Unrealistic assumptions will continue to cause New York teacher pension costs to rise

by Grace

This chart illustrates the teacher pension funding gap that has fallen upon the New York State taxpayers to close.

Unrealistically high rates of returns are assumed, but the actual performance comes in significantly lower.

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. …

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.

Other New York pension funds have made modest changes in an effort to be more realistic.

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.

Meanwhile, the teachers’ pension fund board defends its higher assumed rate of return.

“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.”

The taxpayer contribution for this year increased to about 12% of teacher salaries, and the fund warns school districts that “We anticipate continued future increases in the [rate] beyond this point.”  Unfortunately, they do not offer estimates of the increases, but the author sees a rise to 17%.

One way for school boards to get some relief from the soaring costs of  the pension mandate is to keep salary increases down.

… 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….

Using an improbably high discount rate is a related problem.
In addition to the assumed rate of return, the discount rate is another factor that affects taxpayer contributions to public pension plans.

… 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….

Last week I wrote about the problem with public pension funds using a discount rate that is too high.

In the private sector, a guaranteed benefit must use risk-free returns in calculating future liability.  But for public pensions, the taxpayers are expected to meet the huge gap between overly optimistic promises and the reality of low investment returns.

As most experts explain, public pension funds should use lower discount rates to reduce the investment risk to taxpayers. This typically means that the discount rate should be based on risk-free returns, such as Treasurys. These discount rates would reveal that between half and three-quarters of all public pension debt is hidden by accounting gimmicks. If government pension plans were subject to the same reporting rules as private pension plans, their reported pension debt would nearly triple.

Do the math:
Median discount rate used by largest public pension funds - 8%
Current 10-year US Treasuries rate – 1.6%

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5 Comments to “Unrealistic assumptions will continue to cause New York teacher pension costs to rise”

  1. There are coalitions, like StudentsFirstNY and the state school board organization, trying to pressure for change. But they’re battling against teacher unions, which are the third-largest spending lobby group in Albany. The anti-mandate push is partly fueled by this since the ultimate solution by many is seen as simply dropping the guaranteed pension requirement altogether.

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  2. The appropriate interest rate to assume depends a lot on what time scale you look at, and how much you believe that past performance predicts future performance. If you look at a time scale going back to 1976 (http://www.google.com/finance?q=INDEXSP%3A.INX&ei=FEaZUNDzMueeiQLaggE), then investment returns of 7.7% a year are reasonable. But if you look at the last 12 years, investment seems to be a gambling game with no predictable return (and averaging only break-even). The big question is whether the instability of the past decade is a temporary anomaly or the new norm. Arguments can be made on either side, and it is not as simple as just saying that Treasuries (which have deliberately manipulated pricing) are the standard to judge all pension investments.

    One question that should be foremost among voters is why government regulators have deliberately encouraged systems that result in huge instability in investments (like low taxes for capital gains and encouraging rapid trading, rather than taxing rapid trading like the gambling that it is).

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  3. How is rapid trading encouraged? Are you suggesting we need more controls, similar to the market circuit breaker rule that already exists?

    I still think shifting the risk over to the beneficiaries (eliminating mandated guaranteed pensions and replacing with 401k-type options) is the solution that would help take a lot of the politics out of this fiasco.

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  4. Rapid trading is encouraged by having no transaction taxes and no requirement that stocks be held for any length of time.

    I’ve favored defined contribution pension plans for decades, because the beneficiaries can see how much is being invested in them and determine whether it is enough. Defined-benefit is more opaque. (I complained about the University of California not investing in their defined-benefit plan 25 years ago, and it wasn’t until 2008 that anyone higher up in the UC was willing to admit there was a problem.)

    You can’t easily switch from defined-benefit to defined contribution, though, for existing members of a pension plan, unless the plan has enough of a surplus to entice people to switch voluntarily from the defined benefit to an equivalent value in a defined contribution plan.

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  5. “Opaque” is certainly the word with these defined benefit plans.

    In NY, even the most aggressive pension reform proposals would only offer DC option to new employees. It was never approved, but I imagine the push will continue for this change.

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