Why 8.5% is delusional

I am quoted today in an article on Bloomberg.com about the Connecticut pension fund return assumptions.  The article is here:  https://www.bloomberg.com/news/articles/2017-07-20/connecticut-sinks-deeper-in-debt-as-pension-returns-lag-target

So why is an 8.5% return assumption delusional?

It's pretty simply really.  Assume that your fund is 50% bonds, 50% stocks.  Currently 10-year Treasuries are yielding about 2.3%.  Let's round that up to say 3% to be generous.  Assume an equity risk premium of 5%, and equities will return about 8%.  So our hypothetical pension fund is going to earn:

             50% bonds + 50% equities = 0.5*3 + 0.5*8 = 5.5%

Even with a tweaking the bonds to 4%, and using a risk premium of say 6%, you are looking at:

            0.5*4 + 0.5*10 = 7%

I think 7% is still pretty optimistic, but if we use today's numbers, 8.5% implies stock returns of:

            8.5 = 0.5*3 + 0.5*X

Solve for X, ... go ahead, I'll wait.

           X = 14%.

So stocks would need to return 14% on average, implying an 11% equity risk premium.  That's why it's easy to say that 8.5% or even 8% is delusional.

But just labelling something delusional doesn't really help anyone, and I appreciate this.   Unfortunately to ensure a pension fund is fully funded, and meets a realistic return goal, either contributions have to increase, or payouts have to decrease.  Both are hard choices and there's no easy fix.  Just setting a high return merely kicks the can down the road.

Will fee cutting hurt the pension fund?

In an article yesterday in the News and Observer (http://www.newsobserver.com/news/business/article161425553.html), David Ranii explores whether fee cutting by the pension fund might hurt future returns.

It's a good article, I was interviewed for it, and I recommend that you read it.  I would, however, like to add a small comment/clarification with regard to my comments within the article.

While I strongly support attempts by the pension fund to reduce fees, this has to be done in a sensible manner.  When high cost equity managers are liquidated, the proceeds should be put into an equivalent low cost index fund.  What the pension fund has been doing is to put these proceeds into cash and fixed income.  In the article, I am quoted as noting that this action will likely result in lower returns for the pension fund going forward.  

The article incorrectly portrays me as in conflict with critics of the pension fund's strategy.  This is inaccurate.  I fully agree that cutting fees by firing equity managers and then putting the proceeds into cash is a bad idea.  This will hurt future returns.