Economists on Stock Returns: It Depends on the Weather or Maybe Politics

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Friday, 04 March 2011 05:46

It would be nice if the answers that economists gave us on economic issues did not change when the political environment changed. Unfortunately, we don't live in such a world. This can be seen very clearly in the current debate over the assumption on rates of return that public pensions should make for the assets they hold in stock.

Most economists today seem to be lining up on the side that pensions should only assume that stock will provide the same rate of return as Treasury bonds. Even though the expected nominal return on stocks might be 10 percent, these economists argue that because of the risk associated with stock returns public pension funds should only assume the rate of return on risk free Treasury bonds, roughly 4.5 percent.

The counter-argument is that state pension funds can essentially be indifferent to the risk of market timing. If the market is depressed for a few years, the state pension fund would still have adequate assets to pay all benefits. There would only be a problem if the market remained permanently depressed, which is not plausible if the widely accepted projections for long-term economic growth prove accurate.

This lower rate of return makes a huge difference in the size of pension liabilities. This change in accounting, coming at a time when state budgets are hard-pressed due to the recession, would create substantial pressure to reduce pension benefits and possibly eliminate defined benefit pension plans altogether.

It is interesting to note that the economists' concern with pension fund accounting just happens to coincide with a major push by the right-wing to attack public sector workers and especially public sector pensions. State pensions have been assuming 10 percent nominal returns on their pension's stock holdings for decades. This fact never seemed to trouble economists previously.

Interestingly, many economists had argued the exact opposite position in the context of Social Security privatization. Andrew Biggs, one of the economists who has been very prominent in the debate for lowering the return assumptions on public plans, explicitly argued for assuming a high rate of return for the stock held in privatized Social Security accounts. Other proponents of privatization took the same perspective, which was the main benefit of their proposal.

Even advocates of preserving the current Social Security system wanted to assume a higher rate of return for money held in stock, albeit for stock held in the Social Security trust fund. Two of the country's leading experts on Social Security, Henry Aaron and Robert Reischauer, both explicitly called for putting part of the Social Security trust fund in the stock market to take advantage of the higher rates of return offered by stock. President Clinton made the same proposal.

It is worth noting that these plans for putting Social Security money in the stock market were made near the peak of the stock bubble, when price to earnings ratios were approaching 30. In this context, they were making absurd assumptions about the prospect for future returns, as some people pointed out at the time. By contrast, now that the market has plummeted from its bubble peaks and price to earnings ratios are close to their long-term average, it is plausible that the market will provide its historic rate of return.

If economists were consistent, they would apply the same methodology for assessing stock returns in the context of Social Security privatization in the late 90s as they apply to public pension funds in the current crisis. This does not appear to be the case.