by Leo Koli­vakis, Pen­sion Pulse

Mebane Faber of Cam­bria Invest­ment Man­age­ment sent me an excel­lent paper he authored, What if 8% is Really 0%? Pen­sion Funds Invest­ing with Fingers-Crossed and Eyes Closed:

It is well known that pen­sion funds in the United States are under­funded even if they achieve their pro­jected 8% rate of return. The scope of pen­sion under­fund­ing increases to an aston­ish­ing level when more prob­a­ble future rates are employed. A reduc­tion in the future rate of return from 8% to the more rea­son­able risk-free rate of approx­i­mately 4% causes the lia­bil­i­ties to explode by tril­lions of dol­lars. As bond yields declined over the past twenty years, pen­sion funds moved toward more aggres­sive equity-based port­fo­lios in an attempt to reach for this 8% return.

By invest­ing in a port­fo­lio with uncer­tain out­comes, pen­sion funds could expe­ri­ence increas­ingly volatile and even neg­a­tive returns. Para­dox­i­cally, in an effort to chase the uni­ver­sal 8% rate, pen­sion funds may be lay­ing the ground­work for returns even lower than the risk free rate.

In an effort to offer an empir­i­cal basis for this pos­si­bil­ity, we con­clude the paper with a rel­e­vant com­par­i­son — the return of a hypo­thet­i­cal Japan­ese pen­sion for the past two decades. We believe that pen­sion funds need to at least pre­pare for the unfath­omable: 0% returns for 20 years. Most pen­sion funds, regret­tably, have not ade­quately stress tested their port­fo­lios for these scenarios.

So how does a pen­sion man­ager get 8% in the cur­rent envi­ron­ment? Mr. Faber writes:

With gov­ern­ment bonds yield­ing about 4% plan spon­sors must invest in other out­per­form­ing assets to bring the cumu­la­tive return to 8%. The prob­lem with allo­cat­ing assets away from the risk-free rate is that they are, by def­i­n­i­tion, risky and uncer­tain. If a pen­sion man­ager is employ­ing the bench­mark 60% stock/40% bond allo­ca­tion, the 60% in equity or diver­si­fy­ing assets must return approx­i­mately 11% to achieve 8% total returns.

The sec­ond major prob­lem out­lined in this paper is that pen­sion man­agers, in an attempt to deal with the real­i­ties of under­fund­ing, may be tempted to chase higher per­form­ing and riskier asset classes, and may end up com­pound­ing the under­fund­ing prob­lem even more through expo­sure to these risky asset mixes.

Inter­est­ingly, accord­ing to Biggs, the tar­geted equity allo­ca­tion does not cor­re­late with pro­jected return. Even worse, as shown in Exhibit 1 (above), funds using the high­est return assump­tions have the most under­funded pen­sions, a sce­nario that could be called, “fin­gers crossed and eyes closed”

Mr. Faber goes on to write:

The focus on illiq­uid assets (pri­vate equity, ven­ture cap­i­tal and tim­ber­land invest­ments, for exam­ple) made the Endow­ment Model par­tic­u­larly attrac­tive to funds that in the­ory have long time hori­zons, such as endow­ments and pensions.

Yet, as real money investors sought diver­si­fi­ca­tion through the same method­ol­ogy, their port­fo­lios were, in fact, becom­ing more cor­re­lated to each other while port­fo­lio risks were becom­ing more con­cen­trated and increas­ingly depen­dent upon illiq­uid equity-like investments.

Most real money funds were not pre­pared for the fol­low­ing stress sce­nario to their portfolio:

• US and For­eign Stocks declin­ing over 50%
• Com­modi­ties declin­ing 67%
• Real Estate (REITs) declin­ing 68%

The fig­ures above are the peak draw­downs from the bear mar­kets of 2008–2009, and, impor­tantly, they all occurred simul­ta­ne­ously. It is crit­i­cal that pen­sion funds – espe­cially funds pur­su­ing high equity allo­ca­tions – con­sider all pos­si­ble stresses to port­fo­lio viability.

Mr. Faber then asks a sim­ple question:

Are funds pre­pared for a lengthy bear mar­ket in equi­ties like when stocks declined nearly 90% in the 1930’s? Are funds pre­pared for both rag­ing infla­tion of the 1970’s and 1980’s and sus­tained defla­tion like Japan from 1990 to the present? It is our opin­ion that most funds do not con­sider these out­comes as they are seen as extra­or­di­nary and beyond the scope of either fea­si­ble response or possibility.

He's absolutely right, the major­ity of pen­sion funds are hop­ing — nay, pray­ing — that we won't ever see another 2008 for another 100 years. The Fed is doing every­thing it can to reflate risks assets and intro­duce infla­tion into the global eco­nomic sys­tem. Pen­sion funds are also pump­ing bil­lions into risks assets, but as Leo de Bever said, this is sow­ing the seeds of the next finan­cial cri­sis, and when the music stops, watch out below. Pen­sions will get dec­i­mated. That's why the Fed will keep pump­ing bil­lions into the finan­cial sys­tem. Let's pray it works or else the road to serf­dom lies straight ahead. In fact, I think we're already there.

Below, Mebane Faber talks about the ben­e­fits of the ETF he man­ages, Cam­bria Global Tac­ti­cal ETF (NYSE:GTAA). I thank him for shar­ing this paper with me.

Leo Kolivakis is an independent analyst with a Master’s in Economics from McGill University and over ten years experience in the buy and sell-side. He was a senior investment analyst at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments), where he researched, recommended and invested in traditional and non-traditional asset classes like stocks, bonds, foreign exchange, hedge funds, private equity, infrastructure, commodities and timberland. In 2007, He completed a detailed report for the Treasury Board Secretariat of Canada on the governance of the Public Service Pension Plan. On April 21st, 2009, He was invited to speak at the Standing Committee on Finance on pensions. Feel free to contact me at lkolivakis@gmail.com for specialized consulting mandates on pension investments, or if you have any other inquiries or comments. Read more from the author/contributor here.

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