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By James V. Koch and Robert M. McNab

To paraphrase an old proverb, state public employee pension systems should be rarely seen and not heard. This decade, however, has seen increasingly dire warnings about the risk these funds pose to taxpayers. By the end of 2018, the Pew Charitable Trusts estimated that state pension funds were not only underfunded by $1.5 trillion, but that the problem was getting worse.

The Virginia Retirement System (VRS) is an independent state agency that administers the retirement programs of Virginia’s public sector employees. At the end of September, the VRS held almost $83 billion in assets and served about 722,000 members.

Fortunately for Virginians, the VRS is well-run and has avoided many of the problems that have afflicted public pension programs in Connecticut, Illinois and Kentucky. A common measure of financial health is to compare the current value of a plan’s assets and its liabilities for present and current retirees. Over the last five years, the VRS has significantly improved its financial position but still reported that value of its assets was less than 80% of its liabilities on June 30.

Thus, there is room for improvement. In the 2019 State of the Commonwealth Report, we make four specific recommendations.

First, the VRS should index more of its public equity holdings (stocks), which typically account for 30% to 45% of the value of its overall portfolio. From 1992 to 2017, the VRS reports that its public equity portfolio earned 8.6% annually, less than the 9.3% earned by Vanguard’s VTSMX index fund.

By investing in low-cost index funds, which track the overall market, the VRS could have earned an additional $3.4 billion on its public equity investments between 1992 and 2017. Further, riskiness of these two investment tracks (as traditionally measured by a Sharpe Ratio) would have been virtually identical.

The accumulated evidence in support of indexed public equity investments is overwhelming. From 2002 to 2017, 92.3% of actively managed large cap funds failed to outperform the S&P 500; it was 95.7% for actively managed small cap funds.

The preponderance of actively managed funds not only performed worse than index funds, these funds cost more on average. Lower performance at higher cost tells us it is time for the VRS to change its approach.

Second, we applaud the VRS Board for partially fulfilling our second recommendation by recommending the VRS reduce its target rate of return from 7% to a more realistic 6.75%. The lower rate of return is more in line with historical performance as the most recent VRS annual report noted that its annualized rate of return was 6.1% over 10 years and 6.5% over 20 years.

While a quarter of a percentage point may seem small, the implications for state and local budgets are significant. Estimates suggest that contributions will need to increase $214 million annually, including $95 million from the state general fund, and $108 million from local school systems. We encourage the VRS to prepare for further downward adjustments in its target rate of return.

The General Assembly has made substantial progress in satisfying our third recommendation, which is to move state employees into programs that are “defined contribution” in character. This is a change from “defined benefit” programs that were based primarily on what the state would pay after retirement.

In defined contribution programs, the commonwealth makes financial contributions on behalf of its employees that then become employee property. However, the commonwealth’s financial obligations end at this point. This is the approach pursued by most private sector pension programs, much of the U.S. government and now encouraged by the military. This approach would reduce the chance that the VRS will encounter financial problems in the future.

Finally, we recommend that the General Assembly make all VRS pension programs fully portable so those who leave state employment after a few years are able to take the full value of their contributions (plus those of Virginia and a competitive rate on interest on these contributions) with them to their new employer.

The Bureau of Labor Statistics recently reported that the median time a typical employee spends in their job today is only 4.8 years. It is time for the commonwealth to recognize that we no longer live in a world in which individuals spend 40 years in the same job working for the same employer.

We applaud the VRS for its transparency, its effective management and for its improved financial position. There is always room for improvement and the VRS should continue to build upon its current record of success. This year’s “State of the Commonwealth” report (www.ceapodu.edu) explains why and how.

James V. Koch is Board of Visitors Professor of Economics Emeritus and president emeritus at Old Dominion University. Contact him at: jkoch@odu.edu

Robert M. McNab is professor of economics and director of the Dragas Center for Economic Analysis at Old Dominion University. Contact him at: rmcnab@odu.edu

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