The Virginia Retirement System hit its long-term target of increasing investment income by 7 percent in the recently ended fiscal year, which is good news for the health of state employee and teacher pension plans.
But a new actuarial analysis suggests it’s time for the $78 billion retirement system to take a closer look at its investment assumptions, especially in the near term to cover benefits of current retirees.
Investment returns are critical to the funding of retirement benefits for more than 700,000 active, retired and inactive employees of state government, local government and school systems.
Lance Weiss, a senior consultant at GRS Retirement Consulting, told legislators on Monday that the 7 percent rate of return VRS adopted in 2010 is a reasonable assumption for long-term average investment gain over 20 to 30 years.
But Weiss said the system should consider lowering the target for returns in the short term, or the next 10 years. “Seven percent is not now as conservative as it was in 2010,” he told the Joint Legislative Audit and Review Commission, which hired his firm to perform a four-year audit of the system.
Half of the system’s liabilities represent benefits paid for current retirees, he said. “You’re trying to come up with a long-term assumption, but you do have to consider the short term — so many of the liabilities will be paid in the short term.”
Kimberly Sarte, the commission’s associate director, said the average annual return for the short term would range from 6.4 percent, as estimated by GRS, to 6.8 percent, as determined by Cavanaugh Macdonald Consulting, the retirement system’s outside actuary.
VRS would have to blend the long- and short-term estimates for an overall return that it would use to set contribution rates for state and local government employers — a critical element of the state’s two-year budget. The system will not reset contribution rates until 2019 for the next biennial budget.
Higher investment returns relieve pressure on local and state budgets, but a General Assembly budget leader suggested that Virginia may have to lower its expectations for stock market gains in the future.
“We need to re-evaluate our assumption of 7 percent [annual investment gain] at some point in the near future,” House Appropriations Committee Chairman Chris Jones, R-Suffolk, said after the biannual review of VRS performance.
Reducing the assumed average rate of return to 6.75 percent would raise budget contributions by $55.7 million for state employees and $126 million for teachers, VRS Director Trish Bishop said. Dropping it to 6.5 percent would cost an additional $113.4 million for state employees and $257.4 million for teachers.
With investment income currently accounting for about two-thirds of the money used to pay pension obligations, a lower assumed rate of return also would drive up the unfunded long-term retirement obligations and reduce the funded status of the pension plans that VRS administers.
“It reinforces for me the need for more reserves,” said Secretary of Finance Aubrey Layne, the former transportation secretary who attended his first VRS presentation to JLARC in his new job.
The prospect is sobering for state lawmakers, who have been celebrating their success in lowering pension costs by fully funding contribution rates certified by VRS and saving the system $232 million over the next 20 years by paying off the contributions the state deferred to balance the budget in 2010 during the recession.
Those actions “improve the health of the plans and avoid adding future costs,” Bishop said.
High investment returns are crucial to keeping employer rates down and funded status up. For example, VRS estimated it lowered unfunded liabilities by $1.1 billion in the fiscal year that ended in mid-2017, driven by a 12.1 percent return on investments and accelerated state pension contributions to make up for past shortfalls.
The result was less pressure on the two-year budget that Gov. Ralph Northam signed last month.
VRS does not have final numbers on its investment returns for the fiscal year that ended June 30, but preliminarily expects gains of about 7 percent.
Through the end of May, the system had earned 7.3 percent on investments, but the stock market softened in June, Chief Investment Officer Ron Schmitz said.
VRS’ investments were lagging slightly behind the system’s benchmark on May 31 for overall returns, as well as returns in specific classes of investments such as public and private equities.
The retirement system spends hundreds of millions of dollars in fees to Wall Street firms to manage investments, as well as financial incentives to its internal investment team, which manages about 35 percent of the market portfolio.
VRS also has begun reporting the share of profits it pays to external investment managers through “carried interest” on high-return investments.
From 1989 through 2016, the system paid $3.8 billion to outside managers as carried interest, while keeping $18.1 billion of those investments for its trust fund.
The system’s board of trustees is working with a consultant to evaluate the compensation of investment managers. The consultant is expected to make recommendations to the board later this year.