Guest Post: Rosy Projections of Pensions’ Investment Earnings?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Ed Mendel of Capitol Weekly writes that public pension funds’ rosy forecasts pose problems:

Pension funds have been hit hard by the stock market crash, losing about a third of their value in some cases, and there may be another problem.

Before the crash, some financial experts warned that pension funds were making overly optimistic projections of investment earnings in the decades ahead, often assuming about 8 percent a year.

Investment earnings, the heart of a modern pension system, are usually expected to provide two-thirds or more of the revenue needed to pay retiree benefits in the future.

In public employee retirement systems, a rosy forecast of future earnings means that fewer taxpayer dollars have to be spent to provide generous retirement benefits.

The giant California Public Employees Retirement System assumes annual earnings averaging 7.75 percent in the decades ahead. The California State Teachers Retirement System assumes 8 percent.

Lowering the projection of earnings by even a percentage point or two would create a funding gap of tens of billions of dollars.

CalPERS, an industry leader, warned its 1,500 local government members last fall that their employer contribution rates may increase from 2 to 5 percent of payroll in July 2011 if the stock market does not recover by June 30, the end of the current fiscal year.

Beyond raising rates to plug the big hole punched in pension funds by the stock market crash, the problem could get even bigger if forecasters decide that the critics are right, lowering projections of future earnings.

After the big drop in the stock market last fall, the CalPERS investment portfolio, once a high flier, had an average annual return of 3.32 percent for the last 10 years, well below the forecast of 7.75 percent.

A prominent critic of the high earnings forecasts, David Crane, was a rare appointee to a pension system board, CalSTRS, with a big-league background in investments.

Crane, an adviser to Gov. Arnold Schwarzenegger, helped build a small San Francisco business, Babcock & Brown, into a global investment firm, becoming personally wealthy along the way.

After the governor put Crane on the CalSTRS board and he had served almost a year, the Senate refused to confirm the appointment in June 2006, ousting a board member who had repeatedly questioned the 8 percent earnings forecast.

Legendary investor Warren Buffet, in his annual letter to Berkshire Hathaway shareholders in February of last year, questioned the 8 percent earnings forecast common among the pension funds of major corporations.

“How realistic is this expectation?” Buffet said. “Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3 percent when compounded annually.”

[Note: On the above calculation, a senior pension fund manager wrote me: “Don’t believe everything you read, take out your calculator.” I did and Buffet was right! CAGR= (11,497/66) raised to the power of 1/100 – 1 = 5.3%. But the senior pension fund manager and a senior bond analyst reminded me that if you look at total returns indexes, which includes dividends, then you get close to that 8% figure (dividends were much more important prior to 1960s).]

The founder of Vanguard mutual funds, John Bogle, told a congressional hearing on retirement security last month that corporate pension funds raised their assumed earnings from 6 percent in 1981 to 8.5 percent by 2007, far above historical norms.

“And the pension plans of our state and local governments seem to be in the worst condition of all,” Bogle said, adding parenthetically: “Because of poor transparency, inadequate disclosure, and non-standardized reporting, we really don’t know the dimension of the shortfall.”

The plight of the public employee pension funds has drawn a creative proposal from U.S. Rep. Gary Ackerman, D-New York, to shore up two of the nation’s troubled institutions.

Public pension funds would pool some of their money and buy $50 billion to $250 billion worth of stock in banks. In exchange, the federal government would guarantee the pension funds an annual return of about 8.5 percent.

Earnings forecasts were not a problem in the early days of California public employee pension funds, when investments were limited to fixed-income bonds and mortgages.

In 1966, a ballot measure, Proposition 1, allowed the pension systems to put 25 percent of their funds into blue-chip stocks. Advocates said the change would enable increased retirement benefits and lower employee and taxpayer contributions.

A measure to allow 60 percent of pension funds to be invested in stocks, Proposition 6, was rejected by voters in 1982. But two years later voters approved a far broader measure, Proposition 21, simply requiring that investments be “prudent.”

The ballot pamphlet argument said the measure, still in effect today, is similar to federal law covering private pension funds and is needed to prevent inflation from eroding the value of pension funds.

The ballot argument said pension fund trustees are “personally liable” if they invest funds without “the degree of care expected of a prudent person, who is knowledgeable in investment matters.”

