Ours is an age where hyperbole has not only become accepted, it is almost universally embraced as a part of American culture, and among the chief advocates of hype is the financial service sector of our economy. We lived throughout the 1980s, 1990s and early 2000s in an age when one could not open a newspaper or magazine without reading the amazing returns on investment that could be achieved by investing with this fund or that. In 2008, when the stock market imploded there was some respite from this enfilade of data on returns. However, as the traditional mutual funds were beaten into retreat, they were quickly replaced by a new creature; the hedge fund. These new investment vehicles promised a faster, better, ride because they would trade with and, when right, against the market. Money fled to these funds despite some enormous loads and aggressive profit sharing demands on the part of the smart guys who established them.

2016 was a watershed. The Dow Jones index grew by 15%; the S&P 500 by 11% and the NASDAQ kept pace at 11%. Meanwhile Barclays Hedge Fund Index barely cracked 6% in a world where the “house” routinely takes 2% up front and 20% of performance. So the 6% hedge fund yield was probably closer to 4%. The three-year average for the Barclays is a measly 3%, making even Treasuries look attractive.

These are the elements of the market that get the hype. And they all have teams of public relations and advertising officials to spin the story their way. However, today’s big news comes from the seldom-heard giants of the investment industry; the defined benefit pension managers. They don’t advertise. In fact, they don’t take customer’s investments. They take public employee retirement contributions and are charged with the duty to make certain the government’s promise to pay monthly retirement payments are actuarially sound.

Today’s news is from CALPERS, the largest public employee pension fund in America. This California agency and its analogues throughout the US manage $3.7 trillion in funds. Their customers are governments that have promised retirees a specified payment every month for life. If they cannot meet their projections, they have to demand that state and local governments pony up larger tax payments to fill the gap. And those governments are already screaming at the large percentage of government budgets allocated to covering pension costs.

So what are the big boys saying? In California’s case, they expect annual returns averaging 6.2% for the next decade. Some years will be better, some worse as the projection is an average. After 10 years, they see returns moving back up towards 8%, but the lower returns in the short run will mean more stress on your local governments to increase taxes.

The Ohio Public Employees system has predictions not much different. 6.76% over the next 5-7 years but then a bounce back towards the 8% that California predicts. Canada and Europe in the past years had lowered their expected returns while the US pension plans retained more flowery predictions. The US plans did not anticipate how far and how long interest rates would crater. The long-term prognosis for higher overall rates of return is premised in large part on a gradual return to historic interest rates.

For public employees, the concern about underfunded defined benefit plans remains. Low rates of return in the past several years have a cascading effect because income projections were not met. The Rockefeller Institute reports that the likelihood of a shortfall in income to distribute is 10x what it was 30 years ago. Subpar returns mean that CALPERS pays out more in benefits today than it receives in retirement contributions. We wrote about this looming problem in May 2016. Recently we spoke with Mark Altschuler who runs Pension Analysis Consultants in Elkins Park, PA. While actuaries, like Mark can project things like present value, it is not within their customary orbit to try to evaluate whether pensions will be able to meet their contractual undertakings to pay each beneficiary the prescribed amount on time.

What does this mean for the divorce practitioner and the client? When looking at the historic rates of return on S&P stocks between 1928 and 2014 the average rate of return today is approximately 10%. Some of that return is consumed by inflation. The other factor demanding consideration is risk tolerance. In March 2000, the SP500 stood at 1,527. It did not return to that value until October 2007. It then fell by more than half and did not return to 1,527 until 2013. The only way to gird against these market fluctuations is to integrate investments in stocks with investments in less volatile bonds. This is strategy that major government pension and annuity managers must emulate. It is also a polestar for conservative money managers. The term “going for broke” can be a self-fulfilling prophecy in the world of investment. So while last year the S&P kicked out 11% and that is 1% more than the 1924-2014 historic average, it would be improvident to build a financial plan exclusively around indexed rates of return. If you choose to believe that kind of growth is sustainable on a long-term basis, we encourage you to read Robert Gordon’s Rise of American Growth (Princeton 2016). So, for the medium term, prepare for 6% returns and be thankful if you do better.

We have recently been working with a client married to a “sophisticated investor.”  When we cracked open the documents telling us what Mr. Investor owned, we found a succession of limited partnerships not one of which offered us any information from which we could begin in ascertain value.

Meanwhile, there were eight of these and one formed the impression at the outset that the investments were heavily weighted towards newly formed businesses.  

Valuing any closely held business is a challenge.  The typical approaches employed to do this involve measuring the stream of income or cash flow and efforts to find a comparable company that has recently sold.  The trouble with startup companies is that they rarely have strong financials.  It is not uncommon to engage a business appraiser to have that person come back and report that while they can see value from an intuitive viewpoint, the objective criteria needed to opine about value in an objective report is simply not there.  

Occasionally, the stock market affords us a demonstration of this conundrum and the recent transaction involving Merck’s acquisition of tiny Cubist Pharmaceuticals is a good example.  Cubist was formed in 1992.  It has fewer than 1,000 employees but it has been publically traded at a price that did not crack the $25 mark until 2010.  Startup pharmaceutical companies can be a roller-coaster as good and bad news circulates about the products they are trying to develop.  Moreover, it costs millions if not billions to bring a meaningful drug to market and that investment is typically a multi-year journey.  However, Cubist rose in price on a pretty steady basis until early 2014 when it reached $75 a share.  In 2014, after peaking early, it tumbled back toward $60 and then clawed up to $75 a share.  

In today’s world pharmaceutical companies trade at about 40x earnings.  As December approached Cubist was trading at 87x earnings, more than double the industry average.  It’s profit margin was 5.6%. Operating margin was 9.5%.  Return on assets was 2.3%.  Return on equity 4.47%.  On these numbers one could argue that the market had it a little overpriced. 

Then Merck stepped in offering to buy the company for $8.4 billion; roughly $110 a share.  That’s just about one-third more than the market thought it was worth the day before.  But then, on the very evening when the sale was announced, a court in Delaware issued a ruling that challenged one of Cubist’s patents.  Cubists shares instantly fell 4% and Merck’s shares fell 5%. 

Cubist’s largest individual shareholder holds 176,000 shares.  He saw this transaction coming as he is the CEO.  Let’s assume he was dividing his property with a spouse.  Last Friday his spouse would have been negotiating over shares with a market value of $13,200,000.  On Monday those same shares were worth $19,360,000.  A day later; $2,640,000 less.   If you were being divorced from the shareholder and made your deal on December 5, you would have had no idea that the following Monday would see the shares worth an additional six million.  But then who could predict both a court ruling on Tuesday and just how the market would react.  The experts are saying Merck overpaid by $2 billion. 

The point of this is that we all like certainty when valuing assets.  But even it situations where the stock is publically traded, the tides of the market can change precipitously.  The problem is all the more difficult the smaller the business involved because small companies, like small boats, are less seaworthy in changing economic climates.