Two New Looks at Investment Assumptions

Reviews of the way public pensions measure their ROI and account for liabilities could have a major impact on state and local budgets.
by | March 18, 2010

Girard Miller

Girard Miller is the Public Money columnist for GOVERNING and a senior strategist at the PFM Group.

Two unrelated studies in the public pension arena could create more budget-balancing challenges for public officials. One is an announcement by CalPERS, the behemoth California pension fund, that it is reviewing its investment-return assumptions. The other is the Governmental Accounting Standards Board's (GASB) review of pension accounting procedures. Both could affect the calculation of pension costs for state and local governments.

First to California: Presently, CalPERS assumes a 7.75 percent rate of return on investments for its actuarial calculations. In light of dismal investment performance in the financial markets over the past decade, some critics have charged that the assumption is too optimistic and leaves taxpayers holding the bag whenever the portfolio fails to meet that benchmark. Add to that the admonition of a prominent investment manager that investment portfolios overall will "be lucky to earn 6 percent," and the stage has been set for a serious and thoughtful review of CalPERS's investment program and its performance expectations.

Having chided the CalPERS organization for its governance practices in the past year, I applaud these efforts to come clean on the investment front. Last month, they reported a 50 percent loss in their real estate portfolio in 2009. That write-down was obviously painful for them. But, it was a clear and honest effort to recognize their losses and get on with it, rather than hide behind flimsy portfolio valuations and appraisals the way the banking industry has done. This new announcement by CalPERS's CIO that he's willing to review the investment return targets and the asset allocations that drive them is healthy for the CalPERS system. The staff and the trustees may conclude that some of their far-flung investment strategies are no longer worth the risk. Or, they may decide to stay the course after giving it a no-nonsense review. At least they will be doing so in a transparent and thoughtful way. Good for them. I give the beleaguered CalPERS investment team an A+ on this class.

Other public pension funds should follow suit. The national average rate-of-return assumption for large pension funds was 8 percent in the last survey of the national administrators' association. If CalPERS takes public action to reduce its rate below 7.75 percent, the trustees and executives of other public pension plans will have to ask themselves: What are they seeing, that we haven't thought about? Clearly, those with assumptions above 8 percent must ask themselves whether they are pipe-dreaming.

CalSTRS, the giant sister pension fund for teachers, is considering a similar review of its 15-year-old assumption of an 8 percent return.

The downside of this kind of review process is that a more conservative investment return assumption will require the actuaries to increase the employers' annual required contributions to the pension plan. Employer costs in California and elsewhere are surging higher already as a result of the investment losses of 2008, so a reduction in the returns expected over the next 30 years would only make matters worse for employers in this decade. In the long run, of course, "the benefits will be the benefits" and the more the employers pay into the system now, the less they will pay later, regardless of the actual investment returns. This is ultimately an intergenerational cost-accounting issue, but it's important because our children will end up holding the bag if the long-term assumptions prove too optimistic.

An accounting question. Meanwhile, the accounting wizards at the GASB in Norwalk, Connecticut, are expected to release preliminary views this June on their multi-year pension-accounting study. One of the hotly debated issues that GASB has studied is the actuarial discount rate, and whether the expected rate of return on investments is the right number to use.

A school of actuaries and financial economists has argued that a risk-free rate of return is the better number because nobody can be certain that riskier investments will ever match the assumptions. They call this the Market Value of Liabilities (MVL) school. In today's markets, that would reduce the discount rate for pension fund actuarial calculations from the 8 percent average cited above to something closer to 5 percent. The result would be a whopping 50 to 70 percent increase in employer required contributions.

Speculation in the industry is that GASB has not bought into the entire MVL school of thought. But there is an intriguing variation buzzing around the GASB-gossipers: Unfunded liabilities should be discounted at the employer's borrowing rate of interest, not the investment rate of return. Unfunded liabilities are the pension liabilities already earned but not offset by assets. They are essentially the "soft debt" of the pension fund (or OPEB trust, in the case of a retiree medical plan). Since the unfunded liabilities of a pension plan are not assets, but are liabilities, the accounting concept would be that an investment rate of return based on assets (that don't exist now) is the wrong factor for calculations.

It's far too early to know if GASB will pursue this line of thinking in its preliminary documents -- let alone in the entire deliberative process, which will take at least another year and include substantial public commentary. However, the use of a governmental borrowing rate would inevitably involve a lower discount rate and hence higher employer contributions. I would argue that a taxable borrowing rate is the more appropriate standard under this approach since states and localities cannot borrow tax-exempt to fund a pension or retirement plan investment portfolio under federal arbitrage laws. That would cut the budgetary pain of this approach in half for many employers.

Hopefully the economy and tax revenues will have recovered in the next two years before any potential accounting changes would take effect. That would take a little of the budgetary sting off of these developments. Right now, that seems like a realistic scenario.

Ask before you re-hire employees. Either of the above developments could result in higher costs for employers. Savvy public managers and elected officials will start asking their pension colleagues just how bad things could get for them under either or both scenarios: a lower investment return or a change in accounting standards. Public officials will look silly if they add more employees in 2011, only to lay them off later in order to pay the pension bills that blindside those who fail to look downfield first.


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