Getting Real about Pension Investments

There's a better way to forecast investment returns for public retirement systems, but adopting it would put some pensions even further into the hole.
November 4, 2014
By Charles Chieppo  |  Contributor
Principal of Chieppo Strategies and former policy director for Massachusetts’s Executive Office for Administration and Finance

It's certainly tempting for officials in charge of state pension systems to hike up assumed rates of return. Better investment returns translate into smaller appropriations to fund pensions and can facilitate generous cost-of-living adjustments for retirees.

But wishing for better returns doesn't make them so, and unrealistic assumptions about pension-fund investment performance take a heavy toll over time. A new study quantifies just what that toll is in six states; in five of them, it isn't pretty.

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Investment returns are critical to a pension fund's financial health. To illustrate, after 15 years, the value of a $1,000 investment that earned 8 percent annually would be over 30 percent more than for the same investment earning 6 percent.

The usual methods for determining assumed rates of return (ARR) are highly subjective, based on implausible assumptions and somewhat arbitrary expectations. In a new study published by the Pioneer Institute (I am affiliated with Pioneer as a senior fellow but was not involved in the study), author Iliya Atanasov proposes replacing ARR with historical rates of return (HRR), which are based on actual long-term rate of return covering at least two economic downturns for each of the components of a pension-fund portfolio, such as stocks, treasury bonds and corporate bonds. Using HRR brings the transparency and objectivity that are appropriate for the fiduciary responsibilities of pension-fund management.

Illinois' pension system has certainly earned its reputation as a basket case. Using a weighted average, the ARR for its three state pension funds is 7.89 percent, but the HRR is 6.46 percent. As a result, the pension funds' reported funding ratio -- already dangerously low at 39.4 percent -- drops to 34.3 percent. Lower investment returns mean taxpayers have to kick in more to keep the systems afloat. For Illinois, the annual required contribution would jump from $5.9 billion to $7 billion using HRR.

Connecticut isn't much better. Its five state systems have an aggregate HRR of 6.57 percent. The two biggest systems, the state retirement fund and the teachers' fund, have ARRs of 8 and 8.5 percent, respectively. A shift to HRR would plunge the teachers' system from just over 55 percent funded to 41.4 percent, and the state fund would drop from 42.3 percent to 30.1 percent. The state is directly liable for an unfunded liability of $38.7 billion, more than 125 percent of its 2013 revenue.

The bad news continues with Massachusetts, New Jersey and Pennsylvania. New Jersey's five primary state-administered pension funds have a weighted average ARR of 7.9 percent but an HRR of 6.23 percent. The difference takes the systems' funded ratio down from just under 64 percent to 45.6 percent and would require the annual required contribution to more than double from $1.1 billion to $2.8 billion.

New York provides an island of comparatively good news. Even though the weighted average ARR of 7.7 percent for its two state systems is materially higher than the HRR of 6.64 percent, the systems are still in good shape, going from slightly less than 88 percent funded to just over 83 percent.

Transparency and objectivity may be pillars of good government, but they're not always the norm -- especially when they yield inconvenient truths. Unless public officials can resist the temptation to continue using unrealistic assumptions about investment returns, the Illinois pension debacle will go from being an outlier to being the rule. And taxpayers and public retirees are atop a long list of those for whom that would be very bad news.