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, a pension fund 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.
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.
How the Assumed Rate of Return is Determined
Pension boards typically meet with investment advisors, whose job is to suggest how money added to the fund from employees and taxpayers should be invested. This investment strategy is one way that a pension board plans for the future.
Any investment strategy has degrees of risk. Finance experts can estimate the probability of any given rate of return that portfolio of investments could produce. For example, an investment strategy of 50% stocks, 30% bonds, and 20% real estate might have a 1 in 2 chance of earning a 6% rate of return. That same portfolio might have just a 1 in 4 chance — 25% probability — of earning an 8% rate of return.
Most states direct pension boards to select a reasonable assumed rate of return on investments. Other states ask the state treasurer or other officials to get involved. A few states put the assumed rate of return directly into statute.
If the actual investment performance matches the assumed rate of return, then a pension fund is more likely to be healthy. If actual investment performance is less than assumed, then a pension fund might run into trouble. This is why it is important for pension funds to have reasonable assumptions.
A Few Common Misunderstandings
First, assumed rates of return aren’t historic averages. Analysts look at past performance to inform predictions, but the assumed rate of return is their best guess about the future.
For example, investment returns in the 1980s and 1990s were really strong. As a result, most pension funds have 40-year average investment returns of 8% or 9%. These historic averages are typically higher than the assumed rate of return that pension fund has used. But while the strong investment return is good, it is not a relevant data point for the pension board when they think about what the assumed rate of return should be for the future.
Second, assumed rates of return also do not determine benefits. Benefits are based on formulas that take into account years of service and compensation during the working years of public employees. Pension systems specialists, actuaries, start by estimating the total amount of benefits and then calculate the contribution rate needed to pay them, factoring in an assumed rate of return.
If investment returns are strong, that does not directly cause base pension benefits to increase. And if investment returns are weak, that does not mean pensioners will see their monthly checks cut. Some states have linked cost-of-living adjustments to pension fund investment performance, so retirees might get higher checks when investments are strong. But this is a supplemental benefit, core pension benefits will not be cut if investments underperform. Other states have created variable pension benefits where there is a minimum amount, and the actual payment fluctuates based on market performance. But again, the base benefit these retirees received as a minimum starting point was based on the benefit formula, not investment returns during their working years.
This article is part of Equable’s Pension Basics series. To learn more about how your pension works, check out the other articles in the series:
5. Normal Cost