Conventional wisdom says that public sector pensions are far too optimistic in assuming an 8-percent investment return. Indeed, the stock market has far underperformed that goal lately, leaving pension plans in precarious financial shape.
But, if we expand our time frame to a longer horizon of, say, 25 years, it turns out that conventional wisdom is false. Using actual investment return results from state pension plans as of the end of 2012, the National Association of State Retirement Administrators found that median investment returns actually exceeded state targets over longer time periods:
5 years: 2.9 percent
10 years: 7.5 percent
20 years: 7.9 percent
25 years: 8.9 percent
This 25-year period included the bull market of the 1990s, one of the longest economic expansions in modern history, but it also included the subsequent crash, the disappointing 2000s, and the Great Recession of 2007-09. It wasn’t a “typical” 25-year period, but no 25-year period is typical. In fact, if you look at the performance of a balanced investment portfolio over long time horizons, it almost always beats state investment assumptions. As is often repeated, past performance is no guarantee of future results, but we shouldn’t ignore it, either. It’s tempting to focus on how bad the last five years have been, but it would be odd to argue that we should pay attention to only very recent history while disregarding the longer perspective.
So why are state pension plans in such poor financial shape today? There are two main reasons. One is that at the end of the 1990s, when state pension plans looked like they were in great shape, many states adopted benefit enhancements. State legislators looked at well-funded retirement plans, buoyed by an amazing stock market run, and decided they could support higher benefit payments. They couldn’t. Inevitably, short-term thinking put them in trouble today.
Second, the plans suffer from tremendous volatility. Investment returns now contribute about two-thirds of a pension plan’s earnings in a given year. When they turn negative during an economic crash, plan funding falls precipitously. But looking at a state pension plan after a recession and declaring it financially insolvent is no different than spendthrift state legislators expanding benefits at the end of the 1990s. They’re both driven by short-term thinking.
This second point is important, because there’s a difference between short-term volatility and long-term investment return assumptions. As the data show, the former is a real problem while the latter is not. States could begin to address the volatility problem by taking some easy first steps. For example, instead of setting one investment assumption, they could acknowledge their pension savings are susceptible to market swings by making high and low projections. During flush years, they should hesitate from making hasty benefit enhancements or temporarily pausing state or employer contributions.
This blog entry first appeared on The Quick and the Ed.