'Borrowing In Disguise': For Pension Funds, Lowering Expectations Could Cost Billions
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Public pension funds could be in a much bigger hole than they're admitting. And facing up to more realistic numbers won't be easy.
Across the country, pension funds have set unrealistically high expectations for future income, experts say, projections that could strain already tight city and state budgets. The typical public pension fund projects an 8 percent annual return, a figure that's held steady even after the financial crisis decimated funds' value nationwide.
Over the past 10 years, any investment with consistent 8 percent returns, compounded annually, should have seen an increase of about 116 percent. By comparison, the S&P 500 during that period dropped about 13.5 percent. Despite the weakened economy, funds have retained a pre-crisis optimism.
But lowering expectations by even a small amount could inflate funds' liabilities by billions of dollars, each. When pension funds calculate the size of their liability -- the amount of money they must set aside in order to pay what they've promised to pensioners -- they subtract the returns that they expect to earn on their assets, called the discount rate. Setting this expectation too low represents the liability as unrealistically large, putting an extra burden on taxpayers. But setting the rate of return too high creates the opposite problem, as it makes the liability appear unrealistically small. In such a case, a government would owe more to its pension funds than it thinks.
New York City, whose largest fund has the most members of any municipal fund in the nation, faces an emblematic problem. As the city comptroller John Liu said last week at The Economist's Buttonwood Gathering in Manhattan, lowering the expected 8 percent rate of return by even half a percentage point "would be a tremendous hit to our annual budget." It would, according to a pension expert's calculation, increase the pension liability by about $9 billion.
Some city leaders are worried. "It's overstating it a little bit to say the only one who's done that well is Bernie Madoff," mayor Michael Bloomberg said last month, according to Bloomberg news. "But 8 percent for a long period of time is not something that very many pension funds have ever achieved."
The median expected annual returns at 77 large municipal funds examined in a recent study is 8 percent, a figure that has remained consistent for the past decade. According to the National Association of State Retirement Administrators, this 8 percent median rate is the same as it was in 2001 -- years before the financial crisis wiped out 29 percent of funds' value.
Pension experts say expecting 8 percent annual returns on public pensions is unrealistic. From the end of 2007 through the beginning of 2009, the Dow dropped about 46 percent, and the S&P 500 dropped about 48 percent.
"It's just borrowing in disguise," Northwestern University finance professor Joshua Rauh told HuffPost. "Basically all that you're doing is you're saying, O.K., we're going to make these promises and we're not going to fund them...and we're going to ask future taxpayers to make up the difference -- basically to write insurance on our investment policies."
If Rauh is right, then the problem is widespread.
"There's a trend, and a lot of pressure, for plans to reduce that [8 percent rate] to seven and three quarters or seven and a half," said Steve Kreisberg, director of collective bargaining for the American Federation of State, County and Municipal Employees. "The trend has certainly been to reduce it, not increase it."
But how feasible would a rate reduction be? For New York City, according to University of Rochester professor Robert Novy-Marx, who did the calculation for HuffPost, reducing the rate even half a percentage point would swell the liability by about $9 billion.
Novy-Marx, who co-authored with Rauh an October study on pension fund liabilities, used the latest comprehensive annual financial reports (CAFR) for each of the city's five pension funds (available online) to determine that, with the 8 percent expected rate of return, the city's total stated pension liability is $155.85 billion. If the city were to use a rate of 7.5 percent, the liability would jump almost $9 billion, to $164.78 billion. The city's budget deficit, by comparison, according to the latest statement, is about $96.7 billion.
To pay down that increased pension liability over a period of 30 years, Novy-Marx said, the city government would have to increase its annual contribution by about $300 million, starting in the first year. Considering that would almost certainly require an increase in taxes, it is, at this point, likely a political impossibility.
Liu, the New York City comptroller, who oversees the funds, acknowledged this issue during a question-and-answer session earlier this month at The Economist's Buttonwood Gathering in Manhattan. In response to a question about whether he would reduce the rate, Liu said, "That's quite a question," adding, "You asked a hot question." He said, "there's a movement to reduce this long-term rate of return," but did not say whether he would support such a step.
"The challenge for us as a municipality is that it would be a tremendous hit to our annual budget," he said. "Just lowering it half a percentage point...would introduce a strain of several hundred million dollars a year into our service budget."
Novy-Marx thinks even 7.5 percent is too high. "I think they should be using something quite a bit lower than that," he said. New York state, for its part, announced in September that it would reduce its expected rate of return from 8 to 7.5 percent. "In today's investment environment, the actuary thought it was best to lower the assumption rate by half a percent," Dennis Tompkins, a spokesperson for state comptroller Thomas DiNapoli told HuffPost. "In light of changing markets and volatility, it was a good time to lower it down."
When Sharon Lee, spokesperson for New York City comptroller Liu, was informed that the liability would increase by about $9 billion if the rate were reduced half a percentage point, she expressed surprise. But after repeated requests from HuffPost, the city comptroller's office would not produce a calculation to challenge Novy-Marx's figure and directed requests to Robert North, the city's chief actuary.
North said he will make a complete review of all the pension assumptions and methods in the next year.
If pension funds' assets do in fact yield 8 percent, then this potentially increased liability won't be an issue. And as Liu noted last week, the funds' investments are long-term, so a couple bad years shouldn't matter. The 8 percent figure is not supposed to represent a single year's returns but rather a smoothed-out picture of annual returns over the course of decades.
During the past 20 years, the Dow has climbed about 359 percent. During the past 10 years, though, it's increased only about 5 percent. The S&P 500, during that time, dropped about 13 percent.
"We don't react to one year," Tompkins, the DiNapoli spokesperson, said. "We look at long-term prospects and we try to measure that way."
"Public pension plans are long-term investments," Kreisberg, of AFSCME, said. "And that's the beauty of them."
Liu summarized the debate concisely: "Lots of people say, if you look at the last eight years, the last 10 years, how can you possibly expect an 8 percent annual rate of return on assets?" he said last week. "Others would say that, well, the duration of these pension liabilities are very long. They last for decades. And so if you look at the last 30 or 40 years, is 8 percent that far off from the annual average?"
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First Posted: 11/04/10 02:23 PM ET Updated: 05/25/11 07:10 PM ET