To isolate how public defined benefit (DB) plans’ investment return assumptions affect their asset allocation, the Center for Retirement Research (CRR) at Boston College compared public plans to single-employer private DB plans and found even after controlling for a number of factors, public plans invest more in riskier assets than private plans, and for any given asset allocation, public plan return assumptions are on the optimistic end compared with those of investment professionals.

The researchers point out that private plans do not use the assumed return to value liabilities in their financial statements, and, as a result of the Pension Protection Act (PPA), in 2009 they stopped using the assumed return to set required contributions as well. Therefore, a private-sector comparison can provide insight into how using the assumed return for valuation and funding purposes may impact public-sector asset allocation.

According to the analysis, from 2001 to 2008, the average allocation to fixed income, stocks, and other non-traditional asset classes—alternatives such as private equity, hedge funds, and real estate—was roughly the same for public and private plans. However, from 2009 to 2015, the allocations diverged, with public plans investing a significantly larger share in risky assets than private plans. Specifically, in this latter period, public plans had 72% in risky assets (50% in equities and 22% in alternatives) compared with 62% for private plans (44% in equities and 18% in alternatives).

The question is how much of the difference in allocation to risky assets is due to differences in the incentives regarding the assumed return. The researchers note that other factors could also explain the difference. For example, in 2015, the average percentage of inactive members—current retirees and separated employees entitled to a retirement benefit—for private plans was about 12 percentage points higher than the average for public plans, and prior research suggests that risk tolerance should be lower for more mature plans.

Using a regression analysis and variables representing the differences between public and private plans, researchers found no significant difference in the allocation to risky assets for similar public and private plans for 2001 to 2008 (when private plans used the assumed return for setting contribution targets), but the analysis shows a 13-percentage-point difference in allocation for 2009 to 2015.

Even given the riskier asset allocation of public-sector plans, many investment experts contend that their assumed returns are too high, the research report says. An analysis assessed the credibility of return expectations by comparing the public-sector’s assumed return to an assumed return based on published expectations from BlackRock. For example, the optimistic return assumption for equities by BlackRock is 9%, while the pessimistic return assumption is 7.4%, and the analysis finds public plans average allocation to equities is 49.1%. Over all assets classes, the pessimistic assumed return by BlackRock is 7.4%—equal to the average assumed investment return used for state and local pension plans in 2017.

“This situation is worth monitoring closely because optimistic return expectations could yield required contributions that are ultimately inadequate to meet benefit obligations and, thus, threaten the financial stability of public plans,” the researchers conclude.