Hard Lessons From the Coming Public Pension Plan Shortfall

Mark Hulbert says state and local governments will be hit hard by disappointing returns -- a lesson we all should take to heart.
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I predict that state and local government balance sheets, already reeling from the pandemic, will be devastated in coming years by the stock and bond markets’ disappointing returns.

That’s because these governments’ pension plans are based on unrealistic assumptions about how those markets will perform in the future, and are therefore woefully underfunded. In fact, even with their optimistic assumptions, those funds are already underfunded. Their “actuarial funded ratio” (the ratio of the actuarial value of their assets to the actuarial value of their liabilities) is just 71.5% currently.

These plans are hoping to make up their actuarial deficits by earning outsized investment returns. I’m willing to bet their earnings instead will fall far short of historical averages, and they will have to make up the shortfall either by raising taxes, cutting services, or declaring bankruptcy.

By analyzing their financial woes we can get insight into the adjustments we need to make to our own retirement portfolios.

According to the National Association of State Retirement Administrators (NASRA), the average state and local pension plan is currently assuming it will earn long-term investment returns (the next 20 or 30 years) of 7.13% annualized. To understand why that’s unrealistic, let’s review the expected future returns of each of the major categories of the average state and local government pension plan’s asset allocation:

Public equities: 47%. Given how overvalued the stock market currently is, there is a good possibility that it will go nowhere over the next decade or two — if not worse. Consider eight valuation indicators that prior research has found to have the greatest predictive power in explaining the stock market’s long-term returns. On average they are projecting that the S&P 500 over the next decade will produce an annualized return of minus 3.8%.

Fixed income, including cash: 25%. Unlike the situation with stocks, we can be highly confident what bonds’ long-term return will be: It will be very close to their current yield, which is 2.90% annualized (as judged by Moody’s Seasoned AAA Corporate Bond Yield).

Alternative investments: 28%. This category includes a number of sub-categories, including private equity (9%), real estate (9%), hedge funds (6%), and commodities (2%). Though projecting this hodgepodge’s long-term returns is even harder than it is for public equities, simple math tells us that the category overall will have to produce a 29% annualized return if my projections of the other two categories’ returns are on target and if pension plans are able to live up to their 7.13% annualized return assumption. Though individual hedge funds and private equity funds are able to produce returns that good in individual years, they on average come nowhere close. Since the beginning of 1994, for example, the Credit Suisse Hedge Fund Index has produced an annualized return of 7.4%, versus 10.5% for the dividend-adjusted S&P 500. And there’s also serious doubt that private equity, on average, outperforms the public equity market over the long term.

A Lesson for Everyone

You might think this discussion is irrelevant to you unless you are an employee of a state or local government. But that would be short-sighted. This discussion provides an object lesson for all of us in the dangers of constructing our retirement portfolios with rose-colored glasses.

Consider the National Retirement Risk Index (NRRI), which “measures the share of American households that are at risk of being unable to maintain their pre-retirement standard of living in retirement.” According to the Center for Retirement Research at Boston College, the author of the NRRI, it currently stands at 51%. In other words, more than half of households are at risk of having to cut their standard of living when retiring.

Read, from Robert Powell: What Retirement Savers Need to Know About Capital Gains Tax Changes.

So pension plans are not alone in making unrealistic assumptions.

The risk, for both pension plans as well as us individually, is trying to make up for retirement funding shortfalls by incurring ever-greater risk. That may work over the short term, so long as the markets continue going up. But that greater risk eventually will lead to outsized losses and result in falling even further behind.

If our retirement plans are unrealistic, there’s no better time to make adjustments than during a bull market. Those adjustments only become more painful the longer we wait, especially if we were to wait until after we endure a major bear market.