Dow 100,000, Sunshine Wishes, and Kicking the Can: The Makings of a New Minnesota Miracle

Observations and conclusions about the future of public pension policy from gloomy Eeyore types who aren't sure about a Dow Jones Industrial Average of 100,000 by 2037. March-April 2012.

“Investors are betting that high returns from equities will pay for decent pensions. They are kidding themselves”

— “Too Much Risk, Not Enough Reward” The Economist, March 17, 2012

Add The Economist to the growing list of financial press, investment experts, and pension advisors expressing serious reservations about the optimistic investment returns on which public pension funds are based. It’s a message that now seems to be resonating in other parts of the country.

Since 2008 at least 19 state and local public pension plans have cut their return targets below 8%. New York State’s pension system lowered its assumed investment return from 8.0% to 7.5%; the Illinois State Employees’ Retirement System lowered its assumed return from 8.5% to 7.75%. The board of California’s CALPERS, after a protracted, high profile debate, finally reduced their return to 7.5% only to have the chief actuary argue that 7.25% would actually be better.

Then there is Minnesota. At 8.5% Minnesota’s assumed rate of return is the highest in the nation, a fact not lost on legislators. The Legislative Commission on Pensions and Retirement (LCPR) held a series of meetings last fall on this topic, and the discussion and debate continued through this year’s legislative session. What eventually transpired provides an instructive lesson on the challenges and politics of pension reform.

An Illusion of Change

Going into the 2012 legislative session the policy position adopted by the trustees of the retirement systems for state employees (MSRS) and for local government employees (PERA) was a phased in permanent reduction in the return rate to 8.0% (8.25% for two years and 8.0% thereafter). The retirement system for teachers (TRA) was much more recalcitrant about any change, but ultimately their trustees approved something called a “select and ultimate” approach in which the assumed rate of return would be temporarily lowered to 8.0% for the next ten years (the “select” period) and then increased back again to 8.5% thereafter (the “ultimate” period).

Table 1

Financial Impact of Investment Assumption Change Proposals

Current Law Assumptions 8% for all years** 8% for 5 years, 8.5% therafter*
TRA (Based on actuarial values as of 7/1/2011)
Funded Ratio 77.3% 73.3% 75.9%
Total Required Contributions 16.57% 19.17% 17.33%
Current Law Contributions 12.69% 12.69% 12.69%
Contribution Surplus/(Deficiency) (3.88%) (6.48%) (4.64%)
Future Contribution Increases (FY2012-14) 3% 3% 3%
Adjusted Contribution Surplus/(Deficiency) (0.88%) (3.48%) (1.64%)
MSRS-General (Based on actuarial values as of 7/1/2011)
Funded Ratio 86.32% 82% 85%
Total Required Contributions 11.03% 12.8% 11.3%
Current Law Contributions 10.00% 10% 10%
Contribution Surplus/(Deficiency) (1.03%) (2.8%) (1.3%)
PERA-General (Based on actuarial values as of 7/1/2011)
Funded Ratio 75.18% 72% 74%
Total Required Contributions 13.47% 14.3% 13.92%
Current Law Contributions 13.50% 13.5% 13.5%
Contribution Surplus/(Deficiency) (0.03% (0.8%) (0.42%)
Table 1: Notes
  • *Estimates only
  • **(w/salary & payroll growth adjustments in SF2199/HF1808)
Table 1: Source
  • Legislative Commission on Pensions and Retirement

With these trustee-endorsed positions on the record, LCPR members adopted a “compromise” proposal weaker than anything on the table – an 8.0% assumed return for only five years with a return to the 8.5% rate thereafter.

Such a proposal obviously had the endorsement of the three major plans. It was the policy equivalent of a car salesman disappearing into the sales manager’s office and returning with a counteroffer $500 below the customer’s. Responding to a question in a Senate hearing, LCPR Executive Director Lawrence Martin confirmed that, from an actuarial point of view, this change effectively maintains the status quo because a five-year temporary change is nominal compared to the multi-decade perspective these plans consider.

