The Maryland public employee pension system announced this week that it had achieved a dismal return rate on its investments of 0.36 percent — a figure that, as the Washington Examiner notes in an editorial today, “rounds down to zero percent growth.”
A return that bad would come in well below any pension fund’s return projections, but making things worse in this case is the Maryland pension fund’s overly optimistic projections of 7.75 percent return. As the Examiner’s Hayley Peterson reported this week, the pension fund claims returns of 7.8 percent over the last 25 years, but over the last decade returns have averaged 5.9 percent. Now, one would think that a decade of returns nearly two percentage points below previous performance would be grounds for revising projections downward, but Maryland’s pension trustees have eschewed any such move.
However, the focus on average returns is misplaced. While returns of 7 to 8 percent are achievable, they are not guaranteed to be achieved every year. Moreover, higher returns involve riskier investments, which increase volatility. Pension liabilities by contrast, grow without interruption, year after year. As economists Robert Novy-Marx and Joshua Rauh rightly note, pension fund discount rates should reflect the risks posed by the liabilities. They settle on the Treasury Yields, which carry a much lower, but much less risky, rate of return. AEI’s Andrew Biggs, citing Novy-Marx and Rauh, explains in a July 2012 study:
For our purposes, we will use the average of rates on Treasury bonds with durations of 10 and 20 years. We use rates that were current as of the time pension valuations were undertaken. As of mid-2010, these averaged 3.36%, while as of mid-2011 the average yield was 3.64%. As a broad rule of thumb, pension liabilities rise by around one-fifth for each percentage point change in the discount rate. Thus, a Treasury rate produces dramatically higher liabilities than the 8 percent average discount rate used by pensions today.
Pension fund managers use revenue projections to set the discount rate by which they determine the level of contributions they need to make in order to meet future payout obligations. A discount rate based on higher revenue projections thus allows states to make lower contributions into their pension plans. When those optimistic projections are not realized, or not realized on a consistent basis, shortfalls inevitably result.
Pension underfunding will remain a problem as long as politicians can fudge the numbers for political advantage. Making lower contributions into pension funds frees up government funds to be spent on goodies for present-day constituencies whose support politicians need, while future liabilities are passed on to future taxpayers.
For more on public pensions, see here.