Category Archives: Government workers and pensions

Paying University Executives for Performance

Michael Rao, Virginia's highest-paid state employee

Michael Rao, Virginia’s highest-paid state employee

The Richmond Times-Dispatch published its annual ranking of highest-paid state employees Sunday and, no surprise, university presidents and Virginia Retirement System (VRS) executives dominate the list.

I’m of two minds. On the one hand, if you want the best people running your universities and your pension funds, you have to pay them competitive salaries. Basically, you get what you pay for. Don’t expect exceptional results if you hire mediocre leaders.

The compensation of top VRS executives is largely tied to investment results. Investment mangers get rewarded if they deliver superior returns, a metric that is directly aligned with the interest of Virginia citizens. I have no problem with that. On the other hand, what do Virginia’s public university presidents get rewarded for? I know one thing: not for restraining tuition hikes.

Let’s take a look at Virginia Commonwealth University’s president, Michael P. Rao, the highest-paid state employee last fiscal year. According to T-D calculations, he earned $901,000 in fiscal 2016.

As befitting a public employee, Rao earned a base salary of $183,000. That’s a modest sum for a man running an organization with operating expenses of roughly $1 billion a year, so it’s no surprise that the Board of Visitors supplemented his base salary with:

  • $191,500 in deferred compensation
  • $72,000 housing allowance
  • $50,000 to cover personal expenses relating to his role as president
  • $7,000 for tax preparation
  • $5,000 for disability insurance from his previous contract
  • $2,160 for wireless communications
  • $42,500 for an automobile provided by VCU (and not included in the salary calculation)

Plus, he got paid a $50,000 bonus paid for meeting performance goals in 2014-2016. The T-D noted that the board will meet next week to evaluate Rao’s last-year performance and a new set of measurements to reflect the university’s objectives this year, but did not say what the performance goals were.

The VCU president’s page refers vaguely to three “themes” relating to the universty’s vision and goals: (1)  “provide all students with high-quality learning/living experiences;” (2) “attain distinction as a fully integrated urban, public research university;” and (3) “become a national model for community engagement and regional impact.”

What metrics would demonstrate progress toward achieving those goals? I’m hard-pressed to imagine.

Suggestion to the T-D: Next year, it might be worthwhile to find out exactly what performance metrics were used to calculate Rao’s bonus. As a matter of fact, it would be useful to obtain that information for every public university president. There could be no clearer indicator of university boards’ top priorities. I would be very much surprised to find that “holding the line on tuition charges” is among them.

Quantitative Squeezing

Bond yields have declined steadily for thirty years. As long-term and mid-term bonds expire and get rolled over at lower yields, pension funds generate much lower returns on their bonds portfolios. State and local funding for public pension funds has not kept pace with this market reality. Graphic credit: Wall Street Journal.

Bond yields have declined steadily for thirty years. As bonds expire and get rolled over at lower yields, pension funds have been generating lower returns on their portfolios. State and local funding for public pension funds has not kept pace with this market reality. Graphic credit: Wall Street Journal.

It’s nice to see mainstream media highlighting an issue that I’ve been hammering here at Bacon’s Rebellion for a couple of years now. A front-page Wall Street Journal article discusses how the zero-interest rate policies of central banks around the world are crippling returns on pension portfolios, making it difficult for nations and municipalities to meet their obligations.

Among the numbers cited in the article… Global pensions on average put roughly 30% of their assets in bonds. Investment-grade bonds that once yielded 7.5% a year now deliver almost no income at all. Low rates helped pull down assets of the world’s 300 largest pension funds by $530 billion in 2015.

The California Public Employees’ Retirement System (CALPERS) posted a 0.6% return in fiscal 2016. Its investment consultant, reports the Journal, recently estimated that annual returns will be closer to 6% over the next decade, shy of its 7.5% annual target.