To provide a rationale and justification for this unusual “compromise,” legislators tied the final year of this temporary reduction to the next set of periodic experience studies each plan undertakes to test the various actuarial assumptions used in their funding. Proponents argued this ensured such an influential and important decision would be based on the best available information. However, the last round of experience studies for the major pension plans (published back in 2009) recommended lowering the assumed rate of return to 8.0%. If it was convenient to ignore the best information then, critics can be excused for doubting a change of perspective in the future.

Why the pretense? Even the staunchest supporters of the status quo are aware of the increasing sensitivities surrounding Minnesota’s outlier investment return assumption. But the accompanying table illustrates the issues at stake. School districts clearly have the most to lose by interjecting a stronger sense of conservatism (many would say realism) into pension funding. Changing the assumed rate of return to 8.0% would increase the 2012 contribution deficiency for TRA to almost 6.5% of payroll (meaning current contributions are inadequate to the cost of additional benefits and amortizing unfunded liabilities). Contribution increases totaling 3% of payroll are scheduled to come into effect over the next few years, courtesy of the 2010 pension reforms, but the remaining shortfall could very easily trigger yet another round of contribution hikes.

Putting this into a more taxpayer-friendly perspective, fully eliminating a 2012 TRA contribution deficiency of 6.5% translates into $266 million of additional pension support from some combination of employee paychecks, school district budgets, or higher taxes. During LCPR hearings late last year a few legislators requested evidence that higher pension contributions were in any way threatening or crowding out government services. The potential impact on schools illustrates that the opportunity cost of additional pension support is very real and substantial. Assuming 825,000 K-12 pupils, $266 million translates into roughly $320 per pupil. As a comparison, since school year 2006-07 the state has increased basic education aid by only $250 per pupil. The effect of the pension contribution bump being phased in through FY 2015 (1% of payroll down; 3% to go) is already hitting home, as evidenced by HF 2301/SF 2089 introduced this year that would give school districts the authority to levy for increased pension support.

In short, legislators are caught between the rock of current budget and political circumstances and the hard place of a future when implications that are far more serious may present themselves.

Lessons for the Skeptics

It is possible the nattering nabobs of pension negativism could be wrong and we are entering another era of rich investment returns. To give some perspective on the challenge ahead, 8.0% return for 5 years followed by 8.5% thereafter translates into a Dow Jones Industrial Average of 100,000 by 2037 (or NASDAQ 22,500) – just around the time current unfunded liabilities are scheduled to be paid off.

But for those gloomy Eeyore types – overly-concerned about the risk to future budgets, tax levels, implications for government services, and keeping the promises made to future retirees – what conclusions can they draw from this session’s events? Here are a few:

We should now stop patting ourselves on the back for past reforms that haven’t adequately addressed the problem.

We state for the record – as we have many times before – that the 2010 sustainability reforms were necessary and substantive, required compromise and real sacrifice, and were an important, positive step. We also note that even after of the enactment of these reforms two of the state’s three major pension plans still have contribution deficiencies. Moreover, all three would have reported even higher contribution deficiencies if Minnesota’s assumed investment return was lowered to rates employed by the vast majority of state and local governments across the nation. As we said in 2010, the reforms were necessary but insufficient. The shelf life of the self-congratulation many legislators express regarding their previous actions is now approaching its expiration date.

As Girard Miller of Governing magazine notes, “it is mathematically necessary for a reasonable funding ratio to be higher than 80 percent and rising on a clear path to full funding. Otherwise, the plan is doomed to be chronically underfunded with current taxpayers supporting retirees who didn’t ever work for them…That’s why today’s 70 percent funding ratios are a legitimate concern and a financial burden on younger generations who will inherit this problem that their elders keep sidestepping.“1

Two sets of pension financial statements are likely coming our way.

Currently, public pension plans’ financial statements use their assumed rate of return to discount future pension liabilities. But the Government Accounting Standards Board’s new pension reporting standards to be promulgated later this year are expected to require, among other things, a much lower overall discount rate than the combo 8.0%/8.5% “select and ultimate” rate proposal previously described. It’s possible the legislature might ignore GASB conformity on this particular issue, but that would be a disturbing precedent for bondholders, rating agencies, and other stakeholders. Instead, it is likely we’ll start to see two sets of financial statements; one set of books to satisfy GASB, the other – communicating a markedly more positive description of fund health – to reflect the plan’s funding decisions. It’s a guaranteed recipe for even more complexity and confusion for policy makers and taxpayers.

