More and more experts are criticizing CalPERS and other public pension funds for sticking with outdated, unrealistic return assumptions in the light of the “new normal” of post-crisis super-low and even negative policy interest rates. The latest to weigh in is bond maven Bill Gross. Gross’ perspective is particularly important because at Pimco and presumably now at Janus, Gross is in the circle of bond heavyweights which means that he interacts on a regular basis with Fed officials and thus has a perspective that CalPERS and its advisers lack. From Bloomberg:
Fund managers that have been counting on returns of 7 percent to 8 percent may need to adjust that to around 4 percent, Gross, who runs the $1.5 billion Janus Global Unconstrained Bond Fund, said during an Aug. 5 interview on Bloomberg TV. Public pensions, including the California Public Employees’ Retirement System, the largest in the U.S., are reporting gains of less than 1 percent for the fiscal year ended June 30…
Public pensions have been hurt by the Fed’s zero-rate policy that Gross says has led to “erosion at the margins of business models” such as the ones used for funding public pensions, which depend on assumptions about returns over time horizons of 30 years or more.
“Pensions have to adjust,” said Gross. “They have to have more contributions and they have to reduce benefit payments.”
If you look at the short clip in the Bloomberg article, Gross has taken a very risk averse posture, and is at zero duration which is tantamount to being in cash. Gross’ view, like that of Jeff Gundlach of Doubleline, is based on seeing a dearth of sensibly priced investments at these risk levels. He called bonds “a liability, not an asset” as current levels and sees stocks as equally unattractive given weak fundamentals and the exposure to large losses if interest rates increase. Other experts see embracing risk and leverage as CalPERS has, in its desperation to achieve unrealistic return levels, as dangerous for other reasons: that political instability in advanced economies can produce major dislocations, and risky assets are the worst place to be. As David Llewellyn-Smith of MacroBusiness pointed out:
Markets did not react at all to the French atrocity. They can’t. They do not know how to discount political risk, have virtually no way to hedge it, and they either won’t or can’t countenance asymmetric risk (that is “Black Swans). Rather quaintly, they believe central banks will protect them. It is not that markets are a good judge of these things, they are not, and you should not believe that no movement in equity or other prices is a guide to the events of Europe being marginal. They are not.
The first point to make about asset allocations in this emerging environment is that it is as much higher risk of asymmetric shocks than the decades that preceded it. Thus the strategic narrative for allocations should reflect that risk. In general terms that will mean:
- avoid leveraged and illiquid assets;
- safe haven assets will trade at a premium, and
- cash and cash-like instruments should occupy a much larger percentage allocation than in the past.
Bloomberg also points out that contrary to CalPERS, which has a adopted a plan to reduce its return goals that is so attenuated as to be tantamount to not lowering it, Illinois is taking a hard look at revising its return targets downward:
Illinois’s largest state pension, the $43.8 billion Teachers’ Retirement System, plans to take another look at how much it assumes it will make in the coming year as part of an asset allocation study, said Richard Ingram, executive director. Currently it assumes 7.5 percent, lowered from 8 percent in June 2014….
“Anybody that doesn’t consider revisiting what their assumed rate of return is would be ignoring reality,” Ingram, whose pension is 41.5 percent funded, said in a phone interview.
Mind you, the Illinois plan is deeply underfunded even as currently measured, but that is not preventing state officials of getting a grip on where it really stands.
