Everyone in the Pension arena understands the actuarial formula: B+E = C+I, where outflows (benefits and expenses) equal inflows (contributions and investment earnings). This equation strives for harmony, but as we’ve witnessed through many decades, the uncertainty around I places a greater and greater emphasis on C.
When pension systems were first introduced, it was not uncommon, in fact, it was very common, that pension plans were managed in a similar fashion as lottery systems and insurance companies where liabilities (pension promises) were measured, monitored, and MANAGED. Unfortunately, we are in an environment where securing the promised benefits is passe and the focus has become an arms race trying to create the highest return. In periods of dislocation in the markets sponsoring entities are forced to contribute more and more placing a greater burden on those companies, municipalities, and states to make up for the shortfall. Does this make sense?
I just presented at the FPPTA with two members of a top consulting team. They presented data from Horizon Actuarial that had aggregated data from 39 entities forecasting future returns, risk, and correlation. Given how strong the last 12+ years have been for the markets, it isn’t surprising that the forward view is for below-average returns for the next decade (regression to the mean is a real thing). They used one of their client’s asset allocations and the Horizon forecasts to come up with a 5.3% expected return for this “model” portfolio for the next 10-years. This forecasted return also comes with a +/- 11+% standard deviation.
Wouldn’t it be great if the expected return for equities came with less uncertainty, but in an environment in which the dividend yield for the S&P 500 is only 1.29% (as of 12/31/21), most of the total return needs to come from price appreciation. This hasn’t always been the case. In fact, it was not unusual for the dividend yield on the S&P 500 to be in excess of 5% annually (the average yield has been 4.3% throughout time), with a peak yield being achieved in 1932 at 13.84%. Wow! Can you imagine starting the year with that type of return? You wouldn’t need for stocks to generate any price appreciation/return to meet your return on asset assumptions (ROA). The chart below highlights the importance of dividends on the S&P 500’s total return since 1940.
Why have we as investors in the US equity market accepted this recent development. Why are we assuming most, if not all, of the risk for being an equity investor? Shouldn’t we be demanding that corporate America provide more robust dividends? Sure, there have been changes in tax policy industry/sector exposures that might have led to some of the deemphasis of dividends, but it certainly doesn’t account for all. The current yield is only slightly higher than the lowest level achieved in 2020 (1.11%). The dividend yield used to be a value measure for the index with levels below 4% signifying over valuation. What does the 1.3% seen today portend?
As the chart above highlights, it is critically important that we allow dividends to be reinvested back into the S&P 500, as it drives roughly 60% of the total return over 20-year moving averages and 48% over 10-year moving averages. But, is that what we do within our pension systems? Not really. Plan sponsors are in search of liquidity every month to meet benefits and expenses. They often sweep all available cash from each of their managers irrespective of the growth potential for reinvestment. Given this practice, we would highly recommend that asset allocation strategies bifurcate the assets between liquidity and alpha buckets. The liquidity bucket should use the cash flows from bonds to meet all the current funding needs (liability cash flows), while the alpha bucket can now grow unencumbered as those assets are no longer a source of liquidity.
If the Horizon aggregated information with regard to return, risk, and correlation proves correct, the importance of dividends and dividends reinvested cannot be minimized. Investors shouldn’t accept or settle for a dividend yield in the 1.3% range which places most of the risk on US for a return necessary to meet our pension obligations. Let’s talk.