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Public Pensions’ Assumed Rate of Return Falls Below 7%
The investment return rate has dropped to its lowest level in over 40 years, says NASRA.
The average investment return rate assumption for U.S. public pensions has fallen below 7.0% to its lowest level in more than 40 years, according to the National Association of State Retirement Administrators.
Among the 131 plans that NASRA measured, more than half have reduced their investment return assumption since fiscal year 2020. The investment return assumption used by public pension plans typically contains two components: inflation and the incremental return above the assumed rate of inflation, also known as the real rate of return. The sum of these components is the nominal rate of return, which is the rate that is most often used.
A NASRA issue brief shows that although the average nominal public pension fund investment return has been declining, the average real rate of return rose to 4.60% in fiscal year 2020 because the average rate of assumed inflation dropped more quickly.
One factor that may be contributing to the higher real rate of return, according to NASRA, is the higher allocation public pension funds are devoting to alternative assets, particularly private equities, which tend to have higher expected returns than other asset classes. As of the end of the first quarter of the year, the Federal Reserve reported that public pension assets totaled $5.76 trillion, a decrease of 2.5% from $5.90 trillion the previous quarter and higher than the same quarter a year earlier by approximately $460 billion, or 8.7%.
As the NASRA brief notes, actuarial assumptions fall into one of two main categories: demographic and economic. Demographic assumptions pertain to factors such as changes in the number of working and retired plan participants, as well as when participants will retire and how long they’ll live after they retire. Meanwhile, economic assumptions relate to factors such as the rate of wage growth and the future expected investment return on the fund’s assets.
“Because investment earnings account for a majority of revenue for a typical public pension fund, the accuracy of the return assumption has a major effect on a plan’s finances and actuarial funding level,” says the NASRA brief. “An assumption that is significantly wrong in either direction will cause a misallocation of resources and unfairly distribute costs among generations of taxpayers.”
For the 30‐year period that ended in 2020, public pension funds accrued approximately $8.5 trillion in revenue, according to NASRA, of which $5.1 trillion, or 60%, came from investment earnings. Employer contributions accounted for $2.4 trillion, or 28%, and employee contributions totaled $1 trillion, or 12%.
“The large portion of revenues from investment earnings reflect the important role they play in funding public pension benefits,” says the brief.
It also notes that a challenging aspect of setting the investment return assumption that has emerged recently is a divergence between expected returns over the next five to 10 years and expected returns over the next 20 to 30 years. Because many near‐term projections calculated recently are well below the long‐term assumption that most plans are using, according to NASRA, some pensions face the choice of either maintaining a return assumption that is higher than near‐term expectations or lowering their return assumption to reflect near‐term expectations.
“If actual investment returns in the near‐term prove to be lower than historic norms, plans that maintain their long‐term return assumption risk experiencing a steady increase in unfunded pension liabilities and corresponding costs,” says the NASRA brief. “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.”