Alan Milligan, the chief actuary of the California Pubilc Employees’ Retirement System, is once again urging it to lower its assumed rate of returns. Mr. Millgan last year was rebuffed by the CalPERS board, after a recommendation that the pension fund cuts its rate from 7.75 percent to 7.5 percent. This time he is recommending an even deeper cut, dropping the return from 7.75 percent to 7.25 percent.
The proposed reduction will be considered by a committee Tuesday, and by the full board on Wednesday.
A quarter percent cut is huge. That would have a considerable impact of roughly $1 million in all funds to the City of Davis. A half-percent cut would be monumental and would cost the city as much as $2 million in all funds – although some of that could be absorbed by city employees if they agree to pick it up during the next round of labor negotiations.
Last year, CalPERS was coming off a 20% return on investment and therefore declined to take up the recommendation from Mr. Milligan and others, who warned of weaker future returns in addition to noting the huge losses that the fund sustained during the economic collapse.
At the time, board members expressed concerns that lowering the rate would put a huge burden on local governments.
However, as we reported earlier this year, the fund earned just 1.1% percent in the past calendar year and it has had a rate of return of just 5 percent in the past decade and 7.5 percent over the past 20 years, according to figures from Joe Dear, who is the CalPERS investment chief.
According to the Bloomberg report, “Public funds have come under fire for using investment assumptions that hide the true size of shortfalls. The $238.1 billion fund last adjusted its rate of return in 2004, to 7.75 percent from 8.25 percent.”
“Lowering the return would boost the state’s employee pension costs, as a percent of payroll, as much as 4.2 percent in the year beginning July 1, according to a CalPERS staff report. Local governments could see an increase of as much as 4.5 percent the following year. The costs for some public-safety agencies could jump as much as 6.5 percent,” Bloomberg reported.
Earlier this year, the California State Teachers’ Retirement System, CalSTRS, lowered its rate to 7.5 from 7.75, its second reduction since 2010.
At the time, we predicted this would put renewed pressure on CalPERS to lower their forecasted earning rate, and last month it was announced that Mr. Milligan would make another recommendation to the CalPERS board, though at the time, he did not say what the recommendation would be.
But we noted, “Other big public pension funds have been cutting their forecasts in recent years to reflect a tougher investment climate.”
Concerns began rising last month when it was reported that CalPERS earned just 1.1 percent on its investments in 2011 – far below their forecasted 7.75% model. It should be noted that the 7.75 is a projected 30-year average which gives the fund considerably more leeway.
While pension plans rebounded in 2009 and 2010 from their devastating losses in 2008, they never got back to even. In 2009, the fund got a 12.6% return followed by 12.1% in 2010, but the 1.1% return in 2011 is troubling.
“Despite a strong January, chief investment officer Joseph Dear warned earlier this week that the markets remain tumultuous,” the Bee reports.
In late 2011, Mr. Dear was still comfortable with current targets.
“Over 20 years I’m comfortable with our return target,” Mr. Dear said. “That’s long enough to ride through these cycles. On the short term, I think it’s going to be difficult, and I have said that. I was advised not to be so pessimistic on my point forecast.”
Ed Mendel, who runs the Calpensions website, in late 2011 wrote, “Dear said the next 20 years are likely to be different from the past 20 years. He said part of the evolving CalPERS investment strategy is a shift of focus from asset classes to risk factors.”
“I’m confident that as we do this work, we will find a way to produce the returns that are necessary, even if we run the risk of being different than a lot of other pension funds who are pioneers in that effort,” Mr. Dear said.
But not everyone is convinced that is true.
Ed Mendel reported a few weeks ago, “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.”
“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 has been 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.
While I think a lot of people expected a reduction, few were planning on it being this huge a hit. This, however, was one of the reasons the council had attempted to make a $2.5 million cut to personnel costs and transfer at least $1.5 million of that to either pensions or retiree health.
