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Teaching the Wall Street Journal About Pensions and Stock Returns

Thursday, 11 April 2013 04:28

The Wall Street Journal had a column this week that would terrify its readers, if they took its columns seriously. The piece, by Andy Kessler, derided the 7.5 percent return assumed by the Calpers, the public employer pension fund in California. Other pensions, both public and private, make comparable return assumptions.

The piece tells readers:

"Who wouldn't want 7.5%-8% returns these days? Ten-year U.S. Treasury bonds are paying 1.74%. There is almost zero probability that Calpers will earn 7.5% on its $255 billion anytime soon.

"The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I'm being generous, -1%."

Pretty scary, one wonders if Mr. Kessler tells his hedge fund clients that they should expect to lose 1 percent a year with the money they invest with him.

Anyhow, this is a case where Mr. Arithmetic can provide a big hand. Pension funds like Calpers typically invest around 70 percent of their assets in equities, including the money invested in private equity. The expected return on stock is equal to the rate of the economy's growth, plus the payouts in dividends and share buybacks. It also should include a term for the expected change in the price to earnings ratio, but with the PE ratio pretty much in line with long-term trends, there is little reason to expect much change.

Okay, the long-term growth of nominal GDP is projected at around 4.8 percent, 2.3 percent real growth and 2.5 percent inflation. (The inflation assumption may prove high, but projected pension fund costs will adjust pretty much one to one to a different assumption.) Companies typically pay out about two-thirds of their earnings as either dividends or share buybacks. With a current ratio of price to trend earnings, the yield is around 7 percent. Two thirds of this yield gives us a payout of 4.7 percent. Adding the two together we get 4.8 + 4.7 = 9.5 percent.

With 70 percent of their money in equities, Calpers could get 6.6 percentage points of its 7.5 percent return assumption from its equity holdings. If the fund holds 20 percent of it assets in long-term bonds that provide an average yield of 4.5 percent, this gets us another 0.9 percentage point to get us to 7.5 percent. Any return on the remaining 10 percent is just frosting. (Return assumptions are examined more carefully here.) 

In short, the return assumptions used by Calpers are quite realistic. It would be difficult to envision a situation where the long-term return was markedly worse than it assumes. Arithmetic can be a very valuable tool in addressing such issues. It should be used more frequently.

Comments (16)Add Comment
written by Last Mover, April 11, 2013 6:34
Excellent. The smoke and mirrors of the likes of Andy Kessler pierced through in a few straightforward paragraphs for a subject otherwise incomprehensible to most. Mr Arithmetic indeed.
P/e in line with historical averages
written by Jim, April 11, 2013 8:46
It's at 80% of historical averages wouldn't really say that's "in line" and the payout ratio last year was closer to 75%
written by ltr, April 11, 2013 9:33
Dean, you are wrong and need to look at the work of Robert Shiller in stock valuations since 1880. The price-earnings ratio of the market is now very high from an historical perspective.
Corporate earnings too high?
written by AlanInAz, April 11, 2013 9:49
The P/E may be in line but aren't corporate earnings at record highs. Is this sustainable?
written by liberal, April 11, 2013 10:21
I agree with ltr and AlanInAz.
written by skeptonomist, April 11, 2013 1:25
Here is the Shiller PE:


which is based on 10-year earnings, while Dean apparently refers to the PE based on one year's earnings. That site also gives the standard S&P PE ratio. The Shiller PE appears to me to be more predictive in that high ratios often preceded a decline, although I have not tried to work it out quantitatively.

Based on fundamentals, investment returns have been high since 1980 because both stock and bond prices were at historic lows then. So how have pension funds done over that time? Are they so fat now that they could stand a period of somewhat lower returns?
Current stock prices to trend earnings
written by Dean, April 11, 2013 4:17
I look at ratio of the current value of corporate equities -- taken from the Fed to trend corporate earnings, taken the National Income Product Accounts -- look at the paper, you'll get the exact lines. This is broader than Shiller who is looking at just the S&P. Since pension funds invest in PE you would want the broadest possible measure.
National Income Product Accounts overstate corporate earnings related to s+p
written by jim, April 11, 2013 4:37
shiller p/e is retarded but you are wrong to look at national income product accounts because more firms are being classified as corporate as opposed to private or proprietors' income. the earnings level of last year is 103 and change. 15.53 is well below the historical average of 18 to 19 in the post world war average.
how exactly do you calculate trend?
written by jim, April 11, 2013 4:57
and where does 2.2 trillion over 16 trillion yield 7%?

After-tax profits as a share of income
written by Dean, April 11, 2013 5:18
take an average over 40-years
I think your PE ratio is way too low, but your point still stands
written by Nick Bradley, April 11, 2013 5:18
The real return should be closer to 3.7% instead of the 4.9% you cite.
written by liberal, April 12, 2013 7:24
But the real question here is why corporate profits are so high, and whether they can remain that way. If you believe in mean reversion, then the answer is "no", but to be fair you have to make the case that whatever dynamics typically produce mean reversion would also produce it in this case.

Most of the discussion of these outsized profits claims it's all due to cost-cutting, plus more revenues from overseas operations, but I find that a little hard to believe, just on it's face. I would assume that perhaps debt being so dirt cheap these days has really fattened the bottom line, but I don't have time to poor over numbers (nor would I really know where to locate them).
written by PeonInChief, April 12, 2013 8:35
The financial services industry really, really wants to cut state sector pensions before people discover that, for most people, having a pension is the only reliable way to have a retirement not involving cat food for human consumption.
written by liberal, April 12, 2013 8:42
PeonInChief wrote,
The financial services industry really, really wants to cut state sector pensions...

Maybe, but given their incentives, wouldn't they much rather those pensions be quasi-privatized, so they can extract their usual rents by administering them?
Sounds a bit high on equity return assumption
written by Terry, April 15, 2013 7:23
You are assuming a 7% real rate of return on equities (9.5%-2.5%).

While that has been the average historically, many researchers think it is too high and that 4% - 6% is more reasonable going forward. (I am thinking of the equity-premium literature in the finance literature, especially the Fama-French stuff.)

Using 5% real return for equities gives an expected return of (5%*.7)+(0%*.3)+2.5%=6.0% expected nominal return going forward (long bonds are about zero real return now).

Kessler is still ridiculously low, but there is plenty of grounds for thinking that current assumptions are too high.
Calpers recent nominal returns history
written by John Wright, April 15, 2013 8:19
Here is data from Calpers "Facts at a glance"


Fiscal year to date 1/31/2013 9.8%
3 years for period ended 1/31/2013 10.3%
5 years for period ended 1/31/2013 2.2%
10 years for period ended 1/31/2013 7.9%

Given the headwinds the USA economy could experience from unanticipated climate change costs, a lower rate of return in the future is certainly possible.

And this discussion may indicate why the 401K ("you're on your own") is so popular with employers as it removes them from any retirement plan liability.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.