The brewing pension crisis has been well-documented by a number of platforms and pundits over the past few years. But there are two charts that put it into perspective for investors who find themselves in the same boat as pension managers looking for returns in a world nearly devoid of them.
The average pension fund assumes it can achieve a 7.6% rate of return on its assets in the future. As noted in Monday’s Wall Street Journal, the majority of these assets are invested in the stock market. The rest are invested in bonds, real estate and alternatives. An aggregate bond index fund yields 2.5% today. Real estate investment trusts, as a group, yield nearly 4%. Alternatives are a mixed bag but the point is that, in order for pensions to meet this 7.6% rate of return they require that stocks (and, to a much lesser degree, alternatives) do far better than even that optimistic assumption because the balance of the portfolio is nearly guaranteed to fall short of that mark.
‘The goal of most pension funds is to pay for future benefits by earning 7% to 8% a year. With these assumptions, estimates of their current combined funding shortfall vary from $1.6 trillion to $4 trillion.’ https://t.co/43YjwhaLDT pic.twitter.com/aB8K1GbmO1— Jesse Felder (@jessefelder) January 2, 2018
The trouble is that for stocks to return anywhere near 8% they would need to fall more than 50% first. Warren Buffett famously said, “the price you pay determines your rate of return.” John Hussman puts an even finer point on it this week showing that if you want an 8% rate of return over the coming 12 years you should not be willing to pay more than 1,281 for the S&P 500 today.
‘In order for the S&P 500 to be priced for an 8% expected long-term annual return, the Index would presently need to trade at roughly 1281.’ -@hussmanjp https://t.co/5DEqIpcuz5 pic.twitter.com/eyg1S3N0H1— Jesse Felder (@jessefelder) January 2, 2018
Currently, the index trades at roughly 2,690 thus it would take a major stock market crash for investors to have the opportunity to invest at a level that would enable them to achieve anything close to what pensions now require. But if stocks were to crash again, as they did after the last two times valuations reached current extremes, that would obviously create other problems for pensions that are now fully invested in risk assets and already underfunded to the tune of several trillion dollars. Even if they don’t crash, however, it is now almost inevitable that pensions will face a massive crisis sometime over the next decade or so.
Still, it’s fascinating to note that even though this issue is common knowledge today, investors as a group have decided to ensure they will come to the very same fate. Passive investing, which has exploded in popularity in recent years, is essentially a way for individual investors to model pension investing, typically with an even greater exposure to equities. And it’s terribly ironic that this pension investing model has become more popular than ever only after prospective returns for the strategy have become the worst in history. (It’s also difficult to call passive investing effective diversification for those who already have exposure to a traditional pension fund.)
For investors looking for an adequate rate of return from owning stocks over the coming decade the lesson is this: Feeling entitled to historical rates of return won’t make them come true.
But having the patience and discipline to take advantage of opportunities (aka, crashes) that provide for greater rates of return than markets offer currently almost certainly will. Pensions, sadly, don’t have this ability but individual investors do (hint: it doesn’t involve passively owning financial assets at all times without any regard for their value).