Administration

The Challenge in Lowering Public Pensions’ Return Assumptions

Public plans that reduce their return assumption in the face of diminished near-term projections will experience an immediate increase in unfunded liabilities and required costs, according to NASRA.

By PLANSPONSOR staff editors@plansponsor.com | February 27, 2017

In the wake of the 2008-09 decline in capital markets, and Great Recession, global interest rates and inflation have remained low by historic standards, due partly to so-called quantitative easing of central banks in many industrialized economies, including the U.S., the National Association of State Retirement Administrators (NASRA) notes in an Issue Brief.

Now in their eighth year, these low interest rates, along with low rates of projected global economic growth, have led to reductions in projected returns for most asset classes, which, in turn, have resulted in an unprecedented number of reductions in the investment return assumption used by public pension plans. Among the 127 plans NASRA measured, nearly three-fourths have reduced their investment return assumption since fiscal year 2010, resulting in a decline in the average return assumption from 7.91% to 7.52%.

NASRA says one challenging facet of setting the investment return assumption that has emerged more recently is a divergence between expected returns over the near term (the next five to 10 years) and over the longer term (20 to 30 years). A growing number of investment return projections are concluding that near-term returns will be materially lower than both historic norms as well as projected returns over longer timeframes.

According to the Issue Brief, if near-term rates do prove to be lower than historic norms, plans that maintain their long-term return assumption are likely to experience a steady increase in unfunded pension liabilities and corresponding costs. Alternatively, plans that reduce their assumption in the face of diminished near-term projections will experience an immediate increase in unfunded liabilities and required costs. “As a rule of thumb, a 25 basis point reduction in the return assumption, such as from 8.0% to 7.75%, will increase the cost of a plan that has a COLA, by three percent of pay (such as from 10% to 13%), and a plan that does not have a COLA, by two percent of pay.

“The investment return assumption is the single most consequential of all actuarial assumptions in terms of its effect on a pension plan’s finances,” the Issue Brief says. NASRA suggests, “The process for evaluating a pension plan’s investment return assumption should include abundant input and feedback from professional experts and actuaries, and should reflect consideration of the factors prescribed in actuarial standards of practice.”

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