US Pensions Abandoning 8% Pipe Dreams?

Robert Steyer of Pensions & Investments reports that US public pension funds are abandoning their 8% dreams:

When it comes to public pension plans' assumed rates of return, what is rare today was quite common less than 10 years ago.

Only three (correction: it's six) of 129 public plans tracked by the National Association of State Retirement Administrators have assumed rates of return at 8%.

In 2010, by contrast, 59 plans had assumed rates of return of 8% and another 30 had rates higher than 8%, said Alex Brown, NASRA's research director. As recently as 2015, NASRA reported that 24 plans had rates of 8% and four had rates exceeding 8%.

A common theme for reducing the assumed rates of return has been the low-interest-rate environment, said Mr. Brown, referring to a February 2019 NASRA report that analyzed trends for assumed rates of return.

"The sustained period of low interest rates since 2009 has caused many public pen- sion plans to re-evaluate their long-term expected returns, leading to an unprecedented number of reductions in plan investment return assumptions," the report said.

From February 2018 to February 2019, the report said 42 plans, or 33% in the NASRA database, reduced their return assumptions. Ninety percent have done so since 2010.

Among the plans tracked by NASRA, the median assumed rate dropped to 7.25% this year from 8% in 2010 and 7.5% in 2015.

"There's wide variations but there is a fair amount of clustering" among return assumptions in the NASRA database, Mr. Brown said. Three-fourths of the state plans have rates ranging from 7% to 7.5%.

8 is enough

The Ohio Police & Fire Pension Fund, Columbus, has had its 8% return rate assumption since Jan. 1, 2017, down from 8.25%. The change "was made as a part of a regularly scheduled five-year review of all actuarial assumptions," David Graham, the $15.5 billion fund's communications director, wrote in an email.

"In the review that resulted in our moving to an 8% assumed rate, our independent actuary and investment consultant agreed that over a 30-year period we would have a slightly better than 50% chance of meeting that return," Mr. Graham wrote.

"While returns in the short term (10 years) may be expected to be lower, the 30-year look provided a better probability," Mr. Graham added. "Our next study of assumptions will be in 2021 and we will take these findings into consideration when discussing a potential change at that time."

The pension fund had a funded status on an actuarial basis of 69.9% as of Jan. 1, 2018.

"We continue to meet the state of Ohio's requirement that all unfunded liabilities be paid within a 30-year time frame," Mr. Graham wrote. "We are currently at 28 years."

For the fiscal year ended Dec. 31, 2018, the pension fund had a net return of -2.4%, which was better than the benchmark of -2.67%.

Three-year annualized returns of 7.16% topped the benchmark of 6.83%. Five-year annualized returns of 5.53% exceeded the benchmark of 4.98%. Ten-year annualized returns of 9.54% outpaced the benchmark of 8.89%.

Reasons for 8%

Texas County & District Retirement System, Austin, has chosen an 8% rate for several reasons, such as investment style, said Kathy Thrift, chief customer officer, in an email.

"When compared to the average public pension plan, our asset mix is very different," Ms. Thrift wrote. "The major difference in our portfolio is that we have a very small percentage — 3% — allocated to investment-grade bonds."

She added that the pension system "has used other asset classes with better return characteristics to offset risk in the portfolio," including hedge funds and strategic credit.

Emphasizing that 8% "is a long-term target," Ms. Thrift wrote that market volatility means the pension system won't hit 8% every year.

The system "has other measures in place to manage risk, including a $1 billion reserve fund — as of Dec. 31, 2018 — that may be used to offset future adverse experience," she explained.

The retirement system's board "in good years," can "set aside earnings rather than pass them through to the individual employer plans," she explained. "The reserves are invested with the plan assets. This tool has helped us keep employer rates stable over time."

The $31.9 billion retirement system completed its most recent review in December 2017 to assess its economic and demographic assumptions.

"Two independent outside actuarial firms both concurred that the investment return assumption is reasonable," Ms. Thrift wrote. "We conduct a full review of our assumptions every four years."

Ms. Thrift illustrated the system's long-term investment strategy by noting that members work an average of 18 years and are retired for 20 years or more. The 30-year return is 8% and the benchmark is 6.9% as of the fiscal year ended Dec. 31.

