What States Are Doing to Offset Lower Assumed Returns

Shifts in investments and changes to employer contributions are being used to mitigate the funded status effects of lower return assumptions.

The Pew Charitable Trusts, in a new paper, says that “financial analysts now expect public pension fund returns over the next two decades to be more than a full percentage point lower than those of the past, based on forecasts for lower-than-historical interest rates and economic growth.”

In fact, Pew says, ever since the Great Recession of 2008, public pension plans have reduced their return targets due to changes in the long-term outlook for financial markets. “More than half of the funds in Pew’s database lowered their assumed rates of return in 2017,” Pew says, calling this type of tempered outlook the “new normal.”

As a result, this “increases the actuarially required employer contributions,” Pew says. “Some state pension finds have phased in discount rate reductions—effectively altering how they compute future liabilities. That allows them to spread out increases in contributions over time.”

Pew notes that the Congressional Budget Office (CBO) reports that the U.S. annual gross domestic product (GDP) growth averaged more than 5.5% between 1988 and 2007, but the CBO now projects only 4% growth over the next decade. “As economic growth is expected to perform more modestly, the long-term outlook for stocks and other investments that pension funds hold will be similar,” Pew says.

Likewise, investment-grade bond yields averaged 6.5% a year between 1988 and 2007, according to the CBO, but it projects that will be a mere 3.7% over the next decade.

Pew forecasts that pension fund portfolios will experience a median return of only 6.4% a year for the next decade, taking into consideration GDP growth and interest rates.

To combat this trend, Joshua Franzel, president and CEO of the Center for State and Local Government Excellence, tells PLANSPONSOR, public pension sponsors have been reducing the amount of equities and bonds in their portfolios and increasing their exposure to alternatives. Additionally, he says, “the lower the return assumptions, the more contributions that are going to be required to be made,” Franzel says.

“Part of the reason why we are seeing shifts in investments is not just to chase returns but to manage risk and diversify,” Franzel says. “It is also important to understand that all pension plans are doing experience studies, typically every five years, to see how their expectations are playing out. As to the extent to which sponsors are paying their contributions to the plan, they should be as close to 100% of their required contributions as possible, and they should be closely meeting their investment assumptions related to inflation and mortality.”

The Pew report agrees with the need for public pension plans’ assumptions to be as accurate as possible: “Funds need accurate return assumptions to ensure fiscal responsibility.”

Pew then points to actions by a number of states to counteract lower returns. Connecticut, for example, reduced its discount rate to “help mitigate long-term risks and avoid short-term spikes in contribution requirements.” It reduced its pension plan’s discount rate from 8% in 2017 to 6.9% in 2019 and “adopted a funding policy that would bring down the unfunded liability and stabilize long-term contribution rates. Finally, it extended the time period for the state to pay down the more than $30 billion in pension debt to 30 years and added a five-year phase-in of the new funding policies.”

In California, CalPERs has shifted its investment mix to less risky assets. Wisconsin had a return assumption of 7.2% in 2017 but used a lower discount rate of 5% to calculate the cost of benefits paid to retirees. Any earning above that amount is invested in an annuity.

“Finally, North Carolina effectively uses two discount rates to set contribution policy. The state determines a contribution floor based on the plan’s investment return assumption of 7%, as well as a ceiling using yields on U.S. Treasury bonds as a proxy for what a risk-free investment could return. Any year in which the contribution rate is between the floor and the ceiling, employers will put in an additional 0.35% of pay above the prior year’s rate.”

Above and beyond this, pension plans are carefully examining the fees they are paying to investment managers, and some funds have managed significant reductions. Pennsylvania reports that its fees have gone from 81 basis points in 2015 to 74 basis points in 2017—saving more than $57 million a year in reduced fees.