The financial markets will not save you: the limited effect of investment returns on PSPRS' funding ratio

While we are on the subject of investment returns, I thought it would be interesting to see the effects past years' investment losses have on PSPRS' funding ratio.  The following is taken from PDF page number 23 of the 2014 PSPRS Consolidated Actuarial Valuation Report:

A. Beginning Year Funding Value	$ 5,905,509,127
D. Non-investment Cash Flow	$    (65,772,608)
E.Amount for Immediate Recognition	$    461,000,892
F1. FY14 (Just ended)	$    33,458,496
F2. FY13	$      9,542,555
F3. FY12	$  (72,234,304)
F4. FY11	$    40,557,028
F5. FY10	$      9,473,791
F6. FY09	$ (183,695,537)
F7. FY08	$ (118,855,348)
G1. End of Year Funding Value (Prelim)	$ 6,018,984,092
Total Accrued Liability	$12,233,016,817
Funding Ratio	49.20%

This shows how PSPRS calculates its funding ratio.  The funding ratio is calculated by dividing its funding value (a valuation of its investments as of June 30, 2014) by its total accrued liability (what it needs to pay all the benefits it owes to retirees and current workers).  Calculating the funding value is not as simple as reporting the market value of all its investments as of June 30. 2014.  PSPRS, like many pension systems, uses a smoothing period when recognizing investment gains and losses.  PSPRS uses a seven-year period, while other systems use longer or shorter smoothing periods.

The smoothing period lessens the effect of year-to-year fluctuations in market returns so that funding ratios and contributions do not dramatically change from year to year.  This is especially important to employers who have to budget for employee costs and do not want their contribution rates yoyoing up and down each year.  With the seven-year smoothing period that PSPRS uses, this means that only 1/7th of each gain or (loss) incurred over the last seven years is recognized in the current year's  funding ratio.  Lines F1-F7 represent 1/7th of the gains and (losses) of each of the past seven years above or below the 7.85% expected rate of return (ERR).  The $461 million in Line E represents the expected 7.85% return that PSPRS should have earned on its investments in fiscal year (FY) 2014, which ended June 30, 2014.  This amount is recognized immediately.  The $33,458,496 in Line F1 represents 1/7th of the amount over 7.85% that PSPRS earned in FY14.  This means, for funding purposes, any year that PSPRS does not achieve its ERR will show a loss.

Each year, the oldest year drops off and is replaced by the newest year.  Looking at the table we can see that the two oldest years, FY08 and FY09 covering the two-year period from July 1, 2007 to June 30, 2009, are responsible for gigantic losses to PSPRS.  Over $118 million in losses will fall out of next fiscal year's calculations, and over $183 million in losses will fall out when FY16 ends June 30, 2016.  Hopefully, these losses will be replaced by large gains, but regardless, it is unlikely that losses of such size recur unless we have another financial crisis of the magnitude of the Great Recession. The funding ratio should increase, and that is good news for all of us and our employers. A higher funding ratio will mean lower employer contribution rates and more money available in employers' budgets.

So how much will the funding ratio increase when these losses drop off?  It is impossible to predict what will happen this fiscal year, so the best we can do is simply change some of the amounts in Lines F1-F7. I tried several different scenarios.  The first scenario used was one where PSPRS had suffered no losses or gains in either FY08 or FY09.  This would mean that PSPRS earned exactly 7.85% each of those years.  Under this scenario the End of Year Funding Value (Line G1) would increase to $6,321,534,977.  Liabilities of $12,233,016,817 would remain the same in all scenarios, so the funding ratio would go from 49.20% to 51.68%, an increase of 2.47%.

In the second scenario, I made it so PSPRS suffered no losses or gains in FY08, FY09, and FY12 and earned exactly 7.85%.  Line G1 increased to $6,393,769,281 and the funding ratio improved to 52.27%, an increase of 3.06%.

In the third scenario, I made it so PSPRS, instead of suffering losses, actually gained the same amount each year in FY08 and FY09 as it did in FY14, $33,458,496.  Line G1 increased to $6,388,451,969, and the funding ratio increased to 52.22%, an increase of 3.02%.  The increase here is less than the second scenario since the gains plugged into FY08 and FY09 do not fully make up for the loss in FY12.

In the fourth, most optimistic scenario, I made it so PSPRS actually gained the same amount each year in FY08, FY09, and FY12 as it did in FY14.  Line G1 increased to $6,494,144,769, and the funding ratio improved to 53.09%, an increase of 3.88%. 

These numbers are very sobering.  The losses from FY08 and FY09 falling out of the seven-year smoothing period produce an immediate gain of almost 2.5% in the funding ratio.   That is great.  However, when we look at the most optimistic scenario where all the loss years were turned into years of gains similar to FY14, we only improve our funding ratio by another 1.4% above the initial 2.5% increase.  While I hope I am wrong about this, I think the the gains in FY14 are likely to be as high as PSPRS will ever earn in its current risk-adjusted portfolio.  This means that investment gains going forward will have limited effect on raising PSPRS' funding ratio in the near-term.