"Every year, we update our capital market assumptions, which are forward-looking expectations of the return, risk and correlation of each of our asset classes," she wrote.

"We then model a portfolio targeted to meet our long-term expected return goal with an acceptable level of risk," she added. "If we do not think our portfolio can be constructed to achieve our goal with an acceptable level of risk, we will adjust our expectations."

The system has a funded status of 88.5% on an actuarial value basis, or 91% when reserves are included, as of Dec. 31.

The return, net of fees, for the fiscal year ended Dec. 31 was -1.86%, but still better than the benchmark of -3.31%. The three-year annualized return was 6.57%, topping the benchmark of 6.16%. The five-year annualized return of 5.13% surpassed the benchmark of 4.1%. The 10-year annualized return was 9.02%, exceeding the benchmark of 8.06%.

The other plan in the NASRA database with an 8% assumed rate of return is the Arkansas State Highway Employees' Retirement System, Little Rock. The plan had $1.5 billion in assets and a funding ratio of 83.51% as of June 30, 2018, according to the latest actuarial valuation report

Additional details were not available. Robyn Smith, executive director, didn't respond to requests for information.

‘Unrealistically high'

The latest plan to leave the 8% club is the Connecticut Teachers' Retirement Fund, Hartford. Thanks to a law signed in late June by Gov. Ned Lamont, the plan's assumed rate dropped to 6.9% effective July 1, the beginning of its fiscal year, as part of a major restructuring.

"Eight percent was unrealistically high," Shawn T. Wooden, the state treasurer, said in an interview. He is the principal fiduciary of the $36 billion Connecticut Retirement Plans & Trust Funds, Hartford, of which the teachers' pension fund is the largest component at $18.4 billion as of June 30.

The lower assumed rate and the restructuring "will move the plan to something that is more realistic and sustainable," Mr. Wooden said. "We will move the fund on a long-term path to fiscal responsibility. Inflated assumptions distort unfunded liabilities."

The restructuring includes a special capital reserve fund "to serve as adequate provision for bondholders, to meet the requirements of the bond covenant, which allowed for the re-amortization of the Teachers' Retirement unfunded pension liability over 30 years," said an email from the treasurer's office.

The teacher's retirement fund had a funded ratio of 51.7% on an actuarial valuation basis as of June 30, 2018.

For the fiscal year ended June 30, 2019, the pension fund had a net return of 5.85% vs. a benchmark of 6.84%.

Annualized returns over three years were 9.03%, just below the 9.23% benchmark. The annualized five-year return of 5.96% lagged the benchmark of 6.09%. The 10-year annualized return of 8.84% trailed the benchmark of 9.01%.

Alaska Public Employees' Retirement System, with $16.9 billion in defined benefit assets, and the Teachers' Retirement System, with $8.3 billion in defined benefit assets, both cut their assumed rates of return this year to 7.38% from 8%. Both are managed by the Alaska Retirement Management Board, Juneau.

The board and its actuaries "review actuarial assumptions annually and the investment return assumption was reduced to 7.38% in 2019 to reflect lower prospective investment returns," Stephanie Alexander, the board's liaison officer, wrote in an email.

The board approved the rate change on Jan. 11.

The board "has adopted an asset allocation consistent with this long-term return assumption," she said.

For the 12 months ended March 31, the public employees' pension system had a net return of 5.25%. Three-year annualized returns were 9.34% and five-year annualized returns were 6.58%, according to the website of the Alaska Retirement Management Board, which uses the new 7.38% assumed rate of return as a comparison. The Alaska Public Employees' Retirement System had a funding ratio of 64.6% on an actuarial valuation basis as of June 30, 2018, according to a June 2019 report to the trustees of the Alaska Retirement Management Board.

The teachers' pension fund had the same returns over the same three periods using the same assumed rate as a benchmark. It had a funding ratio of 76.2% on an actuarial basis as of June 30, 2018, the report to the trustees said.

You can read the February 2019 NASRA report that analyzed trends for assumed rates of return here.

