Public pension plans have lowered their investment return assumptions, which generally raises costs, by requiring larger contributions to fund promised benefits. However, the decline in assumed returns is due to lower than expected inflation, which should have no effect on costs (employee contributions) in an inflation-indexed system, according to a recently released report titled: How Has the Decline in Assumed Returns Affected Plan Costs?
Findings from the report, which was published by The Center for Retirement Research at Boston College (CRRB), show that at the same time, plans have increased their assumed real (i.e., net of inflation) investment returns, which lowers costs. “Thus, plans could have lowered costs with these two assumption changes. But, public plans are not fully indexed, so their real costs actually increase as the inflation assumption falls,” the report said. The net effect of these changes has been to increase costs, but the increase is much smaller than if the decline in the assumed return was due to a lower real return, it said.
“For those that study pension plans, it’s a well-known fact they have been lowering their assumed returns since 2001, from 8% to 7.4%,” said Jean-Pierre Aubry, associate director of state and local research, and an author of the report. “We wanted to dig deeper to see what was behind the decline. It may be that plans are expecting the investment environment to be more challenging going forward or, perhaps, shifting to safer assets that provide lower returns,” he said.
“When we investigated the decline in assumed returns, we found that all of the decline in returns was actually due to a decline in inflation expectations. Plans have actually shifted into riskier assets–the opposite of the initial presumption that lower return expectations indicate a more moderate investment approach. If inflation expectations did not decline, the assumed return for plans would have likely increased as they shifted into riskier assets,” Aubry said.
The drop in inflation also matters for plan costs. “Generally, if expected returns go down, plans must contribute more money to payout the same level of benefits (the funding for benefits comes from two sources: contribution and returns. If returns are lower, contributions must increase to get back to the same level),” Aubry explained.
However, if returns are lower due to inflation, so are wages and COLAs. “Lower wages and COLAs mean lower benefit levels, which offsets the cost impact of lower returns. It’s the age old adage that inflation lifts and brings down all ships. Our research shows that the decline in assumed rate of return has increased costs for pension plans, but because the decline is due to lower inflation expectations (which also lowered benefit levels), the cost increase was much less than if only the returns had decreased while inflation stayed constant,” Aubry said.
Bob Jacksha, chief investment officer, New Mexico Educational Retirement Board noted that “From what I have seen, industry wide, it seems the lower earnings and discount rate assumption impacts the actuarial position more than the reduction in the inflation assumption, thus raising the cost of the plan.”He added that “Our plan has a complicated COLA formula, but in general, benefits are not fully indexed to inflation.”
Additionally, “There has been a lot of concern about the reasonableness of the assumed rate of return for public plans–with many concluding that the assumptions are too optimistic at best,” Aubry said. “It would seem that plans have responded to those concerns by lowering their assumed rate of return. What’s interesting is that the decrease in the return assumption does not reflect a more moderate investment approach. In fact, plans are now holding riskier assets than before,” he said.
“In terms of costs, because the drop in the assumed returns is due to lower inflation–which lowers benefit levels–plan costs don’t balloon as much as if only returns had declined while inflation (i.e. benefit levels) stayed the same.”
Breaking it down
The CRRB divided its report into several sections. The first section documents the impact of declining inflation on assumed returns and explains why lower inflation has no impact on costs to pension plans, if benefits are fully linked to inflation.
The second section shows that public plan benefits are not fully linked to inflation, so that a lower inflation assumption leads to higher real benefits and plan costs. The third section describes the increase in plans’ expected real rate of return, which lowers costs. And the fourth section reveals the finding that plan costs have increased, because the lack of full indexing dwarfs the impact of the higher real return. The increase, however, is substantially less than if plans had lowered their real return assumption, it notes.
The final section of the report comes to the conclusion that it is important to identify the source of a decline in assumed returns, because lower inflation and lower real returns have different effects on costs.