Recently I got an e-mail from my friend Kid Dynamite. He asked me an interesting question about pensions and long-duration bonds:
“back to the concept of century bonds. I’m not sure if you read my recent pension post (http://fridayinvegas.blogspot.com/2010/09/problem-with-pensions.html) , but I’m having trouble with the concept of pensions investing in 100 year bonds at 6% while using an 8% portfolio return assumption. Does not compute…(and you can even pretend that pensions have 100 year obligations)
I just don’t get the concept of locking in long duration returns below your long term bogey. That just means that you have to do even better on the balance of your portfolio…which is nice to pretend about, but in reality, if you can do better on the balance, why bother with the 6% fixed income??”
It’s a great question and one that deserves more thought. To do that, we have to separate the accounting from the economics.
When I was a young actuary, I was preparing to take the old Society of Actuaries test eight, which was the Investments exam. An older British actuary made a comment in one of the study notes that I had to think about several times before I understood it: “Risk premiums must be taken as earned, and never capitalized.”
Sadly, the pension profession never got the memo on that idea. The setting of investment assumptions accepts as a rule that risk margins will be earned without fail. Therefore, when looking at a portfolio of common stocks in a pension trust, the actuary will assume that the equity premium will be earned over the long haul and build that into his discount rate assumptions and earned rate assumptions. The same is true of bonds in the pension trust. They may haircut the yield for potential default losses, but they will assume that much of the spread over Treasuries will be earned without fail and thus they capitalize the excess returns.
Let’s pretend that the 6% century bond that Kid Dynamite told me about is risk free. Also, let’s pretend that the pension actually needs bonds as long as a century bond. Defined benefit pension plans, if trying to match cash flows, need bonds longer than 30 years, but probably don’t need bonds longer than 75 years. That said, given the lack of bonds that are longer than 30 years, a century bond will still prove useful in trying to immunize the tail cash flows of the defined benefit pension plan.
What that 6% century bond tells us is that the investment return assumption on an economic basis is too high. And, given that the yields on safe debt shorter than a century is much less than 6%, it probably means that the investment earnings assumption rate is way too high at 8%, and should definitely be lower than 6%.
I know that’s not what GAAP accounting requires. GAAP accounting allows you to choose whatever investment earnings rate you can justify using statistics. That’s not the way GAAP accounting should work though. GAAP accounting should work with discount rates derived from low risk fixed income securities, and use those to develop the investment earnings assumption.
If you earn more than the risk free investment earnings assumption, good. Those excess earnings will reduce the pension plan deficit or increase its surplus.
Okay, then suppose we reset the investment earnings assumption at 4%, because that’s closer to where it should be economically. My, what large pension deficits we see. But now, all of a sudden, that 6% century bond looks pretty good, because it brings the cash flows of the plan into better balance, and earns a decent return in excess of the earnings assumption.
So, the problem isn’t with the century bond, it’s with the earnings assumption. Now why does that earnings assumption exist?
- The US government wanted to encourage the creation of defined benefit pension plans, and so informally encouraged loose standards with respect to the earnings assumption.
- For years, it worked well, while we had bull markets going on, and interest rates were high, which decreased the value of the pension liabilities.
- The IRS took actions to prevent defined benefit plans from building up large surpluses, because it decreased their tax take. Had companies been allowed to build up large surpluses, we wouldn’t be in the mess that we’re in today.
- There is the lazy acceptance of long-term historical figures in setting earnings assumptions, instead of building them from the ground up using a low risk yield curve, and conservative assumptions on how much risky assets can earn over the low risk yield curve.
So in an environment like this, where interest rates are low, and surpluses could not be built up in the past, pension funds are hurting. The truth is, they are worse off than their stated deficits imply. For economic and political reasons, the likely outcome resembles the riddle of how one eats an elephant: one bite at a time.
So we will see investment earnings assumptions and discount rates fall slowly, far too slowly to be the economic truth, but slowly recognizing funding gaps as corporations eat the loss one bite at a time, as they can afford to.
The investing implication is this: for any stock you own that sponsors the defined benefit pension plan, take a look at the earnings assumption and raise the value of the liabilities. Also recognize that earnings will be lower than expected if the deficit is large and they need to make cash contributions in order to fund the pension plan. That said, they could terminate the plan, and I suspect many current defined benefit plan sponsors will do so.
And given that, there is one more implication: if you are employed by, or are a beneficiary of a defined benefit pension plan, take a look at the form 5500, or at the company’s financial statements and look at the size of the deficit. Take a look at what the PBGC will guarantee for you, and adjust your plans so that you are not relying on the continued well-being of the defined benefit pension plan.
I wish I could be the bearer of better news than this, but it is better to be aware of problems, then to learn that what you don’t know can hurt you.