Public pension plans continue to bet on high returns, despite acknowledged risks

Reuters reports that many public pension plans are underperforming their investment assumptions

U.S. public pension funds are cutting their expectations for investment returns over the next 30 years or more, but some do not expect to meet even the new targets over the coming decade. 

After a long period of low interest rates, forecasts by investment analysts show the next 10 years will probably bring slower market growth, leading to reduced expectations for the $3.7 trillion of public pension assets.

But, as we’ve written before, there’s an understandable reluctance for public pension fund managers to change their investment assumptions.

Reuters notes,

But public pensions are wary of lowering their expected return rates, or the discount rate, too quickly because doing so would drastically increase costs for state and local governments and their employees, whose contributions form the funds.

Instead, the funds say they plan to make up for lower returns expected in the coming decade over the next 30 years or more.

There’s an obvious risk associated with hoping things will improve dramatically in the out years. The Washington Research Council has previously addressed this issue,  

We discussed the rate of return issue in detail in an April 2011 policy brief, Reforming Public Pensions. As we noted then, “using their assumed interest rates, states discount future benefit costs. In short, states are expecting that investment returns will lessen the need for contributions to cover benefits. This assumption downplays the risk that returns will be down in a particular year.”

Professors of Finance Robert NovyMarx of the University of Chicago and Joshua Rauh of Northwestern “argue that, commensurate with the level of risk involved, public pensions should use the interest rate on Treasury securities to discount future payments.” Currently, those rates are less than 5 percent.

The risk of underperformance, Reuters writes, has grown in recent years.

Private-sector and public plans in Canada and Europe lowered their discount rates over the past two decades. But U.S. public pension funds maintained higher return expectations and put more of their money in risky assets to help achieve them, according to the Rockefeller Institute. 

As a result, the potential impact of investment shortfalls, relative to government tax revenue, is now more than three times as large as it was in 1995, and about 10 times as large in 1985, the Rockefeller Institute found.

While Washington remains in better shape than many states, the risks should not be ignored.