AN ONGOING SERIES--Twice in recent years the LACERS Board has rejected the recommendation of its expert, longtime actuary to lower its annual investment earning assumption to 7.00%.
Did the Board overrule its actuarial expert based on other compelling information or based on political influence?
I realize that actuarial issues are boring to many people, but it is imperative to discuss them when considering the health of LACERS funding and the impact the assumptions have on the City’s finances, as explained below. To try to minimize the boredom factor, I will attempt to keep the information at a high level and minimize the jargon. Much more could be written about this topic.
Actuarial assumptions are of two types: demographic and economic.
Demographic assumptions are fairly straight forward. They include such assumptions as how many people will terminate city service prior to retirement; when will employees retire; and how long will they tend to live after retirement. For LACERS, the review of demographic assumptions happens approximately every three years. The actual numbers over the prior three years are compared with the previously-assumed numbers and necessary adjustments are recommended to the LACERS Board. While there is some room for shenanigans with the demographic assumptions, it’s fairly difficult to argue with what has actually happened over the prior period of time (these are backward-looking assumptions). Therefore, generally, the LACERS Board has made the correct decisions when it comes to adjusting demographic assumptions, despite the fact that those assumption changes have caused significant short-term cost increases for the City.
Economic assumptions are a whole other matter. These assumptions include such items as inflation; pay increases; and LACERS investment return. Unlike the backward-looking demographic assumptions, the economic assumptions are forward-looking. This makes the economic assumptions less certain than the demographic assumptions and can lead to some honest (and some seemingly dishonest) differences of opinion. Because of this lack of certainty, there is a greater opportunity for political shenanigans.
The rate of investment return assumption is an extremely important economic assumption. If it is set too low, the City pays more contributions in the short-term than it needs to, taking funds away from City services. If the assumption is set too high, the City pays too little to LACERS, thus threating the retirement benefits promised to tens of thousands of City employees and shifting retirement costs to future generations of taxpayers. The failure by LACERS to consistently hit its investment targets is a major reason it is underfunded today.
For many years, LACERS assumed it would make 8.00% per year on average on its investments. That could well have been a reasonable assumption in 1990, when low risk core bonds alone returned more than 8.00%.
In 2011, the LACERS Board, based on a recommendation by its actuary, considered decreasing the assumed rate of investment return to 7.75%. Staff of the Mayor’s Office and the City Administrative Officer along with several union representatives provided public comment asking the Board to retain its 8.00% assumption. A motion to retain the 8.00% assumption was defeated on a 5-2 vote. One Board Member who voted with the majority to defeat the status quo motion was Roberta Conroy. Ms. Conroy had a great background to be a LACERS Board Member (investment and law background) and was a wonderful fiduciary. Shortly after that Board meeting, Ms. Conroy’s pre-signed letter of resignation was accepted by the Mayor Villaraigosa. In essence, she was fired from the LACERS Board. (For more on this topic, please see The Truth About LACERS – The LACERS Board – Part 1 of 2 in this series of articles or see Jack Humphreville’s article.)
The minutes from the next Board meeting (October 25, 2011) indicate there was pressure put upon the Board to maintain the 8.00% assumption or to defer its impact. Despite that pressure, the Board voted to decrease the assumed rate of investment return to 7.75%.
In 2014, the LACERS Board further lowered its investment return assumption to 7.50%. This again was based on the recommendation of LACERS staff and the Board’s hired actuarial expert. So far, so good.
In 2017, the Board again considered lowering the assumed rate of return, this time to either 7.25% or 7.00%, based on the advice of its actuary. This item was discussed over three Board meetings. During the second of those meetings, Board Member and noted economist Dr. Sung Won Sohn twice commented that the actuary’s inflation assumptions (which are components of the investment return assumptions) of 2.75% and 3.00% were both too high, thus providing for an investment return of no more than 7.00% and maybe less.
