The city of Davis had an opportunity to deal with its long term structural problems when addressing the new collective bargaining agreement with its various bargaining units. However, if the fire MOU is any indication, the city has failed to deal with the long term implications. Instead it has traded short-term budgetary needs in lieu of dealing with the bigger issues.
As Councilmember Heystek put it late last week,
“The biggest problem that I have with the contract is that it does very little to address our structural challenges in any meaningful way and it sets the tone for the contracts that we are poised to consider and adopt in the very near future.”
He continued,
“The council apparently decided to take the bait on short-term salary reductions that begin increasing once again in a matter of six months. And so on paper, an outside observer might think that we’re reaping some kind of significant fiscal benefit, when it has been demonstrated that from the first year to the last year, the decrease is minimal to none given the fact that PERS rates are going to be going up and that we are continuing to cover the medical, we’re covering PERS, we’re covering the medical benefits.”
The contract does limit PERS increases in 2010 to 1.5% and in 2011 to 2%, however, given current rate smoothing plans, this defers the big decisions off to 2012 and beyond without giving the city any kind of clear benefit.
The news this week has not been good from a long-term sustainability of pensions. Ed Mendel from Calpensions.com reported on Monday that while the CalPERS investment porfolio has rebounded some after losing $100 billion between October 2007 and March 2009, the investment returns, “when compared with other large pension funds, ranked in the bottom 7 percent during the last year and the bottom 10 percent during the last five years.”
The lagging investment performance is attributed to “the unusually large CalPERS investments in two of the riskiest asset classes, real estate and private equity.”
Mendel goes on to write:
“CalPERS officials say they have a long-term investment strategy, can handle ups and downs and have had good returns in private equity and real estate over the long run. And comparisons, they note, can be slippery because of the timing of loss write-offs and other factors.
Still, the nation’s biggest public pension fund, an industry leader that has pioneered the move into hedge funds and other non-traditional investments, is not accustomed to being ranked at the bottom in much of anything.”
Michael Schlacter of Wilshire Consulting told the CalPERS investment committee:
“Your performance for years and years was top 20 or 30 percent up until about 18 months ago,” he told the board. “Things like AIM (private equity) and real estate were really pushing your returns. And now, obviously, you have taken some very, very large hits in those.
“You are extremely overweight in both assets relative to any other large public fund. It’s not only hurting your performance, it’s also hurting comparisons relative to your peers.
“As those markets recover, we expect to see a flip side.– again, a little more aggressive positions, riskier long-term asset classes which normally drive superior results, if and when those asset classes begin to recover.”
Without getting too much into the minutae of the CalPERS investments, this is what you need to know. Last week, the CalPERS board approved a very controversial plan to avoid a shocking $1 billion increase in the state’s annual pension payment to begin covering investment losses. But in order to rate-smooth over a 30-year period, they have to hit a 7.75 percent annual earnings target. If CalPERS falls short of its earnings target, the state’s annual pension bill will continue to rise in the years ahead and we will be amassing an unfunded liability.
David Crane, an adviser Governor Schwarzenegger told PBS’s Newhour yesterday that CapPERS was too optimistic in terms of assumptions on investment return.
“All public pension funds have done this, is assume very high, fantastical rates of returns, far in excess of what stock markets historically have returned and bonds have historically returned. And, by doing that, they induced governments to put away less than was necessary when the promises are made.”
Newshour’s Spencer Michels continued:
“Some critics also allege, CalPERS and other funds made risky investments in hedge funds urged on by middlemen who got a cut. Still, CalPERS argues, it has no trouble paying retirees what they have been promised.”
As David Crane puts it however,
“CalPERS could lose every penny tomorrow. And these people, the beneficiaries, wouldn’t be at risk, because we’re on the hook for those payments, regardless of how well or how poorly pension funds do.
So, it doesn’t make sense to even ask them whether they’re solvent. Their assets are insufficient to meet our liabilities. And the net result is, they’re underfunded, and we are going to have to come out of our general funds to make those payments.”