If CALPERS is ready to admit that investment returns will remain depressed over the decade ahead, maybe it’s time for the Virginia Retirement System to do the same. The VRS assumes a 7% annual return on its portfolio — not as divorced from reality as many states, but significantly more than justified by bond returns. The problem, of course, is that acknowledging reality will expand Virginia’s public pension unfunded liabilities by billions of dollars — and nobody knows where the money will come from. So, we’ll pretend the problem doesn’t exist… until it becomes a crisis.

$6 Million Bonus for VRS Staff — Justified or Not?

piles_o_cashby James A. Bacon

The Virginia Retirement System (VRS) has awarded $6 million in incentive pay to its internal investment team, raising the issue of whether the Commonwealth of Virginia is creating a caste system of “haves” and “have nots” in its workforce.

The VRS Board of Trustees approved the incentives yesterday, reports the Richmond Times-Dispatch, even though the VRS portfolio generated a return on investment of only 1.9% in fiscal 2016, far short of the 7% long-term goal. The bonus was justified, VRS officials contended, because the pension fund’s internal investment team out-performed the 1.3% return of its benchmark.

As Chief Investment Officer Ronald D. Schmitz explained, the internal team has generated an average of $289 million a year over the benchmark over the past decade, while also saving $26 million in fees to Wall Street investment managers. “A $6 million bonus versus a $300 million gain seems like a pretty fair gain to me.”

However, as the T-D’s Michael Martz observes:

The timing of the investment awards also is awkward, as the state grapples with a projected $1.48 billion revenue shortfall that already has wiped out scheduled raises for state employees, college faculty and school teachers, and state-supported local employees, including sheriff’s deputies.

“State agencies and institutions that charge tuition, sell lottery tickets, license businesses and manage employee pension plans are free to use those funds to give employee pay raises,” said R. Ronald Jordan, executive director of the Virginia Governmental Employees Association. …

“Treating employees based on agency revenue source has resulted in tremendous pay disparity and a system of agency “haves” and “have nots.”

Bacon’s bottom line: Jordan has a point, and it’s understandable why state employees would be demoralized. But what’s the solution? Should we stop rewarding VRS investment professionals for superior performance, a standard practice in the financial services industry? If the internal team can save tens of millions of dollars, doesn’t everyone come out ahead? The alternatives — letting top performers get snatched up by the competition, or settling for sub-par performance by highly paid Wall Street money managers — will only increase the financial stress on the Commonwealth and make it more difficult to raise employee salaries in the future.

I made a similar argument yesterday: Paying top dollar to hire top talent to run the state’s IT services will lead to better decisions that save the state money. State government needs to reward the people in critical functions who do superior work. The alternative is to be “fair” but broke.

Long-Term VRS Performance Not Looking So Good

by James A. Bacon

Governor Terry McAuliffe announced Thursday that Virginia faces a budget shortfall of roughly $1.5 billion in the current biennial budget. That’s a big short-term problem, one of the worst in recent Virginia history — and possibly the worst ever during a period of economic expansion.

However, the long-term picture doesn’t look any better. The prime culprit is unfunded liabilities in an era of chronic low interest rates.

The official actuarial estimate is that the Virginia Retirement System faces a liability of $22.6 billion. As I have noted on many an occasion recently, that assumes that the VRS manages to generate an average 7% return on its $68 billion investment portfolio for the indefinite future. A year ago that didn’t look like such an outrageous proposition. Here’s what VRS’s portfolio performance looked like compared to national benchmarks:


Here’s what the VRS’s most recent (June 2016) comparisons look like:


What a difference a year makes. The average 10-year return is significantly below the assumed 7% figure. The five- and three-year returns do look better, but are they a better representation of likely long-term performance than the 10-year average?

The answer largely depends on which base year we choose to make our comparisons. The three- and five-year comparisons cover periods that were pure bull markets for stocks and bonds. The base year for the 10-year comparison was 2006… just before the Great Recession… thus including a major bear market correction as well as the subsequent bull market. I would argue that the 10-year comparison is more useful because it measures performance from the peak of the early-2ooos business cycle to the peak (or near-peak) of the current business cycle.

