The sponsors of ‘defined benefits’ pension plans controlled, as of December 2004, about US$2.5 trillion in equities belonging, indirectly, to the beneficiaries of these plans.

(See: “Who’s Holding America’s Stock Proxies?“)

In December 2004, U.S. equities, even after the crash of 2000-2001, were still substantially over-valued.

(See: “Equity Values“)

In order for stock prices to reflect values that were customary for a century before the advent of stock buybacks, prices would have to drop between 20% (earnings basis) and 50% (dividend yield basis).

In the case of ‘defined benefits’ pension plans, this would represent a loss of between US$500 billion and US$1.2 trillion in market value of pension portfolios!

To put this in context, such an ‘adjustment’ would be equivalent to from 90% to 210% of before-tax corporate profits in 2004.

In another context, a fall in valuation to historical levels would be equivalent to from one- and to two-thirds of all receipts of state and local governments in 2004.

Impact of the Crash of 2000 on Pension Funds

When the Great Bubble of the 1990s broke, equities belonging to households, held indirectly in private and public ‘defined benefits’ pension plans, fell in value US$987 billion, between 1999 and 2002.

However, most beneficiaries of these plans were hardly aware of the implications of the decline in value on their retirement plans. There was no general expectation that pensions might not be paid, as promised.

Accounting rules that cover reporting costs and liabilities of defined benefit pension plans are lenient, favoring plan sponsors who have more lobbying power with the FASB than pensioners.

Understanding the relevant accounting standards (SFAS 132R and SFAS 51) requires a bit of study.

(For an good summary, see: “Pension Accounting and Reported Earnings“, by Simon Kwan, Research Advisor to the Federal Reserve Bank of San Francisco.)

From purposes of Capital Flow Analysis, the essential points to remember about these accounting standards are:

1. Pension Funds Are Not Immediately ‘Marked to Market’: Accounting rules allow pension plan sponsors to amortize costs of a market decline over five years. This means that, not only were heavy losses from the crash of 2000-2001 diluted over five years until 2005 and 2006, but also that these losses were smoothed by paper profits from the last years of the Great Bubble.
2. Pension Costs Depend On Sponsors’ Estimates Of Future Returns: It is easy for plan sponsors to mask costs of ‘defined benefits’ pension plans, simply by making overly-optimistic estimates of future returns. For example, the study by Simon Kwan (mentioned above), showed that even in 2000, after the crash, 90% of pension sponsors were predicting long-term returns of between 8.2% and 10.0%.

Lack of Standards for Projecting Portfolio Returns

There is no board of standards that establishes a basis for realistic, conservative estimates of long-term returns on pension plans, as might seem to be in the interests of pensioners.

Instead, estimates are made by plan sponsors who have commercial conflicts and incentives to over-estimate projected pension returns.

The typical projections of from 8.2% to 10.0%, mentioned above, should be judged in the light of the following:

Long-term growth of before-tax corporate profits in the United States (1947-2003) was only 5.3%. The current dividend yield on stocks is only about 1.2%.

(See: “Ballyhoo and Earnings Growth“.)

Adding these two figures together produces a reasonable, middle-of-the-road, expectation for future returns on an equity portfolio, of about 6.5%. Considering that pension fund portfolios also include bonds, it would seem that a conservative long-term estimate for most funds would be about 5%.

In any event, since no one can foresee who will be the actual managers for a particular portfolio, ten or twenty years hence, it is hard to understand on what basis a particular portfolio manager might claim results any better than a general expectation based on past growth of corporate profits.

Although some portfolio managers might legitimately expect better returns than the overall market during the time they might be in charge of a portfolio, they have no way to make an estimate if they don’t know who will be managing a portfolio in the distant future, and, in any case, it does not seem reasonable that all portfolio managers should be allowed to claim above-market returns.

However, to justify optimistic expectations, many fund manager can produce examples of ‘total return’ of managed portfolios over the last ten or twenty years (since the buyback movement began), with much higher returns that the long-term growth of before-tax corporate profits, and, on this basis, might argue that his or her estimate is not only reasonable, but based on ‘fact’.

Except for the financial well-being of plan beneficiaries, there is no penalty for over-estimating future portfolio returns.

As a result, it would seem that pension fund managers may be over-estimating projected portfolio returns by as much as fifty percent compared to levels that prudence would allow.

Stock Buybacks To The Rescue

There are two reasons to suspect that ‘defined benefits’ pension plans in the United States are substantially under-funded and that, eventually, many of these plans will produce benefits that will be less than promised, effecting the lives of a great many plan beneficiaries:

1. Current Over-Valuation of Stocks: As suggested, a drop of between 20% to 50% of current market values would be in order to bring the stock market in line with longer-term historical values. This might occur if stock buybacks were to cease, for whatever reason, or when Baby Boomers begin to get out of stocks in anticipation of retirement needs.

2. Under-Estimation of Funding Requirements: Even if stock prices do not fall to historical valuation levels, many, if not most, pension funds may still be under-funded because of lax accounting rules that allow overly-optimistic projected portfolio returns.

But pension fund managers have a not-so-secret weapon whereby they might expect to obtain returns that exceed the growth of corporate profits.

Pension fund managers vote the stock they hold in portfolio and have the ability to elect directors to public companies that will act in their interests (which may not coincide with the interests of pensioners.)

The SEC allows corporations to manipulate stock prices upwards by the device of corporate buybacks.

(See essays on: “Buybacks and Options“).

By supporting buybacks to inflate stock prices, pension fund managers achieve two objectives:

1. They help to postpone a return of stock prices to historical valuation levels; and
2. The provide justification for over-estimating projected portfolio returns.

So far, this has worked out well for pension fund managers, while most Americans remain unaware of the inverse relationship between stock buyback programs and the long-term outlook for their pension plans.

On the horizon, we still have the retirement of Baby Boomers with which to contend.

This entry was posted on Sunday, February 26th, 2006 at 10:14 pm and is filed under Equities, Individual Investors, Fund Managers. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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