Written by David Greenwald Monday, 30 January 2012 07:58
Ed Mendel, who runs the Calpensions website, reports this morning, "While CalPERS reported weak earnings in 2011, a prominent private-sector investment manager, Robert Arnott of Research Affiliates, told the board last week he thinks the most they can expect from stocks and bonds next decade is 4 percent."
He cites another major investor, "Laurence Fink of BlackRock, told the CalPERS board during a similar educational session in 2009 that during the next 15 years: 'You'll be lucky to get 6 percent on your portfolios, maybe 5 percent.' "
"Consultant Girard Miller said in Governing magazine this month, while discussing 12 basic public pension issues, that earnings 'closer to 7 percent' are more realistic until global debt is reduced," Mr. Mendel reports.
And yet, CalPERS has remained steadfast in not revising their earning assumptions, despite recommendations by actuaries who argue they should lower their forecast to 7.5 percent.
Davis' new city manager is skeptical about CalPERS' claims and their forecast.
In early January, he told the Chamber of Commerce that he strongly disagrees with the CalPERS claims "that they have enough money at the moment and that they're not going to increase our rates over the next two years."
He told the chamber in his State of the City address, "We think they're wrong. We think they're basically doing that so that they don't have to give the state an increase in their rate this year so they don't contribute to the state budget deficit."
"But we think they're in complete denial." He said that they don't anticipate any additional cost pressures from CalPERS at this point in time, but the city still plans to set additional money aside in case they change their mind, which he said happens "just about every year."
"Long-term, what's happening with CalPERS is completely unsustainable," he continued. "There's no way they can ever meet their obligations and so at some point in the next five years they're going to come clean and there's either going to be a ballot initiative or some legislative change and both future employees and existing employees are going to see some reduction in the accounting methods - it's just not sustainable."
He hopes this realization comes before they hit the city with a 30 to 40 percent increase in our contributions rates. "There is some point in time when the fiscal laws of nature are going to catch up with [Cal]PERS," he said noting that non-PERS cities are having to increase their rates by as much as 70 percent.
That view is now bolstered by a growing criticism of CalPERS' decision to leave the ARR untouched at 7.75 percent.
Ed Mendel notes, "Even a small drop in the earnings forecast could boost the annual employer payment to the pension fund."
In fact, the City of Davis has projected that for each quarter percentage drop in the earning expectation, the city will have to make an additional $1 million in payment from all funds.
The good news that Mr. Mendel reports that CalPERS has a chance to revisit their forecasts in March, and they are "not turning a deaf ear to the experts.
"Like all talented investment managers, and Rob Arnott is one of the most talented, he laid out a problem - in a low return environment conventional approaches to asset management are likely to disappoint - and a solution - invest unconventionally," the CalPERS chief investment officer, Joe Dear, said to Ed Mendel by e-mail when asked for a comment.
"He did not say we can't earn our target rate of return. He said to do that we'll have to have an investment strategy that is different. Much of what he suggested, such as fundamental indexing, and higher exposures to emerging markets, we are already doing. The low return environment makes achieving our return objective more difficult, but not impossible."
Mr. Mendel explained that experts believe this is a "low return environment" for a number of reasons. For one thing, the continued low interest rates, which the Fed will leave in place until at least 2014, "means that the bond portion of investment porfolios will have lower yields."
"Large government and private-sector debts run up in recent years means debt repayment can crowd out purchases and projects, limiting economic growth and potentially lowering stock returns," Mr. Mendel argued.
Moreover, he argues that population trends in developed economics, including the US, "mean their economic growth is likely to be slower, potentially lowering stock returns."
Ed Mendel cites a report from the Rhode Island investment policy which argues, "Over the next decade, long-term investors should expect lower capital market returns than historical averages."
"A big problem facing public pensions, which often expect to get two-thirds or more of their money from investment earnings, is the need to predict the future. A typical worker receiving a vested pension right at age 25 could live another 55 years or more," Mr. Mendel continues. "But as the PCA [Pension Consulting Alliance] report shows, even predictions for the next decade have little certainty and a wide range of probability. After the short-term swings, the theory is that returns over a number of decades will tend to 'revert to the mean' or an average."
Former Assemblymember Joe Nation, now a Stanford professor, issued a recent report demonstrating the problems that occur if the three state pension funds earn their long-term historical average of 6.2 percent a year.
In a Sacramento Bee op-ed he argued the long-term "shortfall is $290.6 billion, or about $24,000 per California household. Like a mortgage accruing interest that's not being paid, that shortfall grows every day the problem is not addressed."
"The amount of pension debt, the shortfall or 'unfunded liability,' is an important part of the debate over the need for a cost-cutting pension overhaul. But it's an issue not likely to be settled because of the uncertainty in predicting the future," said Mr. Mendel.
On the other hand, the CalPERS chief actuary Alan Milligan argued that the stock dividends over the long term have been twice as high, at four percent, as those used in the report.
