Here is a transcript of my remarks to the PERS Board at their May 31, 2019 meeting. My views have evolved since I started blogging about this issue. I now realize that various gimmicks, such as extending the amortization period of the unfunded liability (passed by the state legislature) do nothing to solve the problem, but only delay the day of reckoning. So bring on the spinach and let’s dig in.

Members of the PERS Board:

I wish to offer some observations and suggestions as you begin the rate-setting process for the next biennium.

From the standpoint of its funding status, we all understand that PERS has been troubled for quite some time. What is supposed to happen with pension systems and economic cycles is that you enter a recession with the pension well-funded. When the recession hits, the pension funding status deteriorates some. Then when markets recover, the funding status again returns to acceptable levels.

PERS has not followed this trajectory. It was pretty well-funded before 2008. Then the financial crisis hit, and OPERF posted big losses. But the key to our current problems is what happened in the decade after 2008. During that time, OPERF recovered some, but the returns could only be described as mediocre. Add to this an inactive state legislature, and the PERS board which has been slow to reduce its assumed rate of return to better match actual OPERF returns, and we find ourselves where we are today. We are at the top of the economic cycle, in the eleventh year of a bull market in stocks, looking at a large unfunded liability that has defied your efforts to reduce it.

A recession is on the horizon, and for PERS to be in such a weak position at this point in the economic cycle is very troubling.  OPERF remains exceedingly vulnerable in falling markets.  We saw this just last year, when the public equity portfolio, comprising 1/3 of all OPERF assets, declined over twice as much as the S&P 500. When the recession comes, OPERF’s losses will once again be substantial, adding billions to the unfunded liability.

How do these predictions affect what you do this year? First, you need to accept that your policy for managing the unfunded liability has not worked and needs to change. Next you need to acknowledge it will become dramatically more difficult to control the liability as the economy heads toward recession.  And finally, you need to acknowledge employer rates need to be a lot higher than they are today.  You should not assume the legislature will step up significantly, or the Investment Council will somehow post better returns. You must make use of your policy-making authority to take action.

My suggestion is this: if you do nothing else this year, you must get the assumed rate of return down to a realistic level. To accomplish that, you need to adopt a new methodology to evaluate and set the rate. Your current practice of trying to predict future investment returns has not worked, largely because OPERF returns have lagged both broad markets and its own benchmarks for years, not to mention that market predictions are notoriously inaccurate.

Stop trying to guess future returns. Instead, look back at what OPERF has actually given you over a relatively long period, in both up and down markets. The latest 10-year period that includes both rising and falling markets was 2008-2017, in which OPERF returned an annualized 6% per year.

Since 2008 was (hopefully) a rare financial event, you might have room to keep the assumed rate a little higher than 6%. But you would be making a mistake if you look at recent OPERF 10-year returns, which no longer include 2008. A quick calculation shows that if OPERF lost just 10 percent in 2019 (definitely a possibility in a recession), 10-year returns drop right back to the mid-6’s, 6.4 percent to be exact.

I call on you to act this year to set your assumed rate of return into the mid 6’s and get on with the hard business of setting employer rates to where they should have been years ago.

Setting the assumed rate to 6.4% will increase the stated unfunded liability dramatically, likely pushing it up by about $6 billion. It will cause a big increase in employer rates, but I argue it’s long overdue. Either you raise rates now based on a realistic funding status, or you will find yourself raising them much more in the future as yearly pension payments increase dramatically over the next 20 years. You do not serve the public interest by continuing to understate the problem. And It’s not your job to keep employer rates low any way you can. Leave the gimmicks to the politicians and make fiscally sound decisions that protect the pension system.