Forecasting the Future: Pension Rates and the Assumed Rate of Return

Barbara T. Reid

The financial condition of pubic pension systems across the country is receiving far closer scrutiny than in the past, primarily due to investment losses in 2008-2009, concern over the level of unfunded liabilities, and the strain that increasing pension costs are placing on state and local government budgets during these challenging economic times. Similar to New Hampshire, many public pension systems are considering, or have already made, changes to their benefit levels and increased the amounts that employees contribute toward their retirement in order to stabilize the costs of these public pension plans.

During the 2011 legislative session, much attention has been focused on statutory changes to the New Hampshire Retirement System (NHRS). These proposed changes are designed to improve the financial viability of the system, address the growing liabilities of the system and curb the spiraling increases in employer contribution rates. The changes being considered this year in both House and Senate retirement reform bills are "plan design" changes that fall under the purview of the legislature and, if enacted, will improve the funding status of the system and allow public employee pension benefits to continue at more reasonable costs to taxpayers.

While the statutory plan designs of a pension program are a major factor in determining the costs and liabilities of a retirement system, another very significant factor in determining the costs is the assumed rate of return on the system's investments. Unlike plan design provisions, such as the required retirement age, years of service, definition of earnable compensation and pension computation formulas, the assumed rate of return is not a statutory provision that falls under the authority of the legislature. Rather, the responsibility to establish the "rates of regular interest for use in all calculations" lies with the NHRS Board of Trustees under RSA 100-A:14, III. Changes to the assumed rate of return can have a significant impact on employer rates and, in addition to plan design changes, this topic is currently the subject of discussion with many public pension systems across the country.

Importance of Assumptions in Employer Rate Calculations
There are only three sources of funding for the NHRS: employee contributions, employer contributions and investment earnings. For many defined benefit public pension systems, employee and employer contributions combined account for approximately one-fourth to one-third of the funds necessary to pay pension benefits. Investment earnings provide two-thirds to three-fourths of the money necessary to meet the long-term financial obligations of a defined benefit program such as New Hampshire's.

While employee contributions are set by state law, currently at 5 percent for non-state Group I members (employees and teachers) and 9.3 percent for Group II members (police and fire)—with legislative proposals being considered to increase those rates—employer rates fluctuate based upon the financial needs of the system. To determine the appropriate level for employer rates, the NHRS engages the services of actuaries, currently the firm of Gabriel Roeder Smith & Company (otherwise known as GRS), to provide long-term projections of the costs of the system based upon the statutory plan designs. The NHRS also engages the services of professional investment managers, currently the firms of NEPC and Alliance Bernstein, to provide market analysis and investment guidance regarding the potential long-term growth of the system's assets available to pay pension benefits. After consultation with these experts, the NHRS Board of Trustees certifies the employer rates, generally adjusting the rates every two years, to meet the provisions of article 36-a of the New Hampshire Constitution, which requires that employer contributions "be determined by sound actuarial valuation and practice."

To accomplish the task of projecting the long-term costs of the system, projecting the assets available to fund those costs and, ultimately, determining the difference that must be made up through employer contributions, GRS must rely on certain "assumptions" as approved by the Board of Trustees regarding both demographic and economic conditions.

Demographic assumptions about NHRS members include the age and years of service when members will retire, the percent of members that will be married with spousal benefits, the rates of mortality and disability, how many members will leave before vesting and withdraw their contributions, and how many vested members will leave before reaching retirement age and either be entitled to a future benefit or withdraw their money from the system.

Economic assumptions fall into three categories. The first is compensation, which includes wage inflation, merit and longevity pay increases and end of career payments. The second is the assumed rate of return on investments and the third is price inflation (which is not explicitly used in the valuation of the NHRS).

Along with the plan design provisions in law, these assumptions provide the framework by which GRS is able to project pension costs and employer rates into the future. However, these assumptions are just that—assumptions about how NHRS members and the economy will behave, with no crystal ball available to predict with 100 percent certainty what those future demographic and economic conditions will actually be. So, how does the Board of Trustees decide on reasonable assumptions to adopt for use by GRS? Well, one helpful tool to assist in determining reasonable assumptions to use going forward is an experience study that looks backward, and compares previous assumptions to the reality that has already occurred. Such a study was recently completed by GRS, measuring actual demographic and economic experience of the NHRS over the past five years (2005-2010) compared to the assumptions used to project system costs and employer rates during that period.