If we accept that logic, VRS is not achieving the portfolio growth it needs to meet its own 7% return-on-investment standard. While we can applaud VRS for out-performing its peer pension funds, we should not delude ourselves that 7% growth is a reasonable assumption. In all likelihood, VRS will fall short, and Virginia taxpayers will be called upon to make up the difference.

Perhaps my view is excessively pessimistic, but it is not implausible. The very least we can do is to conduct a sensitivity analysis. If VRS returns are only 5.6% over the next 10 years, then unfunded liabilities will increase to what level? $40 billion? $50 billion? We need to know our potential exposure should things not work out as we hope. It’s better to know this now, when we can plan for it, than get bushwacked by reality a decade from now.

Stick It to the Hedge Fund Managers!

by James A. Bacon

One of the voices urging reform of the Virginia Retirement System (VRS) is a semi-retired University of Virginia economics professor, Edwin T. Burton III, who served 18 years on the board. He argues that the VRS pays too much in management fees to outside investment firms that pursue labor-intensive strategies and should rely on low-overhead funds that index stock and bond markets.

In fiscal 2016, the VRS generated a 1.9% return but lagged the 3.99% return on the S&P 500. The year before, the VRS generated a 4.7% return compared to a 7.4% return for the S&P. “We haven’t come close” to the 7% rate of return assumed by the VRS in reaching its calculation of $22.6 billion in unfunded liabilities, he told Michael Martz with the Richmond Times-Dispatch.

Getting a higher rate of return is the best way to boost the financial health of the state retirement fund. Of course, that’s easier said than done. Everyone would like to boost returns on their financial investments, but very few investment managers have outperformed the market consistently. While pension funds can tinker with their portfolios, shifting funds between stocks, bonds, real estate, private equity and hedge funds, often chasing yesterday’s hot categories, they can’t control their returns. But they can control how much they pay outsiders to generate those returns.

As it happens, the VRS paid $362 million in management fees in 2015, according to its 2015 Comprehensive Annual Financial Report. (The 2016 report is not yet online.) That sum is divvied up between ten major investment categories such as U.S. and foreign equities, fixed-income, real estate, hedge funds and other alternative investments.

Hedge fund managers stick out like a sore thumb — they collected $87 million in management fees. Hedge funds delivered outstanding returns for many years, which justified their sky-high management fees, but they have stubbed their toes in recent years. With some 10,000 funds playing in the sandbox, typically betting on movements of currencies and commodities, competition has squeezed industry profit margins to nothing. After years of sub-par returns, there is no justification for the overly generous fee structure.

VRS also paid exceptionally high fees to “alternative investment” managers and for its “strategic opportunities portfolio.” Taxpayers might wonder if those fees are worth the returns they generate.

Remarkably, the VRS staff, which manages one third of the portfolio, cost one-tenth that of the hedge-fund and alternative-investment managers.  If the entire portfolio were managed that efficiently, management fees would have cost only $81 million in 2015 — a savings of about $280 million! Over the years, that could amount to billions of dollars.

So, why don’t we fire the hedge fund managers?

It gets complicated. First of all, you don’t mind paying higher fees to managers who outperform the market averages. Unfortunately, the VRS annual report doesn’t tell us the performance of its individual funds, and even its discussion of investment categories (stocks, fixed-income, hedge funds) doesn’t match up with the categories listed in its table of management fees. So, there’s no way the public can tell if the management-fee differentials are worth it or not.

Second, you shouldn’t judge a fund manager based on one year’s performance. Even the best can have a bad  year. What most interests me is the internal VRS performance. Does its track record over the years equal that of other fund managers? If so, why we paying the other fund managers?

Third, there is a benefit to diversifying a portfolio. The idea is to limit exposure to wide swings in any single investment category. Strong performance in one category offsets weak performance in another. A pension portfolio that invested only in stocks and bonds would be distressingly volatile.

