How Has the Decline in Assumed Returns Affected Plan Costs?


Publication Date: June 2019

Publisher: Center for Retirement Research at Boston College

Author(s): Jean-Pierre Aubry; Alicia H. Munnell; Kevin Wandrei

Research Area:

Keywords: State and local pensions; Public pensions; Retirement ; Assumed Returns

Type: Report

Coverage: United States

Abstract:

Many state and local pension plans have lowered their long-term investment return assumptions in the wake of the financial crisis. Such a change is generally viewed as a positive development for pension funding discipline, bringing assumptions more in line with market expectations and forcing plan sponsors to increase annual required contributions. In this case, however, the decline is actually due to lower assumed inflation, not a lower real return (that is, the return net of inflation). In a fully-indexed system where benefits fully adjust with inflation, a lower inflation assumption should actually have no impact on costs. At the same time, plans have changed their asset allocation, resulting in a higher expected real return, which – all else equal – lowers costs. Therefore, a quick assessment of these underlying assumption changes suggests that plans may have actually lowered their costs with the decline in the assumed return. But, public plan benefits are not fully indexed, so the real value of benefits increases as the inflation expectation drops, which increases plan costs. This brief explains the overall impact of these opposing dynamics and compares the net effect on costs with that produced by a lower real return assumption.

The brief proceeds as follows. The first section documents the impact of declining inflation on assumed returns and explains why lower inflation has no impact on costs if benefits are fully linked to inflation. The second section shows that public plan benefits are not fully linked to inflation, so that a lower inflation assumption leads to higher real benefits and plan costs. The third section describes the increase in plans’ expected real rate of return, which lowers costs. The fourth section puts the pieces together – finding that plan costs have increased because the lack of full indexing dwarfs the impact of the higher real return. The increase, however, is substantially less than if plans had lowered their real return assumption. The final section concludes that it is important to identify the source of a decline in assumed returns because lower inflation and lower real returns have different effects on costs.