John Mauldin: Unrealistic Expectations

John Mauldin |


"In the short run, the market is like a voting machine, tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine, assessing the substance [intrinsic value] of a company."
– Benjamin Graham

Way back in the Paleozoic era (as far as markets are concerned), circa 2003, I wrote in this letter and in Bull's Eye Investing that the pension liabilities of state and municipal plans would soon top $2 trillion. This was of course far above the stated actuarial claims at the time, and I was seen as such a pessimist. Everyone knew that the market would compound at 9%, so any problems were just a rounding error.

Now it turns out I may have been a tad optimistic. Two well-respected analysts of pension funds have produced reports this summer suggesting that pensions are now underfunded by more than $4 trillion and possibly more than $5 trillion. I would like to tell you that the underfunding is all the bad news, but when you probe deeper into the problems facing pension funds, it just gets worse. The two reports conclude that pension plan sponsors seem determined to keep digging themselves an ever-deeper hole. But to hear the plan sponsors tell it, the situation is readily manageable and the risks are minimal. Except that pesky old reality keeps confounding their expectations.

And that is the crux of the problem. Whether you believe there really is a problem boils down to the assumptions you make about future returns. If you believe the projections trotted out by pension fund management and the bulk of the pension consulting groups, the underfunding is a mere $1 trillion — a large amount to be sure but manageable for most states.

The emphasis here is on most. Some states and municipalities are in far worse shape than others, and to be honest with you, I don't see how some of them can meet their commitments. Others are trying to be responsible and fulfill their pension fund obligations based on the assumptions their "experts" come up with, but the problem is that those assumptions may be overly optimistic. The seemingly small difference of just 1% of GDP growth can make a huge difference in pension liabilities (and thus taxpayer obligations).This week we begin a series focusing on the problems facing US state and local pension funds. This issue has relevance to you not only as a taxpayer but also as an investor, because it goes to the very core of the question, what is the level of reasonable returns we can expect to see from our investments in the future? This is not a problem that is restricted to the US — it's global. Sadly, we don't live in a Lake Wobegon world where all pension funds and investment portfolios are above average. Not everyone can be David Swenson, the famous chief investment officer of Yale University. Truth be told, David Swenson will have a difficult time being David Swenson in the next 20 years.

Unrealistic Expectations

The past 10 years have seen a growing number of economists and financial analysts questioning the propriety of the methods used to forecast pension fund liabilities. This is more than an academic exercise, as the numbers you choose to base your models upon make massive differences in the projected outcomes. As we will see, those differences can run into the trillions of dollars and can mean the difference between solvency and bankruptcy of municipalities and states. The implicit assumption in many actuarial forecasts is that states and cities have no constraints on their ability to raise money. If liabilities increase, then you simply raise taxes to meet the liability. However, fiscal reality has begun to rear its head in a few cities around the country and arrived with a vengeance in Detroit this summer. It seems there actually is a limit to how much cities and states can raise.

"Aah," cities assure themselves, "we are not Detroit." And it must be admitted that Detroit truly is a basket case. But it may behoove us to remember that Spain and Italy and Portugal and Ireland and Cyprus all said "We are not Greece" prior to arriving at the point where they would lose access to the bond market without central bank assistance.

In response to growing concerns over public pension debt, the Governmental Accounting Standards Board (GASB) and Moody's have both proposed revisions to government reporting rules to make state and local governments acknowledge the real scope of their pension problems. (While it is possible to ignore Moody's, based on the fact that it is just one of three private rating agencies, it is impossible to ignore GASB, which is the official source of generally accepted accounting principles (GAAP) used by state and local governments in the United States.

Under the new GASB rules, governments will be required to use more appropriate investment targets than most public pension plans have been using, bringing them more in line with accounting rules for private-sector plans. Pension plans can continue to use current investment targets for the amounts the plans have successfully funded; but for the unfunded amounts, pension plans must use more reasonable investment forecasts, such as the yield on high-grade municipal bonds, currently running between 3 and 4 percent. From my perspective, not requiring reasonable investment forecasts on already funded accounts is still unrealistic, but the new GASB rules are a major step in the right direction, and I applaud GASB for taking a very politically difficult stance.

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