Expected Rates of Return: A Whipsaw Effect?

Over the past decade, public pension assumptions for expected rates of investment return have steadily declined (see Exhibit A). The decline has been for two primary reasons: 1) low yields on fixed income and high valuations in equities which have lowered capital market assumptions (CMAs); and 2) a reduction in the historical delta of public pension plans’ assumptions over the applicable CMAs. Fast forwarding to today, the general delta of actuarial assumed rates of return and CMAs is much less prominent and expected returns are generally set in-line with capital market assumptions.

Now, public pension plans are experiencing rising bond yields that have altered the trajectory of forward-looking CMAs, increasing expected returns for many asset classes. This new environment leaves public pension stakeholders – investment consultants, plan actuaries, and government entities – with a novel question: what should these recent conditions mean for a plan’s expected return on assets assumption?