Fully Funded? Not Even Close

stock prices2by James A. Bacon

Earlier this month the Virginia Retirement System (VRS) announced that it had generated a 15.7% return on its investment portfolio over the previous year, bringing its total assets to $66.1 billion. It’s always good news when the pension fund for 600,000 state and local employees and retirees goes up, not down. That’s money that state and local governments won’t have to extract from taxpayers.

But pension-fund investing is a game for the long haul, and Jeff Schapiro raises interesting questions in his column in the Times-Dispatch today. Did a decision after the 2007 stock market crash to shift some assets away from stocks and bonds into “alternative” investments like hedge funds leave more than $6 billion on the table?

Schapiro quotes Ed Burton, a former VRS chairman, who criticized the investment strategy, which had the effect of moving from a portfolio of 70% stocks/30% bonds to a more complex scheme equivalent to 65% stocks/35% bonds. As a consequence, the VRS benefited less from the Obama-era bull market in stocks than it could have. It also paid millions of dollars in higher fees charged by hedge fund managers.

While the VRS had a strong year last year, over the past three years its returns have averaged a more modest 8.6%.

Investment strategy can can be argued back and forth forever without ever resolving anything. Maybe the VRS board made the right decision, maybe it didn’t. But there’s a bigger issue that Virginians need to be thinking about. Markets go up and markets go down. For the past few years, aided by an expansionist Federal Reserve Board policy, markets have gone up. Perhaps stocks and bonds will depart from 300 years of history and never go down again. But a prudent man wouldn’t bet on it.

The VRS assumes that it can generate annualized investment returns of 7% for years to come. That assumption is actually more conservative than the investment returns assumed by many states, so the VRS board deserves credit for that. But the Commonwealth of Virginia’s assertion that the VRS will be “fully funded” by the 2018-2020 biennial budget is exceedingly fragile. For starters, the state’s definition of “fully funded” is 80% or more of what the actuaries say is needed to meet pension obligations, as Erik Johnston, director of government affairs at the Virginia Association of Counties, pointed out Monday at the annual conference of the Virginia Chapter of the American Planning Association.

I wonder if the bank would be happy with 80% of my mortgage payment?

The other question is what happens when the Federal Reserve Board reverses years of monetary stimulus, as it has indicated it will do. Everyone agrees that interest rates will go up. But nobody knows how much. That will depend in part upon the strength of the economy — stronger growth will drive up demand for credit and push interest rates higher.

When interest rates go up, the market value of bonds go down. The 30-year bull market in bonds will come to an end. A bear market in bonds also puts pressure on stock multiples (price-earnings ratios), which move inversely with interest rates. It is hard to see how any money manager can replicate the performance of the past few years. All it takes is a few years of sub-7% returns and the VRS goal of “fulling funding” the pension slips farther and farther into the horizon.

Hey, everything may work out just hunky dory. The VRS may be totally vindicated. But there is considerable risk that it will not. Nobody knows the future but we do know one thing: Each percentage point that the VRS falls short of its ROI goals for a $66 billion portfolio translates into a $660 million obligation for state and local government.

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9 responses to “Fully Funded? Not Even Close

  1. The future is easy to see … the General Assembly hands more taxing authority to the localities and continues to crow about the state’s frugality.


    Also, not sure why my old logins don’t work anymore. Jim, was it somethin I said?

    • Blog performance was severely degrading due to the accumulation of some 67,000 spam registrations. Hostmonster said I should delete the registrations. I did so… by hand… around 300 at a time. I tried not to delete genuine registrations but as I reached the eyes-glaze-over stage of monotony, I missed a few. Hopefully, pages are loading faster now.

    • when we say “fully funded” – we obviously don’t mean the current year as anything other than that would be in default so what future year does the “fully funded” (80%) allude to?

      I don’t claim to understand how pension fund actuarials “work” but I think it interesting that the State does this and not the localities… why is that?

      also – local school board taxing authority – it’s the norm in most states (as well as local road commissions in some).

