For many years, the commonplace investment return projections from the money managers were premised on the long-term returns of common stocks. Since 1926 (when the Ibbotson data series begins), these have hovered around 10 percent compounded annual growth. With bonds returning about 5 percent after fees, the crude math was that a portfolio with 60 percent invested in stocks and 40 percent in bonds would therefore produce a blended return around 8 percent. The actual calculations are more complex and sophisticated than that, taking into account other asset classes like real estate, international investments, timberland, private equity, hedge funds and cash and commodities, but the primary drivers of the exercise were typically the expected returns on stocks and bonds which dominate most pension portfolios.
Low Bond Yields. In today's disinflationary environment, especially with the aggressive monetary easing by the Federal Reserve, interest rates are now much lower than previous levels, and this alone has caused some investment advisors and actuaries to encourage greater conservatism in the portfolio forecasts. With bonds, a future increase in interest rates results in negative price changes, so total returns on bond portfolios in the coming decade could easily be lower than today's market yields. As bond managers say, it will now be hard to earn the coupon in the next 20 years. So that alone shrinks the expected returns from the typical 35 percent bond allocation of many pension funds' portfolios. CalPERS recently dropped its 10-year return expectation for this asset class from 4.5 percent to 3.75 percent.
The New Normal. Next, we take into account the New Normal economy, in which we factor in the implosion of the housing market, fragility and tighter regulations of the financial industry, restructuring of household balance sheet, weakening of domestic consumption due to impaired consumer confidence, and massive governmental debt accumulations. These will be hanging over the prospects for U.S. growth for many years. Hedge funds and private equity investors also face tougher sledding in their worlds, as investment growth opportunities are constrained in many markets. Although a pension board should look out over several decades when making its investment return assumptions, the prospects of an anemic American economy for five or more years must be taken into account. Sluggish returns in the first decade of a longer multi-decade period can impair total returns and actuarial results significantly because of the power of compounding. That's true especially if early-retiree baby boomers start drawing benefits during that weak early period. This should cause pension boards to question whether their domestic equity portfolios will earn the historical averages in the foreseeable future.
There are many other factors to consider, including (1) the potential for higher growth rates overseas which may be captured by ramping up the funds' international asset allocations, (2) the risk of dollar depreciation, which has inflation consequences and impacts on domestic vs. overseas investments, and (3) the aging of American baby boomers and other countries' postwar populations and the resultant search for investment yields which could keep interest rates and competing investment returns low for some time.
"Real" rate-of-return considerations. Of course, there is one silver lining to this growing level of investment caution: inflation rates now seem likely to remain subdued for a while. New York State recently trimmed its inflation assumption at the same time it reduced its investment return assumptions from 8 to 7.5 percent. If government employees' salaries grow less in the future, and retirees' cost-of-living allowances are trimmed by lower inflation rates, then the actuaries can take that into account. But herein lies the rub: ballooning federal deficits, the potential for over-accommodative monetary policy with subsequent inflation, the risk of a slumping U.S. dollar and huge potentially inflationary demand for commodities in China and India where their emerging middle classes will rival America's in size suggest that pension plans may be taking too much risk by assuming too-rosy inflation rates down the road. Hence, many actuaries and trustees are rightfully wary of cutting their inflation projections. Thus, the real rates of return on their portfolios (investment returns minus inflation rates) appear to be declining as they look out on the future horizon for their plans.
GASB impact. Finally, we have the potential impact of the Governmental Accounting Standards Board's (GASB) preliminary views on pension accounting, which would change the way investment return assumptions are used in the actuarial process to calculate liabilities and pension costs. GASB's current thinking is that the investment return assumptions are okay to use when there actually are assets in the pension portfolio. But for future liabilities that are expected to exceed the growth of current portfolio assets, GASB now believes the discount rate should be the employer's borrowing rate as measured by a municipal bond index. (Presumably a taxable rate, since tax-exempt borrowing is disallowed in pension finance.) For the unfunded portion of pension liabilities, that probably means a 6 percent discount rate rather than 8 percent in today's general market levels. When blended together to account for the 30 percent average level of pension underfunding, this would result in new discount rates averaging 7.4 percent. Then, if we see a nationwide reduction of investment return assumptions of one-quarter to one-half percent, we will likely see pension discount rates slightly above 7 percent on average. This will raise required employer contributions, along with a more rigorous, shorter amortization period to pay off unfunded liabilities. These will be based on average remaining service lives of the employees and not the 25- to 30-year "stretched" amortization periods now commonly used.
Ironically, the expected GASB rules will actually benefit unfunded OPEB (retiree medical) plans, since they now must use low cash-management yields for their unfunded liabilities and thus will see a higher discount rate and lower net liabilities as a result.
I'm telling governmental budgeters and local officials that they would be wise to have their actuaries compute their liabilities and annual contribution requirements for both pension and OPEB plans under these alternative GASB scenarios. This could prepare them for the now-foreseeable "pension sticker shock" heading their way in 2013. The results will be eye-openers for CFOs, elected officials and unions. In fact, anybody who enters collective bargaining without this information is heading into a gunfight without bullets.
And now, the SEC to worry about. Some trustees might look at these converging trends and ask whether they should leave their investment assumptions alone, given all the accounting changes that will impact them. But in light of the recent SEC settlement with the state of New Jersey over its dubious pension fund disclosure practices, pension officials now face the risk that negligent failure to recalibrate their investment assumptions could result in anti-fraud problems for the employer. Many investment consultants will be more leery of submitting rosy investment projections to document overly optimistic actuarial calculations if they know that the SEC and the class-action tort lawyers will be hauling them into court for fraudulent representation any time the numbers don't pan out. Pension officials may not be named by the SEC because bond disclosures are not their job, but I've never seen a class-action vulture who wouldn't name everybody involved as "co-conspirators" in a civil action for damages to bond investors.
Pension trustees and administrators can't risk burying their heads in the sand. Those whose portfolio strategies can justify a continuation of their current investment return assumptions will be wise to document their decisionmaking foundations. Financial statements and annual reports would be improved by a management discussion of the consequences of error, misjudgment or uncooperative financial markets. Actuarial data on varying probable scenarios might be appropriate in the pension plan's footnotes. Plan sponsors (employers) should ask hard questions and be sure to disclose the consequences of projection errors in their bond documents. My previous column on pension disclosures provides some additional thoughts for readers and fiduciaries to consider.
