The $116 billion North Carolina Retirement Systems has lowered its assumed rate of investment return for the third time in four years, cutting it by 50 basis points (bps) to 6.5% from 7% annually.
The target return had already been reduced to 7.2% from 7.25% in 2017 and again in 2018 to 7%. Prior to then, the rates had been left unchanged for nearly six decades even though the two main state pension funds—the Teachers’ and State Employees’ Retirement System and the Local Government Employees’ Retirement System—have, on average, underperformed their assumed rates of return over the past 20 years. In fact, the new target rate of 6.5% is still higher than the fund’s estimated 20-year return of 6.28%.
In the United States, public pension funds, which have an average investment return target of 7.25 percent, will likely struggle to meet those investment targets and could be severely impacted by plummeting interest rates. Without changes to pension plans’ assumed rates of return, many public pension systems will see an increase in debt.
Unfortunately, many public pension plan managers are not interested in adjusting their investment return targets to realistic levels at this time. Instead, they are seeking riskier, potentially higher-yielding investments in an effort to make up for depressed interest rates and hit their targets.
Gordon thinks very highly of Ben Meng and so do I. I’ve had the pleasure of talking with him a few times since he was appointed CIO at CalPERS and not only is he brilliant, he was always very nice and generous with his time.
The last time I spoke with Ben was in the summer via a webcast where he explained that CalPERS is not leveraging its portfolio by $80 billion. We spoke about a few things and I recommend you read my comment here to gain an appreciation of everything he was tying to do at CalPERS.
The main challenge facing the public pension industry is the high assumed rates of returns on pension assets relative to what equities or bonds are likely to deliver.Many US public pension funds expect a rate of return in the neighborhood of 7% per year. But in today’s capital-market environment, achieving that sustainably over the long term has become an increasingly daunting task.
In fact, this is not a new problem. As Chart 1 illustrates, the gap between the risk-free and assumed rate of return has been widening for the past four decades. In the1980s, the risk-free rate (as approximated by the yield for ten-year US Treasury bonds) was often far higher than the assumed rate of return, making it relatively easy for pension funds to hit their targets. Today, however, the risk-free rate is more than six percentage points below targeted return.