Public Pension Portfolios in a World of Low Rates and Low Risk Premiums

Abstract

Over the 2010s, the assets of public pension plans generated significantly higher returns than their assumed, or actuarial, rates of return. In a sample of 69 US public plans with a total of $2.1 trillion of assets, the return outperformance of assets over the assumed returns was over 200 basis points for the 10 years ending June 30, 2009. The outperformance is driven by their asset allocations being mostly exposed to economic growth, which constitutes nearly 75% of the total portfolio variance. Based on capital markets assumptions with lower returns to growth-sensitive assets, pension plans are less likely to outperform their assumed returns and may also experience significant downturns in scenarios when growth slows. In addition, the forecasted returns for fixed income over the next 10 years are expected to be significantly lower than the historical experience over the last few decades due to much lower starting yields. Optimal pension allocations more likely to meet current return targets generally involve increasing allocations to alternatives and using leverage—explicitly or through portable alpha strategies.