Consider leverage to avoid lowering return rates

New York State Common Retirement Fund announced Aug. 25 a reduction in its assumed rate of return to 5.9% from 6.8%.

"The intent is to set realistic return assumptions that result in stable contribution rates at a sufficient and sustainable level for employers," said Tania Lopez, a spokeswoman for New York Comptroller Thomas P. DiNapoli, who is trustee of the $268.3 billion pension plan, in an email.

Given the lower-for-longer interest-rate environment in the U.S. and other developed nations, the cut appears both prudent and reasonable.

Unless interest rate or other assumptions change significantly, other plans will have to follow suit. But how much will plans have to cut their assumptions?

Using asset allocation data from about 50 large public defined benefit plans' 2020 comprehensive annual financial reports and using the 2021 Horizon Actuarial Services return estimates, Pensions & Investments estimates the average public plan needs to bring down its assumed rate of return by more than 1 percentage point. Using 20-year return horizon estimates mapped to 2020's actual asset allocations, the average plan is estimated to return an annualized 5.99%. New York State Common is estimated to return 6.07%.

Although most plans have dramatically lowered their allocations to fixed income, a typical allocation of 20% to 25% presents a significant headwind to current actuarial assumed returns. Core U.S. bonds are expected to return only 3.23% over a 20-year horizon and even less at 2.09% over the next 10 years. Large allocations to private equity should help and are expected to be the only asset class to return more than 8%.

Missouri Local Government Employees Retirement System is a significant outlier in that its current return assumption is in line with its estimated return. The plan employs a leveraged approach that has been and is projected to be successful.

As of June 30, the plan had net leverage of 21.4%. Returns over the past one, three, five, 10 and 25 years have been significantly above its policy benchmark. In fiscal year 2021, the plan returned 29.48%, which was 12.7 percentage points above it policy benchmark. However, the plan underperformed by 5.21 percentage points in fiscal year 2020.

An important question for most asset owners is whether they too should use leverage. CalPERS' investment staff recently presented different "candidate portfolios" to the board as part of the discussion on asset-liability management, three of which included leverage.

If the Federal Reserve gives you lemons (low interest rates), why not make lemonade? Higher returns could be earned through leverage, albeit with more risk.