Still, Professor Burton has a point. The VRS may be paying way more than it needs to. Saving $280 million a year won’t bail out a pension fund with $22.6 billion in unfunded liabilities (probably an optimistic assessment), but it sure would help, creating less pain for Virginia’s public-employee pensioners and taxpayers. The idea is definitely worth a closer look.

Digging into Rate-of-Return Assumptions


by James A. Bacon

House Speaker William J. Howell is rightfully concerned about the long-term health of the Virginia Retirement System. The pension system’s own actuary estimated a year ago that the $68 billion retirement system has unfunded liabilities of $22.6 billion.

On Sunday, the Richmond Times-Dispatch’s Michael Martz described the debate over restructuring the VRS from a defined-benefits system to a defined-contribution system. Today, Martz reports how Howell is questioning the outsized fees paid to outside fund managers, who handle two-thirds of the system’s assets.

“My biggest concern is the unfunded liability and the fact that it’s just going to grow,” Howell said.

Howell has every reason to be concerned. Unfunded liabilities might turn out to be far bigger than the actuary’s estimate. As I have observed many times, the liability is based upon an assumed 7% annual rate of return on the $68 billion portfolio. If the system under-performs expectations, as the VRS has done the past two years, the unfunded liability can grow by tens of billions of dollars. Writes Martz:

For Howell and other lawmakers on the [Virginia Commission on Retirement Security & Pension Reform], however, the retirement system’s recent investment performance has raised questions about whether the 7% assumed rate of return is too optimistic for the longer term, especially with interest rates keeping bond yields low for the foreseeable future. …

The 7 percent return, lowered by the VRS board from 7.5 percent in 2010 is among the lowest in the country for public pension funds, said Katie Selenski, state policy director for the Pew retirement initiative. “At 7 percent, you’re in a good, prudent position.”

Prudent? Not really. The pie chart above shows VRS’s portfolio allocation. Some 17.6% consists of fixed income assets. Barring some bizarre experiment with negative interest rates in the U.S., there is no way in a zero interest-rate environment that these assets can generate a 7% return. Another 39.8% of the portfolio consists of equities. Insofar as the bull market in stocks over the past 30 years has been driven by lower interest rates and an expansion of earnings multiples, there is no way to replicate the stock gains of the past ten years. Indeed, earnings and earnings quality of stocks are deteriorating, not a good sign for near-term price performance. Meanwhile, the performance of hedge funds nationally has been dismal of late. There is no rabbit to pull out of the magic hat of alternative investments.

For another view on the outlook for long-term portfolio performance, it is instructive to turn to the University of Virginia, which, whatever one might say about the Board of Visitors’ strategic priorities, one must credit with doing an excellent job of managing its endowment. The 10-year return of the University of Virginia Investment Management Company (UVIMCO) has been 10.1 %, according to its 2014-2015 annual report. That compares to 5.8% ten-year performance calculated by the VRS in 2014-2105.

How much do UVa’s masters of the universe think they can earn on their portfolio looking forward? As best as I can tell from perusing UVIMCO’s annual report, they don’t say. UVIMCO doesn’t report that assumption because it isn’t relevant:  Although UVIMCO does have unfunded commitments, it is not a pension fund in which shortfalls must be made up by taxpayers.

Still, it is possible to get a sense of UVa’s expectations from comments made by university officials that they expect the controversial $2.2 billion Strategic Investment Fund to throw off $100 million a year to pay for programs to advance the university’s strategic goals. University officials have not explained what rate-of-return assumptions they are using. But a simple calculation reveals that $100 million is only 4.5% of $2.2 billion.

From that, one can draw one of two conclusions. Either UVa’s investment mavens are assuming a much lower rate of return than the VRS, or they expect a higher-than-4.5% rate of return but plan to retain a substantial fraction of the earnings, presumably in order to grow the size of the portfolio.

It appears that the second conclusion is true. Here’s what the UVIMCO annual report says: “Each year a portion of the endowment value is paid out to support the fund’s purpose, and any earnings in excess of this distribution help build the fund’s market value over time. In this way, an endowment fund grows and provides support for its designated purpose in perpetuity.”

