Pension Returns Depend on the Start Point

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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.