New Jersey State Treasurer Elizabeth Maher Muoio recently announced plans to raise the investment return assumption for the state’s grossly underfunded state retirement system from 7.0 to 7.5 percent, which would likely only exacerbate its funding shortfalls. This is quite a contrast from the relatively well-funded North Carolina retirement system, which, like most other public pension plans, is doing the opposite by adopting more conservative, prudent assumptions.
Last year, the Public Employees’ Retirement System of New Jersey was just 36.8 percent funded and $48.9 billion in the red. The Garden State arguably has one of the worst-funded retirement systems for public workers in the country, along with Illinois and Kentucky.
Things only got worse when Muoio mandated a 50-basis point increase (from 7.0 percent to 7.5 percent) in the retirement system’s rate of return assumption beginning next fiscal year. The rate, she says, will gradually be lowered back to 7.0 percent in five years or so.
Gradually lowering the assumed rate of return to smooth out employer contribution increases can be reasonable — see CalPERS. However, increasing the investment return target in the “new normal” lower yield environment, even temporarily, is a rather rare and dangerous exercise.
Farther down the East Coast things are different, where State Treasurer Dale Folwell successfully urged the 89.5 percent funded North Carolina Retirement Systems (NCRS) to consider and then approve lowering its rate of return assumption from 7.2 percent to 7.0 percent. This is consistent with his previous remarks. In 2017 Folwell noted that “because the projected rate of return has not been met, we must begin taking gradual steps toward reflecting the actual historical rate.”
Indeed, in the 10-year period from 2007 to 2016, the NCRS’s returns averaged out to just 5.0 percent (geometric mean). Like the previous 5-basis point reduction from 7.25 percent before it, Folwell rightly treats the lower return targets as a reasonable protectionary measure. The NCRS pension board has unanimously voted in favor of the change. The impact on employer contributions will be phased in over a three-year period.
It is important to note, however, that past performance is no guarantee of future results. And, to gauge future return prospects, actuaries and financial managers tend to rely on overall return projections. And with major advisors, who supply these projections, lowering their investment return outlooks, the yield curves for institutional investors are looking less positive going forward. To reflect these structural changes, last year Fitch Ratings lowered its investment return assumptions for public pension plan liabilities from 7.0 percent to 6.0 percent. Moody’s Investor Services adjusted its actuarial procedures back in 2013.
The combination of past underperformance and lackluster return expectations is exactly why nearly three-fourths of major American public pension plans have reduced their investment return assumptions since the fiscal year 2010, according to the National Association of State Retirement Administrators. The discount rate, which is almost always equated with the rate of return assumption, directly determines the value of long-term pension liabilities—the total amount of promised pension benefits that pension plans recognize. And with lower yields going forward, the value of pension liabilities should probably be higher. In the same way, the amount of Actuarially Determined Employer Contributions (ADEC) should be higher as well.
As an example, let’s consider a hypothetical situation where, instead of using the 7.2 percent assumption for its June 30, 2017, calculations, NCRS applied a 6.2 percent or 5.2 percent investment return assumption. Then, instead of $75.6 billion, the plan would have been recognizing $84 or $93.4 billion, respectively, in total pension liabilities. In this way, however, NCRS would be more accurately calculating and pre-funding the promised pension benefits, while making more substantial progress in amortizing unfunded liabilities.
One other benefit that often gets overlooked is that tailoring investment return assumptions to market conditions is a reasonable protection from the year-to-year volatility of investment returns and significant investment losses recognized by the plans. For example, in 2016 NCRS investments returned 6.22 percent, versus the 7.2 percent assumption, recording $631.7 million in investment losses for that year. However, if hypothetically the pension plan had used the 6.2 percent return assumption instead, the 2016 returns would not have fallen short of the target, resulting in no losses whatsoever. Lowering the rate of return assumption, however, implies that state or local governments will have to start making more adequate contributions to pre-fund public pension benefits.
Following the 2007-2008 financial crisis, many states and municipalities are facing budgetary constraints that may result in trade-offs in public services or tax increases. But postponing the adequate pre-funding of pensions for public employees is not an answer, because it directly leads to higher contributions in future. Those who continuously put the effort into properly revaluing their pension liabilities going forward will eventually come out of the pension waters financially healthier than those who do not.