Investment expert: ‘Getting 7.5% … is going to be a challenge’

October 28th, 2011 at 10:56 am by under Nesi's Notes

It’s one of the most controversial – and arcane – parts of the entire pension debate: How much can Rhode Island reasonably expect its pension fund’s investments to earn over the coming years?

In April, Treasurer Gina Raimondo got the Retirement Board to lower the fund’s expected return from 8.25% to 7.5%, which helped cause this year’s huge increase in the unfunded pension liability. The board raised lifespan forecasts, too.

Paul Valletta of the firefighters union said Thursday Raimondo “cooked the books” with those changes to create a crisis, and Robert Walsh of teachers union NEA Rhode Island – who helps manage his union’s pension fund – testified that it could be responsibly bumped to 7.75% as a way to help alleviate the pressure.

But Allan Emkin of Pension Consulting Alliance, the state’s investment adviser, said even the new hoped-for return of 7.5% is “optimistic, not pessimistic.” His analysts say the pension fund’s diversified investment portfolio has only a 42% chance of achieving 7.5% over the next 10 years, and a 50-50 shot at achieving 6.75%.

Raimondo sees ‘lofty goal’

“Getting 7.5% in today’s world is going to be a challenge,” Emkin told WPRI.com after Thursday’s hearing. “It’s a different world now.” Raimondo herself has called the 7.5% target “a lofty goal” and said she’s designed the proposed new hybrid retirement plan to reduce the risk to taxpayers if 7.5% isn’t achieved.

That raises concerns not only for the state but for cities and towns, as well. Providence, East Providence and Smithfield are all banking on their locally run pension plans earning 8.5% returns over the next 10 years, and a number of others are expecting 8.25% and 8%.

Before last April’s vote, the state Retirement Board’s previous votes had been to raise the return target, from 7.5% to 8% in 1990 and then from 8% to 8.25% in 1998. Former Treasurer Frank Caprio suggested last year the board should take another look at whether 8.25% was reasonable, though a vote was never taken.

Pension fund trustees across the country are now reexamining their assumptions, though few have moved as aggressively as Raimondo’s Rhode Island, Emkin told WPRI.com. “If there’s an overall trend, the trend is to go lower,” he said. “How much [lower] is the part of the process that’s very complex and unique to each jurisdiction.”

Most places have moved their return rates by 25 or 50 basis points at a time – from 8.25% to 8% or 7.75%, for example – unlike Rhode Island, which dropped its rate by 75 basis points in one fell swoop last April. “That’s a policy decision,” Emkin said.

Small numbers, big impact

Those seemingly small differences have a massive impact on paper. The combined shortfall in the main pension funds for state employees and teachers totals $4.7 billion using an 8.25% rate; $6.8 billion using the new 7.5% rate; $9 billion using a 6.2% rate; and $11.4 billion using a 4.4% rate, according to Gabriel Roeder Smith & Co.

There is no doubt the change pushed by Raimondo is aggressive. The latest Public Fund Survey shows only 24 of the nation’s 126 largest pension funds use a return forecast of 7.5% or lower. The remaining 102 funds use 7.75% or higher, with the most common investment target being 8%. Massachusetts continues to use 8.25%.

The median public pension fund’s investments earned an average annual return of 8.5% in the 25-year period ended June 30, 2011, according to the National Association of State Retirement Administrators – though, as investment advisors often say, past performance is no guarantee of future results.

William “Flick” Fornia, an independent pension actuary hired by local unions, said the new 7.5% return forecast is “desirable” from an actuary’s perspective but the old 8.25% forecast is more desirable for taxpayers, because it would reduce the size of the deposits they are supposed to put into the pension fund.

Emkin and Pension Consulting Alliance first worked for Rhode Island under former Treasurer Roger Begin, a Democrat who served from 1985 to 1989, and was rehired by Caprio. Emkin said his firm revisits its investment outlook annually, and has revised it downward since 2008 to reflect the record-low yields on bonds and unsettled macroeconomic outlook that have followed the financial crisis.

According to forecasts by Emkin’s firm, the compounded return on different asset classes over the next decade will range from 3% for cash to 8.9% for private equity and venture capital, with inflation averaging 2.75%. Pension Consulting Alliance’s forecasts are in line with those of six other major investment advisers.

(chart: National Association of State Retirement Administrators)

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11 Responses to “Investment expert: ‘Getting 7.5% … is going to be a challenge’”

  1. According to the Retirement Fund newletter, the Retirement Fund investment returns for one year for the period ending June 30, 2011, is 20.4%.

    1. Ted Nesi says:

      Yes, and that followed atrocious years like the 12 months through June 30, 2009, when the fund dropped 20.1%:

      http://blogs.wpri.com/2011/05/16/fact-check-kerry-king-on-the-pension-funds-investments/

      That’s why multiyear averages are helpful, especially in a volatile economic period like the one we’re in.

