memo

Council Office of Financial Analysis

To:

Members of the City Council

CC:

Chairman Carrie Austin

Date:

9/6/2016

Re:

Pension fund assumed rate of return

The Council Office of Financial Analysis (COFA) has been asked to provide its opinion on the
appropriateness of the Municipal Employees Annuity and Benefit Fund (MEABF) assumed rate
of return. The current rate of return established by the board is 7.5%. This rate was established
as part of the 2012 valuation, when it was lowered from 8%. At the time that the assumed rate of
return was lowered, that change immediately increased the unfunded liability of the MEABF by
$730,000,000.
For the purpose of the analysis, COFA is going to rely on two primary sources of information.
The first is an examination of the assumed rates of return used by other public pension systems
across the United States. The second is a review of the MEABFs historical rates of return.
Other Current Practices
A pension funds investment returns are a critical portion of the asset reserves of the retirement
system. According to data available from the US Census Bureau and compiled by the National
Association of State Retirement Administrators, of the $6.7 trillion in revenue that public
pension funds have accrued since 1985, 64.3% has been the result of returns on investment.
The assumed rate of return is critical not only for determining the expected performance of the
pension plans investments, but also in calculating the existing liabilities that are owed to a
plans members. If the discount rate is lowered, the liabilities of the plan are increased,
necessitating increased contributions from the plans sponsors today.
The National Association of State Retirement Administrators recently conducted an analysis of
the assumed rates of return of large public pension plans across the United States. Of the 127
plans that they reviewed, they found that the average assumed rate of return was 7.62%, slightly
higher than the MEABFs assumed rate of return of 7.5%. Of the plans that they reviewed, the
Houston Firefighters Relief and Retirement Fund has the highest assumed rate of return, of
8.5%. On the low end, both the District of Columbia Police Officers and Firefighters Retirement

Fund and the District of Columbia Teachers Retirement Fund are utilizing an assumed rate of
return of 6.5%.
Past Performance
While it is certainly true that past performance is not necessarily indicative of future results, it is
important to examine how a pension funds assets have performed in relation to its assumptions
over a longer period of time. The assumed rate of return is typically recommended by the funds
actuary based on the systems target asset allocation and formally approved by the Board of the
MEABF, who have a fiduciary duty to the system. The expected rate of return is what the fund
assumes to get as an annual average over the longer term, typically 30 years, as opposed to what
the fund is anticipated to get on a recurring annual basis.
As of December 31, 2015, over the last five years, the average rate of return of the market value
of the MEABFs assets has been 6.9%. The ten year performance of the fund has been 5.1%, and
the twenty year performance has been 7%. During that period of time, the highest rate of return
was over 20% in 1997 to a low of negative 28.7% in the midst of the great recession. Over the
previous twenty five and thirty years, the average annual return on investment of the MEABF
has been over 8%. The funds experiences over these time frames are largely in line with the
experience of other funds across the country.
Funding Schedule
Without an adequate funding schedule in place, discussion of the assumed rate of return is
largely academic. If current funded ratios of a pension plan are low, and inadequate
contributions to the fund are being made, the fund will likely be in the position where it is
required to sell assets in order to make required payments to annuitants. In the case of the
MEABF, this reality currently applies. Under the existing funding plan, the MEABF is required
to sell 10-15% of its existing reserves for the purpose of making payments to current
beneficiaries.
Best practices for pension funding are generally considered to be an actuarially determined
contribution that is equal to the normal cost (the benefits that are currently being accrued this
year) plus interest so that the fund is 100% funded within 30 years. The statutory requirement
for the Citys contribution to the MEABF is based on a multiplier, whereby the employers
contribution is equal to 125% of what employees contributed two years ago. This has provided
stable contributions for the employer, but it has not proved to be sufficient for the pension plan.
Without an increase in contributions to the MEABF, the fund will be required to liquidate all
assets and operate on a pay-as-you-go basis by 2025.
The employer contribution to the MEABF is currently projected to be $161 million for 2016. The
Actuarially Determined Contribution, which is established as the normal cost plus interest so
that 100% of liabilities are paid for within 30 years, is $962 million when presented on a level
dollar amortization schedule. The deficiencies in the current contributions to the system are
severe and if not addressed will likely lead to a precipitous drop in the value of the assets held by
the MEABF.

Mayor Rahm Emanuel recently announced that the administration will be proposing a series of
water and sewer taxes as part of a five year ramp-up to actuarially based contributions so that
the MEABF will have a 90% funded ratio in the future. Without knowing for certain what
contributions to the fund will look like during the ramp period, it is difficult to say for certain
how deficient the contributions to the MEABF will be, but they will be deficient from what the
actuarially based contributions would be, and those losses would be amortized over the life of
the funding schedule.
If the ramp schedule is patterned off of the schedule that was in place as part of Public Act 98641, contribution increases during the ramp period would continue to have a negative
amortization schedule in place, but the continued deterioration of the fund would be more
limited than existing law. (The dollar value of the unfunded liability is likely to increase under
both a ramped up funding schedule and an immediate move to actuarially based contributions.)
Conclusion
The MEABFs current assumed rate of return is 7.5%. The rate is in line with the average rate
used by public pension systems across the country, and is in line with the long term rate of
return that the fund has received. However, given more recent experience, and a prolonged term
of low interest rates, it would not be unreasonable for the funds board and its actuaries to make
a determination that a lower assumed rate of return is more appropriate, but maintaining the
existing rate is likely justifiable.
Another key aspect to consider is the public disclosure of existing liabilities as it relates to its
assumed discount rate. Changes that are required per GASB 67 and 68 have been implemented,
and the unfunded actuarial accrued liability of the fund if a much lower discount rate is utilized
is currently available. ($9.9 billion on UAAL using the funds existing assumptions compared to
$18.6 billion net pension liability calculated using GASB requirements.)
Lowering the assumed rate of return and the corresponding discount rate pushes up the existing
unfunded liabilities and alters the generational mix of taxpayers that will be paying off the
unfunded liability. But the simple reality is that current taxpayers will already be required to
contribute significantly more to the MEABF with the current assumptions that are in place. The
most important issue for the MEABF today is the receipt of some form of actuarially based
contributions, and until then the funds fiscal condition will continue to deteriorate.