Riley: Why Doesn’t All of Rhode Island Use One Discount Rate?
Tuesday, November 21, 2017
Readers have asked me why there isn’t just one discount rate used throughout Rhode Island to determine the present value of future liabilities? Why does the rate vary from town to town? State to State? Why does Providence use 8% as an expected rate of return when the State uses 7.5% or 7.2% as is used in Narragansett.
There are two important points to be made here. First, unless two investors have exactly the same portfolios, it is very unlikely that they will have the same returns. Typically, the more risk that is taken by that investor, the higher the expected return. A fiduciarily sound portfolio is never 100% in stocks or 0% invested but rather the standard for the last several decades has been 60% stocks and 40% fixed income.
Performance then varies based on specific instruments used and their costs. For some as yet unexplained reason current government accounting standards (GASB) instruct states to discount their liabilities at the expected return on their assets. In the opinion of most economists, doing so creates a false equivalence between future pension payments, which almost certainly will be incurred, and the outcome generated by a risky investment portfolio, which by definition is highly uncertain.
GET THE LATEST BREAKING NEWS HERE -- SIGN UP FOR GOLOCAL FREE DAILY EBLASTEconomists believe since the liabilities are certain and the returns are not, that the liabilities should be discounted at the “risk-free” rate of interest. Currently, risk-free rates in the U.S. are under 3% for 30 years. For those in Rhode Island, who believe 3% is ridiculously low, consider the last 10-year performance in Rhode Island of 4.4% under Caprio, Raimondo, and Magaziner.
This is the main reason that, despite pension reform that included dramatic re-amortization under Raimondo, the funded ratio has actually declined from the reforms of 2012 at 60% to 55% as of June 30, 2016. This trend is very unhealthy, especially considering the exceptionally long bull market in equities.
Who selects the discount rate?
Every Pension fund has trustees charged as fiduciaries. In Providence, for example, Mayor Elorza heads the Investment Commission as did Cicilline and Taveras before them. The commission discusses with the hired actuary the current valuation of the pension assets, the contents of the portfolio and past performance of the adviser. Providence has been above 8% for many decades now in its expected returns despite little evidence of that kind of performance. Some towns or Mayors believe their adviser is super good and better than anyone else in Rhode Island or America for that matter. They choose 8% or more for their expected return.
Coincidently, choosing a very high expected return reduces the amount of money to be set aside today in budgeting. If you expected 10% for some reason as Mayor you could set aside even less money for pensions and spend that money on something else. Maybe on something more popular? The mayor of an economically struggling town could even mask cash flow problems by purposely overestimating returns in the pension fund.
The most important factor in choosing expected investment returns is not your adviser or actuary or portfolio but rather the general interest rate environment. Today there are trillions of dollars earning little or no return. Twenty years ago rates of 6% or 7% were commonplace and investment commissions could easily fund the pension plan expecting 8% with a big slug of low risk fixed income investments. That is emphatically no longer true and politicians across the country are aware of the problem.
Fiduciaries like Mayor Jorge Elorza are currently deliberately overstating investment returns in order to contribute even less to pensions. Providence is currently funded at just 25% using an 8% discount rate. This is the worst funding ratio in the nation yet Elorza is misleading taxpayers and municipal bond markets by overstating investment returns. The SEC should investigate and an outside forensic Audit should check into the accounting in Providence where claims of employee paycheck pension contributions not being invested for months or even years are well known. It’s time for Elorza to come clean on his pension mismanagement and deception.
Michael G. Riley is vice chair at Rhode Island Center for Freedom and Prosperity and is managing member and founder of Coastal Management Group, LLC. Riley has 35 years of experience in the financial industry, having managed divisions of PaineWebber, LETCO, and TD Securities (TD Bank). He has been quoted in Barron’s, Wall Street Transcript, NY Post, and various other print media and also appeared on NBC News, Yahoo TV, and CNBC.
Related Slideshow: Timeline - Rhode Island Pension Reform
GoLocalProv breaks down the sequence of events that have played out during Rhode Island's State Employee Pension Fund reform.
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