The lifting of the restrictions on investing in stocks in 1984 came a few years after legislation allowed public employees to form unions and bargain collectively for labor contracts, which usually include retirement benefits.

A state labor law in 1968 covered local government employees. Teachers were added in 1975 under the Educational Employment Relations Act, state employees in 1977, and University of California and California State University employees in 1978.

Many public employee labor unions went on to negotiate contracts providing generous benefits — up to 90 percent of the final salary at age 50 for some police and firemen — that are expected to be paid mainly by pension fund investment earnings.

Retirement benefits provided by a labor contract have strong legal protection. In a widely watched test case, the City of Vallejo declared bankruptcy last year and asked a federal bankruptcy judge to overturn its labor contracts.

In hindsight, after a historic market crash that may force taxpayers to bail out pension funds, was it prudent to lift the restrictions on investing in stocks?

Calpensions asked an expert, Alicia Munnell, director of the Center for Retirement Research at Boston College.

“In the old days (before the mid 1980s), many public plans had limitations on equity investments,” Munnell replied by e-mail. “Virtually all have eliminated those constraints. Allowing more freedom to the investment managers is probably a positive development.

“The controversial area is the rate of return assumed in the actuarial valuation of pension plans. Public sector sponsors tend to assume high returns (8 percent or more), which makes the taxpayers’ commitment for future benefits seem small and encourages major expansion.

“Bottom line: a free hand for investment managers is a good idea; more cautious assumed rates of return would help check major benefit expansions.”

I always wondered where that 8% came from. With long-term bond yields at historic lows, this figure is pie-in-the-sky because pension funds will be lucky to get 8% a year in the next few years.

In fact, Reuters reports that fund investors see the slump continuing to 2010:

Investors overwhelmingly hold negative views toward credit rating agencies and the Securities and Exchange Commission, and they expect the market slump will continue into next year, a survey by the Greenwich Roundtable and Quinnipiac University found.

The survey of 89 wealthy private and institutional investors in late January and early February found confidence in regulators and in hedge funds was shaken during the credit crisis. It will take six to 12 months of healthier markets before investors jump back in, the survey reported.

“Leverage, liquidity and lack of confidence are still keeping the sophisticated investor on the sidelines,” Steve McMenamin, executive director of the Greenwich Roundtable, said in a statement.

As a result, he said, unprecedented numbers of limited partners refuse to make new commitments to alternative investments, such as hedge funds.

Greenwich Roundtable is an organization for investors who allocate capital to alternative investments, with members representing more than $6.4 trillion in assets.

Among other findings, more than one-third of those surveyed said they lowered allocations to hedge and private equity investments during the past quarter, though more than one-half left allocations unchanged.

One-third reported that as many as 40 percent of their fund managers suspended redemptions, while close to one-quarter were dissatisfied with the way redemption gates were currently structured. Ten percent of investors complained gates were being abused.

These LPs should have checked those gait clauses more carefully before committing the big money to hedge funds. It’s too late to whine about it now!

If investors want cheap exposure to hedge funds, they can now invest in Deutsche Bank’s new exchange-traded fund (ETF) giving investors direct access to hedge funds through a managed account platform.

[Note: I am skeptical of any hedge fund ETF that charges 0.9% per year. Investors should ask who is on this platform and how they performed over the past 12 months. A better solution for investors looking for “passive” liquid exposure to hedge funds is to replicate hedge fund indexes using a few futures contracts (this is tricky too; contact me for more details).]

But that 8% projection of investment earnings needs to come down. Pension funds and their stakeholders need to reassess their growth projections and realize that overly optimistic projections will only aggravate their pension deficits.

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  1. Anonymous

    Just like everyone knew that using your house as an ATM would eventually end so the expectation that you would get a decent pension without significant contributions is disappearing.
    Perhaps we should mention that Los Angeles County Superior Court Judge Helen Bendix tossed a lawsuit last week filed by Orange County supervisors to overturn an agreement with deputy sheriffs in 2001 that boosted their pension benefits by about a third.
    This gives state and county authorities little option but to cut back on employees to fill up the funding gap and when the US start QE then this will most likely go into overdrive. Still a few more trillion borrowed by the government should put that right I guess. Move along, who is next for a bailout.

  2. Anonymous

    1.053^100 = 174.9
    174.9*66 = 11543

    The calculation seems all right to me. Am I missing something?

