traditional pension plans in the US: trouble (ii)


The California Public Employees’ Retirement System (CalPERS) is a bellwether for government employee pension plans around the US.

not fully funded

By its own calculations, CalPERS is not fully funded, meaning that it does not have enough money on hand today to meet the future pension obligations of its members.  That’s even assuming, as it officially does at the moment, that it can earn on average 7.5% on its investments yearly.

assuming a 7.5% annual return

How reasonable is it, though, to think that CalPERS–or anyone else in a similar situation–can earn 7.5% on a diversified portfolio of stocks and bonds?


Let’s assume an asset allocation of 50% stocks and 50% bonds, just to make the arithmetic simple.

bonds first.  Let’s say that the yield on Treasure bonds rises to 4% over the next several years and stays steady at that level from that point on.  When we’re there, CalPERS can earn the coupon each year by holding them, or 4%.  A 4% return on half the portfolio is a contribution of 2% to the entire portfolio   Note:  we already know that the return will be less than that over the time it takes for interest rates rise back to normal.

stocks.  To achieve a 7.5% return on the entire portfolio, assuming bonds deliver 2%, stocks will have to chip in 5.5% per year to the total.  This means achieving an average 11% annual return on the stock half.  How reasonable is this?  Well, over the past ten years the S&P has risen by 58%, or on average by a little less than 5% per year.  If we assume that inflation will remain contained at around 2%, an 11% return would be a whopping 9% real annual return.  Over long periods of time, stock markets around the world have averaged at best a 6% real annual return.

change the asset allocation?

Yes, we could up the overall return by shifting the asset allocation away from bonds and toward stocks.  But the stock portion would have to be above 90%–making calPERS’ assets vulnerable to wide business cycle swings in their value–before it could achieve a 7.5% annual return, assuming a 6% real return on stocks.

In short, the numbers don’t add up.  The biggest issue isn’t CalPERS’ ability, or lack of it, to manage money well.  It’s that the actuarial assumption of future returns is too high.

Over the recent decade or more, pension plans like CalPERS have tried the “magic” solution of alternative investments–hedge funds and private equity–to try to square the circle.  But most hedge funds continually produce returns to clients that are below the S&P 500.  And, again, the allocation to such dubious, and illiquid, vehicles has got to be very large to move the total return needle, even if one believed the promoters’ marketing claims.

changing the actuarial assumption

Interestingly, California has just announced that it is going to accelerate the process of lowering the assumed return on CalPERS investments to what sounds like a target of 6.5%.  To me, this is clearly the right thing to do, and the sooner the better.  But it will also show that CalPERS is more deeply underfunded than today’s official figures suggest.  It will likely mean that state and local governments will have to up their contributions to the fund.

That’s doable for California.  But what about the country’s government pension fund basket cases, like Illinois and New Jersey?  Following suit will show voters for the first timethe reality of how bad the situation is there.


traditional pension plans in the US: trouble ahead

the basics

Corporate pension plans of one type or another have been around in the US since the late nineteenth century.  In their simplest form, they offer specified payments in retirement to company workers who meet criteria spelled out in advance.  Since 1974, these plans have been subject to federal regulation under the Employee Retirement Income Security Act (ERISA) which sets out standards companies must comply with.

Although pension plans are an obligation of the firm, companies don’t ordinarily keep on hand in the plan today enough money to meet all future obligations.  Instead, they (or outside actuarial firms they hire) make intricate calculations of what future payments are likely to be and when they are likely to occur.  Then, using the investment returns that on average they believe their investment managers can achieve, they figure out how much must be in the plan right now to fund expected obligations.

open secrets, sort of

–We know professional analysts have a hard time forecasting what will happen even one year ahead.  What does this say about forecasts that claim to look decades into the future?

–Most traditional pension plans have less in the till today than actuarial calculations say they need.

–The return assumptions used are typically, let’s say, heroic.

public sector workers

The uncertainty inherent in what I’ve just written is why most publicly traded US companies have long since switched from traditional pension plans, where the corporation has responsibility for the risk of miscalculation, to 401ks, where the employee bears it.

There still are significant numbers of traditional pension plans, however.  They’re in the public sector.

dealing with underfunding

To my mind, a substantial reason for the popularity of hedge funds over the past fifteen years or so has been their claim of superior performance as far as the eye can see.  The director of an underfunded pension plan knows that his story is not going to end well as things stand now.  He has two choices:  ask his boss, the governor/legislature, for instance, to fix the problem by allocating (a ton of) more money to the plan; or he can find managers who can consistently exceed the returns the actuaries assume and gradually close the funding gap that way.  Not wanting to be the bearers of bad news, directors have by and large chosen door #2.

the actuarial assumptions

Adding to the woes of pension plan directors, the California Public Employees Retirement System (CalPERS), a leader in the public pension plan sphere, has begun to call into question the assumption that it can churn out average annual gains of +7.5%.

The surprise here, if any, is that CalPERS has finally decided to deal with this chronic problem.

More tomorrow.