Planned lowering of assumed rate of return mirrors other states’ reactions to diminishing bond yields and modest economic growth rates
Later this year, New Jersey will begin a planned lowering of the public-employee pension system’s assumed rate of return for its long-term investments.
The move will bring New Jersey more in line with what other states have been doing in response to changing market conditions, as bond yields shrink and annual economic growth rates are more modest compared to those seen before the Great Recession.
A seemingly arcane aspect of fiscal planning, the change has important ramifications for the state’s budget, in addition to the pension system itself.
It could also have political consequences, since the lowering of the assumed rate coincides with the ongoing effort to ramp up state pension funding to the full amount required by actuaries. The challenge of meeting that goal will likely bring to a head an ongoing policy disagreement involving Gov. Phil Murphy and many lawmakers, including Senate President Steve Sweeney (D-Gloucester).
A recent study published by The Pew Charitable Trusts tracked the trend to lower assumed rates of return by looking at the returns of more than 70 state-sponsored pension systems between 2007 and 2017. None of the funds maintained a 10-year average of returns that matched or exceeded their assumption rates, according to Pew. More than half — including New Jersey’s — are in the midst of making downward adjustments.
It’s considered fiscally responsible to lower assumption rates, but the policy can also come with a potential cost. That’s because expecting less from investments means more of the long-term liability will have to be covered with contributions from taxpayers and workers.
Effects on state budget
Just how much of an impact the assumption-rate change will have on New Jersey’s budget, as well as the budgets for local governments, remains to be seen. The first annual spending plan that will reflect the state’s move to a more realistic rate of return is fiscal year 2021, which begins later this year. Murphy is due to unveil his budget proposal for FY2021 to lawmakers next month.
For well over a decade, New Jersey’s $77.7 billion pension system operated under an assumed rate of return that equaled roughly 8%, which was considered an aggressive figure, especially for a retirement plan that is one the nation’s worst-funded.
But governors and lawmakers from both parties cherished the higher figure because it allowed the state to forecast more revenue coming from its investments than would be required under a more conservative estimate, thereby lowering the employer pension payment coming from the state in the annual budget. (Even with the more favorable math, governors and lawmakers still shorted the state’s annual pension contribution on a regular basis, a trend Murphy, a Democrat, has continued but is also working to reverse.)
Under a plan adopted by Murphy shortly after he took office in early 2018, the new assumed rate for state and local public-worker retirement plans in New Jersey was set at 7.5%. That reversed a last-minute policy change enacted by his predecessor, former Republican Gov. Chris Christie shortly before he left office, when he lowered the rate abruptly from 7.65% to 7%.
There had been an outcry from local governments when Christie lowered the rate because of concerns over the resultant potential increases in their pension payments; unlike the state, they’re not allowed to shirk their annual pension obligations. Their concerns dissipated when Murphy set the assumed rate at 7.5% for both fiscal years 2019 and 2020. But he also put the state on course to drop the rate back to 7%, by FY2023. (The assumed rate will be lowered to 7.3% in FY2021, which begins this year on July 1; will stay at 7.3% in FY2022; and then drop to 7% in FY2023.)
According to the latest reports from the Division of Investment, the agency within Treasury that handles the investment of pension-fund assets daily, returns fell short of the 7.5% assumed rate by more than a full percentage point during the state’s most recently completed fiscal year, which ended on June 30, 2019. And over the last five years, the pension system’s investment returns have averaged 6.55%, according to the DOI’s data.
Falling investment returns
Looking forward, the Pew study suggests the outlook for pension-fund investment returns generally will reflect a “new normal” of more modest gains than those of before the Great Recession, when returns could easily top 8% year-over-year. That suggests New Jersey and the dozens of other states that are taking steps to lower their assumption rates are taking appropriate action.
“Market experts generally agree that lower investment returns will persist going forward,” the Pew study said. “Pew forecasts a long-term median return of only 6.4% a year for a typical pension fund portfolio, considering expected GDP growth and interest rates.”
The study also reinforced the notion that lowering an assumption rate is smart fiscal policy even if it may give governors and lawmakers heartburn when they see how the change influences the long-term projections of overall liabilities owed to retirees, which are calculated into the future using what’s called a “discount rate.”
“Reducing the assumed rate of return leads to increases in reported plan liabilities on fund balance sheets, which in turn increases the actuarially required employer contributions,” Pew said. “Still, making such changes can ultimately strengthen plans’ financial sustainability by reducing the risk of earnings shortfalls, and thus limiting unexpected costs.”
To make long-term pension funding more affordable, Sweeney has been calling for reduced public-worker benefits, including the establishment of a new, less-generous retirement system for many new workers and those with less than five years of service. However, Murphy has been backing proposed tax hikes and policies that generate more revenue by growing the state’s economic base.
The pension payment in the current budget is $3.8 billion. If the state pension funding were ramped up to the full amount required by actuaries, it would require a pension contribution well north of $6 billion in FY2023.