In many aspects of our financial lives we’re cautioned that “past performance is no guarantee of future results.” Oddly though, in the world of public sector pensions – among the biggest institutional investors in global markets – politicians regularly ignore that mantra. Lawmakers pretend they can count on big investment returns every year, while disregarding warning signs, mounting debts and increasingly unsustainable pension systems.
We’re seeing the latest pension fund returns come in, and almost uniformly, it was a terrible year for states – and thus taxpayers. The California Public Employees’ Retirement System, the largest U.S. public pension fund, logged a paltry annual return of 0.6 percent.
Pension systems saw big investment returns for a few years as the stock market rose and recovered from the 2008 crash. CalPERS got astronomical returns of 13.2 percent in 2013 and 18.4 percent in 2014, but those past results weren’t guaranteed to continue. And they haven’t.
CalPERS got a return of just 2.4 percent in 2015, yet happily predicted a return of 7.5 percent for 2016. These miscalculations and poor returns – earning 0.6 percent instead of 7.5 percent this year – matter greatly because when public pensions fall short of having the assets needed to meet their benefit promises to retirees, taxpayers must pay for the difference.
Notably, CalPERS was fully funded in 2007, before the Great Recession, but the subsequent boom years did not return it to fully funded status. CalPERS is currently only 76 percent funded, a figure that will inevitably drop given the latest weak returns.
Pension systems tend to take a “stay the course” attitude though, suggesting that what matters most is their long-term performance. They argue they can weather a bad year or two – or even a recession – given their long investment horizon.
While on the surface this seems like a logical position to take, there’s a growing chorus of market analysts and economists warning that we’re in a “new normal” – a fundamentally different marketplace than we’ve seen the last 30 years. A major factor is the sustained period of historically low interest rates that we’re in, which forces pension funds to invest in riskier and more volatile investments to try and hit their investment targets.
A recent report from McKinsey & Company validates this view, suggesting that investment returns over the next 20 years look much worse than the last 30, with equity returns projected to be up to 50 percent lower and bond yields to be as much as 60 percent to 100 percent lower. Even CalPERS’ own chief investment officer recently noted we’re “moving into a much more challenging, low-return environment.”
“The longer-term returns of the fund – the three-, five-, 10-, 15- and 20-year total returns of the fund – are now below the assumed rate of 7.5 percent for the fund,” Chief Investment Officer Ted Eliopoulos said.
Complicating matters further is that if pension systems, like CalPERS, adopt more conservative investment targets – which they should – there will be a cost. Lowering a pension fund’s assumed rate of return to more realistic levels means that employers and employees will have to contribute more money to pay for promised retiree benefits.
State agencies and local governments participating in CalPERS have already seen their contribution rates skyrocket since 2000. Thus, the prospect of even higher contributions to pensions – even in the interest of promoting less risk-taking and greater long-term solvency – is going to be very unwelcome news. But costs will rise even more if the current situation is ignored, thanks in part to compounding interest.
To deal with this massive financial challenge, policymakers and union leaders need to admit the status quo is unsustainable. They are clinging to return expectations and benefit structures designed for a world that no longer exists. Continuing to reject calls to reform the way investment returns are estimated and pension benefits are awarded will only lead to growing pension insolvency. Ironically, the unions and state leaders failing to grapple with these issues are ultimately jeopardizing the retirement security of their own members and fellow government workers.
Leonard Gilroy is senior managing director of Reason Foundation’s Pension Integrity Project (reason.org).