What if 8% is Really 0%?
Mebane Faber of Cambria Investment Management sent me an excellent paper he authored, What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed:
is well known that pension funds in the United States are underfunded
even if they achieve their projected 8% rate of return. The scope of
pension underfunding increases to an astonishing level when more
probable future rates are employed. A reduction in the future rate of
return from 8% to the more reasonable risk-free rate of approximately
4% causes the liabilities to explode by trillions of dollars. As bond
yields declined over the past twenty years, pension funds moved toward
more aggressive equity-based portfolios in an attempt to reach for this
By investing in a portfolio with uncertain outcomes, pension funds
could experience increasingly volatile and even negative returns.
Paradoxically, in an effort to chase the universal 8% rate, pension
funds may be laying the groundwork for returns even lower than the risk
In an effort to offer an empirical basis for this possibility, we
conclude the paper with a relevant comparison - the return of a
hypothetical Japanese pension for the past two decades. We believe
that pension funds need to at least prepare for the unfathomable: 0%
returns for 20 years. Most pension funds, regrettably, have not
adequately stress tested their portfolios for these scenarios.
So how does a pension manager get 8% in the current environment? Mr. Faber writes:
government bonds yielding about 4% plan sponsors must invest in other
outperforming assets to bring the cumulative return to 8%. The problem
with allocating assets away from the risk-free rate is that they are, by
definition, risky and uncertain. If a
pension manager is employing the benchmark 60% stock/40% bond
allocation, the 60% in equity or diversifying assets must return
approximately 11% to achieve 8% total returns.
second major problem outlined in this paper is that pension managers,
in an attempt to deal with the realities of underfunding, may be tempted
to chase higher performing and riskier asset classes, and may end up
compounding the underfunding problem even more through exposure to these
risky asset mixes.
Interestingly, according to Biggs, the
targeted equity allocation does not correlate with projected return.
Even worse, as shown in Exhibit 1 (above), funds
using the highest return assumptions have the most underfunded
pensions, a scenario that could be called, “fingers crossed and eyes
Mr. Faber goes on to write:
focus on illiquid assets (private equity, venture capital and
timberland investments, for example) made the Endowment Model
particularly attractive to funds that in theory have long time horizons,
such as endowments and pensions.
Yet, as real money investors
sought diversification through the same methodology, their portfolios
were, in fact, becoming more correlated to each other while portfolio
risks were becoming more concentrated and increasingly dependent upon
illiquid equity-like investments.
Most real money funds were not prepared for the following stress scenario to their portfolio:
- US and Foreign Stocks declining over 50%
- Commodities declining 67%
- Real Estate (REITs) declining 68%
figures above are the peak drawdowns from the bear markets of
2008-2009, and, importantly, they all occurred simultaneously. It is
critical that pension funds – especially funds pursuing high equity
allocations – consider all possible stresses to portfolio viability.
Mr. Faber then asks a simple question:
funds prepared for a lengthy bear market in equities like when stocks
declined nearly 90% in the 1930’s? Are funds prepared for both raging
inflation of the 1970’s and 1980’s and sustained deflation like Japan
from 1990 to the present? It is our
opinion that most funds do not consider these outcomes as they are seen
as extraordinary and beyond the scope of either feasible response or
He's absolutely right, the majority of pension funds are hoping -- nay, praying --
that we won't ever see another 2008 for another 100 years. The Fed is
doing everything it can to reflate risks assets and introduce inflation
into the global economic system. Pension funds are also pumping billions
into risks assets, but as Leo de Bever said, this is sowing the seeds of
the next financial crisis, and when the music stops,
watch out below. Pensions will get decimated. That's why the Fed will
keep pumping billions into the financial system. Let's pray it works or
else the road to serfdom lies straight ahead. In fact, I think we're
Below, Mebane Faber talks about the
benefits of the ETF he manages, Cambria Global Tactical ETF (NYSE:GTAA).
I thank him for sharing this paper with me.