State Pensions Lower Their Return Assumptions

Pew Charitable Trusts just released an issue brief stating state pension funds are lowering their assumed rates of return:
State and local public employee retirement systems in the United States manage over $4.3 trillion in public pension fund investments, with returns on these assets accounting for more than 60 cents of every dollar available to pay promised benefits. About three-quarters of these assets are held in what are often called risky assets—stocks and alternative investments, including private equities, hedge funds, real estate, and commodities. These investments offer potentially higher long-term returns, but their values fluctuate with ups and downs in financial markets in the short term and the broader economy over the long run.

Financial analysts now expect public pension fund returns over the next two decades to be more than a full percentage point lower than those of the past, based on forecasts for lower-than-historical interest rates and economic growth. Research by The Pew Charitable Trusts shows that since the Great Recession—which started in late 2007 and officially ended in mid-2009—public pension plans have lowered return targets in response to changes in the long-term outlook for financial markets. (See Figure 1.)

Pew’s database includes the 73 largest state-sponsored pension funds, which collectively manage 95 percent of all investments for state retirement systems. The average assumed return for these funds was 7.3 percent in 2017, down from over 7.5 percent in 2016 and 8 percent in 2007 just before the downturn began.

More than half of the funds in Pew’s database lowered their assumed rates of return in 2017. Following the steep swings during the recession and in the years immediately afterward, these changes reflect a new normal in which forward-looking projections of expected economic growth and yields on bonds are lower than those that state pension funds have historically enjoyed. Reducing the assumed rate of return leads to increases in reported plan liabilities on fund balance sheets, which in turn increases the actuarially required employer contributions. Still, making such changes can ultimately strengthen plans’ financial sustainability by reducing the risk of earnings shortfalls, and thus limiting unexpected costs.

Recently, many plans have worked to mitigate the higher required contributions that have been prompted by increased liabilities linked to more conservative investment assumptions. The present value of future liabilities is typically calculated using the assumed rate of return as the discount rate, which is used to express future liabilities in today’s dollars; lower return assumptions yield higher calculated liabilities. Some state pension funds have phased in discount rate reductions—effectively altering how they compute future liabilities. That allows them to spread out increases in contributions over time.

For example, in 2016, the California Public Employees Retirement System (CalPERS)—the nation’s largest public pension plan—announced it would decrease its assumed rate of return incrementally from 7.5 percent in 2017 to 7 percent by 2021. Even such an incremental change can have a significant impact over time: a 1 percentage point drop in the discount rate would increase reported liabilities across U.S. plans by over $500 billion, a 12 percent rise.

As assumed returns have gone down, asset mixes have remained largely unchanged. For example, average allocations to stocks and alternative investments—which can provide higher yields but with greater risk, complexity, and cost—have remained relatively stable in recent years at around 50 percent and 25 percent of assets, respectively. This indicates that most fund managers and policymakers are adjusting their assumed rates of return in response to external economic and market forecasts, not based on shifts in internal investment policies.

This brief updates research published by Pew in 2017 and 2018 that provided data on asset allocation, performance, and reporting practices for funds in all 50 states. It explores the impact of continued slow economic growth on investment performance, as well as potential management and policy responses to lower returns. Finally, the brief highlights policies and solutions employed by well-funded plans, including the adoption of lower return assumptions, that have helped insulate the plans from economic volatility.

Slow economic growth projected for the next decade

Forecasts of lower-than-historical economic growth and bond yields over the next 10 to 20 years drive the growing consensus among government and industry economists that pension funds will see lower long-term investment returns and suggest a new normal for public fund investments. For example, the U.S. experienced annual gross domestic product (GDP) growth of more than 5.5 percent from 1988 through 2007, while the Congressional Budget Office (CBO) now projects only 4 percent annual growth for the next decade. (See Figure 2.) And as economic growth is expected to perform more modestly, the long-term outlook for stocks and other investments that pension funds hold will be similar.

