Pensions are Still Hiding from the Truth

By Phonlamai Photo @ Shutterstock.com

For years I’ve been writing about how badly pension funds have been ignoring reality when it comes to return expectation (read a sample of these posts here, here, and here). Funds have a choice to make when they set their return expectations, they can:

Shoot low, and require governments or companies to put more funding aside to fund the pensions, or
Shoot high and gamble on having strong enough returns to make up for under-funding their liabilities

Most funds have chosen the second option. This is unfortunate, and could lead to millions of retirees getting less than they were promised years from now when reality finally comes to call.

In the Wall Street Journal, veteran writer Jason Zweig gets brutally honest about this practice at pension funds. He writes:

A new study by finance professors Aleksandar Andonov of Erasmus University Rotterdam and Joshua Rauh of Stanford University looks at expected returns among more than 230 public pension plans with more than $2.8 trillion in combined assets.

For their portfolios, generally consisting of cash, U.S. and international bonds and stocks, real estate, hedge funds and private-equity or buyout funds, these pension plans report that they will earn an average of 7.6% annually over the long term. (That’s 4.8% after their estimates of inflation.) These funds often define “long term” as between 10 and 30 years.

Based on how they divvy up their money, how much are these pension funds assuming specific assets will earn?

They expect cash to return an average of 3.2% annually over the long run; bonds, 4.9%; such “real assets” as commodities and real estate, 7.7%; hedge funds, 6.9%; publicly traded stocks, 8.7%; private-equity funds, 10.3%.

Let’s put all that in perspective.

Take cash first. Three-month U.S. Treasury bills yield 1.4%. The highest-returning institutional money-market funds yield 1.5%, according to Crane Data.

How could cash earn more than twice that rate of return over the long run?

To be fair, Treasury bills over the past half-century have returned an average of 4.8% annually, according to the Federal Reserve. But short-term interest rates would have to rise sharply for cash to earn close to that.

Next, consider bonds. The simplest reliable indicator of how much you will earn from a portfolio of bonds in the future is their yield to maturity in the present. With 10-year Treasurys yielding 2.6% and investment-grade corporate bonds averaging under 3.7%, it would take a near-miracle today to get anything close to 4% out of a high-quality fixed-income portfolio.

Yet the pension plans are expecting their bonds to earn 4.9%.

That isn’t impossible, either, if they throw safety to the winds and buy boatloads of high-yield “junk” bonds and other risky debt. The whole point of a pension fund, however, is not to take excessive risks.

How realistic is the expectation that stocks will return an average of 8.7% annually into the distant future?

That’s below the U.S. average of 10.2% annually over the past 90 years. But stocks were far cheaper over most of that period than they are today, so their returns were naturally higher.

E.J. Smith - Your Survival Guy

Preparing your investments and family for when disaster strikes.

E.J. Smith is the Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH, where he completed course-work in Practical and Defensive Handgun, Conceal Carry Pistol, Shotguns, Precision Scope Rifle and Kidnapping Prevention. E.J. plays a Yamaha Recording Custom drum set with Zilldjian cymbals. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@youngresearch.com. Sign up here to receive all the best content from Richardcyoung.com each week.