Policy Documents

Research & Commentary: Public Pensions and the Assumed Rate of Return

July 23, 2012

In states and municipalities across the country, the high cost of traditional defined-benefit public pensions has become a hot-button issue as unfunded liabilities have raced out of control. These increasing liabilities are further complicated by the fact that in many instances the regulators controlling pension funds have overestimated the value of future investments and the rate of return they can expect from the investments held by the pension fund.

If the estimated rate of return for these pension funds continues to fall short of expectations, pension systems across the country may be in even more trouble than is currently thought. Fortunately, pension fund regulators and lawmakers are beginning to notice this problem and are moving to set more reasonable expectations for investment returns. According to the National Association of State Retirement Administrators, since 2008, 19 public pension plans have lowered the assumed rate of return below 8 percent, and others, including Minnesota and New York, are considering doing so.

Decreasing the expected rate of return does have consequences. Because the rate is used to determine the present value of benefits that will be paid to retired workers in the future, reducing the rate of return will increase the apparent level of obligations. Opponents of the decrease argue it is unnecessary because actual public pension investment returns have exceeded assumptions. Overly optimistic rates of returns, however, have significantly contributed to the recent unsustainability of these funds.

Proponents of a decrease argue that even if state and local pension funds continue the current high return rate assumptions, it will take large-scale increases to bring their funds into actuarial balance, which will prove difficult in the current economy. According to the American Legislative Exchange Council, “Even with a questionably high eight percent assumed rate of return on assets, government employers would have to significantly increase contribution rates to bring the plans into actuarial balance. This would be difficult given the current recession and associated revenue shortfall. The financial crisis encountered over the past decade reveals that many state pension plans are fundamentally flawed.”

In the short term, per-year pension payouts should be capped at a sensible level, the retirement age should be raised, double-dipping should be eliminated, pension rate of return assumptions should be changed, and workers should be required to make higher contributions. In the long term, sustainability will require governments to follow the private sector’s lead and switch workers from defined-benefit pension systems to defined-contribution systems.

The following articles examine state and local pension funds and the assumed rates of return from multiple perspectives.

Public Pensions Faulted for Bets on Rosy Returns
http://www.nytimes.com/2012/05/28/nyregion/fragile-calculus-in-plans-to-fix-pension-systems.html?pagewanted=all
Mary Williams Walsh and Danny Hakim report on the debate over public pension rates of return. They speak with several economists and pension experts on the issue and discuss current reform proposals in several states.

Mass. Needs More Realistic Goal for Pension Fund Returns
http://articles.boston.com/2012-06-24/editorials/32379572_1_pension-fund-public-pensions-pension-increases
In an editorial, the Boston Globe argues the State of Massachusetts needs to start stepping down its pension expectations. The editorial argues for a deliberate approach to limit the impact on government agencies whose employees will have to contribute more.

The State Public Pension Crisis: A 50-State Report Card
http://heartland.org/sites/all/modules/custom/heartland_migration/files/pdfs/27578.pdf
This Heartland Institute report examines problems currently facing public pension systems, including the enormous burdens public employee pensions pose in some locations. The report ranks each state according to the operation and relative disposition of the pension plans in the 50 states and suggests ways states might go about solving their pension system problems.

Are State Public Pensions Sustainable? Why the Federal Government Should Worry about State Pension Liabilities
http://heartland.org/policy-documents/are-state-public-pensions-sustainable-why-federal-government-should-worry-about-sta
Joshua D. Rauh of Northwestern University analyzes the flow of state pension benefit payments relative to asset levels and contributions. Even assuming future state contributions fund the full present value of new benefits, many state systems will run out of money in 10 to 20 years if some attempt is not made to improve the funding of liabilities that already have accrued. The expected shortfalls raise the possibility that the federal government will be faced with a decision on whether to bail out states driven to insolvency by their pension programs. 

Public Pension Plan Asset Allocations
http://heartland.org/policy-documents/public-pension-plan-asset-allocations
Youngkyun Park of the Employee Benefit Research Institute reviews public pension plan contribution behavior from 2001 to 2006, pension asset allocations from 2003 to 2007, and the effect investment performance has on employer contribution volatility. Park concludes that in the short run a significant shift toward a lower-return investment policy in exchange for reduced volatility in employer contributions is unlikely to occur because of plans sponsors’ expected high returns from current asset allocations based upon historical rates of return, their ability to use the assumed investment rate of return as the discount rate in calculating liabilities, and the understandable tendency of investment managers not to deviate from peer group investments. 

Unmasking Hidden Costs: Best Practices for Public Pension Transparency
http://www.manhattan-institute.org/html/cr_63.htm
In this Civic Report from the Manhattan Institute for Policy Research, Josh Barro makes several recommendations for improving the transparency of financial information related to governments’ pension and OPEB obligations. 

Pensions Wrestle with Return Rates
http://online.wsj.com/article/SB10001424052970204450804576620951874861390.html
Michael Corkery reports in the Wall Street Journal on the efforts by lawmakers and pension officials to reduce the roughly 8 percent annual-return assumption set by many public-employee funds, as they argue the rate is unrealistically high given the financial crisis and upheavals in markets around the world. 

State Pension Funds Fall Off a Cliff
http://heartland.org/policy-documents/state-pension-funds-fall-cliff
Barry W. Poulson and Arthur P. Hall consider different measures of historical and current funding shortfalls in state pension plans. Two case studies are examined in depth to explore fatal flaws that have caused funding crises in these plans: the Public Employee Retirement Association of Colorado (PERA) and the Kansas Public Employee Retirement System (KPERS). 

The Market Value of Public-Sector Pension Deficits
http://heartland.org/policy-documents/market-value-public-sector-pension-deficits
Arthur Biggs of the American Enterprise Institute argues that because states currently assume plans can earn high returns without risk, they are underfunded by more than $3 trillion. Although states recognize their public-employee pensions are underfunded, Biggs argues the situation is far worse than their accounting demonstrates. Unless policymakers take proactive steps now, he says, taxpayers will have to cover an enormous shortfall when the bills come due. 

The Origins and Severity of the Public Pension Crisis
http://heartland.org/policy-documents/origins-and-severity-public-pension-crisis
Dean Baker of the Center for Economic and Policy examines the origins of the shortfalls in public pension systems and discusses the appropriate rate of return to assume for pension fund assets.

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the FIRE Policy News Web site at http://news.heartland.org/insurance-and-finance, The Heartland Institute’s Web site at www.heartland.org, and PolicyBot, Heartland’s free online research database, at www.policybot.org

If you have any questions about this issue or The Heartland Institute, contact Heartland Institute Senior Policy Analyst Matthew Glans at 312/377-4000 or mglans@heartland.org.