As shown in figure 5 below, 6 of 129 public plans tracked by the National Association of State Retirement Administrators have assumed rates of return at 8%:

Those six pension funds are listed in Appendix A of this report and they are: Alaska PERS, Alaska Teachers, Arkansas State Highway ERS, Connecticut Teachers, Ohio Police & Fire and Texas Country & District.

The majority of US public pensions tracked by NASRA assume anywhere between 7% and 7.5% assumed rate of return, which is still too high.

Interestingly, the lowest assumed rate of return was at Kentucky ERS -- 5.25% -- where the footnote reads: "The Kentucky ERS is composed of two plans: Hazardous and Non-Hazardous. The rate shown applies to the plan’s Non-Hazardous plan, which accounts for more than 90 percent of the Kentucky ERS plan liabilities. The investment return assumption used for the Hazardous plan is 6.25 percent." (see details here, keep in mind, Kentucky had one of the worst funded state pensions before reforms were introduced)

Back in May, I discussed the coming US pension crisis where I noted:

The discount rate US public pensions are using is still too high but states are reluctant to lower it for the simple reason that to do so would require increasing the contribution rate and possibly other politically unpalatable measures.

In Canada, large public pensions are using much lower discount rates and even though many are fully funded, they're still lowering their discount rate further to build a reserve cushion (eg., CAAT Pension Plan, OMERS, OPTrust, OTPP, and HOOPP).

There are other structural flaws impeding many US public pensions which Canada's large public pensions have addressed by adopting good governance and a shared risk model.

Good governance means pensions can pay their employees very competitively to manage more assets internally, lowering the overall fees while delivering strong long-term returns. Shared risk means the cost of the plan is shared more equitably among employers and employees so in the case of a deficit, they can increase contributions, lower benefits (typically through conditional inflation protection), or both until the plan's fully funded status is restored.

The problem is most US public pensions haven't adopted either of these measures which explains why they're in such a dire situation. The ones that have, like Wisconsin, are doing well and will survive the coming pension crisis.

Unfortunately, when the next crisis rolls around, many chronically underfunded US public pensions will be hit so hard that politicians will be forced to take very difficult decisions to keep these plans afloat.

You should also read a comment I posted at the start of the year, Are US Public Pensions Cooked?

It's a bit of a running gag in the pension industry that the assumed rates of return US public pensions use are still way too high.

Go back to read my recent comment on revisiting the DB pension plan model failure where Wayne Kozun, a former SVP at OTPP who is now CIO of Forthlane Partners, shared this with me:

For some reason Malcolm has had a "hate" on for DB pensions for a long time, which is strange since they fed him for many years.

I don't necessarily disagree with him about using government bond rates to discount pensions. It does seem silly that you can increase the discount rate used, and thereby decrease the pension liability, by changing your asset mix to a more aggressive mix.

But I don't think this is a huge issue in Canada as the pension plans tend to be rather conservative in their discount rates. This data is a couple of years old but I collected data on plans and here is what they were using for discount rates - OTPP 4.8%, HOOPP 5.5%, OMERS 6%, OP Trust 5.15%, CAAT 5.6%, OPB 5.95%, U of T 5.75%

The real issue is in the US. Remember how in Dec 2016 CalPERS voted to lower their discount rate from 7.5% to 7% over three years. 7% is still WAY too high, but this caused a huge outcry from California city governments, etc, as it increased their pension contributions. Using this discount rate CalPERS is about 70% funded - which is a very deep hole. Change their discount rate to something more realistic, say 5%, and the funded status would likely be 50%. (If you assume that assets are 70 and liabilities are 100 and if the discount rate drops by 2% with a liability duration of 20 then liabilities go up to 140 - hence 50% funded.) There is no way that you get from 50% funded to fully funded unless you have 10%+ returns for a decade or more, lots of inflation (and no indexing on liabilities) or you break the pension promise.

I replied:

Thanks Wayne, I agree, the real issue is the US where chronically underfunded plans are one crisis away from insolvency. I do take issue with Malcolm’s insistence on using the government bond yield to discount liabilities, I think it’s silly to treat federally or provincially backed pensions and treat them like private corporations. Anyway, as you state, Canadian plans use very conservative discount rates.

For US public pensions, it’s actually worse than you think especially after a year like 2019 where the pension world is reeling from the plunge in global rates:

The collapse in global bond yields is the biggest story of the year when it comes to pensions.

