, with little sector or geographic focus, may not be the key to the magic kingdom.
Let’s quickly review some numbers that set the stage for this issue of pension tension in terms of demographic circumstances. The following table shows us the point-to-point growth rate of various age specific demographics over the last sixty years, from the dawn of 1950 through March of 2009. Have a look.
|Age Demographic||Growth In Age Specific US Population From 1950-Present|
Clear enough for you? The numbers are simple and completely reflective of a baby boom generation that has been a key driving force of both domestic economic and financial market outcomes for decades now. Nothing new really. As a quick tangent, and although the focus is on financial assets in this portion of the discussion, think about what this means for US residential real estate. Investor after investor have chased foreclosures in the last year or two, all hoping to become real estate kingpins when real estate “comes back”. But these numbers tell us directly and unequivocally that residential real estate price appreciation indeed also faces these same clearly delineated demographic headwind or future demand issues as does the demand for financial assets. When the US is not reproducing its internal population, as has clearly been the case, immigration must take up the slack in terms of forward demand. And what the table above tells us is that as the baby boom generation dies off in the next twenty to thirty years, slack there will be.
So as of right now, we’re looking at 37.8 million folks in the US over the age of 65.
Of course what you see above has been brought to us by the miracles of modern health care, better diets, more awareness of wellness, etc. But it also represents a lot of mouths to feed in terms of currently unfunded SSI and Medicare liabilities. As we add up the numbers, about 12 months back the US had national debt of roughly $12 trillion. The current stimulus/bailout spending will add near another $13 trillion to the money printing/debt accumulation hole if enacted fully. Add in maybe $50 trillion in unfunded NPV of SSI and Medicare promises and the US is looking at something like $75 trillion in forward liabilities to be covered over the decades ahead. There are only two ways this will be accomplished as is clear – default or with “cheaper” dollars. And you already know which choice politicians will make, so we can frame our investment decision making with this constantly in mind.
Very quickly, back to the pension issues. Let's start with the public funds. Why? First, as you may have seen, Moody’s placed the bulk of US municipal specific bonds on negative watch a while back. This is a first, but understandable in terms of a bond rating company trying desperately to make up for past sins. In fact, none other than Barney Frank stood up and declared the action reckless in that it could materially hurt municipal specific cost of capital ahead. Hey Barney, where were you when these folks were putting AAA ratings on mortgage related CDO’s, etc. Oh that’s right, you were distracted while cashing their campaign contribution checks. Whoops, forgot you were “busy”. Just think, bond rating agencies actually trying to tell the truth. At least according to Frank, we can’t have that! But the fiscal issues facing the municipalities are severe. Declining property tax revenues and retail sales tax overrides are meeting up with increased benefit and general obligation costs for these folks. We need to add in the time bomb of pension costs escalating meaningfully at the exact time many a fund is seriously under funded due to financial market losses of the last few years.
As you look at the chart below, it’s absolutely clear that public funds got religion about owning common stocks in the early 1980’s. And from there it has been a straight up shot in terms of increased asset allocation to equities over time. In like manner the near 100% allocation of public pension funds to bonds half a century back (when memories of the stock crash during the depression were still fresh scars), “changed places” with their equity allocations in almost mirror image fashion. In hindsight, this was absolutely the correct allocation shift to undertake, but in recent years this excess weighting has cost these funds dearly.
But as we look ahead, THE big question becomes, are we looking at a multi-decade buyer of US equities that is now set to go into more of a distributory mode as per the character of in place plans? You bet we are. Again, not Armageddon for equities immediately or looking forward by any means, but simply the lessened impact of what has been a meaningful buyer of equities for the last three decades. It’s a generic support to the equity market that will not be as forceful and as important a buyer ahead based solely on the demographics you saw in the table. Simple enough.
One other issue of the moment complicates life just a bit and says something about the forward ability of public pension plans to shoulder risk. The following table documents total public pension fund assets dating back to 1990. THE key issue is that as of the close of 2008, public pension fund assets in nominal dollars stood just a bit below where they had been in 1999. And despite the equity rally since March, it seems a very good bet that YTD 2009 what you see below has not gotten better at all.
