The City’s plan for selling Pension Obligation Bonds has significant risks.
After a century of U.S. equity returns exceeding taxable investment-grade funding costs by about 4% annually, and an even more booming stock market for the past 17 years, it is human nature to extrapolate leveraging pension debt into largely equity investments as a low-risk method of reducing Newton’s long-term pension costs, as proposed by the Mayor and Newton Retirement Board. However, I believe that the perception of low risk is an illusion.
Newton’s pension fund is already leveraged to the stock market. Fully secure funding would be almost entirely in fixed-rate and inflation-linked bonds carrying a substantially lower interest rate than the actuarially assumed 6.9% future return of the fund’s investments, which are largely in public and private equities, carrying more risk.
It is dangerous to assume that future equity returns will nearly match prior long-term returns.
The U.S. stock market’s price-to-earnings ratio is near an all-time historical peak, and dividend yields are near an all-time low. Historically, after such conditions (after 1929 and 2000 peaks in the U.S., after the 1989 peak in Japan), equity returns have on average trailed bond returns for at least a decade.
U.S. corporate profitability as a percent of revenues and GDP has risen to unprecedented levels, and the U.S. stock market appears to be projecting further increases in profit margins never seen before, in part from projected AI-related profits. International competition, especially from China, is a great long-term threat to U.S. corporate profitability.
Newton citizens who wish to increase their equity exposures can do so individually, rather than indirectly through the City’s sale of Pension Obligation Bonds. If the City wishes to increase its leverage, it can do so at lower cost with tax-exempt bonds.
Edward Astrachan
Chestnut Hill
Edward Astrachan is a retired actuary and investment strategist.