The results of the five-year experience study, available online, indicate that modest changes to the demographic assumptions are warranted, some of which will slightly increase employer rates and some of which will slightly decrease employer rates. The assumptions that will have the most significant impact on employer rates, however, are the rate of investment return and the rate of wage inflation, which together are referred to in the study as the aggregate economic assumptions, more commonly called the assumed rate of return. Since employer rates fluctuate in order to adequately fund the pension system, if more money is assumed to come from investment earnings, then less money needs to come from employer contributions. Conversely, if less money is assumed to come from investment earnings, then more money needs to be funded by employers.

Proposed Change in the Assumed Rate of Return
The assumed rate of return used in determining employer rates has been 8.5 percent since July 1, 2007, having been lowered to that rate from 9 percent. In comparison to other public pension plans, New Hampshire's 8.5 percent assumed rate of return is currently at the high end of the spectrum, with the vast majority of plans at 8 percent and a few plans as low as 7 percent. While there is much discussion about the reasonableness of an 8.5 percent or 8 percent assumed rate of return, one fact that is often overlooked is that this is not an assumed real rate of investment return, but that wage inflation (payroll growth) is a significant component of the overall assumed rate of return.

In the five-year experience study, GRS explains this as follows: "The current aggregate economic assumptions includes an 8.5% annual investment return (net of investment expense) and an expected 4.5% annual wage inflation rate, used to project across-the-board annual pay increases (merit and seniority increases are additional). This implies a wage adjusted real rate of return or spread of 4%." (Emphasis added)

To determine a reasonable assumed rate of return, not only does the real rate of investment returns need to be considered, but also wage inflation. As part of the experience study, GRS presented the actual wage inflation for NHRS members from 2005-2010 as shown in Table I.

Based upon this experience (particularly with the sharp drop in 2009-2010), along with analysis of national average earnings over 20 years, GRS recommended lowering the current 4.5 percent wage inflation assumption to within a range of 3.5 percent to 4 percent. They noted that, while an 8.5 percent investment return with a 4.5 percent wage growth is "reasonable, but aggressive," an 8 percent assumed rate of return appears to be a good "middle of the road" assumption at this time, and more in line with the majority of public pension systems nationwide. They further offered the alternatives shown in Table II for the NHRS Board's discussion and consideration.

With the alternatives presented in the experience study and market analysis provided by the investment managers, the NHRS Independent Investment Committee unanimously agreed in March 2011 to recommend an assumed rate of return of 7.75 percent. The NHRS Board of Trustees reviewed the recommendations of GRS, their own Independent Investment Committee, and the information provided by NEPC and AllianceBernstein, and at their May 2011 board meeting adopted an assumed rate of return of 7.75 percent, with 3.75 percent wage growth, which is slightly different from the alternatives presented in the experience study. This approved assumed rate of return will be used in future actuarial valuations necessary to establish employer contribution rates.

Impact on Employer Rates and Contributions
As previously stated, lowering the assumed rate of return results in increases in employer contributions. According to the GRS five-year experience study, a change in the assumed rate of return to 7.75 percent will result in an estimated increase in employer contributions as shown in Table III.

This increase does not account for the impact of any statutory changes, such as the plan design changes proposed in pending legislation, or changes to the level of the state retirement contribution for teachers, police and firefighters currently being considered as part of the state's biennial budget process. Additionally, the percentage increases shown in Table III represent the estimated increases for all four employee categories combined (employees, teachers, police and firefighters). Increases for individual employee categories may be higher or lower than the overall average shown in the table.

The next actuarial valuation will be conducted as of June 30, 2011, and utilize the 7.75 percent assumed rate of return adopted by the NHRS Board of Trustees. The new valuation will be the basis on which the Board of Trustees will determine employer rates for fiscal years 2014/2015 (July 1, 2013-June 30, 2015). Preliminary fiscal year 2014/2015 rates should be available by the end of 2011, providing adequate time for employers to determine the financial impact of the change in the assumed rate of return and budget accordingly.

Visit the NHMA section of the LGC website for updated information on pending retirement legislation and NHRS Board of Trustees action on the assumed rate of return as well as links to related material.

Barbara Reid is Government Finance Advisor for the New Hampshire Municipal Association and New Hampshire Local Government Center. She can be reached at 800.852.3358, ext. 384.

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