Returns on bonds, which make up about 25 percent of pension fund assets, are also projected to be lower than historical averages. Investment-grade bond yields between 1988 and 2007 averaged about 6.5 percent a year, but the CBO projects an average of just 3.7 percent annually through the next decade.

Given these trends, market experts generally agree that lower investment returns will persist going forward. Pew forecasts a long-term median return of only 6.4 percent a year for a typical pension fund portfolio, considering expected GDP growth and interest rates. Other analysts with similar projections include Voya Financial Advisors (6.4 percent), J.P. Morgan and Wilshire (both 6.5 percent), and Aon Hewitt (6.6 percent).

Key trend: Lower assumed returns

Investment returns make up more than 60 percent of public pension plan revenues—employer and employee contributions make up the rest—so funds need accurate return assumptions to ensure fiscal sustainability. A decade into the recovery, states have an opportunity to recalibrate policies to the economy’s “new normal” by adopting return assumptions in line with current projections.

Many plans have lowered their assumed rates of return—which also affects discount rates—to reflect these economic realities, despite the near-term budget challenges they may face as contribution requirements rise with lower discount rates. For example, while only nine of the 73 funds in this study had an assumed rate below 7.5 percent in 2014, by the end of fiscal year 2017, about half had adopted assumed rates below that percentage. Forty-two of the funds reduced their assumed rate in 2017 to better account for lower expected investment returns. Several states—including Georgia, Louisiana, Michigan, and New Jersey—have followed the example of California’s CalPERS fund by adopting multiyear strategies to ramp down assumed rates over the next several years.

Policymakers may raise concerns about the rise in the present value of pension fund liabilities caused by lowering discount rates, the resulting reduction in funded ratios (the share of a plan’s liabilities matched by assets), and the impact of these changes on required contributions for employers and workers. However, the impact on liabilities reflects accounting, not economics. Ultimately policymakers need to structure retirement systems to ensure fiscal sustainability throughout the economic cycle so members receive promised benefits. Although pension funds enjoyed robust investment returns in 2017 (the median one-year return across the 73 funds was 12.8 percent), funds continue to underperform relative to their long-term return targets. For example, in 2017 the median return over the prior 10 years was less than 5.5 percent, and none of the funds in our data met their investment target over that period.

States acting to adopt more conservative assumptions

States are addressing these concerns. Recent reforms in Connecticut provide an example of how a reduction in discount rates can help mitigate long-term risks and avoid short-term spikes in contribution requirements. The state reduced the discount rates 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. Finally, they extended the time period for the state to pay down the more than $30 billion in pension debt to 30 years and added a five-year phase-in of the new funding policies. Collectively, these policies helped ensure that the impact of increased employer contributions would only gradually affect the state budget.

As expected, Connecticut’s changes resulted in an increase in the state’s reported pension debt—the recent reduction in the discount rate for the TRS raised the reported unfunded liability for that system alone 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 the state’s cost predictability and insulates the pension funds 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 side by side with the reported funding ratio.

For example, Fitch Ratings, in its analysis of Connecticut’s 2019 TRS reform proposal, 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 noted the change to an expected return of 6.9 percent as a factor that would lower fiscal risks.

Other states have adopted alternative approaches to increase cost predictability and create a margin of safety against inevitable market downturns. In California, CalPERS put in place a risk policy in 2015 that incrementally reduces the plan’s assumed rate of return and shifts its investment mix to less risky assets each year that funded levels increase because of better-than-expected returns. Such policies help gradually reduce risk and increase cost predictability over the long term in a way that doesn’t put short-term pressure on the state budget.

The Wisconsin Retirement System (WRS) takes an innovative approach to managing risk through return assumptions. The WRS’ long-term return assumption for 2017 was 7.2 percent; however, the plan uses a lower discount rate of 5 percent to calculate the cost of benefits for workers once they retire. Even if investments fall short of the long-term return assumption, the amount set aside for each retiree should be enough to pay for the base benefit without additional contributions from taxpayers or current employees. And, if the returns exceed 5 percent, as they now are expected to do, the excess will be used to fund an annuity increase (similar to a cost of living adjustment). The system would not provide such a boost when returns fall below 5 percent.

