True to the stereotype of America as a nation of optimists, US pension funds are much more confident than their overseas peers about their ability to generate returns.
US institutions are targeting annual returns on plan assets of 8 per cent, according to a recent survey by Pyramis Global Advisors.
By contrast, European and Asian funds are aiming for 5 per cent, while Canadian funds are targeting 6 per cent. Earlier this month, the UK’s Financial Services Authority told pension providers to reduce their midpoint projection for long-term returns from 7 per cent to 5 per cent.
If the rest of the world is correct, then the $5tn US defined benefit pension industry is heading for trouble.
US public sector plans in particular “operate on heroic assumptions” and need reform, says Amin Rajan, head of Create Research, a fund consultancy.
“But any reform will worsen their already bad funding status and force major cash calls on their sponsors – state and municipal bodies – whose own finances are in poor shape,” he adds.
Worries about the health of US pension schemes are nothing new. But the subject is becoming increasingly important because the postwar “baby boomer” generation will start to retire at an accelerated rate in the coming years.
The ambitious targets for annual returns at US pension plans, particularly those in the public sector, are seen by some as a sign that plan sponsors are unwilling to tackle deficits through painful reforms such as cutting benefits or raising the retirement age.
For now, the strategy appears to be to hope for a phenomenal recovery in financial markets in the years ahead.
Mr Rajan says that some US state plans have been granted recovery periods of more than 25 years to eliminate their deficits, a situation that would not be allowed in Europe.
How likely is it that asset growth will prove sufficient? Not very, says Elroy Dimson, a London Business School professor and a leading analyst of long-term investment returns. Pension fund projected returns are “just as unrealistic as they were a decade ago”, he says.
Before the turn of the millennium, funds were aiming for annual returns of almost 10 per cent – a level that proved too ambitious as the dotcom bubble burst in 2000 and the global financial crisis began in 2007.
While target returns appear to have become more realistic over the past decade as they have fallen by 2 percentage points to 8 per cent, Mr Dimson says that is not so. He argues that target returns need to be reduced further because the economic environment has changed dramatically and long-term interest rates have fallen to record lows.
The decline in the “risk free” interest rate – the yield on high-quality government bonds – has hit pension schemes hard by causing the actuarial value of their future liabilities to rise. It has also meant that the amount of money they receive from bond interest payments has shrunk.
So as a result of today’s low-yield environment, pension managers are placing a huge amount of faith in equities.
Consider a US plan that holds 60 per cent equities and 40 per cent bonds. Given that high-quality bonds are now yielding just 2 per cent, the plan would only be able to meet its overall return target of 8 per cent if its equity portfolio returns a stunning 12 per cent.
History suggests that kind of growth is ambitious. Since 1900, global equities have returned 8.5 per cent per year in nominal terms and 5.4 per cent in real terms, according to Mr Dimson and his LBS colleagues Paul Marsh and Mike Staunton.
Common sense also suggests double-digit returns are unrealistic, say sceptics. To achieve a 12 per cent annual return, equities would need to double in value every six years.
All this suggests that target returns will have to fall. The trouble is, lowering their expectations for future returns would force plans to come up with other ways to reduce deficits. Ultimately, that means reducing benefits to pensioners or forcing sponsors or taxpayers to pick up the shortfall.
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