Testing Public Pensions’ Sensitivity to Investment Returns

Public pension funds might never be fully funded in the next 30 years, according to research.

(September 27, 2013) — The inability to make investment returns above inflation has had the greatest impact on public pension funds’ serious underfunding.

“How Sensitive Is Public Pension Funding to Investment Returns?”, written by Alicia Munnell, Jean-Pierre Aubry, and Josh Hurwitz of the Center for Retirement Research at Boston College (CRR), projected dismal future returns for the next 30 years.

The study showed that real return, made over and above the rate of inflation, should be used for long-term targets because benefits are generally indexed for inflation before and after retirement. This was particularly critical for mature plans with large funding, negative cash flows, and lower contributions from pensioners.

This is because while the higher nominal returns would produce stronger revenues for pension funds, the returns were likely to be driven by higher inflation, which would also push the cost of living post-retirement and original benefits higher.

The difference was clearly visible. State and local pension plans’ 2012 average nominal return was 7.75% while real return was 4.45%, according to the data.

When the assumed real return of 4.45% compared to historical returns, the researchers found that the average rolling 10- and 30-year real return for a hypothetical portfolio exceeded the assumption by at least 100 basis points.

This data raised the question of whether future returns will stay at similar levels using assumed real returns, especially considering the recent financial crisis.

Calculations revealed that even if the real return reaches the pensions’ expectations, the volatility in year-to-year returns could generate fluctuations that could adversely affect funding.

This means that returns must be higher than expected if pensions are to be fully funded in the next 30 years. 

The brief named two reasons for such negative outcomes: employers are paying less than the full annual required contribution, and payments to amortize unfunded liability and an open 30-year amortization period yields to lower contributions.

With an average of 7% real returns, plans will be fully funded in 10 years. Plans will be fully funded in 20 years with an average of 5.79% real returns.

However, the likelihood of public pension funds reaching those yields looked uncertain: The CRR found that in the

50th percentile of generated returns over the 30-year projection, assets only accounted for 87% of liabilities.

Using this trajectory, the study concluded that the only way for public pensions to achieve a fully funded status is to gain higher returns.

Access the full paper here

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