We recently published projections by Professors Robert Novy-Marx and Joshua Rauh that showed dozens of city pension plans running dry in the next few years.
The claim that Jacksonville’s fund would become insolvent by 2020 drew a response from Jacksonville Police & Fire Pension Fund Director John Keane.
Keane objects to the assumption of a 4% return on investment. Instead, Keane assumes an 8% return, which would allow the fund to remain solvent through tax amortization. Depending on which rate you use, Jacksonville’s unfunded liability is $4 billion or $1.5 billion.
Here’s Keane’s letter:
Recent Unfunded Pension Liability Study Based on Unduly Conservative Assumptions
By John Keane, Executive Director – Administrator
And Richard Cohee, Deputy Executive Director – Assistant Administrator
Police and Fire Pension Fund, Jacksonville, FL
Being an Administrator for a municipal pension plan, we have read with interest your recent article which highlighted the weakened funded status of State and Local pension plans across the country in the aftermath of the global financial crisis. The article in your publication reported that the unfunded liability for the City of Jacksonville Retirement System was $4 billion in 2009. By contrast, we note that the unfunded liability for the City of Jacksonville’s Retirement System that was reported in the City’s Comprehensive Annual Financial Report (CAFR) as of September 30, 2009 was $1.5 billion. This wide variance in the two reported versions for the unfunded pension liability caused us to examine the manner in which the $4 billion figure was calculated by the authors of the study that was referenced in your article. Our review concluded that the higher figure of $4 billion was based upon the use of a U.S. Treasury risk-free rate by the academic researchers when they discounted the future pay-out of pension benefits. The yield curve used by the researchers when applying this risk-free rate ranges from a rate of below 1% in the early years to about 4.5% in year 30. For purposes of discussion, let us assume that the academic researchers used an average risk-free rate of 4% for purposes of discounting pension liabilities. This discount rate compares to the 8% discount rate used by the typical municipal pension fund that was included in the study.
We do not wish to diminish the recent erosion in the funded status of State and Local pension plans or its impact upon the already strained budgets of governmental units during a weak economic environment. However, we also feel that the academic researchers may have embraced a set of assumptions when publishing their findings that is unduly conservative. The researchers are effectively saying that the financial profile of governmental pension plans should be viewed with the expectation that the long term rate of return for investments for a governmental pension portfolio will be 4%. While we do acknowledge that the average pension plan earned a rate of 4% over the past five year period ended December 31, 2010, we do not feel that this level of return is representative of future expected returns from the financial markets moving forward. In the case of the Jacksonville Retirement System, the past 30 years witnessed an average annual return of well over 9%. In addition, the return over the most recent fiscal year ended September 30, 2010 was 10.7% and the return over the subsequent three month period ended December 31, 2010 was almost 7%. While the most recent five year period ended December 31, 2010 did in fact deliver a 4% return, we must fairly acknowledge that that this time period included the second worst bear market recorded in this country’s history (second only to the Great Depression). Accordingly, the 4% assumed rate embraced by the researchers is not supported by historical facts.
If public pension plans elected to administer an ultra-conservative asset allocation plan that was 100% devoted to U.S. Treasuries, there would be a valid argument for discounting pension liabilities at a rate of 4%. However, this is not the case and therefore, the 4% rate assumed by the academic researchers is flawed. The Governmental Accounting Standards Board (GASB) recently examined a proposal for the use of a risk-free rate and determined that it was not appropriate to convert to this alternative methodology. Beyond these considerations, we must also acknowledge that the U.S. Treasury risk-free rate is currently a function of an extremely low inflationary period, coupled with the Federal Reserve System’s current efforts to engineer a low interest rate environment in order to artificially stimulate the economy. These factors, in addition to the global flight to quality, have produced a particularly low measure of the U.S. Treasury risk-free rate. In others words, the current use of a risk-free rate is particularly conservative on an historical basis in addition to its improper use as an indicator of future return expectations.
Based upon these observations, we would hope that your readers would conclude that the $1.5 billion measure of the City of Jacksonville’s Retirement System is a more accurate reflection of its unfunded pension liability as opposed to the $4 billion measure imputed by the academic researchers that were cited in your recent article.