Wednesday, July 06, 2011

Government Funding & Pension Fund Returns

Following up on yesterday’s post, a large part of the lack of government funding—especially at the local level—is the unrealistic rate of return on pension fund investments used to calculate set asides, as this article from the Sacramento Bee explains.

What leaps out as a solution, is legislation, limiting projected investment returns on pension funds to the historical rate of return (fourth graph down at the jump) which, from 1950-2009 is about 7%.

An excerpt from the Bee article.

“Recently I wrote that culpability for rising pension costs lies with pension fund officials and politicians, not public employees or Wall Street. That conclusion surprised some because conventional wisdom is that pension problems started only after pensions were increased and the stock market crashed in 2008.

“But pension costs started rising before 2008 and would have risen even without those increases.

“Here's why.

“For pensions to work right, enough money must be set aside when the promises are made so that the combination of those set-asides and investment earnings on those set-asides will yield enough money when the promises come due. The key is to set aside enough. If too little is set aside, there will be make-up payments.

“Establishing the level of set-asides is the responsibility of pension funds and politicians and is a function of how well they expect investments to perform over the extremely long period between promise and payment. The higher the expected return, the lower the set-aside. This is where the pension problem is created.

“In order to keep set-asides artificially low in the short term, pension funds have been basing set-asides on the assumption that equity markets in the 21st century will grow 40 percent faster than equity markets grew in the 20th century. That means pension funds are assuming that the stock market, which grew 175 times in a very successful 20th century, will grow more than 1,750 times in the 21st century, or 10 times as much. That's not a typo – that's the power of compounding.”