Finally, North Carolina effectively uses two discount rates to set contribution policy. The state determines a contribution floor based on the plan’s investment return assumption of 7 percent, as well as a ceiling using yields on U.S. Treasury bonds as a proxy for what a risk-free investment could return. That risk-free rate reflects what a guaranteed investment could deliver; state pension plans, like most other investors, take on risk to earn yields above that rate. If the plan is fully funded under the risk-free rate, then employer contributions would drop to simply pay for the cost of new benefits. Any year in which the contribution rate is between the floor and the ceiling, employers will put in an additional .35 percent of pay above the prior year’s rate.

The policies put in place by CalPERS, Wisconsin, and North Carolina are designed to better ensure that adequate assets are set aside to pay for promised benefits, given the fundamental uncertainty of relying on risky investments over a decades-long time horizon. In addition, by lowering their assumed rates of return, more than half of state pension funds made it more likely that they’ll be able to hit their investment targets in future years.

As well as adjusting return targets to reflect changing economic conditions, funds are looking more closely at the fees they pay investment managers. According to the Institutional Limited Partners Association (ILPA), over 140 institutions—including many state and local pension funds—have moved to increase disclosure and transparency for private equity performance fees (also known as carried interest). These fees account for approximately $6 billion, or 30 percent of all fees U.S. state and local funds reported paying to investment managers in 2017 (management fees make up the rest). For state pension funds to accurately report their performance fees, private equity managers need to disclose the total price tag to their clients; an expectation that these fees would be disclosed only recently emerged across state pension funds.

Although fee levels in aggregate have remained relatively constant as a percentage of assets over the last decade or more, some funds have managed significant reductions. For example, in Pennsylvania, reported investment expenses as a percentage of assets have declined from 0.81 percent in 2015 to 0.74 percent in 2017, a shift that saves state pension plans more than $57 million annually in reduced fees. The state continues to focus on the issue, following the recommendations of its public pension management and asset investment review commission. Lawmakers put the panel in place as part of the 2017 state pension reforms, and it has recommended actions projected to offer actuarial savings between $8 billion and $10 billion over 30 years.


The economy is expected to grow at a modest rate over the next decade, and pension fund investment returns are unlikely to return to historic levels for the foreseeable future. In recognition of these trends, public plans are increasingly adjusting their return assumptions to rates more in keeping with economic forecasts.

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 the reductions in the discount rate 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.

States can adopt policies that provide a margin of safety for pension systems in the likely event of an eventual economic downturn. California, North Carolina, and Wisconsin provide examples of alternative approaches that can reduce investment risk for public pension funds and government budgets alike.
Take the time to read this Pew brief here and also look at the boxes and Appendix which I omitted here. You can also print the PDF file here.

Go back to read my recent comment on the American retirement nightmare where I stated the following:
[...] Ed and I discussed the US public pension crisis. I alluded to The Pew Charitable Trusts 2017 study on state funding gaps (click here to read it) and said for many chronically underfunded state plans, they simply cannot afford another crisis, it will place them in an untenable situation where their funded status drops below 30% or worse.

Ed asked me why should Americans care if most of them are not part of these state plans? I again referred to the Pew study which states this:
Kentucky, New Jersey, and Illinois have the worst-funded retirement systems in the nation in part because policymakers did not consistently set aside the amount their own actuaries said was necessary to cover the cost of promised benefits to retirees. As a result, the pension funds in those three states had less than half of the assets needed to cover liabilities in 2017. Underfunding pensions also increases pension costs significantly over time. Pension contributions went up 424 percent in Illinois, 267 percent in Kentucky, and more than 100 percent in New Jersey from 2007 to 2017, reducing resources available for other important public priorities. Despite these increases in contributions, the three states collectively fell $11.5 billion short of the amount needed to keep pension debt from growing.
Those massive increases in pension contributions affect everyone. People which live in states where plans are chronically underfunded can expect higher property taxes to make up for the shortfall as more and more of state budgets go to contribute to these woefully underfunded plans.

