What’s in a number? Quite a lot can rest on the choice of a single figure when it represents a pension fund’s long-term return assumptions. Much rides on these assumptions, which affect current and future contribution rates. There is a great deal to lose if the balance between current and future generations gets out of kilter.
This means return assumptions are a contentious issue, particularly in the US, where public pension plans have for a number of years used optimistic return expectations to cover over the cracks of chronic underfunding. US corporate plans, by contrast, have applied much more conservative return figures in recent years.
Contributors to US public pension plans are structurally undersaving for retirement and arguably passing the bill to future generations of public sector workers, who face lower benefits for higher contributions, or on to local and state taxpayers who ultimately face the bill to plug state and local pension fund deficits. There is increasing evidence that taxpayers are unwilling to foot the bill for public sector defined benefit (DB) pension funds when they do not themselves have access to DB pensions.
Compared with other countries, it can be argued that a country like the Netherlands is structurally over-saving for its collective retirement, with pension assets at more than 160% of GDP and an asset pool in excess of €1trn. Certainly, the situation at ABP is much less precarious than some of the public funds in the US, or indeed in the UK, where underfunding is starting to look structural.
ABP has come in for some criticism for its return assumptions from the Dutch regulator, which wants higher contributions to boost funding to 128%. In its recovery plan, ABP has assumed the maximum permitted return of 7% for equities and 6% for real estate, with an eight-year recovery plan. The average recovery plan for other schemes is 6.5 years. In a delicate political balance, ABP is allowing a real-wage increase for Dutch civil servants by dampening down on contributions, which are high at 19.6% – 13.33% from the employer and 6.27% from the employee.
Making reasoned and reasonable assumptions about future asset class returns is harder than ever now, well over six years since the equity market recovery and approaching the first anniversary of euro-zone quantitative easing (QE). The problem has been highlighted by whipsawing yields in benchmark assets like 10-year Bunds this year, as well as by this summer’s volatility in equity markets. Triggered by the sell-off in China, this has also highlighted weakness in emerging markets and the spotlight has turned to the US as the anchor of the global economy.
ABP might be forgiven for assuming a higher medium-term euro-zone equity risk premium, given the ECB’s QE programme and the effect this is having both on yields and on the fund’s solvency level.
At this point in the economic recovery, there is also a real balance to be struck between future saving and current real wage growth for pension savers. Some period of undersaving, in the form of a modestly longer recovery period, might be the right price to rebalance the equation in favour of higher public-sector take home pay.
No regulator, actuary, economist or chief investment officer has a monopoly on the wisdom of the optimum balance between the two sides of the equation, or of the right calibration of return assumptions. Whether in the US or the Netherlands, such debates introduce a level of intricacy, not to mention acrimony, that hastens the demise of public sector defined benefit in favour of defined contribution savings.