Fairy Tale Pension Projections

Assumptions about return rates and risky investments foreshadow big problems.
by | March 2010

Inside a sales brochure for an investment fund, you'll see a phrase like: "Current performance may be lower or higher than past performance, which cannot guarantee future results." Individual investors know there's an element of gambling in making investments, and that the higher the returns are on today's investment, the likelier they'll fall in the future.

Long-term investing is an ongoing challenge for state and local pension systems. Investment return rates are the major factor in deciding how much to set aside to meet future pension promises: The higher that rate is assumed to be, the less money must be contributed today. Government employers want to earn high returns on their investments, and that mandate to increase earnings can lead to many problems.

The level of annual contributions from employees and employers is now around $110 billion; benefit payments to retirees is $175 billion. More than 19 million workers and 8 million retirees belong to the public systems. And the number of retirees is growing five times faster than the number of working members, according to the U.S. Census Bureau.

The past decade hasn't been good for pension systems. Total returns on equities, according to the Standard and Poor Index, were a bit below zero from the end of 1999 through 2009. During the 2008-2009 financial crisis, the market value of investments held by pension funds fell by an estimated $1 trillion - about 30 percent, according to Federal Reserve data. At the end of 2009, public funds held an estimated $2.7 trillion in assets - well below the $3.2 trillion held at 2007's end.

Most public employee funds assume unrealistic investment return rates, which has led many to invest in riskier vehicles and projects. Take the $5 billion real estate project in New York City - it wiped out billions of dollars in equity, including $850 million in write-offs for state public pension systems.

Public pensions are fixed benefit plans that accumulate funds to pay future benefits. With aggressive return rate assumptions averaging 8 to 9.5 percent, pension systems accumulate added liability for future payments. When this happens, the system must save a fraction of each dollar to, after adding future earnings, make the stipulated pension payments.

The math is complex, but the concept isn't. If equities (stock) earn 11 percent and debt (bonds) 5 percent, then an 8 percent return rate is expected of a portfolio equally weighted with equity and debt. When looking at long-term return rates (1920s to early 2000s), retirement systems averaged returns on equities at about 11 percent and bonds at 5 percent.

But things have changed, and return rates, especially on stocks, have gyrated wildly. Long stretches of time (1930s, 1970s to mid-1980s and the 2000s) have shown there may be little or no return on equities.

A recent survey reported in The Wall Street Journal said individual investors hoped to earn about 14 percent on equity investments over the next 10 years, but after inflation and cost of transactions, the next generation's net return might be more like 4 to 6 percent - a big difference.

Believing a fairy tale about earnings has led too many people into saving too little, and governments to set aside too little to meet their pension funds obligations. But over-optimism's political rewards are great. Higher returns allow for smaller asset accumulation, lower contributions and lower taxes to pay the employers' share. So there are political benefits in trying too hard.

Had public pension systems assumed a 6 percent return instead of 8 percent, the funds they'd have to set aside to reach a target level of funding after 15 years (the average years remaining for workers before retirement) would be about one-third greater-roughly $35 billion additional future annual contributions. Given many systems' current underfunded condition, billions more would be needed to make up for the underfunded legacy.

The solution? Terminate fixed-benefit programs. Freeze the promised benefits as of a certain date, and convert future accumulations into defined contribution plans where employees bear the risk. Though unpleasant for public workers, it's preferable to the unsustainable arrangement in which governments default on pension payments. While drastic, it brings decision-making into the bright light of the tough choices in an aging, slow-growth, high-risk economy.

The day is over when the slack in public savings could be picked up by bubble-induced growth in asset prices. Public employees, whose pensions have been insulated from the working class' new austerity, will share in the national uncertainty.

Join the Discussion

After you comment, click Post. You can enter an anonymous Display Name or connect to a social profile.

More from Public Money