Railroad Retirement Board: Trust Fund Investment Practices Scott Szymendera Analyst in Disability Policy August 2, 2011 The House Ways and Means Committee is making available this version of this Congressional Research Service (CRS) report, with the cover date shown above, for inclusion in its 2011 Green Book website. CRS works exclusively for the United States Congress, providing policy and legal analysis to Committees and Members of both the House and Senate, regardless of party affiliation. Congressional Research Service RS22782 CRS Report for Congress Prepared for Members and Committees of Congress Railroad Retirement Board: Trust Fund Investment Practices Summary Beginning in 2002, a significant portion of the assets of the Railroad Retirement Board (RRB) have been invested in private stocks, bonds, and other investments. Prior to the Railroad Retirement and Survivors’ Improvement Act of 2001 (P.L. 107-90), surplus railroad retirement assets could only be invested in U.S. government securities—just as the Social Security trust funds must be invested. The 2001 act established the National Railroad Retirement Investment Trust (NRRIT; hereafter, the Trust) to manage and invest part of the RRB’s assets in the same way that the assets of private-sector and most state and local government pension plans are invested. The remainder of RRB’s assets continue to be invested solely in U.S. government securities. Congress structured the Trust to assure independence of investment decisions and limit political interference. It also aimed to increase railroad retirement system funding, add enhanced benefits, potentially reduce taxes, and protect system financing in case of market downturns. The Trust’s assets are invested in a diversified portfolio, both to minimize investment risk and to avoid disproportionate influence over an industry or firm. Since the Trust is a nongovernmental agency, it is not subject to the same oversight as federal agencies. However, the act requires an annual management report to Congress. The Trust’s investments have generally followed the markets’ recent performance. From FY2003 to FY2010, the Trust’s annual returns averaged 8.1%. This matches the expectations of the bill’s drafters, who assumed nominal annual returns of 8.0%. The recent economic downturn did not spare the Trust, which lost 19.1% in FY2008 and 0.7% in FY2009. However, the trust rebounded with a 11.2% rate of return in FY2010. As the Trust’s investment portfolio has diversified over time, its administrative expenses have steadily increased, to 33 basis points in FY2010, but remain low compared with industry standards. The Trust is designed to maintain four to six years’ worth of benefits in case of lower-thanexpected returns. In order to maintain this balance, the tier II tax is set to automatically adjust to maintain the fund balance at four to six years. This tax adjustment would not require congressional action. No tax increase is scheduled at the time of this writing. The goal of this report is to inform readers about the Trust, which is of particular interest to policymakers exploring the option of collective investment of the Social Security trust funds or establishing other private investment funds within the federal government. Congressional Research Service Railroad Retirement Board: Trust Fund Investment Practices Contents Background...................................................................................................................................... 1 History of the Trust.......................................................................................................................... 1 Structure of the Trust ....................................................................................................................... 2 Independence............................................................................................................................. 2 Goals.......................................................................................................................................... 2 Impact on Tier II Tax Rates ....................................................................................................... 2 Investment Guidelines ............................................................................................................... 3 Oversight ................................................................................................................................... 3 Accounting in the Federal Budget ............................................................................................. 4 Performance of the Trust.................................................................................................................. 5 Total RRB Assets....................................................................................................................... 5 Comparison to Benchmarks ...................................................................................................... 5 Administrative Expenses ........................................................................................................... 6 Figures Figure 1. Trust Rates of Return Compared with Strategic Policy Benchmarks............................... 6 Tables Table 1. Trust Target Asset Allocations and Ranges, FY2010 ......................................................... 4 Table 2. Trust Expense Ratios.......................................................................................................... 8 Acknowledgments ........................................................................................................................... 