The Role of the Investment Return Assumption

Fox & Hounds Daily, 6/17/10.

By David Crane, Special Advisor to Governor Schwarzenegger for Jobs & Economic Growth

As California’s public pension funds consider changes to their investment return assumptions, it’s helpful to review that assumption’s role and whom it impacts.

The investment return assumption determines who pays for pension costs. This is because it determines how much money must be set aside (contributed) by the generation that got the benefit of the services to which the pension relates.

If the right amount of money is set aside when the promise is made, then the generation that got the benefit of the services to which the pension relates rightly bears the full cost, and only that cost. If too little is set aside, a future generation has to cover some of the cost even though it did not get the benefit of the employee’s services. If too much is set aside, the generation that got the benefit of the services bears too much of the cost.

As an example, CalPERS’s investment return assumption would require a contribution today of $10,650 to meet a payment of $100,000 due 30 years from now.  If the actual return ends up equal to the assumed return, all is well, but if the actual return is less than the assumed return, there will be a deficiency, and because of compounding, those deficiencies can be huge. In this example, if the actual return were just 1% less than the assumed return, there would be a deficiency of $25,000.

This is where the “who” comes in, because that deficiency would be picked up by future governments that didn’t get the benefit of the services to which the payment relates, leaving them less money with which to spend on their own programs. I.e., the consequences of failing to meet an investment return assumption fall on innocent bystanders. Also, because payments for pensions take precedence over all other expenditures except Proposition 98 education spending, those consequences fall disproportionately on programs, such as higher education, that get funding only from the residue left over after preferential claims have been met.

This is a principal reason why state funding for the University of California has declined 5% and student fees have risen 200% as state pension costs have risen 2,500% over the last ten years, and why the state has been hit with an extra $20 billion in pension costs over the past ten years and faces a $270 billion bill from CalPERS over the next 30 years.  (Even that $270 billion is based upon an investment return assumption.  If the miss is equal to the miss over the past ten years, that $270 billion will turn into $1.3 trillion.) As for CalSTRS, which this year will draw $1.2 billion from the state and has liabilities well in excess of its assets, it has announced plans to seek more money from the state.

As these consequences demonstrate, an unrealistic investment return assumption is like the “teaser” rates used by some mortgage brokers to lure homeowners into mortgage loans only to later learn the real cost of those loans.   Through the use of high investment return assumptions, pension funds lure governments into making larger pension promises and/or smaller contributions, not a hard sell to politicians and pension fund board members eager to please certain constituencies. Adding insult to injury, pension costs disguised by the teaser investment return assumption grow, just as teaser mortgage loan balances grow. But while mortgage borrowers in California can walk away from underwater home loans, the state cannot walk away from pension promises. Instead, it’s forced to cut programs. Accordingly, it’s no stretch to say that pension funds using teaser return assumptions are even more cynical than mortgage brokers selling teaser loans.

But are CalPERS and CalSTRS using teaser rates? You be the judge. CalPERS’s investment return assumption implicitly forecasts the stock market to grow 40% faster than it grew in the 20th century, a period of unequaled economic growth. Looked at another way, by 2110 CalPERS implicitly forecasts the stock market to be nearly three times higher than implicitly forecast by super-investor Warren Buffett for his pension plans (that’s why Buffett’s contribution in the earlier example would be 27% higher than CalPERS requires), and CalSTRS uses an even higher assumption.

No one can predict investment yields with certainty but we do know ranges of reasonable expectations and, more importantly, who pays the price when assumptions aren’t met. Young people today should hope and pray that CalPERS and CalSTRS err on the safe side and don’t mortgage their futures.

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