The state of public pensions in 2017

The long-term secular decline in inflation and long-term interest rates has been a boon for past investment returns. Returns over the next 15 years will be harder to achieve without taking on significantly more risk. For instance, the Municipal Employees' Retirement System of Michigan's long-term expected real rate of return for its global fixed-income investments is only 2.18%. The system's expected long-term real rate of return for listed equities is 5.02%.

Assuming listed equities had a constant expected rate of return of 7.5%, a 60/40 portfolio would be well below the assumed rate of return for most plan sponsors. With interest rates at multigenerational lows, a 60/40 portfolio would only return around 5.25%.

With the yield on investment-grade fixed-income securities at multidecade lows, public plans have chosen to dramatically lower and/or shift allocations. Sixteen plans now have dedicated allocations to high-yield fixed-income securities, up from 11 in 2006. The average allocation to high yield also has increased to 6.36% from 4.95%. Some 61% of the Virginia Retirement System's fixed-income allocation is in credit.

Plans have allocated to alternatives, particularly private equity, to generate higher rates of return. Alternatives in aggregate have increased to 24% from 10% in 2006. Oregon Public Employees Retirement Fund, an early investor in private equity, expects a long-term rate of return for private equity of 7.97% vs. 6.70% for large/midcap U.S. listed equities.

Even with a shift to alternative investments, return expectations for entire portfolios have been falling. Numerous plan sponsors will lower their assumed rates of return going forward, such as CalPERS. In 2016, the California Public Employees' Retirement System's board voted to reduce the assumed rate of return to 7% from 7.5% over a three-year period.

Better health care has enabled individuals to live longer. Since the early 1950s, the average person in the U.S. who reaches the age of 60 is expected to have six more years in retirement.

With budget constraints at fiscally strapped governments, the number of active workers has declined over the past decade. Coupled with members retiring and living longer, the ratio of active participants to retirees has fallen significantly. This changes the cash-flow picture of plans dramatically and puts more emphasis on investment returns. In 2006, the Sacramento County Employees' Retirement System had 14,412 active members and 7,108 retirees. In 2016, the plan had 12,393 active members and 8,710 retired members.

Jay V. Kloepfer, an executive vice president and the director of capital markets research at Callan LLC in San Francisco, said decades of insufficient contributions by public plan sponsors have led to the funding problems more than any return shortfalls. "It's not enough contributions. That's it. There are no other factors," Mr. Kloepfer said. On a positive note, these sponsors have started contributing more to plans.

Pension funds have dedicated countless hours and paid at least $7.7 billion in investment fees in 2016 to achieve plans' actuarial assumed rate of return. With low returns on listed equities for the year ended June 30, 2016, the median plan returned only 0.8%. Ten-year returns were better at 5.85%, but were significantly below assumed rates of return. The New Mexico Educational Retirement Board was a standout performer in 2016, returning 2.6%, which was a full percentage point above its policy benchmark. The fund also outperformed its policy benchmark over the three-, five- and 10-year periods.