Public retirement systems have been lowering their assumed long-term rates of return on investments in recent years. But those reductions are not enough, and will continue to make funded levels appear higher than they really are and, therefore, lead to insufficient contributions.
The public pension plans use their assumed long-term rates of return to value their pension liabilities, but those rates don't reflect real economics. Instead, they should use a lower, risk-free rate matched to the duration or maturity of the projected benefit payments.
The California Public Employees' Retirement System is among the pension funds that recently decided to lower their assumed rates. In doing so, CalPERS has become, unintentionally, its own myth-buster, challenging the “myths vs. facts” section of its website that seeks to defend its 7.5% assumed annual rate of return on investment.
The section states, “Myth: CalPERS 7.5% assumed annual rate of investment return is too high and cannot be achieved.” The website dismisses that, noting CalPERS has earned an average annual 7.6% return over the past 20 years and 9.4% over the past 30 years, while in the fiscal year ended June 30, 2013, it returned 13.2%.
As it turns out, the fact is less real and more myth, while the myth is more reality.
CalPERS no longer believes in its 7.5% assumed return and, on Nov. 18, approved a plan that could reduce its expected return to 6.5%. However, under the methodology adopted, the reduction could take more than 20 years to occur.
Richard Gillihan, CalPERS board member, opposed the gradual approach, contending it would take too long to achieve the reduction. He called for an immediate reduction to 6.5%. Although even his proposal is too modest, he is correct in wanting to move immediately to the lower rate. Unfortunately, the majority of the board prevailed against his recommendation.
But the board's move doesn't go far enough; the 6.5% rate is still too high.
Like many public retirement plans, CalPERS' pension benefits are default free, or free of risk of non-payment to participants and their beneficiaries, as recent California municipal bankruptcy cases have concluded.
San Bernardino, for example, under its plan to exit from bankruptcy, will pay CalPERS in full for public employee retirement benefits, while reducing payments to other creditors, such as bondholders. While payments of benefits might be riskless to participants, they are not riskless for taxpayers, who ultimately must fund the contributions to pay for the pensions.
Robert Novy-Marx, professor of business administration at the Simon Business School, University of Rochester, N.Y., in a September 2013 research paper, explained why risk-free benefits should be discounted in value at risk-free rates.
“Payment streams should be valued using discount rates that reflect the cash flows' risks,” Mr. Novy-Marx wrote. The research paper was written for the Pension Research Council of the Wharton School of the University of Pennsylvania and posted on the website of the Pension Benefit Guaranty Corp.
The economic concept is not new, even if it has been ignored by public pension systems.
Donald L. Kohn, then-vice chairman of the Federal Reserve Board of Governors, said in a 2008 speech to the National Conference on Public Employee Retirement Systems, that “public pension benefits are essentially bullet-proof promises to pay.” In the public sector, unlike in the private sector, “accrued benefits have turned out to be riskless obligations,” Mr. Kohn said. Among economists, the “only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.”
CalPERS' approach to reduce gradually its assumed return upset Gov. Edmund G. Brown Jr. In a Nov. 18 statement, Mr. Brown called the approach “an irresponsible plan that will only keep the system dependent on unrealistic investment returns. This approach will expose the fund to an unacceptable level of risk in coming years.” Mr. Brown did not say it, but that means the California taxpayers are exposed to that unacceptable level of risk.
In response, CalPERS President Rob Feckner reaffirmed the board's action.
CalPERS' actual net return on investments for the fiscal year ended June 30, 2015, was 2.4%, a rate closer to its assumed outlook than the double-digit returns it has enjoyed in other recent years.
The use of high assumed rates of return bolsters pension funding levels, making the funds appear more robust than they actually are, while reducing the required contribution, damaging the funding of the plans.
Denise L. Nappier, Connecticut state treasurer, on Nov. 6 objected to the Connecticut Teachers Retirement Board's lowering of its investment return assumption to 8% from 8.5%, saying that is not far enough. Ms. Nappier called for a rate of 7.5% or lower. She's correct to object, but needs to reduce her recommended assumed target a lot more.
Illinois State Universities Retirement System on Dec. 11 reaffirmed its 7.25% investment return assumption, even though its actuarial consultant, Gabriel Roeder Smith & Co., gives SURS a 52.77% chance of reaching that rate, based on SURS' asset allocation and capital market assumptions. As a benchmark, the consulting firm considers as reasonable any rate that has at least a 50% chance of achieving the assumed return.
The average rate of return assumption among state and local retirement systems is 7.68%, according to a report last May of the National Association of State Retirement Administrators.
Even at a high rate, CalPERS' funding ratio is low, at 69.8%, according to its website. At a risk-free rate, the funding ratio would be lower. But even at the current funding level, CalPERS leaves to future generations the responsibility of paying more than one-third of pension benefits participants have earned. That's unacceptable. Pensions should be funded by the current generation of taxpayers who receive the services from the public employees.
Likewise, even using current unrealistic expected rates of return, public plans in general are deeply underfunded. A report last Feb. 25 by Wilshire Associates Inc. found that of the 92 state retirement systems that reported actuarial data for 2014, 87% are underfunded with an average funding level of 73%.
The poor funding ratios demonstrate why CalPERS and many other public retirement systems need to lower their return assumptions to the risk-free rate to boost their contributions. To avoid the shock of a sudden rise in contributions, the systems should set a plan for lowering the rate over a few years, but not as CalPERS plans to do over many years and then by only one percentage point from the current level.
A risk-free rate will result in increased contributions and eventually strengthen the ability of the plans to reach a 100% funded status, where they should be to avoid an unfair intergenerational transfer of pension obligations earned by previous generations to newer generations. Such a rate would make plans more sustainable financially and in public support.
