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.
Anthony Randazzo of the Reason Foundation argues the majority of state pension plans have been too slow to lower their assumed rates of return in response to market changes and real-time yields. He says the reason pension plans have been so unwilling to make necessary changes is that doing so would require an increase in pension contribution rates.
Randazzo points out that even with recent market improvements, which may or may not last, most state pension plan have yet to recover their losses related to the 2008 market crisis. Results from recent years are equally poor, and most plans have missed their assumed rate of return for the 2015–16 fiscal year.
A report from the McKinsey Global Institute estimates, at best, returns on U.S. and European bonds will top out on average at no more than 2 percent per year over the next 20 years. John Hussman of Hussman Funds estimates a traditional mix of stocks and bonds isn’t likely to earn more than 1.5 percent over the next decade.
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. Pension experts recommend states use an expected investment return rate of 3.1 percent, which is based on 30-year U.S. Treasury bond yields.
Fortunately, pension fund regulators and lawmakers are beginning to notice this problem and are moving to set more reasonable expectations for investment returns. The Topeka Capital-Journal notes over “half of the 127 pension plans measured by the National Association of State Retirement Administrators have reduced their investment return assumptions since 2008, according to a February report from the group.” One example is the California Public Employees’ Retirement System (CalPERS). California decided in 2015 to gradually reduce its assumed rate of return on pension assets down from the current 7.5 percent over a 20-year period. This may prove insufficient, however; CalPERS recently announced it may need to reduce the assumed return at an even faster rate.
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. 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.
To protect taxpayers and pension beneficiaries 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, and pension rate-of-return assumptions should be changed. In the long term, sustainability will require governments to follow the private sector’s lead and put all workers in defined-contribution systems.
The following documents examine state pension funds and assumed rates of return in greater detail.
The State Public Pension Crisis: A 50-State Report Card
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.
Pension Funds Expected Rates of Return: Biggest Lie in Global Finance
The Illinois Policy Institute examines the high expected rates of return on pension investments used by state and local governments, arguing the high rates are misleading taxpayers into believing pension funds are more stable than they actually are.
Properly Funding a Defined-Benefit Plan Requires Solid Average Returns and Some Luck
Adam Millsap of the Mercatus Center discusses the problems created by overly optimistic investment-return assumptions and how they add risk to defined-benefit pension plans. “The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans,” wrote Millsap.
Public Pension Investments: Risky Chase for High Returns
Truong Bui writes in Budget & Tax News about a recent Pew report that shows a systematic shift of public pension plans away from fixed-income investments toward equities and alternative investments over the past 30 years.
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.
The Market Value of 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
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.
Keeping the Promise: State Solutions for Government Pension Reform
This report from the American Legislative Exchange Council describes the variety of pension plans governments use today and the advantages and disadvantages of each plan. It also provides several tools legislators can use to ensure governments can affordably fund retirement benefits for their employees.
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 Budget & Tax News website at https://heartland.org/publications-resources/newsletters/budget-tax-news, and The Heartland Institute’s website at http://heartland.org.
Whether sending an expert to your state to testify or brief your caucus, hosting an event in your state, or simply sending you further information on the topic, Heartland can assist you. If you have any questions or comments, contact Heartland Institute Government Relations Manager John Nothdurft at [email protected] or 312/377-4000.