Providence Pension Return Projection Flawed
Wednesday, May 15, 2013
On the heels of the Providence City Auditor's third quarter FY2013 budget analysis and projections released on May 1st showing the city on track to end the current fiscal year with an operating deficit of approximately $10.8 million, questions are being raised as to whether the city's rate of return assumption of 8.25% on its pension fund is feasible -- or possibly flawed.
The most recent valuation of the city's pension fund that was provided to the state municipal finance commission was undertaken by Buck Actuaries, who the City of Providence is suing for failing to account for certain cost-of-living-adjustments during the city's recent pension reform negotiations, which the city calculated to be...a $10.8 million error. Buck was subsequently fired as the city's actuary, and an RFP has been issued for new actuarial services.
At 8.25 percent, the City of Providence's rate of return assumption is significantly higher than the 7.5% being assumed by the City of Cranston, City of Warwick, and notably, General Treasurer Gina Raimondo, who battled to lower the state's pension fund rate from 8.25 to 7.5 percent in 2011.
GET THE LATEST BREAKING NEWS HERE -- SIGN UP FOR GOLOCAL FREE DAILY EBLAST"If I take a look at all of the public sector, [the City of Providence] is rather high," Tayt Odom, an actuary with Nyhart, one of the nation's leading actuarial and employee benefit consulting firms. "I can't however say it's wrong, if they feel that's a good number that's achievable over time."
"Pension Rate-of-Return Fantasy"
In an opinion piece that ran in the Wall Street Journal last month by former hedge fund manager Andy Kessler entitled "The Pension Rate-of-Return Fantasy", Kessler asks the rhetorical question, "Who wouldn't want 7.5%-8% returns these days?"
His answer, however, is, "The right number is probably 3%."
Kessler goes on to point out, "According to the actuarial firm Milliman, the 100 top U.S. public companies with defined benefit pension assets of $1.3 trillion have an average expected rate of return of 7.5%. Three of them are over 9%. Since 2000, these assets have returned 5.6%.
While Kessler focuses heavily on current low fixed income return rates, the City of Providence has a current heavy allocation -- in hedge funds, of nearly 20%. And the hedge-fund and alternative investment-heavy investment allocation under Raimondo has come under close scrutiny for its performance -- or lack thereof.
In an exclusive article that appeared in GoLocal last month entitled "State Pension Fund Lost $200M Under Raimondo", investigative reporter Stephen Beale disclosed that the General Treasurer's investment strategy yielded a rate-of-return of 1.5% over the past year, which coupled with the fact that benefits paid out exceeded current employee and state contributions, amounted to the two hundred million dollar loss.
Beale went on to write, "But some worry that the low rate of return undermines the just-passed pension reform, which included as one of its key assumptions an assumed rate of return of 7.5 percent. “The numbers obviously have been overestimated,” said state Rep. Karen MacBeth, D-Cumberland. “When we passed pension reform this was an expectation and we’re not meeting it with our rate of return.”
Buck on the Books -- and Hook?
Buck's "Employees' Retirement System for the City of Providence Experience Investigation for the Five Year Period Ending June 30, 2011" contained the following chart that showed the investment return of the assets of the System from 2006 to 2011.
"The expected investment income is based on the System's assumed interest rate," Buck wrote. "The current interest rate assumption is 8.25%, which is higher than the 5.75% five-year actuarial rate of return reported."
Buck noted that the "current asset allocation has an equity exposure of 85%, notably higher than the target range," and went on to state, "Only hindsight will tell if a particular combination of economic assumptions is optimal. We believe the current interest rate assumption of 8.25% can be supported based on our analysis assuming the target allocation continues, the assets earn the assumed rate of return, and the City makes the required contributions."
In its recent "Funding Improvement Plan" as mandated by the State by locally administered plans in "critical status", the City of Providence provides projections at the 8.25% level -- and notably as well at a 7.75% level -- and the lower interest rate level would correlate to a higher unfunded fund liability if used.
Looking Forward -- Adjustments Needed?
"Actuaries work on forward-looking assumptions," Becky Sielman with Milliman explained to GoLocal earlier this week. "Nothing should be based looking backwards at trends or history; since they are not indicative of future conditions."
Sielman, who is giving a talk today at the Connecticut Public Pension Forum entitled, "Why Your Actuary is Telling You to Reduce the Interest Rate Assumption and Update the Mortality Assumption," explains that the future forecast on investment returns in currently dim -- and needs to be taken into account by fund managers.
Acknowledging the financial -- and political -- difficulties states and municipalities face in reducing their rates, Sielman states, "It's painful, but it's important to keep assumptions realistic. I can't say [the City of Providence's 8.25%] is wrong, but it needs to be reexamined in light of current thinking."
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