This week we start out with the weather and end up buried in the footnotes of the Pension Benefits Guaranty Corporation as we wonder about expected future returns from the stock market. It is a wide-ranging foray, and I hope an interesting one, as we look at what some see as an impending crisis (which is not all that big, as world ending crises go) and stumble upon the real object where our concern should be focused - our retirement portfolios.
Getting an "A" in College
But first, I noted that my book, Bull's Eye Investing, rose to #19 on Amazon over the weekend (#1 on the finance list), and remains a quite strong 94 as I write this evening. If you have not yet gotten what the New York Times called "serious summer reading," perhaps the comments by readers will help you stop your procrastination. One reader evens speculates on Amazon.com that it could improve your kid's grades. Here is his assessment:
"A Quick Easy Read - and You Might Learn Something Too!" writes R. C. De Graff from Hartford, CT. "I have been a stock broker for over 44 years and have read a myriad of economic books during this period. There is so much common sense in this book that if you are a serious investor, or a stock broker, it is a must read.... Now the clincher. It is an easy read. The chapters are normal length, but the sub chapters are anywhere from two paragraphs to just a page and a half. If I had a book like this in college I would have gotten "A's". Cheerio!!!"
And writing from the other end of the country, Dr. Bob English from Anchorage, Alaska writes "Outstanding read! As a doctor after many years leaving financial decisions to the 'experts' at (I will not mention companies) I decided to be responsible for my investments. It has been a number of years and many mistakes I might add I feel reasonably knowledgeable. This book by Mr. Mauldin is a must read for anyone that is willing to do a bit of work to be responsible for their own financial future. With wise insights into markets and their informational products is exactly as the title suggests. A wealth of information for those that are tired of Wall Street and their Zantac placebos. I eagerly await his newsletter and further publications."
Thanks for the kind words, gentlemen. You can get your copy (and one for your kids and brother-in-law) at www.amazon.com/bullseye.
San Diego, Texas and Other Wonderful Climes
I look over my shoulder at the TV and see pictures of the storms that are raging over Florida. Yet here in Texas we are experiencing weather of the most ideal kind. The highs are in the mid-80's with gentle breezes banishing even a hint of perspiration. It is a perfection in climate not seen in August in the memory of anyone with whom I am acquainted. It is spoken of in awed tones, as if speaking too loud might cause the weather gods to note they had forgotten to turn up the heat. As friends gathered the last three nights in my office (which overlooks right field in the Ballpark in Arlington) to watch the best team that money can buy (the Yankees) take 2 out of 3 from the Texas Rangers, the weather was a conversational source of amazement and pleasure. I noted that if Texas summers were always like this, our housing prices would sky rocket as San Diego would empty, as its citizens would come looking for reasonable home prices and lower taxes.
Normally, it is 100 degrees or thereabouts in Texas in August. A few years ago it got to 115. I can remember a sign in Dallas, not too long ago, noting the temperature had cooled to 105 degrees at midnight. A far cry from today's balmy ambiance.
Strangely, it started me thinking about averages. Before I knew it, I was knee-deep this afternoon in the footnotes of the annual report from the Pension Benefits Guaranty Corporation. Instead of making my way to the golf course or sitting on the deck with a good book (see above), I brooded over small type in an incomprehensible legalese in an effort to determine how retirement portfolios might fair in the decade long secular bear market in which we find ourselves.
Let's set this up with a few paragraphs from chapter 5 in Bull's Eye Investing:
"Would you like to live in paradise? There's a place where the average daily temperature is 66 degrees, rain occurs on average once every five days, and the sun shines most of the time.
"Welcome to Dallas, Texas. As most know, the weather in Dallas wouldn't qualify as climate paradise. The summers begin their ascent almost before spring arrives. On some days, the buds nearly wilt before turning into blooms. During the lazy days of summer, the sun frequently stokes the thermometer into triple digits, often for days on end. There are numerous jokes about the devil, hell, and Texas summers.
"Once winter is in full force, some days are mild and perfect golf weather. Yet others present frigid temperatures, snow, and the occasional ice storm. It's good for business at the local auto body shops, though it makes for sleepless nights for the insurance companies. Certainly the winters don't match the wind chills of Chicago or the blizzards of Buffalo, but the climate in Dallas is far from paradise as its seasons ebb and flow.
"For the year, though, the average temperature is paradise. Contrary to the studies that show investors they can expect 7 percent or 9 percent or 10 percent by staying in the market for the long run, the stock market isn't paradise, either. Like Texas summers, the stock market often seems like the anteroom to investment hell.
"While historically the average investment returns over very long terms of times have been some of the best available, the seasons of the stock market tend to cycle with as much variability as Texas weather. The extremes and the inconsistencies are far greater than most people realize.
"Let's examine the range of variability to truly appreciate the strength of the storms. In the 103 years from 1900 through 2002, the annual change for the Dow Jones Industrial Average resulted in a simple average gain of 7.2 percent per year. During that time, 63 percent of the years reflected positive returns and 37 percent had negative returns. Only five of the years ended with changes between +5 percent and +10 percent--less than 5 percent of the time. Most of the years were far from average--many were sufficiently dramatic to drive an investor's pulse into lethal territory.
"Almost 70 percent of the years were double-digit years, when the stock market either increased or decreased by more than 10 percent. To move out of 'most' territory, the threshold increases to 16 percent--half of the past 103 years end with the stock market index either up or down more than 16 percent!
"Read those last two paragraphs again. The simple fact is that the stock market rarely gives you an average year. The wild ride makes for those emotional investment experiences."
The Bottom Looking Up, or the Top Looking Down?
Human beings tend to fixate upon recent trends and project them into the future, rather than looking at events in absolute terms. The Dow today is just north of 9800. When the Dow was at 6,000, today's number seemed like some far off dream. When the level was finally reached, it was the cause of much rejoicing.
Yet today, that same number causes concern. Because we have reached it coming from much higher numbers, we now worry that it will continue to go lower. Rather than focus on the actual underlying values of the components in the Dow, most investors project future returns simply from an emotional bias, fixating upon recent trends or the need for a certain return to insure their comfortable retirement, and then torture statistics to produce "evidence" which reinforces their bias.
The same might be said of employment figures. In July of 1996, Clinton and the Democrats were justifiably happy with a 5.5% unemployment rate. Unemployment rates had been over 7%. The numbers had been coming down for some time, and the mood of the country was good.
Today, we again find 5.5% unemployment in July. But unemployment was as low as 3.8% in 2000, and thus we come to today's number from the wrong starting point. Democrats are outraged and blame the President. Consumer sentiment is slowly eroding, as is the index of leading indicators.
So, is 5.5% unemployment good or bad? Historically, it is pretty good, but given that we recently remember 3.8%, it does not seem all that good. We fixate upon recent experience.
And we do so as investors, whether as individuals or institutions. We make projections based upon trends or smoothed averages or whatever we need to confirm our experience. But sometimes it is 115 (or 85!) degrees in Texas and there are hurricanes in Florida. Those averages mean little at such times.
Which brings us to pension funds. Specifically, I want to look at defined benefit pension plans. These are pension plans which in theory guarantee a worker a specific set of benefits for his retirement years.
Let's do a simplified analysis. Let's say the pension of Company ABC has $1 billion dollars. The actuaries work to figure out what the fund will need in future years. The managers of the fund make assumptions about how much the fund portfolio will grow in the future from a combination of investments and more contributions by the company. Let's assume Company ABC is going to need its investment portfolio to grow by 9% per year in order to stay fully funded. The more you assume the portfolio will grow, the less ABC will need to dig into its pockets from pockets to fully fund the pension plan.
Assuming a typical 60% stocks/40% bonds mix, what type of returns does the company need from its stock portfolio? Let's be generous and project a 5% return from its bond portfolio over the next decade. That means it will need over 11% from the equity portion of its portfolio!
