Public plans lower assumptions despite robust year

Many public pension plans are lowering their assumed rate of return even after posting record annual investment returns.

While industry observers say the trend has been a long time coming and there's no evidence to suggest that these strong returns drove the decision to reduce the rates, some sources say now is a good time to take advantage of recent gains.

"While it's important to acknowledge that average returns of 27% are a once-in-a-generation performance, forward-looking expectations of economic growth are lower than they were 20 years ago. One year's worth of returns is only one year's worth of returns," said Greg Mennis, director of public sector retirement systems for Pew Charitable Trusts in Washington.

"There's definitely an argument to lower the rate of return based on expectations and take advantage of recent gains without breaking the bank of required contributions," Mr. Mennis added. "A lowered discount rate will raise the required contribution. But since we’re talking about an assumption, the portfolio doesn’t change, so (sponsors) are considering now’s a good time to lower the assumed rate of return.”

The median assumed rate of return from public plans tracked by the National Association of State Retirement Administrators was 7% as of June 30, down from 7.9% 10 years earlier and 8% from 20 years prior.

According to NASRA, the following plans reduced their assumed rates of return in August after posting strong fiscal year returns:

• The $35.6 billion Mississippi Public Employees’ Retirement System, Jackson, to 7.55% from 7.75%.
• The $18.1 billion Maine Public Employees Retirement System, Augusta, to 6.5% from 6.75%.
• The $1.7 billion Arkansas State Highway Employees Retirement System, Little Rock, to 7.5% from 8%.

Other plans that reduced their assumed rates in August after they already reported double-digit returns include the $268.3 billion New York State Common Retirement Fund in Albany, to 5.9% from 6.8%, and the $65.5 billion Maryland State Retirement & Pension System in Baltimore, to 6.8% from 7.4%.

New York State Common became the second plan to have an assumed rate below 6%, after the Kentucky Retirement Systems, Frankfort, lowered the assumed rate of return for its $872 million Employees’ Retirement System (Non-Hazardous) and $349 million State Police Retirement System to 5.25% from 6.75% in 2017.

In addition, plans such as the $491.8 billion California Public Employees’ Retirement System in Sacramento, $95.3 billion Ohio State Teachers Retirement System in Columbus, $85.5 billion Oregon Public Employees Retirement System in Tigard, and $23.6 billion Illinois State Universities Retirement System in Champaign, lowered their expected return rates in June or July, when their boards would have seen preliminary fiscal-year numbers.

The plans’ decisions to reduce their assumed rates have been a long time coming, regardless of recent returns buoyed by strong equity market gains, industry experts said.

“I would not correlate the lowering of return assumptions today to the strong rates of returns that many public plans have experienced in the past year,” said Kevin M. Leonard, partner and leader of the public fund consulting practice at NEPC LLC, Boston. “Plans and actuaries have been looking to lower rate of return assumptions for the past three or four years.”

The NEPC consultant explained that when working with clients and their actuaries to establish the assumed rate of return, the firm develops a long-term assumption based on 30-year projections, and that these recent returns haven’t changed its long-term view.

“Our projected returns over last 30 years have been lower,” Mr. Leonard said, adding that “the one-year fiscal-year returns have benefited portfolios from a funded perspective.”

Regardless, while the recent record returns haven’t influenced plans’ decisions, they are part of the equation.

“If you’re looking at 20-year returns on a consistent basis, every year needs to be part of that equation, even if (the results) are surprising,” Mr. Mennis said.

Steven J. Foresti, chief investment officer at Wilshire Advisors in Santa Monica, Calif., admitted that although “it feels a bit odd to say future return expectations are low when we just had this bonanza of returns, (the) outlook going forward is muted.”

“One reason why discount rates have been going down has been due to market expectations,” Mr. Foresti said. “You can’t just make these numbers up.”

The Wilshire executive pointed to high-quality fixed income as a good barometer to see what to expect in terms of returns. “They’ve been declining over the last few decades,” he said.

Meanwhile, Phillip Nelson, NEPC’s director of asset allocation, agreed that while robust returns don’t control the conversation, they do influence it.

“If you look at the last year or so, funded statuses have improved quite a bit for many plans, so funding gaps have come in,” Mr. Nelson said. “So, it’s opening up a discussion around what is the most appropriate return assumption on a going-forward basis.”

And plans such as New York State Common certainly see the advantage of this influx of assets.

“When you’re in a position of strength, you have more flexibility and have an opportunity to position the fund in ways that make sense for the long term,” said Thomas P. DiNapoli, New York state comptroller and sole trustee of the pension fund, in a phone interview.

The pension fund lowered its assumed rate of return on investments to 5.9% from 6.8% after posting an estimated net return of 33.55% for its fiscal year ended March 31.

The state plan is 99.3% funded.

Mr. DiNapoli said he doesn’t believe these record-high returns are going to be “the new normal” and thinks it unwise to be “overly optimistic.”

“We’re taking a long-term perspective and not being overly optimistic based on current market conditions,” he added. “A more conservative approach makes our plan sustainable and keep us at more than 99% funded.”

Thomas Aaron, a vice president and senior analyst at Moody’s Investors Service Inc. in Dallas, said in a video interview that from a credit perspective, New York’s decision to lower its assumed rate is “an overwhelmingly positive move.”

“This is an opportunity to lower risk on the heels of strong investment returns,” Mr. Aaron said. “Lower return targets mean higher contribution targets, which can be budgetarily painful. And this recent asset boost ... can offset what would be an increase in contributions.”

In February, the Raleigh-based North Carolina Retirement Systems announced it was lowering its assumed rate of return to 6.5% from 7% for the principal pension fund even though it posted a 19.1% fiscal-year return.

North Carolina Treasurer Dale Folwell said that although the plan is one of the best funded in the U.S. (86.8% as of Dec. 31), “we have not achieved our assumed rate of return for 22 years” on average, over the long term.

This is the third time the assumed rate of return has been lowered during Mr. Folwell’s tenure as treasurer, having been reduced to 7.2% from 7.25% in 2017 and to 7% in 2018.

The goal is to get the plan funded at 100%. It was 110% funded in 2001, but 9/11, followed by the global financial crisis, has prevented the plan from reaching that funding level since, he said.

“You need to be more realistic,” Mr. Folwell said. “And as well-funded as our plan is, it has headwinds. Zero interest rates, longer life expectancies and earlier retirement ages. All blessings, but certainly headwinds” for the plan.

Lower inflation, and lower projected future inflation, has been another major factor that’s been driving plans to reduce their assumed rates of return over the past decade.

“Inflation has spiked higher in recent months, and time will tell if higher inflation is durable or transitory,” said Alex Brown, research manager for the National Association of State Retirement Administrators in Washington, in an email.

Despite many plans also seeing strong three-, five- and 10-year fiscal returns, Mr. Brown noted that lower investment returns “continue to be projected for most major asset classes in which public pension funds are invested,” which is another driver of lower assumed rates of investment return.

“Like all projections, these are imprecise, and their accuracy can be affected by unforeseen developments,” Mr. Brown said. “That most plans have exceeded their assumed rates of return for 10- and 20-year periods does not invalidate these projections, as that experience is in the past and lower returns are still expected by most forecasters to materialize in the future.”