Friday, February 3, 2012

Pension fund return assumptions are not a matter of opinion.

I came across this letter written by Curtis Hutchins, the President of the Retired Educators Association of Minnesota.  Mr Hutchins argues against a reduction in the pension return assumption for the state pension fund.  In the letter he states:
Some believe pension fund investment returns should be held to more of a “risk free” rate of return — such as the Treasury yield, which is about 4 percent. The debate over what is an appropriate investment return assumption is largely a philosophical one between optimists and pessimists.
I'm afraid that Mr Hutchins is completely wrong here.  Return assumptions are not a philosophical debate that depends on whether you are an optimist or pessimist.  In fact your opinion about future returns shouldn't influence your return assumptions at all - because it is just that - an opinion!

The risk free rate is more appropriate rate to use because the liabilities of the fund are risk free.  They are promises to the current and future retirees on Minnesota.

The use of a riskless rate to value a riskless liability is based on simple finance.