The State of Indianas public pension fund has become
the first public fund to drop its projection of future
investment returns to below 7.0 percent.
That is just one step among several big moves that the
Midwestern state has been taking to improve the performance of
its $26 billion retirement system.
Bad news about public pension funds has become part of our
daily diet: not enough money to cover future liabilities;
misuse of public funds; battles with labor unions. To mitigate
some of the pain, state officials across the country are taking
actions that range from changes to the funds investments
to cutting public services and increasing employer
The state of Indiana has taken a different route to
solvency, starting with the merger of its bifurcated system,
agreed to by the Indiana General Assembly in 2011. Next came a
decision that gave the newly integrated fund the lowest
investment return assumption among 126 large public systems
followed by the National Association of State Retirement
Administrators (Nasra). In July 2012 the Indiana Public
Retirement System became the first to drop below 7.0 percent
when the newly formed 9-member board agreed that it could not
expect more than a 6.75 percent average investment return on
its pension assets over the next 30 years. According to a
January 2011 report from Moodys Investor Service, the
Indiana state pension fund also has the second-lowest combined
pension and long-term debt liability as a percentage of GDP in
the country. (Only Hawaiis is lower.)
Its all about risk, explains Steve Russo,
executive director of the Indiana Public Retirement System.
In almost anything we do, we ask Whats the
risk? Russo, who had previously been director of
the Indiana Teachers Retirement Fund (TRF) since 2008,
was appointed head of the merged TRF and Public Employees
Retirement Fund (PERF) in May 2010.
Lowering a pension funds long-term return assumption
does not come without pain. The number is important because it
helps determine the future assets required to pay the
ever-growing army of retirees and the allocation of investments
needed to get there. The lower the assumption, the potentially
greater the amount of money needed from sources other than
investment returns, including employer and taxpayer
contributions or public service reductions. Currently, most
state pension funds have projected long-term investment returns
ranging from 7 percent to 9 percent. Of those, 45 have been
lowered since the 2008 financial crisis.
That does reflect a trend across the country of
lowering the discount rate to reflect the more challenging
prospective returns from the capital markets going
forward, comments Neil Rue, an investment consultant in
Pension Consulting Alliances Portland, Oregon office.
Some pension experts believe that given the low interest
rates and volatile equity returns today, most of those return
assumptions are too high. If the rate is set too high, a plan
will appear healthier than it really is, enabling employers to
make lower contributions into the plan, thus jeopardizing
The integrated INPRS fund is one of the oldest hybrid
pension systems comprised of both defined benefit and defined
contribution plans, first established in 1955. It has $20
billion in defined benefit and $5.5 billion in defined
contribution assets that include six smaller funds that were
part of PERF. The defined contribution portion, officially
named the Annuity Savings Account is not your average 401(k).
It has the advantage of leveraging the states defined
benefit managers to obtain amongst the lowest fees of any
defined contribution plan, explains Russo, rather than using
the usual mutual fund array.
Before the funds were merged, the two legacy funds
return assumptions were 7.5 and 7.25 percent. The merger gave
the state legislature the opportunity to adjust the rate down
to 7.0 percent. The expectation of prolonged low interest rate
environment and volatile equity markets pushed Russo and the
board to more closely match fund assets with liabilities.
If by going to 6.75 percent drops our funded status, so
be it, explains Russo.
Low interest rates and uneven investment returns have taken
a toll nationwide with taxpayers on the hook to help support
retired teachers, firemen and police. A paper published in
September by professors Robert Novy-Marx at the University of
Rochester and Jonathan Rauh, at Stanford Universitys
business school and the Hoover Institution, found that
assuming each state grows at its ten-year average (without
taking factors like investment return or economic growth into
account) government contributions to state and local
pension systems will need to rise to 14.1 percent of their own
revenue to achieve fully funded systems in 30 years. The
Revenue Demands of Public Employee Pension Promises,
published in September, found that average employer
contributions would have to rise to 40.4 percent of payroll to
achieve these goals, corresponding to an increase of 24.1
percent of payroll. Per-household contribution increases would
have to start immediately, with an average immediate increase
is $1,385 per household per year.
For his part, INPRS CEO Russo challenges the 30-year pension
return assumption. If you do the math, and you are wrong
for the first 10 years, you could get crushed, he warns.
Three, five, seven years of underperforming, your assumption
has dramatic effects on your contribution rates, he adds.
The Indiana pension officials worked with the investment
team from the ground up perspective to get the investment
return aligned with the new return assumption. Steve
brought it to me, says Adam Horst, the ex-officio board
member, director of the Indiana Office of Management and Budget
and the Indiana State Budget Agency. Its not the
easiest conversation to have. Russos answer:
How can you not do that? It would be shortsighted. To me
its not fulfilling your fiduciary duties.
The INPRS fund and its constituents received a present in
July that helped boost its future position. Indiana law
dictates that if the state budget reserves go over 10 percent,
the extra assets are divided 50-50 between the pension fund and
taxpayers. This year, a total of $360 million was distributed
to the pension funds, bringing its funded status up to 80