Private and public pension plans were able to make extravagant promises over the years by using unrealistically high return assumptions on the assets in their plans. In this way, workers and retirees could be promised generous benefits but funding burdens were minimal.
The game worked pretty well through The Great Bull Market of the 1980's and 1990's, when stocks returned 19% per annum and longer maturity bonds also posted double-digit returns. The problem came when stock returns plummeted, and interest rates moved to low single digits.
Private pension plans eventually gave up, and turned over the responsibility of retirement savings to their workers. The few companies that tried to maintain a pension mostly went bankrupt (e.g. General Motors).
Not so in the public sector. Union pressure and public apathy continued the push for more and higher retirement benefits. Politicians found it easier to make promises for the future, knowing that it was unlikely that they would have to ever have to figure out how to pay for everything.
Today's Wall Street Journal carried a story about Calpers, the huge California state pension plan, which is confronting market reality. The plan apparently is using a rate of return assumption of 7.75% on its pension plan, but numerous investment professionals are saying this is too high.
I would agree, but it's not that I'm necessarily bearish on the economy or the markets. It's really all about math.
Although the article doesn't mention the current asset allocation percentages of Calpers, the typical pension plan has a balanced mix of stocks and bonds. Let's just assume that Calpers has the traditional 60/40 split between stocks and bonds.
Bond yields today are low, as we all know. The 10 year Treasury note yields 3.60% at this writing, and the 5 year Treasury yields 2.30%. Even if Calpers goes totally into corporate bonds for the fixed income portion of its plan (where it could earn slightly higher yields), it is unlikely that the whole bond portfolio returns more than 4% (which I think is generous).
So what does the other 60% of the portfolio (invested in stocks, private equity and a few hedge funds) have to return in order to make the assumed 7.75%?
Using my high school algebra, it turns out that the "risky" part of the portfolio has to return 10.2%.
How likely is this?
It depends on how optimistic you want to be. Over the last 10 years, of course, stocks have returned essentially 0%. On the other hand, as I noted earlier, the period of the 1980's and 1990's saw much better returns.
Since 1926, stocks have returned somewhere between 8% and 10% per annum. However, a considerable portion of these annual returns came from dividends. Dividends added around 4% to the total return from stocks over this period, which means that the capital returns from stocks was around 6%.
However, the dividend yield on the S&P 500 today is 2%. Unless we see a dramatic increase in dividends (which may be desirable but unlikely, in my opinion), this means that the expected return from stocks should probably be closer to 8% for the next 10 years.
Plugging 8% into the equation yields a total return assumption of around 6% for Calpers.
Problem is, California has huge financial problems, so asking taxpayers to make up the difference between today's 7.75% assumption and the correct 6% implies a huge tax increase.
Let's see what Calpers winds up doing.
Here's the article: