How Rates of Return Affect Required Pension Contributions

April 27, 2011

In the post “How Rates of Return Affect Required Pension Assets,” the point is made that depending on the rate of return achievable by the pension fund, there are significant changes to what level of assets are required for that fund to remain solvent. This post takes a slightly different approach; looking at an individual pension participant, how do pension fund rates of return affect how much they will have to contribute into their pension each year?

To make this estimate, the same set of assumptions are used in this post as in the previous post; they are:

• The participant works for 30 years and they are retired for 30 years.
• The participant earns a pension equivalent to 66% of their final salary.
• The participant’s salary, in real (inflation adjusted) dollars, doubles at an even rate between the time they begin working and when they retire.
• The rate of return and the rate of inflation are held constant throughout the 60 year period under analysis.
• The rate of inflation is assumed to be 3.0% per year (this is CalPERS official projection, and is consistent with the historical average for the last 90+ years).

Here’s what we get:

There are a lot of takeaways here, but the most important is this:  Even at a return of 7.5% per year, which is actually slightly below CalPERS official long-term projected annual return of 7.75% per year, using these assumptions there is a contribution requirement of 24% of salary per year. This is well above what most cities and state agencies contribute to their employee pension funds each year. But what if pension funds acknowledge they will NOT be earning 7.75% per year any more? What if their earnings merely keep up with inflation?

As shown on the chart, for every 1.0% the real rate of return drops, the annual pension fund contribution as a percent of salary will go up by 10% or more, i.e., if the fund’s real rate of return drops from 3.5% to 2.5%, the amount required to be contributed into the fund as a percent of salary will go from 33% to 43%.

CalPERS spokespersons love to tout the “computer models” and “investment experts” who are confident they can continue to extract a long-term 7.75% return per year. But notwithstanding the fact that these are a lot of the same experts who had computer models that predicted the Dow Jones Average would reach 35,000 by 2005, or that there “might” be a housing bubble,  their confidence ignores several factors:

– The long-term inflation adjusted performance of publicly traded equities in the United States is not quite 3.0% per year, even taking into account dividend reinvestment. The Dow Jones average in 1930 was 286 (ref. Yahoo Finance), and the CPI was 17.1 (ref. Bureau of Labor Statistics). The Dow Jones average at the end of 2010 was 10,856, but the CPI had risen to 216.7. This means the inflation adjusted long-term performance of the Dow Jones average over the past 80 years was a paltry 1.4%. Compare this to CalPERS official long-term, inflation adjusted projection of 4.75% per year.

– Don’t rely on inflation to bail out pensions. The 2.0% annual cap on COLAs automatically lifts when pensioners have lost 20% of their purchasing power; the liability will then remain proportionally intact. This means it remains the fund’s real rate of return, after inflation, that has to be maintained.

– The potential of the U.S. economy to grow over the past 60 years, fueling these higher-than-sustainable historical returns for CalPERS and other pension funds was for two reasons that will not apply today: (1) the U.S. economy 60 years ago was the world’s only intact post-WWII economy, and grew at an extraordinary rate as we exported manufactured goods to the recovering economies elsewhere in the world. Today our manufacturers face formidable competition from developed and emerging economies all over the planet, (2) as the U.S. began to encounter global competition over the more recent decades, the U.S. embarked on a debt binge that is coming to an end.

– In past decades pension funds represented a smaller slice of the economy, meaning that they could beat the market without causing distortions. Today pension funds are the single biggest source of new investment in the U.S. They can no longer expect to beat the market. They are too big.

– A related challenge is the fact that pension funds are now servicing a growing number of retirees. The ratio of pensioners to active workers who participate in pension funds is approaching 1-to-1, meaning that fund withdrawals to make pension payments is reducing demand for equities because the pension funds are doing more selling than ever before. This, too, puts downward pressure on equities.

– The recent rise in equity values has to be viewed in the context of the above factors, which means what goes up may be coming down, but also in the context of the strength of the dollar. As the dollar devalues, the real value of U.S. equities shrinks apace. But if the underlying viability of these companies has not changed, their dollar denominated equity value has to adjust upwards in order for their value to stay neutral when compared to foreign currencies. And if the dollar strengthens (since all nations are competing to devalue their currencies these days), the value of U.S. equities – all else being equal – will fall again. And, to complete the thought, if the dollar doesn’t eventually rebound against foreign currencies, domestic inflation will offset any gains in equity values driven by dollar devaluation.

A serious discussion about what rate of return gigantic pension funds can really earn in America in this era, as opposed to previous eras, has not yet taken place. The performances of massive government worker pension funds hold dire implications for taxpayers who are on the hook to cover the difference whenever expectations do not meet reality. For these reasons, it would behoove CalPERS and other pension funds to trot their economists into the limelight to defend their assumptions, instead of hiding behind soundbites uttered by public relations specialists with well-modulated voices.