Can Public Pensions Be Fair to Later Generations?

From Via Media we get this nugget, “Can Public Pensions Be Fair to Later Generations?”. Since Joe The Economist has made a pretty good argument that the idea of privatizing Social Security is an idea we can no longer afford maybe a good first step in reforming pension accounting is to embrace a more Dutch-like approach.

So many U.S. states are struggling with unsustainable public pension costs that many are probably wondering: Is an honest, fiscally sound, publicly administered pension plan possible, or are all such efforts doomed to regulatory capture, union abuse, and co-optation by politicians? At least one example suggests that, given sufficient discipline and scrutiny, pension plans can be made to work in the 21st century. An article in the New York Times today praises the Dutch version:

Dutch pensions are scrupulously funded, unlike many United States plans, and are required to tally their liabilities with brutal honesty, using a method that is common in the financial-services industry but rejected by American public pension funds.

The Dutch system rests on the idea that each generation should pay its own costs — and that the costs must be measured accurately if that is to happen. After the financial collapse of 2008, workers and retirees in the Netherlands took the bitter medicine needed to rebuild their collective nest eggs quickly, with higher contributions from workers and benefit cuts for pensioners.[…]

Notably, the Dutch central bank prohibited the measurement method that virtually all American states and cities use, which is based on the hope that strong market gains on pension investments will make the benefits cheaper. A significant downside to this method is that it lets pension systems take advantage of market gains today, but pushes the risk of losses into the future, for others to cope with.

The End of Thirty Years of Irrational Debt Spending

Recently I have been thinking about The 4% Solution: Unleashing the Economic Growth America Needs advocated by the Bush Institute, the CALPERS report that said that they had 1-year return of only 1%,  sequestration, and Mitchell’s Golden Rule. For those unfamiliar with Mitchell’s Golden Rule it states that “the private sector should grow faster than the government”. In this discussion I will use the stronger form which states the private sector should grow faster than the growth in government debt if we want to grow out of our mess.

The 4 percent solution is wonderful idea that appeals to both parties. It states that we should focus our economic planning on those plans that help us achieve a 4 percent growth in real GDP. The problem with this plan is that it is primarily aspirational and is not significantly different than the plans of our last four presidents. In fact it does not address the problem that has plagued our last two presidents, we spent money like we already had the 4 percent growth money in the bank. This has been readily apparent with the economies under the last two presidents. Two different plans were used, some political objectives were achieved but both plans failed to generate the job or GDP growth. We did achieve a fairly spectacular increase in public debt.

CALPERS is the poster child for pension problems in the United States. Like most pension plans they expect their portfolio to achieve a 7.25% return. This seems reasonable since they earned a 7.7% return over the last twenty years. The problem is that their 1-year return was 1%, their 10-year return is 5.7%, and they are spending about 6.4% of their portfolio on benefits. This doesn’t work. They look like they desperately need the government to be successful with their 4 percent growth plans or they might have to resort to Plan B.

Sequestration is not a plan but a veiled threat that becomes more unveiled as we get closer and closer to the spending cuts. The idea of sequestration is not to subtle hint that we would like to chain our legislators to the bargaining table until they made a budget deal that cuts spending. So far the threat has not worked. The Simpson-Bowles and Ryan Path to Prosperity plans are much better than sequestration. Both plans are much better at growing the economy while structurally reforming the spending than sequestration. In fact I think the end game is a budget deal will likely be some variation of one of those plans that partially satisfies both parties. I think it is interesting to speculate what the presidents over the last 100 years would do with the situation that President Obama has in front of him. I suspect all of them would see a budget deal as one of the most significant accomplishments of their administration. I can almost guarantee that the last four presidents would have done a deal before the end of the first term. In my life time all of the presidents except for the current president have been willing to reach across the aisle to get a deal done to pass major legislation.

The key to any successful budget plan will be how to grow the private sector faster than the government debt. This is really simple math. You get a better bang for your tax buck with an increased number of private sector employees. The less these employees are dependent on government spending, the greater the cash flow goes to the government. Adding private sector employees is more efficient at increasing tax revenues then via an equal number of number government employees. For at least the last twelve years growing the government debt does not appear to be helping the GDP or the private sector very much. Here is a graph I created to show that relationship. I am using the S&P 500 as a proxy for the wealth and health of the private sector. To paraphrase the old GM line, what is good for the private sector is good for the country and our pension plans, too. In this graph I deflated the S&P 500 and Total Public debt using the GDP Price deflator so that all three indicators reflect inflation adjusted values using the same deflator. In the graph it looks like the Total Public debt helped the S&P 500 in the 1980’s and 1990’s and significantly hurt it after 2000. I was somewhat surprised to see that an increased Total Public debt does not seem to have helped the GDP at any time on the graph. The GDP kept trucking along at the same pace with only a minor blip during the recessions. Here is an interesting question, “How did government spending let alone debt financed government spending became the preferred vehicle for growing the economy?”