Repeat after me: Pensions are all about matching assets with liabilities. Period. It's not about who has the highest returns, it's all about the funded status.

And since pension liabilities are long dated (going out 75+ years), their duration is bigger than the duration of pension assets.

This is why I keep harping on how plunging yields wreak havoc on pensions, because they disproportionately impact pension liabilities and swamp any gains from pension assets.

The real pension storm is a 2008 type of crisis when yields collapse and pension assets get clobbered concurrently, a double-whammy for global pensions.

But here is the real kicker, something Jim Leech, OTPP's former CEO and co-author of The Third Rail, once told me: "The starting point matters a lot...pension deficits are path dependent."

Why am I bringing this up? Because, to put it bluntly, while fully funded Canadian public pensions won't escape the next crisis, many chronically underfunded US public pensions falling short of their return expectations this year simply can't afford another 2008 crisis, it will eviscerate them. At that point, one of two things will happen:

1. Benefits will need to be cut which is constitutionally illegal or
2. The contribution rate will need to be hiked which will be met with resistance from public-sector unions and cash-strapped state and local governments who will be forced to emit more pension bonds and hike real estate taxes to meet their pension payments (that's not a long-term solution). 

This is why when I wrote my comment on deflation headed to America a couple of years ago, among the seven structural factors that led me to believe we are headed for a prolonged period of debt deflation was the global pension crisis:

1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.

These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and prepare for global deflation.

Now, we can argue whether rates are "unreasonably low" right now as the issue of negative global sovereign bond issues hit a record, but it's clear that America's pensions are falling short of their projected returns, and the biggest reason why is those projected returns are still unrealistically too high.

The 10-Year US Treasury note yield is hovering around 1.6% right now. Pensions are increasingly allocating to illiquid "alternatives" to make their projected return targets but just like stocks, that carries risks.

Over the long run, this may work but again, pension deficits are path dependent, the starting point matters a lot and most US public pensions are not able to withstand another major crisis without falling deeper into the red, passing the point of no return for their funded status (below 50% and 40%).

Lastly, eight years ago, I asked "What if 8% is really 0%?" and noted:

"...the majority of pension funds are hoping -- nay, praying -- that we won't ever see another 2008 for another 100 years. The Fed is doing everything it can to reflate risks assets and introduce inflation into the global economic system. Pension funds are also pumping billions into risks assets, but as Leo de Bever said, this is sowing the seeds of the next financial crisis, and when the music stops, watch out below. Pensions will get decimated. That's why the Fed will keep pumping billions into the financial system. Let's pray it works or else the road to serfdom lies straight ahead. In fact, I think we're already there."

Alright, we escaped another major pension crisis back then, but the music will eventually stop and we won't be so lucky in perpetuity.

So, for all you NASRA members smoking hopium, it's time for a reality check, lower your assumed rate of return to 6% or lower and let the unions and state governments holler all they want, you won't have much of choice. The choice is stark: Pain now or a lot more pain later!

Below, Chris Ailman, chief investment officer at CalSTRS, discusses his investment strategy as he targets a seven percent return. He speaks on "Bloomberg Markets: The Open."

Ailman is very sensible and argues that 7% is realistic over the next 30 years (it all depends on whether deflation is headed to America). Also, listen to his comments on holding private equity longer term. Very interesting, argues in favor of the BlackRock model pioneered by two Canucks.

Update: Malcolm Hamilton sent me an email to clarify something:

In today's blog entry there are a number of criticisms of my alleged view that public sector pension plans should be funded using government bond interest rates to discount liabilities. Let me remind you that these are bogus criticisms leveled by critics who struggle to distinguish pension accounting from pension funding. Specifically I wrote, and you circulated, the following:

"Risk assets over 30 years will pay you a return with near certainty..."

"Large DB pension plan funds invested on a long term basis in a properly diversified portfolio should not hesitate using 6% as the assumed average long term yield. Low interest rates normally play a very small role in such diversified funds."

"The question you are trying to answer is “how much money do we need to set aside to meet the obligation given a reasonable set of assumptions?” If you use any discount rate other than the best estimate of future returns on the portfolio you are going to overfund or underfund the obligation which brings up a whole series of intergenerational fairness issues."

