Berkshire Hathaway sage sees rough seas ahead for pension fund

Colorado Springs Business Journal, Mar 7, 2008 by John Hazlehurst

Warren Buffett's annual letter to the shareholders of Berkshire Hathaway criticizes both corporate CEOs and public pension fund managers for optimistic and manifestly unsustainable projections of future earnings.

"The average holdings of bonds and cash for all pension funds is about 28 percent, and on these assets returns can be expected to be no more than 5 percent," Buffett wrote. "This means that the remaining 72 percent of assets -- which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments -- must earn 9.2 percent in order for the fund overall to achieve the postulated 8 percent."

Buffett's analysis doesn't bode well for the Colorado Public Employees Retirement Association, which provides benefits to more than 250,000 active and retired employees of more than 400 governmental entities, including employees of the City of Colorado Springs and of every public school district in El Paso County.

At the end of last year, the fund had more than $40 billion in assets, which was determined by actuaries to be 74.1 percent of the assets needed to cover future claims. PERA's forecast rate of return on its overall portfolio is 8.5 percent. During the last 10 years, PERA has beaten that benchmark, with an annualized rate of return of 9.2 percent.

But, according to Buffett, that rate of return is unsustainable.

"During the 20th century, the Dow advanced 5.3 percent when compounded annually," he wrote. "For investors to merely match that 5.3 percent market-value gain, the Dow would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3 percent of the last."

If PERA's annual returns decline to the 5.3 percent level that Buffett believes to be essentially unsustainable, the retirement fund will be dangerously under capitalized within a few years. But the retirement association doesn't seem to be concerned.

"The Colorado PERA investment return assumption of 8.5 percent is based on the unique construction of the PERA portfolio that takes into consideration a variety of factors with the ultimate goal of paying benefits now and in the future," said PERA spokeswoman Katie Kaufmanis. "Remember that the 8.5 percent assumption is an average of how the portfolio will perform over a long-term investment horizon of several decades."

Kaufmanis also said that PERA's 25-year average return has been a robust 11.7 percent.

However, it should be noted that that return was achieved during the greatest stock market boom in American history, when the Dow Jones Industrial Average rose from 581 to 12,000.

Colorado Springs financial planner Craig Carnick said that Buffett's projected rates of return are "probably closer to the mark than PERA's."

But, he said that there are a lot of moving parts in the retirement fund's process.

"You're not just looking at investment returns, there are payouts to retirees, employer/employee contributions, and a lot of ways to maintain financial health," Carnick said. "But all long-term projections are risky. Over 50 years, your rate of return may be great, but suppose you have a disastrous year and have to sell investments at a loss to meet (retiree) withdrawals -- you can be in trouble."

He said that PERA participants should be cautious.

"None of us should put all our eggs in one basket," Carnick said. "So if you're a 57 year-old PERA retiree, maybe you should be careful and anticipate that PERA's benefits in the future won't be quite as good as they are today."

Unlike most public employee pension plans, PERA's benefit streams and solvency are not guaranteed by the state, so Colorado taxpayers are not directly liable for any problems the association might encounter. However, any increases in employer contributions to the retirement fund would impact state and local governments because they would be responsible for the additional assessments.

Glenn Gustafson, School District 11's CFO, said that any increases in PERA contributions "would just be a killer."

"Senate Bill 235 (enacted during 2006), which was passed to stabilize PERA, requires us to raise our employer contribution by almost 1 percent every year until 2014," he said. "The impact is about $1.44 million for every percent. In 2014, we'll be paying 16 percent of employee salaries into PERA, while employee contributions will remain the same, at 8 percent. It's equivalent to a 1 percent annual pay raise -- and of course it impacts our ability to serve our students."

Buffett wrote that the pension-cost surprises which are likely in store for shareholders during the years to come will be surpassed many times over by those experienced by taxpayers.

"Public pension promises are huge and, in many cases, funding is woefully inadequate," he wrote. "Promises involving very early retirement and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep."