IDEAS home Printed from https://ideas.repec.org/p/crr/issbrf/ibslp34.html
   My bibliography  Save this paper

How Sensitive is Public Pension Funding to Investment Returns?

Author

Listed:
  • Alicia H. Munnell
  • Jean-Pierre Aubry
  • Josh Hurwitz

Abstract

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 serious 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 exercise, 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 public 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 assumptions 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, when 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.

Suggested Citation

  • Alicia H. Munnell & Jean-Pierre Aubry & Josh Hurwitz, 2013. "How Sensitive is Public Pension Funding to Investment Returns?," Issues in Brief ibslp34, Center for Retirement Research.
  • Handle: RePEc:crr:issbrf:ibslp34
    as

    Download full text from publisher

    File URL: http://crr.bc.edu/briefs/how-sensitive-is-public-pension-funding-to-investment-returns/
    Download Restriction: no

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. John Duffy & Yue Li, 2016. "Lifecycle Consumption Under Different Income Profiles: Experimental Evidence," Working Papers 161702, University of California-Irvine, Department of Economics.

    More about this item

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:crr:issbrf:ibslp34. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Amy Grzybowski) or (Christopher F Baum). General contact details of provider: http://edirc.repec.org/data/crrbcus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.