Public Pension Accounting Deserves a Closer Look
August 11, 2011
Most public sector pension plans assume they'll receive an 8 percent investment return in future years. There are a few problems with that assumption, says Andrew Biggs, a resident scholar at the American Enterprise Institute.
- First, even if 8 percent is an accurate figure, pensions shouldn't be using this number to calculate the value of their liabilities.
- Second, some analysts believe these returns are overestimated.
- But there's a third point: most public pensions are actually assuming returns well in excess of 8 percent.
A pension calculates its funding health by calculating the percentage of accrued benefits its assets could pay if those assets generated some assumed rate of return, usually 8 percent. The problem is that these calculations are based on so-called "actuarial assets," which smooth returns over a 5- or 10-year period in order to mask variability from year to year.
- According to Wilshire Consulting, as of fiscal year 2010, the actuarial value of pension assets was almost 15 percent above market value.
- In effect, pensions are assuming that the market value of their assets will first catch up to the actuarial value and then generate 8 percent from there on out.
- What does that imply for an overall rate of return? Assuming all this happens over a 30-year period, the true assumed rate of return is around 8.6 percent per year.
Will the pensions get that? Maybe -- they've had a good year so far in 2011. But 8.6 percent is more than 2 percentage points per year above what Wilshire projects they'll get; over 30 years, the end value of assets would be almost twice as high under the pensions' assumptions as under Wilshire's. This just shows -- again -- that public pension accounting deserves a closer look, says Biggs.
Source: Andrew Biggs, "What Investment Returns Are Public Pensions Really Assuming?" American Enterprise Institute, August 3, 2011.
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