Pension Rate of Return Reality
According to its March 15, 2011 press release, the Board of Administration for the California Public Employees' Retirement System ("CalPERS") votes to maintain its current per annum discount rate assumption of 7.75 percent. Citing its actuary's take that maintaining the "discount rate at its current level is prudent and reasonable" and its long-term investment posture, this giant pension system justifies the status quo.
A few months ago, CalPERS "slightly decreased the allocation for traditional bonds and shifted the funds to inflation-protected bonds and commodities to reduce volatility risk." Its historical and projected analysis suggests an average gross (net) annual return of 7.95 (7.80) percent for the next several decades. Prior to 2004, CalPERS states that it had assumed an annual discount rate of 8.25 percent.
Not everyone agrees that defined benefit plan rates of returns should hover around the magic eight percent that has been long used for determining funding status. St. Petersburg Times reporter Sydney P. Freedberg describes the dilemma in "Experts say Florida overstates future pension returns" (March 21, 2011). If states assume a rate that is overly optimistic, reported IOUs will be smaller as a result on paper but not in reality. At some point, real money will be required to write checks to beneficiaries. On the flip side, the use of a more likely rate of return will balloon unfunded liabilities, forcing economic and political change right away.
The larger the funding gap (and assuming no changes in contributions), the more likely it is that traditional pension plan decision-makers will steer money towards higher risk investments, in anticipation of higher returns. This may be a valid strategy AS LONG AS new risks are properly identified, measured and managed. Otherwise, the situation could become even worse as out of control risk-taking leads to more and larger portfolio losses down the road.
As described in "Will the Real Pension Deficit Please Stand Up?" by Dr. Susan Mangiero, CFA, FRM (June 22, 2006), the American Academy of Actuaries writes in its July 2004 primer on pension fund accounting and funding that "Amounts calculated under pension funding rules are completely different than those calculated for pension accounting, and one must be careful not to mix the two topics."
The important issue continues to be how long it will take before plan participants, sponsors, shareholders and taxpayers get the real scoop on what is owed, when and by whom.