During the third Board meeting on this topic, a staff member of the Mayor’s Office was pacing in the back of the boardroom. During that meeting, Dr. Sohn again indicated that he didn’t think inflation would get close to 3.00% or even 2.75%, as the central banks have done a good job on inflation expectations. Dr. Sohn’s assertion, based on his expertise, would argue for an assumed rate of investment return not higher than 7.00%. He also seemed to favor a motion to lower the investment assumption to 7.00% and reiterated that an inflation assumption of 2.75% was still too high. Then, there was a break in the meeting and Dr. Sohn was witnessed having a hallway conversation with the staff member from the Mayor’s Office and Board Member Cynthia Ruiz. After the break, Dr. Sohn had a stunning change of heart and backpedaled from his previous comments and opinion. He ended up voting in favor of an investment return of 7.25%, including an inflation assumption of 3.00%! A vote on a motion for a more conservative rate of return was defeated, with all Board Members appointed by the Mayor voting against it and both elected Members who were present voting in favor of it.
The Board’s decision to retain the 7.25% investment return assumption saved the City money in the short-term, but likely will cost the City even more money over the longer-term.
In 2018, the LACERS Board again failed to reduce the investment return assumption to 7.00% despite recommendations from its staff and expert actuary. Both CalPERS and CalSTRS have adopted 7.00% investment return assumptions according to the National Association of State Retirement Administrators (NASRA). Apparently, the LACERS Board believes it can out-earn these huge, sophisticated pension funds – although that has not proven to be the case over the last 25 years. If the Board is wrong, LACERS’ 73% funding ratio will very likely further deteriorate in the coming years.
The examples above are meant to show, in my opinion, the apparent influence that the Mayor’s staff has tried to exert over a process in which the LACERS Board Member are required by the State Constitution and the City Charter to be doing what is in the best interest of the active and retired members of LACERS. These apparent attempts to influence the Board ultimately are bad for the funding of the pension system and, therefore bad for future retirees, the long-term interests of the City’s finances, and for City services on which its residents rely.
In its own way, the City Council also tries to weigh in on LACERS’ assumed rate of investment return. This, more subtle pressure frequently takes place at committee meetings when potential LACERS Board Members are being considered and the Councilmembers try to impose their own beliefs regarding LACERS’ assumptions on the nominees. During the City’s budget hearings, the questions and comments regarding LACERS frequently boil down to two issues. The first issue is the fact that LACERS has never had under an 8.00% return over any 30-year period (this is true for the information that LACERS has on record, which only goes back to investment returns starting in 1983). The second issue is that LACERS current return assumptions are in line with other pension systems across the country.
There are issues with both of these Council assertions. First, as was stated earlier in this article, the investment return assumption is a forward-looking assumption, not a backward-looking assumption. Therefore, very little time should be spent looking at historic rates of return and the focus of the conversation should be on forward-looking capital market assumptions – as the actuary does in preparing for this Board discussion. Second, looking at national statistics can be mildly interesting, but the focus needs to be on the plan at hand, in this case, LACERS. LACERS’ funding ratio has not recovered adequately since the Great Recession despite eleven years of economic recovery and good investment returns. The City politicians were quick to turn to LACERS during the Great Recession to ask for some contribution relief, but have done extremely little in subsequent years to help return LACERS to a more secure financial footing. In fact, they have, in my opinion, appeared to interfere with LACERS receiving appropriate funding.
It is time to put an end to the political actuarial games!
Tom served at LACERS for approximately sixteen years, the last seven of those years as the General Manager of the pension system. He retired in 2018. Tom can be reached at firstname.lastname@example.org.
Previous series articles: < The Truth About LACERS – Necessary Conversations>
< The Truth About LACERS – The LACERS Board – Part 1of 2>
< The Truth About LACERS – The LACERS Board – Part 2 of 2>
< The Truth About LACERS – The City’s Annual Contribution>
< The Truth About LACERS – The Net Liabilities>
< The Truth About LACERS – The Politics of Investing>
(Tom Moutes served at LACERS for approximately sixteen years, the last seven of those years as the General Manager of the pension system. He retired in 2018. Tom can be reached at email@example.com.)