Friday, September 14, 2012

Time Bomb: Lengthening the Fuse

This article is part of a long discussion about the solvency of the State Teachers Retirement System. Other articles can be found here.

This week, the 129th General Assembly passed Substitute Senate Bill 342, the long-awaited legislation to make changes to the State Teachers Retirement System (STRS) in hope of restoring solvency to this huge and important pension plan. Similar bills were passed in regard to the other state employee retirement systems. Now they go to the Governor for signature. I presume that will happen without further debate.

The independent Ohio Legislative Services Commission provides analysis of proposed legislation, primarily so the legislators can understand what they're voting on, but also so the public may review and give comment. Here are some of the most significant changes, as I understand them*:
  • The employee contribution rate to STRS will be increased by 1% each year starting in July 2013, from the current 10% of salary until it reaches 14% of salary (in 2016). The employer contribution rate will remain at the current 14%.
  • After July 2017, the STRS Board will be allowed to reduce the employee contribution rate to less than 14% if the Board's actuary determines that doing so will not harm the solvency of the system. This presumably would happen when their investment portfolio is enjoying extraordinary returns (more on this later).
  • Under the current scheme, the basic retirement benefit is 2.2% of the Final Average Pay (average of the last three years of employment) times the number of years of service. However, there were 'kickers' that engaged for a teacher who completed more than 30 years of service.

    The big kicker was that a teacher retiring with 35 years or more of service would receive 2.5% of FAP times the years of service, rather than 2.2%. This works out to 87.5% of final average pay. Many of our teachers will retire at the top of the pay scale, which is currently $90,855, making the annual pension for those who retire with 35 years of service be $79,500.

    These kickers are being eliminated effective August 2015. Afterward, as I understand it, a teacher retiring with 35 years of service would receive 77% of FAP, which is $70,000 in the case of a teacher with an FAP of $90,855. This nearly $10,000/yr difference will motivate every teacher who hits 35 years years of service in 2015 or before to retire before August 2015. According to data I've seen, there are about a dozen such teachers in our district. Many of those who would have been eligible retired last year via the early retirement incentive program.
  • After August 2015, the FAP will be calculated with the final 5 years of salary, rather than the final 3. This is significant only if salaries are increasing rapidly, and if that is the case, the 5 year averaging will tend to make the FAP be smaller than it would be with 3 year averaging.
  • Starting next year, the the annual Cost of Living Adjustment will be reduced from 3% to 2%. Those retiring before July 2013 won't get the first COLA for one year. Those retiring after July 2013 won't get one for 2 years. Those retiring after August 2013 won't get COLA for 5 years.
  • Permits, but does not require STRS to pay up to 90% of the monthly basic Medicare Part B premium.
  • Permits, but does not require STRS to offer long-term care coverage.
  • Allows 'double-dipping' to continue, but the retiree forfeits two months of retirement benefits.
  • The option to choose a Defined Contribution Plan continues, even though almost no one does this any more. If an employee shifts from the Defined Contribution Plan to the Defined Benefit Plan, STRS is permitted to, but not required to, shift some of the employer contribution made under the DC plan to the DB plan. As I understand it, the choice to switch must be made by the 5th year.
The increase in contributions and the reduction in benefits - both which largely affect only those yet to retire - may be helpful, but a key problem remains:  the assumption that the investment managers will be able to generate returns averaging 8% forever. Last year, according to their own investment reports, their return was only 2.34%.

The STRS management tries to make that look less onerous by 'smoothing' the reported return over 4 years. That seeks to hide a basic piece of investment math: if you lose 20% of your money in one year, you have to earn 25% in the following year to get back to where you were, much less generate the 8% CAGR you need to average over the long haul. Here's an illustration:
click to enlarge
If you start with $100 in 2002, then apply the actual annual earnings rate achieved by the STRS investment managers, then in 2012 you would have ended up with $196, which is a respectable 7% compound annual growth rate. However, the STRS actuarial assumption is 8%, and if they had earned 8% every year since 2002, the $100 would have grown to $216. In other words, the fund has about 9% less money in it than they were counting on.

This week, Federal Reserve Chairman Ben Bernanke announced that the Fed was going to try to keep interest rates near zero for the foreseeable future. This might be great news to the borrowers in this world, but it's a nightmare for those who intend to generate income with interest-bearing investments, notably those traditionally recognized to be the safest of all - US Treasury Bonds.

