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Why We Fight...about Pension Funds' Expected Returns

It just got real for California: Cities and counties feeling the budgetary pain of CalPERS lower discount rate. My thoughts...

In America’s public sector, the pension funds’ expected or assumed rates of return are used to discount the funds’ liabilities. So if you assume your pension fund is awesome (i.e., making 8.5% per year), then your pension liabilities will seem small. But if you assume your pension fund is simply average (say, making 6% returns), then your pension liabilities will be huge. And your public budgets will be affected.

Take California and CalPERS, which recently dropped its expected return 25bps (from 7.75 to 7.50). Even this small change has had tangible impacts on state and local government finances. Indeed, according to Fitch, this drop presents “near-term budget pressures” for budgets:

"We believe that this reduction presents the biggest risk to municipalities and counties with the least overall financial flexibility and strained relationships with their work forces."

For example, the city of Long Beach will see a bump in its pension costs of $7.7 million due to this decision. And, as you might expect, this annoyed the city’s Mayor:

“Simply put, pension benefits are too costly and not sustainable. This is not to point fingers at any of our city workers or the quality of job they do – it is just plain math.”

Yes it is. And the math is increasingly working against public authorities' budgets. Why? Because most pension funds aren’t anywhere near their assumed return targets. Check out the chart at the bottom of the page that one of my research assistants produced. (Thanks, George). It basically shows that return expectations are way out of line with the reality over the past 13 years.

Despite the lunacy of the return targets, politicians and Boards (i.e., proxies for the politicians at the pensions) will continue to fight hard against lowering the discount rates. Because allowing such a reduction would be the same as accepting a reduction in current spending. And, last I checked, politicians generally don’t like to reduce their spending.

OK. So what can be done? Unfortunately, the options aren’t all that appealing. Here’s a paper I wrote back in 2008 explaining this same problem:

“Local and state governments faced with these financial problems have few options with respect to their growing pension problems: they can issue pension obligation bonds, in effect taking the current pension liability and passing it on to future generations of taxpayers. (This represents a significant failure of political organizations to deal with the problem in the present.) They can increase contributions levels. They can cut government services or raise taxes, both unpalatable politically. Or, they can try to cut benefits, though this is frequently illegal. (In the past, state and local governments have even underfunded their pensions to free up space in budgets, but considering the issues under consideration in this paper, this also seems an unlikely solution.)”

That's a bit depressing. One option that politicians could pursue, however, would be to start resourcing their pension funds in a manner that renders the return objectives credible. In other words, if you really want your pension fund to make 8% IRRs, then you should build an organization that can do so! This may require paying high salaries that cab attract the types of people who will acheive those lofty objectives, but , to me, that seems like the path with the least pain.

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