How public pension plans can use last year’s investment returns to reduce debt and future risk

Public pension systems often resist making changes to their plan’s investment assumptions because doing so can come with a high price tag for the state and/or local governments. As a result of this political dynamic, the opportune time to make adjustments to a public pension plan’s investment return assumptions could be after a year of high market returns—when plans have excess or unexpected asset growth.

Last year, 2021, was one such year. Last fiscal year, most public pension plans saw record-breaking investment returns. In 2022, these pension plans have the opportunity to update their investment return rate assumptions.

Discount rates are used to calculate pension costs, and the assumed rate of returns is used to project asset growth. It is often difficult and costly for pension plans to lower their discount rates and assumed rates of return because doing so causes the plan to recognize that investment returns will be lower in the future. Those lower market return projections mean the cost of funding pension benefits will increase elsewhere. Thus, lowering discount rates and assumed rates of return requires state and local governments to make up the difference between the rate they previously assumed investments would return and the new lower rate of returns. That difference means increased contributions from state and local budgets or higher contributions deducted from plan members’ salaries. 

The Pension Integrity Project’s analysis of the Louisiana State Employees Retirement System’s (LASERS) pension debt growth shows that changes to actuarial assumptions have increased how much the state must contribute to the plan to fund retiree benefits. Around $2.4 billion in previously unrecognized debt was revealed between 2000 and 2021 because of changes to investment return assumptions. While not all of this shortfall needs to be paid immediately, this has contributed to the plan’s growing annual costs.

Adjusting actuarial returns sooner rather than later can reduce long-term costs. For example, LASERS averaged a 7.1% compound investment return rate between 2000 and 2021. If the plan had reduced its return assumption closer to 7% immediately after the 2008 financial crisis, it would have increased state contributions to the fund each year, potentially avoiding the debt accrued between 2008 and 2021 when actual returns were falling below the plan’s assumed rate of return. Lowering investment return assumptions would have taken a larger portion of the state budget each year, but pre-funding public pension benefits in this way would have been less expensive than having to pay interest on the $2.4 billion that has been added to the fund’s total debt load as a result of overly optimistic investment return expectations. 

Last year, the LASERS Board slightly reduced the pension plan’s discount rate and return assumption from 7.55% to 7.4%. Incidentally, last year’s investment return of 31.48% translated into $273 million in asset growth. This figure almost exactly matches the $270 million it cost the plan to make the discount rate adjustment, providing a good example of how extra investment gains can help plans fund costly assumption changes and reduce the chance of adding more debt in the future.

Another great use of one year of outstanding investment revenue is paying down existing debt. Per Act 399 of 2014, LASERS appropriates the first $100 million (indexed annually by growth in actuarial assets) of excess returns toward paying down legacy debt). In 2021, LASERS allocated $117.4 million of the excess investment revenue (the actuarial asset return above the assumed rate) toward paying down its legacy debt. 

Per the same policy, however, 50% of the remaining excess revenue went to fund permanent benefit increases, which is an increase in benefits that is not properly pre-funded and arguably one of the worst parts of the plan’s pension funding policy.

Louisiana is not alone in taking action to reduce actuarial assumptions after a year of excellent investment performance. The California Public Employees’ Retirement System—the world’s largest public pension plan—is implementing a plan to lower its assumed return and discount rate from 7.0% to 6.8%, and many other state-managed plans are going below the 7.0% target and bumping up the inflow of annual contributions to brace for the expectation of lower long-term returns. The New York State Common Retirement Fund, the third-largest public pension plan in the U.S., has lowered its return rate target from 6.8% to 5.9% following a staggering 33.5% return in 2021. 

“We have a unique opportunity to better position the funds for the long term because of the outsized returns that we’ve had in the past year [2021],” New York State Comptroller Thomas DiNapoli told Bloomberg.

Lowering investment return assumptions and discount rates are also supported by recent market forecasts which show public pension plans are likely to achieve closer to 6.0% investment returns over the next 20 years.

It is wise for public pension systems to use a single year of impressive investment gains to better prepare their fund for the future. Lowering investment return rate assumptions can help reduce the risks of future shortfalls and ensure proper funding of retirement benefits for teachers and other public workers.