Unfortunately, accrued pension benefit costs today are well above where they stood for these funds in 1999. And that means the public funds are facing meaningful under funding issues. It's estimated that public funds lost 30% of their value last year, a huge number in the world of actuarial pension accounting. Just huge. Do you think Moody’s was taking this into account when it decided to put the individual municipalities on negative credit watch? You better believe they were. And quite unfortunately for municipal employees, unlike private sector funds that participate in PBGC insurance (and we use that term very loosely), public funds have no Federal guarantee. You can count on the fact that before it’s all over there will indeed be a Federal bailout of public sector pension fund obligations. C’mon, what’s another bailout at this point, right? Your grandchildren will be thrilled. Most State and municipal pension fund promises are fixed in nature (defined benefit), unlike so many private sector funds that have gone to defined contribution (with no payout guarantee - think 401(k)) plans. This puts municipalities in a particular bind as they look at these rising costs over time in shock relative to the values that have just been erased from their plan assets. Just for laughs, the NBER (yes, the same folks responsible for calling official US recessions) estimates that within 15 years time, the value of pension promises already made by US public pension funds will approach $8 trillion. You know, that's just a wee bit more than you see in the chart above, made more noticeable by the fact that the last ten years is truly the "lost decade" for public pension plan assets. Assets would have to increase 250% in the next decade and one half to reach projected needs.
So, given these facts the question stands, can public pension funds afford to shoulder more investment risk ahead now that their net funding status has deteriorated meaningfully? Do they go for broke in the hopes of regaining lost ground? Yes or no? And just what does this mean for what has been their multi-decade support of equity prices specifically?
Let’s move on and quickly take a peek at the private pension funds in the US. In broad concept what applied to the public funds above also applies to the private pension fund world. The advantage the private fund sector has is that so many in this space shut down their defined benefit pension vehicles years back and converted to defined contribution plans. No defined obligations as the individual participants in these plans are in many cases in control of their own investment choices and ultimate retirement destiny. It’s simply a good thing these folks have investment guidance counselors like Jim Cramer and Larry Kudlow from which to receive investment wisdom. But we do need to remember that there exist a fair amount of shuttered corporate defined benefit plans in this mix whose current charter and objective is one thing and one thing only – they want to pay out the last nickel in fund assets about five seconds before the last participant departs planet Earth. And that means the key goal is to match fund forward liabilities so the least amount of additional contributions to these plans need to be made over time. And that absolutely implies these vehicles will be net distributory over the decades ahead, selling every month to fund promised benefits. As the boomers age and begin collecting from these vehicles, accepting additional investment risk will not be on the agenda of trustees of these plans, quite the opposite. Their risk profiles will shift markedly with time. So in much the same manner as their public fund counterparts, the support these funds have been in terms of equity demand ahead will dissipate.
You can see below that current private fund equity allocation is already as low as anything experienced in this space since the late 1950’s. Of course current values reflect the significant losses in equity values that have occurred over the last year and one half. The private funds never increased their allocations to equities over the last few decades as had the public funds as the much more adventuresome and progressive private pension sector diversified into alternatives such as commercial real estate, private equity and hedge funds (of course all of which have also been hit pretty hard over the last few years). And at least as of year end 2007, there was very little allocation to fixed income in private funds with which to cushion the asset decline blow we’ve now experienced.
As of year end 2008, the private folks were very much in the same place as their public fund compadres – nominal total asset values rested at a level slightly below what was seen in 1999.
In short, there you have it. In quick summary, pension plan under funding after the financial market debacle of the last few years is meaningful and serious, particularly serious at the public fund level given the pressure on State and municipal budgets of the moment, something that’s not going to change any time soon. Secondly, the ability of these plans to shoulder longer term investment risk is dissipating quickly due increased payout needs that are accelerating right now and will only grow as the boomer generation ages. The risk profile of shuttered defined benefit plans will only become much more conservative ahead as they move into net distributory mode. Undoubtedly unless financial market asset values zoom to the sky very quickly, we will be looking at public pension fund bailouts before it’s over. It’s also a good bet that on the private side of the equation the very meagerly funded PBGC (Pension Benefit Guarantee Corp.) will need many an additional shot in the arm from the Federal Government, and that’s exclusive of the negative influence of corporate bankruptcy possibilities in the current economic down cycle.
What has been a secular tailwind to equity prices due to the accumulation of pension assets over time will turn into a mild headwind in the decades ahead on two important fronts. First, many of these plans will become net distributory and be scheduled sellers by which you could almost set your watch. Secondly the investment risk profile of these funds will shift to become decidedly less aggressive and more risk averse as payouts accelerate. Again, not monumental to equity market outcomes tomorrow, but an issue we need to keep in mind in terms of global and sector specific asset allocation over time. All part of the longer cycle ebb and flow of the influence of the baby boom generation on the real economy and financial markets.
© 2009 Brian Pretti