The impact of persistently low rates of return

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Real interest rates are low and have been declining in fits and starts since about 1980 (after a significant run-up in the 1970s). As noted in my last post, any business with income and expense spread out over a long period of time is affected by the inflation-adjusted rate of return on investment assets. 

Long-term care insurance and pension funds

Consider long-term care insurance. Most LTC policies pay out when the insured is over the age of 80, typically decades after the premium payments have been made. If the insurer’s rate of return over time falls, either the amount covered must fall or the premiums must rise. This helps explains why the number of firms offering long-term care insurance fell from 125 in 2000 to only 15 by 2014.

The low rate of return on investment assets also has changed the financial picture for pension funds. For a pension fund to be solvent, the contributions for current workers must grow at a sufficient rate to ensure that the promised benefits are affordable. Some public pension plans are notoriously underfunded. Expected rates of return determine the amount of money that needs to be set aside today to ensure adequate funds when active workers retire. A shortfall leaves the pension plan underfunded, imposing higher premiums in the future. For the period 2000 to 2008, the average annual return for state pension funds was 5.87 percent, far below the 7.75 percent return assume by the plans.

The perils of seeking higher returns

The Federal Reserve reports that public pension liabilities totaled $9.1 trillion at the end of the second quarter, but are backed by assets worth only $4.2 trillion. New York’s pension system is, thankfully, in better shape than most. Its 2017 assets of $197 billion covered 94.5 percent of its liabilities.

Shortfalls in funding put significant pressure on fund managers. If returns on investments fall short, taxpayers (either current or future) will have to contribute more to supported promised pensions. In many states—like New York—public employee pension funds are protected by the state’s constitution, so the retirees are protected. 

The prospect of tax increases is not pretty—higher investment returns are a much less painful solution. And thisencourages risk taking. In the public pension space, managers have turned to alternative investments like private equity, hedge funds, commodities and real estate. While such alternative investments accounted for 9 percent of holdings in 2005, the Center for Retirement Research at Boston College reports, this share rose to 24 percent by 2015. Contrary to the hopes of managers, the strategy has been a failure. A 10 percent increase in allocation to alternatives between 2010 and 2015 reduced returns by 44 percent, according to the center’s calculations.

Risk taking among private investors

I wonder, too, if some of the venture investments we all observe—from outright scams like Theranos to investments with seriously-challenged math like WeWork or garden-variety “Uber” optimism—are just another side-effect of low investment returns. As the global savings glut persists, there’s a lot of money that is looking for an investment whose annual return beats 5 or 6 percent.

The causes of persistently low inflation and the related phenomenon of low returns on long-term investments are complex. Both pose risks for the stability of the economy and bear watching.

Kent Gardner is Rochester Beacon opinion editor.

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