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Thursday, December 04, 2008

The 7% Solution

Is unlikely to happen. There has been much recent discussion about the likelihood of PERS dropping the actuarially assumed interest rate ("the guarantee") from 8% to something lower. While the current economic climate suggests that a rate guarantee of 8% is probably too high, there are many forces in play to argue that such a change is unlikely in the near future.

Without getting too technical, suffice it to say that the actuarial rate guarantee plays into many aspects of the PERS system. PERS has the legal authority and the fiduciary responsibility to use an assumed interest rate that is attuned to economic realities and fiscal experience. The 8% rate was established in 1989 and so it has been in force for 20 years. Prior to that the rate was lower. There is no precedent that I can find where the system *lowered* the assumed rate. Actuarial tables and their associated mortality factors, which drive the optional benefit forms PERS retirees can select from, are built from the assumed interest rate. Reduce the rates and the mortality factors will change. This will, in turn, lead to lower monthly benefits. Similarly, the Tier 1 regular account balance is driven entirely today by the assumed rate (the 8% guarantee) since no new funds have flowed to Tier 1 accounts since January 1, 2004. At a lower assumed interest rate, account balances would grow more slowly. Again, a lower account balance at retirement will lead to a lower monthly benefit and coupled with lower mortality factors, drives the monthly benefit down significantly. Finally, the employer contribution rates are driven by several factors, not the least of which is the assumed rate at which employer contributions are expected to grow. If the assumed rate is lower, employer contributions will rise because less of the anticipated growth will come from the assumption about earnings. This is the trickiest idea for most people to understand, but any careful research would demonstrate its truthfulness.

Even from the briefest introductions above it is easy to see that both PERS members and their employers have interests that are completely aligned. The coupling of the assumed interest rate makes both parties agree on the direction of the assumed interest rate.

Recently, I had an email exchange with Greg Hartman about this, while a PCC colleague had an almost identical conversation with Paul Cleary, PERS Executive Director. Both mentioned the same set of facts. First, employer rates have been set for 2009-2011 on the assumption of an 8% rate. This means that no change will be made until the next time the PERS actuary undertakes its next system valuation in 2010. That will be used for the 2011-2013 rate setting. Second, the 2009-2011 mortality tables have already been set to take effect on the first of next month. They, too, assume an 8% earnings rate. The take home message here is that none of the crucial decision-making about the assumed interest rate would make any sense until 2010 for implementation in 2011. Both Hartman and Cleary make the same point about the next system valuation. The 2009-2011 rate-setting and mortality table implementation do not take into account the dismal situation in 2008. Those losses will get recognized in the next system valuation in 2010. Since those losses bear on employer rates, there is a strong likelihood that employer rates will rise significantly resulting from the 2008 system losses. If PERS were to add to that a change in the actuarially assumed interest rate, employer rates would rise even further. It was a steep rise in employer rates that triggered the series of events that led first to the City of Eugene case, the 2003 Legislative reforms, and the string of litigation that followed. It is doubtful that anyone has the stomach for that again.

The logical conclusion from this is that, despite the pressure from outside forces to do so, it is highly unlikely that we will see a decrease in the actuarially assumed interest rate anytime in the near future. Of course, a rogue legislature might try to force the issue, but with all the forces who share a common purpose in keeping those rates where they are, it seems unlikely that the Legislature will try to overcome that resistance.


MollyNCharlie said...

What an interesting twist of fate. For most of the years since the PERS reforms, it has looked to me like the PERB has been running in the direction of “reduce Employer contribution rates at all costs,” even to the determent members active and retired. For once this drive of the PERS board could actually work in favor of members! Just when you think you've seen it all......


mrfearless47 said...

Well, if the market hadn't tanked so badly this year, I suspect we would have seen a movement towards lowering the rate. While it would have led to a short-term increase in employer contribution rates, over the longer term it would reduce member benefits which would offset the impact on the employers for the temporary inconvenience of a rate hike. It is an interesting twist of fate, but it has cost ALL of us quite a lot to reach this convergence of interests. Believe me, the employers are only looking out for themselves. If anyone is deluded into thinking they give a rip about PERS members, well I have this large bridge to sell you.

John said...

What you are saying matches my understanding of the PERS "Assumed Rate." However at some point I would expect someone would realize that the lower actuarial valuation is a "paper loss" while calculating benefits at a lower rate is a "real" reduction in the cost of pensions.

mrfearless47 said...

The "actuarial valuation" is a "paper number", but the employer rates, employee and employer guaranteed earnings rate, and the actuarial factors used to convert the account balance into a stream of monthly payments (or whatever) are anything but "paper losses". These represent real dollar changes for both sets of players in the game.

mrfearless47 said...

And yes, over the long run, the employers will end up saving some real money as pension costs decline and retirees earn less in retirement. On the other hand, part of the employer gambit is that with an attractive retirement system, people leave typically at the top of the salary scale, while new employees come in at the bottom, saving even more money. However, if the rates go down, I would predict longer tenures for most employees and any savings to be gained by lower pension costs would be eaten up by higher employee costs. No matter how this game is played, it seems to be a zero sum game in the long run. Maybe not exactly zero, but the savings accruing to employers probably won't come, and the employees will simply work longer to keep income coming in until they can retire with benefits closer to what they expected before the rate change.

Nevertheless, I still don't expect any changes in the rate any time soon, so the argument right now is largely an academic one.