A version of this op-ed appeared in the Financial Times' FTfm on May 29, 2019.
Pension funds and endowments have enough challenges without Warren Buffett telling them how easy their job is. Buffett’s annual letter is widely anticipated and widely read, and it is often brilliant.
This year, however, he offered an idea that we can call Warren’s buffet: it’s all you can eat, but it serves only stocks. Even Warren Buffett diversifies his diet beyond just cheeseburgers, and so should pensions and endowments which, contrary to what he implies, need more than just equities.
Buffett points out that the $114.75 he first invested in the stock market seventy-seven years ago in 1942, would have grown more than 5,000 times if it had simply been in a (mythical, no fee) S&P 500 index fund 1 1 Close The S&P 500 Index began in March 1957, prior to that it was the S&P 90 Index for the entire time. Moreover, he writes that “a $1 million investment by a tax-free institution of that time – say, a pension fund or college endowment – would have grown to about $5.3 billion.” 2 2 Close See page 13 of Berkshire Hathaway’s 2018 Shareholder Letter
Imagine you are the chief investment officer of a public pension, and a politician – worried about a looming tax increase to pay for pension contributions – steams: “I read how Warren Buffett says we would do better if we just invested in the S&P 500. Are you trying to tell me that you’re smarter than he is?”
Buffett’s arithmetic is roughly accurate, but he fails to address the underlying reason that pensions and endowments exist, which is to meet periodic payment obligations. There’s no “invest today and reap the windfall in seventy seven years.” Instead, those monthly pension checks and annual endowment payouts consume most of the returns. This is why assets don’t just mushroom over time.
Unlike Berkshire Hathaway (which, incidentally, does not pay a dividend), each year endowments usually pay out at least 5% of their holdings, 3 3 Close Source: Council on Foundations. 2017 Commonfund Study of Investment of Endowments for Private and Community Foundations Report and the institutions they support tend to count on those funds. That changes the situation an awful lot.
As Buffett says in his letter “let’s put numbers to that claim,” and assume that each year the endowment pays out 5% of its assets. In that case, starting at $1 million, the endowment would not have the $5.3 billion Buffett imagines. Rather, after having paid out almost $145 million along the way, the endowment would have less than $150 million remaining. 4 4 Close Endowment assets grow using monthly S&P 500 Index Total Returns from January 1942- March 2019. The monthly spending amount is calculated using 5% of the average monthly endowment assets for the prior calendar year divided by 12. This is still a great result, but far from the jaw-dropping billions cited in Buffett’s letter.
It’s even more challenging for a pension plan. Typically, a pension fund’s obligations continue to grow as more employees retire and live longer. CIOs have no ability to reduce that payout, regardless of changes to the fund’s asset value. In a prolonged stock market drawdown, those growing benefit payments will consume a larger share of the shrunken plan assets. So, they can’t take too much solace in long-run optimism when in the intermediate run they’re already paying out much of their capital.
And stocks do suffer drawdowns. That’s why in reality, no institution with meaningful annual payout obligations would be invested only in stocks. Now, like Buffett, we do expect stocks to do well in the long-run, but let’s face it, it’s easier to make rosy predictions about the past. And, even if the future does pan out as we hope, we still need to survive until then to find out.
Over Buffett’s 77 years investing, the endowment CIO would see fund assets decline in 23 out of 77 years (when equity returns didn’t cover the 5% distribution), and in the average bad year, the fund would shrink by -12%. 5 5 Close For the 77 calendar years from January 1942 to December 2018 and the same methodology described in footnote 4. But at least an endowment may be able to reduce its spending; a pension fund can’t, so in a bad year, the fraction of pension assets that must be paid out increases substantially. This is why most institutional investors subscribe to a concept that Buffett seems to hate – diversification. He’s said it’s “a protection against ignorance.” We think it is more a protection against hubris.
Institutions do not seek to maximize potential long-term returns, without regard to risks. They often seek to maximize the likelihood that they can meet their payout obligations. They seek to be reliable payers of those obligations. And in the case of pensions, they also seek to make it possible for the employer to have somewhat predictable and affordable contribution obligations. A portfolio of stocks alone doesn’t do that. That’s why asset class diversification is a bedrock principle of modern investing.
So, institutional investors have not followed the Buffett recipe, and for very good reason. They have different goals than Buffett and different obligations than Berkshire Hathaway.
In Omaha, Mr. Buffett’s favorite restaurant is Gorat’s steak house. When Gorat’s offers a buffet, it’s a balanced menu. For institutional investors, we suggest consuming the same; stay diversified for the healthier risk-adjusted returns you need to meet your spending obligations.
Charles E.F. Millard is a consultant to AQR Capital Management, LLC.
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