Negative yields drive pensions to despair

Yvan Berthoux - 5 September 2019

The assumed long-term average return of US pension funds, typically around 7 per cent, has changed little in 20 years. The detachment of pensions funds’ projected returns from reality has become acute in recent years as their tentative diversification into alternative assets has backfired and government bond yields have plunged once more. Worse, pension funds have followed investors of every heft and hue into higher-yielding, but less capital-certain investments. The income shortfall is so severe that, increasingly, pension funds will be required to liquidate capital to fund their pension commitments, undermining the valuation of financial assets.

Across the whole US pensions industry, the accumulated wealth of pension and long-term insurance funds has doubled from 60 per cent of GDP in the mid-1980s to 120 per cent today. Yet, the pensions sector is so underfunded that it is desperate to generate its target 7 per cent return. The protracted period of very low interest rates – and the evolution of negative bond yields – has taken a heavy toll on investment performance. Moreover, the rumoured deterioration of economic fundamentals, amid elevated economic and political uncertainty has favoured traditional “safe havens”, such as bonds, gold, the US Dollar and Japanese yen in the past 12 months.

As most US private and public pension schemes adopt very similar assumptions for long-term returns, the obvious question is: how do you generate a 7 per cent annual return when yields are so low? According to a study from Pew Charitable Trusts, average returns for pension-fund-like portfolios generated returns above 7 per cent only twice in the past 100 years, in the late 1960s and the late 1990s (figure 1, left frame). Ranging from a low of 3.15 per cent to a high of 8 per cent, it seems that the returns trajectory of this traditional portfolio is likely to retest the lower bound of this range very soon.

As a consequence, in the past cycle, we observe that more and more pension funds have reduced their allocation to low-yielding cash in favour of more aggressive credit investments, which exacerbates the intensity of this credit boom and adds more stress in the equity market, as companies then use the increase in cash in their balance sheets to purchase stocks. Credit Suisse has shown that non-financial corporates have been the main (if not the only) buyers of equities in the past cycle with US$3.4tr of buybacks.

Another proposed solution to enhance the average returns of pensions would be to increase their allocation towards equities; as pensions are long-term oriented, conventional wisdom holds that stocks become less volatile as the investment horizon increases (see Jeremy Siegel’s book Stocks for the long run). This decrease in volatility over time comes from the strong mean-reversion component as equities bull markets tends to be followed by bear markets and so on, therefore the long-horizon (30 years) equity holder experiences a lower volatility than the short-horizon (1 year) equity holder.

However, this conventional wisdom has been challenged as it relies on a strong assumption that investors are guaranteed to experience similar returns and price volatility as in the past. Pastor and Stambaugh (2011) show that investors who look forward must factor in not only the historical estimates but also the uncertainty associated with those estimates. Corrected for this uncertainty, the authors argue that stock returns become more volatile in the long run as the uncertainty compounds over time and offset the negative mean-reversion force.

Figure 1:

Source: Pew Charitable Trusts, Credit Suisse

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