Investment expert: ‘Getting 7.5% … is going to be a challenge’

It’s one of the most controversial – and arcane – parts of the entire pension debate: How much can Rhode Island reasonably expect its pension fund’s investments to earn over the coming years?

In April, Treasurer Gina Raimondo got the Retirement Board to lower the fund’s expected return from 8.25% to 7.5%, which helped cause this year’s huge increase in the unfunded pension liability. The board raised lifespan forecasts, too.

Paul Valletta of the firefighters union said Thursday Raimondo “cooked the books” with those changes to create a crisis, and Robert Walsh of teachers union NEA Rhode Island – who helps manage his union’s pension fund – testified that it could be responsibly bumped to 7.75% as a way to help alleviate the pressure.

But Allan Emkin of Pension Consulting Alliance, the state’s investment adviser, said even the new hoped-for return of 7.5% is “optimistic, not pessimistic.” His analysts say the pension fund’s diversified investment portfolio has only a 42% chance of achieving 7.5% over the next 10 years, and a 50-50 shot at achieving 6.75%.

Raimondo sees ‘lofty goal’

“Getting 7.5% in today’s world is going to be a challenge,” Emkin told WPRI.com after Thursday’s hearing. “It’s a different world now.” Raimondo herself has called the 7.5% target “a lofty goal” and said she’s designed the proposed new hybrid retirement plan to reduce the risk to taxpayers if 7.5% isn’t achieved.

That raises concerns not only for the state but for cities and towns, as well. Providence, East Providence and Smithfield are all banking on their locally run pension plans earning 8.5% returns over the next 10 years, and a number of others are expecting 8.25% and 8%.

Before last April’s vote, the state Retirement Board’s previous votes had been to raise the return target, from 7.5% to 8% in 1990 and then from 8% to 8.25% in 1998. Former Treasurer Frank Caprio suggested last year the board should take another look at whether 8.25% was reasonable, though a vote was never taken.

Pension fund trustees across the country are now reexamining their assumptions, though few have moved as aggressively as Raimondo’s Rhode Island, Emkin told WPRI.com. “If there’s an overall trend, the trend is to go lower,” he said. “How much [lower] is the part of the process that’s very complex and unique to each jurisdiction.”

Most places have moved their return rates by 25 or 50 basis points at a time – from 8.25% to 8% or 7.75%, for example – unlike Rhode Island, which dropped its rate by 75 basis points in one fell swoop last April. “That’s a policy decision,” Emkin said.

Small numbers, big impact

Those seemingly small differences have a massive impact on paper. The combined shortfall in the main pension funds for state employees and teachers totals $4.7 billion using an 8.25% rate; $6.8 billion using the new 7.5% rate; $9 billion using a 6.2% rate; and $11.4 billion using a 4.4% rate, according to Gabriel Roeder Smith & Co.

There is no doubt the change pushed by Raimondo is aggressive. The latest Public Fund Survey shows only 24 of the nation’s 126 largest pension funds use a return forecast of 7.5% or lower. The remaining 102 funds use 7.75% or higher, with the most common investment target being 8%. Massachusetts continues to use 8.25%.

The median public pension fund’s investments earned an average annual return of 8.5% in the 25-year period ended June 30, 2011, according to the National Association of State Retirement Administrators – though, as investment advisors often say, past performance is no guarantee of future results.

William “Flick” Fornia, an independent pension actuary hired by local unions, said the new 7.5% return forecast is “desirable” from an actuary’s perspective but the old 8.25% forecast is more desirable for taxpayers, because it would reduce the size of the deposits they are supposed to put into the pension fund.

Emkin and Pension Consulting Alliance first worked for Rhode Island under former Treasurer Roger Begin, a Democrat who served from 1985 to 1989, and was rehired by Caprio. Emkin said his firm revisits its investment outlook annually, and has revised it downward since 2008 to reflect the record-low yields on bonds and unsettled macroeconomic outlook that have followed the financial crisis.

According to forecasts by Emkin’s firm, the compounded return on different asset classes over the next decade will range from 3% for cash to 8.9% for private equity and venture capital, with inflation averaging 2.75%. Pension Consulting Alliance’s forecasts are in line with those of six other major investment advisers.

(chart: National Association of State Retirement Administrators)

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