Impact of Public Sector Assumed Returns on Investment Choices

State and local pension plans use their assumed investment return -- 7.4 percent, on average, in 2017-- to value liabilities and calculate required contributions. Prior studies have suggested that this practice results in overly risky portfolios as plan sponsors seek higher returns to reduce their repo rted liabilities and required contributions. A separate, but related, issue is that – for any given asset allocation – this use of the assumed return could also provide an incentive for plans to take a rosy view of future returns for their investment portfolio. Given these concerns, this brief investigates two questions. First, does using the assumed return to value liabilities and set contributions lead to riskier asset allocation? Seco nd, given the asset allocations of public plans, are their assumed returns overly optimistic? The discussion proceeds as follows. The first section introduces the data and methodology, explaining why comparing public plans to private plans is useful for this analysis. The second section explores the hypothesis that using the assumed return to valu e liabilities and set contribution targets leads to riskier asset allocation. Given their allocation, the third section explores whether public plan return assumptions are reasonable by comparing them to those of investment experts. The final section conclu des that public plans invest in riskier assets than private plans – and that much of the difference is related to unobservable differences between the sectors, including how they use the assumed return. Additionally, given the asset allocation of public plans, their return expectations are on the optimistic end of the assumptions of investment experts.