The closing bell on Wall Street last Friday also marked the end of the fiscal year for many public pension funds across the country, including the New York State Teachers' Retirement System (NYSTRS), which finances pensions promised to 420,000 active and retired professional educators working mainly for school districts outside New York City.
Like its counterparts, NYSTRS is heavily invested in publicly traded domestic corporate stocks, which make up 46 percent of its portfolio. As a result, the value of the pension fund's assets tends to move in the same direction as the S&P 500. The correlation isn’t precise; indeed, on average, the pension fund has outperformed the index. In general, however, a strong stock market equates to strong pension fund returns, and vice versa.
Last fall, NYSTRS was boasting of a “robust" return of 23.2 percent in fiscal 2011, when the S&P 500 gained 28.1 percent. But if the stock market's performance is any indication, fiscal 2012 wasn’t such a great year for the teachers' pension fund. During the 12 months ending June 29, the S&P 500 gained just 3.1 percent, excluding dividends. While the pension fund may have done better than that (it won’t get around to telling us until the fall), it seems unlikely, given the shaky state of global financial markets, that NYSTRS hit its return target of 8 percent in the fiscal year just ended. This is more bad news for the rest of us.
Even after a strong recovery in 2010 and 2011, and excluding a sub-par performance in 2012, the teacher pension fund’s average return on assets has been just 4.4 percent since 2000. This opened an enormous funding gap – which taxpayers have had to close.
Think of it this way: if NYSTRS had hit its 8 percent annual return target since the turn of the century, $100 in fund assets as of June 30, 2000, would have been worth $233 by June 30, 2011. The actual figure was $166. The pension fund’s choppy route to that mediocre return is depicted in the chart below.
Meanwhile, benefit payments have continued increasing at an average rate of 8 percent a year, more than doubling during the same period, according to NYSTRS’ annual financial reports. And this, in a nutshell, is why school districts’ pension costs have risen so much, from an all-time low of 0.43 percent of teacher salaries in 2002 (reflecting double-digit annual returns during the Wall Street boom) to 11.1 percent in 2012.
This doesn’t mean that NYSTRS is doing a bad job of managing its money, given its equity-heavy asset allocation and compared to other pension funds. But it does call into question its practice of continuing to assume earnings of 8 percent a year.
Ok, let’s get technical for a minute. A key factor in determining how close any pension plan comes to being fully funded is the discount rate used to calculate liabilities. This is different than the assumed rate of return; rather, the discount rate is just an expression of the cost of future liabilities today. And the higher the assumed discount rate, the less money needs to be set aside now to cover benefits promised for the future. Accounting rules dictate that corporate pension plans discount liabilities using the interest rate on low risk investments such as the yield on AAA-rated corporate bonds. That's typically 4 to 5 percent these days. By contrast, accounting standards for governments allow public pension funds to discount liabilities using the same high rate of return they hope to earn on their investments. That produces a trade-off -- pay less now, but more in the future if the goals are not met.
In a small step toward a more realistic standard, state Comptroller Thomas DiNapoli has lowered the rate-of-return assumption for the giant New York State and Local Retirement System to 7.5 percent, and New York City will soon go down to 7 percent, which is still high enough to have been compared by Mayor Bloomberg to an investment come-on from Bernie Madoff.
Wilshire Consulting, a respected firm that has done a lot of work in this area, projectsa median long-term return of 6.4 percent for state pension funds that are now assuming 8 percent. And some smart people on Wall Street aren’t optimistic about the short term, either. Goldman Sachs, for one, recently turned quite bearish, adjusting its 12-month target for the S&P 500 to 1350 -- 1 percent below Friday's close.
Last fall, the teachers’ pension fund board approved an important (but widely overlooked) update to its actual assumptions, which will affect pension costs going forward. The most important change was no change at all: as recommended by its actuary, the fund decided to stick with 8 percent. The explanation? This paragraph from the actuarial report (which is not posted online, unfortunately) is pretty much the extent of it:
"The key question is whether or not an 8.0% rate of return assumption continues to be a prudent estimate going forward. We believe it does, and do not recommend changing it at this time. It has certainly been a good estimate for the 20 years it has been in place. Logic dictates that just as we did not increase our assumption in the face of fantastic returns in the 1990s (which followed great returns in the 1980s as well), we should not decrease it now after a poorly-returning decade."
In other words, contrary to a disclaimer that should be familiar to every investor, NYSTRS would have us believe that past performance does point to future results.
DiNapoli’s lowering of the the state and local government pension fund rate was based on an actuarial analysisthat, among other things, included 5,000 groupings of simulated returns for the pension fund over the next 30 years. The median return for those simulations was less than 7 percent—i.e., half came in higher, half lower--and there was just a 35 percent chance that the state pension fund would hit its newly reduced 7.5 percent target.
By contrast, the actuarial report for the teachers’ fund didn’t delve much into quantitative analysis of probabilities—or, for that matter, the issue of financial risk. It did significantly alter a few other assumptions affecting pension costs, though. For one thing, it said retired teachers are living longer, which would make pensions more expensive. On the other hand, it said, teachers also have been retiring a few years later, and their rate of salary growth has waned a bit. These trends would tend to bring down pension expenses.
The net result of all these factors—the 8 percent return assumption, longer life spans offset by later retirement, and slightly smaller salary hikes--is that the contribution rate collected from school districts in the fall of 2013 will be 11.5 to 12.5 percent of total teacher salaries, only slightly above the current rate. However, “this should NOT be interpreted to mean that the [employer contribution rate] has reached a plateau,” the teachers’ fund has warned school districts. “We anticipate continued future increases in the [rate] beyond this point.”
How big will those increases be? NYSTRS just won’t say. While the teacher pension fund is comfortable predicting asset returns 40 to 50 years into the future, it refuses to provide employers with useful guidance on where their pension costs might be headed within the next decade. As a result, school districts throughout the state are negotiating three to five-year teachers’ contracts without knowing how much more pensions might cost three to five years down the line.
In a December 2010 report, Josh Barro and I estimated that the contribution rate could more than double, reaching 25 percent by 2016 if the fund hit its return target in the meantime. Adjusting for the very large return in 2011, we still estimate the rate will peak at 17 percent of salaries.
In short, more misery is on the way – even as the relatively few newly hired teachers become vested in what are (for now) less expensive pension tiers created by the state in the last three years, which won’t yield significant savings for a decade. But while school districts complain that pensions are a state-mandated cost over which they have no control, they are not completely helpless – not as group, at any rate. A concerted effort by school boards to hold down salary increases could have a significant impact on long-term pension costs. How significant? Well, NYSTRS’ latest actuarial calculations dropped the assumed average salary increase from 6.51 percent to 5.61 percent a year. All by itself, the report said, this 0.9 percent reduction was enough to cut pension contribution rates by 1.61 percent of salary.
This doesn’t let the teachers’ pension fund off the hook, however. By refusing to recognize the real long-term cost of teacher pensions, and by refusing to issue long-term projections of annual required contributions, the teachers’ retirement system and its board are doing a disservice to taxpayers and retirees alike.