Indexology^® Blog

Despite strong double-digit gains in the equity markets last year, S&P 500 issues posted record pension and OPEB underfunding in 2012. The double-digit equity gains of 2012 were no match for the artificially low interest rates which vaulted pension liabilities into record underfunding territory. Companies have only 77 cents for each dollar they owe in pensions and only 22 cents for each dollar of OPEB obligations. Overall, pensions and OPEB remain a manageable expense, currently within income and assets levels. Pensions funding should improve since interest rates have risen -> the higher the interest rate used the lower the discounted liabilities.

The full report, “S&P 500 2012 Pensions and Other Post Employment Benefits (OPEB): The Final Frontier”, can be accessed at www.spdji.com/sp500.

Defined pensions underfunding set a new record at $451.7B in 2012, up $97B billion from $354.7B in 2011 (up $206.7B from $245B in 2010). The S&P 500 rose 13.41% and the S&P Global BMI ex-U.S. added 14.05%, but it’s what you owe more than what you have. Pension funding rate decreased to 77.3% from 78.8% in 2011 (83.9% in 2010). Pension return rates declined for the 12th consecutive year, to 7.31% from 7.60% in 2011 (7.73% in 2010). Discount rates declined for the fourth year in a row, falling 78 bps to 3.93% from 4.71% in 2011 (5.31% in 2010), significantly increasing projected obligations.

Funds maintained 2011 allocations in 2012 in an attempt to manage forward risk from markets. Equity allocations ticked up to 48.6% from 48.4%. Fixed income allocations ticked down to 40.4% from 40.9%.

OPEB underfunded increased to $234.9B from $223.4B in 2011 ($210.1B in 2010). Funding rate increased to 22.3% from 21.8%. OPEB remains a target for cuts. Medical coverage is now a political as well as social issue.

Combined, S&P 500 companies have set aside $1.60 trillion in pensions & OPEB funds to cover $2.29 trillion in obligations,  with the resulting underfunding equating to $686.6B, or a 70.0% overall funding rate.

Companies continue to shift retirement risk to the individual. The good news for current retirees is that most S&P 500 large-cap issues have enough cash and resources available to cover the expense. The bad news is for future retirees, whose benefits have been reduced or cut and will need to find a way to supplement, or postpone their retirement. The American dream of a golden retirement for baby boomers has dissipated for most.

Legacy pension and OPEB programs will mostly work their way out of the last bastions of the U.S. labor market over the next several decades. For baby-boomers it is already too late to safely build-up assets, outside of working longer or living more frugally in retirement. For younger workers, there is a need to start early, permitting time to compound their returns for their retirement. For individuals, the personal wealth depletion, via lower housing and equity positions, combined with lower pension and OPEB benefits (as longevity and the cost of staying healthy continue to escalate), has left potential retirees with little ability to retire. The current economic reality of strained government programs, the need for additional revenue (taxes), reduced spending (entitlement programs), and higher social costs have heralded a return to the retirement of prior generations: you work for most of your longer life and spend your remaining years in retirement in a reduced lifestyle.  The result is that the American dream of a golden retirement for upcoming baby boomers is quickly dissipating. The current situation leaves few options for a comfortable retirement, and few years for baby boomers to significantly add to their retirement resources, outside of working longer.

Personal:

Let me put it this way, my teenage kids worked last summer (and this one) and I ‘talked’ them into opening up a Roth IRA, even though they won’t get the money for almost fifty years (I matched their contributions  – think I did good, considering I could have gotten stuck with the entire amount).  It will be difficult for my generation, where many of us are split between our old IRAs, pensions (most being frozen), 401k and savings.  But for the next generation, its looks like it’s all on them.  So they need to start early, and let time compound their early contributions (amazing, I used to worry about their college fund, now I’m trying to help start them off for their retirement – and I’m still working; middle-class is strange, just glad I can do it).

Most stock indices where the weight of each stock depends on its market value are “float adjusted” meaning that the index only counts those shares that are available to investors and excludes closely held shares or shares held by governments or other companies.

The S&P 500 moved to float adjustment in in 2004-2005.  Initially many investors expected substantial changes would result.  By most estimates, between 10% and 15% of the stock of each company in the index is held by ETFs or indexed money managed for pensions, endowments or mutual funds.  With a block that large held by index trackers, it would seem that counting only the stock that is readily available to investors and index trackers would matter.  There were two counter arguments raised by some analysts. First, the stocks in the S&P 500 are all liquid. Currently a stock should exhibit at least 100% share turnover in a year when it joins the index; most companies in the index surpass this by a wide margin.  Second, the index has a long-standing requirement that at least 50% of a company’s outstanding stock be part of the public float when it entered the index so low-float companies were excluded.

Looking back to September 2005, when the index became float adjusted, we can see the results of float adjustment.  The chart shows the official or float adjusted S&P 500 and the same index without float adjustment. (S&P Dow Jones Indices calculates both versions.)  In terms of price performance, the difference is very small – barely visible on the chart.  The difference in index levels on July 26, 2013 – almost eight years since the introduction of float adjustment– is 13 index points or 77 basis points.  The weight of the ten largest stocks in the float adjusted S&P 500 as of July 26^th close is 18.09%, slightly less than the ten largest stocks in the non-adjusted index which were 18.14%.  One of the ten largest stocks in the non float-adjusted index, Wal-Mart, does not make it to the top ten in the float adjusted index because closely held shares are excluded.

Does all this mean that float adjustment was unnecessary? No. Rather the average float factor – the percentage of shares in public float – across all 500 stocks in the index today is over 97%. In the U.S. large cap market segment that the S&P 500 tracks, the vast majority of stock is not closely held.  Compare the 97% to the same statistic for the S&P Small Cap 600, 91% or the S&P Europe 350 at 82%.

