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Public pensions’ unrealistic rate of return assumptions

By Edward Zelinsky


Ten years ago, the financial problems of public employee pensions concerned only specialists in the field. Today, the underfunding of public retirement plans is widely understood to be a major problem of the American polity. Underfinanced public pensions threaten the ability of the states and their localities to provide basic public services while paying the retirement benefits promised to state employees.

Most public pensions mask their underfunding by assuming unrealistically high rates of return for pension assets. The longer the underfunding of state retirement plans is ignored in this fashion, the more difficult will be the ultimate adjustments required of state employees and taxpayers.

When public pensions earn less than the rates of return they assume, taxpayers must pay more to provide public employees their promised retirement benefits, or such benefits must be curbed to reflect reduced funding — or some combination of taxpayer financing and benefit curtailment must bring pension obligations into line with lower pension assets. Elected officials often prefer to perpetuate unrealistic rate of return assumptions rather than confront these painful choices.

To take one prominent example, the California Public Employees’ Retirement System (CalPERS) is the Golden State’s main pension plan for state and local employees. By some measures, CalPERS is the nation’s largest pension plan for public employees. In March of this year, the board of CalPERS purported to confront economic reality by reducing CalPERS’ assumed rate of return on its investments by .25%. Specifically, the CalPERS’ board reduced the plan’s assumed rate of return from 7.75% to 7.5%.

We live in a time when stock markets are performing erratically and short-term interest rates are effectively zero. Nevertheless, California’s pension plan unrealistically claims that its assets will earn an average annual return of 7.5%.

The troubling nature of this assumption recently became apparent when CalPERS reported that it actually earned only 1% over the preceding 12 months. Despite this dismal performance, CalPERS still asserts that it will earn 7.5% on the investment of its pension assets.

CalPERS’ defenders can note that the annual investment return of 7.5% is a long-term assumption and that CalPERS’ dismal investment performance this year was balanced by better investment returns in earlier years. Neither of these defenses is comforting.

We are likely to be in a low-interest rate environment for the indefinite future. Although interest rates will increase at some point in the future, it is unlikely that they will bounce back any time soon to the levels postulated by CalPERS. Public pension plans like CalPERS ignore this reality by assuming investment returns of 7.5%.

The problem of unrealistically high rate of return assumptions is not limited to the Golden State’s pension for its public employees. The problem is ubiquitous throughout the nation.

For example, the Maryland State Retirement and Pension System has just announced that its investment returns for the twelve months ending on June 30th was even worse than CalPERS’ performance. The Maryland pension plan earned just 0.36% on its assets, even as it promises annual investment returns of 7.75%.

A distinguished task force chaired by Paul Volcker and Richard Ravitch has recently highlighted the seriously unfunded condition of public pensions nationwide. This systemic underfunding, the Volcker-Ravitch task force concludes, is hidden by unrealistically high assumptions about public pensions’ rates of return: “The most significant reason for pension underfunding is that investment earnings have fallen far short of previous assumptions.”

Even using public pensions’ overly-optimistic return assumptions, the Volcker-Ravitch task force tells us, such pensions are unfunded nationwide in the amount of one trillion dollars. Bad enough. Using more prudent, i.e., lower, assumptions about expected rates of return, the nationwide underfunding of public pensions may be as large as three trillion dollars.

The implications of these numbers are sobering. Tax money must be diverted from vital public services such as police, fire, and education to finance pensions promised to public employees but not properly funded.

The problem of underfunded public pensions cannot be solved until it is acknowledged. Unrealistically high rate of return assumptions, like those embraced by CalPERS and other public retirement plans, mask the magnitude of the underfunding of public pensions. The refusal to confront the problem of pension underfunding may help state officials to get re-elected by kicking the proverbial can past the next election, but the problem cannot be ignored indefinitely. The longer the problem of underfunded state pensions is ignored, the more difficult will be the ultimate adjustments required of state taxpayers and state employees.

Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University. He is the author of The Origins of the Ownership Society: How The Defined Contribution Paradigm Changed America. His monthly column appears here.

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4 Responses to “Public pensions’ unrealistic rate of return assumptions”
  1. CalPERS earned over the year before last. Additionally, for many years employer contributions to CalPERS were reduced because the fund was doing so well. Markets go up and down. The financial crisis that brought on the Great Recession will take years to recover from. That doesn’t mean long-term earnings assumptions are bad.

  2. Sorry, 1st sentence meant to say, CalPERS earned over 21% the year before last.

  3. Joe Santori says:

    The assumed rate of return should match long-term expected averages. The 30 year average return for pensions is over 7%.

  4. [...] precarious financial state of California’s pension plans demonstrates the wisdom of this fiduciary rule. The Golden State’s public pensions are seriously [...]

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