How is your retirement account doing?
Many households have opened the October statements from their 401K plans or IRA accounts and have seen a nice rise for the month. Stock prices rose strongly during what is normally a bad time of the year for the market.
The Standard and Poor’s 500 Index rose 10.7 percent in October, compared with an average return of only 0.43 percent for the month over the last six decades. This high monthly return for stocks is also well above the average annual return on stocks of 7.3 percent before dividends since 1958.
We can’t expect our retirement accounts to deliver such big gains regularly. Such returns are, however, just what many state pension funds are expecting.
Unlike the self-directed retirement plans most private-sector employees have, state employees are covered by defined-benefit plans. Under defined-benefit plans, states put aside money each year and invest it in stocks and bonds to meet guaranteed retirement benefits for all state employees.
Many states are assuming they will earn 8 percent or more on these investment portfolios, a higher rate of growth than they have guaranteed to pay out in benefits to most retirees. Some plans expect this rate of return even though a large portion of the portfolio is invested in bonds earning 4 percent or less. This is to say nothing of the fact that stocks may not even earn 7 percent.
According to the Pew Center on the States, as of 2010 state pension plans were 78 percent funded, declining from 84 percent in 2008. State governments are not setting aside enough money each year to meet these pension obligations, because they unreasonably assume the existing portfolios of stocks and bonds will earn a higher rate of return than the required payouts.
Idaho’s state pension plan, the Public Employment Retirement System of Idaho, earned more than 20 percent on its investments for the fiscal year that ended June 30, the “best fiscal year in the last 25 years.” The fund earned 64 percent since the market lows of March 2009.
These outsized returns help the fund earn back much of what was lost during the downturn, but will be hard to maintain going forward. Over the long run stocks have earned an average premium over risk-free assets of 7 percent.
With Treasury Bills now yielding practically zero, and continuing high unemployment and low expected growth in the economy, stocks will most likely have many years of lower-than-average returns.
Further, the state pension plans like PERSI are guaranteed. The state is on the hook for retiree benefits no matter what happens to the financial markets. For this reason, PERSI should invest more in assets with a guaranteed returns, like long-term U.S. Treasury bonds.
Long-term bonds are yielding only 3 percent today. Using this lower but more certain return, researchers have found that state pension plans in the U.S. are underfunded by trillions of dollars. Idaho and other state governments will need to devote more of their current tax receipts to pension obligations.
Returns in retirement accounts may look good now, but the next financial crisis — underfunded state pension funds — may be just around the corner.
PETER CRABB Professor of finance and economics at Northwest Nazarene University in Nampa