Our Times Watchdog team answers reader questions after a Seattle Times investigation into past mismanagement problems with Seattle's pension fund.
Readers had strong reactions and lots of questions following a Seattle Times investigation into why the Seattle City Employees’ Retirement System had one of the worst investment returns over a decade of any large public pension. Here are answers to some of the most common questions we received.
Q: If city officials invested pension funds poorly, why do taxpayers have to make up for it?
Seattle has what’s known as a defined-benefits retirement plan, which guarantees payouts to eligible employees based on their salary and years of service. The city (i.e. taxpayers) and its employees jointly contribute to the pension fund, which is invested to generate income that will cover retiree costs. While city workers contribute a maximum of 10 percent of their paycheck, the city’s agreements with labor unions call for it to pay “all necessary contributions beyond” that 10 percent. As investment losses eroded the value of the pension fund, the city’s share has exceeded 15 percent – more than $100 million a year – since 2015.
Q: Why doesn’t Seattle switch to another kind of retirement plan, as the private sector has done?
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Most private-sector companies have abandoned defined-benefit plans, favoring options like a 401(k) that allow employees to invest on their own. Seattle officials considered such a change in recent years but instead created a new defined-benefit plan that provides slightly reduced benefits at a lower cost, with support from city labor unions. Some research suggests there are certain advantages to defined-benefit plans. An analysis by the Center for Retirement Research at Boston College found that defined-benefit plans beat the investment performance of individual plans like a 401(k) by 0.7 percent from 1990 to 2012, likely thanks to lower investment expenses.
Q: Why doesn’t SCERS just invest in low-cost index funds instead of employing active fund managers?
“That’s a very good question,” says Alicia Munnell, director of the Center for Retirement Research at Boston College, which recently found that public pensions with lower investment fees have performed better than ones that pursued more private equity and hedge fund ventures. “The fancier you try to get, the worse you do,” she says.
This same trend has been true for SCERS. Its investments in U.S. stocks (which are mostly passively managed) performed far better than those in private equity (which are actively managed) over the last one-, three-, five- and seven-year periods, according to its latest fund report. As The Times reported, mismanagement in the past of complex bets has dragged down returns. Yet the current investment team at SCERS is not shying away from complexity.
Passive investments make up only 34 percent of SCERS’ entire portfolio. Jason Malinowski, chief investment officer of SCERS, says that it hires active managers “if the particular market segment is believed to be less efficiently priced” – he mentions stocks in emerging markets like China, Brazil and Russia – creating the potential to beat the market return. Its investment consultant, NEPC LLC, predicts that private equity will earn a 9.5 percent return over the next 30 years, compared to 7.5 percent for U.S. stocks and 8.2 percent for global stocks. To avoid the missteps of the past, SCERS has hired Adams Street Partners, a firm specializing in private equity, to make such investments on SCERS’ behalf.
Q: How much does SCERS spend on investment fees?
SCERS spent about $9 million on investment fees in 2016, the latest year for which data are available. Divided by the market value of its holdings, that works out to an expense ratio of about 0.40 percent, roughly the same as the much-larger fund managed by the Washington State Investment Board. By comparison, some low-cost index funds have expense ratios under 0.05 percent.
Q: Why does SCERS assume it can achieve a 7.5 percent long-term rate of return?
For one thing, SCERS achieved a 7.84 percent return over the last 30 years (excluding investment fees), according to its investment consultant NEPC LLC. The consultant also forecasts that with its current slate of investments, SCERS can expect a 7.6 percent return over the next 30 years. Not everyone agrees, however. An advisory committee of investment experts has questioned whether this return is achievable. And Milliman Inc., the consultant that advises SCERS on how to calculate its pension liabilities, recently predicted it could expect a 6.5 percent return over 30 years.
Q: Does it really matter if SCERS assumes an investment return of 7.5 percent instead of 6.5 percent or some other rate?
It does, a lot. This is because SCERS calculates its pension liability based on its expected rate of return. In 2016, using the 7.5 percent expected return, it reported a net liability of $1.31 billion. If SCERS assumed it would earn a 6.5 percent return, that net liability would jump by more than $460 million to $1.77 billion. When this liability goes up, it means that the city and taxpayers must pump more money into the pension fund.
Q: How big a drain are pension costs on the city of Seattle’s finances?
The city (underwritten by taxpayers) injected $108.5 million into the pension fund in 2016, up from $45.2 million in 2010 as it assumed a larger share of the costs. To put that in the current political context, the city’s increase in pension costs over this time is well above the $47 million it expects to raise with the new per-head tax for homeless services. While pension costs have increased faster than the city’s revenue, credit-rating agencies still consider the pension burden to be manageable.
Q: Are the city’s pension costs bigger than they appear?
Researchers like Josh Rauh, a senior fellow at Stanford University’s Hoover Institution, have argued that public pensions effectively hide debt by assuming they’ll achieve a high investment return. “The targeted returns may or may not be achieved, but public sector accounting and budgeting proceed under the assumption that they will be achieved with certainty,” he writes in a 2017 paper. Instead, he argues, a better way of measuring pension liabilities is to assume the return for the least risky investments like a Treasury bond. Using such a rate, the unfunded liability for SCERS would have been about $3.2 billion in 2015, instead of the $1.3 billion that appears in its financial statements, according to Rauh’s analysis.
If assuming a 7.5 percent return is on the optimistic side, Rauh’s view is at the pessimistic end of the spectrum. Justin Marlowe, a finance professor at the University of Washington, says the appropriate assumption for most governments “is really somewhere between their current assumed returns and the risk-free rates.”
Q: Should retired pension holders be worried about SCERS making good on its payments?
No, at least not for the time being. The city has consistently contributed the amounts needed to fund pension obligations even as they have surged in recent years. Moody’s Investors Service says in an April report the city is paying more than it needs to “tread water,” or in other words, to prevent the unfunded pension costs from growing “under plan assumptions.” That qualifying language is significant, because changing an assumption like investment returns could increase the liability.