The most basic principle of investing is that risk and return are inversely related. If one wants little risk, one has to accept little return. To get greater return, greater risk has to be taken. So if the least risky investments generate essentially zero return, then for STRS to achieve 8% return, lots of risk will need to be taken.

Yet most teachers I've talked to are risk-adverse. After all, STRS offers a Defined Contribution Plan in which the contributions are the same as with the Defined Benefit Plan, but with the DC plan, the teacher gets to decide how to allocate their contributions among a variety of investment options, in the same way most 401(k) DC plans work in the private sector. Virtually all STRS members selected the DB plan anyway, leaving all the investment decisions up to professional investment managers who they expect to invest in a manner that generates a respectable return, but also protects them from 'losing their nestegg.'

Of course, when the real estate and stock markets tanked 2007, the investment managers just said "hey, we lost less than most people," even though it was tens of $billions of the teachers' money - a result which directly led to this reduction in future benefits. Nonetheless, the investment managers have been given the green light to pursue investments that they hope will generate 8% returns in a 0% interest rate climate. More return - more risk.

So what happens if the the risks they take don't work out?  This Time Bomb hasn't been disarmed, it's only been given a longer fuse. Even without another stock market crash, the STRS managers will be hard pressed to build a portfolio of investments that will reliably return 8% for decades. What if they never get there? Where will the money come from to pay for even this newly reduced level of benefits if the investment managers don't meet this aggressive goal?

Again, it should not be the taxpayers. We will continue to pay the 14% employer contribution, and then it's up to the STRS managers to decide how to balance their contribution, the benefits they expect, and the risks they want to take. If they win big on the investments, this new law allows all the benefits to accrue to them, such as the reduction in employee contribution (ie there would be no reduction in employer contribution). If that's the case, they lose big, then they can't expect the taxpayers to keep them whole.

* STRS Members: DO NOT rely on anything I have written or said to make decisions about your own retirement planning. Please consult with your STRS representative.


  1. Who are these investment managers promising 8%?

    I mean, Madoff promised 10% (and he was an insider).

    These pension funds are just marks for the investment banks and hedge funds (or 'muppets' as they say at Goldman Sachs).

    When will people understand that stock trading is a zero-sum game. The law of averages dictates that you will lag the market by your transaction costs / management fees....

    Fire the traders and dump it all into a Vanguard index....

    1. I don't know that the actual investment managers are promising 8%. It's probably more like the actuaries said that was what was required to line up with the rest of the parameters (fund size, contributions, benefits), and the investment managers went along.

      After all, if you were one of those guys and really thought you could earn 8%, wouldn't you sandbag and say that gee, oh maybe 5% is all you thought was possible, so you could beat the goal and make a big bonus?

      Stock trading is zero-sum only in the broadest sense. I think it's more like playing hold 'em at the casino. One or two players walk away with most of the chips. Most lose if they play long enough. The house always gets their cut...

  2. Paul - I believe it was the Dispatch (can't be certain) that actually reported STRS was banking on a 7.5% return.

    That's too high, IMO, though the analysis I gave you earlier, which modeled female teachers only (worst case, since payouts for men would be lower) show that a very modest rate of return would be necessary for their benefits in the future. Rather, a large chunk of the 14% matching funds and the assumed rate of return is being used to try to patch the funding hole.

    In an odd way, that's actually a good thing. Why? Well, since we've seen that we really only need a modest return with a 9.2% match rather than a 14% match, it is entirely possible to fall short of that 8% goal and not dig the hole much deeper - because eventually all you would need is that 9.2% match and the ~5% return to fund the pension. So if after 30 years they had only achieved 7% instead of 8%, they might be, say 76% funded (VERY, VERY crude analysis of (1.07/1.08)^30). However, that's still an improvement from 60-65%. And they still only need the 9.2%/ 5% balance going forward even then...

    So if they hit 8%, in 30 years, its likely that they could drop the district match from 14% to 9.2% and drop the assumed actuarial return to a much lower rate. If not, they might not be able to drop the match at that point, but they don't necessarily need to raise taxes/contributions to fill it - they should just need more time.

