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Funding Solution: Lower the Assumed Rate of Return

One of the biggest reasons that guaranteed income pensions have accumulated such a massive funding shortfall is that investment returns have been less than expected. The funding formula for pension benefits requires contributions PLUS investment returns. And the actual returns earned have been less than what actuaries were counting on for that formula to work.

A technically simple solution is to lower the assumed rate of return. This reduces the risk that a pension fund will underperform.

This is not a politically simple solution, unfortunately. Lowering the assumed rate of return means increasing contribution rates to make up the difference. And many states don’t want to pay more out of their current budgets for teacher pensions. But the downside is that they are forcing future taxpayers and educators to pay for the funding shortfall when investments returns don’t meet expectations.

Every state is different, and has different capacity to take on risks. So there is no universally correct assumed rate of return. But at a minimum the current average 7.2% investment return assumption is probably too high, with 6.5% or even 6% seeming more realistic.

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