Posted by Jeffrey Brown on May 3, 2010
Filed Under (Retirement Policy, Uncategorized)
My good friend Douglas Elliott, who is now a Fellow at the Brookings Institution, just issued a new paper “The Financial Crisis’ Effects on the Alternatives for Public Pensions.” The paper is yet one more in a growing chorus of voices pointing out the significant fiscal woes facing our state and local pensions in the U.S. And, as I have pointed out before, Illinois is the poster-child for everything that is wrong with the funding status of our public pensions.
After reviewing the net losses on pension assets, Doug makes the following simple but astute observation:
“The situation is even worse than those figures show on the surface, because pension funds are essentially walking on a treadmill. They need to earn an expected return each year in order to stay standing in place, since the value in today’s dollars of the pensions they have promised to pay goes up each year as those payouts come closer in time. The situation is analogous to inflation. The public pension funds may have lost 15% over two years on a “nominal” basis, but, if their target return was 8% a year , they lost 31% compared to their targeted level of investment value, excluding the effects of contributions and pension payments.”
I have previously noted in this blog that the Government Accounting Standards Board (GASB) allows public pensions to discount future liabilities using the expected return on plan assets. This approach has no basis whatsoever in financial market theory – indeed, I have yet to meet anyone with a PhD in economics or finance who believes such an approach is correct or sensible. Actuaries and plan administrators often defend it, but when you dig below the surface, their defense is often rooted in the political or P.R. ramifications of reporting the true nature of the liabilities, rather than in any good economic reasoning.
Let’s bring this home to Illinois. Specifically, let’s bring this home to the State Universities Retirement System, or SURS.
According to the SURS Investment Update (see page 3 here), the average annual return on the SURS Total Fund over the 10 years ending February 2010 was dismal 3.4%. But SURS, in accordance with GASB, uses an expected return on assets that is more than double this amount. Even worse, SURS credits participants in the old Money Purchase option with an investment return that is far greater than this. Doing so amounts to an implicit transfer from Illinois taxpayers to Illinois pensioners that is above-and-beyond the standard pension formula.
As we discuss pension reform in Illinois and other states, here are three related points that are worth considering:
- We should start with truth in accounting. Stop hiding behind high discount rates and let’s at least define the size of the problem honestly. A starting point would be disclosing the size of the public pension liabilities discounted using something more akin to a risk-free rate. (See here for discussion).
- Let’s stop pretending that we can achieve higher returns without taking on higher risk.
- Let’s stop making irrevocable transfers from taxpayers to pension participants on the basis of “average” or “expected” returns. In SURS, that means bringing the Effective Rate of Interest way, way down from historical levels.