We are going to need more – perhaps a lot more – than 8.5% investment returns going forward.

No pension myth needs to be blown up more than the idea that simply achieving an average 8.5% return over the long-term guarantees pension plan sustainability. For starters, that simple calculus only applies to fully funded pension plans. Because a pension fund must pay out existing benefits and at the same time retain enough assets for investment to make benefit payments, once a plan is severely underfunded it needs to produce substantially more than its assumed rate to earn its way out of a funding deficit.

But there is something even more fundamentally flawed about this pervasive conventional wisdom. SBI reported investment returns ignore pension fund cash flows (i.e. benefits paid out and incoming contributions) because its responsibility is to measure money manager performance. Since money managers can only invest the funds they have, it is completely logical (and standard industry practice) to disregard these cash flows over which they have no control. But when looking instead at investment returns within a pension fund – dollars gained on dollars invested – internal cash flows matter and reported returns can be much lower, especially over time.

This helps explain why SBI’s reported 9.7% annualized return over the past 30 years has still left Minnesota’s major pension funds – conservatively – some $15 billion in the red. It’s also why pension expert Stephen Campisi says that the returns reported by state boards of investment around the country “provide no useful information about the success of investments in meeting the financial objectives of pension plans.”2

The issue is not just investments; benefits and contribution policies also matter. These decisions and their timing determine the amount of assets available to take advantage of available investment returns. Requiring that this additional investment return data be reported would help stakeholders better understand the impact of these actions. It’s the true return benchmark for pension fund sustainability.

Major reform and redesign of government operations may make the pension problem worse.

Redesigning government is a tough slog in any circumstances, but the aging of the public sector workforce appeared to offer a “window of transition” to rethink/reform/reorganize government entities and programs without causing huge public sector layoffs. That may still be the case, but pension obligations would ensure the lunch is not free.

For example, consider that in 1989, for every dollar in benefits MSRS paid out, about two dollars were coming into the system. Today that ratio has flipped – it pays out about $2 for every $1 contributed to invest for the future. Moreover, the boomer-driven slug of public sector retirements has only just begun.

Existing funding calculations do factor in these workforce and demographic effects. But these calculations assume a certain rate of aggregate payroll growth. A major investment in government or program consolidation, the substitution of technology for labor, shared service agreements, expansion of joint powers, public/private partnerships and a host of other strategies would likely reduce the size of the public sector workforce to some extent; indeed that is the primary source of cost savings. But any reduction in employee count and accompanying slowdown in payroll growth can create collateral damage in pension plans, because actual growth in total payroll would likely fall short of expectations. One result: anticipated (and needed) new employee contributions would fail to materialize putting additional pressure on contributions related to the remaining employees and to investment returns to amortize the current shortfall. What would be the impact of a 10% reduction in the size of the state and local workforce over the next several years? It’s a question deserving further investigation.

Any further pension reform will be a Herculean task

There is no such thing as low hanging fruit in pension reform, but some fruit can be squeezed a little easier than others. The 2010 reforms squeezed most – if not all – of the juice out of the existing system in a way that improves the situation without altering fundamental system design. We’ve extended the amortization periods and conditionally lowered or frozen cost of living adjustments. With contributions at their current levels any further efforts will almost inevitably have to address “third rail” issues of base benefit levels and the basic design of the plans themselves.

There remains considerable verbal support for further reforms including investigations into hybrid plans. But watching the pension plans’ own recommendations get watered down this session certainly paints a dismal picture for future pension reform attempts. Subsequent reform will require bold leadership and a critical mass of lawmakers with the ability to look beyond the next biennial budget. We wonder where that will come from.

  • 1 “Pension Puffery,” Governing, January 5, 2012
  • 2 “Time Out: Money-Weighted Return is Better” Pension and Investments, May 16, 2011