Why returns on public pensions vary: CRR study

Returns on public pensions have varied pretty widely between 2001–2016, and the Center for Retirement Research at Boston College analyzed the data to find the reason.

According to the brief “What Explains Differences in Public Pension Returns Since 2001?” the funded status of public pensions depends on two major factors—the payment of plan sponsors’ annual required contribution and the investment return earned on pension fund assets.

Read: 10 states with the best pension funding: A tale of two discount rates

And while earlier CRR studies looked at how inadequate contributions can undermine funding progress, this one examined those plans’ ability to achieve adequate returns.

Considering the variation in returns from 2001–2016, from 6.3 percent for the top quartile to 4.6 percent for the bottom, the analysis evaluated whether the variation could be due to differences in asset allocation and/or to the returns by asset class.

The brief finds that on average, the annualized return for public plans during this period was 5.5 percent; that’s “well below the typical actuarially assumed return.” The variation between plans in the top and bottom quartiles, it adds, amounted to a difference “that could account for roughly a 20-percentage-point disparity in their funded ratios.”

Read: Public pensions gorge on private debt

The study found that asset allocations across quartiles are relatively similar, with allocations to the three broad asset classes differing by less than 10 percentage points.

But the asset classes themselves vary substantially more in returns, so that while the top and bottom quartiles hold a similar level of alternatives overall, “the bottom quartile holds slightly more in commodities and hedge funds and less in private equity and real estate.” And the second quartile holds more in real estate, hedge funds, and private equity than does the third quartile.

And since private equity and real estate had higher average returns than public equities over the period being evaluated, the lower-performing asset classes dragged down the lower-quartile plans.

While public plans at a high level have very similar asset allocations, and for the time period in question “all [public plans] shifted a portion of their assets out of equities and fixed income and into alternatives,” there was variation in “the magnitude and timing of this transition…” In the study’s evaluation of the performance of asset classes, it found that “the small differences in allocation among plans were secondary to the differences in asset class returns. That led to its conclusion that “returns accounted for almost the entire underperformance for the middle two quartiles.”