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Retirement savings, projected investment returns, and volatility [ClearOnMoney]
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Retirement savings, projected investment returns, and volatility

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Commentary

Retirement savings, projected investment returns, and volatility

24 Jul 2010 by Jim Fickett.

Sales pitches for retirement savings plans often include dazzling projections of modest savings magically grown by 7-9% compound returns over decades. State pension plans likewise project optimistic views of their solvency by assuming 8% annual returns forever. A major problem with both views is volatility – if the market is down when the money is needed, one has a problem. For state pension plans, if one projects the value of current savings forward using the risk-free rate, the underfunding is $3 trillion rather than $1 trillion.

Underfunded retirement benefit issues are ubiquitous. According to the US Treasury's Financial Report of the US Government, the net present value of future Social Security and Medicare liabilities, as of 2009, was $46 trillion – compare for scale to 2009 revenues of about $2 trillion. A Pew Center on the States report last February said that states' pension funds were at least $1 trillion short of what they should be. One key reason GM failed was “a $1,600-per-vehicle handicap in so-called legacy costs, mostly retiree health and pension benefits.” For the household sector, the Employee Benefits Research Institute reported in their March 2010 survey that “Three in 10 Americans age 25 and over report they have not saved any money for retirement (29 percent of workers and retirees).”

There are many reasons for this sad state of affairs. One reason, which is obscure to most investors and which confuses even many experts, is inappropriate projections for future investment returns.

Take first the case of the individual investor.

Pitches for retirement savings plans usually include a dazzling computation of 7-9% annual returns (thought to be typical of the stock market) compounded for decades. The MSN retirement calculator is typical in suggesting a 9% average return on investments, up to the time of retirement. The problem with assuming 9% returns, or even 7%, is volatility. You have to take into account that stocks have good years and bad years, and good decades and bad decades. One saw many exchanges like this in late 2008 and early 2009:

Ask the Expert: Retirement Losses: What Now?

by Walter Updegrave

Question: I've just received the statement for my workplace retirement savings account – 99% of which is invested in an S&P 500 index fund – and it shows a loss of 37.5% for 2008. I'm 60, make about $100,000 and I was hoping to retire next year. What immediate next step should I be taking to recover my account value? –Benjamin, Albuquerque, New Mexico

Answer: You, my friend, have way, way too much of your retirement savings tied up in stocks for someone so close to retiring.

As you're now discovering, the big danger in pursuing a pedal-to-the-metal investing policy at your age is that your nest egg can take such a huge hit that it may not be able to rebound in time for you to retire on schedule.

Unfortunately, you're hardly the only person closing in on retirement and sitting on big losses. A recent EBRI report shows that going into last year nearly 40% of people age 56 to 65 had more than 70% of their 401(k) accounts invested in equities, and almost 25% had more than 90% of their balance in stocks.

If you are going to be realistic about the volatility of stocks, and start moving more toward bonds and cash halfway through your career, then you need to plug a much smaller number than 9% into that retirement calculator.

I'll write more about a realistic approach for individuals another time (hint: it doesn't work to ignore inflation in retirement planning). Today I'd like to move on to the case for state governments.

In what follows I am depending heavily on a very useful overview of the accounting issues, The Liabilities and Risks of State-Sponsored Pension Plans, by Robert Novy-Marx and Joshua D. Rauh at Northwestern University, whose work I discovered via mentions in the New York Times and the Economist.

The situation with states is more complicated than that for individuals, because it is ongoing, with a changing mix of employees and retirees, and there is no universal standard on how to plan. But current practice is close to this: you take on the liabilities side of the equation all retirement benefits that have already been earned by current employees, ignoring for now additional benefits that will be earned later by these and further employees, and on the asset side you project your savings forward using your best guess of investment returns. As Novy-Marx and Rauh put it,

One approach for a state is to view the obligation to the worker as fully funded if the fund could deliver an annuity that would cover all retirement benefits that have already been earned. In other words, the state could view its pension liability as though all of its workers were going to quit work today, wait until the retirement age, and collect their promised benefits.

