Reuters has published an article, titled “Despite risks, public pensions put faith in long-term returns” As usual, the article stresses return as the savior of defined benefit plans. But, achieving the return on asset assumption (ROA) has not guaranteed success. We’ve illustrated this point before. But, it has guaranteed much more volatility in the returns achieved.
We understand that the lowering of the ROA target likely increases contribution costs as GASB allows for plan liabilities to be discounted at the ROA. This practice is leading to the habitual underfunding of DB plans. Both the IASB and FASB require plan liabilities to be discounted at substantially lower rates (mark-to-market and AA corporate, respectively).
DB plans can earn substantially less return than the ROA target and still come out ahead. How? Liabilities are bond-like in nature. The present value of a liability rises and falls with changes in interest rates. Liability growth has been fueled in large part by the collapse in U.S. rates. If rates begin to rise, we could see negative growth rates for plan liabilities. In this case, a 4% asset return will look very strong versus a -3% liability growth. You need fewer assets in a rising rate environment to meet your future liability.
Even if plans continue in their attempt to beat the ROA, their targets are still too aggressive. The average ROA for a public plan is estimated at 7.5% to 7.6%. Since 1926, the S&P 500 has produced an average 30-year return of 7.81%. Most plans will not have a nearly 100% allocation to the S&P 500. How are they going to achieve the ROA?
Stop the singular focus on assets, and begin to focus on your plan’s liabilities. Managing a pension plan should be about meeting the promise (liability) at the lowest cost possible.