Why Pension Fund Returns Will Drop Below 7.5%

Why Pension Fund Returns Will Drop Below 7.5%

One major premise underlying the criticisms leveled at pension reformers is that defenders of the current system believe 7.5% is a realistic long-term rate of return for pension funds. This is problematic for several reasons:

1 – A return of 7.5% is too high for the economic era we’ve been living in since 2008, and will be living in for at least another ten years. During the great debt binge that started in the 1980’s, accelerated in the 1990’s, and went totally out of control since around 2000, debt as a percent of GDP in the US tripled; it is now nearly 400% of GDP (that’s all debt; consumer, commercial and government, and does NOT included unfunded liabilities for future commitments such as pensions). This is a higher level of debt than during the great depression. It is difficult to overstate the impact that accumulating debt had on economic growth and therefore on investment returns – with people borrowing more than they were paying back, money was being injected into the economy and this stimulated consumer spending and corporate earnings. Stock and asset values grew accordingly. It is equally difficult to overstate the problems caused when people now have to pay back more than they can borrow. This means there is less money for purchases which stimulate economic growth, which means asset values decline and returns on investments drop.

2 – Along with the fact that we’re now in an era of debt reduction instead of debt accumulation is the reality of our aging population. As the ratio of workers to retirees shrinks, and there are fewer workers for every person retired, the number of people who are liquidating their savings and investments instead of accumulating savings and investments grows. This means there are going to be more people selling assets in the future than there used to be. In any market, this means lower prices. Equities and assets are no longer going to appreciate the way they used to because more people will be selling them to finance their retirements than before.

3 – When pension funds used to earn an average return of 8.0% or more per year, year after year, they were smaller players in the market than they are today. Now that people are beginning to retire under pension formulas that are far better than in past decades, these giant funds will have a much more difficult time outperforming the market. They will be paying out as much in pensions as they are investing with contributions from current workers. And because these pensions are now so big – with over $4.0 trillion in assets already – these pension funds will themselves also start to exert downward pressure on asset values because they are going to be selling as much as they are buying. When public sector pension funds administered smaller benefits to fewer people, and they were buying more than they sold, they could beat the market, and they could exert upwards influence on the market. Now they are the market, and at best their impact on market values is neutral.

4 – Even if public sector pension funds can deliver 7.5% returns into the future, why are taxpayers guaranteeing these returns? Why on earth should taxpayers bail out these pension funds if they don’t hit these long-term projections? When private citizens who have to save for retirement see their investments drop in value, should they really be required to pay higher taxes in order to guarantee the defined benefits for government workers?

5 – The whole idea of investing taxpayer funds in the market for one class of workers, government workers, while providing only social security to everyone else – at a level of benefits far less generous (but far more sustainable) – is fundamentally unfair. Particularly when taxpayers have to make up the difference. Taxpayer supported pension funds should be, ideally, completely out of the business of making high risk investments.

The reality is this:  Public sector unions demanded and got pension benefits for their members that are nowhere near sustainable unless these returns – 7.5% per year or more – can be delivered by pension funds for decades to come. If defenders of public sector pensions are so confident that long-term annual returns of 7.5% or more are achievable, they should have no problem releasing taxpayers from the obligation to make up for any shortfalls that may occur.

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