Friday, March 25, 2011

More on bonds

Following up on my previous post on the S&P - there is another part of my entire deflation theme. Normally, one would think with the government issuing Treasuries like a pimp with one night to live would normally cause bond yields to spike once the Fed stops monetizing the debt.

However, one key thing to remember is that pension funds will have to be major purchasers of fixed income securities over the next twenty years - whether they like it or not. This will have many unintended consequences. Most major Western defined benefit pension plans are in the payout phase of their existence. With the baby boomers entering retirement - more and more of pension fund assets will be used to pay current benefits. This contrasts with the prior twenty years of the stock market boom where pension funds were more concerned with growing assets in order to meet future obligations.

As a result, pension funds will be shifting away more and more from total return models to duration based models - where the duration of the portfolio should be in the same range as the duration of the benefits paid (if you treat the obligation payments as a reverse bond). If you assume that equities exhibit behavior of an ultra-long term bond (i.e. a duration of 50+), we can see the overal duration of pension portfolios dropping dramatically to match their funding obligations.

This will mean a massive shift of pension assets from equities, private equity and other long-duration investments to shorter duration fixed income investments. This shift over the next few years means that there will be a lot of demand for high quality fixed income product that should keep yields suppressed for the immediate future.

The major unintended consequence of this will be that the actuarial assumptions of portfolio returns will have to be reduced significantly. Most U.S. public employee pension funds use unrealistic return assumptions; CALPERS (the California State Employees Pension Plan) assumes a 7.75% return. This return has shown to be unrealistic over the past ten years with the fund heavily invested in equities and "alternative investments", resulting in massive unfunded pension liabilities that the taxpayers are on the hook.

Even though the states are trying to grapple with these unfunded liabilities with modest reforms, they will get socked again as the actuaries have to start reducing their return rates as the funds shorten the duration of their portfolios to meet their current obligations. They will not be able to grow their way out of this mess as they will have significantly reduced equity exposure. State and local governments will be forced to allocate more and more scarce tax revenues to meet their obligations. Sadly, the bulk of the governments have not seriously addressed these problems, and the power of public employee unions bankrolling politicians (i.e. Democrats) will ensure that there ultimately will be tax hikes to make up the shortfall. These state and local tax increases (no deficit spending as they are required to balance their budgets - although they try with accounting gimmickry) will depress aggregate demand on top of the de-leveraging by the American consumer, making the deflationary cycle worse.

Ultimately, I am coming to the conclusion that defined benefit plans should be outlawed and transitioned in an equitable way to defined contribution plans. They are inherently risky for both the funders (as they will have the largest contributions required during down markets, when they are least able to do so) and beneficiaries (the risk of bankruptcy - ask the retired managers of Delphi who had their pensions cut). Add to that the political incentives for mischief (politicians let the Delphi management retirees take a haircut, but he UAW retirees, part of a favored political constituency, didn't; or the political deals to create obscene pension benefits for state employees that were hidden from the electorate) and the conclusion becomes clear: ALL DEFINED BENEFIT PLANS MUST GO!

When thinking of that last sentence, why does Oliver Cromwell come to mind?


Hershblogger said...

Because he was a signatory of King Charles death warrant? Because he was a true believer? Irish massacres?

Mitch said...

I was actually thinking of his speech to the Rump Parliament:

Depart, I say; and let us have done with you. In the name of God, go!

Hershblogger said...