VRS portfolio allocation, Sept. 30, 2011. (Click graphic for more legible image.)
by James A. Bacon
A debate is brewing in Richmond over how much money the Commonwealth of Virginia and local governments should contribute to the Virginia Retirement System, and a key issue revolves around which actuarial assumption to make regarding future VRS financial performance.
According to Times-Dispatch writer Michael Martz, Gov. Bob McDonnell and his allies in the General Assembly want to assume a higher average rate of return — 8% annually over the next 30 years — while the VRS board, chastened after suffering steep market losses during the recession, would prefer to assume a modest 7% rate of return. Assuming that the VRS will make more money on its $52 billion portfolio allows the McDonnell camp to reduce state payments into the retirement fund.
Muddying the waters of the debate is the bizarre fact that local governments are using VRS’s actuarial assumption, not the state’s. Del. S. Chris Jones, R-Suffolk, chairman of the Appropriations subcommittee on compensation and retirement, not illogically says that the state and localities should make payments based on the same rate. But his solution is to propose that the VRS assume an 8% return for purposes of calculating what localities should pay.
Needless to say, none of this inspires confidence in the General Assembly. Indeed, it gives credence to fellow blogger Don Rippert’s characterization of the legislature as a “clown show” and the root of all ills in Virginia. In this instance, I would be hard pressed to disagree with him.
The VRS, which eats, drinks and breathes investing every day and has a fiduciary responsibility to its beneficiaries, is a better judge of what the retirement system is likely to earn than is an elected official like Jones, whose professional background, by the way, is pharmacy. The VRS has even more reason to assume a lower return on investment in light of the Federal Reserve Board’s recent pronunciamento that it intends to pursue a zero interest-rate policy for the next three years.
The pie chart above shows the asset allocation in VRS’ portfolio. Please note: 21% of the entire portfolio consists of fixed income assets. For the next three years, the yield on short-term fixed-income Treasury assets will be about 0.5% while the yield on longer-term assets could range from 2% to 3%. Admittedly, those rates may apply for only three years, if the Fed sticks to its guns. But that exposure will make it significantly more difficult — not impossible, but difficult, and imprudent to assume otherwise — for the VRS to goose its returns. A 7% return on investment seems appropriate to me.
It’s possible that bond yields will rise after the Fed’s pronounced three-year time horizon, allowing the VRS to generate higher returns from its fixed-income investments in later years. But that poses a new problem. Stock prices vary inversely with bond yields. If bond yields go up, they become more attractive by comparison to stocks; money flows out of stocks into bonds, thus depressing stock prices. Many other factors affect stock prices, of course, such as earnings and expectations of future economic conditions, but bond yields are an important influence. As it happens, bond yields stand near historic lows. If they rise, as they likely will once the Fed steps out of the way, stock prices will face a steep uphill climb. What the VRS gains from higher bond yields, it could lose from depressed returns on stocks and other investments.
Right now, the U.S. economy is benefiting from fiscal stimulus in excess of $1 trillion a year plus monetary stimulus of near-zero interest rates. That extraordinary intervention is propping up the performance of everything in the VRS portfolio…. for now. But stimulus of that magnitude is not long sustainable. The VRS is acting prudently to assume a lower rate of return — better safe than sorry — while McDonnell and Jones, recoiling from the political pain of making harsh budget decisions, are acting imprudently.
I agree with James L. Stegmaier, Chesterfield county administrator, who opposes using the higher investment return. “I don’t consider it saving money,” he told Martz. “I consider it borrowing money that you’re going to have to pay back one day.”
If Virginia is to survive the fiscal storm to come, we need to bullet-proof our finances. That means no gimmicks, no short cuts, no sleights of hand.
