Pension Fund Accounting: The Crash Does Not Lower Future Returns, it Increases Them

The NYT had another piece complaining that state and local pension funds are using overly optimistic assumptions on returns. The complaint is that the funds assume an 8 percent (nominal) average annual rate based on the historic returns on the mix of assets held by these funds, rather than a 6 percent rate which would be closer to the average risk-free rate on long-term U.S. Treasury debt.

"The financial crash provoked a few states to lower their assumed returns. This will better reflect reality, but it will not repair the present crisis."

Actually, the opposite is the case. Because the crisis sent stock prices plummeting, the ratio of stock prices to trend earnings ratio is much lower than it had been previously. As a result, it is much more reasonable to now to assume 8 percent average returns going forward than it was before the crisis. State and local pension funds do face substantial shortfalls, but calculations based on a 6 percent rate of return on assets would exaggerate the size of this shortfall.

future returns
written by David Cay Johnston, June 27, 2010 7:01

Based on historical evidence the 8 percent return is more likely, but unanswered are two major questions about whether this downturn may produce unexpected results:
-- the disintermediary effects of the Internet, which allows virtually any job done on a computer to be moved to a super low wage country like India.
-- the enormous unproductive of assets at the top combined with the power of the political donor class, which is damping investment in the public services that are needed for more wealth-building.

Past performance is no guarantee of future outcomes.

That said, the real problems with government pensions lie in policies that fail to set aside enough money, provide COLA for periods longer than one worked and widespread spiking (artificially inflating last year or in rare cases last day pay to increase pension benefits).

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written by skeptonomist, June 27, 2010 9:10

Dean's version of stock-market fundamentals seems to be more optimistic than most others. See the data compiled by Robert Shiller:

http://www.econ.yale.edu/~shiller/data.htm

In Shiller's version the standard P/E ratio for the S&P 500 based on trailing earnings is now about 20, which was exceeded before 1995 only at peaks preceding extended periods of lower prices. If you think that current prices are relatively low, you must accept that financial conditions since 1995 are sustainable.

Dean has said that he uses "trend" earnings. I am not sure what these are but if bond yields are involved it should be kept in mind that yields are lower now than they have been for many decades and they won't necessarily stay this low.

Of course all kinds of projections are excessively high during booms and excessively low during slumps. Despite hundreds of years of experience of cycles, economists still don't seem to be aware of this.

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written by Queen of Sheba, June 27, 2010 9:22

skeptonomist:

To be fair, the author of the NYT piece is a reporter and book reviewer, not an economist. He has spent years writing about the economy in the WSJ and has authored a few books about the economy. He is also a Director of an investment firm. But he is not an economist, and to say that "economists don't understand" something based on Lowenstein's reporting is not exactly fair to trained economists, as most actual economists do understand your point about cycles.

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Pension Fund Accounting: The Crash Does Not Lower Future Returns, it Increases Them

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