Big investment returns for PERS prove NPRI’s pension study correct

Victor Joecks

Last month, NPRI released a study showing that Nevada’s Public Employees’ Retirement System is dramatically understating its unfunded liabilities.

The central claim of NPRI’s study is that PERS does not account for the risk involved in assuming an 8 percent rate of return for investments. A risk-free 8 percent rate of return isn’t available, and as a result, taxpayers are subsidizing the risk in the PERS system. Because PERS’s payouts are guaranteed, a risk-free investment instrument should be used in actuarial assumption to accurately measure future obligations. To accurately account for guaranteed payouts, PERS’ unfunded liability is over $40 billion.

Contrast this with a taxpayer and his 401k, who has to deal with reward and risk. Because it’s a government-backed, defined-benefit system, PERS recipients bear no risk. Even if PERS investments crash, they are still entitled to full benefits.

In response to NPRI’s study, PERS published “Policy Context on NPRI Pension Advocacy Paper.”

In it PERS writes:

Consider this theory in light of the fact that Nevada PERS has generated an annualized investment return of 9.5% for 27 years, exceeding not only the long term investment assumption of 8%, but clearly exceeding the MVL assumed rate (in this case 4%), as well.

Much of this debate is fueled by the difficult market conditions of the last few years. The markets themselves have been extremely unpredictable in the short term. However, even in this most recent decade, Nevada PERS has exceeded the long term investment assumption of 8% in six out ten years. The last two years the System generated 11% and 21% returns respectively. (Emphasis added)

This is precisely the point! If you are earning a 21 percent return, you are taking substantial risks with that money. Sure the return is high for this year, but so is the risk that those investments will lose money – likely a substantial amount of money – in future years. And right now that risk is unaccounted for in PERS’ stated unfunded liability.

As Andrew Biggs writes in NPRI’s study:

Before explaining how economists value liabilities, it may make sense to point out one obvious problem with how public pensions currently measure their finances: A pension plan that takes more investment risk automatically is considered better funded. That improvement in funding occurs immediately, before the higher expected returns are actually earned and increases no matter how much risk the plan chooses to take. As shown above, if PERS shifted its portfolio from one with an expected return of 8 percent to a riskier portfolio with an expected return of 8.5 percent, the measured value of its liabilities would immediately fall by around $2.4 billion and its funding ratio would rise from 70 percent to around 76 percent. On paper, Nevada PERS and pensions around the country could make themselves technically solvent simply by investing in riskier assets.

Reality is a different story. The obvious flaw with this approach is that a portfolio does not become more valuable simply because it has a higher expected rate of return. Simply put, one dollar of stocks is worth the same as one dollar of bonds. Each has a combination of risk and return that buyers and sellers in the market value at one dollar. But according to GASB accounting, one dollar of stocks is effectively worth two dollars of bonds, because it allows a plan to discount its liabilities using a much higher interest rate. Economists, as a profession, simply believe this approach is wrong – no two ways about it.

The other problem with assuming an 8 percent rate of return, Biggs notes, is that it will be more difficult to achieve high returns in the future.

While PERS’ historical performance has been solid, it may be more difficult to achieve projected returns going forward than it was in the past. The simple reason is that the riskless return paid on Treasury securities – the foundation on which a risky portfolio is built – has fallen. In 1985, for instance, the yield on 30-year Treasury securities was over 10 percent, meaning that a pension plan could exceed 8 percent nominal returns while taking almost no risk. Today, the 30-year Treasury yield is around 4 percent, meaning that a plan must take significantly more risk to generate the same nominal return as in the past. At the same time, PERS notes that its goal for real returns, net of inflation, rose from 3 percent in 2000, to 3.5 percent in 2002, to 3.75 percent in 2003 and 4.5 percent thereafter, despite falling yields on inflation-indexed bonds.

It’s (way past) time to overhaul PERS. Starting on page 23, Biggs lays out a roadmap for pension reform.