One of the biggest stories of the coming decades will be whether pension funds, both public and private, will be able to earn an adequate return on their investments. If they do, great. If they don't, there could literally be trillions of dollars of unfunded liabilities, setting up waves of disappointed retirees who learn how fickle the words "guaranteed pension" can be.

Last month, I sat down with Robert Arnott, CEO of Research Affiliates and one of the brightest financial minds of recent history. I asked him his take on whether the return assumptions pension funds are using these days are reasonable. Here's his response, which includes some important financial wisdom. (Transcript follows.)

Morgan Housel: We spoke with the chief investment officer of a major pension fund recently who has a 7.5% assumed rate of return going forward, and he readily admitted that the fund will not meet that within the next five or 10 years, but he said over the next 20 or 30 years he thinks its feasible. When you look at private pensions and public pensions, what rate of return do you think they should be using for the next 10, 20 years?

Robert Arnott: Again, I'm going to be provocative. I think the right assumption is to work off the Treasury yield curve, because anything you earn beyond the Treasury yield curve, which of course tops out in the high twos right now; anything beyond that is earned by dint of either a risk premium or an alpha. And I think pensions shouldn't count on risk premium or alpha until it's been earned.

Now that, in turn, means that if you calculated based on the Treasury yield curve and you're expecting you can do better than that, that you should be content with less than 100% funding. So if you aim for calculating your funded ratio based on the Treasury yield curve, if you're 70 or 80% funded, that's OK. unfortunately, using 7 or 8% is the norm in the public pension fund community. They're not going to earn that unless they invest rather wildly out of mainstream. And if they do so, there's a reciprocal risk of sharp underperformance.

So with a reasonably conventional portfolio, let's say 60/40 stocks/bonds, comprises three-fourths of the portfolio and only 25% is invested outside of mainstream. If outside of mainstream gives you an opportunity to do 3 or 4% better, then you've just added 1% to your return expectations, and anything beyond a 4, maybe 5% return expectation, is heroically optimistic.

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Although Rob Arnott is correct when he says that pension obligations should be measured using Treasuries (or something similarly free of default risk and equity exposure), I disagree with the idea that investing with the expectation of higher returns justifies funding at the 70-80% level, especially in the public sector.

In the private sector, investors who can observe the value of pension liabilities computed using Treasuries can make their own adjustments for asset levels below or above 100%. They can, in theory, adjust share prices based on this observation.

In the public sector, however, less than 100% funding means that future taxpayers will have to make up the shortfall -- either by paying it or by accepting risks (as Rob suggests). But the associated services (police protection, etc.) have served the current generation of taxpayers. Why should the future taxpayers pay? Rob argues that returns above Treasuries may be anticipated and used to make up the shortfall. This means that future taxpayers are underwriting the investment risk -- but they are going to receive less than the full returns earned by taking that risk.

If the plan is 100% funded using Treasuries, and then takes risk, future taxpayers will win or lose the bet they are underwriting. This is fair.

Jeremy Gold, FSA, PhD

January 14 2013 at 11:21 AM Report abuse rate up rate down Reply