The latest barrage has been targeted at the discount rates used in assessing public plans’ financial position and determining the annual required contribution.
The academic party line theory goes something like this. The liabilities of these plans are risk free to the participants, meaning that the benefits are based on a formula defined by the law that is independent of the fund’s investment earnings so there is little risk of those benefits not being paid. Accordingly, the liabilities should be matched against assets (a portfolio of securities) that are also risk free. While there is not universal agreement regarding what constitutes “risk free,” suffice it to say that the anticipated return will be something well south of what might reasonably be expected over the long term from a diversified portfolio of stocks, bonds and alternative investments.
The academic party line then continues with the thinking that when DB plan liabilities are measured using a discount rate that can only be achieved by investing in a diversified portfolio, the plan may ultimately come up short and impose an unanticipated higher cost on future generations who were not participants in the deal when it was struck. Accordingly, the actuarially assumed rates of return being used should be reduced to some “risk free” rate which will reveal their version of the “truth” about public retirement plan liabilities.
So what are the critics doing with their personal financial planning?
Given their vehement opposition to putting retirement assets at risk, one might expect the academics to avoid risk in the investment of their own retirement savings. Surprisingly, when you look at how they are investing their defined contribution (DC) accounts, you find a distribution of holdings not all that different from what you would find at a DB plan today (although the fees they are paying are probably significantly higher). I think it is fine if they wish to invest in that fashion but, to avoid the apparent hypocrisy of their ways, it would seem reasonable to insist that they also be required to waive future rights to any governmental entitlement programs if they come up short during retirement. Or, as an alternative, they should be required to put their personal retirement savings in “risk free” investments and lower their expectations about their personal financial resources during retirement.
Transparency and financial support for academic and think tank “research”
State and local government retirement systems have long embraced the Government Finance Officers Association’s Guidelines for the Preparation of a Public Employee Retirement System Comprehensive Annual Financial Report. Initially released in 1980, public plans were quick to adopt the guidelines, resulting in extensive transparency regarding all aspects of retirement system operations.
The sources of revenue supporting the so-called academic “research” on public pension issues is sorely lacking in transparency. To assure that this research is conflict free it would seem reasonable for the researchers to disclose their sources of funding. Clearly there are organizations that would benefit financially from the demise of DB plans with replacement DC plans and/or the wholesale transition of DB portfolios to so-called risk free securities. By simply disclosing their funding sources, readers of the reports would be able to assess on their own whether or not the information is potentially suffering from financially motivated bias. The academics should either freely disclose information regarding their financial support or explain why they have a problem with transparency.
Investment Advisor Disclaimer
Most of us are familiar with investment advisor disclaimers that typically read something like the following regarding investments in risk assets: “Past performance is not necessarily indicative of future returns, etc.” To support their theory, the academics seem fond of using the first decade of this century which included the bursting of the tech-bubble at the outset and, more recently, the global credit crisis. They conveniently omit reference to the past eight decades. While it also may not be indicative of future returns, I’m more comfortable looking at eighty years than at ten (just as I would not look at the high double digit returns of the 1990s as the basis for forming future expectations). For the record, the annualized return for the past eighty years on a plain vanilla 60/40 domestic stock/bond portfolio was 8%. This period includes the financial crises of the 1930s as well as the credit debacle in 2008-2009.
I think it is also worth noting that by investing in diversified portfolios as opposed to “risk free securities” public retirement systems have, over the years, saved taxpayers billions in contributions and created like amounts of retirement security for millions of public employees. This, of course, is not mentioned by the academics because it runs counter to the conclusion one would draw from the analysis made possible by their data mining.
If I wanted to paint a bleak picture by data mining with a ten year period, I’d probably select 1969 through 1978 when the annualized returns on the U.S Total Stock Market Index and long government bonds were 2.9% and 5.1% respectively and when the Consumer Price Index increased by 6.7% per year concluding the decade with an inflation rate of 13.3% in 1979. Money invested in just about anything but real estate lost value when that was the new normal, but wait – that period would not work for the analysis because public plans survived it nicely and flourished for years thereafter.
It seems that when actual demonstrated practice for a protracted period does not sync with economic theory, the academic solution is to conclude that practice has to be wrong because the theory could not possibly be incorrect. (That is sort of like clipping the wings of bumble bees to validate an academic theory that they are aerodynamically incapable of flight.)
There is no doubt that there are some very smart academics who are strong proponents of the risk free method of measuring pension liabilities and even investing pension assets. I respect the fact that they are smart but I also remember that a number of very smart academics were the brains behind a now defunct money management organization by the name of Long Term Capital Management. Enough said.
- Gary Findlay, Executive Director, Missouri State Employees’ Retirement System (MOSERS).
Mr. Findlay is executive director of the Missouri State Employees' Retirement System (MOSERS), a position he has held since 1994. Prior to that, he spent 16 years as an administration and benefit consultant with Gabriel, Roeder, Smith & Company, a national actuarial and benefits consulting firm that specializes in serving the needs of public employee benefit plans. He was CEO of that firm from 1986 until he joined MOSERS.
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