This method is called the Accumulated Benefit Obligation (ABO) measure. …

For a pension plan to be considered fully funded, its assets should at a minimum be equal to the Accumulated Benefit Obligation. … Other possible measures of obligations take into account some of the increase in benefits expected with future service.

What makes this a natural approach is that the benefits of each generation are funded by that generation.

On, then, to the investment return assumption. 8% is the accepted rule of thumb; almost all public pension funds have an assumed rate of return between 7.5% and 8.5%. There is an ongoing, highly contentious debate on whether this is too high. The states have on their side some historical performance data. The National Association of State Retirement Administrators stated, on 16 Mar 2010,

Although public pension funds, along with most other investors, have experienced sub‐par returns over the past decade, median public pension fund returns over longer periods exceed the assumed rates used by most plans. … For example, for the 25‐year period ended 12/31/09, the median investment return was 9.25 percent. …

Empirical results show that since 1985, a period that has included three economic recessions and four years when median public pension fund investment returns were negative (including the 2008 decline), public pension funds have exceeded their assumed rates of investment return. As the standard disclaimer says, past performance is not an indicator of future results. However, considering that public funds operate over very long timeframes, actuarial assumptions with a long‐term focus should also be established and evaluated on similar timeframes. Viewed in this context, compared to actual results, public pension plan investment return assumptions have proven to be conservative.

Nevertheless, picking any one period, here 1985-2009, ignores the volatility problem. To illustrate the problem, Novy-Marx and Rauh

  1. construct a random function which mimics the average returns and volatility of the aggregate portfolio of public pension funds
  2. run a simulation with many iterations of investing over 15 years, starting with current funding
  3. show that in in most cases funding turns out to be inadequate to cover obligations

In other words, states may well end up in the same position as Benjamin from Albuquerque, who lost most of his portfolio just as he was about to retire. States do not have a single deadline, of course, but it is still bad news for a particular generation of taxpayers if the public pension funds fall to inadequate levels for an extended period. (As an aside, I am not really satisfied with either the current accounting approach, using a single average rate of return, or the simulations of Novy-Marx and Rauh, using a single time period for investment. The real question is something like this: if you want to have 95% confidence that, over the next 30 years, the savings pool will always be at least 85% of the ABO, how much do you need to have in the fund now?)

Novy-Marx and Rauh make a strong case that since the obligations are fixed, fully known, and almost impossible to escape, the investments should also be predictable, safe, and with low volatility. Similar views are held by many pension professionals. Shortly after the Pew report came out, Orin Kramer, chairman of the council that oversees New Jersey's state pension fund, was interviewed by the Financial Times, and said,

If you use government accounting constructs, pension funds are probably about 88 per cent funded. If you just tweaked one variable and said, you know what, instead of using the average assets for the last five years, and assuming that's what we have, let's actually take market values year-end 2009. That brings you down from 88 to 75 per cent funding. And then if you say, let's use corporate accounting that doesn't allow you to assume double-digit returns from equities and so forth, that would make those funds 60 per cent funded, which translates into a $2,000bn-plus shortfall on the public fund side, before you get to the health piece. …

8 per cent annualised returns, which is what they assume, which is more aggressive than I'd want to be …

How much difference does it make if you go to a very conservative assumed rate of return? Back to Novy-Marx and Rauh:

We estimate that if states were required to report Accumulated Benefit Obligation liabilities, but without any changes to current discounting practices, they would report $2.87 trillion as of the end of 2008. Based on our asset estimate of $1.94 trillion, states in aggregate were underfunded by this measure by $0.93 trillion as of the end of 2008. …

How much difference does it make if states used a risk-free rate instead of the typical 8 percent to discount future pension liabilities? … [using] interest rates on Treasury securities as of January 2009 … We find that total liabilities were $5.17 trillion as of the end of 2008, implying that the underfunding in state pension plans net of the $1.94 trillion in assets is $3.23 trillion.

So $3 trillion instead of $1 trillion.

Note that this analysis only takes pension obligations, not healthcare promises, into account, and only state plans, not those of cities and counties. I will come back to a broader estimate in another post.