The eight-percent solution sounds like a gamble

The board of the State Teachers Retirement System of Ohio told members last month that it could not rely on a nine percent return on investment to fund future retirement benefits. The implication is that the board will continue to rely on a long-term return of eight percent.

While that eight percent might seem ridiculous given the vast losses in the stock market, it turns out that just about all public pension funds depend on that rate. It also turns out that public pensions need a rate of return that is much higher-by about one-third-than the comparable figure for private pension funds, which generally calculate growth at a long-term average rate of about six percent.

Why the difference? According to a pension-fund analyst at the Center for Retirement Growth at Boston College, public pension funds generally expect wage growth to be higher for their members than the managers of private pension funds. "The private sector has a little more expectation of trying to keep on top of costs," Jean-Pierre Aubry told The Gadfly.

Getting that higher rate of return means gambling, according to Jay Greene, the chairman of the Department of Education Reform at the University of Arkansas. But, in a Gadfly interview, Greene pointed out that, because public pension funds such as the STRS are guaranteed by the government they are essentially gambling with taxpayers' dollars.

An eight percent return may sound perfectly reasonable to some, he said. "The trouble is we don't know the future will resemble the past. Will the next century look like the last century? We can look over the world and see markets that vary widely. There's no way to know looking at the average return in the recent past."

"We're investing with considerable risk as current events show," he said. "Japan has had 30 years of no returns. It's not inconceivable."

Not making that eight percent is huge, especially in a down market. Boston College's Aubrey was co-author of a report in March that calculated the aggregate assets for state and local pensions have dropped $1.3 trillion since the peak of the market in October 2007. The current level is $1.6 trillion below the expected level based on an assumption of an eight-percent return. Further, the center estimates that, nationally, pension funds need $270 billion in extra contributions over the next four years, and then more than $100 billion extra annually for the following 20 years.

Greene said the market, however, does tell us what the risk-free return should be and that is the rate on U.S. Treasury bonds. They are now at about four percent and, long-term, are much closer to the six-percent general rate on which private pension funds are based.

Assuming a four-percent return, a teacher pension fund that would have been 70-percent funded at eight percent would drop to 44-percent funded. Teachers, school districts, and/or taxpayers would either have to make up the difference or have a very serious discussion about how much less than 100 percent of salary a realistic pension should provide.

Some critics might argue that the Treasury rate is too conservative but Greene argues that the only way to get a higher return is by increasing taxpayers' risk. Of course, over the last year or so, pensions have lost big. During all of 2008, the STRS, for example, lost 29 percent of its value.

The creaky nature of the pension funds (see here) isn't new. Public pension funds are generally considered in OK shape when their assets are roughly 80 percent of liabilities. But generous pension outlays have been so steep (average public pensions far exceed private pensions) that in 2007, well before the financial meltdown, roughly 40 percent of the major teacher pension plans, nationally, were short of future cash needs, according to Greene.

The STRS board warned bluntly at its March meeting that the fund might not be able to meet future obligations without substantial changes such as teachers working longer, an increase in contributions, and alterations to how benefits are calculated (see here).

Lawmakers in more than half the states are considering changes to their pension funds (see here). New Mexico recently hiked employee contributions and required new workers to work longer before retiring. And, in New Jersey, the governor said that he has to balance the state's obligations to its faltering public pension funds against state services such as education and health care, according the Philadelphia Inquirer (see here). The teachers' fund alone was short $14 billion last June.

Perhaps echoing Ohio's future, a New Jersey official told the newspaper, "I just don't see how the state can raise the revenues to make those kinds of payments. It's depressing."

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