Simply put – yes. Most pensions are still calculating their benefits assuming a 7%+ long-term rate of growth. Looking back at the last 30 years of market returns, that doesn’t seem so far-fetched, but unfortunately a pension fund’s ability to deliver on promised benefits is all about what it will in fact earn going forward over the next 10, 20, and 30 years. Here are the hard facts about current and likely future returns: Interest rates on bonds and credit investments are near or at historic lows. The highest quality government bonds pay under 2% and highly-rated corporate bonds don’t pay much more. This is a far cry from the 4-6% historical average, and there is currently no evidence that rates will be returning to those higher levels any time soon.
On the stock front, it’s not news to our readers that with stock valuations at record highs, returns over the next 10-15 years are likely to be nearly flat, or low single digits at best. The logic for this is simple and strongly rooted in historical evidence with respect to almost any asset that trades freely on an open market. If you pay too much for something, it usually will come back down in price once the cycle shifts. At best, it will just stop going up for a few years and trade sideways, although this isn’t generally how cycles work. Either way, that 8-10% historical stock market return isn’t very likely at all to come to fruition given where prices and valuations are today.
With the average pension fund at close to 60% in stocks and the vast majority of the remainder in bonds, the likelihood of achieving that 7% return that all the benefits are based on is, in our opinion, slim to none. If you’re wondering how pension funds can assume such an unrealistically high return number, the answer is really quite simple: If they lowered it to a more realistic one, that would shine a very bright spotlight on just how bad the situation really is and would require huge changes. Of course, pushing that moment off is always the easiest course of action.
So, what does this mean? It can only mean a couple things: Either benefits have to be cut significantly as this reality becomes undeniable, or contribution rates and/or taxes need to be increased significantly to make up for return shortfalls. In our opinion, the first is much more likely as the average person simply cannot afford and may not accept additional increases in taxes and/or contribution rates. So, if you are currently working and have a pension, look into taking a lump-sum distribution upon retirement so that you can invest those savings as you see fit moving forward. The lump-sum figure is likely still based on those unrealistic return assumptions. If you’ve already retired and are collecting a pension, we can hope that any adjustments won’t hit you as hard as future retirees/pensioners. Usually the brunt of any unpleasant adjustments are placed on those who haven’t yet started collecting. Either way, we are advising our clients to plan accordingly.
Editors Note: This article was originally published in the October 2019 edition of our “Cadence Clips” newsletter.