  2. Rlewis says:

    Multiyear averages are helpful, so are the geometric averages as you pointed out. But they never are used when Raimondo is pushing her plan. She carefully chooses pessimistic statistics to make her case as does the Journal. (I do give you credit, Ted, for being the only reporter giving both sides of the story.)
    Do we ever hear from Raimondo what the unfunded liability is using the 25 year historical return? No. The plain fact is that no one really knows what the next ten years are going to bring. No expert, or few anyway, predicted the last ten years and I don’t believe any expert has special insight into the next ten. What were the experts predicting in 1970, 1980, or 1990 for that matter? Whenever I hear that things are different this time, I cringe. Chances are they are not. I’ll trust a statistical reversion to mean over the long term rather than any expert. People were saying things were different during the tech and internet bubble in the late 90′s too. They weren’t.
    Futhermore, I don’t believe we should be hung up on ten years anyway. This is a multi-generational problem. The liabilities/benefits were accrued over decades and the problem should be fixed over decades. (How long is the average worker part of the pension system anyway, 40 years counting work and retirement..?) Why should this generation of workers be burdened for prior underfunding decades ago? As you know, the current workers are covering most of the current pension costs through their own contributions. We hear about inter-generational fairness, but it is the current generation who is bearing the greatest burden.
    If you still wish to hear from an expert, the Boston College Center for Retirement Research has their own study titled “Equity Returns in the Coming Decades”.
    http://crr.bc.edu/briefs/equity_returns_in_the_coming_decade.html

    One of the reasons cited or the lowered expectations of the pension fund is the need for liquidity. But this need is only for one of the plans in ERSRI and not all the plans within it. Why are all the different plans within ERSRI stuck with the same asset allocation when the membership structure, and hence the liabilities, are different for each of the plans?

    And isn’t Mr. Emkin’s projections for equities alone greater than 8% in the next decade..?

    Who signs Mr. Emkin’s checks anyway?

  3. Jake says:

    Why have Harvard, Brown and Yale’s endowments performed so much better than Rhode Island’s pension fund investments? Is there anything to be learned from them that would help us?

    1. Ted Nesi says:

      As of June 30, 2011, Harvard’s returns were 21.4% over the last year, 5.5% over the last five years, 9.4% over the last 10 years and 12.9% over the last 20 years. I assume those are compounded, though I don’t really know. The university endowments are known for aggressive investing with private equity, interest-rate swaps and the like – it might be controversial for Rhode Island’s fund to take those risks.

      1. Rlewis says:

        Those returns are compounding. As a side note, both Harvard and Brown got caught in a squeeze a few years ago holding too many illiquid investments – hedge funds and other alternative investments.

      2. Ted Nesi says:

        Jake, it turns out New York City is thinking along the same lines as you for their own pension fund:

        http://blogs.wpri.com/2011/10/31/nycs-pension-fund-aims-to-match-earnings-of-harvard-yale/

  4. GaryM says:

    People have to look at this problem in terms of where the US is heading long term.

    Between 1995 and 2000 (the tech bubble), the markets played on the growth of Y2K fears and that the internet would cure cancer. That bubble ended shortly after 2000. Then the mortgage backed securities bubble from 2003 to 2008 was again, just a bubble of phony marketing of mortgage backed securities. (God bless the wisdom of repeal of the Glass Steagall Act which created that bubble).

    Now we are in a “bounce off the bottom” bubble from 666 in the S&P 500 and we think this can go on forever. Forget about it! Long term it will not. We cannot keep borrowing money from other countries to pad our economy. When people realize that today’s stock markets are depending largely on continued deficit spending, this current euphoria will also come to an end.

  5. Ken says:

    Ted why won’t you report Dan Beardsly’s testimony that the numbers changed after the Retirement Boards vote and his opinion that most in his organization would probably voted differently? You were present for that.

    1. Ted Nesi says:

      Ken, which statement by Dan Beardsley are you talking about? The only thing he said that seems to fit is this, at about the 10:30 mark, when asked by Rep. Hearn whether cities and towns were surprised by how much their contributions are going up:

      “There were some surprises because the estimates that we had been provided at the March meeting, and which I had disseminated, varied greatly.”

      Is that what you mean? If so, I don’t see why this is such a scandal – they said all through those meetings that the MERS contribution numbers were estimates and wouldn’t be finalized until after April, because each of the 110 plans has to be evaluated separately.

  6. [...] = {"data_track_clickback":true};After reading my story about the Rhode Island pension fund’s “lofty” 7.5%-a-year investment goal, commenter Jake asked a good question: Why have Harvard, Brown and Yale’s endowments performed so [...]