But let's not be so negative. Let's assume bonds will return more and increase our stock investments. Assuming an asset allocation mix of 70% equities and 30% bonds (yielding 6%), stocks would still have to earn 10.7% to attain a 9 % composite return.
Is that attainable? My answer is, "Not really." Quoting from a private paper by Robert Arnott:
"Stock returns have only four constituent parts:
- 1.5% current dividend yield
- +2.5% consensus for future inflation
- +0.0% P/E expansion (dare we assume more??)
- + ?? real growth in dividends and earnings
"This arithmetic suggests that, to get to a 7 percent return estimate, we need a mere 3 percent real growth in dividends and earnings. We can do far better than that, no?
"No. Historical real growth in dividends and earnings has been 1 percent to 2 percent. To get to the 3 percent real growth in the economy, we have turned to entrepreneurial capitalism, the creation of new companies. Shareholders in today's companies don't participate in this part of GDP growth. So, even a 7 percent return for equities may be too aggressive. To get 10.7 percent from stocks, we need nearly 7 percent real growth in earnings, far faster than any economist would dare project for the economy at large, let alone for the economy net of entrepreneurial capitalism."
What if pensions start getting less return in their bond portfolios? It is tough to get 5 percent today without taking some real risk. To get to a 9 percent assumption in a 5 percent bond environment, and if you have 70 percent in stocks/30 percent in bonds, that 9 percent overall return assumes you are getting almost 12 percent returns on your stock portfolio. But what if the Dow drops to 6,000 as it might during the next recession and the NASDAQ goes to 600? What if your returns are negative for the next few years?
How much are you underfunded then, as your portfolio drops another 20 percent? The number becomes mind-boggling. If each of the S&P 500 companies lowered its expected rate of return from the current average of 9.2 percent to 6.5 percent, the total cost to earnings would be $30 billion, according to a report by CSFB. But if the Dow drops to 6,000 the number goes off the chart. Remember, the average drop in the markets is 43% during recessions.
Is it realistic to suggest we will not see a recession within a few years? I think not. As I demonstrated in my book and have written here many times, there has never been a period in history where the stock market has out-performed money market funds over the next ten years when valuations are at current levels (The core P/E for the S&P is around 21). With the exception of the bubble market of the late 90's, returns have been only a few percentage points over a decade following such high valuations. Perhaps the most we could expect over the next decade is a 3-4% return on stocks (including dividends). That is a far cry 12%.
$450 Billion Pensions Fund Shortfall
If we were starting from a point of strength, it might be less troublesome. But the Pension Benefit Guaranty Corporation notes that defined benefit pension plans are under-funded to the tune of $450 billion (the combination of single and multi-employer plans). But that is likely an understatement. How you figure full funding is actually quite flexible. It is an arcane art rife with assumptions and wiggle room. And employees are in the dark about how well their pensions are funded. As an aside, the Bush administration has proposals to require disclosure to employees, but strangely Congress has yet to act on this obviously common sense and long overdue proposal. Let's make sure hedge funds are regulated (we gotta protect the rich), but let corporations hide their pension fund liabilities. I mean, you have to establish priorities.
For example, in its last filing prior to termination of its plan, Bethlehem Steel reported that it was 84% funded on a current liability basis. At termination, however, the plan was only 45% funded on a termination basis - with total underfunding of $4.3 billion. PBGC had to assume that liability. In Congressional testimony, PBGC notes:
"... in its last filing prior to termination, the US Airways pilots' plan reported that it was 94 percent funded on a current liability basis. At termination, however, it was only 35 percent funded on a termination basis - with total underfunding of $2.2 billion. It is no wonder that the US Airways pilots were shocked to learn just how much of their promised benefits would be lost. In practice, a terminated plan's underfunded status can influence the actual benefit levels."
