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A few days ago, when GMO released its quarterly thoughts, most focused immediately on the claim that the market is 75% overvalued. However perhaps an even more important analysis by author Ben Inker, and one which was largely ignored by most, is what front-loading so much market gains thanks to the Bernanke surge in the S&P means for future returns especially as it pertains to pension funds the bulk of which are already underfunded. GMO’s conclusion was not a happy one.
If equity returns for the next hundred years were only going to be 3.5% real or so, today’s prices are about right. We would be wrong about how overvalued the U.S. stock market is, but every pension fund, foundation, and endowment – not to mention every individual saving for retirement – would be in dire straits, as every investors’ portfolio return assumptions build in far more return. Over the standard course of a 40-year working life, a savings rate that is currently assumed to lead to an accumulation of 10 times final salary would wind up 40% short of that goal if today’s valuations are the new equilibrium. Every endowment and foundation will find itself wasting away instead of maintaining itself for future generations. And the plight of public pension funds is probably not even worth calculating, as we would simply find ourselves in a world where retirement as we now know it is fundamentally unaffordable, however we pretend we may have funded it so far.
One person who read this part of Inker’s paper and did do the calculation is none other than Bridgewater’s Ray Dalio. His conclusion is terrifying.
The reason why public and all other pension funds are the least discussed aspect of modern finance, is that while Bernanke has done his best to plug the hole in the asset side of the ledger resulting from poor asset returns, it is nowhere near sufficient since the liabilities have been compounding throughout the financial crisis since the two grow independently. Which means that anyone who does the analysis sees a very disturbing picture.
Indeed, while the asset side can and has suffered massively as a result of the great financial crisis, the liabilities are compounding on a base that has grown steadily. As Dalio notes, each year a growing percentage of assets are paid out in the form of distributions, leaving less assets to compound at a given return.
This dynamic is shown in the chart below, which shows the change of pension fund assets over the past decade relative to the present value of liabilities discounted at a rate that has been roughly constant at around 7.5%, and rising to reflect the growth in future liabilities. Obviously, if the assets equal the value of liabilities, then the fund would be able to make its payments at a 7.5% asset return. The problem is that even with the Bernanke rally of the past five years, public pension assets are now at about the same level as in 2007 while commitments have grown. Sadly, this means that recent good returns have barely closed the gap. Needless to say, the gap grows much faster in the coming years if the future returns are less than the assumed 7.5%, something that was the basis for the GMO observations.
A key component of the pension fund calculation is the increasing portion of annual distributions less contributions as a percentage of assets. Since each year public pensions distribute about 5% of the future value of their liabilities, and these liabilities have been growing at a compounded rate of about 4%, the net cash out as a percentage of flat and/or declining assets has been progressively rising. Today, annual cash outflows amount to roughly 9% of total assets which contributions are a paltry 5% of assets, which has led to a 4% cash flow drag. This increase in net cash outflows from 1.5% of assets in 2000 to 4% most recently is shown in the second chart below. The take home from this chart is that funds need to return 4% a year
in the near term just to avoid losing assets, and thanks to compounding,
over time the rising amount of NPVed liabilities raises the required
return even further.
That’s where we stand now, but where are we headed? Assuming a 4% return and a steady growth of the liabilities means the financial gap will grow at an accelerating pace, making it more and more difficult to close the funding gap. It also means that with every passing year the required rate of return to plug the gap will grow even faster. Today, for example, the required return is 8.9%. In the future, once again assuming a 4% return on assets, means the required rate of return grows to 13% in ten years and 16% in fifteen years. Naturally, if a fund has a larger funding gap, the required return is even larger and the funding gap blows out much faster. As Bridgewater summarizes this feedback mechanism, “the dynamics of compounding cause this case machine to operate like the event horizon of a black hole: the pressures rise exponentially until it is virtually impossible to recovery.”
But the scariest chart of all is the following simulation of the underfunding process over time and total fund assets held, assuming a 4% return on assets, which shows the accelerating decline in the value of asset holdings due to an increasingly negative cash flow yield, causing virtually all pension funds to run out of money. In the case of a 4% return, a pension fund that is assumed to be fully-funded today will run out of cash in 30 years; pensions that are 80% funded run out of money in 25 year, and so on. A fund with just a 20% funding ratio will have no money left in just over 5 years!
Curious what the current distribution of funds that match these criteria is? The chart below shows the percentage of current pension funds at each funding bracket. Nearly 50% of all fund are funded 80% or less.
The charts and simplistic calculations above show not only why virtually all pension funds are set for extinction in the not too distant future, but why Bernanke is stuck artificially reflating asset values if only to preserve the myth of the public pension funded welfare state. Because the biggest threat to Keynesians and monetarists everywhere is the social instability that would result once the myth of the Bismarckian welfare state unwinds.
