The 8.5% Dilemma

“It is only in pension finance that the discount rate for a liability is based on the expected return. Not in banking, not in investment banking, not in project finance, not in home mortgages or consumer finance—and not in government finance. No one else; nowhere else; nothing else.”

—M Barton Waring, Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control

Albert Einstein is purported to have once said that the most powerful force in the world was compound interest. The story may be apocryphal, but the truth of the statement is reflected in the world of public pension funding and politics.

The assumed rate of return on the state’s pension fund investments was the subject of extensive discussion and debate this fall at three Legislative Commission on Pensions and Retirement hearings. Minnesota’s current 8.5% annual assumed rate of return on pension fund investments is the highest in the nation according to a public fund survey conducted by the National Association of State Retirement Administrators. This crucial assumption has profound implications for the reported health of funds and for the levels of contributions pension funds require. This fall, the commission heard extensive testimony on whether the current 8.5% is too optimistic and what the implications would be if this assumption was lowered.

How big a deal would this be? Table 1 prepared by the Teachers Retirement Association (TRA) highlights the impact of lowering the investment assumption by 50 basis points to 8.00%. For the three major state funds ¹ , projected unfunded liabilities would increase by an additional $2.9 billion (on top of the current $10.9 billion in unfunded liabilities in the three statewide general employee plans as of July 2011). But even more important are the implications for contributions to these funds. A contribution sufficiency occurs when existing funding efforts are adequate to pay for current obligations and whatever additional contribution is needed to pay off any unfunded liabilities by the target amortization date. A contribution deficiency means the opposite – funds are falling further behind, creating more unfunded liabilities. The lower assumed return switches PERA from sufficiency to deficiency status while causing further deterioration to the existing contribution deficiencies in MSRS and TRA. Translation: absent additional changes to the benefits being offered, changing this assumption would likely require more contributions from employees, government, or both. Importantly, this analysis includes future contribution increases already scheduled in law.

The debate does not end here. As we have reported in the past, the Government Accounting Standards Board is expected to promulgate new pension reporting standards that would require governments to reduce expected asset return rates in situations where unfunded liabilities exist. In testimony this fall before the pension commission, representatives from the state’s investment board described the potential GASB reporting standard changes as a “major problem.” This comment perfectly captures the insular world of pension debates: unfunded liabilities, continuing contribution deficiencies, and taxpayer exposure are not the “problem,” but rather accounting treatments that provide a more intellectually honest and accurate presentation of pension fund health to taxpayers.

But even this GASB modification is considered wholly inadequate by many pension experts. Barton Waring, quoted above, is a retired Chief Investment Officer for Barclays Global Capital who literally wrote the book on defined benefit pension plan finance. Notably, he is an enthusiastic and unabashed supporter of defined benefit plans. Yet in his testimony to GASB on the proposed reporting standards, he argued forcefully that assumed asset return rates are not only the wrong discount rate to use, they are exceedingly dangerous to defined benefit plan survival because either assets will not be available to pay benefits in the future or contribution levels will eventually go out of control ² . Waring argues that government-sponsored pension plans must join the rest of the financial world and discount liabilities using risk-free rates of return because doing so provides superior risk control, greater cost stability, lower long term funding costs, and less volatility in pension contributions.

To Waring and others, the hotly-contested GASB reforms are actually weak tea. They argue that instead of prolonging the mirage with a GASB-manufactured compromise between basic economic principles and politics, we should accept the real economics of these plans, take our medicine, begin a transition to discounting liabilities using risk-free rates, and make whatever adjustments are necessary to defined benefit plans accordingly.

Such an approach has zero chance of being adopted in Minnesota. In pension commission testimony this fall, Andrew Biggs of the American Enterprise Institute estimated that pensions now reported as 80% funded would likely be only about 40% funded using a risk-free discount rate. The shock waves and contribution hikes triggered by such a decision would be untenable. Instead, it appears some minor tweaking of the assumed rate down from 8.5%, perhaps temporarily, might be in store. However, even that is likely to face challenging political obstacles. In the meantime, the significant contribution and funding risk assumed by future taxpayers continues largely unabated.