by Justin Mordarski
The latest sortie into fixing our broken system is a push by
some to assume an artificially low rate on investment returns.This sounds innocuous, perhaps even prudent…right?
Not even close. Even a very small difference in the assumed rate of return can have a massive effect on forced taxpayer contributions. A recent report on the pension system of Rhode Island illustrates the danger in manipulating the assumed rate of return. Lowering the rate by less than 1%, from 8.25% to 7.5%, increases the shortfall by over $2 billion, from $4.7 billion to $6.8 billion! Lowering it to 6.2%, increases the amount taxpayers owe by $4.5 billion.
Not even close. Even a very small difference in the assumed rate of return can have a massive effect on forced taxpayer contributions. A recent report on the pension system of Rhode Island illustrates the danger in manipulating the assumed rate of return. Lowering the rate by less than 1%, from 8.25% to 7.5%, increases the shortfall by over $2 billion, from $4.7 billion to $6.8 billion! Lowering it to 6.2%, increases the amount taxpayers owe by $4.5 billion.
What does this mean for a Michigan city or township? While it varies by the size of the fund, lowering the assumed rate of return by even 1 percentage point could translate into several millions of dollars per year in additional, required payments by the city or township.
The pension fund’s assumed rate of return, or discount rate,
is one of the primary variables in determining its funded ratio and it is
ultimately the funded ratio that determines the bulk of the amount that
taxpayers are required to contribute to the fund. It is expressed as a percent, usually between 7.5% and 8.0% and it is used discount
the liabilities (what is owed) that are presented on the fund’s financial
statements, so if it is too low, the liabilities appear artificially high and,
most importantly, the required taxpayer contribution toward said liabilities is
much higher than it needs to be.
The exact value of the discount rate should be based on the fund’s historic, long-term average rate of return in its investments. Generally, this period should be rather long, usually 20 to 30 years; provided, of course, the pension boards has accurate records going back that far.
The latest fad in pension “reform” is to lower this rate, sometimes considerably. The belief in is that doing so will somehow be “safer” or “more cautious”, which is why a lot if well intentioned, thought misinformed, conservative activists have been drawn to it.
The problems of artificially lowering the rate of return are significant and real, while the benefits are questionable at best.
First problem is higher taxes.
There is a direct link between the rate of return used and the amount taxpayers much contribute every year: the lower the rate used, the more residents and businesses must pay. There is no way around this relationship. So understand that if some well-intentioned bureaucrat wants to lower it be even 1%, the taxpayers in that city or township would then be forced to increase annual payments to the fund, which, depending on the fund size, could be an extra million dollars a year or more.
This extra money can really only come for one of two places, higher property taxes or service reductions; so either homeowners and businesses pay more property taxes or needed services, such as road repair, are cut.
For most areas, the fragile housing market is just now starting to recover, the last thing we need to do is stunt its recovery by large property tax increases.
While I strongly support closing local pension systems to new entrants, understand that this does not magically make existing unfunded liabilities go away – they must be paid and the assumed rate of return determines how much taxpayers will be paying.So even under the scenario where a traditional pension fund is replaced by the 401 (k) style plan, local residents and businesses could still end up paying hundreds of extra dollars a year in property taxes if too low an assumed rate of return is used to calculate the remaining balance.
Second, there exists a real danger to the taxpayers in overfunding. Pension boards in Michigan have quite a bit of autonomy and are, as a practical matter, usually controlled by the employee groups; and it this autonomy which confers upon them a good deal of discretion in how to deal with any overfunding; overfunding which becomes “extra” money to the board, who historically find a way to spend it to enrich their supporters.
Perhaps the best known example is the infamous 13th Check paid by Wayne County. Even though not required by any contract, the 13th Check was a bonus paid annually to existing retirees. One of the main justifications for doing so was that there was “extra” money in the pension fund, so why not spend it.
More commonly, the “extra” money in the pension fund is allocated to existing employees in the form of enhancements regarding how their pensions are calculated. One frequent methodology is to allow unlimited overtime or unused vacation time to be included in their final average compensation; thereby increasing or “spiking” their pensions considerable.
