More Reasonable Expectations

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I was extremely pleased to read Bridgett Hickey’s recent FundFire article, “Pensions Return Expectations Fall Below 7% for First Time” in which she writes that the average public pension plan return on asset (ROA) assumption “has dropped below 7% this year for the first time in U.S. pension fund history.” I can’t speak to what ROAs looked like from the 1950s to 1981 when I first entered the industry, but it is the first time that I can recall seeing ROAs so reasonably low. I’m thrilled that most plans haven’t extrapolated linearly from the most recent performance period and projected those results well into the future. Given 2022’s results to date, it appears that public pension funds were quite prescient.

According to an Equable Institute survey of 167 statewide plans and 61 municipal plans, the average ROA is now 6.93%, which is down significantly when it was 8% as recently as 2001. This trend is further supported by data from the National Association of State Retirement Administrators that showed the average assumed rate of return was 6.99% in March. Despite the progress to reduce annual return expectations there remain 21 plans that have a 7.5% or greater objective according to Equable. It isn’t a seamless task to reduce the ROA as it impacts annual contributions (and budgets), which rise when the discount rate is reduced. But, contributing more, if possible, reduces the uncertainty around achieving a return target that comes with considerable volatility.

It would be wonderful if this lower return target also came with a rethinking related to asset allocation. We’d highly recommend bifurcating the plan’s assets into two buckets – liquidity and growth. The use of a cash flow matching bond program to meet liability cash flows enables the growth portfolio to grow unencumbered as it is no longer a source of liquidity. Having this extended investing horizon reduces the variability of returns longer-term and enhances the probability of success. As we migrate through a very uncertain investing horizon fraught with high inflation and rising rates, gaining a little certainty with regard to enhanced asset cash flows to meet liability cash flows is very comforting.

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