Last month, however, the Vanguard reported that the city was going to fall well shy of those goals for cuts. With all of the bargaining units up for contract renewals, it was expected that there may be several impasses that develop.
It will be interesting to see if CalPERS does reduced the ARR to 7.25% and how that will impact contract negotiations.
—David M. Greenwald reporting
[quote]”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.”[/quote]
Let’s look at the bright side–at least our City manager gets it.
When we see. 3 member fire crews instead of the current 4, it will show the public this CC is serious about budget change.
Even 7.25 is laughably high, and 4% is realistic, just ask any private fund actuary.
Nobody WANTS to take away the punchbowl, but reality will hit everybody in the face eventually.
The world is in a major economic depression and its not going away anytime soon. The Major indexes are still at levels seen 10 to 13 years ago ! ( zero % ) How the heck can they even keep a straight face when they say 7.25 ! LOL
Better start adjusting expectations now folks.
This is where I diverge a bit from the great economist Rich Rifkin. I think 4-5% range is a more accurate rate of return that we should expect for a well-managed portfolio in the coming decade. The historical rate of return has been long inflated from too many government incentives, subsidies and meddling that we can no longer afford. Rates of return have effectively been propped up.
Today, and going forward, pressures to increase taxes to fund entitlements, pay for PEU commitments, and to pay down our massive public debts, will continue to serve to limit economic expansion. Interest rates are already near zero. The supply of real estate will take several years to be reabsorbed. It is not looking good for another sustained burst of economic growth.
The only valid big variable will be how quick we can deal with our overspending and debt, and then get the economy growing at a decent pace. If Obama is elected, those plans will be delayed and the problems exacerbated another four years. If Romney is elected, we should start making progress feeling a bunch of short term pain to improve our long-term economic prospects. Even so, the average rate of return for this next decade will be significantly less than the historical rates of return.
PERS is a political animal and is protecting their union constituents. Knowledge of the true unfunded pension liability would become an explosive political battle and it would be used against union interests in collective bargaining. This downward projection is just a small bone being thrown to delay the inevitable day of reckoning.
justoutsidetown: [i]”Even 7.25 is laughably high, and 4% is realistic, just ask any private fund actuary.”[/i]
You base that claim on what, exactly?
CalPERS has not had trouble over the long-term achieving rates of return higher than 7.75% in its history. Even taking into account the great crash of 2008-09, it has achieved a long-term ROI better than 7.75%.
[img]http://2.bp.blogspot.com/-iatXTVGd_-k/T1gSYY0iTAI/AAAAAAAAAjU/D0MFN0zadzo/s1600/PERS+returns.bmp[/img]
So you can understand the chart I posted above, let me explain what the number in the right column means. Where it shows 8.41% for 2011, that is the average annual return on investment in the PERS portfolio for the 20 years ending June 30, 2011 (the last day of the fiscal year and the day which PERS has always used to set its agency funding rates). Where it shows 7.79% for 2010, that is the average annual return on investment in the PERS portfolio for the 19 years ending June 30, 2010.
The problem for PERS is one of cash flow, not one of making a reasonable rate of return. Historically, an broad-based index equity fund, like the S&P 500, will always give you a better return on investment than 7.75%.
For example, the 30 year average annual return for the 30 year period from the start of 1982 to the end of 2011 is 12.53% (when dividends, untaxed, are fully reinvested); the 30 year average annual return for the 30 year period from the start of 1972 to the end of 2001 is 13.68% (when dividends, untaxed, are fully reinvested); and the 30 year average annual return for the 30 year period from the start of 1962 to the end of 1991 is 11.52% (when dividends, untaxed, are fully reinvested). See: source ([url]http://www.moneychimp.com/features/market_cagr.htm[/url]).
