I want 8% guaranteed return, too!

(MoneyWatch) COMMENTARY If you participate in a defined benefit pension plan, your employer promises to pay you a specific benefit for life beginning at retirement. The benefit is calculated in advance using a formula based on age, earnings, and years of service. In contrast, if you participate in a defined contribution plan, the employer makes a fixed contribution to the plan into your individual account. The contributions (including any you make) are invested, and the returns on the investment (which may be positive or negative) are credited to your account. On retirement, your account is used to provide retirement benefits, sometimes through the purchase of an annuity.

For very good reasons, defined contribution plans have become widespread and are now the dominant option in the private sector. The reason is that corporations aren't, and shouldn't be, in the business of taking the investment risk that goes along with defined benefit plans.

The result of this shift has been that individuals working in the private sector are now responsible for managing the investment risks of their own retirement plan. However, this isn't true for most of the public sector, which still has defined benefit plans as the mainstay. The result is that the investment risk is being borne by taxpayers.

Making matters worse is that the typical public pension calculates contributions based on an assumed investment return, which is typically around 8 percent. I don't know any financial economist that is currently forecasting the returns of a typical 60 percent stock/40 percent bond portfolio that would even be close to that range, especially with bond yields at current levels.

The result is that most public pension plans are woefully underfunded. And if the investment objectives are not reached, the plans are still required to pay out the defined benefit. The effect is that public employees are being guaranteed an 8 percent return on investment, on both their contributions and those of their employer, regardless of what happens to the market. Contrast that with the roughly 2-3 percent rate you can earn on an equivalent investment in a 10-year or longer U.S. Treasury bond. Wouldn't you prefer the 8 percent guarantee?

Public-employer-provided defined benefit plans that take stock market risk should be made illegal because they provide guarantees when there's no way for the state or municipal employer to earn the returns with certainty. Government employees shouldn't be in the business of investment speculation with taxpayer funds. In addition, the evidence demonstrates that most public plans, because they engage in high-expense active strategies, underperform simple index benchmarks, making the situation even worse. Compounding the problem is that in an effort to achieve the high return required by their assumptions, public plans often take more risk, "investing" in vehicles such as venture capital funds and hedge funds (which have on average failed to deliver appropriate risk-adjusted returns).

Why do these practices continue? It's the fact that public unions vote for the very people who provide them with these benefits -- benefits you and I would love to have, but that don't make any sense. In fact, if things are not changed quickly, many more municipalities will follow in the path of Vallejo, Calif., which declared bankruptcy in 2008. The problem is so bad in Illinois that the state is actually in worse shape than California. And that's hard to believe

It's time for the public to wake up and demand that taxpayers be taken out of the investment guarantee business.

[Julius10000]

Larry,

Sorry I was not clear about what I meant by selection bias.

Past returns must be considered because this is money already earned (or lost?) and credited to the account. This is not meant to be predictive, although GMO's 7-year forecasts call for poor returns because of the relatively recent favorable returns. The programs have recently made money that must be counted.

As to the future, long-term projections (say 30 years) either GMO-style or Bogle-style would look better than the 7-year forecast.

[LarryswedroeCBS]

Julius
Yes past returns should be considered but only to the extent they influence the degree of under or over funding in the plan, not prospectively.

Best wishes
Larry

[LarryswedroeCBS]

banff50

Cities and states are being faced with the inability to fund their obligations, debts and pensions. So they have a choice. They can raise taxes and cut spending as much as possible--which is being done, but raises taxes has its limits, wealthy will leave and so will jobs (see California and Illinois) and so does cutting spending. So eventually they have to decide on which to default. If default on debt then they will lose access to future capital markets and even if get access again costs will be very high. So the alternative is far more likely. They will go back in and renegotiate pensions to force cuts of one kind or another, either lower payments, limits on them or lowering inflation adjustments or more contributions. Alternative is bankruptcy in which case the contracts will be renegotiated anyway.

I hope that is helpful
Larry

[Julius10000]

Larry,

I do not understand why you do not want any risk in investments in defined benefit programs for public institutions. Why would not a prudent level of risk be appropriate, something like that for conservative indidual investors?

There seems to be some selection bias in your article. Should not past returns also be considered?

Thank you for your thoughts.

[LarryswedroeCBS]

Julius, the reason is that the taxpayers are the ones providing the guarantee. If the recipients want to accept the risk that is fine, their choice, but it should not be imposed on taxpayers. IN other words, make it a defined contribution plan.

