Preliminary Reports Suggest Favorable Investment Returns for Pension Funds…this Year.

Commentary

Preliminary Reports Suggest Favorable Investment Returns for Pension Funds…this Year.

Preliminary fiscal year 2017 investment returns for public sector pension systems are starting to roll in, and the news is mostly good. At least for this year.

CalPERS and CalSTRS — the two largest public pension systems in the country — report 11.2% and 13.4% investment gains for this fiscal year, respectively. On the East Coast, the Maryland’s state employee retirement system reports 10% investment yields, far exceeding its 7.55% assumed rate of return. And more preliminary reports show other major pension systems in OklahomaConnecticut, and Virginia are following the suit, surpassing their annualized expectations.

This is a welcome change of pace for retirement systems across the country. Investment returns have been anemic for the past two years (2015 and 2016). Pension systems had mainly reported returns north of zero, but everyone had trouble breaking even with their return expectations, meaning plans were adding to their unfunded liabilities each year.

Some pundits attribute the 2017 market rally — especially yields on stocks — to the investors’ reaction to Donald Trump’s election, and his pro-business agenda. This may well be true. Though understanding the complex source of so-called market confidence is a complicated process, to say the least.

But just as one bad year won’t permanently alter a pension plan’s financial future, one year of impressively large investment gains doesn’t mean public pension systems across the country are out of the woods.

Assumed rates of return are supposed to be representative of long-run averages, not predictions for any specific year. Governments are still grappling with ballooning pension debts, while required employer contributions are cutting deeper and deeper into state and local budgets. And all of the indicators of a long-term future with weaker yields relative to averages of the past three decades remain in place.

While these high investment returns and economic activity have certainly been real in the short term, there’s evidence that the “Trump Bump” may be more of a sugar high. The IMF recently downgraded its projection for US GDP growth to 2.1% for 2017 and 2018, compared to 2.3% and 2.5%, respectively. As far too many economists and policymakers who should have known better are oft to forget, past performance does not guarantee future returns. Indeed, there’s more evidence to suggest that returns will be depressingly sluggish in the medium- and long-term due to structural features of the global economy that won’t change anytime soon.

More important for the immediate future of public-sector pension funding, this one-time investment boost, while certainly good, isn’t even close to a way out of the current pension crisis. As our colleague Anthony Randazzo has previously pointed out, the frequency — not necessarily the magnitude — at which plans achieve their assumed rate of return targets is what eventually shape the financial health of public pension plans.

Achieving long-run investment returns equal to their assumed rates hasn’t happened for most state and local pension systems. Even with strong yields this year, CalPERS’s 20-year average return is 6.6% compared to its assumed return of 7.5%, and the 15-year average is 7.0%. Similarly, CalSTRS’s returns averaged out to 7.0% in the past 20 years, falling short of its 7.5% return assumption.

To undo the damage caused by recent underperformance, plans like CalPERS will need to achieve oversized returns for the next several years, which is very unlikely. In response to this chronic failure to meet expected returns, the plans have lowered their assumed rates of return, and other systems across the country are beginning to follow suit.

According to Moody’s Investors Service, even the “best case” hypothetical scenario of a cumulative 25% investment returns between 2017 and 2019 (or about 7.7% per year) would only reduce unfunded pension liabilities by just 1%. Meanwhile, investment consultants are portending the new normal of low investment returns.

For example, earlier this year J.P. Morgan adjusted its 15-year return expectation for a 60% equity/40% bond portfolio by 75 basis points down to 5.5%-6.0% returns. This finding is consistent with similar forecasts from McKinseyVanguard, and others.

Another concern for plan administrators is the price funds have to pay when investing in riskier assets to chase higher returns. Most of this year’s gains are attributed to equities and alternative investments, such as private equity and real estateand bond prices have nowhere to go but down. As long as these higher returns come with increased risk (i.e. high variance), such investment strategies increase the chances of major losses in future.

The preliminary reports of investment gains this year are something to be happy about, but they won’t come close to fixing the structural problems facing many public pension systems.

Anil Niraula is a policy analyst at Reason Foundation.

Daniel Takash is a policy analyst for Reason Foundation's Pension Reform Project.