In the wake of the 2008-09 financial crisis, global interest rates and inflation have remained low by historic standards, and 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 the National Association of State Retirement Administrators (NASRA) measured in 2017, nearly three-fourths reduced their investment return assumption since fiscal year 2010.
A brief from the Center for Retirement Research at Boston College says such a change is generally viewed as a positive development for pension funding discipline, bringing assumptions more in line with market expectations and forcing plan sponsors to increase annual required contributions.
However, the researchers say the decline in assumed rates of return is actually due to lower assumed inflation, not a lower assumed real return (that is, the return net of inflation). In a fully-indexed system where benefits fully adjust with inflation, a lower inflation assumption should actually have no impact on costs; however, public pension plans have also changed their asset allocations, resulting in a higher expected real return, which lowers costs. “Therefore, a quick assessment of these underlying assumption changes suggests that plans may have actually lowered their costs with the decline in the assumed return,” the brief says. “But, public plan benefits are not fully indexed, so the real value of benefits increases as the inflation expectation drops, which increases plan costs.”
The researchers explain that for a hypothetical plan, where benefits fully adjust with inflation, lower inflation will have no impact on the required contribution because the lower revenue produced by lower nominal returns will be offset by a decrease in initial benefits (through lower wage growth) and the cost-of-living-adjustment (COLA) paid after retirement. However, the actual situation for public plans differs in two ways: 1) Benefits before and after retirement are not fully linked to inflation, so they do not decline one-to-one with lower inflation, therefore increasing the real value of benefits and increasing plan costs; and 2) public plans have shifted into riskier assets, which increases their expected real return and reduces costs.
“Public plans may seem like fully indexed systems, because they provide benefits based on final earnings and offer post-retirement COLAs,” the brief says. “But, in reality, not all benefits are based on final earnings, and most COLAs are not designed to fully compensate for inflation.”
It further explains that if all public-sector workers remained with their employer until they retired, their final earnings would reflect inflation and real wage growth over their work lives, and their initial benefits based on final earnings would be fully indexed; however, 35% of employees who vest in a pension benefit do not retire as public-sector employees, so they receive much lower benefits for their time in the public sector than employees who finish their career in the public sector.
The only way for a worker who leaves public-sector employment before retirement to avoid a loss in benefits would be for the plan to base pension benefits on projected age-60 earnings—that is, index earnings for inflation and real wage growth. Without such indexing, benefits erode in real terms, and the higher the rate of inflation, the larger the erosion. With a lower rate of inflation the cost to the employer increases by making the deferred benefits relatively more expensive. In addition, the researchers say, most COLAs are deliberately designed not to fully match inflation, and some plans provide no COLA or only ad hoc adjustments—meaning the benefits of many retirees erode in value over time with rising inflation.
When the inflation rate declines, since the drop in benefit payouts does not fully reflect the drop in inflation, costs rise. “At the extreme, for plans without a COLA, a 1-percentage-point reduction in assumed inflation produces a 1-percentage-point increase in real post-retirement benefits. The lack of complete indexing of both initial benefits and benefits after retirement means that a change in inflation is not a wash. Instead, as inflation declines, real costs increase,” the brief explains.
At the same time public pension plans have also shifted their investment mix out of fixed income and into riskier asset classes with higher expected real returns, which –all else equal—leads to lower costs, as fewer contributions are required to meet future benefit obligations.
Using data reported under the new Government Accounting Standards Board (GASB) statements, the researchers calculated the net effect on plan costs due to the lower inflation assumption and higher expected real return, assuming a 1-percentage-point decrease in inflation and a 0.4-percentage-point increase in the real return. They found a 2.6% change in accrued liabilities and a roughly 3.6% increase in employee liabilities and the associated normal costs. In addition, using these assumptions, a plan’s required contribution would increase by 0.9% of payroll.However, lowering assumed rates of return due to lower assumed inflation was actually better for plans than if they did so due to a lower assumed real return because the researchers found that under a hypothetical scenario in which lower assumed returns are driven by a reduction in the assumed real return, the increase in the required contribution would be over three times as high, at 3.4% of payroll.