Last week, I observed that, based on the most reliable measures we identify (those having the strongest correlation with actual subsequent 10- to 12-year investment returns across history as well as in recent cycles), “the expected return on a traditional portfolio mix is actually lower at present than at any point in history except the 1929 and 1937 market peaks. QE has effectively front loaded realized past returns while destroying the future return prospects of conventional portfolios, at least as measured from current valuations. As a result, the coming years are likely to see a major pension crisis across both corporations and municipalities because the illusory front loading of returns has encouraged profound underfunding.”
On Thursday, Chicago’s Municipal Employees Annuity and Benefit Fund reported that its net pension liability soared to $18.6 billion, from $7.1 billion a year earlier, as a result of new accounting rules that prevent governments from using aggressive investment return assumptions (thanks to my friend Mike Shedlock for his post on this news). But here’s the kicker –Â the rules only apply after pension funds go broke. In Chicago’s case, pension return assumptions had been optimistically set at 7.5%, and the city had vastly underfunded its obligations.
Still, this isn’t a Chicago problem. It’s a national, even global problem, and it’s going to get much worse. See, Chicago’s assumptions were actually below the national 7.62% average. The following chart is from the National Association of State Retirement Administrators (NASRA). Chicago is essentially the rule, not the exception.
These return assumptions effectively guarantee a widespread crisis in already underfunded state, corporate and municipal pensions in the coming decade. This underfunding has resulted from a failure to appreciate the links between reliable valuation measures, realized past returns and prospective future returns.
To understand this problem, let’s begin by considering the following chart. It’s a graphic version of the thought experiment in last week’s market comment. Imagine paying some amount today in return for a $100 bill 12 years from now. The chart shows the 12-year annual return you will earn, based on how much you pay today. The higher the price you pay for a given set of future cash flows, the lower the long-term return you can expect. Notice that the horizontal axis is on log scale, which is what makes the relationship linear. Each point is labeled: paying $13.70 gets you an 18% 12-year return, paying $25.60 gets you a 12% return, paying $39.60 gets you an 8% return and so forth.
