An interesting article in MarketWatch succinctly explains why many public sector pension funds insist on setting unrealistically high assumed rates of return. Simply stated, it masks the severity of their underlying problems.
Even with the Colorado PERA board’s recent proposals to trim some benefits and increase contribution and member contributions, the underlying assumption that its funds will average a 7.25 percent return would remain unchanged. This despite the urgings almost a year ago of top financial experts that the return rates be set much lower.
Why this stubborn insistence on viewing the rate-of-return world through rose-colored glasses? Here’s MarketWatch’s take:
…the more underfinanced a pension plan, the more likely it was to have overoptimistic return estimates, according to research by Two Sigma Investments.
Though the average pension plan had only made an average annual return of 5.7% in 2001 to 2015, state pension plans tended to shoot for the stars and operated under an expected annual return of 7.6%, they reported…
The analysts at Two Sigma pointed fingers at accounting rules that “foster optimism, because public systems discount their liabilities based on their assumed rate of return instead of an appropriate-duration credit rate.”
In other words, playing around with the so-called discount rate, the expected rate of return, could help hide the extent of troubles. Board members of state pension funds, often public officials, are loath to “mark to reality,” said Michael Collins, a money manager at PGIM Fixed Income.
The article goes on to argue that there are compelling reasons for pension plans to come clean about realistic return rates:
Switching to a low rate of return, on the other hand, can serve as a call to action or reflect a state’s newfound zeal to deal with its pension problems.
“States that consistently fund full required contributions with an actuarial basis and use conservative assumptions and methods are more likely to effectively manage their pension liabilities and the associated long-term budgetary costs than states that do not,” wrote Sussan Corson, a credit analyst at S&P Global Ratings.
And there are other reasons for lowering the expected rate of return. High discount rates have been accused of creating perverse incentives for pension funds to invest in equities and other risky assets, which do offer richer returns but can also prove more volatile.
It will be interesting, to say the least, to observe how this discussion plays out during Colorado’s 2018 legislative session.