As to past returns that is definitely wrong. You don't forecast future stock returns based on past returns. That should be obvious. Consider the following. From 1926-1948 stocks returned 6.3%. So now you forecast going forward 6.3%. By 1999 the historical return is now 11.3%. Do you forecast 11.3% going forward. Only someone who doesn't know finance would do that. The reason for the high returns was that in 1949 the e/p was in double digits, forecasting very high returns going forward. By 1999 the e/p was about 2% forecasting very low returns going forward. The price you pay for assets matters.

The way financial economists forecast is to use the Gordon Model
Take dividends and add expected growth and you get the nominal expected return. Add expected inflation you get the nominal return expected. Everything else is speculation on whether p/es expand or contract.
Historically we have divs of about 4.5% and growth say of 2.5% and inflation of about 3% so there is your 10%
Now we have dividends of only about 2% plus the same growth forecast gets you to nominal return of about 4.5% and add expected inflation of about 2.5% and you get nominal expected return of about 7%. For bonds it is also obvious that the expected return should be the current yield, at least in nominal figures. So take a typical 60/40 portfolio with 7% for stocks and 2% for bonds and you get expected return of about 5%, not 8% or more that most are forecasting.

I assure you that if anything is certain it's that many states and municipalities will default because of underfunding and bad assumptions. We just don't know if they will default on the bonds or on the pension obligations. My bet is that mostly it will be the later because the cost of defaulting on debt and ability to raise capital later is so high it's virtually unthinkable.

I hope that is helpful

Best wishes
Larry

[banff50]

Larry,

Your blogs in general are fascinating and especially this one about pensions.

My question: How would states/cities default on pensions? Aren't those benefits guaranteed?

[Julius10000]

Larry,

Do you likewise object to Social Security, which is in effect a defined contribution program?

[LarryswedroeCBS]

Julius
Few thoughts, first there is no negotiation of benefits with the federal government on SS. Second, there is no assumption of high rates of return that cannot be earned likely by the market, let alone certain. So no I don't have any objection to SS.

The problems with many state and local plans are
a) they are negotiated with the very people who the labor unions help get elected.
b) the unrealistic rate of return assumptions. At least if they bought annuities in the public market and that was the guarantee they provided I would much less of an issue. That way at least the only risks were credit risk of the issuer of the annuity. And that risk could be diversfiied

I hope that is helpful

Best wishes
Larry

[Brian_from_Los_Angeles]

I am not sure where you are from, Larry, but in LA the rate of return for our pension fund over the past 15 years is over 8%. All pension funds hire independent actuaries to determine the proper rate of return. Of course, with the collapse of the stock market, the short term rate of return is nowhere near 8% recently. Many like yourself try to use this economic crisis to support your claims, but it actually hurts your claims. What these tough economic times show is that pension funds are better because they smooth out the investment earnings over a longer period of time than any individual investor as well as smooth them out over many employees rather than a single individual. Second, statistics show that the rate of return for pension funds is far better than 401k funds. This is largely due to the amount in the funds and the ability to hire professionals to handle the investments.

[LarryswedroeCBS]

Brian
First it's possible that the LA plan earned 8% over last 15 years but over last 10 it's not even close, almost certainly as equities up about 3% and intermediate bonds about 6. More importantly most financial economists (not Wall Street firms) forecast equity returns going forward of about 7-8% (using what is called the Gordon Constant Growth Dividend Model) and with bond yields at 2% that would get you a return in the 5% range for a portfolio.
More importantly, there are two issues. Even if LA did manage to match the return of their plan, most have not and the plans are dramatically underfunded as is the state of California (where you live) and Illinois (which has 43% funded status even using the high expected return). Second is that there is no way to guarantee the return in the future--take the Japanese example as one lesson, or the Great Depression period. There is simply no logical reason for taxpayers to bear the burden of guaranteeing someone's pension. None.

While the return for pension plans is better than for 401k plans that is solely because of lower fees they negotiate. So that would not change, as they could still negotiate lower fees based on their large size. One can use for example Vanguard funds with extremely low expenses.

[MrClobber]

I work for a county government in PA. The taxes here were raised because the stock market downturn caused a huge pension account shortage. The local government can do nothing about the problem because the union-influenced state government requires that they have a pension plan for us. Pensions are a rip-off for taxpayers. They have no place in the public sector, and this is coming from a person who stands to lose money if my advice is taken.

