State pension funds' wishful thinking could turn into the taxpayers' worst nightmare. If state pension plans cannot earn their actuarial assumed rates of returns, taxpayers will have to put tens of billions of dollars more into the funds.
Large state plans over the past five years have continued to use an 8% rate-of-return assumption on their investments, the same figure used as the crucial liability discount rate.
Although the return assumption is long term in nature, it is important to evaluate the reasonableness of current assumptions. Unfortunately, they fail to pass muster, and the blame falls squarely on fixed income.
Fixed-income allocations of the top 200 public defined benefit plans have edged higher — to 26.7% as of Sept. 30, 2009, from 25.3% as of the same date in 2005. But interest rates remain at historic lows.
What might be a reasonable estimate for an overall return assumption, given fixed income's target weight and expected return? About 7%. One percentage point would add billions of dollars to already significant funding deficits for state pension plans.
For pension funds to achieve 8% overall, what rate of return would a plan have to assume on other asset classes if the assumption for global fixed income is 5%? That would be 9% for public equities, 8% for real estate, 10% for private equities and 9% for hedge funds. Although these returns are possible, they are on the optimistic side.
Besides praying for high investment returns, other solutions to the funding problems are hard to come by or downright scary. Extra contributions — or any contributions — from states are increasingly difficult to expect. Cutting fixed-income allocations and doubling down on assets with equity in their name is a recipe for volatility.
Until fixed-income investments can reasonably be expected to return more than 6.5%, the only people state pension plans are fooling with their lofty return assumptions are themselves.