Jeff – Ignoring the political points you make, I think it is worth noting that PERS is not just protecting their union constituents, but they are in some way thinking they are protecting local government. Part of the problem is that if they now lower the ARR by .5 they could end up driving more cities to bankruptcy. I think they made a grave error last year by not lowering the ARR by a quarter point which might have forestalled the more direct need this year and the city council was trying to be preemptive on this and the employees I think stalled for timing hoping this would go away.
justoutsidetown: [i]”Even 7.25 is laughably high, and 4% is realistic, just ask any [u]private[/u] fund actuary.”[/i]
There is a fundamental difference between a non-profit fund like CalPERS and a private fund: CalPERS pays no taxes on its dividends or on its capital gains.
Also, if you are quoting someone who thinks “4% is realistic,” that might be adjusted for inflation. The 7.75% figure that PERS has assumed is nominal. It does not adjust for inflation.
Rich: The twenty and ten year averages should be concerning that we will not see them get up to 7.75% and should at least urge caution in trying to. They can always adjust the rates should their fund outperform lowered expectations.
[i]”The twenty and ten year averages should be concerning that [b]we will not see them get up to 7.75%[/b] …”[/i]
What?!!!
When did PERS fail to achieve 7.75% over 20 years?
I am confused by all of these bearish posts, because not one of you has any numbers to prove your point. Jeff Boone attributes political motives for PERS not lowering its assumed ROI last year. But what about the political motives of Mr. Milligan? Has he objectively proved his case? Is it not possible that he is covering his ass by making this overly conservative call? What would he have to lose if he is wrong and PERS continues to produce its normal long-term ROI in excess of 7.75%? Nothing. As David G. said, they will then just go back and make the assumed rate 7.75% again. But if Mr. Milligan says PERS should keep its current assumed rate and PERS has another cash flow problem, his ass would be on the line for not having given this ridiculous advice he is now proffering. To not see Mr. Milligan’s motives is to be blind.
Rich: John Dear reported the 20 year average to be 7.5%
This is from the Bloomberg article: “Calpers earned almost 5.1 percent over a decade and 7.5 percent in the past 20 years, according to Joe Dear, the system’s investment chief. “
Rich… don’t confuse David’s mind with facts… he has already made up his mind.
The problem relying on historical rates of return.
National Debt…
[img]http://www.cscdc.org/miscjeff/nationaldebt.jpg[/img]
DAVID G.: [i]”This is from the Bloomberg article: “Calpers earned almost 5.1 percent over a decade and 7.5 percent in the past 20 years, according to Joe Dear, the system’s investment chief.”[/i]
I have the Bloomberg story on this right here ([url]http://www.businessweek.com/news/2012-02-15/calpers-actuary-proposes-changing-7-75-investment-return.html[/url]). It says the number for 10 years (which does not mean too much) is 5.1% and the number for 20 years (which is still too short a time period to use as a basis for an argument) is 8.36%. [quote]Through Dec. 31, Calpers earned almost 5.1 percent over a decade and 7.5 percent the past 20 years, according to a report prepared for the board by Joe Dear, the system’s investment chief. That 20-year return will rise to 8.36 percent when results through June 30, 2011, are included. The fund uses such fiscal year results in its calculation of employer contributions.[/quote] What really counts, when setting an assumed ROI, is how well a portfolio performs over 30 years and more. I have yet to see one shred of evidence–from you, from Mr. Dear, from Mr. Boone, from Mr. Milligan, or from anyone who is claiming this is a wise decision to lower the assumption–that CalPERS cannot expect to earn avg. annual returns in excess of 8%, let alone 7.75%.
I don’t believe in the last 120 years there has ever been a 30-year period in which the S&P 500 (or its equivalent) ever returned less than 10% per year (for investors who reinvest dividends and pay no taxes on dividends or capital gains). If you, David, or Jeff Boone or Dr. Wu or any other bear can show me that I have that wrong, I will change my tune. Until then, I am right and you guys don’t know what you are talking about.
Jeff… so besides PERS, what do your numbers imply for Social Security, Medicare, etc.?
