July 22, 2013
A NYT article on the fate of Detroit’s retired workers following its bankruptcy made reference to the pension funds’ assumption of an 8 percent return following its bankruptcy. There are two points worth making on this issue. First, it was an error to assume an 8 percent return in 2007 given the ratio of stock prices to trend earnings. At the time, that was over 20, which meant that stock could be expected to provide a real return of less than 5 percent going forward. Adding in an inflation premium of 3 percent would have meant that share of the fund invested in stock could have been expected to give an 8 percent nominal return.
If stock accounted for 70 percent of the fund, this would provide a return of 5.6 percentage points to the funds. If the remaining 30 percent of the fund had an average yield of 5 percent, then it would have provided a yield of 1.5 percentage points for a total yield of 7.1 percent. (It would have also been reasonable to include an adjustment for the expectation that stock prices would revert to their mean price-to-earnings ratio of 15.) Anyhow, the point is that an 8.0 percent return assumption would have been too high in 2007, it would not be today since the ratio of stock prices to trend earnings is close to its historic average of 15 to 1, meaning that stocks can be expected to provide their historic nominal rate of return which is close to 10 percent. (This is discussed at more length here and here.)
The second point is that implied preference in this piece for using the municipal bond interest rate for assessing liabilities would have mattered relatively little in this last decade. This rate, which averaged around 4.5 percent, also substantially exceeded pension fund returns in the economic crisis. In other words, whatever shortfall exists today in Detroit’s pension funds was not caused primarily by overly-optimistic return assumptions.
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