Not for the first time I feel compelled to post a copy of a letter I sent (1 May 2000) to Dr Cullen in his capacity as Finance Minister urging hm to re-consider allowing the Government Superannuation Fund to diversify away from a dominant NZ Government stock holding.

The Letter

Office of Hon Dr Michael Cullen
Minister of Finance
Parliament Buildings
Wellington

Dear Minister

Thank you for responding to my request to furnish me with the analysis
documents substantiating the announced decision to diversify the Government
Superannuation Fund (GSF) investment portfolio beyond Government Stock to
include stock market investments. I acknowledge receipt of the Towers Perrin
group study and the Government Actuary 's trial projections paper based on
the conclusions of the study.

My primary reason for wishing to review this material was to check the
underlying assumptions and plausibility of the stock market return forecasts
that gave you cause to publicly assert that: 'The Government Actuary
estimates that the policy could reduce the amount the Crown pays the Fund in
the form of deferred employer contributions by between $14 million and $44
million a year'.

But as I suspected from the outset the Towers Perrin group merely
extrapolate historical stock market returns over the period from 1980 to
1996 to project future returns: (see Attachment 1, page 1-16 and Section
4.2.11, page 33-34). From my experience and others the consensus among
economists and actuaries involved in this type of analysis is that they can
just plug in an assumption on stock returns that is simply a naive
extrapolation from the past.

Your comments mentioned above alerted me to the possibility that your
advisors had taken this elementary but undefended course of action, to derive
sophisticated present value liability outcomes for the GSF, because of similar
debates taking place in the USA over recent years in respect of their Social
Security Fund.

It is common knowledge that the incumbent Clinton administration wishes to
privatise the Social Security System with a view to diversifying the current
and future surpluses away from US Treasury Bonds into the stock market-
either at a institutional fund manager level or by the private 401K vehicle.
These plans generally assume that stock investments will receive annual
real returns of 7%, the average return on stocks over the past seventy-five
years.

The substance of support for the administration's plans are of the economic
projections of the Social Security Administration Office of the Actuary (OACT)
presented to the Trustees of the Social Security System. In their 1998 Report,
the Trustees of the Social Security System project that over the next seventy-five
years the U.S. economy will grow at an annual rate of 1.4%, less than half the
rate of growth of the past seventy-five years. For stocks to provide returns of 7%
under such conditions, the average price-to-earnings ratio -- already at 30 to 1,
more than twice the historic average -- would have to rise eventually to incredible
levels of over 400 to 1.
l
More recently the OACT technical panel recommended a significant reduction in
the projected rates of return assumed from stock, from a 7.0 percent real annual
rate to a 5.7 percent rate. It also recommended an accounting treatment that
recognises the greater risk associated with stock returns. Unfortunately, the panel
did not attempt to construct a set of projections for stock returns, derived from
projections of its components -- dividends and capital gains -- in the same rigorous
manner that it derived its projections of wage growth from productivity growth. There
is no explanation for the panel's failure to use a systematic approach to projecting
stock returns, particularly since other economists, such as M.I.T. Professor
Peter Diamond and Dean Baker, have shown exactly how such projections can be
made.[see attachments to this email above] Had the panel used such a systematic
approach, it would have projected an even lower return for equities of approximately
3.5- 4.0 percent, or alternatively, a decline of 50 percent in the stock market in the
near future.

There would be little point in placing money in the stock market,
since there is not much difference between this yield and the 3.0 percent
real return projected for government bonds. In fact, the difference in returns is
probably not even large enough to cover the administrative costs in the case
of private accounts.

Furthermore, the latest projections by the Congressional Budget Office (CBO)
show that before-tax corporate profits will actually shrink by 3.8 percent in real
terms over the next decade. It predicts that after-tax corporate profits
will shrink by a slightly larger amount, declining 4.8 percent in real terms
from 1999 to 2010. The latest profit projections are somewhat lower than what
had appeared in CBO's last report. CBO is projecting that before-tax profits
will rise by just 26.2 percent, in nominal terms, over the period from 1999
to 2010. It projects that nominal after-tax profits will rise by 24.9
percent. As indicated before, both are projected to decline after adjusting
for inflation.