For legislators digging into UVa’s controversial Strategic Investment Fund, which is managed by UVIMCO, it would be interesting to know what rate-of-return the university is assuming for its endowment and what percentage it figures on spending and what percentage it figures on retaining. The numbers should be equally interesting to Speaker Howell. It would send out a flashing yellow caution signal if the UVIMCO’s assumption about of future performance was more conservative than that of the VRS.

Virginia Retirement System — Trouble Ahead

Last week as I was watching the business channel, I was very interested in the comments of AIG’s head of investments about the effects of low interest rates on his firm. For those involved in life insurance and other long-term products, today’s historically low interest rates pose a significant problem. With negative rates on investment-grade bonds, insurers have no choice but to raise prices to the consumer or leave markets where bond yields are not high enough to support interest-sensitive products.

This morning’s Richmond Times Dispatch brought the issue a little closer to home. House Speaker William J. Howell wants to shift from the current structure to a self-managed system. In other words, employees would manage their own retirements and, as is the case with 403b plans or IRAs, would take their accounts with them when they shift jobs. (As a retired teacher, I receive a small pension from the Virginia Retirement System.)

It is unclear from the article how, under Howell’s proposal, the employee would fund this. Would employees receive a stipend equal to the amount that school districts currently contribute on their behalf to VRS? Or would they be totally on their own? If the latter, the state would be shifting not only market risk but the actual cost to teachers and its other employees.

Teaching has always been a relatively low wage profession. One of the unspoken deals always was, “You work for a low wage now and we will help you out in your later years.” The article leads me to conclude that Howell wants to destroy that bargain. Sure, we all want to be on our own, but attracting skilled folks to the teaching profession, which has seen a decline in real wages since the Great Recession, will be even more difficult. Funding their own retirement is a risk that few will be able to afford.

— Les Schreiber

Petersburg’s Other Fiasco


Petersburg City Hall

by James A. Bacon

Poor Petersburg. The economically depressed Southside city of 32,000 serves as a vivid warning of just about everything that can go wrong for a local government in Virginia. Not only is the city running a massive General Fund budget deficit, it is falling millions of dollars behind in the collection of revenues for its water system.

The heart of the problem is a botched rollout of a meter-reading system that was pitched as a low-risk way for the city to overhaul its aging infrastructure without a tax increase. The city contracted with systems-controls giant Johnson Controls to install meters that would transmit usage figures electronically, obviating the need to send employees door to door to collect the numbers. Supposedly, the overhaul would pay for itself through more accurate readings and personnel reductions.

But something went wrong. First, the $3.9 million project experienced overruns of $1.4 million, bringing the final cost to $5.3 million. Second, it didn’t work properly. A year and a half later, surely enough time to work out the kinks, some people are reporting that they haven’t received water bills for months, while others say they have been billed too often, sometimes to the tune of thousands of dollars.

City officials blame the vendor, Johnson Controls. Yesterday City Council voted to hire an outside attorney to pursue litigation against the company to seek remedy, and has asked for assistance from the Virginia State Police.

While it is possible that Johnson Controls bungled the installation of the meters (Full disclosure: I own 400 shares of Johnson Controls stock), the City of Petersburg’s track record and evidence in the Richmond Times-Dispatch’s reporting of the story suggest that the city itself might have contributed to the problem.

First, the article mentions that more than a fifth of the cost overrun came from a $300,000 change order the year after the contract signed. No mention of whether there might have been other change orders.

Second, the contract was negotiated by then-City Manager William E. Johnson III, under whose watch the city’s General Fund plunged into such chaos that City Council fired him. If his oversight of city books was dismal, the same might well have been true for his oversight of the contract.

Third, it’s not clear from published accounts that the billing problem can even be traced to the meters. Meters report water usage; they do not send out billing statements. Perhaps the billing problem arose from the integration of the meters with the billing process. If so, responsibility gets murky. A successful launch of the system would have required collaboration between Johnson Controls and the city administration.