Details on float adjustment are available on the S&P Dow Jones Indices web site,

Data as of July 25, 2013

What Municipalities are Higher Risk?

The bankruptcy of the City of Detroit has raised questions about what other municipalities might be the next to focus on.  In general, bonds with higher yields are riskier than bonds with lower yields.  Using bond yields as the sole variable, the following general obligation municipal bond issuers have the highest yielding bond issues* in the S&P Municipal Bond Index:

Maverick County, TX

Scranton, PA

Central Falls, RI

Northern Mariana Islands

Woonsocket, RI

Bellwood, IL

Riverdale, IL

Harvey, IL

• The average yield to worst for investment grade municipal bonds is 3.12% (S&P National AMT-Free Municipal Bond Index).  The yields of the bonds from these issuers range from 7% to over 9.25%.
• The S&P Municipal Bond Index is a broad benchmark index that tracks over 70,000 bond issues from over 20,000 municipal bond offerings representing over $1.4 trillion in par value.
• None of these bond issues are included in the S&P National AMT-Free Municipal Bond Index which tracks only investment grade bonds.

*Review focused on bonds issued by and are the general obligation of counties and cities. No district, special tax or land backed bonds were reviewed.  Only bonds that have not previously defaulted on principal and or interest are listed. 

Market Performance:  

• The high profile default of the City of Detroit along with heavy fund outflows have made the summer of 2013 a hard one for the municipal bond market.
• Investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index saw yields rise by 38 bps this month driving bond prices down and recording a negative monthly return of 1.54%. By comparison, bonds tracked in the S&P U.S. Issued Investment Grade Corporate bond Index have seen yields come down by 6 bps holding returns in positive territory.
• High yield municipal bonds tracked in the S&P Municipal Bond High Yield Index recorded yields rising by 36 bps this month driving bond prices down and recording a negative monthly return of 2.65%. High yield corporate bonds tracked in the S&P U.S. Issued High Yield Corporate Bond Index have seen yields come down and prices rise driving a positive 1.83% return.

What is your long term outlook for gold and where do you see prices moving in the months ahead?

This is one of the questions I was recently asked in a Reuters CCTV2 interview.  While we are not in the business of forecasting, we are in the indexing business where we measure markets – and gold is one of those markets.

Oftentimes the future follows history, so historical index levels are a reasonable place to look in order to get a feel for how prices have behaved in the past.  Please see below for a chart of historical levels of the S&P GSCI Gold.

As I pointed out in a previous post, gold is having its worst year since 1980.  From Jan 1980 until June 1982 gold in the index lost 65%, then rebounded 69% by Jan 1983.  This time gold’s bottom – so far – was on June 27, down 37% from its peak in Aug 2011. This month it is up 8.5% so if the rally looks like last time, there may be about 30% left, but that is only if the rally this time follows the symmetry of history. Another possibility is that gold could fall another 30% and have a loss like in the 1980-82 period.

What prompted the interview on July 22 was the biggest one day move of gold since June 29, 2012. See the Q&A below for the OTHER GOLDEN QUESTIONS:

1. Gold reached a one month high earlier today – it was the biggest 1-day rally in over a year. What triggered today’s rally?  Gold gained 3.6% in the S&P GSCI and DJUBS mainly on some weaker than expected data from the Fed that drove the price higher than 1300, an important point for technical traders. It went further and  broke 1307, then 1315.

2. Why has gold dropped precipitously this year? Gold had it worst two days since 1980 mainly since the US Fed announced in June it would slow its quantitative easing. The demand for gold as a safe haven may have disappeared after that announcement.

3. And – what’s behind the 10% rebound this month? The rebound is on the fundamental story of expanding reserves from the banks, whether it’s the Fed, ECB or Bank of Japan, the demand is picking up while the ETF selloff seems to have eased.

4. Why have commodities become more sensitive to supply shocks? And what does this mean for an investor’s strategy? The world’s economy may be shifting from one driven by expansion of supply to one driven by demand. In that case, inventories may be lower so commodities will be more sensitive to supply shocks. For investors, it means they may benefit from strategies that are more flexible to change weights or contracts based on the fluctuations of inventory and price.

5. Why are we seeing an unprecedented summer surge in exports of gasoline, diesel and other fuels?  There is an oversupply from a demand decline from Asia’s slowdown. Gasoline exports may slow as refiners hit their sales quotas before the government decides whether to increase allocations. Read more from this Bloomberg article.

6. Who is benefiting from this surge?  International consumers benefit from the supply spillover into their respective regions. Generally, the higher the inventory, the lower the prices.

7. And how is this export boom affecting pricing in the oil market? The refiners are the consumers of oil to make the gasoline so if demand slows the impact on oil is negative. However, it varies by regional fundamentals as evidenced by the 14.3% gain in the S&P GSCI (WTI) Crude Oil versus only 80 basis points in more international S&P GSCI Brent Crude. Read more from this Reuters article.

The phrase “past performance is not a guarantee of future results” has never rung more true for active mutual funds.  Our semi-annual publication, the Persistence Scorecard, takes a look at the performance of top quartile active funds over three- and five-year consecutive 12-month periods.  Based on the most recently released report, out of 269 large cap funds that were in the top quartile as of March 31 2011, only 3.35% (amounting to only 9 funds) remain in the top quartile at the end of March 2013.  It is worth noting that of the 102 mid cap funds that were in the top quartile, there was none left at the end of March 2013.

In short, the report is a sobering reminder that we cannot use the past performance figures as the sole or the most important criteria in fund selection.  In addition, the transition matrices in Report 4 and 5 suggest that a healthy percentage of top quartile funds in the subsequent period come from prior period second or third quartiles.