That in turn presents an extremely difficult problem for many pension plan sponsors. First, some background.
If bonds earn 5%, that's a whole lot better for an investor than today's 2.5% rate. Twice as much.
And if stocks earn 4%/5% more than bonds, which they generally do, inflation adjusted stock returns will remain constant whether interest rates and inflation move up or down. But that's not the case with nominal returns.
Pension plan sponsors and their actuaries often assume that invested funds will earn a blended average of 8% over time. This includes an investment mix of stocks and bonds.
{NOTE: Frequently the model used by plans assumes an average annual return for bonds of ~5%, and ~10% for stocks. With 40% of the assets invested in bonds and 60% in stocks, that results in an overall return for the entire portfolio of 8%. On the other hand, if bonds earn ~3% and stocks earn ~8%, that same 40/60 mix yields a return of ~6%.}
Since inflation is quite low today, interest rates are low, too. Government policy has helped create low rates as well. Thus, bonds aren't earning anywhere close to 5% and, of course, stocks are having their problems as well. Hence, the 8% assumption is under heavy scrutiny.
To reiterate, stocks often return ~4%/5% more than the yield on bonds. That makes the 8% overall return assumption not credible today unless inflation and interest rates increase substantially. And the Federal Reserve certainly doesn't want higher interest rates as the economy stays weak. Thus, rates should remain well below their historical averages for at least several more years.
For pension plan sponsors, the difference in cash funding requirements between an assumed and actual 6% and 8% annual average investment return is dramatic. Let's look closer at exactly what this means.
Calpers Lowers Investment Target to 7.5% says this about the nation's biggest pension fund's investment dilemma:
"Calpers lowered a crucial investment target for the first time in nine years in a widely watched move that will add millions of dollars in retirement costs to the state of California, its schools and county agencies.
In a voice vote, the board overseeing the California Public Employees' Retirement System approved lowering the giant pension fund's assumed rate of return to 7.5% from 7.75%.
Wednesday's decision follows a recommendation by a key Calpers committee and the pension system's chief actuary to lower the rate to reflect lower inflation expectations.
Diminishing Returns
Compare assumed rates of return among some public pension plans.
The move, the first by Calpers since 2003, is likely to put pressure on pension officials in other states to lower their investment assumptions. Pension funds across the U.S. have been criticized for using unrealistic investment assumptions, which proved costly during the financial crisis.
Public pension funds such as Calpers use their assumed rates of return to calculate the present value of future retirement benefits and how much money participants need to contribute to pay for them.
Related Reading
By lowering the so-called discount rate, Calpers could ask the state to eventually contribute an additional $300 million annually. The pension board asked the staff to come up with a plan to phase in the increased contributions from state and other government agencies over the next two years to help soften the financial blow.
Concerns about the fallout from a lower investment target snarled discussions among pension officials in Minnesota on Tuesday night. The Minnesota Legislative Commission on Pensions & Retirement put off a decision for a week on whether to recommend lowering the state retirement system's 8.5% assumed rate of return. Minnesota's rate is among the highest in the nation."
Now let's see about Japan's similar dilemma. Tale of Trouble at Japan Pension Funds summarizes the Japanese pension funding issue:
"TOKYO—Most of the pension plans set up by groups of small businesses in Japan are under water, the latest data from the health ministry shows, even as the burden of future payouts grows in step with the aging of the country's population. . . .
The problem, pension-industry trackers say, is that many of these funds are managing money their employees have paid into government pension plans that guarantee returns of 5.5%. Management of the money was transferred to the funds in the 1990s, when markets were booming, but the 5.5% guarantees remain in place.
Yet traditional investments like stocks and bonds now return much less than that. Between 2006 and 2010, the Nikkei 225 Stock Average fell 37%, and the yield on 10-year Japanese government bonds slid to 0.8% from more than 2%. The yield on 10-year government debt is now around 1.01%, and although the Nikkei has risen almost 19% so far this year, it declined 17% in 2011. . . .
The rapid aging of Japan's population, more than 25% of which is expected to be above retirement age by 2015, is compounding difficulties. In many Japanese funds, the number of people receiving pensions already exceeds those paying into funds, analysts say."
Summing Up
Pension plan benefits are guaranteed by the plan sponsor. Investment returns have been quite poor over the past decade. Now low interest rates are adding another difficulty to pension funds having enough money on hand to cover outflows. If investments earn less than what's assumed, less money will be available to pay the promised benefits. Then the taxpayers get the bill to make up for the shortfall.
Unless, of course, plan sponsors decide to increase their cash contributions, earn more on stocks, invest less in bonds or some other combination of the various alternatives.
My view is that more money should be invested in stocks. My further belief is that public plans shouldn't extend guaranteed benefits without taxpayers understanding exactly what they're being asked to do. Taxpayers should also know that a government's decision to stay with a pension plan for public sector workers would be the opposite of what plan sponsors in the private sector are doing.
It's a whole new ball game for investing by pension plans in bonds and stocks.
It's also a new game for plans deciding between guaranteed public sector pension benefits and 401(k) plans, as well as employee and employer contributions, and many other things as well.
Why more stocks and fewer bonds?
Low inflation means a lower nominal rate of return. That said, going to a higher mix of stocks suggests a higher overall rate of return. In addition, as interest rates increase during the next several years, it will even more difficult to earn an acceptable rate of return on bonds. Thus, I would argue for more stocks and fewer bonds, along with a switch in the public sector to 401(k) plans from pension plans.
That's the logical approach.
The logical approach may well not match the unions' and politicians' preferred approach, however.
But whatever is decided, it's time for a fresh look at all this.
In the U.S., Japan, Europe and elsewhere, too.
The taxpayers and affected employees deserve no less.
Thanks. Bob.
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