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WASHINGTON (Reuters) - A testy exchange between a congressman and a governor at a U.S. congressional hearing last week highlighted an issue few Americans ever ponder: rates of return on public pension investments.
"If somebody told me they expected to get an 8 to 8.5 percent return I'd say they were probably smoking those maple leaves," Representative Jason Chaffetz of Utah told Peter Shumlin, the governor of Vermont, which is renowned for its maple trees.
Shumlin countered that his state's expectation of an 8.25 percent annual rate of return is reasonable.
"You'll find we get about an 8 percent return on average," he said. "Obviously there are good years and bad years, but, unlike General Motors, we're not going to go bankrupt and we have to look at averages."
Public pension funds are backed by contributions from employees and employers and by earnings from investments, which provide more than half of revenues.
Typically, when returns are low, governments make larger contributions to their pension funds. But, amid some of the worst budget crises in recent memory, state and local governments cut deposits just as the stock market plunged.
These large liabilities, in turn, could add to states' financial problems over the longer term and make it harder for them to close their persistent budget gaps.
The value of retirement funds' assets peaked at $3.2 trillion in 2007 and then fell by more than a quarter to $2.8 trillion in 2008, according to the Federal Reserve. In 2010, they rebounded slightly to $2.9 trillion.
Getting the rate of return wrong could cause serious troubles for pensioners, states, and the markets, where retirement systems such as California's are a force.
"One downside of setting a rate, any rate, is if you exceed or miss the target, it's hard to plan. That's why there's no consensus on what the rate should be," said Kil Huh, who tracks pension funds for the Pew Center on the States.
States rely on averages because they must look at long-term horizons to guarantee their pension promises, Huh said.
Almost everyone agrees many pension funds can cover promises to current retirees, but not those in the future. Estimates of the total gap range from $700 billion to $3 trillion because of disputes on calculating returns.
More than half of 124 pension funds surveyed by the National Association of State Retirement Administrators expect a return of 8 percent, while 38 expect less and 35 more.
Some states, such as Illinois, are lowering expectations. Rhode Island is looking into dropping its rate to 7.5 percent.
And in Congress, Republicans are calling for pensions to put expected rates of return at around 4 percent.
Going back 20 years, the average annual return is 8.1 percent, Huh said. In the last decade, it is just 3.9 percent.
"For the people who want to cut employee pensions, they'll take 2000 as a reference point," said David Hitchcock, senior director at Standard & Poor's Ratings Services. "They're making the most dramatic case possible."
Joshua Rauh, an associate professor at Northwestern University, has offered the dire prediction of $3 trillion, mostly by projecting asset returns using a "risk-free interest rate" such as that paid by Treasury bills and bonds.
Cutting rates ignores the economy's resilience, said Chris Mier, managing director at Loop Capital Markets, noting returns have been higher than 8 percent over the last two years.
Stateline.org, which follows states' issues, found 20 public employee pension plans had preliminary returns ranging from 10.8 percent to 18.7 percent for the year ended in June.
If the shortfall is only $700 billion, then governments would have to devote 5 percent of their budgets to pensions over the next 30 years, wrote Monique Morrissey recently for the liberal-leaning think tank Economic Policy Institute. They currently put in about 4 percent.
But if the shortfall is in the trillions, states and cities may have to slash spending on other services.
Andrew Biggs, of the conservative American Enterprise Institute, says pension funds are forced to invest public dollars in riskier assets, acting more like hedge funds.
He recently told a state legislators meeting "the absurdity of how public pensions work" is that "the more risk you take, the higher your expected rate of return."
There are also dangers of setting expectations too low, said Elizabeth McNichol, senior fellow at the Center on Budget and Policy Priorities.
Low expectations could force governments to make unnecessarily large contributions, pulling money away from other areas. If returns are better than forecast, employees may ask for more benefits or governments may skip making contributions.
"The problem," she said, "is it's not sustainable and you become underfunded in the future."
Additional reporting by Edith Honan in New York; Editing by Leslie Adler