Crucial to any analysis of pension fund solvency is determining what rate of return a pension fund can earn. And in any such analysis, the “real” rate of return is what matters. It doesn’t matter, for example, if a pension fund investment yields double-digit annual returns, if the fund is returning these impressive numbers in an economy in the grips of double-digit inflation. The real rate of return for any investment is calculated by taking the actual return, or nominal return, and subtracting from that the rate of inflation. For example, CalPERS currently uses a nominal rate of return of 7.75% for their fund’s earning projections, and they assume a 3.0% rate of inflation. Therefore CalPERS currently projects their fund to earn a 4.75% real rate of return.
In several previous analyses we have examined the implications of these rates of return on the ability of pension fund investments to remain solvent. Basically, the higher the real rate of return on pension investments, the lower the required annual payments necessary to adequately fund the same level of future retirement pension benefits. By the same logic, if pension investments earn higher than anticipated real rates of return, it is possible to increase future benefit commitments without increasing the annual funding payments. This second case is what happened back in 1999, during the height of the internet boom, and continued right up until the financial crisis that began in 2007. Even after these bubble booms went bust, some public employee unions continue to push for higher retirement benefits. But in order to consider what may be an equitable and affordable pension, one must decide what rate they believe, ultimately, constitutes a sustainable pension fund return.
We have already looked at this in-depth. In the post “Real Rates of Return,” we estimate how many retirement years a public safety employee can enjoy a solvent pension based on inflation-adjusted fund returns of 3%, 4%, and 5%. We assume the employee works 25 years, and enjoys a 3.0% inflation-adjusted (real) per year increase in pay. We assume that their pension fund payment each year is equivalent to 23% of their salary in that year, which is a typical contribution percentage. We assume that based on 25 years work, times 3.0%, entitles the pensioner to receive 75% of their final year’s wages during their retirement years. Using these assumptions, if the pension fund earns a real rate of return of 3.0% per year, the fund will only have enough set aside to last 19 retirement years before going broke. At a rate of 4.0% per year, the fund will remain solvent for 27 retirement years, and at a rate of 5.0% per year, the fund will remain solvent for 51 years! This is a dramatic difference in scenarios, even though there is only a 2.0% difference between the low estimate of 3.0% and the high estimate of 5.0%. Can CalPERS earn a real rate of return of 4.75% per year? We’ll come back to that.
In the post “Maintaining Pension Solvency” we looked at this slightly differently. We assumed a 30 year working career, followed by a 30 year retirement. We then examined four cases, in all four cases solving for what the contribution percentage would have to be each year – as a percent of salary – in order for the pension fund to remain solvent. The results are interesting:
(1) At a real rate of return of 4.75% per year, a worker would need to set aside an additional 21% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 60% of their paycheck.
(2) At a real rate of return of 4.75% per year, a worker would need to set aside an additional 32% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 90% of their paycheck.
(3) At a real rate of return of 3.00% per year, a worker would need to set aside an additional 35% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 60% of their paycheck.
(4) At a real rate of return of 3.00% per year, a worker would need to set aside an additional 52% of their salary each year for 30 years, in order to enjoy a pension benefit during a 30 year retirement equivalent to 90% of their paycheck.
All of this is to make clear just how crucial it is to make a realistic assumption regarding pension fund returns. CalPERS makes a projection of 4.75%, which they believe to be a prudent number. I believe a real rate of return of 4.75% is not a prudent number, but a best-case number.
Rates of returns on passive investment funds that are measured in the trillions of dollars – which is what pension funds, in aggregate, constitute – cannot grow at rates that exceed the rates of growth of the economies in which they invest. This is because sustainable financial returns are tied to profits, which are, ultimately, tied to (after-tax) operating cash surpluses. These surpluses normalize over time, increasing, for example, when debt is accumulating and spending is stimulated, and decreasing during the inevitable periods when debt is being reduced. If the economy at large is expanding at a real rate of 4.75% per year, then it is reasonable to expect, in aggregate, passive investments can yield similar returns. But over the long-term, economic growth is not demonstrably this robust. In the post “Humanity’s Prosperous Destiny,” there is a chart that compiles data on global economic growth over the past several hundred years. The data indicates a rate of global economic growth of under 2.0% per year until the 50 year period beginning in 1850, when the industrial revolution began to spread around the world. Here’s the reported numbers, in 50 year increments: 1850-1900, 2.2%; 1900-1950, 2.6%; and 1950-2000, 4.6%. But digging deeper, about 1.0% of that 4.6% was the result of unsustainable economic expansion associated with the internet boom.
It’s hard to parse macroeconomic trends, but if you accept the premise that a trillion dollar passive investment cannot sustain growth rates greater than general economic growth, 4.75% definitely becomes a best-case real rate of return. I would argue that a 3.0% growth rate is a more prudent estimate, particularly taking into account the adjustments of the past ten years, and the adjustments ahead as we painfully wring debt out of the system.
Another example of why a real rate of return of 3.0% may be a much more prudent estimate for CalPERS and other pension funds to use in their projections is found by examining the inflation-adjusted performance of the Dow Jones stock index over the past 85 years. An excellent chart can be viewed on “Dogs of the Dow,” a website where the performance of the Dow is charted as it would appear if growth between 1925 and 2010 were adjusted for inflation. If you examine this chart, you will see that the Dow’s value increased roughly ten-fold over the past 85 years – after inflation. While that sounds pretty good, it equates to an inflation adjusted return of 2.8%.
Do you still want to bet your civic solvency on a real rate of return of 4.75%? And if you would prefer to prudently adopt a 3.0% rate of return for your projections, are you prepared to allocate to pension funding an amount each year equivalent to 50% of each of your employee’s annual salaries, in order to keep their retirement pensions solvent? As cities and counties and states stand already on the brink of financial catastrophe, the consequences of unwarranted optimism deferring painful negotiations are more dire than ever – ask anyone who holds municipal bonds, or is taxed enough already.