Why Public Pension Fund Return Expectations Are Flawed

Why public pension fund return expectations are flawed

US public pension plans base thereturn expectations of individual asset classes on their own experience of returns in those asset classes, according to new research that examines how institutional investors set return expectations.

Stanford University’s Joshua Rauh and AleksanderAndonov from Erasmus University, show evidence for the claim that pension plans “excessively extrapolate” past performance when formulating return expectations.

It claims to be the first study that looks at the relationship between beliefs and past experience for institutional investors.

By examining US public pension plans, with combined assets of $4 trillion, it finds that the variation in institutional investor return expectations is influenced by their own past investment histories.

The paper, The return expectations of institutional investors, says a fund’s asset class based expected returns with the system’s chosen weights for each asset class should be equal or at least approximate its discount rate, or overall portfolio expected return.

But the research, which looks at 231 state and local government funds in the US over the period 2014-2016, finds that is often not the case.

The paper details the underlying assumptions, and behaviours of pension plans in making those assumptions, and finds that the average returns experienced in the past 10 years of the asset class, and the extent of the unfunded liabilities, add “substantial explanatory power”.

More specifically it shows that each additional percentage point of past return raises the portfolio expected return by 36 basis points.

And an unfunded liability equal to an additional year of total government revenue raises the portfolio expected return by 14 basis points.

Further, when unfunded liabilities are large, state pension plans are more likely to make aggressive assumptions about inflation in order to justify high nominal return assumptions than to use higher real asset return assumptions for that purpose, the paper says.

Using past performance as an indicator of future performance could be justified, if performance is persistent, the authors say. But there is little evidence, in most asset classes to indicate that is the case.

In fact the authors say that in public equity, skill or persistence in pension fund performance in that asset class is weak or non-existent.

However in private equity there has been some evidence of persistence (insert Schoar article), so the authors investigated this further.

The research separated the private equity investments by date: those older than 13 years old and probably realised; those between nine to 13 years old and most likely realised; and those that are three to eight years old and only partially liquidated.

The results found that the pension funds exclusively extrapolated the returns of the oldest group of investments.

Those that had made fewer investments were more optimistic about the expected returns.

The research uses pension fund disclosed data under US Governmental Accounting Standards Board Statement 67 that requires that public pension funds report long-term expected rates of return by asset class as part of a justification of the plan’s overall long-term rate of return assumption. It reveals the individual return expectations of individual asset classes, alongside their targeted asset allocation.

To access the paper click here