How Sensitive is Public Pension Funding to Investment Returns?

A recent Issue in Brief projected that, under the most likely scenario, the aggregate funded ratio for state and local pension plans will increase from 73 percent in 2012 to 81 percent in 2016. The “optimistic” and “pessimistic” scenarios assume higher or lower, but also constant, rates of return. While this type of deterministic analysis is useful, an analysis that takes into account the variability of investment returns from year to year provides a more complete picture of the risks of serio us underfunding. Hence, this brief builds on the previous analysis by extending the projections of pension funding through 2042, using stochastically generated investment returns to quantify the probability that specific outcomes will occur. This exerci se, for illustrative purposes, centers around the average real return adopted by plans themselves. The discussion proceeds as follows. The first section describes historical investment returns and the assumptions currently used by public plans. A key point is that the real return – the nominal return net of inflation – is the relevant concept for publi c plans because benefits are generally indexed for inflation both before (through salary increases) and after retirement (through cost-of-living adjustments). The second section presents a stochastic “Monte Carlo framework and explains why this model is more helpful than a deterministic model that uses constant rates of return. The third section projects pension funding through 2042 (30 years from the most recent plan data) using stochastically generated real investment returns under alternative assum ptions regarding how much of the Annual Required Contribution (ARC) plans pay and what amortization methods they use. The final section concludes that – even if the median long-run return equals the assumed rate – the potential variability in returns, w hen combined with paying less than the full ARC and the funding procedures currently used by many plan sponsors, will produce less than full funding over the next 30 years.