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Pension funds: rate of return is not the main issue [ClearOnMoney]
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Pension funds: rate of return is not the main issue

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Commentary

Pension funds: rate of return is not the main issue

24 Mar 2010 by Jim Fickett

Since state retirement funds are generally in bad shape, there is considerable controversy about their expected investment returns, which some say are too optimistic. However historical returns suggest expectations are not too far off. Probably the main issues to watch are around (1) promised benefits and (2) fund contributions.

The recent Pew report on state retirement funds gained much attention. It estimated a funding gap of $1 trillion, but also warned that the gap could in fact be considerably larger. This is one of the more important areas of unsupportable debt that needs to be resolved one way or another, and deserves close attention. What to watch? States, in estimating fund adequacy, assume a rate of investment return in the neighborhood of 8%. There has been considerable criticism of this assumption, and for many it seems to be the, or at least a, primary issue. The Pew report is fairly low-key, but does point up the issue:

Given the experience of the past decade, pension plan investment losses in 2008 raise the question of whether it remains reasonable for states to count on an 8 percent investment return over time—the most common assumption for all 231 state-administered pension plans examined for this report. Some experts in the field suggest that an assumed 8 percent yield is unrealistic for the near future.

On the positive side, actual historical returns in the US and UK suggest 8% is not too far off. In the US, the National Association of State Retirement Administrators published a note on 16 Mar saying that the 25-year rate of return was actually 9.25%:

A recent review of empirical data by the National Association of State Retirement Administrators (NASRA) finds that since 1985 - a period that has included three economic recessions and four years when median public pension fund investment returns were negative - public pension funds have exceeded their assumed rates of investment return.

The NASRA Issue Brief, Public Pension Plan Investment Return Assumptions, prepared by research director Keith Brainard points out that median public pension actual investment returns for the 25-year period ended December 31, 2009, was 9.25%, which exceeded the median assumed return rate of 8%. The report emphasizes the long-term focus of the governmental plan investment return assumption, the process by which it is calculated, as well as the public policies surrounding its regular review.

In the UK, International Financial Services London published a note on 22 Feb saying that:

Over the 46 years since 1963 UK pension funds have generated real returns averaging 4.2% a year.

Adding the UK real rate of return, 4.2%, to the US rate of inflation over the same period, 3.9% (CAGR), gives 8.1%.

Do these historical rates of return mean there are no issues with assuming an 8% rate of return? The Financial Times suggested on 4 Mar that would be somewhat optimistic:

Calpers actually has earned its target rate in the past 20 years, but this was a decent period for equities and a great one for bonds. Assuming 2.5 per cent inflation plus the real return since 1928, a nominal return of 7 per cent for a portfolio half in Treasuries and half in equities seems prudent.

I would agree that 8% may be too optimistic, especially in the next few years. Yet given all the above it does not seem too far off. And f the expected rate of return is too high the system is, to some extent, self-correcting, because each year actuaries evaluate the current state of retirement funds and recommend a contribution to bring assets and liabilities back into balance.

The bigger problems are

  1. excessive promises were made and in some cases are still being made, often without any costing by actuaries, and
  2. annual contributions are too low and, in some cases, attempts are being made to borrow and leverage the funds, or to invest in risky ways to try to “catch up”

It is these two areas where the drama will really play out. Over the next few years we will need to know:

  1. Have the states stopped making unrealistic promises? Have they renegotiated some of the least affordable liabilities?
  2. Are they topping up funds each year in a realistic way?

I suspect there will be many interesting developments on both fronts.