Another disastrous use of this “extra” money advocated by pension boards is a DROP, or Deferred Retirement Option Program, which allows employees to collect a full pension while still working. As long as pension boards are allowed to treat overfunding as “free money”, overfunding can be just as costly to taxpayers as underfunding.
Third, it is simply wrong and not supported by the available data.
The exact value of the discount rate should be based on the fund’s historic, long-term average rate of return in its investments. Generally, this period should be rather long, usually 20 to 30 years; provided, of course, the pension boards has accurate records going back that far.
The latest fad in pension “reform” is to lower this rate, sometimes considerably. The belief in is that doing so will somehow be “safer” or “more cautious”, which is why a lot if well intentioned, thought misinformed, conservative activists have been drawn to it.
The problems of artificially lowering the rate of return are significant and real, while the benefits are questionable at best.
First problem is higher taxes.
There is a direct link between the rate of return used and the amount taxpayers much contribute every year: the lower the rate used, the more residents and businesses must pay. There is no way around this relationship. So understand that if some well-intentioned bureaucrat wants to lower it be even 1%, the taxpayers in that city or township would then be forced to increase annual payments to the fund, which, depending on the fund size, could be an extra million dollars a year or more.
This extra money can really only come for one of two places, higher property taxes or service reductions; so either homeowners and businesses pay more property taxes or needed services, such as road repair, are cut.
For most areas, the fragile housing market is just now starting to recover, the last thing we need to do is stunt its recovery by large property tax increases.
While I strongly support closing local pension systems to new entrants, understand that this does not magically make existing unfunded liabilities go away – they must be paid and the assumed rate of return determines how much taxpayers will be paying.So even under the scenario where a traditional pension fund is replaced by the 401 (k) style plan, local residents and businesses could still end up paying hundreds of extra dollars a year in property taxes if too low an assumed rate of return is used to calculate the remaining balance.
Second, there exists a real danger to the taxpayers in overfunding. Pension boards in Michigan have quite a bit of autonomy and are, as a practical matter, usually controlled by the employee groups; and it this autonomy which confers upon them a good deal of discretion in how to deal with any overfunding; overfunding which becomes “extra” money to the board, who historically find a way to spend it to enrich their supporters.
Perhaps the best known example is the infamous 13th Check paid by Wayne County. Even though not required by any contract, the 13th Check was a bonus paid annually to existing retirees. One of the main justifications for doing so was that there was “extra” money in the pension fund, so why not spend it.
More commonly, the “extra” money in the pension fund is allocated to existing employees in the form of enhancements regarding how their pensions are calculated. One frequent methodology is to allow unlimited overtime or unused vacation time to be included in their final average compensation; thereby increasing or “spiking” their pensions considerable.
Another disastrous use of this “extra” money advocated by pension boards is a DROP, or Deferred Retirement Option Program, which allows employees to collect a full pension while still working. As long as pension boards are allowed to treat overfunding as “free money”, overfunding can be just as costly to taxpayers as underfunding.
Third, it is simply wrong and not supported by the available data.
The assumed rate of return is supposed to be based upon real
data, namely, decades of investment return data by the fund or similar
funds. It is not supposed be based on
outliers (a few bad or good year), but on a long-term average. Nor, should it be based on or influenced by
the investment experiences of individual persons. I mention this last point since many
well-meaning activists like to suggest that since they only make 1% in back
CD’s or their personal portfolio only made 4% last year, the pension should
reduce its rate in kind. Pension funds
have a diverse investment pool including foreign currency, stocks, real estate
and exotic investment products too myriad to list, and employ complex hedging
strategies to achieve a fairly consistence average return rate over diverse
economic conditions. A pension fund is
nothing like the investment products used by most individuals. Another mistake many individuals make is to
focus on bond yields (currently very low) and use this as a reason to reduce a
rate of return for a pension fund.
Traditionally, stock and bond yields move in opposite directions, so
when bond yields go down, fund managers just move assets from bonds and into
stocks. A recent report by JP Morgan
indicated that US corporate pension funds increased their funding status from
approximately 77% to almost 100% in just two years, primarily due to gains in
the stock market.