Fourth, Mayor W. Howard Myers admitted that he and other council members were unaware that the project had experienced cost overruns, or that city administrators had approved Johnson Controls’ work months after the system went live and residents had began complaining about faulty billing. This is the same mayor who declared, after being informed that the city had closed the year with a 20% deficit, “I had no idea. I’m like, wow, where is this coming from?” This is not a mayor who is on top of things, and if he blames the vendor for the mayhem, there is no reason to take his appraisal very seriously.

Fifth, in February, Myers hired Paul Goldman, law partner of former state Del. Joseph Morrissey, to investigate the matter at the rate of $330 per hour. But the city terminated the contract before Goldman could complete his job — more money down the drain. (I would conjecture that Goldman couldn’t finish the job because he found the matter to be an indecipherable morass that would take far more time than anyone had initially imagined.)

The business of government is complicated — and getting ever more so. I admire the everyday citizens who dedicate their time to running for office, helping constituents and overseeing government. They don’t get paid enough for what they do. But many of them, especially in smaller jurisdictions, are ill equipped to master the complexities of the job. Frankly, it’s a wonder we don’t see more fiascos like Petersburg’s.

When Balanced Budgets Aren’t Really Balanced

hide_the_peaby James A. Bacon

The politics of fiscal implosion are ugly. Just look at what’s going on in Petersburg and Richmond.

  • Confronted with a massive budget deficit last year in contravention of the state constitution and the prospect of a deficit in the year ahead, Petersburg City Council bravely agreed to cut the compensation of the city’s 600 employees — but carved out exemptions for senior city officials and themselves.
  • Another trustee has resigned from the board of the city of Richmond’s severely under-funded retirement fund, which has been embroiled in governance issues over who calls the shots over investment decisions.
  • City of Richmond officials say they have nearly completed their comprehensive annual financial report for 2015 — seven months late! The city has not completed the required report on time since 2014. City officials blame IT issues.

That’s just in the Richmond region, which I am familiar with because I read the Richmond Times-Dispatch as my daily newspaper. Who knows what’s happening elsewhere? While Virginians pride themselves for their fiscal rectitude, it is increasingly clear that some jurisdictions don’t hew to standards much higher than Chicago, Cleveland or Detroit.

In theory, the state constitutions requires the state government and each political jurisdiction to balance its budget each year. Virginians should be concerned that Petersburg failed to do so in fiscal 2016, that it shows every sign of failing to do so again in fiscal 2017, and that there appears to be no sanction or penalty in sight. Likewise, we should be concerned of the various tricks the state and its localities can use, if so inclined, to hide long-term structural budget deficits. Here are three:

  • Under-fund employee pensions. The Commonwealth drastically under-funded the Virginia Retirement System in the last recession, although it is now doing penance by accelerating repayments. The City of Richmond has under-funded its government-employees pension, which it operates independently of the VRS.
  • Slow pay creditors. This tactic comes straight out of the Illinois Fiscal Irresponsibility Playbook. Petersburg, it has been revealed, delayed payments of millions of dollars not only to the VRS but schools and the regional jail.
  • Defer maintenance. Rather than properly maintain roads, streets, buses, water systems, sewer systems, school buildings and the like, save money by scrimping on maintenance, even if it means even higher costs down the road.

To what extent do local governments rely upon these and other budgetary sleights of hand to balance their budgets? Nobody knows. Let me rephrase that: The public doesn’t know.

The bottom line here is that citizens cannot take at face value that their local governments are truly balancing their budgets. Some might be. I have faith that my home county of Henrico, whatever its other failings, runs a tight fiscal ship and doesn’t play bookkeeping games. But I don’t know it for a fact. Speaking generally, not specifically about Henrico County, government administrators are subject to the temptation of hiding bad news. And in most cases, local elected officials are either too timid or too untutored to ask tough, probing questions about how money is being spent.

