We’ve had plenty of company in warning that protracted central bank policies, ZIRP, QE, and most important, that those represent negative real interest rates, are deadly to banks and long-term investors like pension funds and life insurers.
As a result, one of the things we’ve discussed regularly with CalPERS is how it is continuing to defend the indefensible, namely, its assumption that it will earn 7.5%. It rejected a plan by Governor Jerry Brown to have the giant pension fund lower its return target to 6.5% in return for a cash injection. Instead, CalPERS came up with a convoluted scheme to lower its return…maybe someday. From Reuters last November:
Calpers will reduce its expected rate of investment returns in years after the fund outperforms its 7.5 percent target by 4 percentage points. The goal is to ultimately reduce the rate to 6.5 percent, although that could take decades under the new policy….
In July, CalPers announced that after years of steady returns it missed the 7.5 percent target, returning just 2.4 percent for the fiscal year ended June 30.
Contrast that 7.5% return assumption with Moody’s outlook for fiscal year 2016, which ends June 30, courtesy the Financial Times:
Moody’s, the rating agency, said lacklustre returns in 2015 and 2016 will put severe pressure on the health of US public pension plans and force states and cities to act in order to plug their pension funding gaps.
Tom Aaron, an analyst at Moody’s, said the funding deficit — the difference between the assets a pension fund has and what it has to pay out to current and future pensioners — will grow substantially this year….
In the most optimistic scenario, where average returns totalled 5 per cent, the collective funding gap [for the 56 plans in its study] would still widen by more than $200bn.
Moody’s estimates the scale of the unfunded liabilities is greater than officially reported because of the generous discount rate public pension plans use to value retirement benefits. The rating agency said the schemes collectively have a deficit of $1.7tn, which could rise to $2.2tn this year if the pension plans suffered negative returns.
Now again, in case you missed it: CalPERS’ return assumption of 7.5% exceeds Moodys’ best case scenario of 5% by a full 2.5%.
Mind you, CalPERS, which is 77% funded as of June 30, 2015, is a bit less stressed than the average public pension fund. The most underfunded state plans are those of Illinois, Connecticut, Kentucky, and Kansas. Again from the Financial Times:
A study by Wilshire Associates, the consultancy, published earlier this month, showed that state-sponsored pension plans in the US had just 73 per cent of the assets they needed to pay current and future retirees in mid-2015, down from 77 per cent in 2014. In 2007, this was 95 per cent.
The fact that public pension plans as a whole were adequately funded before the crisis is a stark reminder that the “rescue the banks” plan has come at the expense of savers and retirees. And the optimism of CalPERS and its peers that a higher return environment will eventually bail them out of their problems does not appear warranted. From a post yesterday by C.P. Chandrasekhar and Jayati Ghosh:
Why then are central banks and governments opting for this unusual stance? In a famous 1943 essay on the “Political Aspects of Full Employment”, the Polish economist Michal Kalecki had argued that if the rate of interest or income tax is reduced in a slump (to counter it) but not increased in the subsequent boom, “the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not … eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy.”
If you had any doubt that the Great Moderation, which depended in part on the Greenspan/Bernanke put, was responsible for the lousy new normal, that paragraph should help put it to rest.
But it’s also important to recognize that the underlying problem is not that of public pension plans, but that the whole idea of saving and investing to fund retirement has been upended by the economic misrule of the last 40 years. The benefits of productivity growth were not shared with workers, consumer borrowing served to prop up spending levels, and the corporations became net savers, either underinvesting or worse slowly liquidating via stock buybacks. All of that has resulted in stagnant labor incomes and an unprecedentedly high and unhealthy share of GDP going to profits.
In the 1960s, government pressure made the sharing of productivity gains normal practice. But with businesses wedded to wage squeezing, companies preferring short-term gimmickry to investing, and the public trained to be hostile to what is most needed, more aggressive government spending, particularly in infrastructure. But with both government and business leaders are increasingly of the “après moi le déluge” school of management, both the young and the old outside the top echelon are set to suffer even more.