The PBGC insures pension benefits worth $1.5 trillion and is responsible for paying current and future benefits to nearly 1 million people in over 3,200 terminated defined benefit plans. Benefit payments totaled $2.5 billion dollars in 2003. Benefit payments are expected to grow to nearly $3 billion in 2004. The PBGC is also underfunded to the tune of $11.2 billion, up from a mere $3.6 billion last year. But buried in footnote 7 is a more ominous number. The PBGC makes an estimate as to what its liability in the future might be for companies which will go belly-up. The "reasonably possible" exposure as of September 2003 ranged from $83-$85 billion, up from $35 billion in fiscal 2002.
PBGC was set up by the government as an insurance program. Pension plans pay an insurance premium (currently only $19 per covered employee per year) to have their funds participate in the program. As recently as a few years ago, the fund was well in the black. But with the problems in the steel and airline industries, costs have simply gone off the charts.
Most insurance companies would simply raise rates. However, PBGC must get Congress to raise rates. The PGBC points out: "But the number of defined benefit pension plans is shrinking. Premium income has fallen since 1996 to about $800 million per year, [from almost $1.2 billion] even though Congress lifted the cap on variable-rate premiums that year. The premium has two parts: a flat-rate charge of $19 per participant, and a variable-rate premium of 0.9 percent of the dollar amount of a plan's underfunding, measured on a "current liability" basis. As long as plans are at the "full funding limit," which generally means 90 percent of current liability, they do not have to pay the variable rate premium. That is why Bethlehem Steel, the largest claim in the history of the PBGC, paid no variable-rate premium for five years prior to termination, despite being drastically underfunded on a termination basis."
Since ERISA began in 1974, more than 160,000 companies have voluntarily terminated their plans. From a high of 112,000 plans in 1985, the number of defined benefit plans has shrunk to 32,000. Sometime this year, the number of retirees getting benefits will fall below the number of workers contributing to such plans. Retirees live longer and longer. The average male worker spends 18.1 years in retirement compared to 11.5 in 1950. Medical advances will keep more of us alive in the future.
Falling income? Rising liabilities? Does not this look like a disaster? Well, yes and no. Even with an increase in rates, I think the tax-payers are going to eventually have to step in. But even with the worst nightmare estimates, the annual cost to the tax-payer is a rounding error in total government expenses. No one would be happy, and there would be a lot of finger pointing and blaming, but life would go on pretty much unchanged. I mean, what's a few hundred billion (far more than any worst case scenario) spread out over 3-4 decades? Compared to Social Security and Medicare underfunding, that is pretty tame stuff.
But that is not where I see the real problem. Go back to that throw away statistic a few paragraphs back. The PBGC insures $1.5 trillion in plans. That is $1.5 trillion that pension funds are assuming will grow by 7-9% over the next decade, depending upon how conservative they are. They are currently underfunded by $450 billion.
A Hundred Billion Here, a Hundred Billion There
If I am right about stock market returns being well below 4% for the rest of the decade as we get further into a secular bear market, and given the clear ability of pension funds to overstate their funding positions, it means that companies are going to have to come up with a huge amount of money over the decade to fund their pension plans.
How much? If a pension fund assumes an 8% growth, your principal doubles in about 9 years. But 9 years at 5% is only a 55% growth. On the amount the PGBC insures, that would be a shortfall of about $650 billion, give or take a few hundred billion. That would be on top of the current $450 billion underfunding.
Now, spread out over 9-10 years, corporate America is easily making enough to fund that amount. But such a number would significantly eat into profits. Total US corporate profits (with the odd adjustments) are running north of $900 billion from all companies. How much of that is from companies with defined benefit pension plans? I can find no data to answer that question.
But we can guess where the bulk of the problem lies. It is in the 360 companies in the S&P 500 that have defined benefit pension plans. Credit Suisse First Boston (CSFB) estimates unfunded pension liability as of 2002 for this group was $243 billion. Morgan Stanley estimated $300 billion. The upshot is that companies with defined benefit programs are going to see their earnings under pressure as they will have to divert more and more of their profits into their pension funds. (I can find no more recent statistics to make even a guess, and if someone has a study, I would love to see it and will report back to you.)
