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LAST SUMMER THE INDIANA Public Retirement System (INPRS) created a stir in the U.S. public defined benefit pension world by dropping its long-term investment return assumption to 6.75 percent a year, the lowest of all its peers. The move worsened the system’s funded ratio, meaning that future retirees may risk cutbacks in their pensions unless taxpayers inject more money into the system — no easy feat in these tough times. As unpalatable as those consequences are, Indiana pension officials decided they had to scale back their projections following years of historically low interest rates and the likelihood that those rates would continue to depress investment returns. Six months later not a single large U.S. public pension fund has followed Indiana’s example. Most still operate on the assumption that they can generate returns of    7 to 8 percent a year virtually in perpetuity.

Across the Atlantic a far more austere philosophy reigns. The Netherlands, which runs one of the world’s most rigorous and best-funded retirement systems, requires that pension plans discount their future liabilities using not their hoped-for rate of investment returns but a conservative benchmark tied to long-term interest rates. The standard is so strict that regulators, responding to pressure from pension funds, adjusted the benchmark in October, which raised the discount rate slightly, to 2.42 percent. Executives at Amsterdam-based ABP, the country’s largest pension fund, breathed a sigh of relief:  The move boosted their funded ratio modestly, to 97 percent. The executives can only imagine what it would be like to operate under U.S. rules — if they used Indiana’s discount rate, ABP could claim to be nearly 200 percent funded.

How can two otherwise similar pension funds use such radically different assumptions?    The $20 billion Indiana pension system and €261 billion ($348 billion) ABP, which oversees the retirement assets of Dutch public sector employees, both take in contributions, invest their portfolio and pay pensions to retirees. Yet when it comes to the all-important discount rate, the number used to calculate the present value of future pension payouts, the Indiana and Dutch pension systems part company.

U.S. public funds are free to select a rate that estimates the future returns of their investment portfolios, while the Dutch and most other European pension sponsors must by law use a rate pegged to standard market interest rates. The difference between those methods was relatively modest before the financial crisis, but it has widened dramatically as interest rates have plunged to historic lows in recent years. Today most European pension plans use a rate of     between 3 and 4 percent, with the Dutch being especially conservative, while U.S. public plans use a rate nearly twice as high, on average.

The difference is not just an arcane matter for discussion in actuarial circles. The discount rate determines whether a retirement system is sufficiently funded. The funding status, in turn, dictates the annual contribution rate, or how much money employers and/or employees need to add to the fund. It also exerts a strong influence over the fund’s investment strategy and risk appetite: what mix of stocks, bonds and alternative assets is needed to achieve a fully funded state. Ultimately, the choice of discount rate can spell the difference between a comfortable retirement or an old age spent in poverty for tens of millions of workers.

Not surprisingly, given the stakes involved, the discount rate has become a source of  heated debate in the pension fund community on both sides of the Atlantic. Critics of the U.S. public pension system are scathing about the use of expected investment returns as the discount rate. “What is unethical, unprofessional and unscientific is to make your employees believe they have something that is risk-free and make taxpayers believe it has no cost,” contends Zvi Bodie, a finance professor at Boston University and a longtime pension watcher. “It’s not just a technical issue,” he says, and it raises two fundamental questions: “What is the nature of the pension promise, and is it sustainable?” Bodie believes a 2.5 percent discount rate, similar to that used in the Netherlands, is about right.

Antti Ilmanen, head of the portfolio solutions group at AQR Capital Management in New  York and the author of the 2011 book Expected Returns, warns of the “potential dangers of relying too heavily on using the backward-looking historical average return as expected return.” Ilmanen, along with Ben Inker, head of asset allocation at Boston-based fund manager GMO, projects investment returns of  between 4 and 6 percent for the average institutional investment portfolio over the medium term. “For the whole system it’s hard to see, given current valuations, how to expect more than 5 percent,” says Inker. “If you want 7.5 percent over the next ten years, stocks will have to deliver a lot more than they did over the past ten.”

