The “assumed rate of return” is the single most important assumption that pension systems make to ensure they have enough funding to pay benefits promised.
To determine the amount of required contributions that should flow into the pension fund, the Arizona State Retirement System (ASRS) board and its actuaries make educated guesses about how much they think they can earn by investing those contributions. That educated guess is called the assumed rate of return.
Why does this matter for Arizona?
The primary reason that ASRS currently has $14 billion in pension debt, is because the assumed rate of return for the pension plan has been wrong in most years over the past two decades.
Pension funds depend on investment returns to build assets that can be used to pay promised benefits. When the actual returns for a pension fund are less than expected, that means there is a shortfall. Pension funds hope that over the long-term they will have more good years than bad years. But in the case of ASRS, the goal of averaging 8% investment returns a year has turned out to be too optimistic.
In 2002, ASRS had a 100% funded ratio. Since then, the actual return on investments for Arizona’s state pension fund has been 6.3%. However, up until 2018, ASRS was assuming an 8% return. In some years the actual returns exceeded this, but in most years it was less. As a result, of the $14 billion in pension debt, roughly $13 billion is related to investment returns being less than expected.
How does pension debt affect public workers and taxpayers?
The primary reason for Arizona’s current pension debt problems has been an overly optimistic assumed rate of return – and that pension debt is requiring extra payments. For ASRS, those payments have grown nearly five times since 2002.
Employees that were working back in 2002 when ASRS was last fully funded, have experienced a growth in their contributions, from 2% of each paycheck up to nearly 12% today. This means less money in the pockets of government employees in Arizona.
Government employers using ASRS (including most cities other than Phoenix) pay the same rates as employees. So the taxpayer costs from the state budget and local governments have grown too.
Ultimately, the assumed rate of return matters because getting it right or wrong can be the difference in pension debt levels and required contribution rates.
How does the assumed rate of return work?
The ASRS pension board meets at least once a year to discuss how well investments are performing compared to their assumptions. For decade after decade they kept the assumed rate of return at 8%. Investment advisors and actuaries told the pension board this was reasonable, even if it was optimistic.
A few years ago, actuaries told the ASRS pension board that 8% was no longer reasonable, so they lowered the assumed rate of return to 7.5%. The pension board thinks there is a 50/50 chance that future investment returns will match this assumption.
Actuaries then figure out how much should be contributed into the pension fund each year, assuming there will be future investment returns to help pay for promised benefits.
The higher the assumed rate of return, the fewer contributions teachers and their employers have to make. The lower the assumed rate of return, the higher contributions need to be in order to pay for the benefits promised.
Do historic returns matter?
For the most part, the historic returns of a pension fund have no influence on future investment returns. Over the past 30 years, ASRS has earned 8.3%, and since 1979, ASRS has earned 9.1%. But these numbers are virtually irrelevant when it comes to predicting future investments and setting an assumed rate of return.
The assumed return is an estimate about the future, and how markets will perform. But markets today are very different than in the 1980s and 1990s. Back then, interest rates were high, which meant borrowing money, including mortgages, was more expensive than it is today. It also meant pension funds could buy bonds and get good yields without taking much risk. Today’s interest rates are at historic lows, meaning ASRS has to take on a lot of risk to earn its currently adopted assumed rate of return.
(For more on this, see Fitch Ratings Agency’s conclusion that Arizona has the riskiest pension investments in the country.)
Want to read more?
- See Equable’s series on Pension Basics, including an article about Funded Status.
- Take a look at Equable Institute’s paper on how the ASRS contribution rate just keeps going up and without an end in sight.
- Read Equable Institute’s analysis of how ASRS cost increases are “crowding out” education funding.
- Check out Urban Institute’s paper analyzing the risks that ASRS faces for the future.