So, yes, you'd better pay attention to the public pension crisis because it will impact you regardless of whether you're part of a plan or not.

What will happen to many state plans teetering on the edge of insolvency? As I told Ed, if we get a really bad crisis where asset prices and interest rates plunge and stay low for years, there will be no political will to raise taxes and nobody in their right mind will be buying pension obligation bonds.

At that point, Congress, the Fed and the Treasury department will step in to bail out many US state plans but there will be a heavy price paid for such a bailout, there will be a haircut on benefits and increase in contribution rates.

Those of you who think no bailout is coming, I refer you to two older comments of mine, The Mother of all US pension bailouts and a multibillion Thanksgiving pension bailout which took place a year ago.

If things get very bad, there will be a bailout, it won't be pretty, unions will scream bloody murder but they will bow down to creditors and accept whatever is offered to them.

Of course, as I explained in the $16 trillion global pension crisis, Congress, the Fed and the Treasury won't be bailing out public pensions for the hell of it, they will be doing so to bail out Wall Street and its large hedge fund and private equity clients, all of which benefit massively as long as they can keep milking the US public pension cow in perpetuity.

A lot of people will dismiss such a statement as "absurd" but I tell them to read C. Wright Mills' The Power Elite, to really understand the past, present and future of capitalism.

Just look at the 2008 crisis. Who really benefited the most a decade later and why? (answer: elite hedge funds and private equity funds and the big banks that serve them).

Anyway, I told Ed Harrison, the US public sector pension crisis will only get worse. Why? Because pensions are all about managing assets and liabilities and I foresee low to negative rates being with us for a very long time, especially if deflation strikes the US, which means liabilities will soar to unprecedented levels and assets will not deliver anywhere close to the requisite returns pensions need.

Ed and I got into a discussion of duration of assets versus liabilities. I told him the duration of liabilities is a lot bigger than the duration of assets (typical pension liabilities go out 75+ years) which means when rates fall, pension liabilities mushroom, especially when rates are already at ultra low levels and asset inflation, if there is any, won't make up for the shortfall.

[See a comment Zero Hedge posted, US Stock Markets Up 200%, Yet Illinois Pension Hole Deepens 75%, and more importantly, my comment from the end of August where I discussed why the pension world is reeling from the plunge in yields.]

I also told Ed there is plenty of blame to go around for this dire situation. Bankrupt state governments and corrupt public-sector unions not wanting to abandon their 8% pipe dreams in order to keep the contribution rate low is just one of many structural flaws.

But in my opinion, the biggest problem of all with US public pensions is there are too many of them (need to be amalgamated at the state level) and more importantly, the governance is all wrong!

I told Ed, in Canada, our large public pensions got three things right:
  1. We got the discount rate right. Our large DB pensions use much lower discount rates that the assumed investment returns that US public pensions use to discount their future liabilities (anywhere between 7% to 8%; in Canada, they are discounted at 6% or lower).
  2. We got the governance right. In Canada, our large public pensions operate totally independently from government. This means, independent qualified board members are sought to oversee these large pensions and they hire a CEO who hires senior managers to run the day-to-day affairs of these pensions. They are compensated appropriately and run these pensions much like large businesses, investing across public and private markets all over the world.
  3. We got the risk sharing right. In Canada, large and some smaller public pensions (like CAAT Pension) are jointly governed and the risk of the plan is shared equally among all stakeholders, including retired members. Typically, this means adopting conditional inflation protection where indexation is partially or fully lifted if a pension is experiencing a deficit and restored retroactively once it reaches fully funded status again.
These are the three reasons why Canada's large public pensions are global leaders.
How much lower are the discount rates at Canada's large public pensions relative to the ones US public pensions are using? They are significantly lower, ranging from 4.8% at OTPP (I think it's 4.5% now) which uses the lowest nominal discount rate given the maturity of its plan to 6% for some of the bigger pensions, but still well below 7% or 8% many US state pensions are using to discount their future liabilities.

