The Long and Short of the Interest Return Assumption

 

The Issue

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 Catch

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.

The Flaws

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
(http://www.nasra.org/returnassumptionsbrief)

 

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Fordham Institute report on teacher pensions flawed, not credible

Last week, the Fordham Institute released a study that erroneously claims teachers in Minnesota and in most states would be better off investing retirement contributions on their own rather than receiving a TRA defined-benefit (DB) pension after a career of teaching. The study used flawed calculations and methodologies to arrive at this conclusion by very significantly underestimating the value of a TRA pension and overestimating an individual’s ability to earn high investment returns.

The study’s calculation of future pensions used outdated life expectancy data that predict far shorter life expectancies than Minnesota teachers experience and made other erroneous assumptions about likely retirement ages. These miscalculations shortened the projected pension payout period by 10 years. The study’s numbers also inflate the potential earnings an individual is likely to earn from investing their own contributions. Below is a detailed description of the problems and miscalculations found in the study.

Pension Accumulation/Payouts: The study

underestimates the value of the MN pension benefit for several reasons:

1. The study uses Centers for Disease Control (CDC) 2007 life expectancy tables, which predict far shorter life expectancies than MN-specific teacher mortality tables predict. For example, CDC tables predict an age 60 female will live to age 84 while TRA’s mortality tables predict they will live to age 90.2. CDC tables predict an age 65 female will live to age 84.9 while TRA’s tables predict age 90.3. Due to life expectancy errors alone, the study’s calculations shorten the likely pension payout by between 5 and 6 years.

2. The study assumes a teacher retires at the plan’s statutory normal retirement age, which in TRA’s case is age 66. In reality, TRA’s average retirement age is about age 62. By assuming a beginning payout age of 66, the study shortens the payout period by another four years. These years are excluded in the pension wealth accumulation part of the equation.

3. The study’s combined use of an overly advanced retirement age of 66 and wrong mortality tables results in a predicted payout period of 18 years to 19 years whereas using TRA-specific data results in a payout of over 28 years, a very material difference of over 10 years.

4. There are no references in the study indicating that the authors incorporate COLAs in the calculation of pension payouts.

Accumulated contributions plus interest: The study greatly

overestimates the value of the teacher’s theoretical cumulative contributions plus investment earnings by assuming individuals can invest and earn as much as large institutional investors. This is very optimistic and unrealistic. Here are the study’s flawed assumptions regarding potential investment earnings.

1. The study assumes the individual is capable of earning a very aggressive compound annual return, net of investment fees, of 8.5% in each year of the teacher’s entire working career.

2. According to the National Institute on Retirement Security (NIRS), Morningstar advises individuals making retirement plans to use an expected return on their investments of 5%.

3. Previous studies show that individuals tend to earn 1% to 2% less per year than institutional investors due to high investment fees, less skill than institutional investors, and no access to certain high-performing investment sectors such as private equity and venture capital.

4. Individuals investing their own assets must reduce their risk as they approach retirement age and move more retirement assets into lower-performing bonds and other fixed income investments. This was not taken into account in the study which assumed an 8.5% return each and every year through the age 66 retirement age. The current investment market climate shows how retirees near retirement are struggling to eke out very low single digit returns on bonds and fixed income investments.

Teachers highly value retirement plans as an extremely important job feature. The DB pensions that cover the vast majority of teachers address an essential retirement security need –

replacing income when one stops teaching. The DB pension adds value by assuring that teachers cannot exhaust their retirement savings and will not be hurt by investment losses and inflation. School systems use pensions to recruit, retain and manage the teaching workforce.

Defined contribution plans help teachers manage employment risk, making portability easier for teachers who leave. However, studies have shown that workers need to save more in a defined contribution plans to offset the lower returns in self-directed retirement accounts and make sure that retirement savings last for as long as a teacher will live. Teachers live much longer than average workers and, in TRA’s case are predominantly female. Three-fourths of TRA retirees are women.

