Just where does the return on asset assumption (ROA) come from? Since plan sponsors, actuaries, and asset consultants live and die trying to achieve the ROA, and subsequently the DB pension plan, it must be derived through an incredibly elaborate evaluation of all the relevant data. At least you would think that, wouldn’t you?
At a recent conference, one of the KCS strategic partners asked an actuary how they derive the ROA. The actuary responded that they get it from the plan’s asset consultant. Really? How then does the asset consultant get this number? Well, it seems that they make “assumptions” about future market returns, risks, and correlations based on previous results. But, whether they believe that a 7% or 8% or 9% return is doable over some prescribed period have they looked at the liability side of the pension equation to determine if that is the correct number? No!
Plan sponsors will sometimes make adjustments to the ROA. We’ve witnessed through the last 15 years a steady reduction in the ROA based on the belief that traditional asset classes would not provide enough return (beta or alpha) to generate an ROA-like return. However, in most cases, there has been a reluctance to move the ROA down substantially because of the impact that it has on contribution expense.
Because GASB allows public DB plans to discount liabilities at the ROA, there is a great reticence to lower the ROA, but would there be the same reluctance if the ROA only needed to be 5% in order to beat liability growth? Probably not! In fact, in a rising interest rate environment it is likely that liability growth could be negative. The ROA certainly doesn’t need to be 7.5% in that environment.
GASB Statements No. 67, Financial Reporting for Pension Plans, and No. 68, Accounting and Financial Reporting for Pensions, which substantially improve the accounting and financial reporting of public employee pensions by state and local governments that apply U.S. Generally Accepted Accounting Principles (GAAP).
Statement 68 requires governments providing defined benefit pensions to recognize their long-term obligation for pension benefits as a liability for the first time, and to more comprehensively and comparably measure the annual costs of pension benefits. In order to meet this obligation, pension plan sponsors are expected to perform an asset exhaustion test on their plans. It is through this analysis, and this analysis only, that a sponsor can truly understand what rate of return needs to be achieved in order to keep the plan functioning.
We would be willing to assist you in this effort. We think that you will be surprised to see what the output from this analysis will show. Wouldn’t you like to know that the volatility associated with a traditional asset allocation can be substantially lowered in an environment where your objective is really 3%-5% because your assets (including contributions) are never exhausted?