MuniLand

The two schools of thought on pensions

By Cate Long
March 20, 2013

Public pension funds are essentially big piles of assets that are managed to provide the best investment returns at the lowest risk. The assets are what public employees have to retire on. If they are well managed and employees and governments make their required contributions, the assets grow as they earn investment returns (accounting for over 60 percent of the annual increase in pension assets). The most important part of the pension fund equation is how well the fund managers do earning investment returns.

Even with a rough economy, public pension fund managers have had an 8.9 percent median annualized investment return over the last 25 years, according to Callan Associates. The investment returns have done a lot to keep the funds growing at a steady pace. This is all separate from debates about whether public employees have been promised overly generous benefits, which is a political discussion that must be had. Also, there is very wide divergence in how pension plans perform.

Even though historic rates of return for pension funds have been strong, there is a debate over whether pension funds should use an 8 percent investment return on forward-looking assumptions. In fact, over the last several years there have been disagreements over which investment return to use when projecting the size of future assets. One side is led by Keith Brainard, research director at the National Association of State Retirement Administrators. Brainard argues that actual historical returns are the best foundation for forward-looking projections.

On the other side is Joshua D. Rauh, a professor of finance at Stanford’s Graduate School of Business. Professor Rauh claims that using past performance to predict future returns for pension plans must be stopped. Rauh’s methodology would force pension funds to use the zero-coupon Treasury yield as the benchmark when calculating future investment returns. As you know, the Federal Reserve’s financial repression policy has kept the 10-year Treasury rate at a historic low of about 2 percent.

If pension funds were to recalculate anticipated future returns according to Rauh’s methodology, all state and local governments would likely be crushed by increased pension payments as the predicted amount of future assets shrink dramatically.

It appears that Rauh assumes that the U.S. Treasury rate is a real market indicator that actually signals the cost of credit and future returns. But the Federal Reserve has been actively suppressing the Treasury rate since 2008, and it should not be used as a forward indicator. Rauh and others in his theoretical camp look a little wild-eyed proposing this approach.

There is in fact a lot of academic financial theory that is predicated on the 10-year Treasury rate as a floating market rate. As we enter our fifth year of artificially suppressed interest rates, we might want to rethink some of those theories. Managing assets for the future has become a trickier game. Looking backwards for guidance might be the best approach.

Comments
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Great post, as always. But I hope you can address the impact of new GASB standards as well as new Moody’s standards on Illinois pensions. Our media in IL blindly use the state’s official unfunded pension liability number of $97B, but many outside experts say the liability will be roughly twice that under new standards. So, isn’t it not a matter of opinion, but in fact a matter of what will be required?

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