A sound fiscal decision by the state might end up creating painful fiscal repercussions for the state and for localities.
The Virginia Retirement System holds in trust the retirement investments of hundreds of thousands of local teachers and state employees.
These employees are due pension benefits, and state and local governments contribute to the system in order to ensure the money will be there for employees when they retire. But state and local contributions aren’t the sole funding source; the VRS also grows the pension fund by investing the money. A return on investment that exceeds the rate of inflation is a must; beyond that, the higher the return interest on investment, the more secure the fund will be as pension payments come due.
But the VRS has been criticized in the past by those who believe it is overestimating the rate of return it expects on investments. Overestimating interest income could mean that the money the system expected to have did not in fact materialize, leaving it struggling to meet its obligations to retirees.
Now the VRS is contemplating lowering its expected rate of return on investment to more accurately reflect real results.
The system now assumes a return of 7% on its investments. That strikes critics as unrealistically high.
As it turns out, the fund earned 6.5% in the past fiscal year. That’s a fairly healthy rate — one many investors would be happy to obtain.
But it’s still shy of expectations. If the VRS continues to budget based on expectations instead of realistic results, it could end up unable to meet its full obligations to retirees.
The VRS board is considering lowering the expected ROI, perhaps to 6.5%. That would be a smart move in terms of accuracy of fiscal planning.
But there’s a catch. Retirees are due a set and defined benefit, regardless of what the system earns. If the VRS isn’t earning enough to fill, say, a 0.5% gap, it must get the money elsewhere.
That means state and local governments have to contribute more to make up the difference.
If the VRS reduces its expected rate of return to 6.5% or 6.75%, more in line with actual results, such an adjustment would provide stability for the system’s long-range plans: There would be less likelihood of an eventual shortfall resulting from inaccurate estimates.
But it will contribute to destability for state and local budget planning: Governments unexpectedly would be required to increase their contributions to counteract the expected loss of interest income.
Lowering the expected rate of return to 6.75% would cost $214.2 million a year, $95.3 million of which would come from the state general fund. The remaining $118.9 million would be spread among localities.
If the rate of return were dropped to 6.5%, then state and local governments would have to make up a difference of $442 million.
Both for the state and for cities and counties, meeting that added fiscal obligation could complicate efforts to balance their budgets.
Of course, the VRS should be realistic in establishing expected investment income to help meet its pension obligations, including downgrading those expectations when necessary. Blithely expecting more income than the market is returning is a recipe for disaster, especially over the long haul, as the effects of such mis-estimations compound.
But be prepared: The effects in the short term may come in the form of added pain for state and local governments. Finding an extra $214 million to $442 million might not be easy, especially for local governments already under fiscal stress.