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

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Sunday, 27 June 2010 05:46

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.

At one point the piece presents us with the good news that:

"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.