The Federal Reserve recently announced its plans to keep interest rates near zero for at least the next three years. This shift from the Fed’s longtime strategy of raising rates to ward off inflation is bad news for state pension systems, many of which have been struggling to meet overly optimistic assumed rates of investment return.
Treasury rates have been steadily declining for decades and are now reaching historic lows. The decline in Treasury rates drastically impacts the investment returns that public pension plans are able to achieve, in part, because government and corporate bonds make up about 23 percent of their investment portfolios.
This decline in Treasury rates is another example of what should be considered the “new normal” for pension system investments: The new normal is an investment environment characterized by low interest rates, low economic growth, and low equity returns.
When Treasury rates are low, public pension system plan managers may be forced to search for alternative, higher-risk assets to meet their plans’ assumed rates of investment returns. Ideally, however, these return rate assumptions would be lowered to better fit market conditions. But many public pension plans are loath to absorb the significant increases in public spending that this change would entail due to the higher pension contributions from workers and/or employers that would be required. This is especially true right now, as states across the country are facing major budget deficits due to the coronavirus pandemic and recession.
Even so, many public pension plans will need to reform their funding policies as a result of persistently low interest rates and the subsequent reduction in expected investment returns.
Pension reforms should focus on consistently making actuarially sound payments, as well as ensuring that actuarial assumptions—namely the assumed rate of return on investments—are taking the lowered interest rates into consideration. Reason Foundation’s suggested reforms for the “new normal” environment include lowering the assumed rate of return, adopting a governance structure designed to minimize the role of politics, and planning for downside risk. These reforms would build much-needed resiliency into public pension systems.
Two major recessions over the past two decades, plus a historic trend towards lowered interest rates, has proven the need to focus on such resiliency. Resilient pension plans will implement autocorrecting features, use realistic return rate assumptions, and plan for downside risk. Without these changes, pension systems will be vulnerable to economic and market shocks in the future, which would likely continue to crowd out other priorities in government budgets and force unfair deals upon some stakeholders.
Going forward, the success of public pension plans will depend greatly on how quickly and effectively policymakers recognize and address a future where low interest rates and returns are the norms.