Tuesday, September 27, 2011

Pension fund returns

My colleague, Craig Newmark, links to an article on why Public Pension Plans can't be expected to earn returns of greater than 8% in the future.

The article argues that because the real risk free rate of interest is very low - close to zero, the expected return on pension assets should be reduced also.  I agree, but I would also point out that a non-trivial part of the historic return earned by pension funds comes in the form of inflation.  A far more sensible approach would be to  create pension plan return expectations in real, not nominal terms.

I've posted on this topic before.  Aside from over optimistic return assumptions, the other problem of state pension plans is that they discount their liabilities at the same return that they use for their assets.  Pension plan liabilities are virtually risk free and should be discounted at a much lower rate.  The net result of doing this would be to increase the value today of those liabilities and most likely reveal that most pension plans are horribly underfunded.