But wait, there’s more.
Bridgewater next proceeds to calculate what the economic impact is in a world in which a generous, consistent 4% return on assets is assumed. As Dalio’s fund notes, in such a case the path to public pension sustainability will require some combination of benefit cuts or increased contributions to net out the liabilities and assets and close the funding gap. “Any way you cut it this will reduce someone’s income, with a likely impact on their spending. Higher taxes will reduce the disposable income of workers, although the impact will be different depending on whose taxes are raised; less government spending on other things will hurt growth directly; lower benefits will reduce the disposable income of retirees who have a high propensity to spend; borrowing to finance the deficit will hurt growth less directly and over the longer term.”
Bridgewater concludes that if public pensions don’t delay and start plugging the hole now, they will need to contribute just under $200 billion per year over the next 30 years, amounting to 1.2% of GDP and 8.8% of state and local tax revenues. If funds wait a decade, the impact per year explodes to $325 billion over 30 years and will “cost” 1.2% of GDP and 12.2% of tax revenues. But the most likely, and worst case scenario, is if pension funds do nothing at all, “let the machine run its course”, then the economic damage is unquantifiable as low asset returns inevitably cause lower income through benefits after assets are fully depleted.
And that in a nutshell is why the pension system, erected on an asset-liability mismatch gone horribly wrong, is doomed: a fact well known by the Fed chairman, and whose only countermeasure is to keep doing more of what has been done to date: inflating asset value while monetizing massive amounts of debt in the hope that the higher asset return will offset the funding gap. In principle this is great assuming the Fed can keep doing QE for the foreseeable future. However here, as everywhere else, we run into the fundamental problem with QE – the Fed is currently monetizing 0.3% of all private sector 10 Year equivalents per week, or about 15% per year. Since the Fed already holds about a third of the total, it has one, at best two years of QE left, before it is in control of an unprecedented two thirds of the entire bond market, and before the complete lack of market liquidity from central-planning gone wild, grinds Bernanke’s experiment to a halt.
It is at that point that the entire flawed economic system of the past century will finally be on its last legs, as one of the core pillars of the biggest lie of all, the welfare state, resting on the flawed assumption that asset grow at a faster compounded rate than liabilities, will have no choice but to look into the abyss.
If there is ever a case study about people who built up their reputation and then squandered it for first being right for all the wrong reasons, and then being wrong for the right ones, then Meredith Whitney certainly heads the list of eligible candidates. After “predicting” the great financial crisis back in 2007 by looking at some deteriorating credit trends at Citigroup, a process that many had engaged beforehand and had come to a far more dire -and just as correct – conclusion, Whitney rose to stardom for merely regurgitating a well-known meme, however since her trumpeted call was the one closest to the Lehman-Day event when it all came crashing down, it afforded her a 5 year very lucrative stint as an advisor. Said stint has now been shuttered.
The main reason for the shuttering, of course, is that in 2010 she also called an imminent “muni” cataclysm, staking her reputation once again not only on what is fundamentally obvious, but locking in a time frame: 2011. Alas, this time her “timing” luck ran out and her call was dead wrong, leading people to question her abilities, and ultimately to give up on her “advisory” services altogether. Which in some ways is a shame because Whitney was and is quite correct about the municipal default tidal wave, as Detroit and ever more municipalities have shown, and the only question is the timing.
However, as Citi’s Matt King recent showed, when it comes to stepwise, quantum leap repricings of widely held credits, the revelation is usually a very painful, sudden and very dramatic one. This can be seen nowhere better than in the default of Lehman brothers, where while the firm’s equity was slow to admit defeat it was nothing in comparison to the abject case study in denial that the Lehman bonds put in. However, as can be seen in the chart below, when it finally came, and when bondholders realized they are screwed the morning of Monday, Septembr 15 when the Lehman bankruptcy filing was fact, the move from 80 cents on the dollar to under 10 cents took place in a heartbeat.
It is the same kind of violent and anguished repricing that all unsecrued creditors in the coming wave of heretofore “denialed” municipal bankruptcy filings will have to undergo.Starting with Detroit, where as Reuters reports, the recovery to pensioners, retirees and all other unsecured creditors will be…. 16 cents on the dollar!… or less than what Greek bondholders got in the country’s latest (and certainly not final) bankruptcy.
On Friday, city financial consultant Kenneth Buckfire said he did not have to recommend to Orr that pensions for the city’s retirees be cut as a way to help Detroit navigate through debts and liabilities that total $18.5 billion.
Buckfire said it was clear that the city did not have the funds to pay the unsecured pension payouts without cutting them.