The Dutch pension system has long been viewed as one of the strongest and most secure in the world. From 2009 to 2011 it was ranked No. 1 in the Melbourne Mercer Global Pension Index. (It came in second in 2012, after Denmark; the U.S. placed ninth.) Its high ranking is attributed to its mandatory system with near-­universal coverage, a high funding level, well-established regulations and a discount rate that measures pension liabilities very conservatively.

“The only people getting this right are the Netherlands,” says John Ralfe, a British pension consultant who famously reallocated the £2.3 billion ($3.6 billion) pension fund of Boots entirely into fixed-income securities in 2001, when he was head of corporate finance at the pharmacy group. “They have a very tough, strict funding regime which is not capable of being fudged,” he adds.

But that does not mean Dutch pensions are immune from funding and investment problems. Consider the case of ABP. Like all Dutch pension funds, it valued its liabilities using a flat 4 percent discount rate, until 2007. That year ABP reported a flush funding position: Its assets were worth 140 percent of its projected liabilities.

Then the Netherlands’ Pensions Act 2007 altered the rules to require that discount rates reflect market interest rates. When the financial crisis hit the following year, ABP was socked with a double whammy. The havoc in financial markets caused its portfolio to post a 20.2 percent loss in 2008. In addition, a plunge in market interest rates caused the discount rate to tumble. By the end of 2008, ABP’s once-robust funding ratio had plummeted to 89.6 percent.

“The IFRS [International Financial Reporting Standards] framework and systems we have to adhere to start from market valuation,” explains Onno Steenbeek, director of asset liability management at APG, the Amsterdam-based firm that manages ABP’s assets. “You have a choice after that. The Netherlands chose the most conservative way.” By the last quarter of 2011, when the discount rate stood at 2.74 percent, ABP’s funding ratio had recovered to 93.7 percent, well below the 105 percent level required by law. ABP responded by cutting pensioners’ monthly payments by half a percentage point and raising employer and employee contributions, which already stood at more than 20 percent. The subsequent decline in market rates further depressed the discount rate, which is recalculated quarterly. The rate would have been 2.16 percent at the end of last year if not for the October 2012 adoption of the adjusted benchmark, called the ultimate forward rate, which brought it up to 2.42 percent.

By contrast, as of  June 30, 2012, Indiana reported having only 81.2 percent of the assets it needs to fund its future pension obligations, and that’s using a comparatively generous discount rate of 6.75 percent. If Indiana used the Dutch discount rate, it would have a funding ratio of only about 45 percent, estimates Rebecca Sielman, a principal in the Windsor, Connecticut, office of actuarial firm Milliman. Many other U.S. public pension funds are in even worse shape:  The national average funding ratio stood at 77 percent at the end of 2011, according to investment consultants  Wilshire, and virtually all of those funds use even more generous discount rates than Indiana’s.

HOW DID THE DUTCH AND U.S. PUBLIC pension systems take such different paths on their way to achieving the same goal — retirement income security for their teachers, firefighters and police? In the 1950s most pension plans in the U.S. were insurance products and had very conservative fixed-income investments and liability calculations. The next decade brought a sea change. Bank trust departments, an emerging group of asset managers and, later, investment consulting firms like Frank Russell approached plan sponsors with a new pitch: Abandon the insurance approach and invest in equities for their higher returns.

Plan sponsors signed on but soon discovered that the higher equity returns injected volatility into the equation. When actuaries created smoothing formulas to correct — some say mask — equity volatility, the modern style of U.S. pension investing was off and running.

U.S. pensions built an equity culture, and their European brethren eventually followed. By 2005, ABP had just under 37 percent of its assets in fixed income, with an equal amount in equity. The remainder of the portfolio was allotted to alternative investments like hedge funds (3.2 percent), commodities (2.5 percent), inflation-linked bonds (4.1 percent) and others. The key difference: Unlike U.S. public funds, the Dutch never used expected return on assets in their asset-liability calculation.

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