It’s official: after a decade in which the New York State pension fund’s annual return on assets averaged less than half its target rate, the fund will need to jack up its taxpayer-funded contribution rates next year, Comptroller Thomas DiNapoli announced today. DiNapoli said the rate in 2011-12 would rise from 11.5 percent of salary to 16.3 percent for members of the Employee Retirement System (ERS) and from 18.2 to 21.6 percent for members of the police and Fire Retirement System, (PFRS).

This is no surprise.  In fact, almost precisely the same rate of change in pension contributions was projected by Governor Paterson’s Division of the Budget (DOB) eight months ago, in the 2010-11 Five Year Financial Plan (see table on page 59).

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New York’s state comptroller reportedly is going to reduce the state pension fund’s discount rate from 8 percent to between 7.5 percent and 7.75 percent, Bloomberg News just reported.  The lower the discount rate, the higher the required tax-funded employer contribution.  So the public pension bill for New York taxpayers is about to grow higher. even higher than already expected given the fund’s performance over the past few years.** [See postscript for caveat, however!]

The comptroller’s move comes as no surprise, given the recent performance of the pension fund’s assets.  The problem is that even a 7.5 percent rate — the lowest used by the fund since 1985 — will significantly understate the true size of the pension fund’s liabilities.

The discount rate applied to future obligations is a crucial determinant of any pension system’s necessary funding levels: the lower the rate, the larger the contributions required to maintain “fully funded” status. Private pension plans must discount their liabilities based on a market rate—typically, a corporate or U.S. government bond rate—which is often much lower than the plans’ projected returns.

Public funds, however, are allowed by government accounting standards to discount their long-term liabilities based on the targeted annual rate of return on their assets—which, for most public funds, is still pegged at an optimistic 8 percent or higher. In other words, the risk premium in the investment target is compounded in the liability estimate.

The typical public pension manager doesn’t just hope to earn 8 percent a year. For all intents and purposes, he or she assures trustees, beneficiaries, and taxpayers that the fund is certain to earn an average, long-run return of 8 percent.  In New York’s case, it appears this target is about to be lowered every so slightly.

But ask yourself: do you know anyone in the world of private investing (anyone not named Madoff, that is), who is willing to guarantee you a 7.5 percent rate of return?  How about 7 percent?  Or even, for that matter, 6 percent?  No junk bonds allowed.  Remember: public pensions are guaranteed by the state Constitution.  The money has got to be there.

While most public pension managers continue to resist the idea, a growing number of independent actuaries and financial economists agree that the net present value of risk-free public pension promises should be calculated on the basis of low-risk interest rates such as the rate on a thirty-year U.S. Treasury bond, most recently dropped below 4 percent.  This is not an argument for actually investing pension funds in T-bills, mind you; it is simply a way to recognize how much it actually costs to guarantee generous such generous pension benefits.

At 8 percent, the state pension fund discount rate is an economic fallacy.   At 7.5 percent, it will still be an economic fallacy.

** PS — For the state government, and for local governments that opt into a pension “amortization” (i.e., borrowing) plan initially proposed by Comptroller Thomas DiNapoli, a change in the discount rate won’t necessarily affect annual pension fund contributions.  Under a gimmick approved as part of the 2010-11 state budget, the annual increase in contributions will now be  capped at a percentage point a year and required payments over that amount in any given year can be spread over a 10-year period.  For participating  employers, a higher discount rate effectively will translate into more borrowing from the pension fund, pushing an even larger (but still underestimated) liability onto the backs of future taxpayers.**

PPS — New York City has separate public pension plans unaffected by the state comptroller’s action.  The city’s pension actuary recently began a customary five-year review of assumptions,  which could easily lead to a similar change, however.

State Comptroller Thomas DiNapoli yesterday issued a happy talk news release touting the state retirement system’s 26 percent return on investments in fiscal 2009-10, which ended March 31.

“The Fund remains one of the strongest in the U.S.,” DiNapoli said. “We’ve come through one of the toughest recessions in modern times, and now the Fund is well positioned to benefit from the national economic recovery we hope is taking hold. We’re not all the way back yet, and as we’ve seen in recent weeks, there are still challenges in the marketplace. But our foundation is strong. We’re moving in the right direction.”

In fact, even after that gain, the pension fund as of March 31 was nearly $56 billion below the level it would have attained if it had achieved its 8 percent target rate of return for the past five years.  The blue line in the chart below shows returns at the targeted rate; the red line shows actual returns, including the fiscal 2009-10 gain the comptroller is boasting about.

As for those marketplace “challenges” DiNapoli mentioned: since March 31, the Dow Jones Industrial average is down 8 percent, while the S&P 500 has dropped 8.6 percent.

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City Comptroller John Liu was asked at a Crain’s NY Breakfast last week whether he would favor shifting future municipal employees from a defined-benefit pension system to a 401(k)-style defined-contribution system.  His reply, according to Crain’s Insider:

“There’s no difference between the cost of benefits, whether they’re defined benefits or defined contributions. There is a difference in who bears the risk,” Liu says. “In defined benefits, the government bears the risks but also enjoys the fruits [if returns are robust]. For defined contribution plans, it’s the participant who bears the risk. To provide the same level of benefits in the long term, it’s cheaper for a large sponsor to pay because of economies of scale and because a large sponsor can ride out fluctuations in the markets.”

