Juiced Earnings And Fanciful Figures

It took 6 years for pension plans to recover from the last recession. Now, heading into an "L" shaped Recession that rates to be far worse than the wimpy recession of 2001, Pensions face funding rerun.

Liability-driven investing, which insulates pension plans from market and interest rate volatility, has been an often discussed yet infrequently implemented strategy for the vast majority of corporate pension plan sponsors. But fresh off of a quarter that wiped out nearly a full year’s worth of gains for some of the largest corporate pensions, many of these plan sponsors are expected to stop talking and start doing something about employing LDI to bolster the faltering funded status of their pension plans.

It has taken most corporations years to recover from the one-two punch of drastic declines in the equity markets and falling interest rates that drove pensions into the red earlier this decade. But finally, at the end of 2007, the majority of large corporate pension plans managed to post a pension surplus for the first time since 2001, according to data from actuarial firm Milliman Associates. The 100 largest corporate sponsors—from General Motors and its $117 billion pension plan to Ingersoll-Rand’s $2.5 billion plan—collectively improved their funded status last year by $85 billion, going from a roughly $15 billion combined deficit at the end of 2006 to a $70 billion surplus at the end of ’07.

Sweet. But short: Most of their gains evaporated in the first three months of this year.

This solution, Mr. Morgan and many other pension experts contend, will now increasingly come in the form of LDI approaches, which generally invest a pension plan’s assets specifically to meet its expected pension obligations (as opposed to exceeding an investment benchmark). LDI strategies can vary widely—plan sponsors can invest pension assets in long-duration fixed-income vehicles, for example, or they can use derivatives such as interest rate swaps in their portfolio, and both would qualify as LDI. Ultimately, these types of strategies are designed to make pension plans less vulnerable to swings in equity markets and interest rates, produce more consistent and predictable investment returns, and lower the risk of underfunding.

Because LDI strategies are designed to reduce the risk in a pension plan’s portfolio and produce more predictable returns, it also lowers the likelihood that corporations will be forced to make unexpected contributions to their pension plans. “If you can eliminate the peaks and valleys, then you’re always going to be in a better position to manage your budget and anticipate cash contributions,” said John Ehrhardt, principal and consulting actuary at Milliman.

Juiced Earnings And Fanciful Figures

In his latest annual report Warren Buffett talks about How Public Companies Juice Earnings.

For the 363 companies in the S&P that have pension plans, assumptions in 2006 averaged 8%. Let’s look at the chances of that being achieved.

The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.

This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.

How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually.

Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.

It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?

No Free Lunch

There is no free lunch for pension plans. The problem with pension plans is expected rates of return are simply too high. The risk free yield on 5 year treasuries is under 3%. Even as little as 6 months ago one could have locked in 5%. But that is not enough when assumptions are 8%.

Yet we are now told by Paul Morgan, senior consultant and director of capital markets at Evaluation Associates, that the solution is "Liability-driven investing".

This is of course complete nonsense, and it should not take a genius to figure it out. By what miracle can LDI return 8% a year if the long term average is 5%?

Morgan is also touting interest rates swaps and other derivatives as LDI as if those never blow up. Morgan might be advised to take a look at Jefferson County Death Spiral Swaps and a possible bankruptcy of Jefferson County Alabama. If it happens it would be the largest municipal bond bankruptcy in history.

What's going to happen, and perhaps it is happening right now with this "bottom is in" rally, is corporations are going to shift out of treasuries into equities, swaps, commodities, and God knows what else hoping to make 8% returns. When the market heads south again, they are going to regret it big time. It rather hard to make 8% out of 5% but it's even harder to make 8% out of negative 20% should the stock market head south in a major way.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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