I'm a morning person, especially on these beautiful summer morns. I love the quiet, the girls sleeping, my papers waiting for me in the driveway, and a day full of possibilities. Occasionally that tranquility is shattered by something stupid I read in the papers. Today was one of those days. On the front page of Section B in today's Post Gazette I see the following headline, City Pension Board Rejects Studying "Realistic" Returns. The link can be found here: http://www.post-gazette.com/stories/local/neighborhoods-city/city-pension-board-rejects-studying-realistic-returns-650328/
My blood starts to simmer before I even begin reading the article. The City of Pittsburgh's Pension Board rejects studying using realistic return assumptions. They didn't reject actually adopting realistic return assumptions, they rejected the absurd notion of even studying the use of realistic return assumptions!
Now pension accounting can be fairly absurd in and of itself, but in a nutshell here's how it works. A city or state has pension obligations that they have promised their employees. Over the years the employees contribute part of their earnings to the pension plan and the city (i.e. Taxpayers) kick in the rest. In the case of Pittsburgh the employees contribute about 6% and the taxpayers kick in the other 94%. Pension fund accounting allows the municipality to assume a rate of return on their investment in order to defray the annual amount that the taxpayers need to contribute. The higher the return assumption the less the taxpayers have to kick in. Of course if those return assumptions don't turn into return realities then the pension fund becomes woefully underfunded, and either the pensioners take a huge hit or the taxpayers take a huge hit, or most likely both. As of June 30, 2012 the plan was only 57% funded.
In the real world (where you and I live), if we are saving for college or retirement, we actually put real money based on real assumptions into our investment plans. We base our contributions on actual returns, not hoped for returns. Oh well, politicians don't live in the real world, and they don't like math.
I'll give Mayor Luke some credit though. He says that he doesn't want to study realistic return assumptions because he knows it will lead to higher contributions, which can only be funded with higher taxes. The Mayor states, "To me this is where this is going, and I'm not going to do it." He fully understands that reality bites, and he chooses to ignore it.
Since City Controller Michael Lamb was shot down by proposing a projected return study, I thought I would do my mornings allotment of community service by doing the study for him pro bono.
Over the years I've managed investments for numerous pension plans while at Mellon Bank, Federated Investors, and National City Bank, including our beloved City of Pittsburgh. I've sat in these board meetings, and have always tried to bring a modicum of reality to the presentations. So speaking in real terms for Controller Lamb here's his study:
According to the most recent Investment Policy posted on the City's web site dated March 2009 (they're not very good at providing current information), the city uses a fairly standard asset allocation of 65% Equity and 35% Fixed Income. The City uses a fairly static "buy and hold" asset allocation strategy, versus a more dynamic tactical asset allocation. Over the five year period ending December 2010 (again, the most recent numbers posted on their web site) the City's plan earned an annual return of 3.5%.
For the sake of our study lets assume that the plan is still invested 65% in equities and 35% in fixed income. What type of "realistic" returns can we expect?
Let's start with Fixed Income since it's the easiest. News Flash - Yields are low!
A two-year Treasury bond yields 0.25%, a ten-year Treasury bond yields 1.65%, and a 30-year Treasury bond yields 2.75%. Investment grade corporate bonds yield a few basis points more than treasuries. High-yield corporate bonds yield about 6%.
Using current interest rates and looking out over the next ten years, a diversified fixed income investor, willing to own some high-yield bonds, could expect a return in the 2.5% - 3% neighborhood. We'll say 3% since we're in a generous mood.
Projections for equity returns are a bit more complicated, but not too bad. Equity returns are a function of three items, 1) the current dividend yield, 2) the current earnings and projected growth rate of those earnings, and 3) the P/E ratio (price-to-earnings) that investors will be willing to pay for those earnings in say 10 years.
1) The current dividend yield is easy; the S&P 500 currently yields 1.95%.
2) For the S&P 500, current year GAAP earnings are projected to be $100. Earnings growth is a function of GDP growth and inflation. For the last 82 years earnings have grown at about 6% annually, and GDP has grown at 3.3%. Considering demographics, and the massive (and increasing) deficit the nation is burdened with, it is fair to assume that future GDP growth in the neighborhood of 2% is realistic.
With 2% GDP growth we could realistically assume that corporate earnings will grow at about 4-5%, again lets be generous and say 5%.
3) Price-to-Earnings Ratios. The current P/E ratio for the S&P 500 is 14x. Over the last 82 years the average PE was 16x. PE's are a function of investor confidence, the more confident investors are that future return assumptions will play out, the more willing they are to pay for those returns. The less confidence they have in the future, the less they are willing to pay for those return assumptions. Today investors are faced with global macro risks that have rarely been faced in history. The very real specter of higher taxes on both dividends and capital gains also eats into returns. The greater the level of uncertainty, the lower the PE. A conservative/realistic investor would probably assume a future PE ratio of about 12-14x. With a few policy errors it would not be unusual for the PE to drop to 10 or lower.
Putting all of these variables together (a dividend yield of 1.95%, future earnings growth of 5%, and a terminal PE of 12-14x) we get an expected return on equities of 4-7%. Let's use 6% for arguments sake.
OK, so over the next ten years we can reasonably expect to earn 3% on our 35% fixed income allocation, and 6% on our 65% equity allocation, for a combined realistic return assumption of 4.95% ((.03*.35)+(.06*.65)). Again, being in a generous mood we'll just call it 5%.
So there it is Mayor Luke and Controller Lamb, your pro bono pension return assumption analysis says that if you hope to move your currently woefully underfunded pension closer to funded status you should use a return assumption of 5%. Of course this would require making tough decisions on raising taxes and cutting services, but isn't that what we pay you for?
Be careful out there, and keep the lights on,
Chris Wiles, CFA
412-260-7917
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This article contains the current opinions of the author but not necessarily those of the Rockhaven Capital Management. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
