When plans are made at the Minnesota Legislative Commission for Pensions and Retirement, the topic of the investment return assumption or investment rate assumption flares up. This is the assumed rate of interest returning on funds held through the State Bureau of Investments. These investments may be equity stocks, various bonds, real estate or other instruments presumed to increase in value over time.
In order to plan for the future in the pension system, agencies need to predict the number of people who will be working and thus contributing to the invested funds, what the changes in the actual cost of living will be, whether there will be inflation or deflation of the dollar and how much, the number of people retired and retiring, and how much interest will be earned on invested funds. These factors are planned out over 30 or 40 years. To put that into perspective, imagine where you were and what you were doing for Thanksgiving in 2006. How closely do you think you would have predicted the economic changes that occurred in the next ten years?
Left to experts, these exceedingly complex calculations are generally inaccurate in detail, but generally better than 50:50 in broad strokes. By comparison, index fund investments (funds automatically composed of top performing investments) perform somewhat better than the average performance of funds managed by humans. The index funds are like bookies, setting the odds, and the fund managers are like punters, playing them, at a race track.
So, why do pension commissioners care so much about this investment return assumption? Well, while the picture of the future of the funds may be drawn with invisible ink which will only become visible as it becomes history, the drawing is the best guess they have of what the future will be. It is a blueprint of where, when and how much public money – taxpayers’ and workers’ dollars – will be in the fund, and so how healthy they think the fund will be in 10, 20 or 40 years.
The health of the Minnesota Teacher Retirement Association pension fund, and all state public employee pension funds in Minnesota, is very important to the State’s finances. The public employees’ pensions are an obligation of the State and the employers; they must be satisfied. If the money is not in the funds to make the mandated payments, the State and school districts, cities, and other employers, and the public employees’ paychecks, all of whom share responsibility, must make up the difference. That means citizens will pay either by tax increases or by loss of jobs and/or the services these jobs provide. This would be very bad.
To avoid this eventuality without contributing more into the funds before disaster strikes, some politicians and many others have an interest in changing the whole system from a defined benefit plan (the State defines what your retirement benefit will be) to a defined contribution plan (the State defines what contribution it will make to your own investments, i.e., there is no state fund.) This change would shift the pension responsibility to each individual.
So here’s the catch: assuming a lower rate of return means assuming that the fund will not grow as much over the next 20 or 40 years; the fund will look more insufficient to meet its obligation to pay our pensions. If that looks like it’s going to be the case, hadn’t the Pension Commission better shift to a plan for which the state will not be held responsible?
Many decisions are made based on the impact the investment return assumption has on the picture of the fund’s future, employer and employee contribution rates, retiree benefits, etc.
There are two flaws to this reasoning however: a big flaw and a huge flaw.
The big flaw is that reasoning based on an investment return assumption is equivalent to reasoning based on the odds of a 40 year long horse race. Yes, the odds may be based on past experience, but that hasn’t ever been a perfect predictor of horse races. That’s why they’re called odds. And the investment return assumption has not been a very good predictor of economic outcomes. Changing the odds doesn’t change the outcome of the race. Changing the investment return assumption will not change the future investment returns on pension funds. It only draws a gloomier or brighter future picture, which is then used by elected officials to make crucial decisions.
The huge flaw is that shifting from a defined benefit (DB) plan to a defined contribution (DC) plan, in an effort to avoid the States’ obligation, would make public sector jobs harder to fill with well qualified workers, and would thereby universally diminish teachers’ and other public sector workers’ quality of retirement. Individuals would be forced to provide their own retirement plans by managing their own investments in a market already presumable predicted to be weaker than is necessary to sustain a fund managed by the State Bureau of Investments is risky at best. Think of the difference between the value of an individual insurance plan and a large group insurance plan. Paying an investment broker or advisor further depletes the amount getting into the fund. And in 2017 the greater part of American workers are woefully under-prepared for any retirement. This bodes very ill for tens of thousands of additional workers in Minnesota should the plans be changed. Furthermore, the State and its funded employers must still find millions of dollars to meet their existing obligations as the pension funds diminish to zero.
Yes, the investment return assumption really matters, even if though it’s just a guess.
This has been the short explanation. I know. It’s not short, but it’s shorter than the long explanation that is attached.
The Long of It
NASRA Issue Brief: Public Pension Plan Investment Return Assumptions, Updated February 2017