What is an Appropriate Interest Rate Assumption for Illinois Police and Fire Pension Funds?

ILLINOIS PUBLIC PENSION INSTITUTE 

April 10, 2003
Wyndham Hotel, Lisle

OUTLINE OF PRESENTATION OF SANDOR GOLDSTEIN


What Does the Interest Rate Assumption Represent?

The interest rate, or investment return assumption represents an estimate of the expected long-term average rate of return for the fund, including capital appreciation.  In setting the investment return assumption, the recent experience of the fund is of limited value, since the assumption applies over a period of 50 to 60 years.

 

What is the Impact of the Interest Rate Assumption?

The interest rate assumption used in the actuarial valuation has a very significant impact on the actuarial liabilities and contribution requirements produced by the actuarial valuation.  The higher the interest rate, the lower the liabilities and contribution requirements.  The financial impact of a pension fund earning less than the assumed rate of return will be to increase the fundís unfunded liability and its contributions requirement.

 

What is the Long-Term Expected Rate of Return for Illinois Police and Fire Pension Funds?

Illinois police and fire pension funds can currently invest a maximum of 45% of their total assets in equities.  We will therefore estimate the expected return for a pension fund that invests the maximum 45% of its assets in equities and the remaining 55% in fixed income securities.  Based on information recently supplied by several investment consultants, the following expected return and risk assumptions would appear to be appropriate:

 

                                                            Expected                                  Expected
Asset Class                                          Return                                      Standard Deviation

Equities                                                   9.0%                                             20.0%
Fixed Income                                          5.0%                                             10.0%

Based on an asset allocation of 45% equities and 55 fixed income and the above expected returns, the long-term expected rate of return for the pension fund is estimated to be 6.8% per year.

 

What Actuarial Standards Apply to the Selection of the Interest Rate Assumption?

The Actuarial Standards Board, Established by the actuarial profession, is the organization that sets standards that are intended to apply to the standards of actuaries.  Actuarial Standards of Practice No. 27 deals with the selection of economic assumptions, including the interest rate assumption, for measuring the pension obligation.

The standard provides that the actuary should develop a best-estimate range for the investment return assumption.  The best-estimate range is defined as the narrowest range within which the investment return has at least a 50% probability of falling.  The actuary should then select a specific investment return within this range.

Based on the above expected returns and expected standard deviations for equities and fixed income securities, it is estimated that there is a 50% probability that this pension fundís expected return will be between 6.1% and 7.5%.  Therefore, an investment return assumption within this range would be in line with Actuarial Standards of Practice No. 27.