“It was a function of the mathematics,” said Buckfire, who said he did not think it was necessary for him or anyone else to recommend pension cuts to Orr.
“Are you saying it was so self-evident that no one had to say it?” asked Claude Montgomery, attorney for a committee of retirees that was created by Rhodes.
“Yes,” Buckfire answered.
Buckfire, a Detroit native and investment banker with restructuring experience, later told the court the city plans to pay unsecured creditors, including the city’s pensioners, 16 cents on the dollar. There are about 23,500 city retirees.
One wonders by how many cents on the dollar the recovery to pensioners would increase if the New York-based Miller Buckfire were to cut their advisory fee, but that is not the point of this post (it will be of a subsequent).
What is the point, is that creditors across all products, aided and abetted by the greatest credit bubble of all time blown by Benny and the Inkjets, will find the kind of violent repricings that Lehman showed take place whenever hope dies, increasingly more prevalent. And since retirees and pensioners are ultimately creditors, this is perhaps the fastest, if certainly most brutal way, to make sure that the United Welfare States of America is finally on a path of sustainability.
The only question is how will those same retirees who have just undergone an 84 cent haircut, take it. One hopes: peacefully. Because among those whose incentive to work effectively has just been cut to zero, is also the local police force. In which case if hope once again fails, it is perhaps better not to contemplate the consequences. For both Meredith Whitney, who will eventually be proven right, and for everyone else.
- Detroit pension cuts ‘function of mathematics’ -investment banker (uk.reuters.com)
- Judge allows banker’s Detroit bankruptcy testimony (crainsdetroit.com)
- Matt Taibbi: Wall Street hedge funds are stealing public workers’ pensions (rawstory.com)
They’re Coming For Your Savings. (FULL ARTICLE)
Another of history’s many lessons is that governments under pressure become thieves. And today’s governments are under a lot of pressure.
Before we look at the coming wave of asset confiscations, let’s stroll through some notable episodes of the past, just to make the point that government theft of private wealth is actually pretty common.
• Ancient Rome had a rule called “proscription” that allowed the government to execute and then confiscate the assets of anyone found guilty of “crimes against the state.” After the death of Julius Caesar in 44 BC, three men, Mark Anthony, Lepidus, and Caesar’s adopted son Octavian, formed a group they called the Second Triumvirate and divided the Empire between them. But two rivals, Brutus and Cassius, formed an army with which they planned to take the Empire for themselves. The Triumvirate needed money to fund an army of its own, and decided the best way to raise it was by kicking the proscription process into overdrive. They drew up a list of several hundred wealthy Romans, accused them of crimes, executed them and took their property.
• In the mid-1530s, English king Henry VIII was short of funds, so he seized the country’s monasteries and claimed their property and income for the Crown. As historian G. J. Meyer tells it in The Tudors: The Complete Story of England’s Most Notorious Dynasty:
“By April fat trunks were being hauled into London filled with gold and silver plate, jewelry, and other treasures accumulated by the monasteries over the centuries. With them came money from the sale of church bells, lead stripped from the roofs of monastic buildings, and livestock, furnishings, and equipment. Some of the confiscated land was sold – enough to bring in £30,000 – and what was not sold generated tens of thousands of pounds in annual rents. The longer the confiscations continued, the smaller the possibility of their ever being reversed or even stopped from going further. The money was spent almost as quickly as it flooded in – so quickly that any attempt to restore the monasteries to what they had been before the suppression would have meant financial ruin for the Crown. Nor would those involved in the work of the suppression … ever be willing to part with what they were skimming off for themselves.”…
- Cyprus-Style Wealth Confiscation Is Now Starting To Happen All Over The Globe (conservativeread.com)
- Information on Bail-INS (thehovistrader.wordpress.com)
- Government Theft, Gold, Silver & A Chart That Will Shock You (sgtreport.com)
- Obama supporters Sign Petition Banning Gold Coins & Confiscating Coins From Safe Deposit Boxes to Help the Economy (chasvoice.blogspot.com)
- Poland Confiscates Private Pensions – Yours Are Next (sgtreport.com)
- Cyprus Has Finally Killed Myth That EMU Is Benign (ritholtz.com)
- Guess What: You are an Unsecured Creditor! That Means Your Money Is Not Safe In The Big Banks from a Confiscating Government (sgtreport.com)
- Russian Leader Warns,’Get All Money Out Of Western Banks Now! United States are preparing for the largest theft of private wealth in modern history. (intelwars2.wordpress.com)
- Poland Confiscates Private Pensions – Yours Are Next (dollarvigilante.com)
- Polish Government Seizes Private Pension Assets (fromthetrenchesworldreport.com)
- Bank Confiscation Scheme for US and UK Depositors (ritholtz.com)