State retirement systems are adjusting to a “new normal” of lower expected economic growth over the next 20 years and are lowering their assumed rate of returns en masse, according to a report from Pew Charitable Trusts.
Research by the Trusts shows that from late 2007 to mid-2009, during the so-called “Great Recession,” public pension plans lowered return targets as a result of changes in the long-term outlook for financial markets. The report said that while the US experienced annual GDP growth of more than 5.5% from 1988 through 2007, the Congressional Budget Office (CBO) now projects only 4% annual growth over the next decade.
Pew’s database includes the 73 largest state-sponsored pension funds, which in aggregate manage 95% of all investments for state retirement systems. The think tank said that more than half of the funds in its database lowered their assumed rates of return in 2017 to an average of 7.3%. That’s down from more than 7.5% in 2016 and 8% in 2007 just before the recession hit.
“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,” said the report.
Although lower assumed rates of return leads to higher plan liabilities and increases required employer contributions “making such changes can ultimately strengthen plans’ financial sustainability by reducing the risk of earnings shortfalls, and thus limiting unexpected costs.”
The research found that despite the decline in assumed rates of returns, pension plan asset allocations have remained largely unchanged. Stocks and alternative investments have stayed relatively stable in recent years at around 50% and 25% of assets, respectively. Pew said that this indicates that most fund managers and policymakers are adjusting assumed rates of return in response to external economic and market forecasts, not on shifts in internal investment policies.
Pew said that many plans are using clever tactics to alleviate the higher required contributions that come from more conservative return assumptions. Some state pension funds have done this by phasing in discount rate reductions. That effectively alters how they calculate future liabilities and allows them to spread out increases in contributions over time.
The report cited policies enacted by retirement systems in California, Wisconsin, and North Carolina that attempt to deal with the problem of a lower return environment.
The California Public Employees Retirement System (CalPERS), for example, announced in 2016 that it would decrease its assumed rate of return incrementally from 7.5% in 2017 to 7% by 2021. Pew said that even such incremental changes can have “a significant impact” over time as a one percentage point drop in the discount rate would increase reported liabilities across US plans by more than $500 billion.
The Wisconsin Retirement System’s (WRS) long-term return assumption for 2017 was 7.2%; however, the plan uses a lower discount rate of 5% to calculate the cost of benefits for workers once they retire. North Carolina effectively uses two discount rates to set contribution policy. The Tar Heel state determines a contribution floor based on the plan’s investment return assumption of 7%. It also has a ceiling using yields on US Treasury bonds as a proxy for what a risk-free investment could return.
“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,” said the report. “California, North Carolina, and Wisconsin provide examples of alternative approaches that can reduce investment risk for public pension funds and government budgets alike.”