Rate of return assumptions and contribution rates in public defined benefit pension plans

Underfunding of defined benefit pension plans has become a serious problem within the US. In 2001, a survey of the largest pension plans indicated that the average funding ratio – the value of assets in plan investments divided by the present value of future liabilities – was 91%. By 2011 that had dropped to 75% and this was the projected range of funding levels over the next few years (Munnell, 2013). By point of reference, pensions are commonly thought to be adequately funded if they have funding ratios in excess of 80%, although many have questioned that arbitrary figure (American Academy of Actuaries, 2012). Many observers have suggested that excessive investment return assumptions may lead to systematic underfunding of pension plans (see e.g., Van Bogaert, 2012). Specifically, the claim has been made that high return assumptions lead to lower contribution rates, essentially providing elected and appointed city officials along with employee groups an opportunity to take a “funding holiday” by reducing pension contributions below the level that would be required given more accurate return assumptions. However, to our knowledge this claim has never been systematically tested. We propose and test a model of pension contribution rates on a panel of state and local pension fund data. The data covers the largest US public pension funds over the period 2001-2011. We test whether current and prior rate of return assumptions cause changes in contribution rates using a dynamic panel data model. This type of model controls for the endogeneity of the relationship between contribution rates and return assumptions through using lags of the potentially endogenous variables as instruments for the lagged contribution rate. Using this model allows us to examine the dynamic effect of rate of return assumptions on contributions. The results of our analysis will have implications for the debate over the valuation of public pension plans as well as more generally the debate over defined benefit versus defined contribution plans.

Bogaert, D. V. (2012). "Solving the Public Pension Plan Dilemma." Journal of Pension Benefits: Issues in Administration 19(2): 37-46.

American Academy of Actuaries. (2012). The 80% Pension Funding Standard Myth Issue Brief (pp. 4). Washington, DC: American Academy of Actuaries.

Munnell, A. H. A., Jean-Pierre; Hurwitz, Josh; Medenica, Madeline. (2013). The Funding of State and Local Pensions: 2012-2016 Issue in Brief (pp. 15). Boston: Center for Retirement Research at Boston College.