Posted on 04/07/2010 6:36:09 AM PDT by SeekAndFind
California has done some really really stupid things (like a tax credit for first time homebuyers), but the NYT did the state and its readers a disservice in going after California's pension fund liabilities. The basic story is that if you assume a 4.14 nominal rate of return on pension fund assets, then the state's pension liabilities look really really bad.
The big question that readers should ask is, so what?
There have been few people who have been more critical of assuming exaggerated market returns than me, but 4.14 percent nominal? Anyone want to take a bet that California's pension funds will do better than this?
Look, the market has plummeted from its prior levels. This is good news for future returns. Lower price to earnings ratios open the door for higher future returns. The logic is simple: you are paying much less for each dollar of profits. For this reason, the assumption of 4.14 percent average nominal returns (that gives us just over 2.0 percent real, assuming a 2.0 percent inflation rate) is ridiculously low.
Suppose we assume that pension liabilities grow at the nominal rate of 5 percent a year. If we sum the liabilities over 40 years, using a 4.14 percent discount rate gives a 70 percent higher cost than using a 7.0 percent discount rate. Stocks have historically provided a real return of 7 percentage points above the inflation rate, so assuming a nominal return of 7.0 percent for the mixed portfolio is hardly unreasonable.
In short, the story of outsized pension liabilities in this article is driven largely by a ridiculous assumptions about pension returns. There is no reason whatsoever that the state of California should use this 4.14 percent discount rate in assessing its pension liabilities. This calculation would lead it to exaggerate its pension liabilities and therefore raise taxes or cut pensions and/or other spending unnecessarily.
Dean didn't figure it out until the last sentence.
If it's such a good bet, ask the pensioners if they want to bet and shift the risk to them.
Oregon’s PERS system has been guaranteeing returns of around 8% for quite some time, and the Legislature has never been able to reform it in any meaningful way.
Why?
Because the biggest voting block in the State of Oregon is current and retired State union employees, and they will tolerate nothing that costs them one thin dime. The burdens PERS places on small communities around the State has caused towns to lay off police and firefights so they could pay the pension liabilities for their retirees and the active force that is left.
And many of these pension funds are invested all over the place; some in real estate derivatives, some in foreign investments. It’s a big enough mess that I don’t see any of it getting sorted out any time soon. About the only way to fix it is scrap what they have and start over fresh...
A compnay owner would be jailed for this kind of promise.
That’s exactly the point, how do you guarantee a return?? PERS does though, and it is an enormous drain on local economies as you can well imagine...
“How do you GUARANTEE a rate of return ?”
The “Guarantee” is in:
)1) How the higher rate of return is touted, “estimated” in defense of how the funds will meet the earnings needed to pay the “defined benefits”.
(2) With that implicit guarantee in fund performance, the formulas for the defined benefits are approved (x yrs of svc times y % of avg last 5 yrs salary = pens benefit - or some similar formula) AND GUARANTEED FOR THE PENSIONER
(3) THEN no matter what actually happens in the economy or the investment world, the government entity is required to provide whatever additional funding is needed to bring the funds to the estimated level that was implied would be there to meet the defined benefits that were guaranteed.
“Defined benefit” pensions for public workers is the problem and they must be banned. Public workers existing pensions plans need to convert the pension funds into “defined contribution” accounts and defined contribution pensions for all workers not yet retired.
A defined contribution pension “guarantees” ONLY the rate at which the employer (and maybe also the employee) will pay into the employee’s pension account each year. Period.
The pension benefit is a simple actuarial calculation at the time of retirement and primarily dependent, and simply primarily dependent on how much has been put in the account, period. Such pensions are NEVER “underfunded”, never in need of additional funds to meet some formula.
The pension account is what it is (total contributions + investment earnings @ today’s market value) and simple actuarial calculations determine the annual/monthly benefit level that that account can fund for the estimated remainder of the pensioners life.
Defined Benefit pensions, as most government pensions are “guarantee a benefit defined by a formula” and neither the formula or the defined benefit CARES ONE TWIT WHAT ACTUALLY HAPPENS IN THE REAL ECONOMIC WORLD. And so, when investments and investment earnings are doing well, the fund looks O.K., and when they’re not doing so well, the fund becomes “under funded” and the governmental unit must pay additional funds - 9beyond the current year’s normal contribution - to make up for any market (or mortality) shortfall.
It’s a crime. Why? The governmental unit is asked to “guarantee” a specific, formula based pension, NO MATTER WHAT, yet, the reality is, no matter how well or how prudent the governmental unit invests the funds, IT CANNOT GUARANTEE HOW WELL THE FUNDS WILL ACTUALLY DO.
It’s based on the wrong-headed idea that the employee should not have to take any part of the risk that IS INHERENT IN INVESTING FOR THE FUTURE; that “someone” is supposed to guarantee a certain golden retirment NO MATTER WHAT HAPPENS.
So who actually pays for it? Like social security, it is the active worker that pays the extra taxes to make up for any lack of funds needed for the “guarantee” made to retirees.
We are headed for full-fledged generational warfare.
Dean Baker is misinformed. He is confusing an expected return with a guaranteed return. These pension plans have incredibly strong legal protections. The protections are so strong that it is not clear that pension obligations can be discharged or modified in bankruptcy. Pension obligations will ahead of every other government obligation.
Because of the strong protections, pensions must be managed with risk free (or almost free) discount rates. The Single Premium Immediate Annuity marketplace uses this approach to guarantee lifetime income. This industry purchases relatively low risk corporate bonds (such as AAA Moody Industrial). Interest rates for lifetime income are typically 4% to 5% on these policies. Even with this conservative approach, this industry has seen failures. The public employee pension industry is committing a grand fraud by treating expected returns as guaranteed returns.
In addition to the basic fraud in treating expected and guaranteed returns as the same, expected return assumptions are easily manipulated for political purposes. Expected returns do not capture underlying risk. Making a bet on fixed liabilities with highly variable returns may result in bankruptcy in down markets.
Brilliant.
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