 

RE: CalPERS Reports Preliminary 2011-12 Fiscal Year Performance

Yesterday CalPERS released a press report yesterday titled, CalPERS Reports Preliminary 2011-12 Fiscal Year Performance of 1 Percent. Since I recently read their financial documents and made a comment about them, I was surprised that they compared the investment return to their 20-year investment return rather than their five or ten year investment return. When you compare the latest investment return to a ten year return of 5.7% there is a greater call for action by the board. Since they are spending the equivalent of 6.4% of their fund on pension benefits each year($15 billion), they are between a rock and a hard place. The time for action was several years ago. Now they are just being stubborn.

 

“It’s important to remember that CalPERS is a long-term investor and one year of performance should not be interpreted as a signal about our ability to achieve our investment goals over the long-term,” said Henry Jones, Chair of CalPERS Investment Committee.

CalPERS 1 percent return is below the fund’s discount rate of 7.5 percent, a long-term hurdle lowered recently in response to a steady decline in inflation and as part of CalPERS routine evaluation of economic assumptions. CalPERS 20-year investment return is 7.7 percent.

California’s Bad Bet Makes JPMorgan’s Look Minor – Bloomberg

I was casually catching up on some blogs and found this gem at Bloomberg. This led me to the article, SB400 pension boost: uncanny forecast unheeded, on calpensions.com. Wow! For a long time I have been wondering how we got into this mess with defined benefit pension plans and there is probably no better example of the problem than the largest pension fund in the United States, Calpers. From the SB400 article we can see in retrospect the legislators were overly optimistic about investment returns versus expenses. The legislators were expecting an annual average of 8.25 percent and they got a 3.1 percent return according to according to a Wilshire consultants report in March 2010. In the latest Calpers Fact at a Glance the latest ten year total return is listed at 5.7%. According to Calpers the assets went from $172.2 billion in 2000 to $237.5 billion in 2011. Although this looks good at first glance, the compounded rate is only 2.97%. It is pretty obvious that if you are spending like you are getting a 8.25% return and you are getting somewhere between 3.1% and 5.7% returns you are going to be in trouble. Then I tried to compare Calpers to the savings in my 401K. If my calculations are correct the average wealth saved per participant(237.5 billion/1.6 million participants) in Calpers is $148,000.  This doesn’t look too good but it is about the same number reported about Calpers in the pension plans article in Wikipedia. If we look at only the current retirees(536,234) this number goes up to $448,000. This is an ugly number for those people expecting something close to 50% of their salary over a 20 year retirement . Regardless of how you want to slice and dice these numbers to come up with the more precise actuarial values, there is too little money in the fund for the retirees’ benefits. Something has to give. The interesting part of examining the problems facing Calpers is that it reminds me of another bubble, residential real estate. Both bubbles received bipartisan support for overly optimistic outlooks about the future. In one case it is residential real estate appreciation and the other it is stock market performance. The irony is that the warning symptoms in both bubbles were apparent early on. That is where it takes the contributions from a lot of very smart people to turn a bad decision into a really big, bad decision. Finally the solution to these bubbles require very difficult political choices. So even though it is relatively easy to identify the cause of the bubbles, finding legislators willing to try and fix the consequences from bad decision making in the past is particularly difficult. It appears we have a decision making system in which bad decisions are too easy to make considering that it takes decades to undo their consequences. I can’t wait to see how the health care decisions turn out!

 Winking smile

I will leave you with what David Crane wrote in the Bloomberg article, California’s Bad Bet Makes JPMorgan’s Look Minor.

The pension deal was a stunning example of nondisclosure. The legislators didn’t inform the taxpayers that:

1. The state was on the hook for deficiencies if actual investment returns fall short of assumed investment returns.

2. The assumed investment returns implicitly forecast that the Dow Jones Industrial Average would reach about 25,000 by 2009 (it barely made it over 10,500 that year) and 28,000,000 by 2099.

3. Potential costs to the state were uncapped.

4. Members of the Calpers board had received campaign contributions from beneficiaries of the legislation.

If Social Security is a Ponzi scheme, does that make CalPERS a Ponzi scheme, too?

If Social Security is a Ponzi scheme then all of our defined benefit pension plans such as the California Public Employees’ Retirement System (CalPERS) risk falling into the same category. CalPERS is a $226 billion pension fund with an estimated $240 billion unfunded liability according to a Reuters article. So even if you are willing to concede the point that Social Security and CalPERS are primarily "pay-as-you-go" systems as advocated on the Social Security site, you are confronted with three almost insurmountable problems.