Calculations for school districts conflict with results of more extensive analyses of alternative retirement plan designs done for teacher pension plans. Colorado Public Employees Retirement Association (COPERA) is an example of a system recently studied by the state’s auditor in an extensive 217-page analysis of typical teacher tenure patterns based on several plan design alternatives. In every situation, COPERA’s pension replaced a higher level of income than all of the alternative designs. For example, even a teacher who teaches for only three years would receive 40 percent more retirement income from COPERA than from investing the $6,700 refund and buying an annuity.

Courtesy of Communications Office

Teachers Retirement Association

Public Employees Retirement Association

Minnesota State Retirement System

 

Investing in Your Retirement Income

How is investing in your retirement income like keeping yourself in food? Well, how do you keep yourself in food now?

Feed-Me #3: I eat at my parents’ until they invite (force) me out to work and live on my own. Okay. Partying, social media, Starbucks platinum level may have to back off in place of serious work, rent and utilities, and eating out—but giving up international cuisine is asking too much. After all, you only live once, right? And this is how it will go until I drop or marry into money, the latter of which is not likely to happen when I pass the retirement age of 70+. By then inflation is likely to have out-paced wages by 100%. Hello, cat food.

I had no pension plan, except Social Security, and years of small government conservative shrank that and Medicare to something less than the poverty level and free clinic visits. No one explained to me that not everyone wins the lottery or winds up in the top 2% of wealth.

Feed-Me #2: I make a plan before moving out to own a house by 35, so save for a down payment while working hard and long—a day job plus a part time. I buy smart and healthy at the co-op and learn the best buys in wine and craft beers. I take a cooking class or two and master some pretty good dishes that impress my friends and partner. Our children don’t appreciate the food, but demand much in clothes, sports activities and tech-toys. Our kids go off to very good schools, which we hope will earn them high paying jobs.

By the time we settle in to paying off the house and college loans, we realize that there has never been a time to contribute the advised 20% of income to an IRA. We will be working past retirement age if we can, but those last 5 years of life, which cost half or more of our total life medical costs may have to be covered by the kids. I may be watching a modest life drain away into a long, sad decline. It all balances out.

Feed-Me #1: I live at home, paying costs to my parents until I have a steady career job. I plan on buying a home as soon as I can arrange it. I live as cheaply as I can manage, valuing people over things, parks over concert halls, Mr. Coffee over Starbucks. I use public transportation, which alone saves enough for a down payment on a house in about five or six years. I buy smart and healthy at the Cub. I have learned what foods have real value and are affordable. As soon as I can, I get a garden plot to supplement the expensive stuff I can grow. Once I get a house, I plant an apple tree in the yard and a big garden in the back. These investments, along with running and biking, help keep me fit as well, and will reduce my medical costs even into very old age. Live starts early and ends late after all.

I was fortunate enough to have a public pension plan which with Social Security took about 15% of my salary, and that was matched by my employer. I have paid off my house, and the kids’ public college loans are handled. Since I also saved in 430(b) and 457 plans almost from day one, I will have enough income for the next 20-25 years to equal about 80% of my final working salary. That means travel, visiting the kids, and even reinvesting against expensive final years.

Just as I planted seeds in my garden, I planted financial seeds in my retirement plans, and because I started early and waited, as I did with the apple tree, I can actually wind up with more than I absolutely need. Just as I understand the growing season, I see the value of treating life as a whole process. I could have just lived on the harvest collected by others; then I would have been feeding the others as well, and that would be expensive and would have no end. I could have joined the harvesting, cutting the wheat I could later eat, and that would have reduced the cost, but because of waiting until late in the process, it would have offered too little a return, and even that return could be threatened by a bad crop. Worse, next season, when I wasn’t working, I would earn no return at all.

Even starting early, planning and exercising some prudence, while it could earn proportional wealth compared to those early years, — even that case offers no guarantee. Climate change, mining operations, social disorder, any number of things can spoil the crops or even poison the land. Social Security and Medicare can still be gutted, pension plans can be subverted, or the world economy can collapse.

