Expected Rate of Return Basics
The expected rate of return is the assumed annual rate of growth that a pension fund expects to earn on its investments over the long term. The expected rate of return is a key factor in maintaining the financial soundness of a pension plan.
The formula for pension soundness
Contributions + Investment earnings = Benefit payments + Expenses.
The “Annual Required Contribution Basics” Talk discusses the importance of contributions to the pension system's investment assets and ultimate soundness.
Importance of the Expected Rate of Return
This rate plays a central role in determining the financial viability of a pension system. It affects how much a pension plan needs to collect in contributions today to ensure it can meet its future obligations to retirees. An accurate expected rate of return allows for proper planning and funding, while an unrealistic one can lead to either overfunding or underfunding the plan.
Key Factors Influencing the Expected Rate of Return
Several factors ought to be carefully considered by trustees and investment professionals: Historical Performance: Past investment returns provide a baseline for expectations, but relying solely on historical data can be misleading if the market environment has changed significantly.
Capital Market Assumptions: Investment professionals use capital market assumptions, which are estimates of future returns for various asset classes, to project what future returns might look like based on current economic and market conditions.
Economic Conditions: Macroeconomic factors such as inflation, interest rates, and global economic growth can significantly impact investment returns. For example, rising interest rates may decrease bond returns but could create new investment opportunities in other sectors.
Risk Tolerance: The level of risk a pension fund is willing to accept will also influence its expected rate of return. Funds with a higher tolerance for risk may invest more in equities or alternative investments, which can potentially yield higher returns but come with greater volatility.
Balancing the Expected Rate of Return
It is critical to balance an optimistic rate of return with a realistic assessment of market conditions. Setting the expected rate of return too high may lead to underfunding, where the pension plan does not collect enough contributions to cover future liabilities. Conversely, setting it too low may result in unnecessarily high contributions, which can strain plan sponsors and employees.
The Role of Trustees
Trustees play a key role in determining the expected rate of return. They must work closely with investment consultants and actuaries to evaluate economic conditions, investment performance, and long-term projections. Trustees should ensure that the expected rate of return aligns with the pension fund’s long-term goals and liabilities, while also considering factors such as risk tolerance and capital market conditions.
Lessons Learned
The expected rate of return is a fundamental component of a pension plan's financial health. It affects how much money the plan will have to pay future benefits, and trustees must take a thoughtful, well-informed approach when setting this rate. By balancing historical data with forward-looking assumptions, trustees can help assure the sustainability of the pension system for current and future retirees.