Defined benefit pension plans are a thing of the past for most private companies. Those plans guarantee payments to retired employees based on years of service. While a wonderful concept that was viable when American industry had little competition following World War II, these plans became untenable as worldwide competition increased. As a result, most American businesses that offer pension plans have moved to 401(k) &plans whose funding requirements are more flexible and can be kept in line with a company’s economic realities.
In defined benefit pension plans, the real costs are hidden within complex actuarial tables that require assumptions on long-term returns. Should the assumptions be overly optimistic, which they often are, what may look like a financially healthy company quickly become insolvent.
While most of the private sector has addressed its pension responsibilities, the public sector still offers many governmental employees defined benefit pension plans. This has created a dangerous economic model for many municipal and state governments, which is being exasperated by decreasing returns for pension plan investments.
Timothy W. Martin’s recent article in the Wall Street Journal highlights the growing problem of public-sector pension plans. The problem is being brought to a head as long-term plan assumptions by necessity are being decreased due to the long term economic downturn and low interest rates available on fixed income investments.
Historically, annual pension return assumptions have been set at 8%. This assumption was used to calculate the rate of growth of pension fund investments. This rate of return has not obtainable for some years. However, the 8% return rate assumption was maintained by pension fund managers as a way of masking problems within their funds. As a result, states and municipalities were able to underfund their plans and push liabilities off to a future time. That time is rapidly approaching.
Martin points out that:
- Over 60% of state retirement systems have cut their assumptions in the past seven years with the average now being just under 7.7%. This Blog proffers the view that even this lower assumption is overly optimistic. In fact, it has been reported that for the first half of this year the average annual return for pension funds was less than 4%.
- Last week one of the nation’s largest public pension funds, the New York State Common Retirement Fund, cut its return rate a half a point to 7%. Similarly, the San Diego County Employees Retirement Association cut its assumption quarter point to 7.5%. The Oregon Public Employees Retirement System and Texas Municipal Retirement System have also lowered their forecasted return rate by a quarter point.
- America’s largest public retirement fund, The California Public Employees’ Retirement System, is considering dropping its current return assumption rate from 8%.
While lowering the return assumptions by state and local governments is ultimately a positive step, forcing governments to adequately fund their pension obligations, there is significant pain associated with this action. Increased taxpayer dollars will be required to fund the pension plans. This will decrease funds available to support governmental services. For example, Martin reports that Boulder, CO has eliminated 100 positions and cut services in order to add $1.7 million to its pension fund.
States and municipalities have increased their funding of pension programs by over $120 billion in the past 10 years. That would pay for a lot of government services!
Pension problems for state and municipal governments will grow significantly since even the new lower assumptions are overly optimistic. In the 1960s, for example, return assumptions were less than 4%. Should pension fund returns approach those levels, the result would be catastrophic. As Martin points out, every 1% decrease in a fund’s returns leads to a 12% increase in the pension’s liabilities.
While the looming public pension crisis was created by state and municipal governments using unrealistically high return assumptions and offering benefits that they could not afford, the problem has been exasperated by the low interest rate policies of the Federal Reserve that further depresses fund returns. This is one example of the significant consequences of the Fed’s interventionist policy that has distorted expenses for some, cajoled investors into higher risk investments as they seek returns, and created bubbles including overpriced equity valuations. These problems are just now beginning to percolate. When they boil over, books will be written on the fallacy of the Federal Reserve’s low interest rate policies.