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State Pension Plan Rates of Return under Review

More than half of state pension plans use a rate of return assumption of 8 percent, according to a 2011 PBS report. While the assumed rate of return may sound like an academic exercise, it influences billions of dollars in taxpayer expenses when applied to the future funding requirements of pensions and benefits for retired school teachers, fire fighters, police officers and other public employees.

The Pew Center on the States estimates that there is a $1 trillion shortfall between the $2.3 trillion in employees' retirement benefits already funded by states and municipalities, and the expected cost of $3.3 trillion associated with these promised benefits.

Pension funding levels vary widely across states according to the Pew Center, with New York and Florida being fully funded while Illinois and Kansas are less than 60% funded.

The rate of return assumed in calculating future pension obligations plays a critical role in determining current taxpayer liabilities, even though the longer term commitments remain fixed.

High Rate of Return Assumptions Lower Out-of-Pocket Costs

Pension plan sponsors, through their actuaries, rely on assumed rates of return to determine the amount their cities, states, and workers must contribute to a pension system to adequately fund future obligations.

As the assumed rate of return increases, current funding requirements decrease. Conversely, a lower assumed rate of return requires a higher current funding level in order to meet future obligations. By one industry estimate, each 1 point reduction in the assumption rate means 10 percent more in current contributions.

Some critics believe that 8 percent is too high and that it is no longer appropriate in today’s financial market with historically low interest rates. Their concern is that investment return assumption rates are artificially inflated to reduce the required contribution amounts required by those paying into the pension system.

Rates of Return also Project Pension Investment Income

Even more critical, pension plans rely on these rates to calculate the plan’s return on investment, which frequently accounts for a significant portion of the plan’s revenues. These return assumptions can affect the size of the plan’s funding gaps—the amounts by which future liabilities to retirees exceed current pension assets. When there are funding gaps due to lower assumption rates and other factors, employers and employees will be required to contribute more to the plan.

Critics of the 8 percent rate also claim that in addition to keeping assumption rates high to avoid necessary obligations, pension fund portfolio managers might be tempted to take on more risk to sustain better-than-market returns.

The U.S. stock market has not had a sustained increase in value over the past decade. Further, relatively low bond rates and excessive debts accumulated by consumers and governments in the past two decades have contributed to slower global growth. This means a potentially greater liability on the part of the pension to meet obligations. As such, pension actuaries (or the states that hire them) may be hesitant to reduce high assumed rates of return despite the fact that the assumed rate may exceed actual return on investment.

Public Pension Financial Reporting under Scrutiny

Nevertheless, legal considerations loom for state pension sponsors who seek to avoid reducing their assumption rates to avoid contribution obligations. The Governmental Accounting Standards Board (GASB) proposed new pension accounting rules on July 8, 2011 which, if adopted, will require annual disclosure of a pension fund's asset mix and its expected rate of investment return by asset class.

Under the GASB proposal, governments will be required to report a “net pension liability” on their balance sheet. At present, an unfunded pension liability may not be clearly defined, and therefore not reflected, in financial ratios involving debt and other long-term liabilities. Recognition of pension shortfalls in the financial statements, taken together with other liabilities such as outstanding bonds, claims and judgments, and long-term leases, will enable taxpayers and plan participants to better understand long-term obligations.

Other provisions in the GASB proposals relate to the disclosure of discount rate assumptions and the impact on the total liability of a 1 percent change in the discount rate.

The goal is to provide taxpayers, plan participants, and investors with higher quality financial disclosure. If plan sponsors and trustees are inflating their numbers to minimize current obligations and assume more risk, they may be exposed to lawsuits for violating their fiduciary duties.

November 2011

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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