For the last 20 years, state and local pension plans’ assumed rates of return have been far too optimistic. The distributions of average (geometric mean) assumed investment returns and actual returns from 2001 to 2020 demonstrate this. The figure below shows the distribution of the average assumed investment return rate versus actual investment returns for 200 of the largest state and local pension plans in the United States. The median assumed rate of return over the last 20 years was 7.7 percent per year, the median actual rate of investment return for these public pension plans was 5.7 percent.
This two percent difference helps to explain the nearly 30 percent drop in the average pension plan funded ratio over the same period. In recent years, many pension plans lowered their assumed rates of return.
The visualizations display how private equity investments have grown in popularity. Private equity allocations are now the third-largest asset class for public pension plans, growing from 3.62 of nationwide plan portfolios in 2001 to 9.15 percent in 2019.
Portfolio managers should be free to pursue whatever investment philosophies they believe are in the best long-run interests of their plan members. However, policymakers, pension plan members, and taxpayers should be aware of these trends and the risks that come with them. Pension systems and lawmakers need to address the growing risk of volatility in ways that maintain a plan’s resiliency to unpredictable market factors. Also, plan stakeholders should be wary of a situation where the tail wags the dog—with pension systems swapping safety for risk and volatility as they chase outdated and overly optimistic investment return assumptions.
Over time, changes in a pension plan’s funded ratio, also referred to as a pension’s funded status, can show the rate at which the plan’s debt is growing.
In 2001, West Virginia was the only state where public pension plans had an aggregate funded ratio of less than 60 percent. However, 18 years later, in 2019, nine states faced aggregate funded ratios below 60 percent.
In that same time period, the number of states with funded ratios below 70 percent (but above 60 percent) grew from three to 14. Together, these numbers show that, as of 2019, 23 states had less than 70 percent of the assets on hand that they need to be able to pay for promised future retirement benefits.