It is also critical to understand that all investors are facing the same underlying problem. Even though institutional investors are having a difficult time, going to the Wall-Street-enriching solution of fobbing the problem off on retail investors, is barmy. They would see what little in the way of returns they earn chewed up in fees, and that’s before factoring in that retail investors are more easily snookered than professionals, and typically dent their returns by overtrading. As we wrote:
With its head-in-the-sand response, CalPERS is making it difficult even for those who believe in pension funds to defend them. The best solution societally for retirement savings is to have them funded federally, since the US is a sovereign currency issuer, and needs to deficit spend on an ongoing basis due to the fact that businesses chronically underinvest. Moreover, having the federal government provide for an adequate level of retirement income would align incentives much better, since officials would correctly come to regard retirement payments as coming out of the productive capacity of the real economy, as opposed to the confused focus on financial asset values (remember, a financial asset is always and every someone else’s financial liability, and will have the value you hope it will have only if the party on the liability side performs well over time). But if we are in a second-best world of inadequate Federal retirement payments, professionally managed programs are clearly preferable to individual plans. Cathy O’Neil gives one reason:
It’s actually, mathematically speaking, extremely dumb to have 401K’s instead of a larger pool of retirement money like pensions or Social Security.
Why do I say that? Simple. Imagine everyone was doing a great job saving for retirement. This would mean that everyone “had enough” for the best-case scenario, which is to say living to 105 and dying an expensive, long-winded death. That’s a shit ton of money they’d need to be saving.
But most people, statistically speaking, won’t live until 105, and their end-of-life care costs might not always be extremely high. So for everyone to prepare for the worst is total overkill. Extremely inefficient to the point of hoarding, in fact.
Instead, we should think about how much more efficient it is to pool retirement savings. Then lots of people die young and are relatively “cheap” for the pool, and some people live really long but since it’s all pooled, things even out. It’s a better and more efficient system.
Another reason, as any fan of John Bogle will tell you, is that institutional investors pay vastly less in fees and costs than retail investors do, and those savings make a huge difference in total returns over a 20 to 40 year time horizon. And that’s before you get to the fact that 401 (k)s have all sorts of nasty hidden fees.
But instead of calling attention to the real problem, such as the destructive impact of central bank policies on savers of all sorts, as well as the damaging impact of bank-favoring post-crisis policies on growth, CalPERS is trying to snooker its beneficiaries on the fantasy that the old normal is coming back. 25 years of post-crisis malaise in Japan, near deflation in Europe, and nearly a decade-long weak recovery in the US, with no reason to expect better on any front, should disabuse them of that notion.
CalPERS’ tactic of resorting to aggressive denials when the fact are against them is only going to further weaken its already damaged reputation and make it hard even for natural allies to defend them. Their refusal to acknowledge how difficult a fix they are in is making a case against, not for, public pensions. If you want to help your enemies, this is precisely the way to do it.
16 comments
Comments are closed.
I think Gundlach is on record saying that whoever is elected, we’re going to see more deficit spending. This seems to be true from what I understand of Trump’s economic ‘blueprint’. So there is a real possibility that government spending will finally ramp up and help the economy grow into asset valuations for risk assets. I think the commodity rally has something to do with this narrative.
Treasuries are another story.
Although Ike isn’t really running for president, the long bond bear market which launched before he took office and rolled on until 1981 could happen again under the conditions you describe.
From the end of 1951 (the year of the Treasury-Fed accord, when the Fed stopped pegging long Treasury yields) through Sep. 1981, the yield on the 7-year T-note averaged 5.65%, starting at 2.4% as 1951 ended and reaching an eye-popping 15.9% in Sep. 1981. But its return to an investor was only 3.68% annually compounded [data from CRSP], reflecting relentless price return losses from rising rates.
If another bond bear market haircuts 2 percent off starting yields of near zero, where’s that gonna leave us? Up a creek, brother.
Not only does the commodity really have something to do with this narrative, but also total return commodity funds potentially are part of the solution. Commodities were pretty quiet during Ike and Mamie’s administration. But by the Sixties and Seventies, as the twin pestilences of Vietnam and Nixon destroyed the dollar, they were popping good.
Whether the commodity strategem will work again in a new secular bond bear market depends on how the fiat fanatics’ competitive devaluation race to the bottom goes. It’s the old bathtub math problem revisited: as your purchasing power gurgles out the drain thanks to the money printers, the open tap of commodity returns replaces the loss, and perhaps (with luck) the water level remains stable till you’ve finished your ablutions.
