More Tough Times For US Public Funds

A Story in Five Numbers

Kurt Winkelmann, Raghu Suryanarayanan, Ferenc Szalai

The solvency issues of US public defined benefit plans are well-documented . Extraordinary investment performance in 2020 and 2021 combined with generous Federal funding have certainly  relieved some of the funding pressures, in part by compensating for low contribution rates for the previous decade. However, here are five reasons and seven charts that show why investment performance alone is unlikely to provide sustainable relief. At a minimum, public pension funds should regularly use scenario analysis, and develop contingency plans based on those analyses. Better would be a careful re-examination of the process used to set target investment returns .

Long-run real growth is likely to be low

Asset returns depend on the path of real economic growth: historically, economies that have experienced higher long-term growth have also experienced higher realized real equity returns. Thus, the starting point for any long-term investment problem should be a view on long-term real growth .

Exhibit 1 shows two views of long-term real growth - Navega’s and the Federal Reserve System’s. The Navega outlook is driven by the standard model of real economic growth. According to our models, US long-term real growth is around 1.7%. This figure is at the lower end of the Fed’s range of 1.7% to 1.9% . Importantly, all of these figures are well below the average real growth rate of approximately 3.0% observed between 1990 and 2007.

Exhibit 1 - Long Term Real Growth Is Expected to Be Low

 Long Term Real Growth Is Expected to Be Low
Source: Navega Strategies LLC Research, Federal Reserve Board (FRB)

Long run equity returns are just as likely to be low

Expected long run equity returns depend on both the level of real growth and the level of uncertainty about long run growth. Realized equity returns (i.e., the returns experienced by investors) depend on changes in growth uncertainty and growth expectations. Real growth drives equity cash flows, while growth uncertainty drives discount rates. 

Exhibit 2 plots our estimate of growth uncertainty from 1990 through June 2022. As is evident from the exhibit, growth uncertainty is currently higher than its long-term average. And expected long-term growth has trended down since before the Global Financial Crisis of 2007-8.

Exhibit 2 - Long Run Growth Is Uncertain

 Long Run Growth Is Uncertain
Source: Navega Strategies LLC Research

Exhibit 3 shows the levels of expected equity total returns conditioned on three levels of expected long-term real growth and growth uncertainty: (a) Navega’s baseline scenario (see Exhibit 1); (b) high growth with low uncertainty,  and c) low growth with high uncertainty. Under these scenarios, expected total equity nominal returns range from 6.0% to 10.8%. These expected returns are well below the average return of 12.5% observed between 2012 and 2022. Exhibit 3 also shows the important role of real growth and growth uncertainty in determining expected long-term nominal equity returns.

Exhibit 3 - Expected Returns and Expected Real Growth Are Linked

Expected Returns and Expected Real Growth Are Linked
Source: Navega Strategies LLC Research

Target returns are still too high

Public pension funds make asset allocation decisions on the basis of their target return. Over the last two decades, public funds actual investment performance has trailed their target returns by about 100 basis points. Indeed, over the period 2001-2021, only 11 of 169 public funds met or outperformed their target return on a cumulative basis. This point is illustrated in exhibit 4. The exhibit suggests that over the past 20 years, target returns have been too high .

Exhibit 4 - Actual Returns Have Not Met Targets

Actual Returns Have Not Met Targets
Source: Navega Strategies LLC Research, Pew Charitable Trusts

What about projected performance? Exhibit 5 shows the projected distribution of public fund performance relative to their target returns on a 10-year forward basis. The analysis shows the impact on projected performance of three different scenarios for long-term growth and growth uncertainty. Only in the high real growth scenario are the majority of funds projected to meet or outperform their target .

Exhibit 5 - Real Growth Will Determine Whether Targets Are Met

Real Growth Will Determine Whether Targets Are Met
Source: Navega Strategies LLC Research

The main reason that funds have underperformed their targets is that target returns have been slow to adjust. To give a simple example, had funds kept a constant risk premium, and adjusted return targets with US Treasury rates, then 112 out of 169 funds would have achieved their targets over the 21 year time period . (The process in this example has the benefits of being responsive to market conditions and being straightforward to calculate).

Demographic changes are unfavorable

Why is it unlikely that real growth will go back to its pre-2005 trend? The two main drivers of real growth are growth in hours worked and growth in total factor productivity (TFP). Growth in hours worked depends in turn on the growth of the potential labor force. The simplest way to understand this point is through the dependency ratio (the ratio of retired workers to those currently working). Exhibit 6 shows that the US dependency ratio has increased slightly since 2016, and is projected to increase substantially through 2060, i.e. there are projected to be fewer working age people relative to retired people. Hence, it is reasonable to project that hours worked will also grow at a slower rate over the long term . This issue is particularly acute for public sector workers: since 2009, public sector employment growth has been at best flat, whereas private sector employment has increased at an annual rate of 1.1% . The bottom line is that relatively fewer people working makes it more challenging to finance benefits for retirees.

Exhibit 6 - The Dependency Ratio Is Projected to Increase

The Dependency Ratio Is Projected to Increase
Source: US Census Bureau (Current Population Reports, Updated February 2020) and Navega Strategies LLC Research Calculations

Inflation pressures could increase benefit payments

It goes without saying that observed inflation rates since the beginning of 2021 have been quite high relative to the experience between 1990 and 2019. However, long-term inflation projections are much more benign. Exhibit 7 compares Navega’s long-term inflation forecast  with the Fed’s and the bond market’s (the spread between nominal and real 10-year bond yields).

Obviously, the long-term forecasts are well below the levels of observed inflation in 2022. A substantial part of the explanation for these differences lies in the distinction between supply- and demand-side effects . To the extent that supply-side tensions dissipate, then demand-side effects would lead to the long run figures in the Exhibit. 

Exhibit 7 - Long Run Inflation Expectations Are Muted

Long Run Inflation Expectations Are Muted
Source: Navega Strategies LLC Research, Federal Reserve Board (FRB), Refinitiv

The distinction between realized (actual) short-term inflation and projected inflation is important because high observed inflation rates make it likely that the demand for restoration of COLAs will increase. However, it is hard to see how the demands for restored COLAs will be financed if expected asset returns and real growth are low. The combination of increased benefits and low asset returns could be disastrous for public pension solvency .


What should public fund investment staff and trustees do? In the absence of wholesale pension reform, we see three practical steps that plans can take. First, investment professionals should more fully embrace stress tests (both macro and extreme equity market events), and develop contingency plans based on those stress tests. Second, staff and trustees should discuss projected returns in terms of risk premiums, not total returns . Finally, target returns should be an agreement between investment staff and state Treasurers, preferably with an independent third-party as arbiter (e.g., a state insurance commissioner). These discussions should be based on market prices - any deviations from market prices should be documented and justified, and should incorporate the same distinction between total returns and risk premiums.

Each of the steps outlined above are practical and feasible, and add transparency to the public fund investment process. In our view, these steps should be adopted regardless of whether further reform to public pensions are considered .

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