Public Pensions Lower Return Assumptions, But Taking More Risk

The Wall Street Journal reports that public employee pension plans are getting more realistic about the returns they assume for their investments. But, as I show in a new report released by the American Enterprise Institute, they’re not being nearly realistic enough. In fact, state and local pensions are taking even more risk in an effort to gamble their way out of their financial problems.

The projected return on pension investments is a crucial assumption that can make or break a government’s ability to make its annual contributions.  Roughly speaking, for each percentage point a public pension reduces its assumed investment return, annual required contributions rise by about 20 percent. So it’s important that the Journal reports that

More than two-thirds of state retirement systems have trimmed assumptions since 2008 as the financial crisis and an uneven U.S. recovery knocked many below their long-term goals, according to an analysis of 126 plans provided by the National Association of State Retirement Administrators. The average target of 7.68% is the lowest since at least 1989. The peak was 8.1% in 2001.

The question is, have plans reduced assumed returns enough?

As the table below shows, assumed investment returns have dropped by 0.37 percentage points since 2001. But this is a period when yields on 10-year U.S. Treasury securities fell by 2.67 percentage points, over seven times more.  The Treasury yield is important because the expected return on a pension’s risky portfolio of assets is a function of the riskless return plus some premium for taking risk. If the riskless return falls then, all else equal, the pension’s total portfolio return should decline along with it.

So, yes, public pensions have moderated their investment return assumptions, but not nearly enough to account for the lower returns paid on safe assets. Public pensions are assuming they will earn a far greater risk premium over safe assets than they did in the past: in 2001, pensions assumed a total return 3.03 percentage points above the Treasury yield, while today they assume they’ll earn a 5.33 percentage point risk premium.