So this morning (4/10/2013) I read the Wall Street Journal, as I do each morning before the day starts, and found a very timely Opinion piece written by Andy Kessler: The Pension Rate-of-Return Fantasy. It just so happens that over the last several weeks I had been thinking deeply about this so-called pension assumption fantasy that exists in both the public and private pension plans. Municipal bankruptcy headlines and the delivery of company Annual Reports and Proxy Materials prompted me to conduct my own pension liability exercise.
Just this week alone I received a few Annual Reports. Having been trained in accounting in addition to finance, I started reading from back-to-front focusing on the Notes to the Financial Statements. Any serious investor should at least skim these sections over to gain a better understanding of any company's operations and financials. Of the three that I received this week so far, I offer my own take on their pension return assumptions:
|Company||Internal Assumption||My Assumption||Current Funded Status|
|Murphy Oil||6.20%||6.00%||-$258 Million|
|General Electric||8.00%||6.00%||-$18.8 Billion|
|Norfolk Southern||8.25%||6.00%||-494 Million|
For illustration purposes only
My assumptions for example in GE's mix of assets is as follows:
US Equities - 7.00%
International Equities - 8.00%
Debt Securities - 3.00%
Private Equity - a generous 12%
Real Estate - 8.00%
Other (Mainly of Hedge Funds) - 5.00%
The bottom-line without boring you with the details and an "honorary certificate" in pension accounting is that when actuarial rate of return assumptions are higher than what they should be, pension obligations (read liabilities) can be understated and pension expenses reduced. The logic being that whatever the company does not contribute, the market performance will make up - yeah right! There is another issue with the discount rates being overstated given current low interest rates but I think the conclusion directionally is correct without digging too much further into that part of the actuarial assumptions made by pension committees. Why is this important? In GE's case for example a 0.50% reduction in return assumption would imply an increase of $200 Million in pension cost in the following year. If the discount rate was reduced by 0.25% pension costs would increase by $200 Million and Pension Benefit Obligations would rise by $2 Billion. If we were to reconcile theirs with my assumption GE would have an additional $800 Million pension cost expense and an increase in Pension Benefit Obligations.
California Public Employees' Retirement System, or Calpers, has a 7.50%. The reality, as Mr. Kessler argues, is that the realized return in the future will likely be lower than expected. I could not agree more given my own calculations.
J.P. Morgan's latest Guide to the Markets slide #66 illustrates that of the S&P 500 company pension plans, 94% are underfunded and the average return assumption is 7.3% as of 2011. Given today's expected rates of return for various asset classes, 7.3% seems quite high. Hence, both pension costs and liabilities are both being underestimated systemically.
The time may have come where reality needs to set in for pension plans across the globe to carefully ask their consultants and themselves the tough question - are our assumptions realistic? Fiction and fantasy is fun in books, movies and playing with my 4-year old but in real life this kind of fantasy can only end up hurting people in the end one way or another.
There are few ways to address the "pension cliff," just like any other deficit situation. One can either increase the contributions to fund the future liabilities while adjusting assumptions in a measured manner or benefits can be cut. Either way the expense of doing either is very dear and could have serious bottom-line implications over the medium to long term time horizon.
Yet another reminder that we all have to be accountable for our own standard of living in retirement. Start planning appropriate steps to secure your financial well being in the future by setting an appropriate course for yourself and live within your means.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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