The following blog post was written on January 22, 2018. We were trying, once again, to encourage plan sponsors to take some of the risks out of their portfolios by adopting a great focus on plan liabilities. We were concerned that plans would not be able to generate returns from traditional asset classes that would support the exclusive pursuit of the return on asset (ROA) objective. Unfortunately, this is proving correct. Here is the post.
The WSJ published an article on Sunday that questions return assumptions by America’s pension plan sponsors and their consultants. The author, Jason Zweig, is particularly concerned given that U.S. stocks are currently at all-time highs.
Zweig references a study by professors Aleksandar Andonov of Erasmus University Rotterdam and Joshua Rauh of Stanford University who looked at expected returns among more than 230 public pension plans with more than $2.8 trillion in combined assets. The professors estimate that the average return on asset assumption (ROA) for these plans is 7.6%, which is roughly 4.8% above an inflation assumption. Almost 25% of these large plans still expect to generate a return in excess of 8%.
The study looks at the average pension plan’s investment profile by asset class. The average plan has exposure to cash, bonds, both U.S. and international, U.S. and international stocks, real estate, hedge funds, private equity, and real assets (commodities). In order to achieve the 4.8% real return, plan sponsors were asked to forecast the returns that they would get over the long-term (10-30 years). The study reveals that plan sponsors expect to achieve a 3.2% return from cash, 4.9% from bonds, 8.7% from stocks, 6.9% from hedge funds, 7.7% from real assets, including real estate, and 10.3% from private equity.
Given that interest rates are substantially below the cash and bond expectations for future returns, a plan would have to make a dramatic switch into lower quality instruments in order to come close to those return targets. Furthermore, corporate America has produced a roughly 6.3% annual growth in dividends and earnings for about the last 100 years, while the stock market has generated a 6.5% real return. How likely is it that stocks will achieve the forecasted 8.7% with valuations at these levels? Not likely.
As we’ve discussed in previous blogs, the U.S. pension game has morphed into a return seeking endeavor as opposed to the original mandate, which was one predicated on providing the promised benefits at the lowest cost. Pension plans can protect their funded status in this environment by adopting a bifurcated approach to asset allocation. By adopting this approach the pension plan can reduce cost and volatility by cash flow matching near-term retired lives, while extending the investing horizon for the balance of the corpus, that now benefits from more time to capture the liquidity premium that exists in equities, real assets, private equity, etc.
Most U.S. defined benefit plans will not survive another major market crash. The plans may be perpetual on paper, but that doesn’t mean that they are sustainable. Regrettably, we’ve already seen a move to alternative retirement structures among public pension sponsors, and that movement will only accelerate as contribution costs become a bigger share of a state’s or municipality’s annual budget.
DB plans need to be protected, but doing the same thing that has been done for the last 50 years is not the approach needed in this environment. Take the path less traveled, as you are less likely to get trampled when the rest of the plan sponsor community heads for the exits.