Many personal financial planning tools will evaluate an investment portfolio and present a projected return based on the historical performance of the underlying investments. While these tools can optimize portfolio construction for past conditions, the relevance of this number compared with future returns is at best, uncertain.
A globally balanced portfolio of 60 percent stocks and 40 percent bonds — generally a neutral allocation that is not considered aggressive or conservative — could easily present a projected average annual return of 7 percent to 8 percent based on historical precedent.
With income from bonds at historic lows (even negative in much of the world) and U.S. stocks seemingly expensive (even after the Brexit event), I don’t think it’s an intellectually honest assessment to project 7 percent or 8 percent returns for anything short of an aggressively positioned portfolio.
This creates a bit of concern when I review the investment account that has the widest effect on Washington residents. The Washington State Investment Board manages funds to meet the retirement pension obligations for government employees (teachers, police, firefighters and other state workers). The largest pool of this money — a little over $80 billion as of March 31 reporting — is in the Retirement Commingled Trust Fund. This fund receives contributions from employees and employers but more significantly relies on investment returns to grow this pool of money significantly enough to meet future pension obligations. Current state law has set the return expectation for these funds at 7.8 percent per year over time. Next July 1, the return assumption will decline to 7.7 percent per year.
For many years, this return didn’t appear prohibitive. In fact, some similar investment pools around the country targeted meaningfully higher returns. Official return expectations have come down but may need to continue retreating to reflect reality. The realized 10-year average annual return for this Commingled Trust Fund ending March 31, 2016 was just 6.12 percent. And investment conditions don’t appear to support higher returns any time soon.
I occasionally review projected returns for a variety of global asset classes from different firms. When applying these assumptions (which are usually targeted for the next seven to 10 years) to the state’s Commingled Trust Fund investment mix, the result is a projected portfolio return of less than 6 percent, well under the 7.8 percent return that is currently planned for by the state.
This state portfolio has a target asset mix of 37 percent public stocks (U.S. and international liquid stocks traded on public exchanges), 23 percent private equity (several types of investments only available to certain sophisticated investors in closed markets), 20 percent fixed income (publicly traded bonds from governments and corporations), 15 percent real estate (commercial properties around the globe, mostly privately traded) and 5 percent tangible assets (real assets such as commodities).
Heavy Lifting Required
Given this allocation, it’s clear that the state investment board expects the illiquid investments in private equity and real estate to do a lot of heavy lifting to generate returns above the broad portfolio target of 7.8 percent on an annual average basis. These excess returns will likely be needed to offset lower forward returns from bonds. The bond market landscape of today may be challenged to contribute 3 percent annual returns over the next decade. This may require private equity to exceed its 10-year return in the state pool of 9.6 percent to offset the reduced contribution from bonds.
The state investment board is not alone in expecting excess returns from private equity investments. It is a common asset class in institutional portfolios. The state also is not alone in its 7.8 percent return target. Of 127 state pension plans evaluated by the National Association of State Retirement Administrators, 44 of them have expected average annual returns at 7.8 percent or higher.
Implications of Shortfall
Even a 0.5 percent difference in average annual investment returns would be massive over time. In just 10 years, if the $80 billion state pool earned a 7.3 percent annual return instead of 7.8 percent, the account balance would be over $6 billion less.
This sort of shortfall could eventually require employees to contribute more, or accept less retirement income in the future, to make up the difference. It is a significant challenge for any entity that accepts the investment risk of addressing huge pension liabilities. Even if actuaries suggest the plan is well-funded today, continued returns well short of the target may put stress on the ability to meet future obligations.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor. Reach him at firstname.lastname@example.org.
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