With 3, 5, and 10 Year Stock Returns Negative, Why Are Pension Funds Assuming 8% Returns?

by: Kenneth Hackel, CFA

A good question, and one that is soon to haunt many stock investors.

How?

The median S&P firm assumes their defined benefit plans will be able to return 8% on their plan assets, far short of that which appears reasonable. Even with yesterday’s 3.1% rally, stock returns have been quite negative in almost every period over the past decade. And what about real estate? For firms that thought commercial properties would raise their long-term returns, those returns have been poor as well. No help there.

With the economy, including employment, lagging, is there any reason to believe financial assets will return to the 8% annual level? We think not.

And if firms decided to terminate their plans and place those assets in insurance annuities? Forget it, as annuities are yielding about 4.5%, depending on the contract being written and the risk the pension sponsor is willing to take back. This compares to a discount (settlement) rate that averages at least 150 basis points higher.

Aside from the exorbitant investment return assumption, sponsors are also benefiting from other liberal actuarial assumptions, such as the spread between the investment assumption and the salary assumption, the latter now 4% on average. The problem is that the investment assumption is a more powerful variable, as it applies to both the active and retired workforce.

For pension plans that were underfunded 2 years ago and received the benefit of last year's financial market rebound, the chances are they have returned to underfunded status, probably requiring stepped-up contributions. To the extent they hold this off, they are overstating their cash flows.

It is an area worth exploring - as investors in GM learned.

Disclosure: No positions