In the discussion on public pensions, there’s been a great deal of focus on the projected rate of return. I’ve posted on what I think is PERA’s optimistic 8% here, and on the fact that that’s actually an improvement from the 8.75% that they were projecting as recently as 2002. That said, for pension estimates, their inflation assumptions matter as much as their raw return assumptions. The actuarial consequences of poor inflation estimation are too much to summarize here. But even on the basic question of returns inflation matters: the real return on an investment is the nominal return minus inflation.
Over the last 10 years, public pensions have gotten some credit for modestly reining in aggressive growth assumptions. PERA, for instance, has moved from a 8.75% growth assumption to 8%, and CalPERS has made similar adjustments. Overall, the average growth assumption has dropped slightly from 8.04% to 7.86%. But the average inflation assumption for public pensions nationally has dropped from 4.0% to 3.31%. This means that instead of decreasing the real return assumption has actually gone up from just over 4% to just over 4.5%.
For the record, PERA’s inflation assumption was dropped from 4.5% to 3.75% in 2003, where it has stayed. Both the investment return and inflation numbers are higher than the national average and national median, though.
I don’t really think that the inflation numbers here are unreasonable. And my problem with PERA’s 8% return assumption goes beyond the average itself – 8% has been the historic return on stocks, and doesn’t take into account the additional volatility and risk that come with higher return. But it’s clear that PERA and other plans have been dining out on their flexibility on returns, while the increase in real expected returns goes unremarked-on.
The disconnect also highlights the price we’re going to pay – in accuracy, and eventually in dollars – for using the rate of return as the discount rate. Interest rates are closely tied to expected inflation, and here the funds themselves are admitting that the gap between the rate of return and the proper discount rate has been growing.