That’s why I own some commodities. It’s been the pain trade since 2008, but they are insurance. Something ‘in my little finger’ tells me now is not the time to bail on them…
You should do some due diligence on commodity investing. For 99% of people (and institutions) that dabble in it, it’s a lose-lose proposition -unless you have impeccable and mystical short-term timeing abilities. A very good article in the Financial Analysts Journal this month that pretty much lays bare that it’s just another investment product with little if any justification other than the fees it produces.
Article = Conquering Misperceptions about Commodity Futures Investing
Calpers will continue to avoid the hard questions facing it simply because they know they are toast. Years of mismanagement, illogical decisions and an overriding “fail conventionally” attitude have come home to roost.
Gross is one to talk though his recent peformance is just as dismal
Illinois has a 2 teir pension that will help it…though not those in teir 2. And the supreme court rulings state the contract is with the state for retirement benfits. There is no fund for retiree health care but it must be paid….and the state tax rate of 3.75%….and we have to pay 50% of medicaid….Texas beloved state of online commentators only has to pay 40 %
Here is a current LA Times article about the plans for state-run retirement accounts. This being from the Golden State, expect that the matters will be handled with all of the transparency and comprehension of the CalPERS/CalSTRS PEU issues.
What we see when talking about these kinds of big picture, long-term issues is a group of people who have benefited handsomely from quantity-based economics unwilling – and even unable – to adapt to the reality that inequality, not growth, is the major economic problem of our time.
Things are so out of whack at this point that there are retirees making more money than tens of millions of people who are working. CAGR and index funds won’t save us. A radical paradigm shift in the way public policy handles money is coming, one way or another.
I agree. But your comment deserves some elaboration. In Oregon, the state entered into an employee contribution AND capital gains matching scheme in the late 80s, just ahead of the tech boom, leading to many retirees earning more than working stiffs. There is a political problem with public pensions that I’ve not seen discussed. Fear. Politicians fear the fallout that might come from public employee strikes or work stoppage and so are willing to provide over-generous retirement packages as that is a cost for their successors to deal with. This is especially true of police and firemen, our first-responders. And, of course, the pension fund managers routinely predict 7.5% returns in a 1% environment. In fact, while Oregon PERS is going around the state informing communities that they will have to increase their contributions to the fund, they continue to assume a 7.5% return as worst case. Oregon is facing a huge problem with PERS and there are no easy answers. http://www.oregonlive.com/politics/index.ssf/2015/11/pers_costs_to_soar_in_2017_and.html
Agreed, there’s much elaboration to dive into the details. Yves has been doing an awesome job prying into details for years now on the pension front.
What I have noticed a little bit, though, is that no one’s talking about the high level view, the executive summary. A little bit of a tweak here or there at the micro level won’t fix the situation where high level law enforcement, for example, receive both oversized compensation packages while working and then receive oversized pensions on top of it. It’s not sustainable. PE charges excessive fees, of course, but that’s quibbling at the margins.
We have to decide, at a basic level, is retirement a right or not, and if the former, what standard of living should that entail. Taxation, not investment returns, is the only way to pay for a meaningfully shared system of retirement; it is taking the entire effort of public policy simply to keep asset inflation going. With ZIRP, we’ve reached the end of the line. Our 35 year experiment of using falling interest rates to hide looting is over. Either the looting becomes more overt, or we have to distribute resources more equitably. Those are the only two high level options.
Younger workers have no connection to the whole pension debacle. They’ve been earning lower current compensation and virtually no pension for decades now. And not only is that the long term trend over the past three plus decades, but perhaps more troubling in the paradigm shift sense is that essentially no one’s talking about it. Our post-war system of political economy has never dealt with a situation where older households were hoarding wealth at the expense of younger households. The consequences, both social and political, of the growing gap between younger and older workers are both large and unpredictable. So I completely agree, there is a lot on which to elaborate.