8 Congressional Research Service Railroad Retirement Board: Trust Fund Investment Practices Background The Railroad Retirement Act authorizes retirement, survivor, and disability benefits for railroad workers and their families.1 The Railroad Retirement Board (RRB), an independent federal agency, administers these benefits. Workers covered by the RRB include those employed by railroads engaged in interstate commerce and related subsidiaries, railroad associations, and railroad labor organizations. These benefits are earned by railroad workers and their families in lieu of Social Security. Railroad retirement benefits are divided into two tiers. Tier I benefits are generally computed using the Social Security benefit formula, on the basis of earnings covered by either program. In some cases, RRB tier I benefits can be higher than comparable Social Security benefits. For example, RRB beneficiaries may receive unreduced tier I retirement benefits as early as 60 years old if they have at least 30 years of railroad service; Social Security beneficiaries may receive unreduced retirement benefits only when they reach their full retirement ages, currently rising from age 65 to 67. RRB tier II benefits are similar to private pension benefits and are based only on railroad work.2 History of the Trust Beginning in 2002, a significant portion of railroad retirement assets have been invested in private stocks, bonds, and other investments. Prior to the Railroad Retirement and Survivors’ Improvement Act of 2001, P.L. 107-90, surplus railroad retirement assets could only be invested in U.S. government securities—just as the Social Security trust funds must be invested.3 The 2001 act established the National Railroad Retirement Investment Trust (NRRIT; hereafter, the Trust) to manage and invest assets in the Railroad Retirement Account in the same way that the assets of private-sector retirement plans are invested. The Railroad Retirement Account is used to fund RRB tier II benefits and supplemental annuities. This account is also used to pay for tier I benefits that are higher than equivalent Social Security benefits, such as early retirement benefits for railroad employees with at least 30 years of railroad service. Assets in the Social Security Equivalent Benefits Account, which is used for RRB tier I benefits that are equivalent to Social Security benefits, continue to be invested solely in U.S. government bonds, as required by law. 1 45 U.S.C. § 231 et seq. For additional information on the RRB, see CRS Report RS22350, Railroad Retirement Board: Retirement, Survivor, Disability, Unemployment, and Sickness Benefits, by Alison M. Shelton. 2 Railroad employers also finance a supplemental annuity program for certain railroad employees hired before October 1981. General revenues finance a vested dual benefit for certain railroad employees who were eligible for benefits before 1975. 3 The Social Security trust funds may not be invested in private markets. For additional information on current practices, see CRS Report RS20607, Social Security: Trust Fund Investment Practices, by Dawn Nuschler. Congressional Research Service 1 Railroad Retirement Board: Trust Fund Investment Practices Structure of the Trust Independence Congress structured the Trust to be independent and to resist political interference and the Trust is independent of the RRB and is not part of the federal government. It has no responsibilities for administering RRB benefits. The Trustees of the Trust are required to act solely in the interest of the RRB and the participants in the railroad retirement system. The fiduciary rules governing the Trustees are similar to those required by the law that governs the private pension system, the Employee Retirement Income Security Act (ERISA).4 The board of the Trust is made up of seven Trustees who have expertise in managing financial investments and pension plans. Three of the Trustees are selected by railroad labor unions, three by railroad management, and one by the other six Trustees. Each of the Trustees’ terms is three years. The Trustees hire a professional staff to handle day-to-day operations of the Trust and independent investment managers to invest the assets of the Trust according to the investment guidelines established by the Trustees. Each investment manager may control no more than 10% of the Trust’s assets. Each manager must vote all proxies he or she holds in the Trust’s portfolio in the sole interest of railroad retirement participants and beneficiaries, in accordance with written guidelines provided by the Trust. Votes must also be recorded and provided to the Trust upon request. Finally, all investment managers must certify each year that all proxies have been voted in the sole interest of railroad retirement participants and beneficiaries.5 Goals Congress designed the Trust to increase RRB funding. Investing railroad retirement funds in private markets was expected to yield higher average annual returns than investing solely in government securities. The higher returns were intended to pay for the enhanced benefits that were established in the act and to potentially reduce future tax rates for railroad employers and employees.6 Impact on Tier II Tax Rates The Trust is also designed to maintain four to six years’ worth of benefits in case of lower-thanexpected returns. To maintain this balance, the tier II tax is set to automatically adjust to maintain the fund balance at four to six years without congressional action. Since the inception of the 4 For additional information on ERISA, see CRS Report 95-926, Regulating Private Pensions: A Brief Summary of ERISA, by Patrick Purcell. 5 National Railroad Retirement Investment Trust, Annual Management Report for Fiscal Year 2010, January 2011, Appendix F, http://www.rrb.gov/pdf/nrrit/convltrsFY2010.pdf. Hereafter cited as NRRIT, Annual Management Report for Fiscal Year 2010. 