[i]”the number for 20 years (which is still too short a time period to use as a basis for an argument) is 8.36% …”[/i]
I should add that if you see my spreadsheet above, you will note I get an 8.41% avg. annual rate of return. The difference is likely one of rounding. I used the fiscal year figures from CalPERS (see page 3) ([url]http://www.calpers.ca.gov/eip-docs/about/facts/investments.pdf[/url]) and ran them on Excel to get my numbers.
hpierce,
I think my numbers (and other similar numbers) imply that we are going to suck much more out of the economy to pay off our debt and this will have a deflating impact on economic growth. Contrast this against the last couple of decades of very high growth… but it was propped up by high government spending and artificial controls. We simply are fully leveraged and have no choice but to start paying for all of this. Our rates of return will not equal the historical rates for at least a decade depending on our political leadership.
I wonder why people throw around 10-20 year rates of return when most retirees from this systems work longer than that before retiring?
Mr. Toad: You are missing the point. CalPERS projects their earnings over a 30 year running window. Now one way to judge how we will perform over the next 30 years is to look at how we have performed over past periods and what the actuary is arguing is that the earnings over ten and twenty years is lower than their current project.
From a Reuters article…
[quote]Most state and municipal pension funds assume a long-term rate of return around eight percent, reflecting a portfolio invested in equities, bonds and alternative assets such as hedge funds. That number reflects the approach preferred by actuaries. It’s supported by actual investment history, and it’s endorsed by the Governmental Accounting Standards Board (GASB), the independent accounting and financial standards reporting group for state and local governments.
Economists, meanwhile, prefer a more conservative approach adhering to standard financial theory: cash flows should be discounted at a rate that reflects their risk. Measuring pension funds, that requires use of a “riskless rate of return” assumption reflecting what could be earned on Treasuries or corporate bonds, around four to five percent.
Joshua Rauh, an associate professor at the Kellogg School of Management at Northwestern University, says the riskless rate method pegs aggregate unfunded liabilities of state and local governments north of $3 trillion — a sum larger than the overall $2.6 trillion of debt on state and local government balance sheets. The GASB-endorsed eight percent assumption indicates a smaller $1.3 trillion aggregate funding gap, he calculates.
“You can write out a simple equation on how to keep a pension fund in balance,” says Karen Harris, vice president of capital markets research at Callan Associates, an investment consulting firm that has researched the riskless rate-of-return issue. “The benefits paid plus expenses of running the plan must equal contributions plus investments. You can only pay for the program through contributions or investment returns, or a combination of the two. So the rate of return assumption is important in understanding how you are funding benefits.”
The argument for eight perecent is based on actual historical rates of return — and the fact that investment time horizons for pension funds are very long. Harris says that for a worker who starts a job at age 20 and retires at 60, a pension fund won’t need dollars to pay out benefits for 40 years, and the total investment horizon is 55 years, when life expectancy is included.
“Next, an actuary asks what she can earn over that time horizon,” she adds. “And what she’ll say is, ‘I can earn something.’” Part of that return will come from buying the longest government and corporate bonds available, holding them to maturity and reinvesting the proceeds; the difference must come from returns on equities where risk is involved on everything but dividends.[/quote]
[i]I think it is worth noting that PERS is not just protecting their union constituents, but they are in some way thinking they are protecting local government.[/i]
David, in CA, I see them as one in the same. You are either cutting entitlements or PEU member’s pay and benefits… or you are raising taxes first and then doing these things later. Or, you are going to eventually file for bankruptcy. It is the unions that are most afraid of municipal bankruptcy because it allows the invalidation of labor contracts and forces them back to the negotiating table with less negotiating leverage. They also do not want to be put in the position of entitlements being in conflict with PEU pension benefits. Today the Dems and the unions have done a great job blaming the wealthy and the GOP for attacks on entitlements. Once the truth gets out, the public employee unions are toast.
JEFF: [i]”I think my numbers (and other similar numbers) imply that we are going to suck much more out of the economy to pay off our debt and this will have a deflating impact on economic growth.”[/i]
That would be true if we raised taxes (as a % of GDP) substantially to pay down our debt. Much more likely is we will pay back our debt by deflating the value of the dollar. That is the normal course for countries which get deep in hock.
