U.S. Fed Funds Rate. Source: Trading Economics
U.S. Fed Funds Rate. Source: Trading Economics

by James A. Bacon

The Virginia Retirement System earned an estimated 1.5% return on its $68 billion portfolio of investments last year, spurring discussion over whether state and local governments are contributing enough to maintain the long-term financial integrity of the retirement plan for Virginia school teachers and government employees.

For purposes of calculating the system’s financial integrity, VRS officials assume that the return on investment will average 7% annually over the long term — an assumption that is more conservative than many government pension plans. But is it conservative enough? After earning 1.5% the past year and only 4.7% the year before, is the 7% assumption still defensible?

VRS Chief Investment Officer Ronald D. Schmitz assured lawmakers that it is. “Over a 20-year horizon, we’re comfortable with a 7 percent return,” he said at the first meeting of the Virginia Commission on Employee Retirement Security and Pension Reform created at the urging of House Speaker William J. Howell, R-Stafford.

Getting that assumption right is no easy task. Investment returns fluctuate widely from year to year, losing money one year and then making spectacular gains the next. Investment performance varies considerably, depending on the time frame used. According to the VRS 2015 report issued a year ago (the 2016 report is not yet available), annualized investment returns averaged 10.6% over three years, 10.3% over five years, but only 6.7% over ten years.

The question is whether the past twenty or thirty years is a useful yardstick for predicting the next twenty or thirty years. The United States has benefited from a 35-year bond market boom, over which time interest rates have trended consistently lower to the near-zero rate that it has held steady for the past seven years (as seen in the graph above). All other things being equal, lower interest rates push stock and bond prices higher. Consequently, U.S. pension funds have enjoyed 35 years of rising prices for stocks and bonds (with short interludes of falling prices) in their portfolios. But as interest rates approach zero, it is impossible under conventional economic theory for them to drop any lower. Perhaps, as we are seeing in some places around the world, it is possible for central banks to engineer below-zero interest rates, but we have no historical experience by which to judge how economies, bond markets and stock markets will perform under such circumstances.

While no one knows with any certainty where interest rates, bond prices and stock prices are headed — perhaps changes in the global economy have repealed the laws of classical economics, and below-zero interest rates will do no harm — it is safe to say that a reversion of interest rates to historical norms would be disastrous for stock and bond prices, indeed asset prices of all kinds. And it is reasonable to say that there is at least a risk that such a reversion could take place. Whether such a reversion to historical norms takes places or not, is indisputable say that central banks cannot replicate the past 35 years of falling interest rates, and that the primary driving force behind the bull market era of the past 35 years has run out of steam.

It is almost inconceivable that the future 35 years of investment returns will match that of the previous 35 years, one of the great bull market eras of U.S. financial history. Therefore, the VRS (and other all pension funds) are reckless to assume that recent history will be any guide at all to future performance. Stretch out the frame of analysis for 50 years, 100 years, or longer, and the case for equities and bonds may be as favorable as ever. But the VRS cannot look out 100 years. Baby Boomers in the state workforce are retiring in large numbers now: One quarter of the state workforce will be eligible to retire within five years. Virginia will need the money in the next 20 to 30 years.

At least one state official in a position of responsibility, House Appropriations Chairman S. Chris Jones, R-Suffolk, is worried. As the Times-Dispatch quoted him: “I’m thinking that 7 percent might be aggressive at the end of the day.”

Jones is absolutely right. The VRS needs to lower its assumption, and the General Assembly needs to allocate more money to the VRS than in the past. Such an action surely will be painful, given all of Virginia’s other budgetary constraints. But Virginians will be grateful that the legislature acted with foresight when investment returns tank. It won’t get easier to do later what we should be doing now.

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9 responses to “The Seven Percent Assumption”

  1. Hill City Jim Avatar
    Hill City Jim

    Billion. Not million.

