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Home Publications Blogs Beat the Press Pension Returns Depend on the Start Point

Pension Returns Depend on the Start Point

Monday, 04 August 2014 04:57

A New York Times article on New York City's pension funds implied that its assumed rate of return going forward is too high based on past returns over a highly selective period:

"But excessive optimism can lead to financial disaster, because regular shortfalls could ultimately leave the city unable to fulfill its required payouts. For years, the investment return expectation was set at 8 percent. In reality, the system’s returns have often fallen well short of that, earning just 2 percent on average from 1999 to 2009, for instance."

It should not have been surprising that returns would be well below 8 percent in a period that started in 1999 when the price to trend earnings ratio in the stock market was close to 30. The funds should have adjusted their return projections downward in line with the unprecedented run-up in the stock market.

On the other hand, the fact that it is possible to find a year where the market has slumped badly and thereby provided very low returns is completely irrelevant to the a pension fund that in principle can exist forever. It had no need to cash out large amounts of its holdings in 2009, nor is there a plausible scenario in which it would. Of course returns have been far above the 8 percent average in the years since 2009, as the piece notes.

Given this reality, it is entirely reasonable for pensions to use the expected rate of return on their pension assets as the discount rate for future liabilities. This would lead to the smoothest flow of funding. The alternative risk-free rate which is advocated by this article (it uses it in the main chart) would effectively have pensions pre-fund their obligations so that future payments would be much lower relative to revenue. This would be equivalent to building up a large account so that the police or fire department could be paid out of the interest. No policy experts would advocate such an approach.

The piece also misleadingly blames pensions for cutbacks in city programs;

"Already, the growing sums consumed by the pension funds have forced officials to scrimp on certain programs or abandon them, said Marc La Vorgna, a press secretary during Mr. Bloomberg’s administration. One casualty was the Advantage program, which helped homeless people move out of shelters and into apartments. It was eliminated in the Bloomberg administration."

It is equally accurate to say that these programs were only possible (assuming no other revenue or spending cuts) because the city wasn't meeting its obligations to the pension funds. In other words, rather than paying for possibly worthwhile programs, the city was taking the money from its workers' pay in the form of their pensions. It seems more than a bit misguided to blame the pensions for putting an end to this practice.

The points the article makes on the needless cost of investment advisers and questionable returns from private equity investments are well-taken.

Comments (7)Add Comment
The Post Office Ossification of American Government
written by Last Mover, August 04, 2014 6:48

Exactly. America must understand that to survive economically, any pension associated with anything that looks like government, acts like government and walks like government - must be government ...

... and therefore must be funded like the US Post Office, enough so that future retiree withdrawals are funded with interest alone.

There is no other way to save UPS and FedEx from the subsidized competition they face from the commie Post Office.

The hell with P/E ratios. Save the parasitic private sector that preys upon the public sector. Fund the future value of public pension funds now, so when they go broke the private sector can move in and occupy the starved beast with even more plundering and pillaging.
written by Squeezed Turnip, August 04, 2014 7:47
This would be equivalent to building up a large account so that the police or fire department could be paid out of the interest. No policy experts would advocate such an approach.

Wouldn't this then be equivalent, when played out in reality, to stealing the workers' contributions or their returns (since they would never recoup their principal)?
Pension Returns
written by JayR, August 04, 2014 8:04
Yes Dean Baker is assuming that Wall Street scams will not play that big of a role in future pension fund earnings. A recent example of a Wall Street scam would be home loans rated AAA that are actually toxic junk. Unfortunately I think Dean is wrong. The private equity investments that Dean briefly mentions are the vehicle used to transport weapons of mass financial destruction.
Maybe City Governments Offered Too Much in the First Place
written by Al, August 04, 2014 12:33
But, why did NYC's government offer pension benefits it could not afford in the first place? Or, if we are to assume that NYC can in fact afford to fund these pension plans, why doesn't it do so properly?

Mr. Baker does not shed light on that question at all.

written by urban legend, August 04, 2014 3:33
But, Al, they could afford them and they can afford them. These were promises made in lieu of wages. The promise was that the city/state would contribute to the fund in a certain formula, with employees bearing a significant portion or a majority of the contribution. Since it is a legally binding promise, it must be taken as a given that it will be funded. There may be no trade-off with other programs, just as there is no trade-off with Social Security and other Federal programs. If it takes more tax revenue to pay for its legal obligations and also to do what the people of New York want the government to do, then it takes more tax revenue.
If NYC can't afford its pensions then it will have to declare bankruptcy
written by Dean, August 04, 2014 6:07

I see no reason to believe that the city can't afford its pensions, but if that were the case then it will have to default on its debt also. It doesn't get to pay its bondholders and tell its workers to get lost -- at least not under the law.
pensions were expanded in the late 90s
written by pete, August 05, 2014 1:03
Dean is correct, somewhat, that expected market returns may depend on the current P/E (though there is little evidence of that), but indeed California pensions were increased due to the huge gains in Calpers in 1999.

I had a colleague who was running down the halls in 1998 and 1999 shouting about the stock returns and saying "After today I can retire a year earlier!" Exactly parallel to the silly changes to pensions in the 90s. PS he is still working.

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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.