Pension plan sponsors face significant challenges. Retirement obligations continue to increase, and the two major equity market setbacks in 2000 and 2008 have produced widening funding gaps. So what does the future hold? Will their plans be able to reliably achieve their stated return objectives?
Unfortunately for plans relying solely on traditional equities and fixed income, the prospects look grim. Our analysis suggests these plans will likely experience a 2% shortfall per annum over the next seven to 10 years.
Public and private pension plans rely on formal return targets to match their funding requirements against the present value of estimated future retirement benefits. Return targets for U.S. public pension funds typically range between 7% and 8.5%, with a median target of about 8%, according to Wilshire Associates. For our analysis, we chose a slightly more conservative rate of 7.75%.
Plans also are required to revisit their target return assumption periodically. For example, in March 2012 CalPERS, the largest U.S. public pension plan, voted to reduce its return target to 7.5% from 7.75% to reflect diminished forward market expectations. As pension funding gaps continue to widen, other plans around the country have begun to follow suit.
Although CalPERS' proposed reduction of just 25 basis points might appear minor, the impact on state and local funding levels, plan contributions and total benefits could equate to a very meaningful $167 million per year. With this in mind, it is easy to see why a potential 2% per annum shortfall has potentially large and serious consequences.