Joshua Elliott-Traficante

February 2012

 

Earlier this month, the New Hampshire Retirement System (NHRS or ‘the System’) released its Comprehensive Annual Financial Report (CAFR) revealing the current state of the System at the close of the last fiscal year. Fiscal Year 2011 saw assets grow by nearly $1 Billion, however the funding ratio dropped more than a percentage point to an unhealthy 57.4%. Though this seems counter intuitive, this shows the folly of judging the financial soundness of the System by looking at a single data point. Instead the following paper seeks to take apart the complex CAFR and explain the financial status of the pension portion of the System in layman’s terms, as well as look at the troubling historical trends.

 

Asset Growth

 

It is critical for any retirement system is to see solid returns on investments, and 2011 was certainly a stellar year for the NHRS. The System saw a 23% return on its investments; over $1 Billion, which added nearly $993 million in assets to the system. Under 5 year smoothing, the first 8.5% is recognized immediately, with all growth over that amount phased in over the following five years. However, it is important to recognize that for all the gains made in the past year, the system is still absorbing the losses of 2008 and 2009.

 

An Apples to Apple Comparison: Liabilities, Reforms and the Rate of Return:

 

While undoubtedly an investment return of nearly $1 Billion is excellent news for the financial health of the NHRS, it only tells half of the story. It is the liabilities that tell the crucial other half of the story. Put simply, the liabilities of any pension system is the sum of money needed today, given certain assumptions about payroll growth, the rate of return on investment and retirement age, among a litany of other metrics, to pay for future retirement benefits.

 

As is the nature of actuarial assumptions, these are regularly tweaked to fit a changing workforce as the need arises. For the most part, apart from a major unforeseen demographic change in the state, they are usually small adjustments. However, when it comes to the assumptions regarding the assumed rate of return on investments and how benefits are calculated, this can cause major changes in the value of the liabilities for the System.

 

The revision of the anticipated rate of return from 8.5% to 7.75%, on the advice of the Gabriel, Roeder and Smith (GRS) and approved by the Board of Trustees, increased the liabilities of the system by roughly $757 million. With the reforms in the calculations of benefits, which passed last year, decreased the unfunded liability by roughly $430 million for a net result of a $327 million increase in the unfunded liability due to these reforms.

 

In order to do an apples to apples comparison of the growth of liabilities over past years, these reforms must be taken into account. Doing so, by backing out these two changes, the liabilities of the System increased $717.3 million.

 

Net investment income, allowing for 5-year smoothing, was $993 million, leaving in a theoretical net gain $275.7 million under this scenario.

 

Current Liabilities

$9,998,251

Revision of rate of return

-

$757,000

Revision of payout calculations

+

$430,000

Adjusted Liabilities

=

$9,671,251

 

Even taking into account this reforms, liabilities still grew by 8.19%. This is where, in part, the problem lies with the pension system: the growth of liabilities.

 

Fiscal Year

Liability Increase

2011 (Adjusted)

8.19%

 

Though this increase is below the old rate of return of assumed rate of return of 8.5%, it is now above the new rate of return of 7.75%. Taking a longer view of the system, we see this troubling trend more clearly:

 

 

 

Over the past 22 fiscal years, the compounded annual growth rate in the liabilities of the system was 8.93%, outstripping most of the projected rates of return for that time frame, as well as the 7.19% compounded growth rate in assets, leading to the growing unfunded liability.

Compounded Annual Growth Rate

Assets

7.19%

Liabilities

8.93%

 

Granted, this time frame covers two revisions in the rate of return (1992 from 9.5% to 9% and in 2005 from 9% to 8.5%. Figures for 2011 have adjusted to account for the recent change) as well as two changes in accounting methods in 1992 and 2007. While the CAFRs from the respective years do not detail the extent to which the changes affected the growth or decline in liabilities, below details the average yearly growth in liabilities for all of the 22 years analyzed as well as a the average yearly growth with the atypical years removed. The results are essentially the same.

 

Average Yearly Growth Rate of the Liabilities

All 22 Years

9.51%

Atypical Years Removed

9.54%

 

As mentioned in earlier works, one cannot judge the soundness of a financial institution by looking at one side of the ledger sheet. Below is the same liabilities data alongside the actuarial value of assets.

 

 

 

It should be stressed that the asset figures are not investment rate of return figures, rather they are the actuarial value of assets figures, which are used in calculating the unfunded liability of the system. Again however, we see the same trends: the rate of increase in the liabilities is outstripping the rate of growth of assets. As always there are years which are anomalous, in the case of assets, 2007, where due to legislative reforms, previously siphoned off funds were returned to the pension Trust Fund.

 

Average Yearly Growth Rate

Liabilities

9.51%

Assets

7.88%

 

So what does this all mean? Simply put, the retirement system is on less than stable long term financial footing. This is not to say that the system is going to collapse, but the trends over the past 22 years are not good ones and point to issues greater than just short term market cycles.

 

These trends stand for themselves. Years of record investment returns of the 1990s, which averaged nearly 14.5% a year from 1990 to 2000, played a role in masking the problem with the growth in liabilities. In those years the growth in liabilities were overshadowed by the investment returns, so there was no problem; as long as the investment returns were consistently in the double digits, year over year.

 

But this highlights the issues facing the current system, which without consistent double digit investment returns, it cannot keep up with the growth in liabilities. Again, this is not a problem with investment returns; this is a liability growth issue.

 

While the current amortization schedule will fix this problem over a 30 year period, we cannot keep in place a system that only works well for everyone when it realizes double digit return on investments.

 

Looking Towards the Future: A Defined Contribution Plan

 

One policy decision that could be made to prevent this from happening again is to switch all new employees to a defined contribution plan. Currently under consideration is SB229, which proposes to do just that.

 

Under such a plan, the state’s liabilities end once the employer contributions are deposited into the employee’s accounts. Thus, there can be no unfunded liability to the system. This gives the state, counties, cities and towns budget certainty because there is a set amount that goes into the employee’s accounts and that figure does not change based on what happens in the market. Such certainty is critical for local and state government to be able to hire more teachers, police officers and firefighters.

 

Such a system also protects the employees. Once those funds are deposited into their accounts, that money is theirs and only theirs, no legislative actions can change that.

 

An added benefit of a defined contribution system is that since the employees own the accounts, it travels with them when they change jobs. We live in an era where people typically do not work in the same industry for 30 years and a pension model does not fit the needs of these people as well as a defined contribution plan would.

 

Defined contribution plans have been adopted in several other states across the country, Michigan has had one in place since 1996. What this shows is that not only is it possible to create and implement a defined contribution plan for government employees, but that it works, and it can be done well.

 

Joshua Elliott-Traficante is a Policy Analyst at the Josiah Bartlett Center for Public Policy, a free-market think tank based in Concord, NH. He can be reached at joshelliott@jbartlett.org