The Role of the Investment Return Assumption

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

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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