"But I don't think this is a huge issue in Canada as the pension plans tend to be rather conservative in their discount rates. This data is a couple of years old but I collected data on plans and here is what they were using for discount rates - OTPP 4.8%, HOOPP 5.5%, OMERS 6%, OP Trust 5.6%, CAAT 5.6%, OPB 5.95%, U of T 5.75%"

These might be important points if I was advocating the use of government bond interest rates to fund public sector pension plans. I am not now, nor have I ever, advocated this. I have criticized public sector employers for the way they account for the cost of pensions. I have criticized public sector employers for the way they price pensions as an element of employee compensation. I have criticized the injustice of giving public employees 100% of the risk premium when the public, not the plan members, bears most of the risk. I have, on occasion, criticized plans for ignoring the heroic reduction in interest rates during the last 15 years in setting their return expectations, but I suggested only that they lower their expectations, not that they adopt government bond rates.

The following quotation comes from the introduction to the report Philip Cross and I wrote for the Fraser Institute last year.

 "Canada’s public sector DB plans have done a superb job for their members. The plans are capably and efficiently administered by boards operating at arm’s length from government. These boards faithfully represent the interests of plan members. They collect contributions, maintain records, pay pensions, and manage investments. Their practices, as described in the World Bank study, are exemplary.

Canada’s public sector DB plans deliver extraordinary pensions at an affordable price. They are well funded. Their investments perform well relative to other pension plans and relative to the benchmarks they set for themselves. They operate efficiently by exploiting economies of scale. Most importantly, they enjoy the confidence and support of their members."

Our criticism is the use of a discount rate equal to the expected return on assets to put a price on the pensions that employees earn as part of their compensation. Using this discount rate, as opposed to the yield on long term government bonds, cuts the estimated cost of the pension in half. By so doing, it distributes 100% of the expected reward for risk taking to members who bear at most half, and in some instances none, of the risk. I thank Wayne, Michael, Bernard, Jim and Leo for their comments. They are welcome to their views of how one should fund public sector pension plans and how one should estimate the future returns on a pension fund. These things have nothing to do with my criticism of public sector pension plans.

Let me repeat my criticism as it relates to the most egregious abuser, the federal government. The pension fund managed by the PSPIB is not a trust fund. The plan members have no right to the assets in, or the returns on, the pension fund. The pensions are not paid from the pension fund. Basically, it is public money set aside in a "shoe box". The directors have a statutory duty to represent the interests of plan members in setting investment policy but the benefits owed to plan members are not influenced in any way by the performance of the pension fund. The benefits are a statutory obligation of the federal government. What then is the purpose of the pension fund? It is to allow the federal government to cut the reported cost of the pension plan in half by giving the chief actuary an excuse for using a 6% (4% real) interest rate, which he or she does. The reduced "price" helps only members, who are paid more and contribute less. Consequently the reward for risk taking goes to the members while the public bears the risk. Perhaps someone could comment on this.

I thank Malcolm for clarifying his position and you can see my comments on the dirty secret behind Canada's pensions and more on Canada's dirty pension secret for more details.

Bernard Dussault, Canada's former Chief Actuary, had this to say on Malcolm's comment above:

I agree only partially with Malcolm’s view above (last paragraph) in respect of the federal public service DB pension plan (FPSPP).  That is, I agree only in respect of the pre-April 2000 FPSPP accruing pensions because they are financed on a pay-as-you-go basis backed by notional federal bonds. Besides, the members-related contributions were actually paid for real through salary deductions, but were directed to the Consolidated Revenue Fund account (CRFA) and not used explicitly for pension expenditures purposes.

Unfortunately, nothing can be done to address this issue other than the proper continuation of the cash payments from the CRFA of the related individual monthly pensions when they become due up until the death of the last survivor of the concerned public servants and eligible surviving spouses. On the other hand, the post-March 2000 FPSPP is actually financed on a real fully funded actuarial basis. And the associated pension fund managed by the PSPIB is a real fund actually invested in the private markets. And the portion of any individual pension having accrued after March 31, 2000 is really and actually paid form the PSPIB fund. 

I thank Bernard for sharing this with my readers.