New Return Target for Illinois Teachers’ Pension

(September 21, 2012) – It’s official: the board of trustees for Illinois’ Teachers’ Retirement System (TRS) voted 11-2 in favor of cutting the fund’s assumed rate of return from 8.5% to 8%.

This decision boosts the system’s unfunded liability ratio to 57.6% from 54.8%, necessitating an estimated $300 million increase in state contributions for the 2014 fiscal year. The fund has $36 billion in assets under management, and total liabilities of $89.1 billion–$5.6 billion more than when calculated with the previous discount rate.

“The assumed rate of return greatly influences the financial future of TRS. Reducing the rate from 8.5% to 8% is a prudent move that balances reality with the needs of TRS members,” said Executive Director Dick Ingram in a statement. “The Board’s decision takes into consideration many things: the volatility of the world economy, the fiduciary duty we have to keep the System strong, the financial problems faced by Illinois and state government’s long-term responsibility to teacher pensions.”

Earlier this month, Illinois’ Governor Pat Quinn made a strong push to start solving these financial problems through pension reform. Quinn called lawmakers back for a special session to vote on an overhaul package, but the bill did not pass. Reform may now have to wait until the start of the next legislative session in January.

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In Illinois, unlike many other states, the public pension system does not have to seek legislative approval to change its discount rate. Ingram has been publicly mulling over the decision since early June, based on advice from TRS’ actuaries.

“Our process is very deliberate and considerable analysis is used to develop this estimate,” Ingram said. “It is the fiduciary duty of the Board to set a rate that is realistic and will fairly distribute the cost of TRS benefits among several generations of taxpayers.”

TRS has been using the 8.5% rate since 1997, and has returned an average of 9.3% since 1981. Over the past five years, however, TRS’ investments have far missed their benchmark, returning an average of 2.7%.

At 8.5%, TRS had become an outlier among its peers. Many major asset owners have concluded that such returns may be wishful thinking in the current economic climate. More than half (54%) of public funds in the US forecast annual returns of less than 8%, according to the Public Fund Survey’s study of 126 pension systems. The most common target is 8%, with 44 pensions following it. In early August, Indiana cut its assumed rate from 7% to 6.75%, making it the lowest of any pubic fund in the United States.

The sustainable investing debate has started to be heard more loudly over the last year, Towers Watson explains in a report, adding more fuel to the tension.

(September 21, 2012) — Asset owners and asset managers worldwide are struggling with what it means to be a sustainable investor, Towers Watson explains.

This tension–as outlined by the consulting firm–shows no signs of subsiding. “There is some concern amongst asset owners, however, that sustainable investing may not be aligned with their fiduciary obligation,” the paper noted. Asset owners contacted by aiCIO reiterate drawbacks of environmental, social and governance (ESG) investing, namely that asset class restrictions impedes portfolio diversification.

Drawing on research from Oxford University, Towers Watson concluded that in order for institutional investors to achieve long-term success with environment investing, they need better models and tools. According to the report, typical impediments to sustainable investing–defined as a strategy that meets the needs of the present without compromising the ability of future generations to meet their own needs–include issues relating to fund structures and governance. Other impediments relate to the state of knowledge (for example, the potential long-term impact of natural resource scarcity and environmental degradation on investments), fiduciary interpretation and relevance, and limited data or analytical tools.

The report notes that the largest mind-set change among investors to adopt to environmentally-friendly principles involve adapting to a different time horizon. “Most investment contexts involve multiple horizons and multiple stakeholders. There is a mix of agency issues, behavioral biases, over confidence and legal structure issues that make long-term investing exceptionally difficult,” Towers Watson says. “We observe that the gap between effective and current practices on this dimension alone is very considerable. The roadmap we describe sets out ways to reduce the gap and harvest the long horizon premium.”

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Towers Watson’s paper continues to note that the impact of externalities–spill-over effects of production or consumption that produce unpriced costs or benefits to other unrelated parties–tends to be recognized in profit statements and balance sheets when they become internalized. “One of the challenges facing asset owners (and their asset managers) of the future will be to anticipate these effects and adapt investment portfolios accordingly. Exercising ownership rights will also have an important role in dealing with externalities,” the report concludes.

Earlier this year, Gordon Hagart, head of ESG risk management at the Future Fund, which manages roughly $93 billion of sovereign wealth on behalf of the Australian government, explained how he is aiming to create incentives to lower externalities. “I study the physical impacts of environmental issues and regulatory changes such as ‘polluter pays’ legislation. On the social side of things it’s about understanding how companies’ relationships with suppliers, customers, regulators, society at large, and how they manage their human capital, affects the bottom line. That can be a source of substantial financial risk and opportunity for long-term investors,” he said. “We need to create an environment where agents are motivated to act as if the long term mattered and as if the capital entrusted to them was their own. Why? Simple—better returns for beneficiaries,” he concluded.

Read Towers Watson’s full report here.