Mr. Nation claims the lower figure was used by Warren Buffet to show that pension earning assumptions are too high. Mr. Milligan argued "if the correct 4 percent dividend is used, the 6.2 percent return in Nation's report becomes about 7.75 percent."
"You end up right where we are," said Mr. Milligan. "I hear those arguments about our rates of return being unrealistic. But I'm sorry, it's not true."
As Mr. Mendel points out, "Milligan said the recommendation last March to lower the CalPERS earning forecast to 7.5 percent was intended to preserve 'conservatism,' a cushion if earnings turned out to be lower than the 7.75 percent expected when that forecast was adopted."
"He said the board decision to leave the forecast at 7.75 percent still accurately reflects expected earnings. But in the new 'low return environment,' the conservatism cushion is gone and the risk of not hitting the earning target has increased," Mr. Mendel reports.
"Given that the state of the economy has put severe pressure on employers' budgets, we recognize that it may be appropriate to reconsider the level of margin for adverse deviation," said Milligan's report to the board last March.
"The balancing of the level of risk taken on the funding of the plan with the impact on employers, stakeholders and the public in general is fundamentally a task of the board."
Many have charged political reasons for the CalPERS board not to take a more conservative approach. The impact down the line of these decisions could be devastating for local government and the state.
Fortunately for Davis, they are looking to hedge their bets, but the CalPERS decision makes it far more difficult for Davis to win at the bargaining table where this fight is going to have to go.
---David M. Greenwald reporting
a prominent private-sector investment manager, Robert Arnott of Research Affiliates, told the board last week he thinks the most they can expect from stocks and bonds next decade is 4 percent
For those who do not know, Rob Arnott is very widely respected. Although he is not an academic his work is research oriented and rigorous. His pioneering work is in non-market cap weighted index funds(which his work and other's show yields a higher return than cap weighted) which many large pension funds and other institutional investors now use (and are available as etfs through Wisdom Tree and other firms).
In short, when Rob talks, we should listen. Note the quote refers to stocks and bonds. Some on this blog have cited the long term return on stocks, which is higher than 4% but CalPERS, like most pension funds, owns a blend. Also the stock market is still over valued today, implying a lower return, at least over the next ten years, which is when the #$@& will hit the fan.
CALPERS is unsustainable. I expect pensions will be capped at around $100k at some point and other mechanisms will be put in place (or we will have high inflation, eroding the real value of these pension). AS a CALPERS member I am not happy, but at least Arnott is telling CALPERS what they need to hear.
Devaluation of the dollar that goes along with inflation will no doubt be a major part of the manner in which this issue is addressed as politically, it is the path of least resistance. The upside will be that manufacturing in the US will become more globally competitive and manufacturing job growth will return to the U.S. Retirees will need to spend their money within the US to get the best value for their dollars. A life-style that includes a lot of foreign travel for retirees will be sharply curtailed for many.
"(Robert Arnott) ... thinks the most they can expect from stocks and bonds next decade is 4 percent."
If Mr. Arnott is setting a 4% over/under line, I would bet the over very strongly. Long-term historical returns are much closer to 8% for the S&P 500 index.
It's hard to know what events in the future will cause major corporations to be highly profitable or not. It is, after all, their profitability which determines the value of stocks and thus the value and growth of stock portfolios.
The S&P had great growth in the 1980s. But in 1980, who would have known that? Would an analyst like Arnott have predicted at the start of the 1980s that inflation would have been tamed, interest rates would have fallen, taxes were lowered and corporate profitability would have taken off the way it did?
The S&P again had great growth in the 1990s. But in late 1992 we were mired in a recession. The S&L crisis had sapped the financial sector of its energy. It appeared that we were losing our technological edge just when American manufacturing was moving overseas. Also, the huge budget deficits of the 1980s seemed to be catching up with us, and most economists were convinced that "crowding out" had begun. What no one foresaw was the computer revolution and massive productivity gains which resulted here. Those drove profits to unforseen heights and allowed for the 1990s to be another decade of high investment returns in the stock and bond markets.
At the start of the last decade, in 2000, things were looking very strong. How many stock analysts predicted that we were going to be in for the worst investment decade since the S&P was created? Who knew then that many sectors of the US economy would be crippled in the wake of the 9-11 attacks? Who knew then that the housing market would bubble up to new heights and then come crashing down? Who knew then that many of leading our investment banks and the entire domestic auto sector would be bankrupt by late 2008? Or that the public debt would rise to levels never seen since 1945?
I suspect that Arnott and others who think the next 10 years will be dire or at best sluggish are overly influenced by the present state of the economy. But current numbers are often bad predictors of what will happen over the subsequent 10 years. A better predictor is the long-term performance of stock companies. With dividends included, I know of no reason the big companies that make up the S&P 500 won't grow at their historical norms over the next decade.
"Devaluation of the dollar that goes along with inflation will no doubt be a major part of the manner in which this issue is addressed as politically, it is the path of least resistance."
