Public Sector Pensions – The Investment Return Conundrum




Since the fervor on the topic of public sector pensions seems to be ongoing, I thought I would add another element to the discussion in pursuit of a fully informed readership. That element is the investment of pension fund assets with the intent that investment income will help pay for pension promises made.

Investment income is an important component of the financing of pension funds and future earnings must be forecast in order to develop employer and employee annual contribution rates. Public retirement funds often use an annual investment return estimate of 7% to 8%. A recent study of the State PERS retirement system by a group of Stanford University graduate students used what researchers felt was a “more realistic” 4% rate of return and the results more than doubled the forecast unfunded liability of the fund. Some anti-public pension organizations and advocates feel this proves that the fiscal health of public sector retirement funds is worse than admitted and that a future pension tsunami is a certainty, while others view the use of such a low rate of return as a tool to grow the hysteria over public pension fund financing.

One of the many criticisms directed at public sector retirement funds is that the estimated rate of investment return they use to determine how much each employer and employee must contribute to the fund each year are unreasonably high, thereby producing a lower annual contribution requirement for the public agency employer and the employees. Public sector retirement funds tend to base their estimated average annual investment return on their own rate of return experience or history over time. Thus there is a track record that the estimate being used has been what has been achieved in the past. The issue seems to boil down to whether using past results to estimate the future is realistic in today’s world. And if it isn’t, what is a reasonable approach to develop an assumed rate of investment return?

The following investment return information is illustrative of the wide range of return rates that have been realized in the past:

  • The June 13, 2011 issue of Fortune magazine, in a story titled “Retirement Guide 2011- Take Control and Win” reports that “The S&P 500 has returned an average of 9.1% annually over the past 20 years, yet the average equity investor earned only 3.8% annually over that period, says research firm Balbar”.
  • The Orange County Employees Retirement System (OCERS) reports that its investment rate of return in 2009 was 18.52%, and in 2010 it was 11.7%. My review of OCERS data led me to conclude that over the last decade the funds’ rate of investment return was 6.52%, including the unprecedented recession-driven loss of 20.71% in 2008.

Are there any fiscal experts out there in O-Juice land who would like to stake their reputation for accuracy on any particular investment return forecast going forward over the next 20 years or so? Please enlighten us!

About Over But Not Out

A retired Orange County employee, and moderate Republican. The editor seriously does not know OBNO's identity as did not the former editor, but his point of view is obviously interesting and valued.