September 26, 2014
The declining health of public employee pension funds throughout the State of Illinois is primarily due to two causes: inadequate employer contributions over a sustained period and recent investment losses. This blog will discuss the role of investment rate of return in public employee pension funding and provide an update on the investment returns of Chicago-area pension funds in FY2012, the most recent year for which data are available.
A pension fund invests the contributions of employers and employees in order to generate additional revenue over an extended period of time. Investment income provides the majority of revenue for an employee’s pension over the course of a typical career. Therefore, a pension fund’s actuarial assumptions should be aligned with its investment policies in order to achieve appropriate risk and yield levels for the plan’s portfolio. Investment rate of return assumptions are reviewed and approved annually by pension fund boards. The chart to the right shows current assumptions for Chicago-area pension funds, all between 7.5% and 8.5% for FY2012.
The assumed investment rate of return plays an important role in the calculation of actuarial liabilities. It is used to discount the present value of projected future benefit payments. The discount rate has an inverse relationship to actuarial liabilities, such that a higher discount rate will result in lower liabilities. A higher assumed rate of return may be desirable
because it minimizes liabilities, but it should remain realistic.
The appropriate discount rate to use for public pension funds has been a subject of considerable debate in recent years. The Governmental Accounting Standards Board issued new pension accounting standards in 2012 that will require a blended discount rate for financial reporting that will likely be lower than the rate currently used by many funds in this report, increasing reported liabilities. Moody’s Investors Service also recently announced a new approach to assessing government pension assets and liabilities that will be used as part of its methodology for assigning governments credit ratings. The new approach discounts liabilities using a long-term bond index rate.
The chart below shows actual investment rates of return in FY2011 and FY2012 for ten local public employee pension funds.
The FY2012 average rate of return for those funds with a January 1 to December 31 fiscal year (eight of the ten funds) was 13.0%, increasing from 0.5% in FY2011. The average rate of return for funds using a July 1 to June 30 fiscal year (the Teachers’ and Park District funds) was 0.8% in FY2012, falling from 23.9% in FY2011. Differences in investment returns may reflect timing differences, investment allocation choices of the funds, the performance of investment manager or all three.
For more information on recent changes to the assumed investment rates of return for State of Illinois public employee pension funds, see this post on the IIFS blog.