Back in February the Virginia Retirement System (VRS) and Gov. Bob McDonnell were disputing what rate of return to assume on the VRS’s $54 billion in assets –8% as McDonnell wanted, or 7%, as the more conservative VRS board preferred. By assuming that the VRS will make more money on its investments, the governor’s assumption of a higher return would allow the state to contribute less money to make up the gap between VRS assets and retirement liabilities.
I’m not sure how that discussion was resolved, but the issue needs to be revisited. One could argue that even the VRS’ conservative assumption was too generous. Recent news and analysis suggests that there are at least two reasons for doing so, and I would add a third.
Thank you, Helicopter Ben. Responding to the sluggish pace of economic growth, Federal Reserve Board Chair Ben Bernanke has indicated that the Fed may engage in another round of monetary stimulus, which means that the Fed will act to keep interest rates lower… for longer… than ever before. I’ll leave it to the pundits to debate whether or not the flood of dollars has kept the U.S. out of another depression. But one thing we can say for certain is that Fed policy has held down the borrowing costs of the world’s largest debtor, the U.S. government, which otherwise would be paying $100 billion or so more per year in interest payments than it is now. The flip side is that savers and creditors are making less money. Among the largest creditors in the country are Social Security and state, local and corporate pension funds.
Thanks to lower interest rates, Social Security earned only 4.4% on its $2.4 trillion portfolio of Treasury bonds in 2011, compared to 5.9% on a smaller portfolio ten years before. That’s one reason, among several, that the Social Security trust funds will run out out sooner than previously forecast. Meanwhile, writes Martin Hutchison with the Prudent Bear, the unfunded pension liability of the S&P 500 companies reached a record level of $355 billion in 2011, an increase of over $100 billion from the end of 2010 and $50 billion more than at the bottom of the 2008 bear market.
Finally, despite widespread actions by state legislatures to shore up their state-employee pensions, as reported by Reuters earlier this month, the average “funded” ratio — assets versus liabilities — for the 50 U.S. states had declined in 2010 to 73.7%, down from 75% in 2009. That represented an improvement from the previous year, which had seen a 7% decline. But down is still down. (Performance varied widely from state to state. Funding ratios varied from 45.4% in Illinois to 99.8% in Wisconsin.)
One rule for me, another rule for thee. The pension situation is actually worse than it looks, contends Andrew G. Biggs in “Public Sector Pensions: How Well Funded Are They Really?” writes Biggs:
The accounting rules followed by U.S. public sector pensions are more forgiving than those required for private sector pensions or public sector plans in other countries. So-called “fair market valuation” more fully reveals the value of public sector plan liabilities and shows that the average public employee pension plan in the United States is only around 41 percent funded while total unfunded liabilities as of 2011 are roughly $4.6 trillion.
The trick is how to account for risk. Once upon a time, pension funds invested primarily in lower-return, lower-risk bonds. Over time, to increase their returns, they have taken on more risk by investing in stocks, private equity and hedge funds. Those alternate investments may, in fact, generate a higher rate of return. But they also have a higher risk of loss. To insure against that risk is a cost that public U.S. pension funds aren’t taking into account. Both Canada and Great Britain accounting rules are stricter for government pensions. Writes Biggs:
The International Public Sector Accounting Standards Board … dictates that the discount rate should not incorporate a risk premium and should be based upon government bonds or high-quality corporate bonds, not, as U.S. public pensions do, the expected return on stocks, private equity or hedge funds.
For what it’s worth only 21% of the VRS’s portfolio is invested in fixed income. The rest is in a diversified portfolio of riskier assets.
Boomergeddon or Boomergeddon Lite, take your pick. We are not in normal times. There is enormous downside risk to all categories of investments, which are currently being held aloft by super-low interest rates and a general expectation that somehow we’ll manage to muddle through. As I have argued for two or more years now, the U.S. economy is spinning out of control. We may be experiencing crummy, sub-par growth, but with $1 trillion-a-year fiscal stimulus and zero-interest rate monetary stimulus, this is as good as it gets. We have jammed the pedal to the floor, and the ol’ jalopy can’t move any faster.
I hew to the school of thought that the U.S. political class will continual to defer the hard choices that must be made, that U.S. fiscal integrity will continue to erode slowly at first, and then, triggered by some external event, it will unravel with terrifying speed. Borrowers will stop buying federal debt, the government will be unable to sustain its spending, the Fed will become the T-bond buyer of last resort, flooding the economy with dollars, the dollar will collapse and runaway inflation will ensue. The unlikely, best-case alternative is that Congress finds a fiscal spine and actually brings the fiscal gap under control by means of spending cuts and/or higher taxes. In either case, the effect will cripple economic growth. Whichever scenario you choose, the outcome is highly bearish for pension fund investments (and everyone else’s).
Bacon’s bottom line: Virginia’s pension-funding issues are far from over. We have patched them up for now, but the fundamentals continue to deteriorate. The United States has entered an age of austerity, and we had better get used to it. Making unrealistic assumptions about future returns on the VRS portfolio may ease Virginia’s fiscal pressures today, but will wreak a terrible vengeance when those assumptions prove to be unfounded and the commonwealth is legally committed to meet its pension obligations.