Public pension funding is extremely sensitive to investment returns, according to a study by the Center for Retirement Research at Boston College.
To determine the sensitivity of pension funding to investment returns, the analysis projected funded ratios through 2042 for large public plans using a stochastic (variable) model of year-to-year returns; and a median real return of 4.45 percent, the average used by plans in 2012.
In 2012, the nominal, long-term return assumption used by state and local pension plans averaged 7.75 percent. While the nominal rate of return usually receives the most scrutiny, the assumed real return — the nominal return minus the assumed rate of inflation — is of primary importance, the report’s authors found.
The average inflation assumption in 2012 for plans in the Public Plans Database was 3.3 percent, well above the 2.3 percent reported by the Federal Reserve Bank of Philadelphia Survey of Professional Forecasters and much higher than the Federal Reserve’s inflation target of 2 percent, according to the report.
Deducting each plan’s inflation assumption from its assumed nominal return yields real returns ranging from 3 to 5.5 percent, with an average of 4.45 percent, the Center found.
Historically, returns on equities have exceeded the 4.45 percent over the long-term, with the 10-year average sitting at 5.81 percent and the 30-year return at 6.21 percent.
The stochastic model was used to simulate potential return outcomes for each asset class in a portfolio that are based on an assumed probability distribution and each asset class’ average return.
It found that even if the long-run return matches a plan’s assumptions the volatility in year-to-year returns can create large fluctuations in required contributions and, if poor returns are concentrated in the early years of the period, could have an adverse effect on funding, according to the Center for Retirement Research.
The baseline results of the analysis showed that the funded ratio for the 50th percentile outcome does not reach 100 percent because plans pay only 80 percent of annual required contributions and amortization approaches produce inadequate contributions.
It deduced that paying 100 percent of the annual required contribution and using more robust funding approaches led to near full funding by the end of the period. But even under these more favorable scenarios, the variability of returns still posed risks of funding shortfalls.