(April 11, 2012) — Pension and insurance funds must reduce their return estimates to better reflect worsening economic conditions since the financial crisis, the UK’s Financial Services Authority has asserted.
According to the FSA, firms must lower average estimates of a 7% rate of return for investment products that are a mix of equities and bonds to between 5.5% and 6.5%. The recommendation is based on the results of a study by PricewaterhouseCoopers LLP. The projected returns are “reasonable central estimates over a 10-15 year time period,” the report said.
The report continued: “The near future remains highly uncertain and we should continue to expect volatility as markets react to any signs of recovery or further weakness. Effective policy actions in the Eurozone are crucial, but analysis of economic trends cannot easily predict the outcome of those decisions. The movements of the key macroeconomic variables over the next five years or so will reflect a process of adjustment back to trend and so are likely to differ from long-term trends.”
According to the FSA, banks, consumers and the government are in the process of repairing their balance sheets, and the degree to which this needs to take place is influenced by the extra risk imposed by uncertainty in the Eurozone.
In an email to Bloomberg News, Peter Smith, Head of Investments Policy at the FSA, said: “It is crucial that projection rates are set at a realistic level so that investors are not misled…Today’s independent research indicates that our maximum projection rates should be reduced.”
According to Towers Watson’s Karen Wells, the issue for pensions and insurance funds is that their assumed investment rate is based on a long-term environment which must be updated. “We’re in such a different environment today with rates so low for so long,” she told aiCIO.
Wells added: “I do think there are some organizations that didn’t lower return assumptions when they should have.”
In March, for example, the California Public Employees’ Retirement System (CalPERS) Board of Administration — the largest public pension in the United States — heeded advice to lower its assumed rate of return to 7.5%.
The pension fund’s assumed rate of investment return — also called the discount rate and calculated based on expected price inflation and real rate of return — was last changed a decade ago when it was reduced to 7.75% from 8.25%. Since then, critics have continued to claim that the scheme’s return target was overly optimistic to keep up over the long-term.