Cathy O’Neil:
This is an apples and oranges comparison. Your “401K” [sic — it’s “401 small-k,” referring to a section in the federal code] belongs to you. If you die in your boots pulling at the corporate traces, you can leave it to your heirs.
Not so with Soc Sec — if you die before retirement age, your retirement bennies go poof.
When I hear some do-gooder talking about “efficiency,” I reach for my revolver.
Jim, “Not so with Soc Sec — if you die before retirement age, your retirement bennies go poof.” My wife paid into Soc Sec for over 40 years – she died at the age of 60. Both she (before she died) and I didn’t think of “poof”, we thought of others who would benefit (not market-thinking I know, nevertheless we didn’t think of any loss).
“Not so with Soc Sec — if you die before retirement age, your retirement bennies go poof.”
Not quite. If you die before retirement age and you have minor children that were in your care they are entitled to minor child survivor benefits. Your spouse who is caring for your minor child is also entitled to survivor benefits. Your spouse is also eligible for your benefits at his/her full retirement age if your benefits would be greater than his/hers. This usually helps widows more than widowers. If you become disabled before full retirement age you are eligible disability benefits. The benefits aren’t princely, but they make a real difference in people’s lives. Try finding a 401k with those features. So no, the bennies don’t go “poof”.
An utterly fundamental difference between private and public plans is that the former are obliged by federal law to use high quality corporate bond yields to discount their liabilities. Corporate yield curve data is posted both at Treasury and IRS to facilitate this mandatory calculation:
And it’s great data, going back to 1984. Moody’s data extends back to 1919, but it’s only for 30-year corporates, not the whole yield curve.
By contrast, state and municipal pension schemes adhere to a hinky GASB (Government Accounting Standards Board) rule which allows them to “write their own ticket.”
As Andonov, Bauer and Cremers point out in their landmark paper, “Pension Fund Asset Allocation and Liability Discount Rates,” public funds game the system by setting unrealistic expected returns. These in turn make the present value of their liabilities lower, concealing the full extent of underfunding.
Were Calpers to use high quality corporate bond yields published by the US Treasury — currently 2.91% on a 10-year bond and 3.82% on a 30-year bond — their 76% funded status would revert overnight to around 50% — the real number.
Cornered rats can lie, but the math don’t.
ZIRP is destroying savers’ income and pensions’ long term funding calculations. ZIRP is a “black swan” event. But ZIRP, stupid and shortsighted as it may be, is the current state of play. It’s hard to believe the FED would willingly destroy savers to protect the TBTFs, but there is is. Reversing ZIRP would help but that doesn’t look likely anytime soon. (And keeping rates at Zero or even negative has the perverse effect of causing people to save even more, slowing economic activity further.) So… what to do? Go on as usual by betting on decent returns via risky investments? (CalPERS, et al.) Recalculate the assumed return on the basis of the new facts? The first is the least immediately painful. The second is immediately painful but likely the most clear sighted.
Glad to see others picking up this story. Thanks for your continued reporting.
One quibble. I agree overall with you, but this isn’t a shortsighted policy, and the Fed can’t undo it. It’s a fundamental characteristic of the Reagan-Obama era, or said a bit differently, of the post-Bretton Woods (roughly late 1960s – mid 1990s) and post post-Bretton Woods (roughly mid 1990s – present) systems of American leadership. ZIRP is merely the logical conclusion of over three decades of looting via progressively lower interest rates substituting for fair wages domestically combined with the global empire we run. I’ve noticed a lot of people over the years trying to present the GFC and our current environment as new or unique. But really, the break between productivity and wages goes back to the 1970s*. The GFC and ZIRP aren’t short sighted developments; they’re symptoms of the end of the line of quiet stagflation.
We are in a transition period, collectively trying to decide whether the excessive concentration of wealth and power should become more brazen or be reined in.
*I don’t support a return to the London Gold Pool era of hard money, by the way. It’s just important to understand that a bad system coming to an end is no guarantee that a good system will follow.