  2. Steve Haner Avatar
    Steve Haner

    This is not an academic discussion in my household since the monthly VRS deposit already arrives….but before I agree that the 7 percent projection is too aggressive, what is the projection for the same period on inflation? If inflation returns to a more normal 2-3 percent then the 7 percent projection is less problematic. In the context of the current zero-to-negative interest rate environment, VRS’s recent returns don’t look so bad. If that zero-to-negative environment continues for 30 years, as Bacon the Boomer knows, we’ll have lots of other problems. But it means you need less annual returns to meet VRS obligations. Too soon to panic, guys….

    Also, fiscal year notwithstanding, what has VRS done since Jan 1? Bet it looks pretty darn good….

    1. Steve, If inflation creeps up to 2-3% and stays there, investors will demand a higher inflation premium, which means that interest rates will go up and stock/bond multiples will go down. We’ve painted ourselves into a corner. As a state pensioner, you don’t have to worry — Virginia will make good on its obligations. As a taxpayer, well, that’s a different story…

      1. Cville Resident Avatar
        Cville Resident

        Here’s another interesting data point on the ongoing discussion about global economics, which also addresses Mr. Haner’s points….

        Japan, yes Japan, which has gone to negative interest rates for months now and whose deficits make the U.S. look positively austere……has just cut its inflation forecast for the year from 2% to 1.4%.


        That’s right, Japan is desperately fighting deflation with Debt to GDP approaching 250%.

        I hate to sound like a broken record, but there simply is no explanation for what is going on economically if you cling to classical theories of economics. In any classical model, Japan would be fighting hyperinflation. The fact that it’s fighting deflation is amazing. And let’s not forget, Japan isn’t some tiny country that we can just write off as insignificant. It’s the third largest economy in the world.

        While “this time it’s different” is easy to mock, there’s a hell of a lot of evidence piling up that simply doesn’t correspond with current economic models.

        1. LarrytheG Avatar

          what you can be absolutely sure of … is that this is the fault of the govt!!


        2. “There simply is no explanation for what is going on economically if you cling to classical theories of economics.”

          That’s not true. Public attention has focused on the role of increases in the money supply as the driving force behind inflation. But classical economics suggests that inflation comes from a combination of two things — the increase in the money supply and the velocity of the money supply, i.e., the speed with which money turns over in the economy. My understanding is that the velocity of the money supply has slowed dramatically, and this is probably a function of what banks are doing with all the money created by the Fed.

          If the velocity picks up in conjunction with a helicoptering-money monetary policy, you’ll be in hog heaven, Cville, because you’ll get all the inflation you want.

          1. LarrytheG Avatar

            well – some folks at the Fed in St. louis have opined along these lines”

            ” What Does Money Velocity Tell Us about Low Inflation in the U.S.?”


          2. Cville Resident Avatar
            Cville Resident

            I’ve heard the velocity of money theory before, but…..I think that relates to another point that is also history-making: We’re old! The entire developed world is old. The older the demography, the slower the velocity of money. Which makes sense. Old folks deleverage and downsize.

            The theory that I’ve heard about Japan is the inverse of Boomergeddon. Since the population is so old in Japan, they’ll never end up with hyperinflation. They can print yen all day long, but nobody’s spending money. Thus, the gov’t gets to keep funding through debt with no real monetary consequences.

            Obviously, they haven’t had serious economic growth in 2 decades, but they’re also able to run up huge deficits w/o consequence because of no to little growth.

            As always: Interesting discussion.

  3. LarrytheG Avatar

    what doesn’t make sense. IF the stock market is doing fine… then what happened to the 7%?

    so this is the WSG headline:

    ” Dow Record Ends Year-Long Drought
    The Dow Jones Industrial Average charged to a record Tuesday, surpassing its May 2015 milestone and ending the longest period without a record since the drought from October 2007 to March 2013.”

    Curious the stock market is doing so well but workers and their pensions are not.

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