State pension systems dropped the rate of return they assume for their investment portfolios again, continuing a two-decade long trend that public-finance experts say is necessary, even as it presents some challenges for the entities that participate in such plans.
The search for high returns takes many pension funds far and wide, but the Pennsylvania teachers’ fund went farther than most. It invested in trailer park chains, pistachio farms, pay phone systems for prison inmates — and, in a particularly bizarre twist, loans to Kurds trying to carve out their own homeland in northern Iraq.
Now the F.B.I. is on the case, investigating investment practices at the Pennsylvania Public School Employees’ Retirement System, and new questions are emerging about how the fund’s staff and consultants calculated returns.
The error in calculating returns was a tiny one, just four one-hundredths of a percentage point. But it was enough — just barely — to push the fund’s performance over a critical threshold of 6.36 percent that, by law, determines whether certain teachers have to pay more into the fund. The close call raised questions about whether someone had manipulated the numbers and the error wasn’t really an error at all.
“If you can’t change the benefits, and you can’t change the contributions, the only lever left for these people to pull is investment policy — that’s it,” said Kurt Winkelmann, a senior fellow for pension policy design at the University of Minnesota’s Heller-Hurwicz Economics Institute. “And that exposes younger beneficiaries and taxpayers to a lot of risk.”
Private equity investments underperformed broad US stock indexes for the fiscal year that ended June 30, 2020. Importantly for taxpayers and governments, this underperformance of private equity weighed down public pension system asset returns during a particularly difficult year for investments.
These investment results may mark the beginning of the end of superior private equity returns that have characterized early 21st century institutional investing. If private equity returns have now fallen “back to earth,” many public pension systems can expect heightened scrutiny over their allocations to this asset class and the high investment costs that go with it.
The very notable exception is New Jersey’s Teachers’ Pension and Annuity Fund (TPAF), which is by far the single-worst public pension in the Brookings study. TPAF is New Jersey’s largest public pension fund and covers all active and retired teachers. New Jersey’s Public Employees Retirement System (PERS), the pension plan for state and municipal workers, is second-worst but not nearly in the dire predicament of TPAF.
This is what Brookings had to say about TPAF: Under any of their investment return scenarios, TPAF is in “near-term trouble” — meaning near-term insolvency. Brookings projects that TPAF will run out of assets in 12-to-15 years, at which point the $4.5 billion-plus in benefits payments will have to be made from the New Jersey’s perpetually strained state budget. This would be a fiscal disaster for New Jersey and a retirement crisis for TPAF’s 262,000 beneficiaries.
The board of Pennsylvania’s biggest pension fund adopted an inflated number for its investment performance even after the state treasurer raised skeptical questions about the calculation last summer, newly obtained documents show.
That decision by the PSERS board has emerged as a costly and disruptive mistake, raising the possibility that the $64 billion pension fund for teachers may soon have to hike their payments to support the mammoth but underfunded plan. The panel is to meet Monday to consider doing that.
In his August 2020 letter, then-Treasurer Joe Torsella raised doubts about a decision by the fund’s professional staff to go back almost a decade to revise — and improve — figures for past investment performance.
The board in December found that PSERS yearly investment returns had averaged 6.38% over the last nine years — just above the 6.36% threshold needed to avoid an increase in pension payments from 100,000 school employees hired since 2011.
In 2010, the state adopted a so-called “risk sharing” mandate that requires school staff to pay more, as taxpayers do, when PSERS investments underperform. The law mandated that the review in 2020 look at average returns over the past nine years.
In December, consulting actuary Buck reported that PSERS had reached a 6.38 percent average annual rate of return across the prior nine years, just barely above the minimum threshold of 6.36 percent and thus averting a rate increase.
Those calculations were called into question at the time and, more recently, PSERS admitted that they may have been incorrect.
On Friday night, after a nearly 2-hour-long executive session with no public discussion, PSERS’ audit committee approved hiring two law firms to investigate the error and offer recommendations.
In December, PSERS consulting actuary Buck reported that the system’s investments had netted a 6.38 percent average annual rate of return over the nine previous fiscal years between 2011 and 2020. That meant employees were spared a contribution rate increase by slimmest of margins. The investment benchmark was a 6.36 percent rate of return.
The risk mandate, of course, was a response to the system’s chronic underfunding. According to the most recent estimates, which themselves are fungible, the system reported an unfunded pension liability of at least $44 billion. That means it has just over 59 percent of the money necessary to meet current pension obligations.
On Friday night, the system’s board of trustees announced an audit, including the possible hiring of an outside firm to investigate, after it was “made aware of an error regarding the reporting of investment performance numbers.”
Overall, the typical pension fund is now expected to return approximately 6% annually over the next 20 years, compared with 6.4% pre-pandemic (Figure 4). This change in outlook is consistent with the reduction in the median long-term return found by a recent survey of pension investment consultants13 and aligns with revisions for public pension return expectations published by S&P Global.14
A strong second half rebound helped the Massachusetts Pension Reserves Investment Trust (PRIT) end calendar year 2020 with a 12.6% return, beating its benchmark’s return of 10.8% and raising the fund to a record high of $86.9 billion in assets, according to Pension Reserves Investment Management (PRIM), which oversees the fund.
The fund also surpassed its benchmark over the past three, five, and 10 years, with annualized returns of 8.8%, 10.4%, and 8.9%, respectively, compared with 8.0%, 9.5%, and 7.6%, respectively for its benchmark over the same time periods.
The $116 billion North Carolina Retirement Systems has lowered its assumed rate of investment return for the third time in four years, cutting it by 50 basis points (bps) to 6.5% from 7% annually.
The target return had already been reduced to 7.2% from 7.25% in 2017 and again in 2018 to 7%. Prior to then, the rates had been left unchanged for nearly six decades even though the two main state pension funds—the Teachers’ and State Employees’ Retirement System and the Local Government Employees’ Retirement System—have, on average, underperformed their assumed rates of return over the past 20 years. In fact, the new target rate of 6.5% is still higher than the fund’s estimated 20-year return of 6.28%.