Many of these companies are essentially owned by their retirees, who are going to get more and more of the profits. This is not going to be good for shareholders in the company, or for S&P 500 index mutual funds. During the next recession, these companies are going to be required to make up the underfunding in their plans at a time when their earnings will be down. The projected growth in their investment portfolios will be hurt because they will have so much money invested in large cap companies just like themselves who are facing underfunded pension problems.
In a study by the FDIC, we note that: "The U.S. automobile industry shows the effects of higher pension costs on the bottom line. The results of a Prudential Financial study state that pension and retiree benefits represent $631 of the cost of every Chrysler vehicle, $734 of the cost of every Ford vehicle, and $1,360 of the cost of every GM car or truck. In contrast, an article in the Detroit Free Press reported that pension and retiree benefit costs per vehicle at the U.S. plants of Honda and Toyota are estimated to be $107 and $180, respectively."
They later casually note, "GM recently has used about $13 billion of a $17.6 billion debt offering - the largest ever made by a U.S. company - to help close its pension gap. On average, GM will pay a 7.54 percent yield on the debt, and hopes to earn 9 percent on the proceeds contributed to its pension fund. While cash flow requirements have been eased for now, if this long term expectation regarding returns proves problematic over time, GM will need to find other sources to pay their obligation."
Can they really earn 7.54% in a secular bear market? I think not. What will be the other sources for the funding? It will have to be either profits or lowering pension commitments. Try and get the latter through the unions.
The steel industry dumped its pensions on the PBGC. Over half of the PGBC's liabilities are from steel. The second largest group is airlines, and it is set to grow even more. United Airlines is going to emerge from bankruptcy, giving its pension obligations to the PBGC. It will have much lower costs going forward. New low cost airlines like Jet Blue do not have these pension woes. You can bet American and Delta will take notice.
We should take notice of a few of the corollary effects. When PGBC takes over a pension fund, benefits are reduced. Bethlehem Steel workers saw their pensions fall from $30,000 a year to $18,000. Companies are going to start freezing pensions or converting them to 401k plans. A recent survey suggested 21% of these companies would freeze benefits and another 17% will stop giving them to new employees. If companies were required to immediately re-fund pension shortfalls, cash flows would be directed away from capital investment, expansion, and debt service. Old-line industries would be particularly hard hit, and the global competitiveness of these companies undoubtedly would suffer. The credit of many of these companies will be down-graded, adding further to their costs.
Bottom line? If you insist on owning stocks at this time, you should generally avoid companies with defined benefit pension plans. Maybe not this year or even next year, but at some point, the chickens will come home to roost. Avoid large cap index funds, which will have so many of these companies in their holdings.
A Change in Plans
I had thought I would be home for most of August, enjoying the placid Texas weather. Alas, last minute business forces me to go to Orlando and Philadelphia next week. At least in Philly, I am going to try and get in some golf. I have avoided golf for almost a year, trying to get my back into shape to play again. We will see. I am sure it will be terrible golf, but it will be better than the office, and it will be with my Steve Blumenthal and friends at Capital Management Group.
Writing tonight has been interesting. I got started late and tonight the Texas Rangers played Tampa Bay, so I had a little distraction outside my office windows. I turned the TV to the game, which had a 7 second delay. When the crowd would yell, I had time to turn around and watch what happened on the screen. It added to the time in writing today's letter, but was a pleasant distraction as we finally won a game. Talk about fixating on recent returns, only a few weeks ago, I was looking at World Series dates. Now we simply hope to hang on. But if Florida and the '63 Mets could win the World Series, anything is possible.
I know there are more than the usual typos in this letter, and for that I apologize, but it is late and time to give it up. Enjoy your week.
Your tired and ready to go home analyst,