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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.