Liu says the current system, which pools risk, is more cost-effective than having individuals bear risk. It is more efficient for one investor to manage $1 billion than for 10,000 investors to manage $100,000 each. In any case, he says, “The idea of getting rid of the risk for municipalities and shifting it to retirees is silly.”

“Silly”?  The city’s pension fund contribution for fiscal 2011 is now projected at $7 billion—more than 10 percent of the entire budget, and a sevenfold increase since 2001; this directly reflects the cost to taxpayers of “riding out the fluctuations in the market” on behalf of employees who can retire early with generous benefits constitutionally guaranteed against diminution or impairment.  (more…)

Employee compensation in the state and local government sector increased at twice the private-sector rate during the 12 months ending in December, according to national data released today by the federal Bureau of Labor Statistics.

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Buried in the so-called Tier V pension bill just passed by the state Legislature is an incredible set of special concessions to unionized school teachers in New York.  None of these changes were contained in Governor Paterson’s original “pension reform” proposal, which was a colossal missed opportunity to begin with.  The worst of the giveaways to teachers in the final bill–effectively locking in one of the fastest-growing, most difficult to control components of school district compensation costs–is not even mentioned in Paterson’s press release hailing the bill’s passage.

The teachers’ union had their way on three major items:

• While the minimum full-benefit retirement age after 30 years service was raised from 55 to 62 for all other civilian employees, it will set be at 57 for teachers.  In 2007-08, the median retirement age for New York State Teachers Retirement System (NYSTRS) members was 58.
• The Legislature promised to enact a three-month early retirement window for teachers who are 55 but have only 25 years of service.  Districts will greet this as a cost savings, but it also will shift a so-far uncalculated cost to an already stressed pension fund.
• Last but not least, the Tier V bill makes permanent a temporary law, annually renewed since 1994, barring school districts from “diminishing” health benefits for retired school district employees unless “a corresponding diminution of benefits or contributions” applies to active workers.  Since changes in benefits for current employees must be collectively bargained, the provision effectively gives unions a veto on the matter.  This provision of Tier V, described the Assembly’s press release on the bill as “mak[ing] permanent retiree health protections,” goes unmentioned in the Governor’s celebratory release.
  

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The market value of assets in New York State’s Common Retirement System increased by 18.3 percent during the first half of the 2009-10 fiscal year, Comptroller Thomas DiNapoli announced today.   That brings the total fund value to $126 billion — which, it should be noted, is still $30 billion below its fiscal 2006-07 peak.

The retirement system still has lots and lots of ground to make up.   Over the past five years, the return has averaged just 1.1 percent, according to the latest Comprehensive Annual Financial Report.  That’s nearly seven points below its targeted annual rate of return.  When returns fall short of 8 percent over a five-year moving average, the taxpayers are forced make up the difference through higher pension contributions.

Here’s another way to look at it:

Even if the pension fund ends the fiscal year with a gain of over 20 percent, it appears that taxpayer-funded employer contributions will need to more than double over the next five years to make up for the losses of the past three years, based on projections from previous modeling by the comptroller’s office.

DiNapoli also released this summary of the retirement fund’s asset allocation.  Seventy percent of the assets are classified as equities—which would qualify as a “high-risk” mix for an individual, but is typical of taxpayer-guaranteed public pension funds.

In their weekly outlook, Municipal Market Advisors (MMA) tries to dampen the hysteria over a “coming municipal market collapse,” saying that although “state and local credit quality is undeniably getting worse,” we’re unlikely to see mass-scale municipal defaults in this economic cycle.

Rather, MMA says, “pensions and OPEBs” — that is, the pension and retiree healthcare obligations that states and local governments continue to take on — “will, in the long run, divert tax revenues from infrastructure finance and service provision and thereby drag down economic growth prospects.”

Feel better?

The number of retired New York government employees with six-figure pensions is apparently growing at a 20 percent annual rate.  This complete list of pension recipients, newly posted by the Journal News of the lower Hudson Valley, lists 1,081 individuals with pensions of $100,000 or more.  That’s up from a reported 899 a year ago.

To be sure, in the public pension sweepstakes, New York’s state pension fund is lagging behind California’s giant CalPERS system, which has nearly 5,000 government retirees with pensions over $100,000.  Then again, the state figures at the Journal News site don’t include teachers or New York City employees.

New York’s public pensions are exempt from state income tax and federal payroll tax, and are supplemented in virtually all cases by low-cost health insurance policies.

Today’s “DRP Did You Know” from Governor Paterson’s office says the governor’s proposed pension changes for new newly hired employees will save $60 billion over 30 years.  But here’s the missing perspective: for state government, the modest changes proposed by Paterson would ultimately—i.e., over a decade from now—represent a roughly 23 percent annual reduction* in a pension bill that is poised to increase by 155 percent in just the next three years.

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