Virginia Pension Shortfall Still Horrendous

by James A. Bacon

Last July I argued that, despite the significant pension reforms enacted in the 2012 session of the General Assembly, Virginia had only partially restored the actuarial integrity of state and local government pensions. (See”Virginia’s Pension Bomb Is Still Ticking.“) The debate at the time: whether the Virginia Retirement System should assume that it would generate an 8% annual rate of return, as preferred by Governor Bob McDonnell, or a 7% rate of return, as recommended by the VRS board. Though a single percentage point seems to be a small difference, it amounted to $540 million a year — not exactly chump change — that would have to be made up by state and local governments.

Apparently, the VRS board carried the day. According to an August 2012 document published by the National Association of State Retirement Administrators, the VRS was assuming a 7.0% return. That was the most cautious assumption of almost any state retirement plan in the country — only the Indiana pensions assumed a lower (6.75%) rate of return.

Unfortunately, even the VRS assumption is likely way too optimistic.

Andy Kessler, a former hedge-fund manager and author of “Eat People,” lays out the case in the Wall Street Journal for assuming a 3% rate of return for the indefinite future. How bad is that? To make up the difference, Virginia state and local government would have to cough up an extra $2 billion a year! Good luck with that.

Kessler boils down the math as follows:

The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I’m being generous, -1%.

To some, that may sound unduly pessimistic. Hasn’t Kessler noticed — the stock market is hitting new highs almost every day!

Don’t count on the boom lasting. The United States has enjoyed a long-term bull market in bonds and other interest rate-bearing instruments since the early 1980s. Since 2000 the long-term composite for 10-year Treasuries, a key benchmark, has tumbled from 6.9% to 2.7% today.

The earnings multiples of stock, real estate and other assets move inversely with interest rates. When interest rates go down, price-earnings ratio (essentially, the value placed on a dollar of earnings) for alternate investments go up. Thus, the long, secular decline in interest rates has driven a significant portion of the generous return on pension investments over the past 20-30 years.

With interest rates near zero, however, it is impossible for them to fall any more… which means that it is very difficult to expand the earnings multiples of stocks and other investments. Indeed, if the Federal Reserve Board ever decides to end “quantitative easing” and interest rates return to historical norms,  earnings multiples will shrink, as Kessler suggests.

The current bull market is predicated on the belief that the Fed will maintain near-zero interest rates for years to come. If the economy remains weak and inflation stays quiescent, maybe they will. Perhaps Kessler is too pessimistic. Perhaps we won’t see a rise in interest rates and a consequent contraction of earnings multiples. Perhaps earnings multiples will remain stable. Perhaps pension funds will generate long-term returns of 4% annually, not 3%.

Gee, that would mean Virginia is under-funding its pensions by a mere $1.5 billion a year more than officially acknowledged.

Virginia has done more than most states to put its government pensions on a sound actuarial footing. But that’s more a comment upon the total ineptitude, cowardice and, in the case of Illinois, fraudulent misrepresentation of other state officials than a kudo for our own. We need to deal with this issue now. Every year of delay will make the final reckoning only harder.

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7 responses to “Virginia Pension Shortfall Still Horrendous”

  1. I guess I object to the word “ineptitude” to describe a phenomenon that has adversely affected virtually every pension plan whether it be corporate, govt or even privately IRAs.

    It seems like every opportunity that Jim Bacon has to take a fork in the road to the future – he unerringly takes the gloom & Doom path.

    even good news is instantly doused with the righteous ruin due the Godless!

    I’m not discounting the problem. It IS a problem. It’s a problem for individuals with their own plans also. Would we characterize those who saved into an IRA as “inept” or “reckless” or worse because they naively did what corporate and public pension administrators also did – believed the financial soothsayers? … like there were other smarter options and everyone and their dog make the wrong choice and not they should be spanked for their sins?

    we got trouble in River City no question about it but we need to put those “the world is going to end” guys on soapboxes on roller skates with low rolling resistance!


    1. DJRippert Avatar

      Ineptitude is exactly the right word. In 1985, 89 of America’s 100 biggest companies offered defined benefit pension plans. In 1998, 67 of the top 100 offered these plans. In 2010, it was 17 out of 100. I’ll wager that none of America’s 100 biggest companies offer these defined benefit pensions by 2020.

      There is no reason whatsoever for public organizations to offer defined benefits pension plans. But they almost universally do so. Why? Because they are inept.

  2. In 1986, the “inept” Federal Govt moved from defined benefit to defined contribution.

    but what exactly caused the shift to start with and were all the corporates and governments “inept” for initially setting up defined benefit plans to start with?

    There’s plenty of room to castigate govt and corporate but when dealing with changing trends… that effect everyone.. I’m not sure characterizing virtually everyone involved as “inept” is dead on correct.

    why did we start out with defined benefit and why did that change?

  3. DJRippert Avatar

    Really – the federal went to a 401(k) program in 1986? Does that include military retirement? How about Congressional pensions?

    Inept, Larry – that is the right word.

  4. it includes them all:

    but the folks who started working before 1986 still get the earlier CSRS defined pension.

    the FERs is also a defined benefit plan to be honest, but it’s more in line with what corporations offer and it was done explicitly to ramp down the future liabilities for the govt and also to get employees to consider more skin in the game AND to allow them to keep what they have and continue to contribute in they change jobs.

    I just do not believe that “ineptitude” is a proper description of ongoing changes that affect everyone whether govt, corporate or individual unless you want to take the position that everyone is basically inept at dealing with changes that they had no control over – as opposed to people knowing the realities .. unchanged.. and still chose to do stupid things.

    that seems to be the tandem doom & gloom schtick these days:

    1. – big changes are in process

    2. – you are dumb if you do not see them and react perfectly

    we do have big changes… fundamental changes.. and yes .. people and institutions prefer to not change unless forced to change… but they eventually do… not without getting nicked up pretty good sometimes but that’s not the same as mankind as we know it ending in a burning heap of dog dooo… which seems to be the essential message from some folks now days.

  5. the other thing to keep in mind when we talk about pensions with the Fed Govt is what percentage overall of the total pensions is National Security – which is way more than just DOD?

    We, as a country, say we want a strong national defense and we devote at least half of our tax revenues to pay for it.

    there are about 4 million Federal employees. 1.5 are active military but another 1.5 are national defense civilian employees. Less than one million are non-Defense employees.

    you want a strong defense? You got one and it costs like there was no tomorrow and it translates into not only Federal Pensions, but Social Security and Medicare for the retired civilian and military employees.

  6. Breckinridge Avatar

    This is not an academic discussion in this household. I’m no actuary, but right now (has anybody been watching the market?) I’m not that uncomfortable with 7 percent and I would consider 3 percent ridiculously low, given the historical returns at VRS. I’m a bit surprised you’d base your arugment on that, Jim. The fed’s cheap money policy, driving down real interest rates to zero and below, will not last but another year or so. On Game of Thrones, “winter is coming.” In this Game of Central Bank Madness, “inflation is coming.”

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