Public Funds and Assumed Rates of Return

Many public funds are facing increased scrutiny regarding their required rates of return. These important projections, often referred to as a plan’s “interest assumption”, are used to document the long-term return goals of a pension plan’s investment portfolio and are used in part to determine the level of funding contributions that may be required to support future benefit payments. Specifically, there are concerns that the interest assumptions used by many plans may not be attainable given the recent projections of where market indices may go over the next 10-15 years.  Outlined below are 6 items Trustees can reference if you are facing these pressures.  This list is by no means exhaustive, but we hope you will find them helpful.

 

Let’s take them one at a time:

1. Understand the Basic Equation for Funding

Benefits + Expenses = Contributions + Investment Earnings

Remembering the above equation will help Trustees ask educated questions and employ their professionals to run the appropriate reports to help understand what impact lower investment earnings will have on contribution rates.  Also, if investment earnings are lower Trustees can identify if better management of benefits or controlling expenses could help offset the lower earnings.  Remembering this equation will encourage good conversation and facilitate better long-term decision making.

2. Consider Lowering Your Assumed Rate of Return (Interest Assumption)

If return expectations are coming down and there is pressure to lower your interest assumption – consider doing it! Based on #1 outlined above, it is important that you first understand what impact this has to the other inputs of the funding equation.  As a reference, since 2001 the National Association of Retirement Plan Administrators (NASRA) has shown that the average State Retirement System has lowered their investment assumption from 8% to 7.5%.  Of the 129 plans surveyed 117 were less than 8% and the majority were between 7%-7.5%.  In 2001 the majority were 8% or higher.

3. Review Your Asset Allocation

Work with your professionals and review your asset allocation.  Evaluate how different asset allocation strategies may impact your required rate of return.  Along with the return projections make sure to review the risk component as you change the asset allocation structure and what that might do to funding over the short term.  There are many different asset allocation scenarios that can be modeled and reviewed for conversation. Some examples include increasing equity, credit, alternatives and a comprehensive adjustment.  Whatever is decided, we feel it is important that asset class exposures have meaningful allocations of generally at least 5% so the asset class can impact results going forward.

4. Be Disciplined

Review your strategic asset allocation and rebalance to targets at least annually.  Since 2001, annual rebalancing on a 60% stock (S&P 500) and 40% bond (Barclays Aggregate) allocation back to strategic targets would have added .50% (50 bps) of excess return relative to the same portfolio that didn’t rebalance[1]. In a low return environment, an extra 50 bps is very important and can be driven from disciplined investing.

5. Long Term Perspective

Try not to get caught up in the recent headlines and the 30-90 day performance game.  Public pensions typically represent the longest of long-term investing.  While timely conversations and studies are important to make sure current strategies and positioning make sense (and to provide detailed information to the cynics), the largest asset any of these public pensions have today is time.  Over a rolling 30-year period a 50/50, 60/40, 70/30, 80/20 or 90/10 S&P 500/Barclays Aggregate Index has never fallen below 7.50%[1].  Keep the long-term perspective.

6. Be Transparent

Many public pension boards are considering lowering their required rates of return, reviewing their asset allocation structure, rebalancing diligently and structuring their portfolio for the long term.  Share what you are doing with interested parties so they can understand that you aren’t operating based on what worked yesterday.  Being proactive with this communication will help calm the noise of those cynics that seem determined to eliminate a retirement program that can work if administered well.

 

Important Disclosure Information

The views and opinions expressed are solely those of AndCo Consulting. This should not be regarded as investment advice or as a recommendation regarding any particular course of action. AndCo does not provide investment advice to individual participants and you should confer with your financial advisor for additional information. This is not an offer to sell or a solicitation to buy securities.

This document has been prepared for educational and informational purposes only, and is not intended to provide, and should not be relied upon, for legal or tax advice. Certain information is based on sources and data believed to be reliable, but AndCo cannot guarantee the accuracy, adequacy or completeness of the information.

Opinions expressed reflect prevailing market conditions at the time this material was completed and are subject to change. Moreover, the material provided herein is valid as of the date of posting and not as of any future date and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after such date.

AndCo Consulting is an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”). Registration as an investment adviser does not constitute an endorsement of the firm by securities regulators nor does it indicate that the adviser has attained a particular level of skill or ability.

[1] Generated by Investment Metrics PARis.