More Evidence for the Public Pension New Normal for Investment Returns

The “new normal” of a lower-yield investment environment for state and local pension funds is quickly becoming an established fact. A new report from J.P. Morgan Asset Management Company (JPMA) suggests that this lower performing investment trend is likely to continue, with low returns for most asset classes within the next 10 to 15 years, and marginally higher fluctuations in annual yields, all relative to what plans used to get 10 to 15 years ago. This offers yet more evidence justifying continued efforts by public pension funds to adjust their long-term return assumptions, and ‘de-risk’ investment portfolios.

The prevailing message from the JPMA report is simple: the combination of lower returns from fixed income and equity investments, as well as an anticipated decline in the economic growth, brings the actual market rates uniformly down. The company expects a 60% equity/40% bond portfolio to earn somewhere between 5.5% and 6.0% in the next 10 to 15 years — down 75 basis points from its 2016 assumptions.* This finding is consistent with similar forecasts from McKinsey and Vanguard.

This new normal for investment returns is a problem for a myriad of reasons. To start with, assumed returns for most public plans is set above 7%, as a result the public pension industry is being structurally underfunded. Further, in order to try and compensate for the lower return environment, public plans will be forced to continue their recent pattern of pushing into alternatives in order to chase the higher yields necessary to hit those assumed returns that are above what an equities/bond portfolio can provide.

Over the past couple of decades, many public pension funds have moved from fixed income only allocation to equities and fixed income mix, and now further into more volatile international stocks and so-called alternatives. As a result, in 2015 more than 70% of public funds were exposed to equities and other riskier assets. According to Milliman actuary Tamara Burden, “[m]ost public pension funds don’t have a truly effective risk management strategy.”

As a matter of fact, state and local funds are quite vulnerable to even short-term market fluctuations, as on average around two-thirds of public plan revenue is intended to come from investment gains. This means that market volatility is a very costly proposition for an average-sized public plan.

To put this in a more tangible context, consider the struggles of the South Carolina Retirement System. Reason Foundation’s analysis of South Carolina’s largest public pension system, which covers state and local employees plus teachers, has found that the plan returned just 5.0% on average in the past 15 years, falling consistently short of its 7.5% long-term return target. This investment underperformance has resulted in more than $7.0 billion (or 165%) increase in plan’s unfunded liabilities during the same period.

Even though there is some progress for public plans in adopting more reasonable assumed returns — for example, CalPERS, CalSTRS, and other smaller plans in Rocky Mountain States are already taking actions to reduce their return assumptions to 7.0% and below — as many as 75% of state and local plans in the country are still assuming returns north of 7.5%.

Given the new normal in investing, it would be more rational for state and local pension funds to pursue ‘de-risking’ asset allocation strategies — as CalPERS has just started doing.

* The J.P. Morgan report used a portfolio based on a 60% Morgan Stanley Capital International All Country World Index/40% Bloomberg Barclays US Aggregate Bond Index split.