A few days ago, when GMO released its quarterly thoughts, most focused immediately on the claim that the market is 75% overvalued [9]. However perhaps an even more important analysis by author Ben Inker, and one which was largely ignored by most, is what front-loading so much market gains thanks to the Bernanke surge in the S&P means for future returns especially as it pertains to pension funds the bulk of which are already underfunded. GMO's conclusion was not a happy one.
If equity returns for the next hundred years were only going to be 3.5% real or so, today’s prices are about right. We would be wrong about how overvalued the U.S. stock market is, but every pension fund, foundation, and endowment – not to mention every individual saving for retirement – would be in dire straits, as every investors’ portfolio return assumptions build in far more return. Over the standard course of a 40-year working life, a savings rate that is currently assumed to lead to an accumulation of 10 times final salary would wind up 40% short of that goal if today’s valuations are the new equilibrium. Every endowment and foundation will find itself wasting away instead of maintaining itself for future generations. And the plight of public pension funds is probably not even worth calculating, as we would simply find ourselves in a world where retirement as we now know it is fundamentally unaffordable, however we pretend we may have funded it so far.
One person who read this part of Inker's paper and did do the calculation is none other than Bridgewater's Ray Dalio. His conclusion is terrifying.
The reason why public and all other pension funds are the least discussed aspect of modern finance, is that while Bernanke has done his best to plug the hole in the asset side of the ledger resulting from poor asset returns, it is nowhere near sufficient since the liabilities have been compounding throughout the financial crisis since the two grow independently. Which means that anyone who does the analysis sees a very disturbing picture.
Indeed, while the asset side can and has suffered massively as a result of the great financial crisis, the liabilities are compounding on a base that has grown steadily. As Dalio notes, each year a growing percentage of assets are paid out in the form of distributions, leaving less assets to compound at a given return.
This dynamic is shown in the chart below, which shows the change of pension fund assets over the past decade relative to the present value of liabilities discounted at a rate that has been roughly constant at around 7.5%, and rising to reflect the growth in future liabilities. Obviously, if the assets equal the value of liabilities, then the fund would be able to make its payments at a 7.5% asset return. The problem is that even with the Bernanke rally of the past five years, public pension assets are now at about the same level as in 2007 while commitments have grown. Sadly, this means that recent good returns have barely closed the gap. Needless to say, the gap grows much faster in the coming years if the future returns are less than the assumed 7.5%, something that was the basis for the GMO observations.
[10]
A key component of the pension fund calculation is the increasing portion of annual distributions less contributions as a percentage of assets. Since each year public pensions distribute about 5% of the future value of their liabilities, and these liabilities have been growing at a compounded rate of about 4%, the net cash out as a percentage of flat and/or declining assets has been progressively rising. Today, annual cash outflows amount to roughly 9% of total assets which contributions are a paltry 5% of assets, which has led to a 4% cash flow drag. This increase in net cash outflows from 1.5% of assets in 2000 to 4% most recently is shown in the second chart below. The take home from this chart is that funds need to return 4% a year
in the near term just to avoid losing assets, and thanks to compounding,
over time the rising amount of NPVed liabilities raises the required
return even further.
[11]
That's where we stand now, but where are we headed? Assuming a 4% return and a steady growth of the liabilities means the financial gap will grow at an accelerating pace, making it more and more difficult to close the funding gap. It also means that with every passing year the required rate of return to plug the gap will grow even faster. Today, for example, the required return is 8.9%. In the future, once again assuming a 4% return on assets, means the required rate of return grows to 13% in ten years and 16% in fifteen years. Naturally, if a fund has a larger funding gap, the required return is even larger and the funding gap blows out much faster. As Bridgewater summarizes this feedback mechanism, "the dynamics of compounding cause this case machine to operate like the event horizon of a black hole: the pressures rise exponentially until it is virtually impossible to recovery."
[12]
But the scariest chart of all is the following simulation of the underfunding process over time and total fund assets held, assuming a 4% return on assets, which shows the accelerating decline in the value of asset holdings due to an increasingly negative cash flow yield, causing virtually all pension funds to run out of money. In the case of a 4% return, a pension fund that is assumed to be fully-funded today will run out of cash in 30 years; pensions that are 80% funded run out of money in 25 year, and so on. A fund with just a 20% funding ratio will have no money left in just over 5 years!
[13]
Curious what the current distribution of funds that match these criteria is? The chart below shows the percentage of current pension funds at each funding bracket. Nearly 50% of all fund are funded 80% or less.
[14]
The charts and simplistic calculations above show not only why virtually all pension funds are set for extinction in the not too distant future, but why Bernanke is stuck artificially reflating asset values if only to preserve the myth of the public pension funded welfare state. Because the biggest threat to Keynesians and monetarists everywhere is the social instability that would result once the myth of the Bismarckian welfare state unwinds.
But wait, there's more.
Bridgewater next proceeds to calculate what the economic impact is in a world in which a generous, consistent 4% return on assets is assumed. As Dalio's fund notes, in such a case the path to public pension sustainability will require some combination of benefit cuts or increased contributions to net out the liabilities and assets and close the funding gap. "Any way you cut it this will reduce someone's income, with a likely impact on their spending. Higher taxes will reduce the disposable income of workers, although the impact will be different depending on whose taxes are raised; less government spending on other things will hurt growth directly; lower benefits will reduce the disposable income of retirees who have a high propensity to spend; borrowing to finance the deficit will hurt growth less directly and over the longer term."
Bridgewater concludes that if public pensions don't delay and start plugging the hole now, they will need to contribute just under $200 billion per year over the next 30 years, amounting to 1.2% of GDP and 8.8% of state and local tax revenues. If funds wait a decade, the impact per year explodes to $325 billion over 30 years and will "cost" 1.2% of GDP and 12.2% of tax revenues. But the most likely, and worst case scenario, is if pension funds do nothing at all, "let the machine run its course", then the economic damage is unquantifiable as low asset returns inevitably cause lower income through benefits after assets are fully depleted.
And that in a nutshell is why the pension system, erected on an asset-liability mismatch gone horribly wrong, is doomed: a fact well known by the Fed chairman, and whose only countermeasure is to keep doing more of what has been done to date: inflating asset value while monetizing massive amounts of debt in the hope that the higher asset return will offset the funding gap. In principle this is great assuming the Fed can keep doing QE for the foreseeable future. However here, as everywhere else, we run into the fundamental problem with QE - the Fed is currently monetizing 0.3% of all private sector 10 Year equivalents per week, or about 15% per year. Since the Fed already holds about a third of the total, it has one, at best two years of QE left, before it is in control of an unprecedented two thirds of the entire bond market, and before the complete lack of market liquidity from central-planning gone wild, grinds Bernanke's experiment to a halt.
It is at that point that the entire flawed economic system of the past century will finally be on its last legs, as one of the core pillars of the biggest lie of all, the welfare state, resting on the flawed assumption that assets grow at a faster compounded rate than liabilities, will have no choice but to look into the abyss.