Investment returns make up more than 60 percent of the revenues that public pension plans need to ensure their financial stability, so it’s imperative that funds apply accurate return assumptions when calculating required funding levels. That’s why many have lowered those assumptions to reflect expectations of slower economic growth in the years ahead.
During the bull markets of the 1980s and 1990s, managers of state and local pension funds commonly assumed that they would earn at least 8 percent returns on their investments over the long term. For the most part, this reflected the prevailing market outlook as the United States experienced annual gross domestic product (GDP) growth of more than 5.5 percent from 1988 to 2007.
However, the Congressional Budget Office (CBO) now projects only 4 percent annual growth for the next decade. With more modest expectations, consensus is rising among government and industry economists that pension funds will see lower long-term investment returns over the next 10 to 20 years.
Returns on bonds, which account for about 25 percent of pension fund assets, are also projected to be lower than historical averages. Investment-grade bond yields from 1988 to 2007 averaged returns of about 6.5 percent a year, but the CBO projects an average of just 3.7 annually through the next decade.
Considering expected GDP growth and interest rates, investment experts and research by The Pew Charitable Trusts now forecast a long-term median return of approximately 6.5 percent a year for a typical pension fund portfolio. Pew’s data, published in a December 2019 issue brief titled “State Pension Funds Reduce Assumed Rates of Return,” show that many plans lowered their assumed rates of return over the past 10 years to reflect these economic realities, despite the near-term budget challenges they face as contribution requirements rise.
Only nine of the 73 funds studied had an assumed rate below 7.5 percent in 2014, but about half had adopted rates below that percentage by the end of fiscal year 2017. Forty-two reduced their assumed rate in 2017 to better account for lower expected investment returns. And several states—including California, Georgia, Louisiana, Michigan, and New Jersey—adopted multiyear strategies to ramp down assumed rates over the next several years.
Although reported liabilities will rise because plans are calculating the cost of pension promises using more conservative assumptions, the lower assumed rates of return ultimately decrease pension funds’ investment risk, increase pension cost predictability for taxpayers, and factor positively in state credit analyses. By pairing lower return targets with policies to smooth out the cost impact—or by adopting such changes as part of broader reform efforts—policymakers can moderate the impact on state and local budgets.
Recent reforms in Connecticut provide an example of how reduced assumptions can help mitigate long-term risks and avoid short-term spikes in contribution requirements. The state lowered return targets for the Connecticut State Employees’ Retirement System (SERS) and Teachers’ Retirement System (TRS) from 8 percent to 6.9 percent in 2017 and 2019, respectively. Concurrently, policymakers adopted a funding policy that would bring down the unfunded liability and stabilize long-term contribution rates. Collectively, these policies helped ensure that the impact of increased employer contributions would have a gradual impact on the state budget.
As expected, Connecticut’s changes resulted in an increase in the state’s reported pension debt—the lower return targets for the teachers’ system raised the reported unfunded liability from $13 billion to nearly $17 billion. But the changes ultimately set the state on a path to pay down that debt in a sustainable manner that increases cost predictability and better insulates the pension system from market volatility. Indeed, rating agency analyses of Connecticut’s credit have taken a forward-looking approach that considers future market risk and long-term financial sustainability in conjunction with the reported funding ratio.
In its analysis of Connecticut’s 2019 TRS reform proposal, Fitch Ratings noted that the fund’s previous assumed annual return of 8 percent was an “unrealistic target for future investment returns … resulting in actuarial contributions that are inadequate to support long-term funding improvement, thus exposing the state to severe fiscal risk.” The rating agency said the change to an expected return of 6.9 percent would help lower fiscal risks.
Finally, it’s important to note that although assumed returns have gone down, asset mixes have remained largely unchanged. This indicates that most fund managers and policymakers are adjusting their assumed rates of return in response to external economic and market forecasts and are not basing them on shifts in internal investment policies.
Susan Banta is a director and Keith Sliwa is a senior associate with The Pew Charitable Trusts’ public sector retirement systems project.