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 TeachersCalifornia State Teachers' Retirement Systemn 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.