May 23, 2016

Further Reforms Are Needed for the Retirement System of Alabama

Daniel J. Smith

Associate Professor of Economics, Troy University

Defenders of Alabama's tenuous pension status quo accurately point out that we have not yet seen the full effects of the 2011 and 2012 reforms to the Retirement System of Alabama. Unfortunately, that is not an excuse to avoid further action.

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Defenders of Alabama's tenuous pension status quo accurately point out that we have not yet seen the full effects of the 2011 and 2012 reforms to the Retirement System of Alabama (RSA). Unfortunately, that is not an excuse to avoid further action.

My recent study (coauthored with my colleague John Dove) finds that unfunded pension liabilities, as reported by the RSA, represent a substantial budgetary problem for Alabama, even with the recent reforms. The reality is that the problem is much worse than even the numbers reported by the RSA.

Robert Novy-Marx, a professor of business administration at the Simon Graduate School of Business at the University of Rochester, and Joshua Rauh, a professor of finance at the Stanford University School of Business, find that state pension plans across the nation use economically invalid actuarial methods that obscure the true extent of the looming pension crisis. In fact, an overwhelming majority of surveyed policy economists believe that state pension funds, like the RSA, use misleading actuarial methods to understate liabilities. Novy-Marx and Rauh conservatively estimate that properly accounting for these pension liabilities adds $3.23 trillion to state debt across the nation. This has led some scholars to warn of a coming "fiscal ice age" that state and local governments are going to face as pension obligations consume a larger portion of their budgets, leaving less for schools, infrastructure, and public safety.

All actuarial calculations rely on assumptions. For instance, the RSA's reported funded ratio depends on the RSA's assumed 8% rate of return. Pension experts believe this poses two problems. First, it doesn't reflect the realities of the low-interest rate environment of our current economy. Second, even if an 8% rate of return is justified, it does not make economic sense to use the RSA's assumed rate of return as the discount rate for liabilities. 

On the first problem, Andy Kessler, in the Wall Street Journal, calls inflated assumed rate of returns in public pensions the "biggest lie in global finance."  While the RSA assumes an 8% rate of return, its rate of return over the 2014-15 fiscal year was 1.04% (TRS), 1.05% (ERS), and -.54% (JRF). The RSA's 10-Year returns for the TRS, ERS, and JRF were 5.41%, 5.16%, and 6.10%. The reality is that it is hard to achieve an 8% rate of return in today's low-rate environmentwithout taking on additional risk.

By comparing the RSA's assumed 8% rate of return to the risk-free rate of return each year, we can calculate the RSA's assumed risk premium, a measure of how much risk the RSA would be taking on to achieve its target rate of 8%. Since 2003, the RSA's risk premium has increased 35%. In comparison, the RSA's assumed rate of return would be around 6.5% if they had maintained a constant risk premium over this time period. With the RSA's reported funding health increasingly relying on higher levels of assumed risk, these assumptions have translated into real risk exposure for taxpayers. Equity investments, the riskiest class of investments, have increased from 43.5% of the TRS's portfolio to 66.8%. The ERS (47% to 65%) and JRF (48.6% to 70.6%) have similarly shifted to riskier investment strategies since 2001.

On the second problem, the RSA's funded ratio calculation takes their assumed 8% rate of return and then uses it as the discount rate for their liabilities. In their study published in the Journal of Economic Perspectives, Robert Novy-Marx and Joshua Rauh find that using an assumed rate of return as a discount rate does not have a "valid economic motivation." The only justification for discounting liabilities at a higher rate than the risk-free rate (the guaranteed rate), would be if the State of Alabama and the RSA were assuming that these pension obligations weren't guaranteed, meaning that, in evaluating the funding health of the RSA, they are factoring in a probability of defaulting on their own promises made to RSA members. Using a higher rate to discount liabilities substantially understates the liabilities owed to retirees, making it more difficult for the state to plan and budget to meet these obligations.  If the RSA's promised benefits are, in fact,guaranteed, they should be accounted for using a guaranteed, risk-free, discount rate.

Using an economically valid risk-free rate to discount liabilities provides a much more realistic assessment of the health of the RSA. For instance, the funded ratios–the percentage of actuarial liabilities that are covered by actuarial assets–for the TRS, ERS, and JRF fall to as low as 32%, 32%, and 29% respectively using a 15-Year Treasury bond rate. This risk-free discount rate brings total TRS, ERS, JRS, unfunded liabilities to $61 billion. Even if we put every cent of our tax revenues towards paying this liability, it would take a staggering 6.66 years to completely fund these pension obligations (based off of constant 2014 tax revenue).

We hope that RSA members, policymakers, and concerned taxpayers will take the time to read our report. Many states across the country are facing similar pension problems and have undertaken, or are considering, the structural reforms necessary for establishing a sustainable retirement structure for state employees, teachers, and judges.

RSA members and Alabama taxpayers have too much at stake to settle for temporary reforms.