The seven per cent problem

Illinois is mired in pension debts. Most states have them, but we have them worse. Accountants look at three main numbers when they calculate pension obligations: the number of years that people will be receiving a pension; the size of the pension payments; and the investment returns. Part of the problem is that people are living longer. Part of the problem is that politicians sweetened pensions to keep labor piece and voters didn’t ask questions as long as their taxes didn’t go up. But a huge part of the problem is that most pensions assumed a return of about seven percent, which seemed conservative at one time.

But no one has received a seven percent return with any consistency any time recently. Hedge funds became popular because absolute return funds seemed to offer institutions just that, but few have been able to deliver.

To some extent, that’s the source of so many of our problems. Parents haven’t saved enough to send their kids to college because they were assuming they would make a least a little money on their investments. State college savings plans are underfunded because they assumed that they would have investment returns. Pension boards assumed that the markets would go up at least a little bit. People facing retirement would have more money if interest rates were even one percent!

I’m mostly a fan of Dave Ramsey. I like his emphasis on thrift and on eliminating debt. Taking care of those two things will help most people get ahead. Then, if you can earn a return on investments that beats inflation, you’re set. But those returns are elusive. Ramsey has long used a 12 percent return assumption, and that was aggressive even before the year 2000. If we could get anywhere close to that, so many personal and political financial problems would disappear.

Many of the shortfalls that people and government are facing are not due to personal failings. Many of them are due to the fact that the financial markets have been outright crummy. It can’t last forever, but who knows what will make it turn? You’re better off if you put money aside, even at zero interest. The example of Illinois shows that if you don’t put the money aside, you’re really screwed; the example of other states shows that you can be screwed even if you put the money aside.

A seven percent return on a blended portfolio is a good assumption for the very long term. But that doesn’t solve any problems here and now.

 

A white woman with green glasses and gray hairAnn C. Logue

I teach and write about finance. I’m the author of four books in Wiley’s …For Dummies series, a fintech content expert, and an avid traveler. Among other things.

Latest Work

Hedge funds for Dummies Cover

Hedge Funds for Dummies, 2e
My first book has been completely revised! Updated to reflect changing markets, accessible strategies through ETFs, and new potential due diligence pitfalls.

MORE »

VIEW ALL WORK »

Latest Work

Cover of Day Trading for Dummies

Day Trading for Dummies, 5e
With five revisions, countless interviews with successful traders, and lots of research, this is the definitive guide to getting started, managing risk, and staying in the game.

MORE »

VIEW ALL WORK »