Pension fund rate of return will get scrutiny in 2012

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State lawmakers are mulling a significant change to the state’s pension policy as they prepare for the 2012 legislative session. In the wake of a succession of stock market dives and in anticipation of tepid economic growth for the foreseeable future, lawmakers are afraid that the assumed rate of return for the state’s pension investments, at 8.5 percent, is too high.

Rep. Morrie Lanning, R-Moorhead, who chairs the Legislative Commission on Pensions and Retirement (LCPR), has held a series of meetings this fall in which the panel discussed the rate of return issue in detail. The LCPR is scheduled to choose issues for the 2012 legislative session on Nov. 9 and 10, and Lanning said he expects the policy on future investment returns to be a central component of next year’s omnibus pensions bill.

“Minnesota is one of the highest in the country in what we assume as a rate of return,” Lanning said, “and we’ve heard a lot of concern about that. In our meetings, a couple of major funds have already recommended dropping that rate.”

Before the tech bubble burst, Minnesota’s three major statewide pension plans were 100 percent funded. The recession in the early 2000s opened up funding shortfalls that were further exacerbated by the real estate bust and Wall Street meltdown in 2008 and 2009. In 2010 state lawmakers took steps to shore up the pensions by increasing employee and employer (i.e. the state’s) contributions to pensions and by lowering the annual increase in retiree benefits.

But economic troubles make lawmakers like Lanning and officials like State Economist Tom Stinson skeptical that the state can reasonably expect an 8.5 percent return from its investments going forward.

“I think that a prudent movement would be to reduce it from the 8.5 to the 8 level,” Stinson said. “The reason is that over the next several decades, the best evidence is that we’re going to have really quite small labor force growth nationally. If you don’t have remarkable productivity growth nationally, you’re going to have slower economic growth. Slower economic growth means slower corporate profit growth and slower equity growth as well. So I think looking on out into the future that the information we have about past performance is likely to be overly optimistic.”

Such a move, however, has financial consequences for the three pension funds: the Minnesota State Retirement System (MSRS), the Public Employee Retirement Association (PERA) and the Teachers Retirement Association (TRA). Lowering the assumed rate of return would increase the pensions’ unfunded liabilities, noted Mark Haveman, executive director of the Minnesota Taxpayers Association.
“What would instantaneously happen is your contribution deficiencies would increase,” Haveman said. “It would result in these funds being reported in worse conditions.”

Among the three funds, only TRA has voiced concerns about lowering the rate.

If the rate of return was dropped to 8 percent, TRA’s funding ratio would drop from 78 percent to 74 percent funded, based on the value of TRA’s investments as of June 30, said TRA Executive Director Laurie Fiori Hacking.

“What our board has said is, think about this before you do it. We think the return can stay at 8.5 percent for the long term,” Hacking said. She notes that TRA’s actuarial consultant has verified that 30-year compounded returns going back to 1955 have almost always been above 8.5 percent, even in times when the Great Depression is included in the 30-year frame of reference.

“Those returns incorporate the Great Depression,” Hacking said. “They incorporate two world wars. To say that we are really in a worse situation than we were in the aftermath of the Great Depression is pretty pessimistic.”

The funding ratio is an issue of importance for retired teachers because of changes that were made in the 2010 pension bill that shored up the pension funds. The legislation signed by Gov. Tim Pawlenty suspended teachers’ benefit increases for two years. In 2013, benefits will start to increase at 2 percent annually, which is lower than the 2.5 percent increases that were in law before 2010. The old level won’t get reinstated until TRA is 90 percent funded. And a 90 percent level would be bumped further into the future if the rate of return was lowered.

Lanning acknowledges TRA’s concerns. But in light of the volatility of the markets that have marked the last decade, he’s doubtful about the future. “I understand the reluctance,” he said, “but my feeling is that we can do more harm down the road to school districts and to retirees if we continue to make promises that cannot be supported.”

The move to adjust the rate of return isn’t as dramatic a change to state pension structure as Republicans have considered in previous legislative sessions.

In 2010, Sen. David Hann, R-Eden Prairie, proposed to stop new workers from entering into the state’s defined-benefit pension plans. In a floor amendment that was defeated, Hann would have established defined-contribution plans for new public employees in which they bear the risk and make their own investment decisions. Lawmakers have been counseled against the move, because it would leave the state to bear the burden of liabilities to retirees under the old plan, which would no longer be receiving contributions from new workers. The idea was essentially killed by a report from the three pension funds that predicted transition costs to the state of $2.8 billion over 10 years.

Nonetheless, lawmakers are pursuing the possibility to create a hybrid plan to give workers more control of their investments without doing away completely with the old system.

“My hunch,” Haveman said, “is that [the report] killed the idea for an immediate switchover to a defined-contribution plan because the transition costs are so extraordinary. What it opened up, I think, is some discussion of a hybrid plan and what that would entail. A hybrid plan retains an element of the defined benefit and combines it with defined-contribution piece. But more importantly, it allows you to keep the funds open so those extraordinary transition costs are mitigated.”