by Robert Maynard
Last June True North Reports ran an article pointing to our state’s pension funding shortfall as the single greatest risk to our financial system:
“This funding shortfall represents the single greatest risk to the financial integrity of the system.” This November 2011 quote from State Treasurer Beth Pearce was part of an Ethan Allen Institute sponsored presentation by David Coates on the fiscal crisis represented by the state’s unfunded liabilities. The presentation was given last Tuesday to a standing room only crowd at the University Amphitheatre in the Sheraton Burlington Conference Center. Given the magnitude of the problem suggested by the above quote, one would think that the topic would be at the top of our political discussion. Unfortunately, our current political leaders have really paid little attention to the issue. This deserves to be put front and center in the coming campaigns. It would be harder to ignore the message if our political leaders felt some heat on this.
The problem is that not enough pressure is being put on our political leaders regarding this issues and few of them seem willing to tackle it in the absence of such pressure. Part of what is driving the state’s coming employee pension fund crisis is assumptions on the expected rate of return on pension fund accounts that can best be described as a fantasy. This Wall Street Journal article exposes such Alice and Wonderland assumptions and the pending bankruptcy of political entities:
It has been said that an actuary is someone who really wanted to be an accountant but didn’t have the personality for it. See who’s laughing now. Things are starting to get very interesting, actuarially-speaking.
Federal bankruptcy judge Christopher Klein ruled on April 1 that Stockton, Calif., can file for bankruptcy via Chapter 9 (Chapter 11’s ugly cousin). The ruling may start the actuarial dominoes falling across the country, because Stockton’s predicament stems from financial assumptions that are hardly restricted to one improvident California municipality.
Stockton may expose the little-known but biggest lie in global finance: pension funds’ expected rate of return. It turns out that the California Public Employees’ Retirement System, or Calpers, is Stockton’s largest creditor and is owed some $900 million. But in the likelihood that U.S. bankruptcy law trumps California pension law, Calpers might not ever be fully repaid.
Part of the problem is the expected rate of return on invested pension funds:
Pension math is more art than science. Actuaries guess, er, compute how much money is needed today based on life expectancies of retirees as well as the expected investment return on the pension portfolio. Shortfalls, or “underfunded pension liabilities,” need to be made up by employers or, in the case of California, taxpayers.
In June of 2012, Calpers lowered the expected rate of return on its portfolio to 7.5% from 7.75%. Mr. Milligan suggested 7.25%. Calpers had last dropped the rate in 2004, from 8.25%. But even the 7.5% return is fiction. Wall Street would laugh if the matter weren’t so serious.
The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I’m being generous, -1%.
If a 7.5% rate of return is an expectation that would make Wall Street laugh, we here in Vermont may want to ask whether any of our own political leaders are providing some of the comedy. The answer is an unfortunate yes: ‘Or as Utah Rep. Jason Chaffetz told Vermont Gov. Peter Shumlin, upon learning at a 2011 House hearing about that state’s unrealistic pension assumptions: “If someone told me they expected to get an 8% to 8.5% return, I’d say they were probably smoking those maple leaves.”‘
To recap, our political leaders are expecting a rate of return near 8.5% when the realistic rate of return is more like 3%. That means they are probably over esttimating the pension funds’ rate of return by nearly a factor of three. Perhaps someone should tell Govenor Shumlin and company to stop “smoking those maple leaves.”