Taxpayer Funding of Public Sector Pensions and Our American Future

Pension plans generally assume that their investments will earn a return of ~8% annually over the long haul. Doing so means that a dollar invested would double every 9 years (rule of 72).

At 6% that doubling would take 12 years.

Thus, a dollar invested today that earns on average 8% annually will be worth $16 in 36 years compared to $8 had it earned a 6% rate of return. Twice as much.

Compounding makes a big difference over time. Up or down. Good or bad.

Pensions Wrestle With Return Rates summarizes recent experience with several state public employee pension funds and their assumed annual return rates:

"Turmoil in Europe, the sluggish economy and low interest rates are intensifying pressure on public pension-fund systems to reduce the annual-performance assumptions they use to determine contributions from taxpayers and employees.

Some lawmakers and pension officials are pushing to abandon the roughly 8% annual-return assumption set by many public-employee funds, saying the rate is unrealistically high given upheaval in markets around the world and the preceding financial crisis."

One portion of the article highlights the performance of Minnesota's public employee investment fund. For the recent 3, 5 and 10 year periods ended June 30, 2011, Minnesota's public fund has earned ~5% annually. For the past 20 years, however, performance was 8.8% while the 30 year annual compounded rate of return was 10.1%. In the past twelve months, the fund earned 23.3%, and its long term assumed annual rate of return is 8.5%.

My view is that lawmakers and pension officials of these state public funds are worried about the wrong thing. Instead they should be considering a move to 401k type defined contribution funds where the investment risk is placed on the participating employee. That's pretty much the way private funds operate today, and the trend is growing.

Besides, if money is invested properly for the long term, employees should earn a greater than 8% rate of return. With a 401k, that "excess" return would accrue to the sole benefit of the employee. Thus, the taxpayer takes on no risk and the employee keeps the "excess" return. A win-win.

So let's look at the reasonableness of the ~8% annual compounded rate of return assumption itself. For evidence we have an abundance of historical performance available for review and analysis.

With respect to stock appreciation historically, summary results are presented in the book "Stocks for the Long Run" by Jeremy Siegel on page 13. The takeaway is that achieving an 8% annual rate of return over time has not been a problem in any long term period.

But what if 8% is not achieved in the future? Should public sector employees be asked to bear that risk?

To which I reply, taxpayers who toil in the private sector already bear that risk in their own 401ks. Should those same private sector taxpayers also be required to bear the added risk for public sector employees as well?

And if private companies' stocks won't earn 8% annually over the long haul, what does that say about the future of America? Then the burdens on private sector employee taxpayers would be even greater than expected. That certainly wouldn't be fair to them.

But let's talk reasonableness of expected returns for stocks in the future. I know of no reason why they shouldn't earn 8% over long periods of time. They always have.

From 1802-2006, stocks earned 8.3% compounded annually. From 1926-2006 stocks earned 10.1% and from 1946-2006 they earned 11.2%. From 1946-1965 returns were 13.1%, while from 1966-1981 only 6.6% was achieved. Then 17.3% was attained from 1982-1999 and from 1985-2006 the annual compounded rate of return was 12.4%.

It's good that the states are now nervous about their retiree pension obligations. That said, it would be a whole lot better if they converted those pension plans to defined contribution plans. Then taxpayers, along with state officials, could all breathe a little easier.

As for the public sector employees involved, if they take the long view, make adequate contributions and stick with stocks, their 401k performance will do just fine. In fact, they can then keep the excess (greater than 8%) return for themselves, unlike the pension plans of today.

For the country as a whole, maybe we'll even learn to start cheering on our private sector as we compete globally for business, jobs, earnings, compensation and stock market appreciation. When companies win, we all win.

Why don't more of us understand that simple fact of American life?

Thanks. Bob.