Despite historic 2021 returns, many public pension plans are wisely preparing for lower investment returns
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Commentary

Despite historic 2021 returns, many public pension plans are wisely preparing for lower investment returns

Public pension plans also need to resist the temptation to use last year's one-off, one-year investment return windfalls to fund new benefits like higher cost-of-living adjustments.

Last year, investment returns for public pension systems hit record highs. The median return for state-managed plans was 27% in 2021. Despite beating investment return targets by 20% in 2021, many public pension plans are now taking the opportunity to reduce their investment risks by lowering investment return rate assumptions to more realistic long-term growth rates.

Using the latest capital market assumptions from established financial firms, Reason Foundation’s Pension Integrity Project built a portfolio simulation tool, which gives an idea of the range of returns that financial experts are expecting for pension funds for the next few decades. For a portfolio representative of the national average public pension system, median investment return projections in the tool fall in the range between roughly 4.5% and 7.5%. Four out of six market projections provide a median compound annual growth rate of less than 6%.

Setting a pension plan’s assumed rate of return at a lower, more achievable target lowers the likelihood of accruing unfunded liabilities—debt—in the future. Assumed rates of return are used to project out asset growth. When a plan’s expected return rate is too high and it fails to meet investment projections, the plan accumulates unfunded liabilities due to the lower-than-forecast returns. Several public pension plans have wisely lowered their assumed rates of return to reflect the long-term forecasts and reduce the potential for accruing debt.

In 2021, the New York State Common Retirement Fund lowered its assumed rate of return by nearly a percent, from 6.8% to 5.9%. The Maryland State Retirement and Pension System lowered its expected return rate 60 basis points to 6.8%, and dozens of other public pension plans have dropped their investment return assumptions by at least a quarter-point since last year.

The Ohio State Teachers Retirement System (STRS) lowered its investment return assumption by nearly half a percent, but STRS is now exploring an expansion of its cost-of-living adjustment (COLA) which would immediately burden the fund with more debt.

On Jan. 27, the pension board’s actuary presented the cost of a 2% COLA, which would add nearly $14 billion in liabilities (increasing the plan’s unfunded liabilities by 66%). Currently, STRS is not in the position to add to its liabilities. The Ohio State Teachers Retirement System has an 80.1% funded ratio, meaning it has just 80 cents for every dollar it already knows is needed to pay for the pension benefits that have already been promised to current and future retirees.

Since these funding measurements are based on return assumptions that are likely underestimating the system’s funding gap, Ohio’s pension system may be worse off than is currently being reported. In the same Jan. 27 board meeting, the plan’s investment consultant projected that the “10-year return for STRS Ohio’s current asset mix is 6%.” While the rate was recently lowered, the plan’s assumed rate of return remains at 7%, which is a full percentage point higher than its own consultant’s projection.

Last year’s strong returns should not be misread. Many pension plans, like Ohio STRS, are still in a fragile financial position. During the Great Recession of 2007-2009, the Ohio teachers plan’s funded ratio dropped from 79.1% funded to 60% in one year—and kept declining until 2013. When the COVID-19 pandemic hit, a Great Recession-like scenario loomed. While there was a steep sell-off in the second quarter of 2020, asset prices were buoyed by the federal government’s unprecedented fiscal and monetary intervention.

We are, unfortunately, sitting in an economically uncertain time. Consumer sentiment is lower today than it was in April 2020. Although unemployment is approaching pre-pandemic rates, labor force participation is 1.2% lower than it was in February 2020. Uncertainty regarding the pandemic, supply chains, and inflation remain.

In markets, the S&P 500’s 10-year price-to-earnings ratio is reaching a level not seen since the tech bubble. While policymakers certainly need to be careful extrapolating historic results to predict the future, an analysis of annual market growth going back to 1979 demonstrates that 2021’s phenomenal investment returns were quite clearly an exception, not the rule.

The great investment returns in 2021 can be seen as an example of the upside of markets, but public pension plan administrators also need to be fully prepared for the downsides. Public pension systems can largely avoid burdening taxpayers with unforeseen debt and putting workers’ retirement plans in jeopardy in the future by continuing to lower their assumptions on investment returns to better match the consensus 20-year forecasts of market experts.

Public pension plans also need to resist the temptation to use last year’s one-off, one-year investment return windfalls to fund new benefits like higher cost-of-living adjustments. Investment returns like those of 2021 are very unlikely to occur with very much consistency or regularity. While 2021 was a great help to improve the funded ratios of most public pension plans, those types of years should be viewed as times to help buoy public funds so they are better prepared for the market’s similarly unpredictable down years.

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