The return on asset assumption (ROA) for a public pension system is a critical variable in whether a plan is ultimately successful in meeting its promises (pension liability). The ROA is used to value the plan’s liabilities, as well as to determine the annual contribution into the plan. Unfortunately, many public pension systems are using inflated ROAs, which has lead to the systematic underfunding of these systems.
According to various studies, most public pension systems are using an ROA assumption between 7.25% and 7.50%. The focus on achieving the ROA has injected far more volatility into the process then is necessary. We are aware that long-term returns would suggest that equities are the place to be over multiple decades, but given the poor level of funding and escalating contribution expenses, these plans can’t afford to wait for decades to be proven correct.
Furthermore, employees have consistently contributed to their plans, and benefit reductions are not an appropriate alternative to building a more sound approach to the day-to-day management of these systems. When defined benefit plans were first offered, the plan’s liabilities were defeased in a similar way to how a lottery system ensures that future assets are available to meet future liabilities. Regrettably, the focus on generating a greater return to “lessen” employer costs has forced the retirement industry to adopt a new playbook. It hasn’t worked.
Public pension systems, as well as multiemployer plans, need to get back to basics before they collapse under the weight of the plan’s weak funded status. The Butch Lewis Act (BLA) adopts as one of the core principals a return to pension management in the past. If a low-interest rate loan is taken, the proceeds MUST be used to defease the retired lives portion of the plan’s liabilities. By doing so, the plan’s liquidity to meet benefits is improved, highly interest rate sensitive fixed income is replaced by a cash flow matching portfolio, and the investing time horizon is extended for the remaining assets to capture the liquidity premium in less liquid assets, which will be used to meet future plan liabilities.
There is nothing wrong with getting back to basics and proven pension management techniques, especially when the new-fangled strategies have produced very poor results to date.