The bottom line is that the city of Davis had a window of opportunity when everyone realized that current pension plans are unsustainable to really reform the way they provide pensions and change the costs to the city. Instead, they opted for a very temporary and probably meaningless cap in costs for two years. There is no two tiered plan to change the system, no increase in employee contributions, no real reform.
Councilmembers like Don Saylor have basically suggested that we need to approach reform incrementally. Councilmember Heystek however strongly disagreed with the idea of leaving reform to future councils:
“Things that concern me the most are those things that some of us would trust future councils to go farther on. The issues of vesting or new hires, retiree medical benefits, the sharing in the decrease in PERS rates, etc. All these things, we tell that we are going to give them a letter and tell them this is what our thinking was and this is what we would do in the future. There is nothing to guarantee that any of us will be on a future council to effect any change. So when we say that we’re going to have to count on future councils to continue and carry the torch, I can’t as much as I’d like to trust people who are following us to do that kind of work, there’s nothing that guarantees that they will do that. In fact, as we continue to play politics with certain bargaining groups, the prospect that we will drive a harder bargain will be less.
The time was now for structural change. I really believe that the moment was now and we’re not nearly where we should be or where we need to be.”
The Council has unfortunately now lost out on a chance to create meaningful and sustainable reform of our pension plans and we will have to hope that future councils can succeed in three years where this one has failed. If the economic climate is not ripe for that kind of reform however, it may end up becoming the train roaring unstoppably over a the proverbial cliff.
How bad a problem will this be? Time will tell, but given the amount that city’s like Davis are already paying in pensions, the problem is likely to compound itself. Already the city of Davis pays nearly eight times more for pensions now than it did in 2000. The small two year caps in city costs are unlikely to make a huge impact, because CalPERS is now betting the house on its ability to grow at an annual 7.75% rate. The analysis above from the consultant suggests that may be unlikely and if that is the case, city’s like Davis will experience a mounting unfunded liability in terms of pension costs that will come due not this year or next year, but rather down the line. And for that, the current MOU does nothing to resolve.
—David M. Greenwald reporting
[quote]… CalPERS is now betting the house on its ability to grow at an annual 7.75% rate. The analysis above from the consultant suggests that may be unlikely … [/quote] OBviously, CalPERs has failed to hit its 7.75% target growth rate for the last few years. (In fact, it’s had negative returns.) However, if you look at longer term historical S&P 500 returns — which I think are a fair proxy for a market-rate of return — [i]7.75% (unadjusted for inflation) is not unreasonable[/i], unless the fees and expenses taken out by PERS are quite high.
Going back to January 1, 1964, these are the 20-year average returns (Compounded Annual Growth Rates) in the S&P 500 for each year ending:
31-Dec-83 — 8.26%
31-Dec-88 — 9.55%
31-Dec-93 — 12.82%
31-Dec-98 — 17.87%
31-Dec-03 — 13.07%
31-Dec-08 — 8.43%
As you can see, there is volatility, even over 20-year cycles. Had you invested $10,000 on January 1, 1979, it would have been worth $267,957 after 20 years*. By contrast, if you had invested $10,000 on January 1, 1989, it would have been worth $50,465 after 20 years*.
Where things get dicier is with shorter term returns. These are the historical S&P average compounded returns (unadjusted for inflation) ending December 31, 2008, going back each number of years listed:
45–9.12%
40–8.99%
35–10.04%
30–11.04%
25–9.81%
20–8.43%
15–6.44%
10—1.47%
5—2.31%
As you can see, the last 15 years don’t meet the 7.75% return threshold. And if you reduce these numbers by say 1% per year (to account for fees and expenses), the failure is greater. However, despite the bad market of 2008 (it’s substantially better right now), it still managed to exceed 7.75% per year compounded, if you go back 20 years.
————-
*Assumes no transaction costs and reinvestment of all dividends and no money taken out for taxes. These are actually reasonable assumptions for a public pension fund, because their transaction costs are near zero and they don’t pay taxes on their gains.
P.S. If you would like to see the source data, go to money chimp ([url]http://www.moneychimp.com/features/market_cagr.htm[/url]) and use the CAGR calculator.
