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Letter from the US: Lower expectations

Most US state retirement systems are cutting their investment return predictions. But this is still not enough, according to critics, and a minority of public pension funds are retaining optimistic assumptions and aggressive strategies.

State and local government retirement systems hold assets of about $3.8trn (€3.4trn), according to the National Association of State Retirement Administrators (NASRA). They use expected investment returns on assets to calculate whether higher contributions are required or whether benefits must be reduced. In 2001, the average annual target was 8.1%, but the 2008 financial crisis shook fund managers’ belief that the right mix of stocks and bonds could achieve that goal. Since then, more than two-thirds of state retirement systems have trimmed assumptions, according to an analysis of 126 plans provided by NASRA. Now the average target is 7.68%, the lowest since 1989. 

Among the large public pension funds that have cut their assumed returns are the New York State Common Retirement Fund (the third-largest one with $184.5bn in assets), the Oregon Public Employees Retirement System (PERS, $71bn) and the San Diego County Employees Retirement Association (SDCERA, $10.3bn). PERS and SDCERA dropped their level to 7.5% from 7.75%. The New York State fund went even to 7% from 7.5%, after cutting a half-percentage point five years ago.

The California Public Employees’ Retirement System (CalPERS), which is the largest pension fund with $301bn in assets, is discussing a new reduction below 7.5%. Its new target could be as low as 6.5%. Last year, CalPERS claimed that 7.5% could be realistically achieved. But in the meantime its return on investments for the 12 months to 30 June 2015 fell short of expectations: it was only 2.4%, the poorest year since 2012, and down from 18.4% in 2014. 

Ted Eliopoulos, CalPERS’ CIO, stressed that the fund’s 20-year investment return stands at 7.76%, above its target. However, since he was appointed last year, he has focused on simplifying the portfolio and reducing risk, including divesting from hedge funds. In general, CalPERS is planning to move more money into safer investments.

The year ending 30 June was tough for public retirement systems: their median return was 3.4%, their worst annual performance since 2012, according to the Wilshire Trust Universe Comparison Service. Those results are putting pressure on revising financial assumptions.

The problem is that lowering investment-return expectations by one percentage point means increasing pension liabilities by 12%, according to Jean-Pierre Aubry, an assistant director at the Center for Retirement Research at Boston College. That gap has to be filled with higher contributions by governments and/or workers if they do not want benefit cuts.

Private companies have adopted lower targets, because they have different funding rules: the average level for Fortune 1000 companies dropped to 7.1% in 2014 from a high of 9.2% in 2000, according to Towers Watson.

Moreover, a panel of US actuaries and pension specialists has recommended that public pension funds use conservative assumptions – a 6.4% annual return. If that sounds drastic, it should be recalled that in the 1960s pensions estimated 3-3.5% returns from portfolios invested in cash and bonds; today pension funds are mostly returning to strategies with greater fixed income allocations to match their liabilities.

Of the public plans, Houston Firefighters’ Relief and Retirement Fund has retained the highest assumptions, with expected returns of 8.5%. Todd Clark, chairman of the fund, is confident that they can achieve that target, based on strong past performance, such as a 10-year investment return of 9.7% as of 30 June 2014. But it is a small fund with $3.9bn in assets, and the 2015 fiscal-year results have not yet been published. Some 25% of the portfolio is invested in alternative assets, mimicking the policy of certain endowments. But this is not bullet proof: the 2015 fiscal-year return was 11.5% for Yale, but only 5.8% for Harvard, as both bet on private equity, real estate and absolute return strategies.

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