(August 19, 2013) — “There are two aspects of the pension cost problem upon which management can have a significant impact: (1) Maintaining rational control over pension plan promises to employees and (2) increasing investment returns over pension plan assets.”
So begins a memo from exalted investor Warren Buffett on the subject of corporate pensions, dated October 14, 1975. The memo, sent to Katherine Graham the then publisher of The Washington Post, outlined the problems and pitfalls facing employers that had signed up to provide pensions for employees.
The 19-page document provided some light-hearted opinions about aspects of financial markets.
“Consulting actuaries are very good at making calculations,” Buffett said. “They are frequently terrible at making the assumptions upon which the calculations are based. In fact, they well may be peculiarly ill-equipped to make the most important assumptions if the world is one of economic discontinuities.”
Actuaries are trained to be conventional, and their business would be “ill-served” if they were to become “more than mildly unconventional”, Buffett asserts, implying they are unsuited to calling a sporadic financial world.
Buffett’s own illustration of liabilities uses hamburgers as an analogy. Promising to pay a member of a pension scheme a set amount of money either for life or in a lump-sum on retirement is very different to promising to make payments that match the cost of living.
“If you promise to pay me 1,000 hamburgers a month for life which, superficially, may sound equivalent to the previous proposition [$500 a month] (assuming a present hamburger price of 50c), you have created an obligation which, in an inflationary world, becomes most difficult to evaluate.” One thing is certain, Buffett claimed. “You won’t find an insurance company willing to take the 1,000-hamburgers-a-month obligation off your hands for $65,000—or even $130,000. While hamburgers equate to 50c now, the promise to pay hamburgers in the future does not equate to the promise to pay 50c pieces in the future.”
On the subject of investment, Buffett nailed his colours to the mast. The rise of the asset management industry was born of a vacuum identified by Wall Street to help companies work their pension capital for as much gain as their original business lines were producing.
Buyers should beware, however, as most managers will underperform the market—and to an even greater extent after fees are deducted.
“For some intermediate period of years a few are bound to look better than average due to chance – just as would be the case if 1,000 “coin managers” engaged in a coin-flipping contest.”
Those who demonstrated success over a five-flip period “with their oracular abilities confirmed in the crucible of the marketplace, would author pedantic essays on subjects such as pensions”.
Just a few managers will outperform due to any skill, and investors should get to know a manager, understand and be confident of his process and ability to see beyond the market noise, but even this does not ensure a pitfall-free run, the sage said.
There is one golden rule, however.
“I am virtually certain that above-average performance cannot be maintained with large sums of money. It is nice to think that $20 billion managed under one roof will produce financial resources which can hire some of the world’s most effective investment talent. After all, doesn’t the big money at Las Vegas attract the most effective entertainers to its stages?”
No, Buffett said. Armies of analysts, economists and portfolio managers may well suggest a shop that has the best possible advantage, but “down the street there is another $20 billion getting the same input”.
More money means fewer choices due to larger asset pools being unable to nip into opportunities, and therefore all the large funds end up in the same investments.
“In short, the rational expectation of assuring above average pension fund management is very close to nil.”
One glimmer of hope offered by Buffett is to find a smaller fund manager—“Then hope no one else finds him.”—but even these are not guaranteed to find success.
“Wall Street is a succession of fashions. Obviously some individuals will have got the most recent fashion, and their record will look correspondingly good—maybe sensationally good if they have a reckless streak and have played a particular trend very hard. But fashion-hitting has never been successfully maintained, to my knowledge.”
Buffett added that this type of manager also “know what he is expected to do. He is to perform—and quickly. So the new small managers’ decisions frequently are characterised by high turnover, major mistakes, and even more furious activity to catch up.”
Whether Graham followed this advice to the letter is unknown, but when the Washington Post was subject to a takeover earlier this month it was revealed its pension fund was in surplus—around 141% funded.
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