Don't worry; be happy
- Gretchen Tegeler is president of the Taxpayers Association of Central Iowa.
Since July 1, the news has been full of stories about the poor returns experienced by public pension plans for the fiscal year that ended June 30, 2016. The Iowa Public Employees Retirement System (IPERS) earned just over 2 percent, and the Iowa Municipal Fire and Police Retirement System (MFPRSI) netted less than one percent -- both far short of the 7.5 percent annual average assumed by the plans.
This is the second year in a row for poor pension returns, and once again the standard refrain from the public pension industry is to downplay the results and emphasize the results over the long term. (See: Des Moines Register: IPERS Fund Facing $5 Billion Shortfall - Misses Investment Goal.)
The plans are justified in keeping a long-term perspective, and wise to avoid over-reaction in any given year. Returns are going to be more volatile than they once were because a larger share of plan assets are invested in higher return/higher risk classes. For example, in 2013 the IPERS portfolio earned +15.88 percent! We can expect this volatility to continue.
While volatility creates its own problems (such as a higher risk of another funding crisis), there’s also the big question of whether the returns experienced over the long-term past are actually indicative of what to expect over the long-term (30-year) future. More and more the answer is “no.”
IPERS’ own investment manager, Wilshire, expects the next ten years to return an annual average of 6.27 percent, more than a full point below the assumed 7.5 percent.
According to a May 2016 McKinsey & Company report, “returns on equities and fixed-income investments in the United States and Western Europe over the next two decades could be considerably lower than they have been in the past 30 years.” The McKinsey report cites a variety of causes including aging populations in the developed world and China, and low interest rates and inflation.
Another expert, Alice Munnell from the Center for Retirement Research, said last month: “The consensus among industry officials is that returns will continue to be lower in the future due to a number of factors, including low bond rates and the stock market being at an all-time high.” (See: Washington Budget Finance - Should States Lower Estimates for Pension Investment Returns.)
It turns out the past 30 years have been extraordinary, and unlikely to be repeated.
Some systems have recently been lowered or begun to lower their return assumptions below 7.5 percent. The California Public Employment Retirement System (CALPERS) announced last year it would lower its 7.5 percent rate gradually to 6.5 percent. The Illinois Teachers Retirement System, in a state not known for its fiscal prudence, reduced its rate of return assumption from 7.5 percent to 7 percent, which will precipitate an increase in contributions.
What would happen if IPERS were to reduce its return assumption from 7.5 percent to 6.5 percent?
Payments to erase the shortfall would need to go up by about 50 percent, or rise from around $400 million per year statewide to more than $600 million per year for the next 25 years. Those are big numbers (and they only cover the debt payments, not the cost that accrues with each new year of service) -- more than enough to fund a statewide water cleanup program, for instance.
Few wish to change the return assumption, because it requires more public money at a time when we already struggle to fund priorities like education.
It would make it more painfully obvious that we simply cannot sustain these plans, and that we should be talking about a new structure for future employees.
Instead, the plans hang on to the current assumptions and keep shifting their assets into riskier classes that offer the possibility of higher returns. Of course they also carry the same possibility of larger losses. The public takes on more risk without even knowing about it!
If we wait, and it turns out that 6.5 percent would have been a better number -- or if there is another financial crisis that hits at a time when the plans are already vulnerable -- it will be even more difficult, if not impossible, to dig out later. Then everyone loses.