Could state, city afford ‘risk-free’ pension plans?
Even General Treasurer Gina Raimondo agrees there’s a failsafe system of funding municipal pensions, although she is not recommending it. According to her general counsel, Mark Dingley, the state is following Government Accounting Standards Board (GASB) for reporting pension liabilities and advises that cities and towns do the same.
That’s just what Warwick did when it revised the projected rate of return on investments and mortality schedule last year.
However, in the opinion of Eileen Norcross, a senior researcher with the Mercatus Center at George Mason University, a 7.5 percent rate of return on investments is unrealistic and the city should adopt a 2.4 percent “risk-free” return based on U.S. Treasury Bond yields.
Norcross and Benjamin VanMetre, also of the Mercatus Center, completed a 15-page “working paper” on the state’s local pension debts last November, concluding that the unfunded liability of locally administered plans would leap from $2.4 billion to $6 billion if the “risk-free” model were used.
“The result of this miscalculation is that many municipal governments are in far worse shape than is currently reported, which presents serious challenges for a number of Rhode Island municipalities,” reads the paper’s summary.
Within the last couple of weeks, Norcross narrowed her focus on Warwick, arriving at the conclusion that, to fully fund pensions, Warwick must triple its contributions to $51 million annually, or about half of its $115 million budget [excluding schools]. She went on to say that, with the addition of $7 million in health care benefits for retirees, $12 million to fund health insurance for current workers, and the city’s bonded debt of $8 million, the city would have only 26 percent of its annual budget left to spend on current services.
Mayor Scott Avedisian retorted, saying he put his faith in the findings of city actuaries and Raimondo and Gov. Lincoln Chafee. Warwick is not listed as a distressed community, as is Providence, although, of its four major locally administered pension plans, one is only 22.3 percent funded. Funding of the other plans range from 70.9 percent to 86.5 percent.
Norcross’ comments, and her conclusion that “by undervaluing their pension promises to workers and setting aside too little to fund them, Warwick’s government has put itself into a major financial hole,” sent shivers through those concerned by the city’s long-range financial stability.
In a follow-up call last Friday, Norcross was asked to justify use of the 2.4 percent return. Also, calls were made to Raimondo to get her take on Norcross’ analysis.
Norcross said that liabilities and assets should be kept separate when calculating pension debt.
She made the analogy of a family financial plan that uses an individual retirement account [IRA] and monthly mortgage for comparison.
“You wouldn’t skip a mortgage payment because the value of your IRA went up,” she said. Yet, she reasons, that’s what the city is doing when it looks at the rate of return on its pension portfolio and, in years when returns exceed projections, decides it can reduce annual payments.
The fact is the city’s municipal employees’ plan is closely tied to market returns. In years when those returns are down, retirees are not granted increases. This differs from many municipal plans that have a cost of living adjustment [COLA] that automatically kicks in and is compounded, regardless of how the plan performs.
Norcross reasons, “you don’t get a rate of return by assuming it.” Further, she says, income projections don’t change the liability that is based on projected benefit payments and mortality assumptions.
She said, “You don’t pick the discount number [rate of return] and solve the problem.”
She sticks by her conclusion that the city should be using a “risk-free” rate of return.
“It’s better to look at the real numbers and come up with a plan to fund it,” she said.
That would be some tough medicine for Warwick, not to mention most of the state’s municipalities.
In response, Dingley writes in an email, “While the state acknowledges that there can be challenges in achieving a consistent 7.5 percent return on assets in today’s volatile markets, actuarial assumptions operate over a long-term horizon of 50 years or more.”
In the November paper, Norcross and VanMetre point out that while the state has lowered the rate of return from 8.25 to 7.5 percent, actual returns over the decade were 2.28 percent. Local plans averaged 1.97 percent over five years, they found.
“This highlights a basic flaw in selecting a discount rate based on the performance of plan assets,” they conclude. “Public pensions represent guaranteed payments to workers, but there is no guarantee that assets will return according to their historic performance.”
In April, the city administration released a comparison of the five-year average rates of return for the city’s three public safety pension plans. According to an actuarial valuation, as of June 30, 2011, Police/Fire I averaged a 5.04 percent; Fire II was 4.58 percent; and Police II was 5.14 percent for the year. The five-year averages were 5.45, 4.10 and 5.93 percentages respectively.
What of the GASB rules the treasurer followed in establishing the 7.5 percent, which the city also now uses?
“I say GASB is a mistake,” answers Norcross.
She goes further in her report, saying the GASB method implies that governments can guarantee high investment returns without risk.
“But this logic implies that taxes could be eliminated if the government simply borrowed and invested in high-returning assets.”
Norcross recognizes for the city to adopt a “risk-free” rate of return would mean dramatic adjustments requiring higher taxes or changes in pension benefits and or reduction in services.
She doesn’t suggest what the city should do, but feels that, under the current system, the city could face major financial problems in five to 10 years.
Editor’s note: In the May 24 story the Beacon ran on this issue, the pie chart [that was not published but referenced by the mayor] showing the city’s pension and health care liabilities relative to its budget was said to show only $14 million remaining for salaries. The $14 million left is for all other city expenses, including salaries.