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Wednesday, August 22, 2012
Regarding a lower, assumed annual rate of return for the Illinois Teachers’ Retirement System
According to the, Governmental Accounting Standards Board, “The discount rate used to discount projected benefit payments to their present value will be based on a single rate that reflects (a) the long-term expected rate of return on plan investments, as long as the plan net position is projected under specific conditions to be sufficient to pay pensions of current employees and retirees and the pension plan assets are expected to be invested using a strategy to achieve that return; and (b) a yield or index rate on tax-exempt 20-year, AA-or-higher rated municipal bonds to the extent that the conditions for use of the long-term expected rate of return are not met.” Thus, the Illinois Teachers Retirement System is contemplating the reduction of its expected investment rate of return on August 23rd.
I am asking these questions with limited knowledge about market valuations, long-term growth and returns on capital:
· Isn’t the GASB expected investment method (risk-free all-bond investments) rather than the proven diversified investments strategy actually used by TRS to value future liabilities inconsistent with the overall 30-year average (of nine percent despite losses during the Great Recession)? Of course, it would also be unrealistic to believe that any entire investment portfolio would consist of municipal bonds. TRS has exceeded its assumed rate-of-return (more often than not) by using a diversified portfolio.
· Does the lowering of the TRS investment rate-of-return have anything to do with the risks posed by the unfunded liabilities that were caused by past Illinois General Assemblies?
· Are we now considering the flawed analysis of Robert Novy-Marx and Joshua Rauh as an accurate prediction (low investment returns), despite reputable, substantiated rebuttals from Keith Brainard of the National Association of State Retirement Administrators (Faulty Analysis is Unhelpful to State and Local Pension Sustainability Efforts, October 2010), Monique Morrissey of the Economic Policy Institute (Discounting Public Pensions, April 2011), Diane Oakley of the National Institute on Retirement (Public Pension Asset Exhaustion – Only a remote Possibility, May 2011), and Dave Urbanek of TRS (Voice of the People, Chicago Tribune October 25, 2010 & November 30, 2010)?
To paraphrase Bob Lyons, TRS trustee, an expected lower investment rate-of-return will require larger contributions from the state and increase the state’s unfunded liability. Senator Christine Radogno recently talked about a “$130 [billion]” public pension unfunded liability in an interview. I assume the $130 billion she refers to will be the new unfunded liability as a result of a lower risk-free rate.
“Conservative critics… have gotten considerable political mileage from claims that public pensions’ unfunded liabilities are… two to six times larger than the conventional measures based on pension reporting… Their arguments hinge on assumptions that current and future pension fund investments will earn historically low rates-of-return going forward…
“Most economists believe that the expected return on stocks is significantly higher than the risk-free rate… Critics never address the practical implications of using a ‘discount rate’ … below the expected return on pension fund assets. Furthermore, simply discounting with a risk-free rate does not actually safeguard returns or encourage prudent investment practices, it just makes all pension funds appear underfunded.
“It also allows critics to argue that public-sector workers are paid more than they appear to be paid since the cost of their pension benefits (i.e., what must theoretically be socked away) is supposedly greater than the contributions made to the funds… [Moreover, regarding a 90 percent funding target by 2045 based on the flawed “Pension Ramp-Up,”] there is no need for pension funds to closely match assets and liabilities, though some boutique investment firms earn high fees advocating this approach” (Morrissey).
Since TRS’ recent projections are based upon “smoothing,” or the averaging procedure that includes both gains and losses over a five-year period to determine funding data, the return rate has been, indeed, low. According to Lyons, the current rate-of-return for the last five years is 2.5 percent. Of course, we all know the last five years include The Great Recession. TRS investments lost a combined 27.7 percent of its income in 2008-09.
Consider the following excerpts from Pension Liabilities: Fear Tactics and Serious Policy by David Rosnick and Dean Baker (January 2012) of the Center for Economic and Policy Research:
· Participants in the debate over pension accounting have a variety of agendas. If the purpose is to make the situation of these pension funds appear as dire as possible, then using a risk-free rate-of-return to assess their liabilities can be useful…
· If the goal is to actually manage a pension fund holding equities in a way that minimizes the need to increase contributions above the normal level, and therefore implicitly raise taxes, then it is desirable to use a funding rule that is based on an economically-conditional rate of return of the assets held by the fund…
· A pension fund that adjusted its expected return assumptions based on the ratio of stock prices to trend earnings would have a much smoother contribution path than a fund that always maintained full funding using the risk-free rate-of-return as the discount rate…
· If the goal of pension fund managers is to maintain a smooth flow of funding and avoid temporary tax increases needed to meet funding targets, then the conditional-funding rule… is unambiguously superior to a funding scheme that maintains full funding using the risk-free rate-of-return as the discount rate.
· Pension funds should adopt a funding principle that is consistent with a return on holdings, conditional on the state of the market…
· The expected ‘conditional rate-of-return’ used in making this assessment will vary depending on the current ratio of stock prices to trend corporate earnings…
· An optimal funding rule would maintain a roughly constant ratio of contributions to payouts…
· A pension fully funded under the choice of a risk-free rate would… require contributions even larger than those under the conditional rate. Of course, [public] pensions are rarely fully funded [and don’t have to be]…
· A proposed switch in the discount rate affects the current funding status of the pension…
· A decrease in the chosen discount rate pushes a pension father below funding…
· Under the economically-conditional discount rate, pensions rarely must make contributions in excess of payouts…
· It is far more common for a pension funded under a risk-free discount rate to pay current benefits exclusively out of contributions…
I wrote in a previous post: before changing the expected rate of investment return, why not wait until FY2014 to obtain a more realistic assessment of the TRS’ investment returns that are not based on asset values that include the exceptional market lows of the Great Recession? Since actuaries use “smoothing,” why not wait a few more years before drawing further conclusions about expected returns? After all, the State of Illinois does not face an urgent liquidity crisis (pension fund liabilities are long-term). Why not re-evaluate two or three years from now to see whether the economy and Market have fully recovered? Focus instead on the more honest and critical issue of revenue restructuring to pay the state’s debt problem that legislators have incurred.