I don't think US policymakers will ever intentionally devalue the dollar. But I do think there is good reason to believe that the dollar, in a jolt or more slowly, will lose its value over the next 5, 10, 15 and maybe 20 years. Why? Because we have run a current accounts deficit for a very long time, and the result is that many foreign banks (including central banks) are holding too many dollars or dollar-denominated notes. That is unsustainable. And when, say, a major central bank in Asia decides to stop buying t-notes, the game will be up.
As D-2 says, that will bring about price inflation here and the devaluation of our currency. If that happens, it will make all of us in the US poorer, but it will also be a great boon to debtors, like CalPERS. It will, in effect, allow them to have built up a big liability with expensive dollars and pay it off with cheap dollars.
Rich - very useful summary and you have pointed to an issue that does not get the attention it deserves: the current accounts deficit. The only other person who I have seen write consistently about this is Dean Baker. Thanks for adding your thoughts on this and it is worth adding that when you say "it will also be a great boon to debtors" this includes the US government.
I wonder two things in relation to this: is CalPERS expecting (counting on) a devaluation to happen? And why DON'T policy makers try to intentionally devalue the dollar (in a hopefully orderly fashion)? That is, who benefits from a strong dollar?
"That is, who benefits from a strong dollar?"
Every American consumer and every American traveler does.
The price of almost every item we consume or use is priced in the international market and how much we can afford is based on the value of the dollar. If the dollar falls by half, the real income (adjusted for inflation) of every American will fall by half. If you now make $80,000 per year, your real income will fall to around $40,000. If you now have $500,000 in savings, that savings will be worth only $250,000 in real dollars.
Let me give a few examples of how this will affect consumption:
Food. If you go to Safeway today and say you want to buy a pound of salmon, it will cost you roughly $8 to $10, depending on mark-up. If the dollar loses half of its value relative to other major currencies (say compared with the Japanese Yen, the Euro* and the Chinese Yuan), that pound of salmon will cost you about $16 or more.
You can get a good pound of whole coffee beans now for about $8 to $9 per pound. If the dollar devalues by half, those same coffee beans will go for $16 to $18 per pound.
Even food items which are not internationally traded--such as locally grown fresh produce which is sold in the local markets--will be affected by a dollar devaluation. The sellers of those products will expect a much higher price; and if they don't get it, they will (by and large) start growing different food products for the export market.
While all people who eat milk, cheese, fish, beef, produce, canned goods, cereal, peanut butter, pasta, herbs, garlic and so on will be able to afford much less after a devaluation, obviously those Americans with less money will be hurt the most by such changes. Without greater volumes for food stamps, many poor folks who now can afford proper nutrients will go hungry.
Durable goods. The price of everything from computers to refrigerators to cars to a winter coat will double in cost, compared with your income in real dollars. As such, Americans will be poorer for it. We won't be able to afford new TVs, new PCs, or new blue jeans. Most of us will have to go without or use such products even after they are out-of-date.
Travel. Anyone who has ever traveled abroad knows that even a small change in the exchange rate can make a big difference in travel costs. I recall traveling in Europe and the Middle East in the 1980s when the dollar was very strong. It made everything incredibly cheap. A nice hotel room in a big city in the US then cost about $75 per night. The same quality of hotel in Madrid or Rome was half that. (I remember paying $20 for a room at a luxury hotel in Florence called the Bernini Palace. Today that place goes for around $150.) Today, travel costs for Americans in Europe are far higher, all due to the exchange rate. If the dollar drops by half against the major currencies, it will make the price of long distance flights, hotels, food, tickets to museums, rental cars and so on cost-prohibitive to many Americans who now can afford vacations.
The real winners (in the US) from a weaker dollar will be exporters, including those who are now only selling their goods domestically but will with a weak dollar have an incentive to start exporting, and companies which sell services to foreigners, especially visitors to the United States.
Over a very short period of time, as we get poorer, our economy will shift from a consumption economy to a production economy. We will make more cars and buy fewer. We will grow more wheat and consume less of it. We will build more hotels and sleep in them less often.
*As troubled as the Euro may look right now, with the crisis in Greece and the debt problems of Italy and Spain, it is worth noting that one Euro costs us $1.314. When the Euro started, it was intentionally set at $1.00 for 1 Euro. After selling for less than $1 a few years after its introduction, the dollar has steadily lost ground to the Euro. Over the last 5 years, the Euro has cost us on average about $1.40, and once reached $1.60. My view is that if the Greece situation clears up, the Euro will cost us roughly $1.50 before too long.
"If the dollar falls by half, the real income (adjusted for inflation) of every American will fall by half. If you now make $80,000 per year, your real income will fall to around $40,000."
One perhaps positive result of a weaker dollar will be a reduction in housing costs. That is, given the same supply of housing, the real demand for housing will fall considerably, because people will need to use so much more of their money for other goods, where the price is set in the international market. The cost of housing (i.e., rent), however, is the intersection of supply and demand at the local level. I would think that inflation adjusted rents should fall substantially if the value of the dollar falls and its new, lower position is relatively stable.