Unfortunately for pensioners, reports of their retirement security have been greatly exaggerated. The Economist calculates the 10-year return on an average diversified portfolio to be a mere 2.7 percent. That’s the fourth-lowest level since 1871. This estimation comes to the chagrin of any investor, but for government pension-holders and fund managers it is much grimmer.
In nominal terms, the return on that same diversified portfolio (with a 60/40 equity to bond ratio) is close to 5 percent. Yet, when calculating their liabilities, US public pension funds use a nominal return of 7.5 percent as their discount rate. They base that figure off of long-term averages, typically of about 30 years, meaning that their expectations include the roaring returns of the early 1980s—when you needed two digits to record the average yield on Treasury bonds.
Discount rates and liabilities are inversely related, thus using a higher discount rate allows the funds to claim less liability. If this doesn’t sound bad enough already, consider that the 5 percent nominal rate is actually quite generous. Other recent, foreboding reports use a “risk-free” discount rate of 3.225 percent.
The bottom line is that by any conservative calculation US pension funds are nowhere close to covering their liabilities. As this reality becomes impossible to ignore, the government will have two choices: shift the burden onto taxpayers through increased taxes, or welch on their promised payments.