The investment return assumption allocates costs
Recent articles about California’s latest pension cost increases reflect confusion about the role of the investment return assumption. While it’s correct that current pension costs increase when investment return assumptions decrease, the articles usually fail to point out that future pension costs will decline by more than a 1:1 ratio and produce a more equitable allocation of cost between citizens and public employees. Here’s how it works:
Pensions are payments for past services. They are supposed to be pre-funded when the pension is promised so that the cost is borne by the employer that got the benefit of the services to which the promise relates and by the employee who will receive the payments. Pre-funding takes the form of contributions to an investment fund in the expectation that the combination of those contributions and investment earnings will be sufficient to make the payments as they fall due. The investment return assumption determines contribution size. The higher the assumption, the lower the contribution. Generally both employers and employees participate in that contribution (“Normal Cost”) but shortfalls (“Unfunded Actuarial Accrued Liabilities”) burden employers only. Because shortfalls arise after services are provided, they burden future employers who did not get the benefit of those services.
Thus, the investment return assumption allocates costs. Great tension accompanies that process, as explained here and here. The consequences are also great. For example, in 2005 California’s largest pension fund (CalPERS) assumed an unrealistic 8 percent return. It earned 6.2 percent over the next ten years, a wonderful return but because it was less than assumed, a $111 billion shortfall developed. With interest, that shortfall will cost more than $300 billion. No shortfall would’ve arisen had CalPERS assumed a reasonable return, as pressed by me and others. 100% of the burden of that $300 billion falls on citizens in the form of reduced public services, higher taxes, or both. Additional shortfalls have developed since 2015.
An understanding of the role of the investment return assumption is critical to understanding why current government officials and employees usually seek the highest possible investment return assumption. An artificially high assumption produces an artificially low burden for them but at the expense of greater burdens on future officials and employees. There are exceptions — e.g., Governor Jerry Brown has fought for lower return assumptions while in office. But that behavior is rare and even when CalPERS recently announced a cut to its assumption, it deferred most of the consequences. Because unrealistic assumptions currently remain in place, California is deferring $4.5 billion of pension cost to future generations this year alone.
Investment return assumptions in California are set by boards dominated by self-interested public employees who have an incentive to push costs to future citizens. Legislators need to propose a change to that system. Until then, they should press those boards to assume reasonable returns.