These profit projections are radically at odds with what the stock market
appears to be assuming. It is virtually impossible to see how stocks will be
able to produce returns that are anywhere close to their historic average if
these profit projections prove accurate. This can be shown with a simple
arithmetic calculation.

The return on stocks is equal to the annual dividend payout plus the capital
gain. Because current price to earnings ratios in the stock market are at
record highs, the dividend payout rates are at record lows. Currently the
dividend payout rate is approximately 1.5 percent of share prices (this
figure includes money used to buy back shares as dividend payouts).

This means that in order to provide the 7.0 percent historic rate of real
return on stocks, real stock prices would have to rise by 5.5 percent
annually (7.0 percent, minus the 1.5 percent dividend payout). Given the
decline in profits assumed by CBO, this would imply that the price to
earnings ratio would rise from approximately 30 to 1 at present to almost 60
to 1 by 2010. Even if the real returns in the market averaged just 6.0
percent over the next decade, the CBO profit projections would still imply a
price to earnings ratio of 52 to 1 in 2010. There are few, if any,
economists or market analysts who view such price to earnings ratios as
plausible. Clearly, investors in the market have a very different view of
the economy than the economists at the Congressional Budget Office

In summary, given the above, I challenge you to defend the assumptions
upon which you have declared significant savings for the tax payer by proposing
that the GSF invests in New Zealand and overseas shares.

If the public is to support and fund a GSF investment reform proposal that relies
on higher projected returns in the stock market both domestically and internationally,
it seems incumbent on the proponents of such plans to produce a detailed description
of their assumptions on stock returns. Specifically, this description would present
the year by year assumptions for the two components of the stock return, dividend
payouts and capital gains, in precisely the same manner that the Government Actuary
presumably lays out its assumptions for the current investment in New Zealand
Government Bonds.

It may be possible to construct a plausible scenario in which stock returns average a
nominal 11.6 percent annually assumed by Towers Perrin group and the Government Actuary.
But such an account has not yet been produced and until it is, this assumption about
rates of return does not deserve to be taken seriously in the GSF investment class debate.

ps - the author of this letter freely admits plagiarising text from Dean Baker's compositions.

The two document referenced attachments in the article can be viewed here:

http://www.omo.co.nz/Stock%20Return%20analysis%20-%20Dean%20Baker.htm

http://www.omo.co.nz/Expected%20Stock%20Returns-%20Prof.%20Diamond.pdf

Yours faithfully

Stephen L Hulme

Raf

I mean there is a time for everything.

I posted the above more as a cautionary tale about investment timing i.e. increasing the odds of success.

Bonds have enjoyed a spectatular run from 1982 until now.

Maybe and just maybe yields are too close to zero in some price determing jurisdictions that have significant influence in determing the prices of our domestic government debt market.

Hence it would not be prudent to load the book with such securities (government bonds) unless one had an ulterior motive.

Super Funds soaking up the significant projected supply of taxpayer's liabilty (debt) today to pay it back tomorrow is certainly convenient at this juncture, but not necessarily savvy.

But a mark to market crisis can be endured if the institution can hold out to maturity and we remain solvent enough to pay our taxes to purchase such debt and service it until we are old enough to receive the promised rewards.

Government entities purchasing Government Bonds? Sounds a lot like Quantitative Easing to me.

In the face of rising long-term interest rates, currency appreciation and a growing spread between the OCR here and that in Australia, maybe not such a stretch?

Comments/opinions welcomed.

andy & Scott.

To be QE wouldn't it have to be increasing the amount of $$$ in circulation? Does it do that?

Pete Says: "To be QE wouldn't it have to be increasing the amount of $$$ in circulation? Does it do that?"

Repositioning (selling) equity allocations in Government Superannuation Portfolios to buy new Government Bond issues (debt) is only increasing $$$ in circulation if the Government Budget spends the money.

Isn't that the Governments objective, to refinance current debt and to stimulate the economy out of recession through spending on infrastructure?