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As part of his continuing coverage of Making Sen$e of financial news, economics correspondent Paul Solman reports from Rhode Island on the struggles that states are facing over how to calculate investment returns for public pension funds to keep them fully funded.
Next, questioning some basic assumptions about public pensions.
Cities and states around the country are pushing to overhaul or make changes to pension plans. This week alone, there are big votes in Atlanta and New Jersey.
Tonight, in his third story from Rhode Island, economics correspondent Paul Solman looks at the debate over how to calculate investment returns for that state's troubled pension fund.
It's part of his ongoing reporting effort, Making Sense of financial news.
GINA RAIMONDO, Rhode Island treasurer: I would like to call the meeting to order and ask Frank to call the roll.
Thank you, treasurer.
Rhode Island Treasurer Gina Raimondo, a Democrat, presiding over the board that runs the state's $7 billion pension fund.
We're still about a billion dollar off of where we were before the market crashed, when we were at $8.4 billion.
The fund is now billions in the hole, in part because of past investment assumptions that proved too bullish.
JOSEPH NEWTON, actuary:
What we're trying to do is set kind of the most probable scenario that we believe will come to play based on the data that we have today.
The question here is one confronting states across the country. What's a realistic rate-of-return assumption? The answer could mean higher taxes, lower pensions, bitter politics.
I'm going to ask you to please put the politics aside. I know there are pressures. I feel these pressures myself.
Like most states, Rhode Island invests about 60 percent in stocks. But, over the past decade, the market has barely budged.
Consultant Allan Emkin:
ALLAN EMKIN, Pension Consulting Alliance:
The 2001 tech bubble, the credit bubble in 2007-2008, over those two periods, you had a 70 percent cumulative loss, and, effectively, over the whole period, the equity market generated zero. You had a lost decade.
Since most of the other 40 percent is invested in low- paying bonds, the hired experts told Rhode Island: Get real. Drop your assumed rate of return from the current 8.25 percent per year to 7.5.
The problem is, the lower the assumed rate of return, the greater the official underfunding of the retirement plan, the more that taxpayers or workers must contribute to make up the shortfall that would arise from a more sober assumption.
Public employees, who make up almost half the board, were unhappy.
Said retired engineer Michael Boyce:
MICHAEL BOYCE, state retiree: Quite frankly, I'm not going to vote for 7.5.
That's because dropping the rate to 7.5 percent would force the state to come up with some $300 million more every year to replenish the fund, a huge hit to angry taxpayers, or their new scapegoats, state employees.
So, board lawyer Michael Robinson, pushing to cut the rate assumption, targeted workers like Boyce.
MICHAEL ROBINSON, board lawyer: To act contrary to the recommendations of your expert without a sound and considered basis in fact would really constitute a breach of your fiduciary obligations.
If I follow Mike's rationale, I would guess that we shouldn't even have to be here, because, if the actuary says 7.8, do 7.8.
No, no, not at all, Mike.
I have the floor, please. I'm taking offense at almost being told that I better vote to what exactly he said.
Richard Licht, state director of administration, sided with the experts.
RICHARD LICHT, Rhode Island director of administration: While reasonable people can differ, past experience shows we should be a little more on the cautious side. That's all. And I will vote yes.
But some prominent economists say even a 7.5 percent target is far too high.
ZVI BODIE, Boston University:
They should be using something like 4.5 percent, because, over any time period, there is no guarantee whatsoever that that portfolio of stocks and bonds is going to produce enough to pay the promised benefits.
Finance Professor Zvi Bodie says that, to earn more, pension funds have to make risky investments that could fail, in order to pay for benefits that are guaranteed.
So, why not invest all the money in safe U.S. Treasuries, which have been paying about 4-4.5 percent lately? That way, the pension fund earnings will also be guaranteed?
Those are long-term obligations which are going to be paid for sure. Pension benefits are just like that.
By contrast, Bodie points out, stocks are subject to all sorts of risks. Imagine the reaction to, say, an act of nuclear terrorism, a tsunami that floods New York, a meteor barrage that signals the attack of a killer asteroid? OK, Hollywood scare films may seem a bit extreme for pension planning.
But, says Bodie, back in 1989, when the Japanese stock market peaked, the disaster there since would also have been utterly implausible.
You and I both remember in the 1980s how everyone you talked to thought the Japanese economy was overtaking the U.S. economy. Twenty-two years have gone by since then, and the market in the U.S. is up. The Japanese, who were supposed to outperform us, the market is now roughly a quarter of what it was.
So, what about a Japan-like catastrophe? We asked Pension Consultant Emkin.
Could it happen? Yes. Is it likely? In my opinion, no. Do you plan for the worst possible event, or do you plan for the most likely event, or do you plan for an average?
DEAN BAKER, Center for Economic and Policy Research: We can't plan our lives as though we're going have a complete economic disaster.
Economist Dean Baker echoes the consultants, and makes the case that you hear from unions, too — 7.5 percent is the least a state should assume, because its pension fund is eternal.
Governments are in a different situation from individuals. We, as individuals, are all going have finite lives. The market has its ups and downs, so it might just be the case we plan to retire in three years, and it turns out, bad news for us, the market just fell 20 percent. State and local governments are going be there indefinitely.
Moreover, says Baker, if you play it too safe, you're probably investing more conservatively than taxpayers or pensioners would want you to.
Most people, in their own investments, certainly anyone who has a 401(k), they are willing to take some risk. And it's a little perverse if we say, here, you could have an individual taking risks with the stock market, individuals knowing that things happen, that you're going to have to retire at a certain point in time, and, on the other hand, we have the government that's going to be there, in principle, forever, and they can't take the risk. That would seem very perverse to me.
But the government entity is taking a risk with its taxpayers' money.
There's no way to avoid that. We'd be asking people, do you want to pay higher taxes in order to avoid taking the risk in the stock market? I think most people would say no to that.
The stock market has been misbehaving.
But Professor Bodie says that, if pension funds don't make their assumed rates of return, the taxpayers will be in for a shock and higher taxes at that point.
If things don't work out, taxes are going to have to be higher on the next generation of taxpayers to pay the current generation's pension benefits.
Now, I say that's fine, as long as everybody knows that is the risk that is being taken. But, of course, nobody knows that, right?
Treasurer Raimondo is trying to steer a middle course on risk. At a women's shelter she helped build, she explained that cautious investing is expensive. Taxes rise. Services, like this one, get cut.
But, at the other extreme, over-optimism could mean failure and an empty till when retirees are due their money.
Because I care about state employees, I want to make sure their pension is there for them. And because I care about all of Rhode Island, including the women who are here, I want to make sure the state can afford and have enough money left for all the other services that we need.
Back at the retirement board meeting, the vote on lowering the assumed rate of return.
By 9-6, the board cut the assumption to 7.5 percent, low compared to other states.
On the basis of what we have heard from our financial advisers, it was prudent to assume 7.5 percent. Having said that, if we keep benefits the same and the investment return comes down, the taxpayer will pay more.
In fact, the board has since voted to hike taxpayer pension contributions by 50 percent. The lower rate of return and the higher contributions go into effect next year. Raimondo says the fund is still in crisis, however, while it continues to place most of its bets on stocks, like pretty much every state in the union.
And you can watch the previous stories in Paul's series on his Making Sense page on our website.
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