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 [...] Read More