Rate of return
The rate of return is the ratio of money earned or lost on an investment relative to the amount of money invested. The average expected return on assets used in most public pension valuations is close to 8 percent, with a range from 6 percent to 8.5 percent.
Critics of the average expected rate of return normally assumed in public pension funds, such as Andrew Biggs of the American Enterprise Institute (AEI) and Robert Novy-Marx of the University of Chicago and Joshua Rauh of Northwestern University together, claim that public pension funds are allowed to assume high rates of return without recognizing risk. Both assume lower rates of return for the funds based on valuation methods similar to the private market. Biggs estimates what public pension promises would be worth if they were valued using private sector methods, and Novy-Marx and Rauh estimate rates of return utilizing present-value methods.
Since the financial crisis began in 2008, at least 19 state and local pension plans have cut their return targets, while more than 100 others have held rates steady, according to a survey of large funds by the National Association of State Retirement Administrators.
While public pension funds expect to earn a certain rate of return annually to meet its funding obligations, fund administers typically spread out gains and losses over a period of years to “smooth out” potential spikes and dips in order to determine how much the fund will ask from taxpayers each year to pay for employer contributions. In CalPERS, the fund assumes a 7.75% rate of return and “smooths out” returns over a period 15 years.
- Understanding the true cost of state and local pensions, American Enterprise Institute, February 13, 2012
- Just How Big are Public Pension Liabilities?, State Budget Solutions, March 3rd, 2011
- Public pension primer, State Budget Solutions, April 16, 2012
- California Pension Funds, Nation’s Largest, Gain Most in Decade, Businessweek, July 18, 2011