Unlike Warren Buffett's Berkshire Hathaway, endowments usually pay out 5 per cent of their holdings annually. Photo / AP
Unlike Warren Buffett's Berkshire Hathaway, endowments usually pay out 5 per cent of their holdings annually. Photo / AP
COMMENT:
Pension funds and endowments face huge challenges without Warren Buffett telling them how easy their job is. Buffett's annual letter to Berkshire Hathaway shareholders is widely anticipated and it is often brilliant.
This year, however, he offered an idea that we can call Warren's buffet: it's all you caneat but it serves only stocks. Even Buffett diversifies beyond cheeseburgers and so should pensions and endowments which, contrary to what he implies, need more than just equities.
Buffett points out that the US$114.75 he invested in a US business in 1942, when he was aged 11, would have grown more than 5,000 times if it had simply been in a (mythical, no-fee) S&P 500 index fund for the entire time.
Moreover, he writes that "a US$1m investment by a tax-free institution of that time, say, a pension fund or college endowment, would have grown to about US$5.3b".
Imagine you are the chief investment officer of a public pension, and a politician — who is 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 77 years". Instead, those monthly pension cheques 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), endowments usually pay out at least 5 per cent of their holdings annually. The institutions they support tend to count on those funds, which 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 per cent of its assets. In that case, starting at US$1m, the endowment would not have the US$5.3b Buffett imagines.
Rather, after having paid out almost US$145m along the way, the endowment would have less than US$150m remaining. This is still a great result but far from the jaw-dropping billions cited in Buffett's letter.
Warren Buffett's arithmetic is right but he forgets why pensions and endowments exist. Photo / AP
It is 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 are already paying out much of their capital.
Stocks do suffer drawdowns. That's why no institution with meaningful annual payout obligations would invest only in stocks. Now, like Buffett, we do expect stocks to do well in the long-run but, let's face it, it's easy to make rosy predictions about the past.
Even if the future pans out as we hope, we need to survive until then to find out.
Over Buffett's 77 years in business, the endowment CIO would see fund assets decline in 23 out of 77 years (when equity returns failed to cover the 5 per cent distribution), and in the average bad year, the fund would shrink by 12 per cent.
At least, though, an endowment could 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 maximise potential long-term returns without regard to risks.
They try to maximise the likelihood that they can meet their payout obligations. They aim to be reliable payers of those obligations. And in the case of pensions, they desire to make it possible for the employer to have predictable and affordable contribution obligations.
A portfolio of stocks alone doesn't do that. That's why asset-class diversification is the bedrock of modern investing.
Institutional investors have not followed the Buffett recipe for very good reason. They have different goals to Buffett and different obligations to Berkshire Hathaway.
In Omaha, Buffett's favourite 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.
- Michael Mendelson is a principal at AQR Capital Management.
Want to see more from Financial Times? Sign up here for the Business News newsletter to get the best premium stories sent to your inbox daily.
