Thursday, November 18, 2010

NYC Pensions Adjusting to the New Normal?

Bloomberg reports, New York City May Cut Assumed Rate of Return on Pension Assets, Liu Says:

New York City may reduce the assumed return on its $100.5 billion of pension investments from the current 8 percent rate, Comptroller John Liu said today.

The move would increase the amount of money the city must contribute to its five public retirement plans even as it faces a $2.4 billion budget deficit next year, Liu said after a speech at the Union League Club in Manhattan. The city’s pension costs are expected to rise more than 15 percent next year, to $8.3 billion, budget director Mark Page said today. That’s about 20 percent of municipal tax revenue, he said.

“The city has maintained an 8 percent assumed rate for a long time,” Liu said. “It’s fair to say that the assumption will be lowered at some point.”

Public-pension funds from New York state to Illinois are cutting their expected returns amid market losses and in the face of a sluggish economy. New York state’s $132.8 billion retirement fund lowered its target to 7.5 percent from 8 percent, while the Illinois State Employees’ Retirement System cut its rate to 7.75 percent from 8.5 percent, Tim Blair, the system’s executive secretary, said in a telephone interview.

In the 10 years from July 1999 to June 2009, New York’s pensions returned 2.09 percent, according to the city’s comprehensive annual financial report for the fiscal year ended June 30, 2009.

Trustees’ Approval

Liu didn’t say when the change might occur or what the new assumed rate might be. The decrease must be approved by the trustees of the five funds for civil employees, police officers, firefighters, teachers and school administrators as well as the state Legislature. The plans cover 334,000 city employees and 237,000 retirees and beneficiaries.

Liu’s prediction of a more conservative investment outlook follows remarks by Mayor Michael Bloomberg last month calling the pensions’ assumed rate of return unrealistically high.

New York City is seeking more power to set pension benefits for workers as retirement costs grow.

Mayor Bloomberg is absolutely right, the assumed rate of return is unrealistically high. Many US pension plans still grasp onto this ridiculous 8% assumed rate of return, which is why they've reached their breaking point. With 10-year bond yields hovering around 2.9%, an 8% assumed rate of return is a pipe dream. Sooner or later, trustees will have to adjust their expectations accordingly.

Even 7.5% is not realistic. I don't care if pensions shove all their assets into alternatives (hedge funds, private equity, real estate, infrastructure, etc.), they'll still come up short. Tyler Durden at Zero Hedge discussed GMO's 7-year asset class return forecast (click on chart above):

Jeremy Grantham, who has been rather vocal in his condemnation of the Fed recently, and has been rather lukewarm in his endorsement of equities as an asset class, has released an updated (as of Oct 31) estimate for 7 Year returns by asset class. And it has bad news for pension funds which have a rather high bogey of about 8% per year.

If Grantham is correct the 'new normal' (which is really the normal normal but with the cheap credit spigot taken away due to a new deleveraging regime) also means that pension fund actuarial models have to be scrapped as they will likely not be able to attain the kinds of returns needed to keep them solvent based on capital appreciation expectations.

Where Grantham sees the best return potential is in international and emerging equities, presumably on the assumption that decoupling will take place. On the other hand, many are increasingly seeing the possibility of a China topping as a major risk factor. While Grantham is bearish on small cap US equities and sees just a modest outperformance of large caps, what he hates the most are all bonds, where in four out of five categories he see a negative 7 year return. Perhaps it is time for a Rosie-Grantham round table.

I'm inclined to side with Grantham on bonds, but I'm also acutely aware that JGBs outperformed the S&P 500 over the last ten years and was the number one performing asset class during Japan's lost decades. All that quantitative easing by the BoJ and the so-called Japanese bond bubble still hasn't popped. Lots of smart hedge fund managers shorting JGBs got their heads handed to them in the last 15 years. Could the same thing happen in the US over the next decade? Who knows? All I know is that more pension plans will have to adjust to the new normal or they risk seeing their pension deficits spiral out of control.

***Feedback***

Bernard Dussault, former Chief Actuary of Canada, had this to say on this topic: ''Reducing the assumed gross return from 8% to 7.5% is in the good direction. Still too high, should not exceed 7%, or more precisely the real rate of return (gross minus inflation, presuming that benefits are indexed) should not exceed 7%.''

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