Public Pension Investment Return Assumptions (updated 3/28/11)

This post is here to share some of the many published opinions regarding public pensions’ rates of return.  The full articles are available via the links with each piece.  Here are a few to start off, I’ll post more later in the week.  Please feel free to comment with any questions.


Dean Baker
Returns on Public Pensions – What Rates Should We Assume?
Center for Economic and Policy Research – March, 2011

“My contention is that because a state or local government is essentially an infinitely lived entity, it need not be as concerned about the variance in returns as individuals. Therefore state pension plans can make their projections based on the expected value of their stock holdings.”

Baker offers the above statement in response to the claim that pensions should maintain an assumed return lower than their expected values in order to safeguard against risk.  He uses the analogy of the insurance industry.  Insured individuals share risk to prevent catastrophic losses, whereas the risk of pensions being unable to meet current obligations is offset by the ability to draw from reserves that would otherwise go towards future payments.

Note: The list of funders for the CEPR is available here.  Many of them are social justice/insurance organizations.


Dean Baker
The Origins and Severity of the Public Pension Crisis (as mentioned earlier by David Chase here)
Center for Economic and Policy Research – February, 2011

“ … $80 billion of the shortfall is the result of the fact that states have cutback their contributions as a result of the downturn … It is worth noting that if pension funds stop investing in equities, as some have advocated, this would imply higher taxes and/or lower benefits for public employees. ”

Baker claims here that the primary cause of public pension underfunding is the recent market downturn, and that contribution reductions account for less than 10 percent of the shortfall.  He further explains the problems associated with assuming a risk-free return rate.  Assuming this rate when the expected fund investment return is likely much higher will lead to excessive contributions relative to the fund’s obligations.


David Reilly
Pension Gaps Loom Larger
Wall Street Journal – September, 2010

“The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.

“Earlier this month, New York State Comptroller Thomas DiNapoli said he would reduce the expected rate of investment return for his state’s pension system, the third-largest in the nation, to 7.5%, from 8%.”

As one might expect, this WSJ article suggests that existing return assumptions are unrealistically high.  It points out that many public pensions, including Calpers, are reviewing their assumptions and possibly decreasing their return expectations.

This article includes an excellent graphic showing the return assumptions of both public and S&P 500 companies.


Chad Aldeman, Andrew J. Rotherham
Better Benefits: Reforming Teacher Pensions for a Changing Work Force
Education Sector – August, 2010

“Annual employer and employee contributions help fill public pension plan coffers, but as plans become larger over time, they rely more heavily on investment returns … Also, as funds rely more on investment returns over time, their total asset value becomes more susceptible to market fluctuations.”

“… state pension funds earn returns that are about 1 percent higher than what the typical individual investor could expect.”

This paper describes the nuts & bolts that go into pension calculations. The “Tricky Assumptions” sidebar on page 5 of the PDF covers return assumptions in great detail.  One notable claim is that pensions become increasingly susceptible to market fluctuations over time, since their guaranteed income (member contributions) becomes smaller relative to investment returns.  According to his calculations shown in Figure 4, Massachusetts maintains one of the highest levels of unfunded liabilities per capita.


Andrew G. Biggs
An Options Pricing Method for Calculating the Market Price of Public Sector Pension Liabilities
American Enterprise Institute – February, 2010

This paper uses an options pricing method to calculate the market value of taxpayer guarantees underlying public sector pensions.  The average funding ratios declines from 83 percent under actuarial accounting to 45 percent under this options pricing approach.

(Dean Baker responded to this paper in this post.)

Andrew’s thesis is that the level to which public pensions are underfunded is far greater than is commonly published, with the reason being the accounting methods employed.  Using monte carlo simulation, he claims that the “typical” public pension has only a 16% chance of meeting existing obligations with current assets.

3/28 Update: As with Mitchell’s paper below, this is an apples-to-apples comparison of current assets and already-accrued benefit liabilities.  He refers to the concept of interperiod equity as a basis for this comparison.  Originally, I thought it might refer to current assets vs. accrued and expected future liabilities.


Keith Brainard
Public Pension Plan Investment Return Assumptions
National Association of Retirement Administrators (NASRA) – March, 2010

Empirical results show that since 1985, a period that has included three economic recessions and four years when median public pension fund investment returns were negative (including the 2008 decline), public pension funds have exceeded their assumed rates of investment return.  As the standard disclaimer says, past performance is not an indicator of future results. (emphasis mine – AA)

This briefing reaches more optimistic conclusions than Biggs’ paper.  It also explains some of the actuarial standards used by public pensions.  However, it should be noted that valuation techniques are what Biggs took issue with in the first place, so it’s understandable that they would reach vastly different conclusions.

Note: NASRA’s membership is detailed here.  Its members are directors of public retirement systems, and its associate members are private sector firms that work with public retirement systems.


Olivia S. Mitchell
Implications of the Financial Crisis for Long Run Retirement Security
Pension Research Council – January, 2010

Dr. Mitchell’s paper covers retirement security in general, rather than simply pensions.  Her findings include the following quote about public pensions:

… The problem was that US pension funds leaned heavily toward equity, and when the market crashed, so too did the plan funding levels.  In the public sector, it has been estimated that states and municipalities hold only about 55% of the money needed to discharge benefit promises.

I was originally unclear on the specifics of this quote.  Essentially, this is an apples-to-apples comparison of current assets and already-accrued benefit liabilities.


Dave Beal
Minnesota’s public pension commission is in limbo as the work piles up – March, 2011

Beal’s article includes the return assumptions of many public pension experts from different sides of the aisle.  He discusses the split of assets that come from employee contributions vs. those from investment returns, as well as some recent news regarding state employee pensions:

“(Minnesota’s three major public pension) funds’ actuary, Mercer, has recommended lowering the 8.5 percent.”

“The actuary for CALPERS … recommended that it come down from 7.75 percent to 7.5 percent.”

Note from this site’s About page: “MinnPost is a nonprofit, nonpartisan enterprise whose mission is to provide high-quality journalism for news-intense people who care about Minnesota.”

More about the Calpers decision here.


Jed Graham
Public Pensions in the Red Even With Rosy Assumptions – March, 2011

Mr. Graham espouses the view that return assumptions should be lowered from current levels.  He stresses the importance of such assumptions with a very clear graphic and quotes like the following:

Assuming 6% returns, (Florida’s) official $16.7 billion unfunded liability would more than triple to $52.7 billion and the funding ratio would fall to 69% (from 87.9%).

He also shares quotes from Professor Robert Novy-Marx, for example:

“For pension funds, return assumptions and the discount rate are one and the same, and therein lies the problem”

More of Novy-Marx’s work can be found here, with an example specific to public pensions here.

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