What’s your prediction for investment returns over the next 30 years?
If anyone knew the answer to that precisely, they may well be both clairvoyant and very wealthy. In reality, financial experts do seek to understand how the macroeconomic forces underlying our economy will change and how that change affects future market returns.
Predicting investment returns over a short period of time is particularly difficult. The Great Recession deeply affected confidence in financial markets. Enormous financial losses created so much concern that some feel the global economy may be on a much more conservative course for decades to come. However, there is still value to be gained.
Unrealism Versus Realism
The media and critics of public pension systems frequently state that public sector pension plans set unrealistic assumptions about their future investment earnings. They reason that public sector plan assumptions should be more consistent with the returns assumed by private sector plans. Such statements expose their lack of understanding about how pension funds operate.
In fact, the expected returns of public sector plans remain consistent with the assumed investment returns of private sector pension plans. Milliman, one of the world’s largest actuarial firms, with both public and private pension plan clients, publishes an annual report on pension funding of the 100 largest (private) defined benefit plans. In their most recent, 2013 Corporate Pension Funding Study, Milliman lists an average expected investment return of 7.5 percent for the 100 largest defined benefit pension plan assets. A rate identical to the 7.5 percent assumed investment return used by CalSTRS.
In the 10-year period ending March 31, 2013, CalSTRS earned an average annual return of about 8.5 percent. In the past 20 years CalSTRS earned 7.5 percent annually which equals our assumed annual return.
Discount Rates, Pension Liabilities and the Missing Contribution Link
In order to set appropriate pension plan contribution levels, long-term assumptions on the investment rate of return must be made. This holds especially true for a globally diversified portfolio such as CalSTRS.
Public fund critics often refer to the discount rate, or the rate that a private plan uses to calculate its pension liabilities, as a more appropriate rate when discussing long-term pension funding. Due to federal regulations, for reasons that aren’t applicable to public plans, private plans use a discount rate that is much lower than their expected return on investments. For 2012, the discount rate for the average private plan sits at slightly more than 4 percent. Public plans use a discount rate that is equal to their investment assumption.
If CalSTRS contributions were based on the same 4 percent discount rate used in private plans, and CalSTRS earned the 7.5 percent annual investment return it assumed, substantially more money in contributions would be collected than would be necessary to fund the benefits. This recommendation heralded by critics actually imposes an unnecessary financial burden on taxpayers.
While no one can be sure of what the future holds, it’s wise to use history as the best indicator of future performance.