by James A. Bacon
Last July I argued that, despite the significant pension reforms enacted in the 2012 session of the General Assembly, Virginia had only partially restored the actuarial integrity of state and local government pensions. (See”Virginia’s Pension Bomb Is Still Ticking.“) The debate at the time: whether the Virginia Retirement System should assume that it would generate an 8% annual rate of return, as preferred by Governor Bob McDonnell, or a 7% rate of return, as recommended by the VRS board. Though a single percentage point seems to be a small difference, it amounted to $540 million a year — not exactly chump change — that would have to be made up by state and local governments.
Apparently, the VRS board carried the day. According to an August 2012 document published by the National Association of State Retirement Administrators, the VRS was assuming a 7.0% return. That was the most cautious assumption of almost any state retirement plan in the country — only the Indiana pensions assumed a lower (6.75%) rate of return.
Unfortunately, even the VRS assumption is likely way too optimistic.
Andy Kessler, a former hedge-fund manager and author of “Eat People,” lays out the case in the Wall Street Journal for assuming a 3% rate of return for the indefinite future. How bad is that? To make up the difference, Virginia state and local government would have to cough up an extra $2 billion a year! Good luck with that.
Kessler boils down the math as follows:
The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I’m being generous, -1%.
To some, that may sound unduly pessimistic. Hasn’t Kessler noticed — the stock market is hitting new highs almost every day!
Don’t count on the boom lasting. The United States has enjoyed a long-term bull market in bonds and other interest rate-bearing instruments since the early 1980s. Since 2000 the long-term composite for 10-year Treasuries, a key benchmark, has tumbled from 6.9% to 2.7% today.
The earnings multiples of stock, real estate and other assets move inversely with interest rates. When interest rates go down, price-earnings ratio (essentially, the value placed on a dollar of earnings) for alternate investments go up. Thus, the long, secular decline in interest rates has driven a significant portion of the generous return on pension investments over the past 20-30 years.
With interest rates near zero, however, it is impossible for them to fall any more… which means that it is very difficult to expand the earnings multiples of stocks and other investments. Indeed, if the Federal Reserve Board ever decides to end “quantitative easing” and interest rates return to historical norms, earnings multiples will shrink, as Kessler suggests.
The current bull market is predicated on the belief that the Fed will maintain near-zero interest rates for years to come. If the economy remains weak and inflation stays quiescent, maybe they will. Perhaps Kessler is too pessimistic. Perhaps we won’t see a rise in interest rates and a consequent contraction of earnings multiples. Perhaps earnings multiples will remain stable. Perhaps pension funds will generate long-term returns of 4% annually, not 3%.
Gee, that would mean Virginia is under-funding its pensions by a mere $1.5 billion a year more than officially acknowledged.
Virginia has done more than most states to put its government pensions on a sound actuarial footing. But that’s more a comment upon the total ineptitude, cowardice and, in the case of Illinois, fraudulent misrepresentation of other state officials than a kudo for our own. We need to deal with this issue now. Every year of delay will make the final reckoning only harder.