There are no guarantees; there are risks. The trick is to minimize the risks, and that is best done by pooling our efforts. Going it on your own, no matter how good you are, leaves you the most vulnerable. There is safety in numbers. It doesn’t matter how confident you are in your abilities, the thing that will get you is beyond your control or anyone else’s. Life is a challenge; rise to it; don’t try to play it. Your public employee pension plan is your best hedge against tragedy. It’s your right. Support it.

Pension Awareness Week

The Minneapolis Committee of Thirteen: Advocating for your defined benefit pension system and educating for a secure retirement with dignity.

It’s autumn, the time of year we gear up for the legislative session in which public employee pension systems are mulled, debated and very often modified here in Minnesota. During the next few months, the Legislative Commission of Pensions and Retirement, the LCPR, a joint House and Senate committee, meets to hear about, discuss and shape legislation about TRA, MSRS, PERA and other Minnesota public employee pension systems. How much active teachers, principals, clerks, ESPs and other workers in state funded jobs contribute to their pension systems, and how much those who are retired from those jobs get in pension payments.
It is also the time we ask active teachers and principals to sign up for payroll deductions of $1, $2, $5 or whatever amount they can manage to help meet the costs of advocating for them at the LCPR meetings as well as in face to face meetings with Representatives and Senators from across the state. Contributions are also used to help fund to campaigns. It used to be that campaign contributions from political action committees, PACs, were limited to a few hundred dollars during the campaign year, 2016, and there was a limit on how many total dollars candidate could accept from PACs. Those limits have now doubled and contributions cover a two-year span, currently 2015-2016. Well funded opponents of public employee benefits, including your pension, will have no trouble meeting those new limits, but we may be able to keep up without your help.

Next week will kick off the Pension Awareness Week. When active Minneapolis Public School teachers and principals see the bright green and yellow wristbands in their buildings, they’ll know the Actives Campaign is underway. If you are wearing a Pension Awareness Day wristband, be prepared to explain it to your colleagues; you’ll know what to tell them by then because other materials will be sent out at the same time.

Raising awareness is the first step in standing up for our earned benefits. Sharing that awareness then strengthens us all. And that’s what the Committee of Thirteen is all about:
* Supporting your future security by protecting your defined benefit pension system, TRA and Social Security.
* Understanding how an investment in your pension system and other places assures your later years will be a reward for your working years, and not a purgatory suffered under the influence of greed and economic inequity.

Please be ready and do what you can.

Forever Young?

With any luck, you’ll be reading this when you have a spare minute. It’s important, because you will get to be old one day. Think not? Or just trying not to think about it? Well, think of the alternative for a moment. I know you don’t have a third option, because if you did, you wouldn’t be teaching for long hours and low wages in an environment where you’re having your feet held to a fire by a corporate-political messaging campaign.

So let’s think about that for a moment; why are you doing this job? Well, I hope it’s for the love of kids and a belief you can make lives better for them. Assuming that’s the case, thank you for contributing to a civilized America. At the same time, there are some other benefits to teaching that might not be so clear and profound. One of those benefits is the promise of a pensioned retirement once you do get older. Now, you’re giving up higher salaries and rich salary increases, and you’re giving up a slice of the salary you do get all so you can have this promised pension. What you’re getting for that is twenty or maybe thirty years of secure income for the last piece of your life. That’s a lot. And it has a history.

In the old days, really old days, grandparents would reach a point where they could no longer do the heavy work they had done, so they switched to light domestic work and child care in the family home. Three generations lived together, caring for one another, and at the two ends of life being cared for by the rest of the family. These days, in a truly supportive society, we have reassigned the familial roles into societal roles. As a caring society, we care for the very young and the very old—the whole village idea.

