With some equity markets near historic highs and interest rates in the U.S. poised to rise, achieving returns going forward may be more challenging for public defined benefit (DB) plans than in the past few years. In addition, public defined benefit plan sponsors will need to consider a number of other important factors as they contemplate investment strategy and asset allocation in 2015 and beyond, according to Michael A. Moran, senior pension strategist at Goldman Sachs Asset Management in New York City.

New accounting standards from the Governmental Accounting Standards Board (GASB) will move the valuation of assets from an actuarially smoothed methodology to a market value framework. The new GASB rules were finalized in 2012 but are just now starting to go into effect. As of now and over the course of 2015, public defined benefit plans will start new reporting, Moran says.

He explains to PLANSPONSOR that for valuing assets, the new rules move to mark-to-market accounting. Previously, public DBs used an actuarially smoothed asset value, for which gains or losses were spread over a period of time—generally five years. The new rules say public DBs will now use market asset values.

On the liability side, historically plans had used as a discount rate their expected return on assets assumption (EROA), but under new rules they will be able to use only the EROA for the expected benefit payments for which they expect to have assets to cover. For expected benefit payments that are unfunded, they must use the municipal bond rate.

“The upshot is, moving to mark-to-market on asset side will introduce a lot more volatility to that side of the calculation, so funded status will be more volatile. On the liability side, blending the EROA and municipal bond rate will reduce the total discount rate for some plans, so it will increase liabilities and decrease funded status in those situations,” Moran says. He points to a recent disclosure by the state of New Jersey as an example.

According to news reports, in a bond offering supplement released on November 25, New Jersey said its pension system has enough assets to cover 32.6% of projected liabilities, as of June 30, down from 54.2% a year earlier. The state said the lower ratio is because of new GASB rules. Fitch Ratings said New Jersey is the first to disclose the numbers under the new requirement.

Funded status based on asset market values now exceed funded ratios calculated based on actuarially calculated asset values for the first time since before the financial crisis; however, some plans will still face daunting deficits under new rules. Moran says despite the asset gains in recent periods, the need for return generation in portfolios is still strong.

In client communications, Moran says potential changes to mortality tables could also place even further downward pressure on funded status for some plans. “It is our understanding, based on conversations with those in the actuarial community, that many of the largest state and local plans develop their own mortality assumptions based on the actual experience of their participants. Indeed, the [Society of Actuaries’] project actually excluded public plan data from its analysis on the basis that mortality for public sector employees differs from private sector participants. Consequently, the changes [finalized] by the Society may not have any impact on some public plans. But for others that do rely on the Society’s mortality tables, these proposed changes could place downward pressure on funded levels, although perhaps implemented more slowly than what we are likely to see in the U.S. corporate DB universe,” he wrote.

Moran suggests that using an investment strategy to adjust risk as funded status fluctuates (i.e., a glide path strategy) may be a consideration for public defined benefit plans. “It has become fairly mainstream in the corporate DB community. At a high level, a glide path strategy says, ‘I’m going to change my risk exposure as certain factors change, such as funded status,’” he explains. As funded status increases, corporate defined benefit plans shift, for example, to longer-duration bonds, since pension obligations are valued based upon market interest rates of high-quality, long-duration bonds. This results in assets having similar characteristics to liabilities.

However, he notes that the public plans do not value pension obligations on market interest rates, and many will still be able to use EROAs, so buying long-duration bonds will not hedge the accounting liability. So what change can public DBs make at different funded levels? It could be tilting equity to less volatile strategies or smart beta strategies, keeping equity exposure but reducing risk, Moran says. “Glide path investing makes sense, but using different methods than in the corporate space. Perhaps we should have more dynamic strategies in public DBs. We could have used this in the 2000-to-2002 and 2008-to-2009 downturns to help protect the higher-funded levels at those times,” he adds.

According to Moran, over the past several years, the trend of public defined benefit plans increasing their allocations to alternative assets has been well-documented, though some have maintained little or no exposure to these asset classes and the use of alternatives varies widely between plans. He contends that it is likely more plans will at least explore increasing the allocation to alternatives, given that: 1) equity valuations are, in some markets, at historically high levels; 2) there is an expectation of rising interest rates; 3) funding gaps still need to be closed; and 4) some of them, potentially, desire to minimize the volatility of asset values due to the aforementioned change by the GASB to move toward a mark-to-market type of framework for calculating funded status.

In addition, investors seem to be increasingly coming to the conclusion that choosing investments based on environmental, social and governance (ESG) factors is not just about “doing the right thing” but that these factors are fundamental and can have a material impact on investment performance (see “Doing Well by Doing Good”). Moran says Goldman Sachs suspects more public plans will move in this direction.

Finally, Moran notes that under old GASB rules, public defined benefit plan sponsors had to calculate an annual required contribution (ARC). The ARC was not really “required” because the GASB has no authority to dictate plan funding, but it was intended to give a guide to fund normal cost and the amortization of plan deficits over 25 years or so. Even though it was not really required, many plans would use that as their de facto funding requirement. With new standards, the ARC is eliminated, so do we need something else? Moran queried. Pension funds need to think about a new mark, he says, with actuaries involved in the calculation.

Establishing actuarially-driven funding policies, and contributing in line with them, has proven to be a key to maintaining a well-funded plan, Moran notes.

“With the GASB rule change, nothing economically changes. It doesn’t change contribution requirements or benefit payments, but we know when we have a rule change, it tends to affect behavior and the way plans are viewed. So it will be interesting what the reaction will be as, over the course of the next year, like New Jersey did, public plans report new numbers,” he says.