As such, our long-run rate of real growth (not nominal) will almost surely continue to depend on improvements in labor productivity, as it always has.
[i]”Contrast this against the last couple of decades of very high growth… but it was propped up by high government spending and artificial controls.”[/i]
The empirical evidence suggests that the driving force of growth following the 1991-92 recession was the rapid increase in computer technology which improved labor productivity. Since 2000, however, we have not had very high rates of real GDP growth, though we have had very high rates of government spending.
[i]”We simply are fully leveraged and have no choice but to start paying for all of this.”[/i]
I think there is truth in this, but the strong dollar and our continual current account deficits suggest the time to start paying for all of this” has not yet arrived.
[i]”Our rates of return will not equal the historical rates for at least a decade depending on our political leadership.”[/i]
Your conclusion is a non-sequitur. It does not logically follow that the large and smartest global corporations which make up the S&P 500 (and most of the value of all publicly traded equities) will not be able to figure out ways to make profits in the world economy if China stops buying US treasuries and our Congress is forced to stop issuing new debt.
Let me add this to my last paragraph: It’s important not to confuse US rates of real consumption with global consumption. If the dollar declines, US consumers will be poorer and will consume less. But the dollar’s value is always relative to other currencies. So if it falls, others go up. And when the others go up, consumption will rise in those other places. In the short run, consumption is a zero-sum game. But over time it will grow globally as productivity grows. And so once again, the only real question about global income growth is how much productivity growth there is. Wherever productivity grows fastest, that is where major multinational companies will be investing and making profits.
I would like to emphasize the point that Rich Rifkin made: The rates of return that we are discussing are nominal, not inflation adjusted. While personally, I agree with David that the rate assumptions are high, they are not as high as they sound if you take inflation into account.
This is from the Social Security Advisory Board:
(http://www.ssab.gov/publications/financing/estimated rate of return.pdf)
…
“III. Implications for Future Returns
The implications of current valuations for future returns depend on whether the market has
reached a new steady state, in which current valuations will persist, or whether these valuations
are the result of some transitory phenomenon.
If current valuations represent a new steady state, then they imply a substantial decline in the
equity returns that can be expected in the future. Using Campbell and Shiller
I wonder if the fact that more people are living longer will also have a dilatory effect on pension funds. In other words, bc folks live longer, the pension funds have to keep paying out more and more into the future. Additionally, with the unemployment rate high, that is less workers paying into the pension fund system…
Frankly, my gut feeling is PERS is being overly optimistic in its projections. Past performance is no guarantee of future performance if underlying assumptions/conditions change…
“The only valid big variable will be how quick we can deal with our overspending and debt….”
…not necessarily. A potential game-changing variable is when a critical mass of the voters recognizes that their personal self- interest resides in increasing taxation on the 1%, increased government spending(yes, with some reduction in the value of the dollar) and regulation and taxation of the Wall Street financial sector.
[i]”I wonder if the fact that more people are living longer will also have a dilatory effect on pension funds. In other words, bc folks live longer, the pension funds have to keep paying out more and more into the future.”[/i]
The actuaries regularly make adjustments based on new life expectancy data. In 2009, CalPERS reported that cops and firefighters live just as long as other employees. [quote] Here are the CalPERS life expectancy data ([url]http://www.newgeography.com/content/001145-police-pensions-and-voodoo-actuarials[/url]) for miscellaneous members:
— If the current age is 55, the retiree is expected to live to be 81.4 if male, and 85 if female.
— If the current age is 60, the retiree is expected to live to be age 82 if male, and 85.5 if female.
— If the current age is 65, the retiree is expected to live to be age 82.9 if male, and 86.1 if female.
Here is the CalPERS life expectancy data for public safety members (police and fire, which are grouped together by the pension fund):
— If the current age is 55, the retiree is expected to live to be 81.4 if male, and 85 if female.