6 U.S. Congress, House Committee on Transportation and Infrastructure, Railroad Retirement and Survivors Improvement Act of 2001, Report to accompany H.R. 1140, 107th Cong., 1st sess., May 24, 2001, H.Rept. 107-82 Part 1 (Washington: GPO, 2001), pp. 14-15. Hereafter cited as H.Rept. 107-82 Part 1. Congressional Research Service 2 Railroad Retirement Board: Trust Fund Investment Practices Trust, the tier II tax rates have never increased and have been lowered twice. In 2005, the tier II tax rate on employers was automatically lowered from 13.1% to 12.6% and the tax rate on employees was lowered from 4.9% to 4.4%. Tier II tax rates were lowered again in 2007 to their current levels of 12.1% on employers and 3.9% on employees. The statute requires that the tier II tax rate on employers range between 8.2% and 22.1% caps the tax rate on employees at 4.9%. Investment Guidelines The assets in the Trust are invested in a diversified portfolio, both to minimize investment risk and also to avoid disproportionate influence over a particular industry or firm. The investment guidelines adopted by the Trustees include a target asset allocation developed by the Trust’s investment staff in consultation with an independent investment advisory firm. These targets change over time. For example, from FY2006 to FY2008, the Trust moved away from fixed income investments (from 35% of total investments in FY2006 to 27% in FY2008) and toward private equity (from 5% to 10%) and real estate (from 5% to 10%). The Trust’s adoption of a more aggressive investment strategy coincided with market downturns. In 2009, the Trust adjusted its target allocation ranges, but not its individual target allocations, to provide for greater flexibility during periods of market volatility.7 As shown in detail in Table 1, in FY2010 the target allocation to equity (i.e., stock) was 58%. The target allocation to fixed income (i.e., bonds and cash) was 27%. The target allocation to alternative investments was 15%. The target allocation ranges include between 5% and 20% for opportunistic investments. Opportunistic investments, including cash, are investments which do not fit into the existing asset classes but which are believed to offer the Trust attractive riskadjusted investment returns or otherwise help the Trust achieve its strategic investment goals. Outside investment managers hired by the Trust invest the assets according to these guidelines. The resulting investment performance is monitored by the Trustees and the Trust’s Chief Investment Officer. Oversight Because the Trust is an independent nongovernmental agency, it is not subject to the same oversight as federal agencies. The act outlines specific reporting requirements, including an annual management report to Congress. The report must include a statement of financial position, a statement of cash flows, a statement on internal accounting and administrative control systems, and any other information necessary to inform Congress about the operations and financial condition of the Trust. The financial statements must be audited by independent public accountants. A copy of the annual report and audit must be submitted to the President, the RRB, and the Director of the Office of Management and Budget (OMB). The RRB has the authority to bring a civil action to enforce provisions of the act. However, the RRB Office of Inspector General (OIG) has expressed concern about the effectiveness of the oversight of the Trust. The OIG argues that the annual financial audit required “is not adequate to support the RRB’s enforcement responsibility because such audits are not 7 National Railroad Retirement Trust, Annual Management Report for Fiscal Year 2009, January 2010, p. 15, http://www.rrb.gov/pdf/nrrit/reportFY2009.pdf. Congressional Research Service 3 Railroad Retirement Board: Trust Fund Investment Practices intended to provide information about all areas of risk that could indicate the need for enforcement action.” 8 There are fewer safeguards protecting the Trust than there are for the retirement investments of federal government and private sector workers. For example, there is no requirement for performance audits of the Trust, which would assess program effectiveness, economy and efficiency, internal control, and compliance with the law. Table 1. Trust Target Asset Allocations and Ranges, FY2010 Asset Class Target Allocation (%) Target Allocation Range (%) 58 35-75 Domestic 26 20-33 International 22 15-27 Private 10 0-15 Fixed Income 27 15-40 Domestic 17 11-25 International 10 4-15 15 2-22 Commodities 5 2-7 Real Estate 10 0-15 NA 5-20 Equity Alternative Investments Opportunistic Investments Source: National Railroad Retirement Investment Trust, Annual Management Report for Fiscal Year 2010, January 2011, p. 17. Accounting in the Federal Budget As required in the 2001 act, purchases and sales by the Trust initially produce no direct budgetary cost or income.9 The law did not prescribe the treatment of unrealized capital gains and losses on the Trust’s investments. The Congressional Budget Office (CBO) and OMB agreed that any capital loss or gain resulting from changes in market prices would be recognized in the year in which the price change occurs, and interest payments and dividends would be recorded as offsetting receipts.10 As a result, income and capital gains reduce outlays and the deficit, and losses increase them. This reflects the change in real economic resources available to the government as the value of the Trust changes. As for future performance, both CBO and OMB use risk-adjusted rate of return assumptions—that is, they assume that the Trust’s investments will earn the Treasury bond rate. 8 Railroad Retirement Board, Office of Inspector General, Statement of Concern: National Railroad Retirement Investment Trust Lack of Provision for Performance Audits, March 31, 2008, http://www.rrb.gov/pdf/oig/REPORTS/ nrritStatement.pdf. 9 For budgetary purposes, purchases by the Trust are not considered outlays, but as an exchange of assets of equal value; redemptions are not considered offsetting receipts. This differs from long-standing budgetary rules, which usually treat an investment in nonfederal securities as the purchase of an asset, recording both an obligation and an outlay equal to the purchase price during the year of the purchase. 