The TEXPERS Blog

Public funds and the investment return assumption

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By Tony Kay, Guest Columnist

Many public funds are facing increased scrutiny regarding their actuarial assumptions, none more openly than their investment return assumption. 

This projection, sometimes referred to as the actuarial assumed rate of return, is used to document the long-term investment return expectations of a pension plan. It is used in part to determine the level of funding by plan sponsors and members required to support benefits. As with all actuarial assumptions, the goal of the investment return assumption is to project the most likely picture of the plan’s operation over the long term. Some outside parties believe that the assumptions used by various Texas plans no longer represent an accurate long-term depiction of future experience and, as a result, are understating the costs of pensions. 

The call to reduce the investment return assumption is routinely rooted in the belief that future investment returns will not meet historical levels for many of the most commonly held asset classes. Interest rates in the U.S. are low, but generally rising, creating an environment where income from U.S. bonds is low and the possibility of negative returns is elevated.  U.S. equities have performed well since 2008, but valuations have increased.  Furthermore, the current economic expansion is one of the longest in U.S. history. Many other asset classes face challenges as well.

Facing the decision to change the investment return assumption is difficult for many boards.  Even small changes can have a big impact on a plan’s amortization period, the contribution rate of members and plan sponsors and potentially even future benefits. How is a board to know if it is making the right decision? 

To start, it’s important to know how pensions are funded. Knowledge of the following equation will help trustees understand the impact of changes to plan assumptions on other areas of the plan: Benefits + Expenses = Contributions + Investment Earnings

It’s also important to get clear and understandable guidance from the professionals you engage. Your actuary can help you understand your current assumptions and how they differ from actual plan experience. All assumptions, including the investment return assumption, should be reviewed periodically and adjusted as needed. 

Your investment consultant can help you understand the historical return for your plan and how changes to your asset allocation will impact the risk and expected return of your portfolio. For example, what should you expect if you increase your exposure to stocks by 5% or add a new allocation to global infrastructure? There are an almost unlimited number of asset allocation scenarios that can be modeled for consideration.

Finally, it’s important to be transparent and inclusive. As you gather information and seek guidance, share what you are doing with interested parties. Being proactive with this communication will help to calm the noise of those that seem determined to attack and/or eliminate retirement programs that work if administered well. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of AndCo Consulting or TEXPERS. 

Tony Kay

About the Author:

Tony Kay is a consultant at AndCo and is based in the firm's Dallas office. He has 13 years of financial industry experience and currently advises more than $3 billion of institutional assets. Kay currently provides consulting for a diverse client base including public and private pensions, defined contribution, and foundation clients. His work includes both strategic and tactical asset allocation, process development and oversight, and policy documentation. Kay concentrates his efforts on client consulting, capital markets, manager research, and portfolio monitoring. He leads and assists with investment research projects and manager analysis for our clients. He has also assisted in research covering opportunistic and non-traditional assets, including core real estate, non-core real estate, private equity, distressed debt, and energy infrastructure assets such as Master Limited Partnerships. Kay was recently invited to speak at TLFFRA about meeting investment return expectations. He has a bachelor's degree in business administration, finance, from University of Tulsa.