[LarryswedroeCBS]

Nothing wrong pension plan, it's the defined BENEFIT plan that is the problem.

[SeanN33]

To Larry:

See my comments to R9619. As for the personal comments, you deserved them.

[LarryswedroeCBS]

Sean
Defined contribution plans to start can have exactly the same amount contributed to them as a defined benefit to start. The difference is one doesn't guarantee benefits, the other does. And there is no logic to having taxpayers being in the investment return business.

Now as to plans having problems, I fully agree. That is easily fixed in that they should be required to offer low cost passively managed funds like those of Vanguard or DFA. Not high cost actively managed funds. That is the way to fix that problem

[NicelyNicely]

With all respect, you want 8 percent too? Then join a union and negotiate for it! It does nothing to further your argument by ignoring the fact that all union benefits are the result of hard NEGOTIATIONS, meaning that this benefit was gained by the members GIVING UP something else in exchange. It is also unfair (as any mortgage lender will tell you) to declare down the line that the contract you agreed to (maybe ten, twenty years ago) was not something you can afford is the fault of the other party. Using the "private sector" as a benchmark of fairness in compensation is also absurd; what makes the CEO of one corp. worth $2 million and another $20 million except for the fact that the one making the higher amount had a more pliant Board wiling to pay it? It may be fashionable politics at the moment, but the last place you should target when trying to save the taxpayers money is the working class they employ. Those people, unlike most of the wealthy in our society, are taxpayers too.

[LarryswedroeCBS]

Nicely
The problem is that, as FDR about as liberal a President as we have had noted, you cannot have situation where the people you negotiate with are the people you get to vote for. That is like allowing the fox in the hen house. That is exactly why Federal employees do not have collective bargaining rights and neither should state or local employees either. It's not a negotiation when you vote in the people who promise to give you what you want. IT's a rip off of taxpayers.

This has nothing to do with the issue of compensation you talk about. It's a question of whether or not taxpayers should be in the investment return business. Besides, as you will learn, and others have learned already, those guarantees will prove worthless because they will be defaulted on when investment returns are very poor because taxpayers will revolt and refuse to have taxes raised sufficiently to pay for them. This is what is happening across the country already and will continue.

Best wishes
Larry

[NicelyNicely]

With all respect, you want 8 percent too? Then join a union and negotiate for it! It does nothing to further your argument by ignoring the fact that all union benefits are the result of hard NEGOTIATIONS, meaning that this benefit was gained by the members GIVING UP something else in exchange. It is also unfair (as any mortgage lender will tell you) to declare down the line that the contract you agreed to (maybe ten, twenty years ago) was not something you can afford is the fault of the other party. Using the "private sector" as a benchmark of fairness in compensation is also absurd; what makes the CEO of one corp. worth $2 million and another $20 million except for the fact that the one making the higher amount had a more pliant Board wiling to pay it? It may be fashionable politics at the moment, but the last place you should target when trying to save the taxpayers money is the working class they employ. Those people, unlike most of the wealthy in our society, are taxpayers too.

[SeanN33]

To R9619:

1. Larry argued employers should eliminate defined benefit plans (pensions) and offer strictly defined contribution plans, like a 401(k).

2. See http://www.nasra.org/resources/NASRACostsBrief1202.pdf. See also "When I'm Sixty Four" by Teresa Ghilarducci.

3. See http://truth-out.org/news/item/8539-the-war-on-public-sector-workers.

4. See http://www.nytimes.com/2012/04/28/opinion/nocera-my-faith-based-retirement.html?_r=1&ref=joenocera. When the average savings for someone nearing retirement in the U.S. is about $100,000, asset location is the least of their worries. Nevertheless, you'll note I made reference to index funds as well.

The bottom line is that defined contribution plans aren't going to cut it for the average worker, not unless they like the taste of cat food. That's particularly true when you consider that many of the plans are a complete mess - conflicts of interest, unnecessary fees and expenses, etc. I'm not the only one making that point. Jack Bogle and others have been saying the same thing for quite some time.

Pay employees fair compensation for their work, which means paying lower level employees more and corporate executives less. Also, cut the size of the financial services industry. It's become a big skim, draining resources from business, government, and individuals. Slash it.