Visitors Now:
Total Visits:
Total Stories:
Profile image
By Reason Magazine (Reporter)
Contributor profile | More stories
Story Views

Now:
Last Hour:
Last 24 Hours:
Total:

Moving Forward Despite Low Market Returns

Tuesday, November 8, 2016 7:17
% of readers think this story is Fact. Add your two cents.

(Before It's News)

Meager institutional investment returns for pension funds in 2015 and 2016 have marked the low overall returns of the past decade. That period has included losses from the financial crisis, but also several subsequent years of huge returns as markets bounced back. Despite recovery in most areas of the financial markets, pension funds have not seen their long-term averages rise to expected levels, and this is in part because the meager returns for 2015 and 2016 also draw bleak future market outlooks suggesting significantly lower returns over the next few decades relative to the last few. These investment return forecasts have prompted many pension fund analysts to suggest that public pension systems should lower their rate of return assumptions, or else face an even greater swell of unfunded liabilities.

A recent report by S&P Global provides a good explanation on the implications of the new investment return realities for public pension plans around the country. By looking at factors that influence pension plans’ funded status, including lowered expected fund performance, along with analysis of different approaches from states to growing unfunded liabilities, the report offers some helpful insights for public plan managers on how to move forward in the market “new normal.”

Even in the post-recession market upswing, most state and local pension plans were not able to fully recoup their losses after the 2008 crisis, and virtually every plan has missed their assumed rate of return for the 2015-16 fiscal year. Future prospects do not look very optimistic either; the S&P report references a recent Boston College Center for Retirement Research paper that assumes a 6% expected return in its analysis of pension liability and contributions. Meanwhile, McKinsey estimates that U.S. equities may return up to a maximum 6.5% (in the most optimistic scenario) over the next 20 years, while returns on both U.S. and European bonds are estimated to top out at no more than 2% a year on average during that period. Further still, John Hussman estimates that a traditional mix of stocks and bonds isn’t likely to earn more than 1.5% over the next decade, as my colleague Anthony Randazzo discussed on this blog yesterday.

What does this mean for public pension plans and their strategies for improving pension health? The S&P report highlights the fact that if assets are growing at a slower pace than the growth of promised pension obligations, the result will be ever increasing unfunded liabilities. Furthermore, if the “new normal” investment return environment means consistently underperforming investment returns, then the smoothing methods used to gradually phase in asset gains and losses will not be effective at moderating contribution rate growth.

This does not imply that it is easy for public pension plans to realign plan assumptions with market conditions and lower their rate of return expectations by de-risking portfolios. The S&P report authors note that, as in most cases in public policy, “these decisions represent a difficult tradeoff between reducing the long-term risk associated with uncertain and volatile market returns in exchange for increased budgetary pressure.” Put differently, there is a direct trade-off between minimizing near-term contribution rate volatility and risking long-term underfunding.

This trade-off debate was a focal point of the recent decision by the Illinois Teachers’ Retirement System board to lower the plan’s assumed rate of return from 7.5% to 7%. The result of adopting a slightly more realistic assumption about investment returns was a budgetary increase of $421 million for the coming year. This would help the state avoid even more in unfunded liability amortization payments spread out over future budgets, but these decisions nonetheless are fiscally challenging for today’s legislatures.

Similar to Illinois, New York State lowered its return assumption from 7.5% to 7.0% as of its 2015 fiscal year end valuation, and Oregon’s Public Employees Retirement system adjusted its return assumption from 7.75% to 7.5% effective, January 1, 2016.

But not every state is making the same marginal steps towards more realistic investment return expectations. The S&P report affirms what a lot of the asset allocation data from state administrated plans has shown over the past few years—some pension plans are simply investing larger percentages of their portfolios in more volatile, riskier, illiquid, non-transparent asset classes such that they can keep current assumed return rates in place. The report authors write: “actual five-year average returns through 2015 still generally exceed the assumed rates of return for the largest state pension plans, investment allocations have also grown riskier in the previous five years.”

Regardless of the strategy adopted, it is important for public pension systems to have clear indicators to illuminate whether or not they are on the right track to a healthier funding status. To that end, the report highlights four major factors impacting the future long-term health of pension plans and state and local government budgets that can serve as a guide:

  • Plans are making some annual progress on funding the unfunded liability;
  • Funding policies are well-crafted and plan managers proactively target realistic assumptions;
  • Governments are committed to adequate annual funding; and
  • Governments are successful in pension reform initiatives to control growth in liabilities.

While all four are important, perhaps the most fundamental are a fund’s annual progress in paying off the total pension debt and adopting a funding policy based on realistic actuarial assumptions.

In fact, realistic assumptions are most critical because they feed into the actuarially determined contribution (ADC). Employers should always pay at least 100% of the ADC, but if that contribution rate is underpriced by the assumptions, the plan is still being tacitly underfunded. As the report notes, “effectiveness at reducing the overall liability is only as good as the assumptions used to calculate it.”

Perhaps the key takeaway from the S&P Global report is that the future will probably not look the same as the past 30 years, which will intensify the trade-offs in maintaining overly optimistic return assumptions, and likely lead to growing unfunded liabilities in the long-run. And unless public sector pension funds continue lowering their assumptions, taking more investment risk, or advancing pension reforms, their health status will only get worse. The report finds that in the past the states that consistently made full required contributions based on relatively conservative actuarial assumptions were mainly those that now have the highest pension funded ratios and are showing the strongest progress in annual pension funding.

To read the full paper, go here.

Report abuse

Comments

Your Comments
Question   Razz  Sad   Evil  Exclaim  Smile  Redface  Biggrin  Surprised  Eek   Confused   Cool  LOL   Mad   Twisted  Rolleyes   Wink  Idea  Arrow  Neutral  Cry   Mr. Green

Top Stories
Recent Stories

Register

Newsletter

Email this story
Email this story

If you really want to ban this commenter, please write down the reason:

If you really want to disable all recommended stories, click on OK button. After that, you will be redirect to your options page.