Forecasting Investment Returns
This is never easy, but the board of the largest U.S. pension fund is taking a new look at what the future might bring. The California Public Employee’s Retirement System (Calpers) plans to lower the current 7.5% goal to 7.0%, phased in over the next thee years.
With this decision, Calpers is changing its business plan, projecting that future investment returns will cover a smaller portion of retirees’ pensions than previously. The shortfall will have to be covered by increased employer (local governments) contributions, requiring either higher taxes and/or reduced public services. It is likely that workers are also going to see increased payroll deductions relating to the cost of their pensions.
The difference between 7.5% and 7.0% may seem small, but a modest change in the assumed rate has a material impact, as it is multiplied across decades and large numbers of employees.
While the foregoing discussion addresses changes at Calpers, the economic and investment realties behind the expected reductions in investment returns are applicable to all defined benefit pension plans, whether public or private. Investors should note that, companies with defined benefit plans will have to review their investment return assumptions and are likely to find that they will have to increase company contributions to existing plans, and/or negotiate higher employee contributions. Increases in company contributions will be a direct charge to earnings.
All comments and suggestions are welcome.
Walter J. Kirchberger, CFA®