Citizens unite! There are active taxpayer groups in Arlington, Fairfax County and Virginia Beach that I know of. I hope and pray that there are others of which I remain ignorant. Rather than fight lonely fights, they need to pool resources and expertise. I invite like-minded citizens to join Bacon’s Rebellion to create a platform to share knowledge and hold state and local governments more accountable than our elected officials seem able to do on their own. If anyone is interested in such a collaboration, please contact me at jabacon[at]

The Seven Percent Assumption

U.S. Fed Funds Rate. Source: Trading Economics

U.S. Fed Funds Rate. Source: Trading Economics

by James A. Bacon

The Virginia Retirement System earned an estimated 1.5% return on its $68 billion portfolio of investments last year, spurring discussion over whether state and local governments are contributing enough to maintain the long-term financial integrity of the retirement plan for Virginia school teachers and government employees.

For purposes of calculating the system’s financial integrity, VRS officials assume that the return on investment will average 7% annually over the long term — an assumption that is more conservative than many government pension plans. But is it conservative enough? After earning 1.5% the past year and only 4.7% the year before, is the 7% assumption still defensible?

VRS Chief Investment Officer Ronald D. Schmitz assured lawmakers that it is. “Over a 20-year horizon, we’re comfortable with a 7 percent return,” he said at the first meeting of the Virginia Commission on Employee Retirement Security and Pension Reform created at the urging of House Speaker William J. Howell, R-Stafford.

Getting that assumption right is no easy task. Investment returns fluctuate widely from year to year, losing money one year and then making spectacular gains the next. Investment performance varies considerably, depending on the time frame used. According to the VRS 2015 report issued a year ago (the 2016 report is not yet available), annualized investment returns averaged 10.6% over three years, 10.3% over five years, but only 6.7% over ten years.

The question is whether the past twenty or thirty years is a useful yardstick for predicting the next twenty or thirty years. The United States has benefited from a 35-year bond market boom, over which time interest rates have trended consistently lower to the near-zero rate that it has held steady for the past seven years (as seen in the graph above). All other things being equal, lower interest rates push stock and bond prices higher. Consequently, U.S. pension funds have enjoyed 35 years of rising prices for stocks and bonds (with short interludes of falling prices) in their portfolios. But as interest rates approach zero, it is impossible under conventional economic theory for them to drop any lower. Perhaps, as we are seeing in some places around the world, it is possible for central banks to engineer below-zero interest rates, but we have no historical experience by which to judge how economies, bond markets and stock markets will perform under such circumstances.

While no one knows with any certainty where interest rates, bond prices and stock prices are headed — perhaps changes in the global economy have repealed the laws of classical economics, and below-zero interest rates will do no harm — it is safe to say that a reversion of interest rates to historical norms would be disastrous for stock and bond prices, indeed asset prices of all kinds. And it is reasonable to say that there is at least a risk that such a reversion could take place. Whether such a reversion to historical norms takes places or not, is indisputable say that central banks cannot replicate the past 35 years of falling interest rates, and that the primary driving force behind the bull market era of the past 35 years has run out of steam.

It is almost inconceivable that the future 35 years of investment returns will match that of the previous 35 years, one of the great bull market eras of U.S. financial history. Therefore, the VRS (and other all pension funds) are reckless to assume that recent history will be any guide at all to future performance. Stretch out the frame of analysis for 50 years, 100 years, or longer, and the case for equities and bonds may be as favorable as ever. But the VRS cannot look out 100 years. Baby Boomers in the state workforce are retiring in large numbers now: One quarter of the state workforce will be eligible to retire within five years. Virginia will need the money in the next 20 to 30 years.

At least one state official in a position of responsibility, House Appropriations Chairman S. Chris Jones, R-Suffolk, is worried. As the Times-Dispatch quoted him: “I’m thinking that 7 percent might be aggressive at the end of the day.”

Jones is absolutely right. The VRS needs to lower its assumption, and the General Assembly needs to allocate more money to the VRS than in the past. Such an action surely will be painful, given all of Virginia’s other budgetary constraints. But Virginians will be grateful that the legislature acted with foresight when investment returns tank. It won’t get easier to do later what we should be doing now.