— If the current age is 60, the retiree is expected to live to be age 82 if male, and 85.5 if female.
— If the current age is 65, the retiree is expected to live to be age 82.9 if male, and 86.1 if female.[/quote] [i]”Additionally, with the unemployment rate high, that is less workers paying into the pension fund system …”[/i]
This works in two directions at once. On the one hand, it means less cash flow into PERS, which makes it harder for PERS to pay out its current pension benefits from its portfolio. On the other hand, it means a lower pension burden for PERS-affiliated agencies now and in the future.
[i]”Frankly, my gut feeling is PERS is being overly optimistic in its projections.”[/i]
You need a gut-check. The empirical evidence does not support that conclusion.
Rifkin:[i]”The empirical evidence suggests that the driving force of growth following the 1991-92 recession was the rapid increase in computer technology which improved labor productivity. Since 2000, however, we have not had very high rates of real GDP growth, though we have had very high rates of government spending.”[/i]
Agreed. However, I would emphasize the last point. I don’t think we can extract much greater productivity from private industry, and we certainly cannot sustain the high levels of government spending. Lastly, with the US economy’s tendency for high domestic consumption and trade deficits, I don’t see how we can match the level of growth we previously experienced.
[I]”It does not logically follow that the large and smartest global corporations which make up the S&P 500 (and most of the value of all publicly traded equities) will not be able to figure out ways to make profits in the world economy”[/I]
Now, I will concede that investment strategies are going global and will be increasingly less reliant on just our domestic economic growth. So there is this global hedge against more anemic domestic growth and returns. But this brings up the point of risk. Foreign investments, and investments in companies with a greater stake in foreign markets, will likely always include greater risks. I am worried about pension fund managers developing a greater risk appetite as they struggle to maintain these committed high rates of return. I would add to our ROR expectation greater market volatility going forward. I think we can say that the last decade has demonstrated this as the markets have bounced around. For example, what would a new Mid East war with Iran do to the market over concerns of oil cost inflation?
Elaine: [I]”I wonder if the fact that more people are living longer will also have a dilatory effect on pension funds.”[/I]
I read a very interesting article a few days ago that sheds some new light on the expectation that we are continuing to live longer. I will look for it online and post a link if I can. The article was based on a new study that shows life expectancy trends are starting to level off.
However, I agree that this is another factor related to the “required” ROR. Think of a defined pension as an immediate annuity. To price one of these, you need three factors: 1 – the monthly payout, 2 – the rate of inflation, 3 – the number of months. If the number of months increases due to greater life expectancy, the cost of the annuity will increase. If the cost of the annuity increases, so will the required ROR for the investments that would need to be liquidated to fund the annuity. Said another way, all things being equal, we would require a higher ROR today and tomorrow compared to the past when life expectancies were lower. The actuaries run the numbers and come up with the needed ROR. My concern is that there is political pressure to project and ROR that prevents the real financial picture from causing us to start demanding greater spending cuts and greater contribution from PEU members.
[quote]ERM” “Frankly, my gut feeling is PERS is being overly optimistic in its projections.”
Rifkin: You need a gut-check. The empirical evidence does not support that conclusion.[/quote]
Only time will tell who is the one with the faulty gut 😉
[quote]However, I agree that this is another factor related to the “required” ROR. Think of a defined pension as an immediate annuity. To price one of these, you need three factors: 1 – the monthly payout, 2 – the rate of inflation, 3 – the number of months. If the number of months increases due to greater life expectancy, the cost of the annuity will increase. If the cost of the annuity increases, so will the required ROR for the investments that would need to be liquidated to fund the annuity. Said another way, all things being equal, we would require a higher ROR today and tomorrow compared to the past when life expectancies were lower. The actuaries run the numbers and come up with the needed ROR. My concern is that there is political pressure to project and ROR that prevents the real financial picture from causing us to start demanding greater spending cuts and greater contribution from PEU members.[/quote]
This is how I see it too…