But just like the old days, there are some who try to fly solo, loners who strike out Pinocio-like from the family and hope to make it on their own, lured by charlatans.  Some do make it and some don’t make it, but they all believe they’ll soar. What didn’t happen then was that the loners forced their risky life style on the whole family. That’s just what some free marketers would like you to do now, because like a croupier, they’ll take a litle piece of every play made, win or lose. So the more people they can get to the table, the better for them, but there won’t be any more winners, just more players who wind up losers. So put this together with getting older.

Think about getting older, and what it will mean to do that with a secure financial base or your casino winnings. The Minnesota Teacher Retirement Association is part of good family-style management, the pain we feel now rather than the much bigger pain of an empoverished old age. And you get this pension for caring about kids and making their lives better. A fair return on that investment. So be informed and engaged; protect your investment in your future.

 

The 75(k) Retirement Plan (repost)

Do you spend $2 a day on coffee, Monday to Friday, the 50 working weeks of the year? Well, that comes out to 250 $2 cups of coffee—$500. What if you invested that in something other than cardiovascular disease? What if you invested that money in something like bonds?
Now this only applies to those who can afford those cups of coffee, and who are unwilling to sacrifice such a small pleasure. They work hard in a stressful job, under paid and over worked. Of course caffeine probably doesn’t help that situation, but common sense isn’t the point here. Let’s switch to the other end of the work spectrum–retirement at age 67. It may be higher in fifty years, but there’s not much short term financial interest in keeping us alive much longer than we do now. It will be easier to raise the cost of those last five years of life that are some 80% of our medical costs over a lifetime.
So, at age 67, retired, could you use an extra $75,000? It may actually only be worth between $45,000 and $60,000 in today’s dollars, but that’s still pretty nice—world travel? taking grandchildren to Disney Galaxy? sailing the coastal waters? This is figured using an inflation rate of 2% or 3%, (only 0.5% on the cost of coffee!) against a low investment return of 4%, for saving the cost of 250 $2 cups of coffee a year from the age of 20. Current inflation is about 1%, of course, but it will rise, and equity returns average well above 4%, if you don’t cash out in a crash cycle. And yes, if you saved twice as much, it would grow to twice as much. Also remember, this is on top of your Social Security and/or other retirement account income.
The coffee you buy today may be a good short term solution, but it has a short term effect, measured in hours at best. Your needs for advanced years are long-term needs. They are real and will be measured in years. You have three choices there: poverty or near it, working until you drop, or planning ahead starting now. You choose. It matters. It’s your life.

The 75(k) Retirement Plan

     Do you spend $2 a day on coffee, Monday to Friday, the 50 working weeks of the year? Well, that comes out to 250 $2 cups of coffee—$500. What if you invested that in something other than cardiovascular disease? What if you invested that money in something like bonds?

Now this only applies to those who can afford those cups of coffee, and who are unwilling to sacrifice such a small pleasure. They work hard in a stressful job, under paid and over worked. Of course caffeine probably doesn’t help that situation, but common sense isn’t the point here. Let’s switch to the other end of the work spectrum–retirement at age 67. It may be higher in fifty years, but there’s not much short term financial interest in keeping us alive much longer than we do now. It will be easier to raise the cost of those last five years of life that are some 80% of our medical costs over a lifetime.

So, at age 67, retired, could you use an extra $75,000? It may actually only be worth between $45,000 and $60,000 in today’s dollars, but that’s still pretty nice—world travel? taking grandchildren to Disney Galaxy? sailing the coastal waters? This is figured using an inflation rate of 2% or 3%, (only 0.5% on the cost of coffee!) against a low investment return of 4%, for saving the cost of 250 $2 cups of coffee a year from the age of 20. Current inflation is about 1%, of course, but it will rise, and equity returns average well above 4%, if you don’t cash out in a crash cycle. And yes, if you saved twice as much, it would grow to twice as much. Also remember, this is on top of your Social Security and/or other retirement account income.

The coffee you buy today may be a good short term solution, but it has a short term effect, measured in hours at best. Your needs for advanced years are long-term needs. They are real and will be measured in years. You have three choices there: poverty or near it, working until you drop, or planning ahead starting now. You choose. It matters. It’s your life.