  1. How do you scale back the future benefits in an equitable manner?
  2. How do you convince current contributors to contribute more money at the same time you are scaling back benefits?
  3. In the case of defined benefit programs that are partially advance-funded, who is responsible for investment risk?

This is not a new problem. For many years companies had difficulties managing the funding and benefits of their pension plans. An additional problem was what to do with defined benefit plans for companies that no longer existed. This problem became very apparent when the steel companies disappeared in the 1970’s. In 1974 the government created the The Pension Benefit Guaranty Corporation(PBGC) to take over the defined benefits for pensions for bankrupt companies. The funding for the PBGC came from fees charged on the remaining existing corporate defined benefit plans. This policy seems to have worked. In the following years most private companies converted their pension plans into defined contribution plans and problems with the remaining defined benefit plans diminished considerably. On the other hand public sector fully embraced the defined benefit plans. Part of the allure was that the promise of future benefits was a major issue in collective bargaining agreements. Instead of pay raises they were promised future health and pension benefits.  The long history of problems that the private sector had with funding and managing defined benefit pension plans seems to have been ignored by the public sector. Since the management of defined benefit plans were not being managed differently than the way the private sector managed their plans it is inevitable that they would duplicate the same mistakes. Considering the size and extent of the public sector unfunded pension and health care liabilities, most of these agreements were done in bad faith and led to deliberate mismanagement of pension funding and benefits. It will probably take some form of the PBGC for state and local governments that is funded by the public sector pension funds and has strict funding and benefit rules to clean up the public sector pension mess.

Social Security is different from the public pension plans but it shares many of the same mismanagement of funding and benefits problems and a more puzzling style of investing. Considering the size of unfunded liability for Social Security, the funding and benefits have been negotiated in bad faith, too. So although comparing Social Security to a Ponzi scheme may seem too severe, it shares the same bad faith negotiations and plan mismanagement as public sector pension plans. A pension plan relying solely on "pay-as-you-go" financing and funky investing may have been a viable option for my father’s generation but not my son’s generation. The pact between one generation and the next is about to be broken. The future of defined benefit plans in general is in doubt. Defined contribution plans are the preferred option in the private sector but suffer from inadequate savings rate. This problem can be fixed by a relatively simple solution, policies to encourage a higher savings rate. It remains to be seen whether defined benefit plans can overcome their predisposition to bad faith negotiations and mismanagement and create a better pension outcome than those offered by defined contribution plans.

The Problem with Defined Benefit Plans is the same as the Problem with Defined Contribution Plans

The problem with both the defined benefit and defined contribution plans is that we do not put enough money in them. The primary difference between the plans is who we blame for not having enough funds.

EVEN WITH ROSY ASSUMPTIONS, public pensions are deep in the red. “A 2010 Pew study on public pensions nationwide put the funding gap at about a half-trillion dollars based on states’ own assumptions. But Novy-Marx and North western University’s Joshua Rauh say it’s $3 trillion using a risk-free discount rate.” I think a 4% rate is realistic. But note how bad things look assuming even a 6% return.

EVEN WITH ROSY ASSUMPTIONS, public pensions are deep in the red. “A 2010 Pew study on public pensio…
Glenn Reynolds
Sun, 27 Mar 2011 01:55:48 GMT

Instapundit » Blog Archive » MORE PUBLIC-PENSION PROBLEMS, IN CINCINNATI: City’s Pension Funds Tank. Losses Drive Up Long-…

Ouch! This hits close to home. Living outside Cincinnati I have to say I am surprised. Cincinnati’s city government has a long tradition of being dysfunctional but this exceeds their low standards by quite a margin. It is as bad as the public pension problems in Illinois and California. Like most cities Cincinnati has been battling the migration of their tax base to the suburbs. It will be practically impossible for the city government to tax their way out of this mess. This leaves the city government with several really bad plans for solving this problem. My guess is that all of the plans will involve serious cutbacks in the pension benefits. With so many cities and states promising extremely generous pension benefits that are also being forced to reduce their staff due to low tax revenues, I doubt the US recession will end until most of the cities and states resolve their pension problems. This is a particularly thorny problem for the Democrats since they have shown an ineptness for dealing with major city issues such as poverty. As Glenn Beck pointed out last year in a commentary on poverty,  Cincinnati has not had a Republican mayor since 1984. It looks like the Democrats own both of these issues.

MORE PUBLIC-PENSION PROBLEMS, IN CINCINNATI:

City’s Pension Funds Tank.

Losses Drive Up Long-Term Deficits.

Generous Pensions In Deep Hole.

Instapundit » Blog Archive » MORE PUBLIC-PENSION PROBLEMS, IN CINCINNATI: City’s Pension Funds Tank. Losses Drive Up Long-…