What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed

It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return. By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate. In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison - the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.