Adjusted long term rate of return

What Is Adjusted Long-Term Rate of Return?

The Adjusted Long-Term Rate of Return refers to a projected average annual rate of return expected from an investment portfolio over an extended period, which has been modified or updated to account for various factors like changing market conditions, inflation, or actuarial valuations. It is a critical actuarial assumption used predominantly in pension funds and other defined benefit plans to estimate future assets and liabilities within the broader field of actuarial science. This rate is fundamental for financial forecasting and ensuring the long-term solvency of such plans. Unlike a historical return, which looks backward, the Adjusted Long-Term Rate of Return is forward-looking and subject to periodic revisions based on expert analysis and economic outlooks.

History and Origin

The concept of projecting long-term investment returns for future financial obligations has been integral to actuarial practices for centuries, evolving alongside the development of pension systems and life insurance. Early actuarial methods relied on conservative interest rate assumptions to ensure sufficient reserves. As financial markets matured and investment strategies became more sophisticated, the need for a more dynamic and "adjusted" approach to long-term return expectations became apparent.

Public pension funds, in particular, began to formalize the process of setting and periodically adjusting their expected rates of return on plan assets. This became crucial after periods of significant market volatility, such as the dot-com bubble burst in the early 2000s and the 2008 financial crisis, which highlighted the impact of unrealistic assumptions on funding levels. Regulatory bodies and professional organizations increasingly emphasized the importance of transparent and realistic long-term return assumptions. For instance, many state and local government retirement systems in the United States have steadily reduced their assumed rates of return over the past two decades in response to lower long-term investment prospects, with the average falling from around 8% before the Great Recession to below 7% more recently.⁵

Key Takeaways

• The Adjusted Long-Term Rate of Return is a forward-looking projection of investment earnings over many years, often used by pension plans.
• It is a key actuarial assumption that influences the calculation of future liability and required contributions for defined benefit plans.
• This rate is periodically reviewed and adjusted by actuaries and investment committees based on market trends, asset allocation strategies, and economic forecasts.
• A higher Adjusted Long-Term Rate of Return can lead to lower current contribution requirements for a pension plan, while a lower rate necessitates higher contributions or adjustments to benefits.
• It plays a vital role in assessing the funding ratio and overall health of long-term financial commitments.

Interpreting the Adjusted Long-Term Rate of Return

The Adjusted Long-Term Rate of Return is a critical assumption that directly impacts the valuation of future financial obligations, particularly in defined benefit plans. When actuaries and plan sponsors set this rate, they are essentially estimating the average annual investment returns their portfolio will achieve over decades.

A higher Adjusted Long-Term Rate of Return implies that plan assets are expected to grow more rapidly, which in turn reduces the present value of the plan's future benefit obligations. This can lead to lower required contributions from employers and employees in the short term. Conversely, a lower Adjusted Long-Term Rate of Return suggests more conservative growth expectations, increasing the present value of liabilities and typically requiring higher contributions to ensure the plan remains adequately funded. The challenge lies in balancing optimistic growth expectations with realistic, sustainable projections, as an overly optimistic rate can lead to underfunding over time.

Hypothetical Example

Consider a hypothetical public pension fund, "Evergreen Retirement System," managing a defined benefit plan for municipal employees. In 2024, Evergreen's actuaries are reviewing their Adjusted Long-Term Rate of Return assumption.

Historically, Evergreen had used an 8.0% long-term rate. However, due to persistent low interest rates, revised capital market assumptions, and a shift in their asset allocation towards more conservative investments, their investment consultants now project a more realistic long-term average return of 6.75%.

The board decides to adjust the rate to 6.75%. This adjustment means:

1. Revaluation of Liabilities: The present value of future pension payments owed to retirees and active employees will increase, as those future payments are now discounted at a lower rate.
2. Increased Contributions: To maintain the plan's solvency and ensure it can meet its obligations, the required contributions from the municipality and its employees will likely need to increase. If Evergreen previously calculated that $100 million in annual contributions were needed at an 8.0% rate, the new 6.75% rate might require, for instance, $108 million to achieve the same funding target.
3. Impact on Funding Status: The plan's funding ratio—the ratio of assets to liabilities—might initially appear to decline due to the increased liability valuation, even if the actual asset value remains unchanged. This scenario illustrates how adjustments to this rate directly influence financial planning and funding decisions.

