Why Public Pension Return Forecasts Are Always Wrong

Local cultural factors are likely to influence public pension funds’ expectations for future performance as much as—and potentially more than—legal and regulatory boundaries, according to a new research paper.

Raj Aggarwal and John Goodell, of the University of Akron, Ohio, made the observations in a working paper published by the Federal Reserve Bank of Cleveland, titled “Determinants of Expected Returns at Public Defined Benefit Pension Plans”.

“Culture also influences future return estimates indirectly through its interaction with institutional environments.” —Aggarwal and GoodellFocusing on US public pensions, the authors contended that some funds used much higher expected returns to model their liabilities than others, despite being bound by broadly similar rules on accounting and investment. Overshooting on return forecasts had been a factor in the poor funding levels across public sector pensions in the US, they added.

“Culture influences return estimates directly through the propensity to tolerate risk and through its influence on transactions costs,” Aggarwal and Goodell wrote. “Culture also influences future return estimates indirectly through its interaction with institutional environments.”

Specifically, they cited individualism—a cultural bias towards the power of the individual rather than a larger group—and masculinity. For the latter, Aggarwal and Goodell described it as “greater competitiveness [which] increases the return expectation of pension funds because there will be less societal concern for any undermining of fund viability that might result from an inflated expected rate of return.”

The authors added that in an “imperfect environment, the responses and actions of contracting parties will depend on factors such as the ethical, social, and cultural environments as well as on institutional features like regulatory, disclosure and legal frameworks.”

The full paper can be accessed on the Social Science Research Network website.