Most of the math behind public pension funds can be dense and befuddling. I promise to skip over that part.
My attention is focused instead on relatively simple - but important - assumptions about the investment gains our state’s $48.5 billion pension portfolio will earn in the future. The process of predicting a rate of return in any public pension portfolio can turn into wrestling match between common sense and political expediency.
Artificially high assumptions seem to make the problems funding the state’s pensions melt away, but they can be dangerous. They simply paper over actual deficiencies and increase real-world risks.
Pension funds across the country are lowering their expected returns, or at least considering a reduction. Calpers, which covers retirement obligations in California and is the nation’s biggest public pension fund, decided this week to cut its assumed rate of return from 7.75 percent to 7.50 percent. The Calpers staff had recommended a cut to 7.25 percent.
Considering the decision in California and other states, you might look at the 8.25 percent gain Massachusetts presumes its pension fund will earn every year and conclude that number is out whack. You would be correct.
State Treasurer Steve Grossman thinks the number is too high, as well. Grossman is chairman of the Massachusetts pension fund, and he is trying to build support on Beacon Hill for the idea of reducing the target rate to 8 percent - in line with pension forecasts by many other states - but believes it could take a year to change.
“Moving to an 8 percent number within the year is my hope and expectation,’’ he says. “Some people would say perhaps it should be lower, but you take these things in stages.’’
In fact, the rate should be lower than 8 percent. That it would take a year to achieve that kind of reduction is disappointing.
Any agreement to make even small changes in those assumptions poses a political challenge because big portfolios and long timeframes magnify the impact. Reduce the Massachusetts pension investment assumption by just a quarter of a percentage point and the unfunded portion of the state’s plan - that which it owes future retirees- increases by about $1.5 billion.
Many states have gaping holes in their pension plans. Massachusetts isn’t among the worst offenders, but it operates with an $18.6 billion funding deficiency that will supposedly be closed by the year 2040 - based on the old assumption the fund will earn an average of 8.25 percent every year till then.
Grossman believes the pension can still be fully funded by then, even at a lower 8 percent target. But who wants to make the pension hole $1.5 billion deeper just to change an investment assumption that may turn out to be right or wrong years from now?
I do. For starters, we’re better off knowing the true scale of pension obligations. Future investment gains will generate a lot of the money to pay benefits, and we have no choice but to forecast the amount of those profits. The quality of that estimate and a willingness to adjust it as warranted are important.
Unrealistically high investment expectations also create an environment for even bigger problems. Any investment manager expected to clear a higher annual profit hurdle will take more risks to do it. Is that a trade worth making? It’s certainly important to acknowledge.
The state’s pension fund has actually exceeded its average annual target over a period stretching back to the 1980s. As of January, the fund has earned 9.5 percent annually since inception.
Those returns were earned through many years of a roaring stock market. Exceptionally large investments in alternative assets - like private equity and hedge funds - performed especially well in good times.
But the fund has fallen short of the target, gaining 6.7 percent a year on average, over the past decade, despite a strong performance in the last fiscal year.
So what about market conditions ahead? There are reasons to be optimistic, but few people expect a return to the 1980s and ’90s. Grossman says analysts forecast the state’s portfolio will earn 7.9 percent annually over the next five years and a bit better over the next two decades.
Lowering the state’s pension profit forecast would do more than change a number on a piece of paper. It would realistically adjust our view of a big funding hole and avoid unnecessary risks. That’s a change worth making.