10 For more information on accounting for government investment in private markets, see Congressional Budget Office, Evaluating and Accounting for Federal Investment in Corporate Stocks and Other Private Securities, January 2003, http://www.cbo.gov/ftpdoc.cfm?index=4023&type=0. Congressional Research Service 4 Railroad Retirement Board: Trust Fund Investment Practices Performance of the Trust To date, the Trust’s average annual performance has matched the expectations of the bill’s drafters. It was assumed that investments by the Trust would earn an average annual return of 8.0%.11 From FY2003 to FY2010, the Trust’s annual returns have averaged 8.1%. Prior to FY2008, the average rate of return on Trust investments was 14.7%. The Trust had negative rates of return in FY2008 and FY2009 but rebounded with an 11.2% rate of return in FY2010.12 Since railroad retirement funds were first invested through the Trust in September 2002, a total of $21.3 billion has been transferred to the Trust, with no transfers taking place after the end of FY2004.13 The Trust earned a total of $12.4 billion from its inception to the end of FY2010.14 As of March 31, 2010, the Trust held $25.3 billion, and since inception $10.8 billion in earnings have been used to pay RRB benefits.15 Total RRB Assets At the inception of the Trust in February 2002, the value of the total assets of the RRB, including assets in the Trust and assets held in reserve in accounts at the Department of the Treasury was $20.7 billion. At the end of FY2010, the value of total RRB assets was $25.1 billion, with $23.8 billion held by the Trust and $1.3 billion held in reserve accounts at the Treasury Department. The net increase in total RRB assets since the inception of the Trust is $4.4 billion.16 Comparison to Benchmarks The Trust’s rates of return have generally compared favorably to its benchmarks. A benchmark is a standard used for comparison when measuring investment performance and the NRRIT strategic policy benchmark is based on a series of benchmarks corresponding to each of the eight major asset classes in the Trust.17 For example, the current benchmark for the Trust’s investments in domestic equities is the Russell 3000 Index.18 As shown in Figure 1 in FY2003 through FY2005, the performance of the Trust exceeded its strategic policy benchmarks. In FY2006 and FY2007, the Trust’s performance was roughly equal to its benchmarks, whereas in FY2008 and FY2009, the Trust’s investments had lower returns than its strategic policy benchmarks. In FY2010, the strategic policy benchmark rate of return of 9.9% was exceed by the Trust’s rate of return of 11.2%. 11 H.Rept. 107-82 Part 1, p. 14. NRRIT, Annual Management Report for Fiscal Year 2010, p. 7. 13 Ibid., p. 13. 14 Ibid., p. 13. 15 National Railroad Retirement Investment Trust, Quarterly Update for the Period Ending March 31, 2011, April 2011, http://www.rrb.gov/pdf/nrrit/qrtlyupd033111.pdf. 16 NRRIT, Annual Management Report For Fiscal Year 2010, pp. 7-8. 17 Benchmarks for each of the Trust’s asset classes are provided in NRRIT, Annual Management Report For Fiscal Year 2010, Appendix B, p. 2, http://www.rrb.gov/pdf/nrrit/appendicesFY2010.pdf. 18 Additional information on the Russell 3000 Index is available on the website of Russell Investments at http://www.russell.com/indexes/data/fact_sheets/us/russell_3000_index.asp. 12 Congressional Research Service 5 Railroad Retirement Board: Trust Fund Investment Practices Figure 1. Trust Rates of Return Compared with Strategic Policy Benchmarks FY2003 to FY2010 25% 20% 15% Rate of Return 10% 5% 0% FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 -5% -10% -15% -20% -25% Trust Actual Trust Benchmark Source: Data for “Trust Actual” and “Trust Benchmark” taken from National Railroad Retirement Investment Trust, Annual Management Report for Fiscal Year 2010, January 2011; and previous editions. Administrative Expenses The Trust’s administrative expenses have steadily increased as its investment portfolio has diversified over time, as shown in Congressional Research Service 6 Railroad Retirement Board: Trust Fund Investment Practices Table 2. However, administrative expenses remain low compared with industry standards. In FY2010, the Trust’s expense ratio was 33 basis points (expenses were 0.33% of average net assets).19 In comparison, in 2010, the average expense ratio for all investors was 95 basis points for stock funds, 72 basis points for bond funds, and 26 basis points for money market funds.20 19 NRRIT, Annual Management Report For Fiscal Year 2010, Independent Auditors’ Report, p.18. Investment Company Institute, Trends in the Fees and Expenses of Mutual Funds, 2010, March 2011, http://www.ici.org/pdf/per17-02.pdf. 20 Congressional Research Service 7 Railroad Retirement Board: Trust Fund Investment Practices Table 2. Trust Expense Ratios FY2003 to FY2010 Fiscal Year Basis Points 2003 2 2004 4 2005 9 2006 15 2007 24 2008 25 2009 26 2010 33 Source: National Railroad Retirement Investment Trust, Annual Management Report for Fiscal Year 2010, January 2011; and previous editions. Acknowledgments An earlier version of this report was prepared by Kathleen Romig. Congressional Research Service 8