December 27, 2016 / 5:59 PM / 9 months ago

Rate hikes will help U.S. pensions, but not enough

U.S. Federal Reserve Board Chairwoman Janet Yellen testifies before a Congressional Joint Economic hearing on Capitol Hill in Washington, U.S., November 17, 2016. REUTERS/Gary Cameron/File Photo - RTSU8U4

CHICAGO (Reuters Breakingviews) - Interest-rate hikes will help America’s underfunded public pensions in 2017. Relief could be fleeting, however, especially if the U.S. economy falters. Illinois and Dallas, in particular, are canaries in a $1 trillion coal mine.

That’s roughly the size of the gap between the value of assets owned by U.S. states’ pensions and their actuarially calculated obligations to retirees. Looked at another way, their holdings fall about 25 percent short of their $3.7 trillion of total liabilities to former police, teachers and the like. The low interest rates prevailing since 2008 have sapped returns on bonds, making an already tricky funding situation worse.

Higher rates would help get the number down, because government-bond yields are used to discount pension liabilities. It would be a largely symbolic victory, though. The $1 trillion of underfunding is itself an accounting fiction, since it’s based on pension systems’ own assessments of their likely long-run investment returns.

The average public pension fund made just 1 percent in the fiscal year to June, according to Wilshire Consulting. Consultants at Cliffwater estimate the median U.S. state pension system made a 6.8 percent annual return over the 10 years to June 2015. Yet most still assume that they’ll make a 7 percent to 8 percent annual return on their assets indefinitely.

Even if yields perk up further, a 5 percent long-run return assumption may be more realistic. Breakingviews estimates that cutting forecast returns to 5 percent from 7.5 percent would more than double the underfunded amount. To overcome that, rates would either have to rise sharply, which could hurt the broader economy, or pension plans would have to dive into riskier assets, hoping to get lucky. Either scenario makes a bad outcome more likely.

The worst has already happened in Texas, where an ill-fated foray into real estate sparked a bank-like rush to withdraw savings from the $2.7 billion Dallas Police and Fire Pension System. Meanwhile, in Illinois, an official warned in August the state could face “hundreds of millions of dollars in higher taxes or reduced services” from a mere quarter-point reduction in the long-term return assumption at the state’s biggest pension fund.

The bleak conclusion for pension bosses is that even if rates move higher, it’s unlikely to provide much comfort.

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