The US economy is sitting on a trillion-dollar time bomb, in the form of unrealistic pension return expectations. It affects defined benefit, defined contribution and cash balance plans alike.
Is this an alarmist proposition? Alarming, yes. Alarmist, no. The average pension fund in the US is assuming a 9% return for plan assets, in gauging the earnings impact and funding contributions for their pension plans, and more than 9% if we focus only on corporate plans. Let’s assume they actually earn 6%, not just next year, but as a long-term IRR for their assets. The difference is 3%. Multiplied by aggregate DB plan assets for the 1,000 largest plans of $3.6trn (e4.1trn), this works out to $100bn. This means that contributions are too low by $100bn and, given that corporate plans are roughly half of the total, reported earnings are too high by $50bn. But, 6% returns are ridiculous, no? No, but humour me on this for a moment.
Actuarial smoothing will take care of the $100bn, no? No. It’s not a one-year problem, if long-term returns are 3% below plan assumptions. It’s $100bn a year. Smoothing can amortise last year’s $100bn (indeed, far more than $100bn, if we consider last year’s falling asset values), and this year’s $100bn, and next year’s. But, in time, all of these amortised slices grow to become a $100bn yearly increase in pension contributions and, if we look only at the corporate side, $50bn more in pension expense. The magnitude of the problem is actually the net present value of $100bn a year.
Warren Buffet was interviewed by Fortune as a testimony to this problem of using too high an assumption for return on assets. Buffett warns companies with ROA above 6.5% that “anyone choosing not to lower assumptions – CEOs, auditors and actuaries all – is risking litigation for misleading investors. And directors who don’t question the optimism thus displayed simply won’t be doing their job.”
How does this $50bn compare with corporate earnings? Well, in 2000 and 2001, earnings for the S&P1500 totalled $524bn and $252bn, respectively, with P/E ratios of 25 and 46 times earnings. If return assumptions had been dropped by 3%, then reported earnings would have been $474bn and $202bn, respectively, and the yearend P/E ratios would have been 28 and 58 times earnings. Yes, $50 bn a year is significant.
No problem … we’ve got a DC plan. No asset/liability problem to worry about, no? Wrong. Our employees have an asset/liability problem to worry about, one that they don’t even begin to understand. They’ve seen literature showing how well they’ll do in retirement based on ‘conservative’ 8% or 10% returns. If they earn 6% (or less, given the higher expenses of DC plans and the less-than-professional asset allocation decisions made by the participants), they’ll just have to defer their retirement plans by enough years to make up the difference.
Well, we’ve got company. The rest of the world is in the same boat, no? No. Assuming 2–3% consumer price inflation, US plans are expecting their pension assets to deliver around a 7% real return. Canada, the UK, the Netherlands and Japan are all clustered around 4% for their presumed real returns. Again, a 3% difference.
But, we’ve earned double-digit returns over the last five, 10, 15, 20 and 25 years. It’s preposterous to expect 6%, no? Not really. Assuming an asset allocation mix of 70% equities and 30% bonds (yielding 6%), stocks would have to earn 11% to attain a 9.5% composite return. Stock returns have only four constituent parts:
q 1.5%: dividend yield;
q +2.5%: consensus for future inflation;
q +0.0%: P/E expansion (dare we assume more?), and
q + ?? : real growth in dividends and earnings.
This arithmetic suggests that, to get to our 6% return estimate, we need a mere 2% real growth in dividends and earnings. We can do far better than that, no? No. Historical real growth in dividends and earnings has been 1– 2%. To get to the 3% real growth in the economy, we have turned to entrepreneurial capitalism, the creation of new companies. Shareholders in today’s companies don’t participate in this growth. To get to 11% for stocks, we need 7% real growth in earnings, far faster than any economist would dare project for the economy at large, let alone for the economy net of entrepreneurial capitalism.
How did we get into this bind? We have seen the largest bull market in history, by most measures. In the rise from 1982 to 1999, the dividend yield on stocks fell from 6% to 1%, while the earnings yield (the reciprocal of the price/earnings ratio, or the dollars of earnings for each $100 invested) tumbled from 13% to 3%. This 5% drop in the dividend yield and 10% drop in earnings yield must reduce our return expectations for stocks by no less than several percent.

1982 2002
Dividend yield 6% 1.5%
Earnings yield 13% 3.0%
Bond yields 13% 6.0%
ROA assumption 6.5% 9.2%

Suppose a bond investor buys a 10% bond and watches the yield tumble to 5%, and enjoys a 20% return in the process. Does the bond investor say, “Gosh, my 10% return assumption was too low; let me boost my assumption to 12%.” No. The bond investor says, “Thank you very much for the 20%; now I’ll regrettably have to settle for 5%.” Our industry has done the opposite, ratcheting return assumptions up from 6.5% to over 9% in the course of the mightiest bull market in US capital markets history. In 1982, the 6.5% assumption was half the bond yield and was barely higher than stock market dividend yields; in 2000, the 9.3% assumption was half again the bond yield and eight times the dividend yield on stocks.
So, do I suggest that institutional investors eliminate their stock holdings or go to their CEO with a recommendation to cut actuarial return assumptions to 6%, or that consultants counsel their clients to take these steps? No, I’m not in the business of recommending career suicide.
I do not recommend slashing the equity allocation: bonds don’t necessarily offer higher long-term returns than stocks at today’s yields.
I do suggest that our institutional investors hold a bit less stocks than their peers, so that they aren’t outliers on the aggressive (and dangerous) end of the spectrum.
I do suggest that the quest for alpha and the prudent but aggressive use of alternative investments may help individual plans meet their objectives, but this cannot solve the problem for the market at large.
I do suggest that our institutional investors err on the side of caution on actuarial assumptions, insofar as their management permits them to do so.
I do suggest that the consulting community should alert their clients that they have a bridge to cross.
I do suggest that investment managers take account of pension assumptions in gauging the quality of the earnings of their holdings.
$100bn is not $1trn. So, where did that wacky, hyperbolic number come from? The average duration of pension liabilities is 15 years. So, right now, pensions are relying upon roughly a $100bn underestimate of pension expense and required pension contributions over an average of 15 years. That’s $1.5trn. And that’s just the DB side. Our employees are blissfully unaware of their own asset/liability problem, which is on a similar scale, albeit a notch smaller.
Oh, one last request. Please don’t shoot the messenger!
Robert Arnott is managing partner at First Quadrant LP in Pasadena, CA