Friday, July 10, 2009

The 8% Delusion

The governor is ready to sign a bill (A8933/S5918) sponsored by the city to extend for one year the 8% actuarial assumed rate of return for the assets of the city pension funds. This rate of return controls the size of the city's annual pension costs. It is so important that it requires legislation. It is not left up to the discretion of the actuary or the pension board trustees.

Maintaining the 8% rate of return is crucial to the city's budget. If the 8% were lowered to 7 or 6%, the required contribution would radically increase. Even with the 8% rate, the employer’s contributions for the five city pension funds in FY-2010 are $7.6B. In the city's case, it is paying $6.4B or 17.5% of its totally payroll.

Once upon a time in the 1990’s, 8% was a realistic target but not since 2000 has anyone been able maintain an 8% trend. Over the last ten years, the actual rate of return for the five city pension funds has averaged only 2.4%. The pension funds have missed their rate of return target by $53B during this period. This figure, however, is only the sum of the shortfalls for each year. It doesn't capture the significant effect of annual compounding.

As an example, since 2000 NYCERS has missed its 8% target by $24B. If it had achieved 8%, NYCERS would have a closing balance of $63B as of June 30, 2009. Instead, it has closing balance of $29.8B, $33B less than the $63B. The additional $9B shortage beyond the $24B is the result of annual compounding.

In addition to the obvious underfunding that the 8% target rate has produced, it has also had a nasty impact on the investment strategy pursued by the pension funds. Because the 8% target was a high threshold, the actuary for the pension funds advised the trustees of the funds that a conservative investment plan would never support the 8%.

A conservative strategy is something along the line of a 50/50 split between domestic stocks and high grade government/corporate bonds. While this is conservative for a mature pension fund, it still has a significant level of risk. In the current market, the city pension funds might still have lost significant assets.

In the NYCERS fund, the trustees have 46% of the assets in domestic stocks, 28% in higher risk investments, and only 29% in high grade bonds. NYCERS lost $9B in FY-2009. The conservative strategy could have possibly reduced that loss to $6B for the year.

The 8% rate has caused both underfunding and higher investment losses. The pension funds must become more transparent, if they are to survive. There is too much closed door arm twisting going on.

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