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Home Publications Blogs Beat the Press Chris Farrell Is Mistaken, Pension Funds Will Get 8 Percent Returns

Chris Farrell Is Mistaken, Pension Funds Will Get 8 Percent Returns

Thursday, 19 May 2011 05:00

On Marketplace radio this morning Chris Farrell told listeners that state pension funds will only get 4-5 percent nominal returns in the years ahead, not the 8 percent that many have assumed. This is wrong. Given the mix of assets held by these funds, current stock market valuations, and projected economic growth, 8 percent is the expected rate of return on these funds. It is virtually impossible to describe a scenario in which returns will only be the 4-5 percent rate suggested by Mr. Farrell.

Many people who want to see the benefits of public employees reduced are complaining now that current assumptions on returns are excessive. In fact, they should have complained in the late 90s, during the stock bubble years, when the assumptions of returns were demonstrably excessive. It is striking that many of the same economists, who completely missed the stock bubble and then the housing bubble, are now the experts that the media turn to when assessing the market's prospects going forward. 

Comments (11)Add Comment
Silent but Strong: Heroic Economists
written by izzatzo, May 19, 2011 6:23
It is striking that many of the same economists, who completely missed the stock bubble and then the housing bubble, are now the experts ...

Baker is simply out of the loop on this point. Many of these economists have been hired by various national security entities as informants on who caused the housing bubble and obviously cannot speak up in their duel roles to vindicate themselves.

Baker should be ashamed for the cheap humiliation of these dedicated professionals protecting the country from a threat even greater than terrorism.
written by foosion, May 19, 2011 7:18
4%-5% is too low, but 8% is too high.

Two popular models for predicting stock returns are the dividend discount model and the earnings yield. Current yield on treasuries is a good estimate of future returns.

The dividend rate is currently about 2%, growth in existing stocks (which is slower than GDP growth) has been about 2% and inflation might be 3%, for a total of 7%.

Current p/e is about 18x, so earnings yield is about 5.5% Add 3% for inflation and you get 8.5%.

Long term treasuries are about 4.3%.

Averaging the higher equity estimate and bond you get about 6.8% for a 60/40 portfolio.
Don't believe 8% returns
written by tony, May 19, 2011 7:53
Dean, how can you say that 8% returns are expected in the future, when nobody knows what the future is? If you look at the history of the dividend yield of the S & P 500, going back over the last 100 years or so, its average yield is about 4.3%. Today, it is at about 1.7%. There are many ways that you can quess (and it is only a guess) of what is a fair value of the S & P 500, and using the dividend yield as a indicator, it is telling me that the S & P 500 is about 2 1/2 times overvalued. The average return of the S & P 500, including dividends since 2000, when this secular bear market began, has been about a 2 1/2% average annual return. This is more or less, the returns that you would expect to get in a secular bear market. And of the last four secular bear markets that we have had, none of them were less then 15 years in length. So we probably have a few more years of underperformance in the markets. And the Economic Cycle Research Institute, who I consider the best source in perdicting the business cycles, is already forecasting another economic slowdown coming this summer, which means probably more underperformance in the stock markets. So a 4-5 percent return for the average balanced portfolio, seems to me to be a very reasonable target, and a 8% plus return is probably not going to happen until we start are next secular bull market.
written by skeptonomist, May 19, 2011 9:16
Current stock P/E ratios are low relative to those of the 90's because corporate earnings are extremely high - higher with respect to GDP than at any time since WW I. Dean's projections assume that these corporate profits will continue to be high. He recognized the housing bubble, and maybe the stock bubble before that, but should everyone assume that he (or any other pundit) can never be fooled about the existence of a bubble somewhere? It is probably foolish to assume that stock prices can only go up from current levels.

Investment in bonds has given good returns since the early 80's because interest rates have come down steadily. Whatever the imaginary bond vigilantes may do, it is not possible that interest rates will go down as much in the future as they did over the last 30 years. The only way anyone is going to make 8% on bonds is with some kind of leveraging or short-selling. Municipalities have gone bankrupt trying such things in the recent past.
Some people are crying doom for pension funds for political reasons, but an estimate of 4-5% return is not extreme or absurd - no more so than Dean's estimate of 8%.
The 8 Percent Return is Based on CBO Growth Projections
written by Dean, May 19, 2011 11:45

you are welcome to trash the CBO and call them all sorts of names, but the folks who whine about pensions take the CBO numbers as gospel. The calculation of 8 percent returns are derived for the CBO numbers. This means that the whiners are just wrong or not being truthful when they dispute the fact that pensions will get 8 percent nominal returns. In their world, they will.
written by ltr, May 19, 2011 12:08
Dear Dean Baker,

Can you please explain why your price to earnings ratios are so vastly different from those of Robert Shiller. Are the Shiller ratios of no consequence and if so why?
written by ltr, May 19, 2011 1:42

Robert Shiller has price-earnings ratios using both 10 years earnings figures and yearly earnings figures that are far higher than yours. Please do explain where the data is from which your figures can be duplicated.
let's see how things are in 10 years' time
written by tew, May 19, 2011 2:13
I just made a PDF of this page. The claim of 8% annual returns is at odds with analysis by the best and non-partisan investment analysts I can find. (But I guess even Jeremy Grantham, who is constantly reminding us of the urgency of addressing climate change, is somehow some sort of right wing partisan when viewed by hyper-partisans on the left.)

Thanks also to CEPR for "The Origins and Severity of the Public Pension Crisis" which has become my go-to example of logical fallacy and misuse of statistics.
facts vs. forecasts
written by tew, May 19, 2011 2:21
Wow. Stunning from Mr. Baker in the comments. First, the school boy bullying of those who would question him or his Appeal to Authority, referring to them as "whiners". Then there's the unsubstantiated claim that those who question these return projections otherwise "take the CBO numbers as gospel". Finally - and this is just in one short comment, folks - he states that those whose analysis differs "dispute the fact that pensions will get 8 percent nominal returns". Incredible. I never knew that forecasts of long term investment returns were "facts"!

It would be laughable, but it's actually frightening, that people who pose as serious policy analysts - whether on the right or left - are so full of invective, paranoia, and bias that they cannot even entertain other analysis, no matter how well founded.
great post by skeptonomist
written by tew, May 19, 2011 2:29
Thanks for the well considered post skeptonomist. One statement in particular stands out: "Current stock P/E ratios are low relative to those of the 90's because corporate earnings are extremely high - higher with respect to GDP than at any time since WW I."

This is critical and Hussman has presented rigorous analysis on this point and Buffet and Grantham have mentioned this point with respect to stock valuations.

Now, here's an interesting question: What does Mr. Baker think about this historically high level of corporate profits as a percentage of GDP? Would he suggest policies that would encourage this to "revert to the mean" (which means a larger share for labor)? Mr. Baker's politics strongly suggest he would be critical of the current profit levels and would support a reduction. Ah yes, but out of the other side of his mouth he's glad to imply that those profit levels persist indefinitely into the future to support a forecast of high future returns in the context of public pensions.
written by ltr, May 19, 2011 7:32
Dear Dean Baker,

Please do address why your price-earning ratios differ so much from the of Robert Shiller. The Shiller p/e ratio has been in the 23 range for months now. Is this relevant at all?

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.