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ODU’s State of the Commonwealth Report Makes Four Suggestions to Improve VRS

State pension funds not only provide retirement and disability benefits to current and former workers, they are an increasing source of financial risk to taxpayers. In some cases, state and local governments have not provided enough resources to meet future obligations. In others, state pension fund administrators have assumed that they can beat the market, only to be disappointed by underwhelming performance.

With several state pension funds in financial peril, the 2019 State of the Commonwealth Report from Old Dominion University's Dragas Center for Economic Analysis and Policy examined the performance of the Virginia Retirement System (VRS).

The VRS ranks as the 15th-largest public pension system in the United States, overseeing more than $80 billion in net assets and serving more than 720,000 members, retirees and beneficiaries.

Dragas Center economists conducted an independent, noncommissioned, uncompensated analysis of the VRS and the challenges it has overcome and will face in the coming years. They found a fund that has performed efficiently and has avoided many of the problems that have plagued other state pension funds.

"We applaud the VRS for being a transparent, generally well-managed operation," said Robert M. McNab, Strome College of Business economics professor and editor of the State of the Commonwealth Report.

Dragas Center economists argue that the VRS is in a difficult position, as it must work to earn the highest possible performance without incurring significant risk. One recommendation is for the VRS to rely more on low-cost index funds that mirror the performance of the overall stock market. While the exactly amount of the money "left on the table" is hard to quantity, this strategy would have likely increased the performance of the VRS over the last two decades.

Another recommendation is that the VRS seek to reduce its reliance on outside hedge fund managers, whose fees also have increased the VRS's investment expenses, which totaled more than $457 million in fiscal year 2018 alone.

"The lesson is that most public pension funds have the potential to reduce their expenses if they opt to use indexed public equity funds rather than their own staff or external fund managers," the report noted.

In addition, the report recommend that the Commonwealth accelerate the movement of state employees from defined benefit programs into defined contribution and hybrid retirement programs, reducing future financial risks and exposure to the VRS. Virginia should also improve the portability of state employees' VRS accounts, as current policies (which do not reflect the high degree of mobility in today's workforce) result in a substandard benefit for employees who do not finish their career with the state.

Lastly, the Report applauds the recent recommendation by the VRS Board to reduce the target rate of return for the VRS from 7% to 6.75%, a recommendation that will require over $200 million in additional state contributions in the next biennial budget. The Report recommends a continued but gradual reduction in this target rate over the coming years to align expectations with historical market performance.

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