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

Abstract

During the 2010s, the assets of public pension plans generated significantly higher returns than their assumed, or actuarial, rates of return. In a sample of sixty-nine U.S. public plans with a total of $2.1 trillion of assets, the return outperformance of assets over the assumed returns was more than 200 basis points for the ten years ending June 30, 2019. The outperformance was driven by the asset allocations being mostly exposed to economic growth, which constituted nearly 75 percent of the total portfolio variance. Based on capital market assumptions with lower returns to growth-sensitive assets over the next decade, pension plans are less likely to outperform their assumed returns and also may experience significant downturns in scenarios where growth slows. In addition, the forecasted returns for fixed income over the next ten years are expected to be significantly lower than the historical experience over the past few decades due to much lower starting yields. Optimal pension allocations that are more likely to meet current return targets generally involve increasing allocations to alternatives and using leverage explicitly or through portable alpha strategies.

Keywords: Public Pension Portfolios, Alternative Investments, Leverage, Portable Alpha Strategies

JEL Classification: G11