Thursday, July 20, 2017

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.