20 May 2018

Pension Funds Making Promises They Can’t Keep

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The value of investments by public pension funds declined last quarter, widening the gap between what these funds say they will earn and what they actually make.

Pension funds across the U.S. must each year estimate how much they expect to earn on investments, a projection that determines the amount the government that is affiliated with the pension fund must pay into it. Robust returns reduce the need for government support.

But forecasts don’t always square with funds’ actual experience. Retirement plans across the country still project their investments will increase at a median annual rate of 7.25%, according to Wilshire Consulting, an adviser to pension funds. Yearly returns on public pension plans have returned a median 6.79% over the past decade and 6.49% over the past 20 years, according to Wilshire Trust Universe Comparison Service, a database.

Unlike corporations, public pensions have wide latitude in projecting investment returns.

In the first quarter, public plans lost a median 0.23%, according to Wilshire TUCS. Such a lackluster return will serve as a reminder to the public officials who manage billions of dollars in pensions for America’s firefighters, police and other public workers of the daunting shortfalls many funds face.

“With all of the major asset classes falling, it was pretty tough for investors to have any positive returns. They didn’t have much of a chance to make money,” said Robert J. Waid, managing director at Wilshire Associates.

Public retirement systems had an average 72% of assets they need to pay for retirement promises in 2016, according to the latest data available in the Public Plans Database, which tracks about 170 pension funds. The figure a decade earlier was 85%.

Before the first quarter, pension plans had experienced nine quarters of positive returns. That rise had brightened the picture for public retirement systems and closed some of the gap between expectations and reality.

These pension funds have also steadily narrowed this gap on their own. Three-quarters of the 129 state pension plans monitored by the National Association of State Retirement Administrators have reduced their investment return assumption since fiscal year 2014.

But government officials seeking to make their investment targets more conservative have a powerful disincentive: Assumptions of high returns appeal to elected leaders because they reduce the amount governments need to set aside to cover pension promises. For some, pensions have already caused budget pressure.

Companies don’t have the same flexibility to set return expectations on pension plans. Pension plans sponsored by S&P 1500 companies have an average 87% of assets needed to cover their pensions promises, according to consulting firm Mercer.

California and its school districts will have to pay a projected $15 billion or more into a state public worker pension plan over the next 20 years after the plan, the California Public Employees’ Retirement System, in 2016 decided to reduce its investment target to 7% from 7.5% over a three-year period.

Other governments—loath to cut services or increase taxes—have made a riskier choice, putting more of their money into riskier investments with higher expected returns, such as real estate, commodities, hedge funds and private-equity holdings.

These alternative investments rose to 26% of holdings at about 150 of the biggest U.S. funds in 2016, according to the Public Plans Database, compared with 7% more than a decade earlier.

“They’re taking a lot [of] risk in their plans with high allocations to equity and other return-seeking assets,” said Ed Bartholomew, a consultant. “Someone is bearing that risk, and the question should always be ‘who is bearing that risk?’ ”

Birmingham, Ala., raised its target rate on one of its pension funds to 7.5% from 7% in 2016 after moving some of the money out of fixed-income investments and into stocks. The move made the city’s annual contribution to the Retirement and Relief System less costly than it otherwise would have been.

“Why Birmingham changed the investment rate return…is a bit questionable,” said Richard Ciccarone, president and chief executive of Merritt Research Services LLC, a research firm.

A city finance official said in an email that the state had reduced the amount of fixed-income investments the fund was required to hold and now “allows greater flexibility for investment management.” He said the change was made with the advice of an actuary and an investment consultant.

But Tom Aaron, senior analyst at Moody’s Investors Service, said the temporary budget relief comes at a price.

“You’re supplanting a budgetary contribution with increased risk taking. If those [investment] assumptions don’t pan out, that’s going to result in higher than expected budgetary contributions down the road.”

Click here for the original article from The Wall Street Journal.

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