State and local government pension funds are making unrealistic assumptions about their likely future returns.
That’s bad news for more than just the government workers whose retirement security is dependent on receiving their pension benefits. It’s also bad news for taxpayers who will ultimately foot the bill of overcoming shortfalls. And it’s also bad news for the economy as a whole, given the sheer size of those deficits.
To put the pension funding deficit into perspective, consider the student loan crisis, which has gotten lots of attention in recent years for its potential to trigger another credit crisis like the one we saw in 2008 and 2009. Total student loan debt is estimated to be $1.5 trillion, which turns out to be only a fraction of the state and local government pension fund shortfall.
Consider that such pension funds held $4.8 trillion in assets at the end of 2019, and that Goldman Sachs estimates that those assets represent less than 60% of pension fund liabilities. That implies a funding shortfall of over $3 trillion, double that of student loan debt.
And unrealistic return assumptions are likely to make the problem get progressively worse in coming years. According to a February report from the National Association of State Retirement Administrators (NASRA), the average public pension plan is assuming a 7.22% annualized return going forward. I seriously doubt this target will be met.
According to NASRA, the bulk of public pension plans -- 71% -- is invested in stocks and bonds, with approximately two-thirds of this amount allocated to stocks and one-third to bonds. Let’s first consider the contribution that bonds will make to hitting the pension funds’ return target. We know with some precision what that contribution will be, since bonds’ initial yield is very highly correlated with bonds’ long-term subsequent return -- as you can see from the accompanying chart. (The correlation coefficient of the two series is an incredibly high 0.97, just shy of the theoretical maximum of 1.0.)
So we can forecast with high confidence that bonds’ future return from here will be around 2.5% annualized, which is where Moody’s Seasoned Aaa Corporate Bond Yield currently stands. A quick back-of-the-envelope calculation tells us that stocks will have to produce a 9.5% annualized return in order for the average pension fund’s stock-bond portion to hit its return target of 7.22% annualized return.
That’s a long shot.
Consider the projections of seven valuation indicators I follow, each of which has a statistically significant track record of forecasting the stock market’s subsequent 10-year real return. I know of no other indicator that has as good a track record. These seven are: The q-ratio, the Buffett ratio, the price-to-book ratio, the price-to-sales ratio, the dividend yield, the cyclically-adjusted P/E ratio, and household equity allocation.
On average, these seven currently are projecting a 10-year real-return for the S&P 500 of minus 2.4% annualized. (The range is from minus 9.4% annualized on the low end to plus 2.4% annualized on the high end.) Add in expected inflation over the next decade of 1.2% annualized (according to a model devised by the Cleveland Federal Reserve) and we arrive at a nominal (before-inflation) return forecast of minus 1.2% annualized.
Putting together these bond and stock forecasts, our best guess of the future return of the stock-bond portion of the average pension fund is therefore about 1.7% annualized. That’s 5.5 annualized percentage points shy of the average fund’s target return.
None of this will come as a surprise to pension plan administrators, which is why they have steadily increased their allocations over the years to alternative investments -- now 19.3%, according to NASRA.
The hope is that these alternatives will produce much higher returns than equities, of course. My review of the research suggests that these advertised higher returns are exaggerated. But even if not, bear in mind that those alternative investments are much riskier, so during any economic downturn they could produce outsized losses. In any case, this alternative-investment category will have to produce wildly unrealistic returns to overcome stocks’ and bonds’ low expected future returns.
We can all hope that this analysis is wrong, of course. But hope is not a strategy. It is far better to be realistic, since the longer that state and local governments put off real solutions the harder it will be to overcome their pension funding shortfalls.
Each of us individually should also take these lessons to heart. While you may not know with precision the return target that is assumed by your retirement financial plan, that target very much exists at least implicitly. It behooves you to find out what it is, and then to subject it to historical scrutiny. If you decide that you should lower your return target, and that this in turn reduces your projected retirement income, it’s far better to know that now and plan accordingly.