CIOs Pressured to Lower Discount Rates Discuss Spiraling Consequences
Art by Ryan Peltier
As public pension plans grapple with a funding shortfall, many chief investment officers (CIOs) are under pressure to continue to ratchet down the discount rates, or the long-term expected return on the assets the plans hold, which they use to calculate how much money they will need to generate over time. This trend is also pressuring governments to say how they will make up the missing money, and whether it will be derived from tax revenues or higher employee contributions.
Plans have begun to drop their discount rates over the past few years. In fact, 64% of public plans surveyed have dropped their rates, or plan to do so, according to an annual report from the trade group National Conference on Public Employee Retirement Systems (NCPERS).
In 2017, Utah noncontributory plan lowered its discount rate from 7.2% to 6.95% after its actuary recommended changes based on its triennial experience study, according to the plan’s fiscal 2017 annual report. And the Connecticut Teachers’ plan, which has a discount rate of 8%, is holding ongoing discussions about reducing it, Chairperson Clare Barnett announced at the plan’s November 7, 2018, board meeting, according to published minutes.
In October 2017, the Ohio Police & Fire pension plan shifted its discount rate from 8.25% to 8%. The plan’s investment consultant and actuarial firm worked together, for the first time, on forecasting the plan’s returns, and came up with the new discount rate, says John Gallagher, the plan’s executive director.
“We’ve been at 8.25% for as long as I can remember,” says Gallagher, who’s worked for pension plans since 1980 and at OP&F since 2013.
Demographics, as of the most recent actuarial valuation, were 28,212 active members and 29,361 retirees (including surviving spouses).
Public safety pension plans typically use a higher return assumption than other public plans, because their participants retire earlier than other government workers due to the nature of police and fire jobs. The higher return assumption is done to incentivize the investment managers to get higher returns.
The anxiety that’s led to calls for lower discount rates stems from the last decade of fear in the markets, starting with the global financial crisis of 2008 and 2009 and continuing with years of ultra-low interest rates, Gallagher says.
“For those who want to suggest we should use a 3% return to calculate our chances of meeting our liabilities, we can’t take benefits away from policemen,” Gallagher says.
Even an adjustment to benefits causes a political spiral. In 2018, it switched health coverage for retirees from providing a group health plan to a stipend system, where members can buy their own insurance. It’s unpopular, but Ohio Police & Fire can’t afford to pay for the health insurance while also keeping the pension funded. The state laws require the pension to be able to pay off its liabilities within 30 years, and OPF can now pay its off in 28 years.
“We’re going through hell right now because we’ve been able to support employee healthcare for 45 to 50 years, but we had to remove ourselves from the self-insured health plan at the end of the year and that’s leaving a lot of our employees disenchanted,” he said.
As chief investment officers struggle with a bevy of considerations, the median discount rate at public pension plans stands at 7.5%, down from 8%, according to NCPERS data.
Funds set their discount rates by considering underlying rates of inflation and expected GDP returns as well as the plan’s own investments, says Emily Kessler, senior staff fellow at the Society of Actuaries in Chicago.
Most are working from the same economic building blocks, Kessler says.
One reason for the gradual lowering of discount rates is that plans have downshifted the economic assumptions underpinning their calculations, essentially signaling that investment managers expect low inflation in the long term, she says.
That makes sense from an actuarial perspective, Kessler thinks.
“Leading with risk management and cash flow, you end up at the conclusion that you should have lower discount rates, because it does create higher costs but lower volatility and more stability in the plan,” she says.
In defined benefit plans with lowered discount rates, contributions will have to go up, either from the public entity itself or from the employees, or both. Because the benefits are guaranteed by law, or enshrined in state constitutions, says Hank Kim, executive director of NCPERS. Pension plan participants should be comforted rather than alarmed when plan boards move discount rates down, because it means the plans are more likely to last longer rather than flame out, he says.
“I think the continual lowering of the anticipated returns, particularly since the Great Financial Crisis, is a conservative view by plans that at least for the near term, while interest rates may be rising incrementally, at least for the next handful of years, we’re going to be very cautious and conservative in estimates of our returns,” Kim says.
In the near term, some plans have been lowering new-hire benefits, while honoring old promises to current employees by requiring them to contribute more from their paychecks.
“So it’s effectively a benefit cut—you’re paying more to get less—but it’s not explicitly a cut to the benefit, which you can’t do under the law in most states,” says Jean-Pierre Aubry, associate director of state and local research at Boston College’s Center for Retirement Research.
The Governmental Accounting Standards Board, which sets the rules for how public pension funds report their finances, has permitted state and local governments to use the expected return on their investments as the discount rate, says Olivia Mitchell, a Wharton professor who studies retirement economics and heads the business school’s Pension Research Council.
“Nobody really believes that’s what the pensions will be able to earn on assets, so that’s one concern,” Mitchell says. “The other concern is that if they use these high discount rates, it means they’re investing in very risky assets.” That could imperil the funds’ ability to pay out retirees’ benefits if the assets don’t perform as hoped, she says.
Many in the industry hold that if taxpayers are guaranteeing public pensions, then the discount rate pensions use should be the rate on the state’s bonds, which is about 4% to 5%, considerably lower than the average discount rate. This could cause problems, since every time the discount rate falls by 2 percentage points, the level of underfunding goes up by 25 percentage points, contributing even more to an underfunding drought totaling some $4 trillion across the landscape of public plans, Mitchell says.
“If they were all to use lower discount rates, there wouldn’t be any money left to do anything else like fill potholes, have police and firefighters, education—everything would be much more expensive,” she says.
The difficulty for pension funds is “math and opportunity,” says TJ Carlson, CIO at the Texas Municipal Retirement System (TMRS) in Austin. The plans can only generate returns if the assets they own do well.
“It does put investment teams in a tough spot when the governance authority tells you that can only invest in these five things, you have to own all five of them, and none of them earn more than 7%. If they want you to make 7.5%, the math just doesn’t work,” Carlson says. He considers himself fortunate that the TMRS policies require him to keep 35% in public equities and 10% in fixed income, leaving him discretion over the remaining 55% of the plan’s portfolio.
“We’re not forced to use something that’s going to keep us from hitting our numbers,” he says.
In 2015, Carlson’s plan lowered its discount rate from 7% to 6.75%. This followed TMRS’s switch, after the global financial crisis, from investing all the plan’s assets in fixed income to choosing some alternative investments, including real estate, credit, and private equity. Four years ago, the plan also updated the actuarial figures it uses for life expectancy, adopting generational-mortality tables that recognize the longer lifespans of today’s workers. Although the actuarial switch and the lowered discount rate both negatively affected the plan’s funded status, it’s still about 90% funded, Carlson says. That’s high compared to the average public plan’s funding level of 72.2%, according to NCPERS.
“Next year we’re going to talk about whether we lower [the discount rate] to 6.5% and why or why not,” Carlson says.
Regardless of the political dynamics, the current 7.5% average will keep falling, pension executives say.
“Certainly going forward, eventually most funds are going to need to be in the mid 6% range,” says Gary Anderson, who retired as the executive director of TMRS and now runs the board of pensions and health benefits for the Rio Texas Conference of the United Methodist Church.
For some public plans, even lowering the discount rate won’t return them to financial health. The plans in most dire circumstances, like New Jersey and Kentucky, will need more drastic action, Aubry says.
“The political reality may force other solutions,” Aubry says.
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