    That's one of the beautys of the Ohio system - in California, they don't even try to close the gap, they just "reform" just to keep it from getting worse. Then if they fail to meet their targets, it HAS become worse. In Ohio, with the 30 year funding requirement, failure to meet your targets may just mean that you need a bit more time. That's why many analysts actually praise Ohio's system for being semi-responsible. When there's a shortfall, the fixes are much more aggressive than pretty much any place around.

    I'd still recommend that ANY new teacher take the defined contribution plan, though - even with today's abysmal rates, a 5% annual rate of return isn't that hard to get and still be conservative. A good conservative Vanguard balanced fund should get you that no problem, and you don't have to worry about politicians screwing you over... and when you retire, you can just dump the thing into a fixed life annuity to get the same benefit without worrying about outliving it... (current immediate annuities for 60 year old females run around 5.8% yields, last I checked - better than what you need in the STRS revised plan for actuarial balance).

  3. The most recent investment performance report published by STRS seems to indicate that their current blended goal is 7.7%, but with different return expectations for different classes of investments:

    Domestic Equities: 8.5%
    International Equities: 8.8%
    Fixed Income: 4.8%
    Real Estate: 6.5%
    Alternative Investments: 10%

    I don't recall the target blend of these classes, and haven't found the document where it's published yet. But their 2012 results were nowhere close to these goals, doing about twice their goal on real estate, but taking a big whack on international equities.

    Thanks for the dialog.

  4. "I'd still recommend that ANY new teacher take the defined contribution plan, though"

    Say what!?!? This advice seems to be at odds with your second to last paragraph (and against all conventional wisdom). All plans have their risks (some foreseen, other not), but at this point I wouldnt think twice about trading in my 401k for a teacher pension.

    "5% annual rate of return isn't that hard to get and still be conservative"

    Over what time period? In the past, yes. But today's stockmarket bears little resemblence to the stockmarket of even 10 years ago. (I am referring mostly to high frequency trading and the "shadow banking" system, but also the regulatory capture of the SEC, and the Fed Reserve skewing asset prices by injecting the banks with $$$).

    Ask a Japanese money manager how easy it is to earn 5%...

    1. T -

      30 year treasury bonds have a current yield of 2.84%. That means that your risk premium has to average just 2.16% to hit a 5% annual rate of return. That low of a risk premium allows you to take a VERY conservative portfolio. You're making the mistake of assuming that you have to go heavy into the stock market to get returns of 5%. You don't.

      Current 20 year corporate bonds with A ratings are at 3.91%. That's a very, very low risk investment.

      A quick search of Fidelity's current offerings on the secondary market show 229 total investment grade corporate issues currently available on the secondary market with yields to maturity of 5% or higher.

      It isn't hard to get 5%. You just have to be careful not to aim for the stars. By focusing on the Nikkei, you're looking at the wrong place to get low risk returns.

    2. Maybe I slept through that finance class, but isn't the 'risk premium' the additional return on expects for taking the risk? In other words, if a US Treasury instrument is paying x% for y duration, then for a long time we've said that x% was the 'riskless' return rate, and that to invest in any other security, one would have to see a return well above x% to compensate for the risk.

      So if the 30 year T-Bond is at 2.84%, then I would invest in something paying 5% only if I felt that the additional 2.16% of return over 30 years vs the T-Bond was worth it.

      Of course, the 2.16% 30 yr T-Bond rate isn't without risk. Ignoring the tiny risk of default, the primary risk is rising interest rates, and I have no doubt that they'll rocket through 2.16% once the Fed decides they've printed enough money (buying all the Treasuries the President wants to issue).

      Investors all over the world are chasing yield, and not having much luck. Yes, there are players who have made a ton of money since 2007. I wish I possessed the guts to have bought big into a DJ30 index fund in 2007 when it played with 7,000. But at 7,000, I wasn't sure it might not keep going to 5,000 or lower. Still not sure that won't happen.

      The stock market today is like playing poker, and has been ever since the $billions started pouring into IRAs and 401(k)s in the 1980s. Money can be made in equities, but as Kenny Rogers said, "you got to know when to hold 'em, and when to fold 'em."

      Most of us don't.

      Even the so-called professional managers bluff their way through things. When the tide caused all boats to rise in the 90s, they had no problem taking credit. Then when the tide went out, their claim was "we didn't lose as much as the next guy."

      Now during the ebb tide, they're lost as to what to do. Maybe they'll guess right, maybe not.

      Sounds like the risk premium needs to be pretty sizable these days...