The hardest part about being a public pension manager is admitting you’re wrong.
American state and local pensions have less than 73% of the assets they need to fund future obligations to public workers, according to a survey of 180 plans by Boston College’s Center for Retirement Research. They believe they can help keep that gap from widening by earning an average of 7.4% annually.
The surveyors “take plans at their word” when it comes to these investment assumptions, says CRR’s Director of State and Local Research Jean-Pierre Aubry. Maybe we shouldn’t.
Based on public funds’ historical experience, 7.4% might seem prudent. Their actual rolling 30 year returns through 2017 were almost 8.6%. Had one asked an investing expert three decades earlier if 8.6% was a realistic return for an investment portfolio, he or she probably would have agreed. At the end of 1987 a 30 year U.S. Treasury bond yielded about 8.9%. Meanwhile, the S&P 500 had returned 9.7% annually in the preceding three decades.
Yet the very fact that stocks and bonds have enjoyed bountiful returns since the 1980s explains why they probably won’t in the future. A 30 year Treasury bond today yields less than 2.6%. Meanwhile, the cyclically-adjusted price-to-earnings ratio (CAPE) compiled by Nobel laureate Robert Shiller, which a Vanguard Group study found had the best ability to predict medium-term stock returns, is above 30 today. It was at just 16 back at the end of 1987.
When the CAPE has been above 25 then subsequent S&P 500 10-year returns have averaged just 4.1% over the ensuing decade based on data going back to 1928. A portfolio 70% invested in stocks and 30% in high-quality corporate bonds today might therefore be expected to return about 3.8% over 10 years. It could be higher, but even the best historical result would fall short of pension funds’ forecasts.
Unlike most Americans who decide only what their contributions are to retirement vehicles such as 401(k) plans and who may rely on wishful thinking when estimating how well or long they can live on that pot of money in the future, pension funds make that bet in reverse. Their obligations to beneficiaries are ironclad and in many cases constitutionally guaranteed, but what they happen to be on paper depends on projections they decide themselves. That lessens contributions today, but the odds of hitting those numbers are slim indeed.
To get a sense of how meaningful a shortfall could be, consider the California Public Employees’ Retirement System, known as Calpers. Its forecasts are on the cautious side compared to peers, yet it still assumes a return of 6.1% annually over the coming decade from a portfolio 50% in public equities, 8% in private equity and 28% in fixed income. Its own calculations show that a 1 percentage point change in its assumed discount rate would reduce its funded level by 8 or 9 percentage points, increasing its funding gap by around $30 billion or around $2,600 per California household.
Asked how it arrived at 6.1%, Eric Baggesen, a Calpers managing director, mainly credits outside consultants. He acknowledges that they might have an optimistic bias.
“Obviously the world assimilates good news more rapidly than bad news,” he says.
Share Your Thoughts
How much should pension funds expect to earn in the future? Join the conversation below.
For Calpers, which has California’s municipalities as clients, suddenly taking a more conservative tack would mean more than just admitting its analysis had been too rosy. Since the discount rate moves up and down with return assumptions, they would have to greatly increase the contributions from these cities, forcing many into bankruptcy. Instead, when returns in any single year fall short, smoothed assumptions require only a modest boost in contributions.
Yet being proven wrong in the long run and being more realistic in the short run isn’t so different. It is just a question of when additional money is added.
“There’s no way to escape what your returns are going to be,” says Mr. Aubry.
One disturbing side-effect may be more risk-taking by funds, like a gambler desperate to break even. Calpers’s Chief Investment Officer, for example, said at a meeting earlier this year that “We need private equity, we need more of it and we need it now.”
That category has done well recently, but it may be a dangerously crowded bet now. Expect blowups if managers of America’s public funds can’t get their heads out of the clouds.
Write to Spencer Jakab at firstname.lastname@example.org
Copyright ©2019 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8