While the fact that past performance is not a guarantee of future results is a familiar refrain, it appears public pension funds’ return expectations do correlate with how they’ve performed in the past.

A paper by Aleksandar Andonov, an associate professor of finance at the University of Amsterdam and Joshua Rauh, director of research and senior fellow at Stanford University’s Hoover Institution, has found that institutional investors rely on past performance to set return expectations and these expectations affect target asset allocation.

The paper examined U.S. public pension plans, which have been required to report long-term expected rates of return by asset class beginning in fiscal year 2014. “This disclosure separately reveals institutional investor target allocations and expectations about returns in individual asset classes such as public equity, fixed income, private equity, hedge funds, and other asset classes,” the paper noted.

Without the bias of previous experience, the expected return of a pension plan would hinge on the inherent risk associated with the asset classes in the portfolio at a given time. However, the paper found that there seems to be considerable variation away from what those expected returns would be in that case, noting “. . . we find that asset class weights explain only around 25 per cent of variation in the [portfolio expected return], leaving a large role for variation in beliefs about expected returns in the different asset classes.”

Reviewing how an individual plan has performed over the past decade, the paper found “. . . each additional percentage point of past return raises the [portfolio expected return] by approximately 25 basis points, even after controlling for the percentage allocated to each class of risky assets, the volatility of past returns and the fiscal stress from unfunded liabilities.”

This enhanced view of expected returns is compounded when those in leadership positions at a pension plan have been with the plan for an extended period and therefore been around to experience the positive investment outcomes, the paper said.

The phenomenon of anticipating inflated returns can also be enhanced by a continued relationship between a pension plan and an investment consultant, the paper said. “Specifically, controlling for interaction terms between the past return and each of the five consultants with the largest market share in our sample explains approximately half of the coefficient on past returns. This result also shows that there is significant variation in the reliance on experienced past returns in setting future expectations.”