Corporate pension plan sponsors appear to have accepted that they can't invest their way out of their unfunded pension liabilities in any reasonable time frame. Many of them have stepped up their contributions while at the same time cutting back exposure to equities and using a broader range of alternative investments to limit volatility of returns.
Public pension plan sponsors ought to consider whether the corporate plans are correct and likewise step up their contributions and reduce their exposure to equities. (A few have cut equity exposure, but not as far as many corporate plans have done.)
Of course, many corporate plan sponsors can increase their contributions because their earnings have rebounded since the recession, a result of cost cutting and some uptick in sales.
Most public plan sponsors, on the other hand, have been hit by severe declines in tax revenues, which make it difficult for them to increase contributions, even if there was the political will among politicians to do so.
Politicians may continue to believe that investment returns will bail out the public employee plans without pain, but that is unlikely for a couple of reasons.
First, the holes in which the public employee retirement plans find themselves are likely to be too deep for historic investment returns to bail them out. That is, in part, because many state and local governments have underfunded their plans for years.
Recent studies by Professor Joshua Rauh of the Kellogg School of Management and Northwestern University and Robert Novy-Marx of the University of Rochester suggest that state employee pension plans may be underfunded by as much as $3.4 trillion, while municipal plans may be underfunded by as much as $754 billion.
They calculated that public pension funds in seven states would run out of assets to pay benefits by 2020, even if the funds achieved the 8% annual return that many assume. Twenty-five states will run out of assets by 2027.
While the Roger Ibbotson and Rex Sinquefield study of the long-run returns of stocks, bonds and Treasury bills suggested that stocks produce a real return of 8% over the long run, work by Robert D. Arnott of Research Affiliates LLC and the late Peter L. Bernstein suggested in 2002 that returns in the future would be much lower. That same year, Elroy Dimson, Paul Marsh and Mike Staunton of the London School of Economics independently reached similar conclusions.
So far, the events of the past eight years suggest they may be right, and that investors ought to lower their return expectations. Messrs. Arnott and Bernstein suggested that, barring unprecedented economic growth or unprecedented growth in earnings as a percentage of the economy, future real stock returns will probably be roughly 2% to 4%, similar to bonds.
Many public plans argue that return assumptions of 8% or more are not unrealistic because over the past 20 to 30 years they've been in that range. The question is, can those returns be achieved in the future?
For public plans, the problem is compounded by the fact that, if return assumptions are reduced then the discount rate for calculating the present value of liabilities must also be reduced, and that increases the size of the liabilities and hence the underfunding.
That in turn increases the annual contributions required to maintain the current level of funding, something most politicians resist even in good times.
Nevertheless, public fund officials should consider the possibility that Mr. Arnott et al. and corporate pension plans are right and begin to prepare politicians, employees and taxpayers for some difficult choices.
These include whether to adopt lower return assumptions and lower-risk investment strategies, along with some combination of higher contributions (thus higher taxes) and reduced benefits at least for new employees, or maintain the current asset allocations and return and discount assumptions, gambling that the market lifts the funds out of the holes rather than digging even deeper ones.
That would require something better than the 8% historic real rate of return on stocks, a heroic assumption.