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Between a rock and a hard place

Dismal returns, poor projections push public plans to pare investment gain expectations

Allan Emkin
Allan Emkin said the next decade won’t replicate historical returns.

As public pension plans disclose a second consecutive fiscal year of lackluster returns, amid projections of diminished investment earnings for the next decade, more public asset owners will have little choice but to lower rate of return expectations, consultants and analysts said.

U.S. public pension plans earned a median return of 1.07% in the fiscal year ended June 30, according to the Wilshire Trust Universe Comparison Service, worse than the median 3.43% in the prior fiscal year. It is the second year in a row that returns were nearly flat and well below the yearly 7.5% return target of many plans.

“I think they have to lower their rate of return; and if you look at the trend, that is what has, in fact, been happening,” said Allan Emkin, whose firm, Pension Consulting Alliance, consults for some of the largest defined benefit plans in the U.S., including the $303.3 billion California Public Employees' Retirement System and the $188.7 billion California State Teachers' Retirement System.

“There are unprecedented headwinds: the lowest historic rates of return in the bond market, and risk assets are all fully priced,” said Mr. Emkin, co-founder and managing director at PCA in Los Angeles.

“It's really difficult to see how historic rates of return will be replicated in the next 10 years,” he said.

The investment performance of the past 30 years reflected a “golden era” that won't likely be repeated, said Sree Ramaswamy, a Washington-based senior fellow at the McKinsey Global Institute. He projects that total returns for U.S equities over the next 20 years could average 4% to 5%, because of slowing GDP growth and increased competition from abroad, roughly 250 basis points below the average from 1985 to 2014.

One challenge for pension plans is the assumed inflation rate, which is factored into expected rates of return, and the question of whether plans have reduced those assumptions enough to account for what economists believe will be a long-term, low-rate inflation environment. Another issue: Most public pension plans are paying out more in benefits than they take in from contributions and investment income in a given year, meaning they have to sell assets to pay retirees, a problematic answer when markets are struggling.

In any case, lowering return assumptions can have big implications. It increases the unfunded liabilities of U.S. public pension plans, a figure that the Federal Reserve says increased to $1.7 trillion in calendar year 2015, from $1.4 trillion in 2014 and $354 billion in 2005. As a result, governmental units must make larger pension contributions.

Florida Retirement

One pension system that is considering lowering its rate of return is the $141.4 billion Florida Retirement System, Tallahassee, which earned a return of 0.61% in the fiscal year ended June 30.

“Obviously the persistent low interest rate environment we have been in has depressed returns and likely will continue to do so,” said Dennis MacKee, director of communications for the Florida State Board of Administration, which oversees the fund. Mr. MacKee said the SBA would likely be supportive of a reduction in the system's 7.65% assumed rate of return. The actual rate, he said, is set by the Actuarial Assumption Conference, a government body that meets each fall and evaluates adjusting the rate of return.

Dick Ingram, the executive director of the $43.8 billion Illinois Teachers' Retirement System, Springfield, is still waiting for a calculation of the fund's June 30 fiscal year returns but noted, “It wasn't a lights-out year for anyone.”

Mr. Ingram said a review of the system's rate of return should be completed by spring. He said he didn't want to prejudge what will ultimately be a retirement system board decision but did say, “Certainly there's plenty of evidence that we're in a protracted low-return environment.”

The largest public pension plan to lower its assumption in the last 12 months is the $181 billion New York State Common Retirement Fund, Albany, which cut its rate of return assumption to 7%, from 7.5%, in September 2015.

Most recently, the $8.4 billion Oklahoma Public Employees Retirement System, Oklahoma City, lowered its rate to 7.25% from 7.5%.

Other plans that have made reductions include: the $7.2 billion New Hampshire Retirement System, Concord, which lowered its rate of return to 7.25% from 7.75%, the $48.5 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, which lowered its rate of return to 7.25% from 7.5%, and the $8 billion Missouri State Employees' Retirement System, Jefferson City, which lowered its rate of return to 7.65% from 8%, show data from the National Association of State Retirement Administrators.

Two pension plans reduced their rate of return to less than 7% in 2016. The $12.3 billion Maine Public Employees' Retirement System, Augusta, went to 6.875% from 7.125% and the $10.8 billion Kentucky Retirement Systems, Frankfort, went to 6.75% from 7.5%. They joined the $24 billion Texas Municipal Retirement System, Austin, whose board in July 2015 approved reducing its rate of return to 6.75% from 7%.

Continuing trend

Keith Brainard, research director of NASRA, said the latest round of reductions is a continuation of a trend that began after the financial crisis when many public pension plans began cutting their rate of return assumptions to 7.5% from 8%. Currently, he said, the average public pension plan anticipates a 7.5% rate of return, but he added a number of plans have begun to review those assumptions given the cloudy economic forecast for coming years.

But many plans, including CalPERS and CalSTRS, have not made a decision yet on lowering the assumed return. CalPERS earned 0.6% in its most recent fiscal year, while CalSTRS did slightly better at 1.4%; both significantly underperformed their 7.5% return assumptions.

CalPERS Chief Investment Officer Theodore Eliopoulos told the system's investment committee on Aug. 15 that the retirement system's general investment consultant, Wilshire Associates, expects an annualized average investment return of 6.21% over the next decade, 90 basis points lower than its prediction two years earlier.

“The next two years, the next five years and, perhaps, the next 10 years are shaping up to be the most challenging market environment for us, for institutional investors and for pension funds going forward,” Mr. Eliopoulos told the investment committee.

Wilshire Associates did issue a rosier long-term prediction for CalPERS: an annualized 7.83% return for 30 years.

The CalPERS investment committee voted last November to lower the fund's rate of return to 6.5% from 7.5% over 20 years, but the plan only lowers the rate of return and reduces the amount of riskier assets, like equities, in extended periods during which the system has returns over 7.5%.

Last year's action doesn't prevent CalPERS from making a more immediate rate of return reduction, but Mr. Eliopoulos would not comment on that possibility. The investment committee is scheduled to review rate of return assumptions starting next year.

Increasing strain

Even without lowering return assumptions, the $1.7 trillion in U.S. public pension plan unfunded liabilities already is putting increasing strain on state, local governments and school districts, said Thomas Aaron, a Chicago-based vice president and senior analyst at Moody's Investors Service.

He said a Moody's sample of 108 public pension plans across 50 states shows the median government contribution rate relative to payroll reached 16.3% in 2015, up from 9.9% in 2006. Another concern is that many public pension plans are relying on riskier assets to drive returns of more than 7%, he said.

“We currently have heightened unfunded liabilities and contribution requirements, which are pressuring government budgets like never before, and at the same time there still remains a lot of downside asset risk that could further result in more unfunded liabilities and even higher contribution requirements,” Mr. Aaron said.

This article originally appeared in the August 22, 2016 print issue as, "Between a rock and a hard place".