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Friday, February 12, 2016

The big question looming over PSPRS reform : What will the expected rate of return be in the future?

They say the devil is the details, so let us look at a detail of the PSPRS reform proposal that may not be getting enough attention.  If you watched the video presentation by the union representatives or read the Reason Foundation Powerpoint, you see a point made about PSPRS’ expected rate of return (ERR).  While most discussion has, understandably, been about specific changes that affect us individually, we would be remiss if we did not point out how the ERR has and will continue to have an outsized effect on all of us.

The ERR is what PSPRS assumes (or expects) it will earn on its investments, and it is sometimes referred to as the assumed rate of return.  There are many factors that actuaries must use to calculate normal costs and unfunded accrued actuarial liabilities, such as wage inflation, mortality rates, membership, and ERR.  Of all these, ERR is probably the easiest for laypeople like us to understand since we can relate to it in our daily lives.  If we go to the ever-useful Bankrate.com and use their savings goal calculator, we can illustrate this quite easily.  If we set a goal of a half million dollars in savings after 25 years at an ERR of 5.0%, compounded monthly, we would have to save about $840 per month for that 25 years.  If we keep everything else the same but change the interest rate to 7.5%, compounded monthly, we would only have to save about $570 per month for 25 years.  Even raising the interest rate 0.25% to 5.25%, would mean that you would drop the monthly savings amount $31 from $840 to $809, which saves $9,300 over 25 years.  If this additional $32 per month was invested at the 5.25% rate, you would have $519,000 saved up instead of $500,000.

So we can see how important the ERR is for the pension.  The lower your ERR, the higher your contributions will have to be, and vice-versa.  Using the same figures from the last paragraph, returning only 5.0% on your savings when your ERR was 7.5% will leave you about $160,000 short of your half million dollar goal because your monthly contribution rate was too low.  You contributed for the 7.5% ERR but earned at the actual rate of 5.0%.  This is PSPRS’ problem.  Employer and employee contribution rates were based for many years on an ERR they failed to actually earn, and like our examples, this produced a shortage.  However, unlike our examples, this is not a saver who just failed to reach a goal.  PSPRS was accruing a liability to its members and had to earn that money.  We also should remember that, not too long ago, PSPRS’ ERR was all the way up to 9.0%.  It has been dropping over the past few years, and currently stands at 7.5%.

PSPRS has changed its investment policy to be more risk-averse, and consequently will be unlikely to earn 7.5%.  The past two fiscal years PSPRS earned 55-60% of the Russell 3000, so in order to earn 7.5% the Russell 3000 would need to earn 12.5-13.6%, which would be very difficult to do over a long period if PSPRS stays with its current investment strategy.  The Russell 3000 would need to earn 8.0-9.33% in order for PSPRS to earn 5.0%, which would still be difficult but much more realistic under the current strategy.

The operating principle that is supposed to be used with ERR’s is that your ERR is supposed to reflect the likelihood of paying off the debt.  If you are buying a junk bond that has a high chance of default, you should expect a high rate of return.  If you are investing for a public pension, which theoretically is an “undiminishable” and “unimpairable” obligation, you should have a rate that is as close to risk-free as possible.  Public pension obligations must be paid under any circumstances, and whatever you invest in should have as close to a guaranteed return as possible.  The risk-free rate has traditionally been the rate on some type of US Treasury bill.

So if PSPRS’ ERR is too high, what should it be?  4%, 5%, 6%?  Regardless, any lowering of the ERR will have major consequences, yet there seems to be no guidance as to what the ERR will be in the future.  When PSPRS dropped its ERR 0.35% from 7.85% to 7.5%, it raised the aggregate employer contribution rate 3%.  What would a decrease of 2.5% do?  This is why it is so important to know what the ERR will be in the near future.  A drop in the ERR will increase the unfunded liability for Tiers 1, 2a, and 2b overnight and will burden employers with even more costs since PSPRS members in these tiers have a fixed contribution rate. 

For Tier 3 members, this will have an even bigger effect on them since they have to split normal costs 50/50 with employers.  If normal costs go up 3%, Tier 3 members will have to pay an additional 1.5% out of their paychecks into PSPRS.  This is why we should all be asking what ERR was used to get the 18% normal cost for Tier 3 members.  In the video presentation, Bryan Jeffries and Will Buvidas gave this as the projected normal cost rate, meaning employees would have to only pay a 9% contribution rate.  If the 7.5% ERR was used, this is an inaccurate rate if PSPRS is planning to move to a lower ERR in the near future, which they almost certainly will have to do since PSPRS cannot earn 7.5% with its current investment strategy.

Furthermore, as we mentioned earlier, lowering the ERR will increase the unfunded liabilities on the other three tiers.  This increased unfunded liability will have to be paid by employers, who will have to find the funds in their already overstretched budgets.  Where do we think these funds will come from?  Even worse for Tier 3 members, this unfunded liability will likely take decades to pay down, so long after most Tier 1 and 2a members are retired, Tier 3 members will still feel the effects of that unfunded liability, a legacy from one generation to another, a gift that will keep on taking.

The only potential good news for Tier 3 members would be an increase in inflation.  PSPRS is a debtor to all its members, and debtors like inflation.  An increase in inflation would mean an increase in the risk-free rate with a corresponding increase in returns on all of PSPRS’ riskier investments.  PSPRS could actually earn more than its ERR without taking on additional risk.  Tier 3 members would see their contribution rates go down as PSPRS earned more and, if their union locals are on the ball, wage increases to keep up with inflation.  PSPRS’ improving finances would also lower its unfunded liability and decrease costs to employers still paying off legacy debt incurred from other tiers.  This would be in addition to a decreased employer contribution rate, which might make employers more amenable to paying raises to their employees.

As we discussed in the last post, retirees will find no benefits in inflation.  They will be stuck with a fixed COLA rate as the dollars they are paid can buy less each year and their standard of living slides.  Raising the COLA will be difficult since it will require another voter referendum to change it.  However, who do you think will be in charge of the firefighter and law enforcement unions then, as retirees go hat in hand to ask them for help.  Hopefully, Tier 3 members will be in a forgiving mood if that day ever comes.

As in so many cases with PSPRS, we see incentives misaligned.  We have retirees competing with active workers competing with people who aren’t even on the job yet.  If an independent board with retiree representation could determine COLA’s on a yearly basis, this might be avoided.  When Inflation reduced the unfunded liability of retired tiers, it could free up funding for higher COLA’s, while still allowing active Tier 3 members to benefit.  Everyone pulling in the same direction for the betterment of all, what a concept!  This almost sounds like something a—what is the word I’m thinking of—oh yeah, a UNION should do.

1 comment:

  1. Check this out: http://www.counterpunch.org/2016/04/01/81260/


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