Reports Highlight Public Pension Problem: High Assumed Rates

(March 20, 2011) – Two recently prepared reports – one a primer for new pension trustees, the other detailing different return scenarios – issued by consultants regarding the State of Florida’s $125 billion pension system highlight what increasingly is becoming a national issue: the effect of discount rates on pension liabilities.

Milliman and Hewitt EnnisKnupp, reporting to the Governor and State Board of Administration (SBA), respectively, both raise the issue of discount rates’ effects on pension liabilities. The state currently uses a 7.75% figure; according to the Milliman report – entitled “Study Reflecting the Impact to the Florida Retirement System of Changing the Investment Return Assumption to One of the Following: 7.5%, 7.0%, 6.0%, 5.0%, 4.0% or 3%” – lowering this figure would increase the pension obligation of the State’s fund.

This problem extends outside Florida, but different states and cities are dealing with the issue in various ways. Some are lowering their rates: New York State’s $130 billion pension system recently lowered its rate from 8% to 7.5%; The Illinois State Employees’ Retirement System has made a similar cut, from 8.5% to 7.75%; New York City is currently considering such a cut as well, according to City actuary Robert North. Others, however, are holding firm: On March 15, a California Public Employees’ Retirement System (CalPERS) panel voted to keep the system’s assumed rate of return at 7.75%. The CalPERS Chief Actuary, Alan Milligan, had recommended that the pension fund adopt a lower discount rate of 7.5%, but also told the Committee that keeping the rate unchanged was prudent. “As pension fund administrators, we want to make sure CalPERS remains financially sound over the long term,” the actuary said in a statement. “The discount rate adopted is reasonable and achievable, and appropriate for funding the promised benefits.”

Private corporations, as mandated by the government, must use a rate based on high-quality bond yields. This rate is currently between 5% and 6%, according to numerous pension chief investment officers contacted by aiCIO.

While few pension managers are willing to comment on this issue, some do speak out. Leo de Bever, CEO and CIO of the Alberta Investment Management Corp – generally considered a thought leader in the institutional investment space – is one of them. “The return on risk has been grossly overstated and the year-to-year variability of that return has been grossly understated,” he told The St. Petersburg Times, adding that “…at some point in the future, a prolonged period of low return could cause the whole thing to blow up.” At least some consultants are in agreement: “It’s widely reported to be a $1 trillion problem, but if you dig into the numbers, it’s a $2 to $3 trillion problem,” David Kelly, an actuary at Mercer Investment Consulting’s Financial Strategy Group, tells aiCIO. “The reported liabilities are understated by using an optimistically high discount rate,” the result being a misstatement of what the plans actually owe.

(This story has been altered from an earlier version.)