Practical Applications

The Adjusted Long-Term Rate of Return is a cornerstone in several key areas of finance and financial planning:

• Pension Fund Management: Public and private pension funds heavily rely on this rate to calculate their future liabilities and determine the necessary contributions from employers and employees. It is arguably the most significant assumption in ensuring the long-term solvency of these plans. Organizations like the National Association of State Retirement Administrators (NASRA) track and report on these assumptions, noting that investment earnings account for a majority of public pension revenues.
• ⁴ Actuarial Valuations: Actuaries use the Adjusted Long-Term Rate of Return when performing valuations for various long-term commitments, including insurance policies, retiree health benefits, and other post-employment benefits (OPEB). This rate helps determine the present value of future cash flows.
• Financial Reporting: Companies with defined benefit pension plans must disclose their expected (or assumed) rate of return on plan assets in their financial statements. This assumption impacts the reported pension expense. The U.S. Securities and Exchange Commission (SEC) provides guidance on how companies should report these weighted-average assumptions, including the expected return on plan assets.
• ³ Governmental Accounting Standards: Governmental accounting boards issue standards that dictate how state and local governments report their pension liabilities, including the appropriate discount rate to be used, which is often tied to the expected or assumed long-term investment return. Similarly, the Internal Revenue Service (IRS) publishes specific segment rates that pension plans must use for funding purposes, which are essentially long-term interest rate averages used for discounting future benefits.
• ² Long-Term Budgeting and Fiscal Policy: For government entities, the Adjusted Long-Term Rate of Return used by their pension systems directly affects budgetary allocations. A lower assumed rate means more taxpayer money or higher employee contributions are needed to fund pensions, impacting other public services or tax rates.

Limitations and Criticisms

While essential for long-term financial planning, the Adjusted Long-Term Rate of Return faces several limitations and criticisms:

• Forecasting Difficulty: Predicting investment returns over multiple decades is inherently challenging. Economic cycles, technological advancements, geopolitical events, and unexpected market shocks can significantly deviate actual investment performance from even the most carefully calculated long-term assumptions.
• Political Influence: In public pension systems, the assumed rate of return can sometimes become a point of political debate. There can be pressure to maintain an optimistically high rate to reduce immediate contribution burdens on taxpayers or government budgets, potentially leading to underfunded plans in the long run. Critics argue that public pension funds often set unrealistically high discount rates, which can mask the true extent of pension liabilities.
• ¹ Impact on Funding: An overoptimistic Adjusted Long-Term Rate of Return can lead to chronic underfunding. If actual returns consistently fall short of the assumed rate, the funding gap widens, necessitating larger future contributions, benefit cuts, or increased debt, which can be politically and economically painful.
• Lack of Uniformity: There isn't a single, universally mandated methodology for determining this rate across all pension plans or jurisdictions. While professional bodies offer guidance, the specific approaches can vary, leading to inconsistencies in how liabilities are valued and funded status is reported. This can make comparisons between different plans difficult.
• Reliance on Historical Data: While adjustments are made for future expectations, the initial basis for many long-term return projections often includes historical average compounding returns. However, past performance is not indicative of future results, and relying too heavily on historical averages, especially from periods of exceptionally high returns, can lead to inflated expectations.

Adjusted Long-Term Rate of Return vs. Assumed Rate of Return

The terms "Adjusted Long-Term Rate of Return" and "Assumed Rate of Return" are often used interchangeably, particularly in the context of pension fund management and actuarial science. However, the nuance in "adjusted" highlights the dynamic nature of this critical financial projection.

Essentially, the "Assumed Rate of Return" is the specific rate that a plan is currently assuming it will earn over the long term. The "Adjusted Long-Term Rate of Return" can be seen as the outcome of the process where that assumed rate is reviewed, updated, and refined based on new information or revised expectations. Therefore, while technically distinct in emphasis, they largely refer to the same concept in practice: the estimated long-term growth rate for plan assets.

FAQs

Q1: Why is the Adjusted Long-Term Rate of Return important for my pension?

A1: This rate is crucial because it directly influences how much your employer and you need to contribute to the pension fund today to ensure there's enough money to pay your benefits in the future. If the rate is too optimistic, the fund might be underfunded, potentially leading to future contribution increases or benefit adjustments. If it's too conservative, it might lead to excessive contributions. It's a key factor in the overall financial planning for your retirement.

Q2: Who determines the Adjusted Long-Term Rate of Return for a pension fund?

A2: Typically, the board of trustees or an investment committee for a pension funds, often advised by independent actuaries and investment consultants, determines this rate. They analyze long-term capital market assumptions, the fund's asset allocation strategy, and economic forecasts to arrive at a reasonable and sustainable projection for investment performance.

Q3: How often is the Adjusted Long-Term Rate of Return updated?

A3: The frequency of updates can vary by plan, but it is typically reviewed annually as part of the actuarial valuation process. Significant changes in market conditions, regulatory requirements, or the plan's investment strategy can trigger more frequent assessments or adjustments.

Q4: Does the Adjusted Long-Term Rate of Return guarantee actual investment results?

A4: No, it is a forward-looking assumption, not a guarantee. It represents the best estimate of future average annual investment returns over an extended period. Actual returns can, and often do, deviate from this assumed rate due to market volatility and unforeseen economic events.