      I think that would be a GOOD THING in Virginia by the way – it would make school board elections much more relevant to those paying the taxes and force the school systems to provide more information about what they are spending money on. Right now most school systems budgets are virtually inscrutable beyond 10,000 feet spending categories.

      re: bonds… vs stocks… consider the dynamics of municipal tax-free bonds in a local context – essentially the county borrowing money from the taxpayers and paying it back with interest… right?

  2. In fairness:

    1.) A 7% rate of return is conservative even if you take a 100 year look at equity and bond markets.

    2.) VRS changed in 2014. Now, the maximum multiplier for any new hire is 1% instead of 1.7% for defined benefits. I think it’s fair to wait 5 years and see how this affects actuarial accounting. Such a change isn’t going to be effectively measured in 2 or 3 years.

    3.) What’s the benchmark of funding for private defined benefit plans? I doubt it’s 100%.

    • C’Ville Resident:

      Congratulations on Charlottesville being named the Happiest City in America by Good Housekeeping. No wonder you think everything is OK with VRS. You’re just too damn happy to get mad!

      Your points are well taken (with some caveats).

      The biggest caveat is differentiating between nominal and real returns.

      From 1928 – 2013 a 3:1 mix of S&P 500 and 10 year T-Bills would have averaged nominal returns of 9.925%. However, inflation during that period was 3.09% for a real return of 6.835%.

      Another issue is that the benefits of the plan will pay out over a couple of decades rather than a century.

      From 2004 – 2013 a 3:1 mix of S&P 500 and 10 year T-Bills would have averaged nominal returns of 7.215%. Inflation during that period was 2.47% for a real return of 4.745%.

      If the VRS assumed rate of return of 7% is not adjusted for inflation (and they adjust benefits paid to take inflation into account) then 7% is probably fine. If it is 7% adjusted for inflation I’d say it is optimistic over the relevant range of the investment to payout period.

      • DonR,

        Great point about nominal v. inflation-adjusted. I have no idea what the VRS target is.

        One other point about the change in VRS. Personally, I think that a lot of the “public pension crisis” talk may be a wee bit overblown. Why?

        Well….what explodes liability in a pension system is long-serving employees. If trends revert to pre-recession norms, it just doesn’t appear that the Millenials and other younger workers plan to stay with any organization for 40 years. There’s a lot more job-hopping than with older generations. This would be a huge benefit to VRS’s “unfunded liability.” The fewer payees, the better for the system.

        I could be wrong. But when I talk to younger workers, I find very few who think that staying in one place is their plan.

  3. I don’t know how they’ve figured these numbers but they look pretty good to me, and surprising as (if I recall) there were some years when the State didn’t pay its full share of the contributions. Do you really think that 100% funding of a future liability makes sense. Comparison to your mortgage is nonsense; have you prepaid 100% of your mortgage – you’re just tweaking us aren’t you?

  4. re: ” … have you prepaid 100% of your mortgage – you’re just tweaking us aren’t you?”

    or perhaps even better – have you prepaid 100% of your retirement midway or 3/4 through your work life?

    some say VRS and it’s ilk are modern-day dinosaurs – that people – even government workers who think they have a career – are better off with more portable pensions.

    The Feds went to more portable pensions way back in 1986 I believe when they switched over from CSRS to FERS.

    but this issue actually begets a bigger issue – which is – if you do have your own portable pension – and your own personal responsibility to fund it and to decide how to invest it – are you better equipped to do that – that say VRS?

    I think not. I think what VRS does might be subject to criticism perhaps rightly so and they are not immune to mistakes – but overall – there has to be more and better expertise with VRS than the average person has including virtually all of the folks who are vested in VRS. On balance – VRS is going to do a better job at risk and actuarials than individuals even if they have “advisers”.

  5. how come we centralize pensions for localities at the State level but not health insurance?

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