  3. Leo Kolivakis

    I apologize, I just checked it too and the calculation is just fine!

    In the last century (100 years), the CAGR of the Dow was 5.3% I edited my note and I apologize for the confusion.



  4. Anonymous

    Obviously, the assumption of 8% per year is astoundingly stupid. Everyone thinks that if someone else made 8%, then I can too. Real rates of return in the world economy are low and always have been low. They only way you can assume 8% per year is if you assume that inflation will be high. And of course, there is a market problem with more and more money flowing into equities. Ummm, that means less money is flowing into providing credit, which increases the cost of debt, which decreases equity returns. This is the problem with pension funds and endowments plowing into equities. The more they do that, the less chance there is for equities to have the high returns they once had.

  5. Anonymous

    “A senior pension fund manager” was right after all – don’t believe everything you see.

    There is a thing called dividends that makes all the difference in the world. In the past century dividends averaged around 4%. With dividends reinvested the total return will be around 9.3%.

    Based on this logic the fund managers are not too wrong to assume 8% return in this future.

    There is no need to use cheap tricks to prove a fundamentally valid point, i.e. 8% return is way too optimistic.

    The main driver of the economic development is the population growth. Between 1900 and 2000 the population in the US grew from 76 million to just under 300 million. On the whole people were young and became net buyers of stocks. To have the same rate of growth in the 21st century, our population will have to go up to about 1.1 billion in 2100.

    If that’s the prediction you are making, then 8% will be a reasonable return estimate.

    However, if you expect a large portion of the US population to “attempt” to retire in the next 20 years, then it won’t be surprising if in 2030 the DJIA will be around where it is today. If it sounds too incredible, take a look at Japan.

  6. Elizabeth

    But herein lies the rub:

    At previous S&P 500=1500 levels with record profit margins, 8% was patently ridiculous.

    Now that the market has fallen for more than 50%, we should actually assume higher returns.

    Using historical numbers as the future assumptions is really dumb – in good times it is way too optimistic and in bad times it is way too pessimistic. I cannot grasp why they don't use valuation-based assumptions like GMO ( does.These do work over time and help guide investment allocation as well. Here's an economist article looking at track record. do our own version and we come up with similar results to GMO.

  7. Leo Kolivakis

    A senior bond analyst reminded me that dividend yields were much more important prior to the 1960s, so the correct way to calculate the compound annual growth rate (CAGR) is to look at total return indexes.

    According to him, if you do this, then the CAGR comes closer to that 8%.

    Importantly, he reminded me that even if stock prices go sideways for many years, as long as the dividend yield is larger than the bond yield, then you come out ahead investing in stocks.


    Leo Kolivakis

  8. Leo Kolivakis

    That senior pension fud manager also emailed me “what about dividends?”.

    He, and the senior bond analyst, are absolutely right, to look into compound annual growth rates you need to look at total return indexes which take dividends into account (yes, dividends were important at one time!).

    Now, I want to answer Elizabeth here. She is also right, you can’t invest looking at past returns just like you can’t drive a car forward looking at your rear view mirror.

    When projecting future returns, you need to know your starting point. With current 10-year bond yields yielding 2.87%, you can’t expect much in stocks (depends how much of an equity risk premium you assign).

    Remember that in 1982, long bonds were yielding a lot more, so it was normal to expect higher rates of return over the next 10 or 20 years.

    Will dividends come back in vogue? This is possible, but I think that specualtive activity is here to stay so people will keep looking for price appreciation on stocks. The demographics, however, argue for dividends to come back in vogue.

    But the most important point is that we cannot expect anywhere near historic returns going forward because we are starting from much lower bond yields.


    Leo Kolivakis

  9. fred

    I don't mean to sound flippant, but where we're headed 8% a year will be trivial. Our government is busily engineering inflation that will make the 70's look trivial. This will solve all the pension problems, indebtedness, etc. Look for S&P 500 to hit new highs within three or four years, and then quickly double from there.

    I'm not saying this with enthusiasm, because it will all prove to be devastating in the end, but that's how it will be solved.

  10. Anonymous

    The return assumption is flawed b/c pensions do not invest 100% in stocks. Most are at least 30% fixed income and returns there will obviously be well below historical averages over the next decade. Unless equities are going to return double digits over time the pensions are not going to get 8%. The corporate pension plans are just as screwed.

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