And unlike many US state pensions, OTPP, HOOPP, and CAAT Pension have adopted conditional inflation protection and others like OPTrust and OMERS are fully funded or very close to it.

What else? Some of Canada's largest pension plans enjoy a surplus and are increasing some of their benefits or lowering contributions to members but still saving a large fraction of this surplus to deal with any storm coming their way.

And as Ron Mock, OTPP's CEO who is retiring next week, explained to me recently,  OTPP dropped the contribution rate over the last few years but he said: "Thank god we have conditional inflation protection which along with the surplus offers an additional relief valve if we ever run into trouble." He added: "This allows us to run with a level of risk we are comfortable with to attain our 4.5% real target-rate-of-return."

Now, Pew Charitable Trusts is a non partisan group but I'm surprised they didn't discuss conditional inflation protection which was a critical element Rhode Island's state pension adopted to address its looming pension crisis.

The same goes for Wisconsin's big public pension cheese, they too have adopted conditional inflation protection to ensure their plan stays fully funded and yet none of this was mentioned in this brief.

What else? That last part about Pennsylvania's State Employees Retirement System reducing its fees is a bit sketchy. As I have said plenty of times, if US public pensions got the governance right allowing these pensions to operate independently from government, they would be able to bring more assets internally across public and private markets instead and lower fees considerably if they hired experienced private equity employees who can analyze co-investments swiftly and diligently.

To do this, however, requires a huge political shift which understands that the compensation for these state plans must be set by an experienced, independent board, not some government apparatchiks in the state capital who are completely clueless on competitive compensation policies.

Again, none of this is discussed in any Pew Charitable Trusts report because these are "contentious issues" which Pew conveniently and consistently sidesteps, therefore not addressing a serious structural deficiency which has been plaguing US public pensions for decades.

All this to say, I'm glad US state pensions are lowering their return assumptions (they need to lower them to 6% or less to be realistic) but a lot more needs to be done.

Chief Investment Officer recently reported on how CalPERs recently re-tooled its investment policies to enhance liquidity and diversify its investment approach but is still falling short of its 7% target.

I think we need to be realistic on what CalPERS can and can't deliver in this environment without taking undue risks, and I'm afraid 7% is still too high.

And as I keep telling you, pension deficits are path dependent, meaning the starting point matters. If you are a state pension which is chronically underfunded (50% or lower funded status), then taking undue risks can lead to even larger problems down the road.

These state pensions need a multipronged approach to address their widening pension deficits and that typically means:
  • No contribution holidays, ever!
  • Get the discount rate down to a realistic level even if it means higher contributions
  • Adopt conditional inflation protection
  • Get the governance right!
I keep referring to that last one because it's critically important to bring more assets internally across public and private markets, lowering overall fees while improving performance.

Anyway, let me end with some interesting clips.

Below, DoubleLine CEO Jeffrey Gundlach was recently interviewed on CNBC stating he sees long-term rates marching higher as recession risks recede.

Importantly, Gundlach says the Fed won't raise rates unless it sees signs of "persistently high inflation" but what he fails to disclose is the Fed doesn't control inflation expectations (only asset inflation) and by his own admission, the labor market isn't as strong as everyone claims ("employment growth is weaker under Trump than Obama").

Still, if Gundlach is right and rates march higher, it will bring much needed relief to the pension world which was reeling in August after the plunge in yields. I'm not so sure rates will back up as much as Gundlach thinks or publicly claims.

Next, David Rosenberg, economist at Gluskin Sheff, joins BNN Bloomberg to discuss why he thinks the current spread between CCC-rated credit and BBs in the corporate bond market looks a lot like mortgage spreads in 2007. 

Rosenberg thinks a lot of non-bank players (like pensions, mutual funds, insurance companies) are exposed if the credit markets seize, calling it a canary in the coal mine. 

He may be right, the junk bond market seems awfully bubbly here but as Keynes stated, markets can stay irrational longer than you can stay solvent. I'll come back tomorrow with my weekly market comment and share some more market thoughts with you.