When it Comes to Pension Reform, Focusing on an ‘Ideal’ Assumed Rate of Return Misses the Mark

bigstock-Colorful-Graphs-Charts-Marke-91031582As some pension plans across the country continue to struggle with growing unfunded liabilities, we hear a lot these days about pension reform.  One common topic these reforms address is the assumed rate of return used in calculating the fund’s required contribution rate.  While it is imperative that all assumptions used in the calculation of an employer’s pension cost are reasonable and reviewed periodically, it seems that blaming a fund’s chosen rate of return for any funding shortfalls is probably missing the mark.

While policy makers continue to grapple with the question of what is a ‘realistic’ or ‘ideal’ investment assumption, a pension plan experiencing funding difficulties is likely less because of the actual assumption and more the result of not consistently making the required contributions, or failing to adjust the contribution rate when plan experience doesn’t meet the assumptions. 

If, for example, a plan has a required contribution rate of 8%, but only contributes 6%, the plan will experience compounding shortfalls that will result in underfunding of the plan.  On the other hand, if the a plan makes their full contribution, but has investments that falls short of their assumption and subsequently does not increase the annual contributions going forward  to make up the difference, they will also experience long-term underfunding.

Some argue that lowering plan assumptions to a low-risk or no-risk assumption, such as the Treasury bond rate, would be best public policy and most responsible plan administration.  While this would certainly make it easier for plans to hit or exceed their assumption, the trouble with this approach is that plans who can achieve higher rates of return by implementing a different investment strategy will end up grossly overcharging today’s participants for their benefits. This conundrum isn’t unique to the pension universe, as the same would be true for an individual investor who chooses to use a 401(k) over a savings account or money market.  They too hope to reap the benefits of market returns to maximize their benefit, and so are also exposed to the risk of over or under saving.

So where does the balance lie?  LAGERS wants every assumption we use to as closely reflect reality as possible.  This helps ensure that we are not overcharging or undercharging Missouri taxpayers for the benefit earned in our system. To accomplish this, LAGERS performs an experience study at least once every five years to make sure our assumptions reflect changes to demographic and economic conditions over time.  As part of that process, our internal investment staff conducts a market analysis and collaborates with leading industry experts in various asset classes to review these market projections for our portfolio.  After which, our actuary consolidates the data and runs upwards of 5,000 scenarios modeling 20-year projections on our specific portfolio to help us arrive at a recommended investment assumption. 

Using this process, LAGERS feels comfortable that we are using a ‘realistic’ assumption, but more importantly than the number we arrive at, is the requirement that we continue to evaluate and adjust not only the assumption, but the annual required contributions rates as they relate to the assumptions. When we don’t meet our assumption, contribution rates go up as an offset, when we exceed our assumption, contribution rates go down. In doing this, a plan can fully fund benefits regardless of where their investment assumption is today.

There are real, and sometimes unintended consequences to every policy decision.  While it may be easier to take a no or low-risk approach on a plan's investment assumption, plan sponsors will feel serious effects of this.  Taxpayer dollars that could be invested in infrastructure, public safety, community development, and public works will have to be unnecessarily diverted to retirement costs.  LAGERS believes pension plans are an important tool for public employers to attract and retain great public workers, and also a tool to help those workers adequately prepare for an inevitable exit from the workforce.  While navigating the waters of pension reform across the nation, we must continue to be conscious of how policy decisions can unnecessarily affect the cost of providing these important benefits, afterall, all hardworking Americans deserve the peace of mind of a secure retirement.

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