The data over the last several decades strongly supports the 8% average rate of return used by most pension funds both in Michigan and throughout the nation. According to the National Association of State Retirement Administrators, the median, average annual rate of return for all public pension funds was 8.5% in the 25 year period 1986 to 2011. The average for the state of Massachusetts’s pension funds has been 9.6% since 1986. Even the much maligned CalPERS (one of largest funds in county) posted a 8.38% average 20 year return. These returns are reported by the funds themselves, so perhaps it is healthy to be skeptical. Even sources outside the pension funds themselves support the 8%. The Standard and Poor’s Composite Index retuned 10.14% for the period 1926 to December 31, 2013. Even the Wall Street Journal recently reported that the 30 year annual return of a large bundle of stocks selected by Morningstar was 11.1%. The data is pretty conclusive that an 8% projected rate of return is more accurate than the 4% or less some are suggesting.
The data over the last several decades strongly supports the 8% average rate of return used by most pension funds both in Michigan and throughout the nation. According to the National Association of State Retirement Administrators, the median, average annual rate of return for all public pension funds was 8.5% in the 25 year period 1986 to 2011. The average for the state of Massachusetts’s pension funds has been 9.6% since 1986. Even the much maligned CalPERS (one of largest funds in county) posted a 8.38% average 20 year return. These returns are reported by the funds themselves, so perhaps it is healthy to be skeptical. Even sources outside the pension funds themselves support the 8%. The Standard and Poor’s Composite Index retuned 10.14% for the period 1926 to December 31, 2013. Even the Wall Street Journal recently reported that the 30 year annual return of a large bundle of stocks selected by Morningstar was 11.1%. The data is pretty conclusive that an 8% projected rate of return is more accurate than the 4% or less some are suggesting.
Forth, this is distracting us from the real issues and does nothing to fix the underlying problems with most municipal pension funds. The demise of a municipal pension fund in our state usually follows a simple, basic path: the municipality will contribute to the fund based upon an employee’s base salary, say $50,000; then, usually just before retirement, an enhancement is added (this can take the form of allowing overtime to be included, unused vacation pay, a ceremonial promotion, or any of a number of things) and these enhancements now increase the pension to say $80,000. It is the gap between the $50,000 pension the funding was predicated upon and the actual pension of $80,000 that produces the shortfall. This $30,000 may not sound like much, but it paid every year the person receives his or her pension; so $30,000 a year for 40 years is a $1.2 million shortfall in the fund for just one person!
The other problem starting to afflict more and more pension funds relates to mortality assumptions: retirees are simply living longer than the pension board had predicted. Every incident of pension distress I have seen here in Michigan came from one, or both, of these causes. I honestly cannot find one fund where distress was caused by investments not achieving an appropriate, long-term return on investments.
(If you know of any, please send me an email , because I have been looking and
still cannot find even one.)
This brings us the so-called Grand Bargain in Detroit and the desire by some to use almost $200 million in state money to bail-out Detroit. So why are they asking citizens from Grand Rapids, Plainwell, Graying and every other city and township in the state to contribute their hard earned tax dollars to Detroit? It seems all this money is going toward the two Detroit pension funds since Orr wants to lower the rate of return to around 6.5 % for each fund. As demonstrated earlier, all lowering this number does is increase the amount of money the taxpayers are forced to contribute. Another issue with the $200 million Orr wants state taxpayers to spend is that it is based on old valuations of the funds, valuations that likely do not reflect recent gains in the stock market. It seems rather plausible that is Orr used a rate of return based upon historical averages (closer to 8%) and applied to a more recent valuation, the $200 million in bail-out money would not even be needed.
In summary, there is no need to pay higher taxes to fix a problem that does not even seem to exist. Instead, we should focus on the true and proven problems in our pension system, such as pension spiking, and address those. This current fad of trying to manipulate the rate of return in pension funds for political reasons needs to go the way of other past fads such as popped collars on dress shirts.
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