Myth: The assumed rate of return determines the value of your benefits.
Fact: The calculation of your pension benefit value is determined using a formula completely separate from the assumed rate of return.
You may believe that your pension benefit value calculation is based on how well your pension fund’s investments perform relative to the plan’s assumed rate of return. The impact of the assumed rate of return on benefit value is a very common myth or misunderstanding, but there is no link between investment performance and your pension benefit.
While pension funds do their best to predict investment returns, the assumed rate of return is just that—an assumption. It depends on external forces that pension systems can’t control, and assuming a rate of return provides no guarantee that investments will actually earn that rate. Rates of return could be, and often are, significantly higher or lower than assumptions.
The calculation of your pension benefits is determined using a formula that takes into account years of service, final average salary, and age related qualifications to start receiving benefits. How well your pension fund’s investments perform have no bearing on the value of your benefits. (However, in some states, investment performance can impact whether or not you will receive a cost-of-living-adjustment in a given year).
The Teachers Retirement System of Texas (TRS) assumed for more than three decades that it could earn an 8% return on its investments. This was a long-term projection, so when the economy hit a recession in 2001, they didn’t change it. When they lost money in the Enron scandal, they didn’t change it. Even after the financial crisis of 2008–09, they didn’t change it.
Over the past two decades, TRS earned positive investment returns. In fact, from 2001 to 2018, there were nine times when annual investment returns were larger than 8%. Unfortunately, the years where investment returns were lower than expected began to add up.
The average investment return for TRS between the time when the pension was last fully funded (2001) and today was around 6%—less than the 8% predicted. Even worse, financial advisors now believe that the odds of TRS earning an 8% return in the future are just 1 out of 5. TRS recently lowered its assumed return to 7.25%, trying to be more conservative in its future outlook. They might lower it again in the future.
This reduction in the assumed rate of return did not change the value of benefits provided for retired or active teachers. They will still get the same pension benefits promised to them. And this because the value of benefits is not based on the assumed rate of return in any way.
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