Submitted by Keith Dicker of IceCap Asset Management [6] [6]
Elementary my Dear Watson
If you’re into mysteries, there’s certainly no shortage of them around the world. Enjoying them is one thing, solving them is quite another.
In the mystery solving world, Sherlock Holmes was clearly heads, hands and feet above everyone else. His unorthodox thinking was the key to solving the mystery behind the Hounds of Baskerville, while shrewd decision making always proved valuable when up against the maniacal Moriarty.
Lieutenant Columbo meanwhile, was also a sharp cookie. Whereas Sherlock dove straight into a mystery and aggressively confronted his foes, the affable Columbo excelled at bumbling around the problem which caused his foes to underestimate him. Which of course, always helped everyone’s favourite detective gather more clues and crack the case.
Mysterious hounds and mysterious criminals certainly help keep our minds razor sharp as well as entertained. Yet, perhaps the biggest mystery in the world today involves - pension plans.
Many people have them, and most people fully know what their eventual pension payout will be. Unfortunately, the average person doesn’t know how their pension plan is actually taped together, and fewer still, appreciate that the “promise” of their “eventual pension payout” is not as guaranteed as they may believe.
Let’s leave no doubt - considering the mysterious complexity of these plans, to understand them one must certainly be a sharp cookie – that’s the easy part.
However, to fully understand them, one must use unorthodox thinking and make shrewd analytical decisions. Last but not least, never underestimate how today’s financial environment is about to leave many pension plans scratching their heads with confusion and despair.
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Pension Plan Assets
Everyone knows their pension plan owns stocks and bonds. What few know is how they are actually valued.
Because stock and bond markets can be very volatile in the short-term, and pension plans provide benefits over the long-term, many argue that it is unfair to determine the financial health of a pension plan based upon short-term, recent market performance.
Unless of course, the short-term market performance is exceptionally good – then the above doesn’t apply.
However, if markets whipsaw around like they did in 2012, 2009, 2008, 2002, 2001, 1998, 1994 (we could go on but...), then pension plan consultants prefer to smooth out these return fluctuations when reporting their financial check-up.
The main tool used for smoothing returns is called the Expected Rate of Return. It isn’t the actual rate of return, but rather, it is an estimate of what the pension plan will earn over the long-term.
Now, here’s the trick – the higher the expected rate of return, the higher the expected value of plan assets.
The higher the expected plan assets, the lower the expected deficit.
And, the lower the expected deficit, the lower the expected contributions that is required by the employer.
Note: these expected returns are theoretical - not actual.
In a nutshell – high expected rates of return are good. But only good if they retain a semblance of reality. And since most people live in reality, the expected rate of return used by pension plans should also resemble reality.
And this brings us to the very big problem for pension plans today. Theoretical or expected returns used by pension funds today are no where close to what may be earned in reality.
60% Stocks + 40% Bonds
In order to better appreciate reality, one must first understand that most pension funds typically hold about 60% in stocks and 40% in bonds.
The popularity of DBP pension funds really surged in the 1980s only to plateau in the 1990s. And during that time, a diversified portfolio with a roughly 60-40 split almost always produced a really nice return experience, which made everyone really happy.
And since all of today’s consultants cut their teeth during this period, or learned from people who worked during this period – then a balanced 60-40 split will do just fine for everyone today. After all, the 80s and 90s happened over 25 years ago. For any investment strategy to endure over that amount of time, it must be good.
Unfortunately, due to high expected rates of return, many pension funds are actually living in a fantasy world.
Case in point, consider the Expected Rate of Returns for:
- Ohio Police & Fire Pension Fund = +8.25%
- California Public Employees Retirement System = +7.50%
More conservative Expected Rates of Return can be found with:
- Nova Scotia Public Service Superannuation Plan = +6.50%
- Healthcare of Ontario Pension Plan = +6.34%
To the naked eye, these return expectations may appear quite reasonable – after all, we’ve always been told that over 100 years, the stock market always averages 10% annual returns or higher.
However, our regular readers know that it isn’t the stock market that worries us. Instead, it’s the bond market that should be keeping people awake at night.
Yet, even long-term stock market returns have a major flaws. For starters, the 10% number comes from the well-known Ibbotson/Morningstar studies which show that since 1926, the US stock market returned 10% annually.
With almost 90 years of history, this must be pretty darn accurate. However, if the Ibbotson study started 20 years earlier, the annual return declines to about 7% a year (source: Crestmont Research).
Think about this; a 90 year study shows a 10% annual return, but a 110 year study shows a 7% annual return. That’s a pretty big difference, and certainly throws doubt on what exactly is the long-term average.
Better still, Chart 1 (this page) shows the 10% average return is actually rarely achieved. Since 1900, 44% of the time the average 10-year return was < 8%.
Think about that one – whether you exceed an 8% return has effectively become a flip of the coin.
While that describes the challenges of using long-term returns from the stock market, our real concern is actually with the bond market. We’ve written, presented, interviewed and even web-casted many times before about the bubble in the bond market. It’s a very big deal, and when it bursts it will have cascading effects in every market, all over the world.
And considering that the average pension plan has 40% of its investments in the bond market – this is a BIG deal.
To fully appreciate how big of a deal this is, one needs to appreciate the complete picture of:
- expected rates of return
- stock market returns
- bond market returns
Since most pension plans hold about 60% in stocks and 40% in bonds, the pension plan’s total return is simply:
60% * Stock Market Return + 40%*Bond Market Return
As an example, if Stocks increased 10% and Bonds increased 5%, the pension plan’s total return = 60%*10% + 40%*5% = 8% Total Return.
Simple enough and in theory, that’s how it works. However, it’s reality that has us concerned.
To demonstrate exactly why pension funds are in trouble, note the above calculation. Due to the way the bond market works, it is fairly easy today to accurately predict the maximum return achievable – we’ll get to the minimum return in a moment.
Today, the yield or interest received on a 10 year US Government Treasury Bond is about 2%. This means if you buy the bond today, the best return possible is 2% a year for the next 10 years.
This is where our technical readers point out that bond investors also hold corporate bonds, junk bonds and emerging market bonds which will increase the yield further. As a result, even using the Barclay’s US Aggregate Bond Index as a different return proxy still only increases the yield to 2.2%. For this example, we’ll simply round down to 2%.

Putting it all together: below we show using a 6.5% Expected Rate of Return and a 2% Bond Market return, the pension plan would need a 9.50% return from the stock market to meet it’s return objective.

Most people would agree that over the long-run stocks will produce a 9.50% return.
This is true for a 6.50% Expected Rate of Return. Watch happens to the poor folks at the Ohio Police & Fire Pension Fund who has elected to use a 8.25% Expected Rate of Return.

Whoa - this pension plan needs a +12.45% return from the stock market to meet it’s return objective. And considering everyone swims in the same stock market, the probability of the Ohio Police & Fire Pension Fund meetings its return objectives are next to 0%.
And that’s assuming a +2% return from the Bond Market.
Next, and this is the most critical aspect of the pension mystery and why we are writing about it – what happens to pension funds when (not if), the bond bubble breaks?
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The full note can be read in the pdf below (link [8])