I have never, in my entire working life, had the luxury of a pension. What I have been able to save (and excluding social security) has to generate all of my income for the rest of my and my wife’s life, period. If I screw it up by making bad choices or others screw me by creating economic disasters which I have to pay for because up till then I did do things right, or the government redistributes my money via higher and higher taxes, then I am screwed , period. There is no organization out there protecting me that if it failed would be bailed out by others. Why should my tax money ever be used to save someone elses pension when if my self-created-and-directed pension goes under I receive no help, period.
homeless… sorry about your situation… why should MY tax money (Social Security, Medicare, other taxes that support public health), and my contributions towards charities helping people like you (STEAC, etc.) be used to protect you if you “fail”? My contributions towards people in your situation exceed $5,000 per year. God bless you & yours in 2010.
Rpierce,
Are you responding to the screen name or to the comment ??
Rich:
The long run real rate of return on US stocks is approximately 6%. However, CALPERS, like all pensions has a mixture of stocks and bonds so one needs to adjust down. A reasonable assumption would be 4-5% real returns. I am not sure if the 7.75% is real or nominal. It makles no sense for it to be nominal since CALPERS adjusts for cost of living. Given that, the 7.75% assumption is way to high. This si a ticking time bomb.
[quote]The long run real rate of return on US stocks is approximately 6%.[/quote] That is true if you adjust for inflation. The average return adjusted for inflation is 5.99% over the last 100 years.
However, an inflation adjusted return is meaningless when considering what CalPERS needs to achieve with its portfolio. The unadjusted Compound Annual Growth Rate for the S&P 500 (for 100 years) from January 1, 1909 to December 31, 2008 is 9.39%. CalPERS expects to average 7.75% unadjusted.
Over the last 20 years, the S&P CAGR was 8.43%. Over the last 30 years it was 11.04%. Most 20-year periods over that time-span have unadjusted CAGR’s much greater than 7.75%, including the period we are in now.
One which didn’t — the worst I found — was the 20-year period from Jan 1, 1913 to December 31, 1932, when the annualized return for the S&P was just 4.32%. But outside of the Great Depression, it’s hard to not average 7.75% over 20 years with the S&P 500.
[quote] I am not sure if the 7.75% is real or nominal. It makles no sense for it to be nominal since CALPERS adjusts for cost of living.[/quote] It is nominal; and it does take into account the built-in COLAs of 2% per annum on its expense side.
What I don’t know about CalPERS — and it is a significant question — is how high its expenses* and transaction fees run. If they eat up 1.5% of the annualized return on investment, that could turn a strong market average into a losing portfolio. Also, CalPERS has invested a lot of its money into land development and some into real estate management. Real Estate has never (over the long-term) performed as well as the stock market. So the total averages for CalPERS could be hurt by investing in land and buildings. Also, not all of CalPERS’s non-real estate money is in U.S. stocks. I imagine they buy some U.S. Treasuries and other bonds and foreign stocks. If those average less than the S&P, that could be a problem, too.
*They have, for example, a gorgeous office building in downtown Sacramento. I imagine they pay good money to their stock analysts and investment advisors. (It’s doubtful to me whether such “experts” ever add any value at all.)
CALPERS outlays are linked to inflation–there is a COLA. However if inflation gets very high, a distinct possibility, the inflation rate may exceed the maximum COLA allowance as it did in the 70s.
So you really need to look at real returns (that is, adjusted for inflation).
I believe CALPERS expenses are reasonably low. Most pension funds expense rations are far less than 100 basis points (1%). However I expect the private equity and other alternative investments have much higher fees, and as it turns out not so high returns.
[b]PHIL[/b] [i]”CALPERS outlays are linked to inflation–there is a COLA.” [/i]
The COLA is capped at 2% for pensioners. It is not tied to the rate of inlfation or to the CPI.
The growth in expense to the fund from the 2% COLA is fully accounted for when the rates CalPERS charges to its member agencies are set. Let me quote directly from the “What You Need to Know About Your CalPERS Benefits” booklet: [quote] The standard cost-of-living adjustment is [u]a maximum of 2 percent per year[/u]. If the Consumer Price Index registers a lower rate of inflation, you could receive a lower percentage.[/quote]
FWIW, there is a good article on the S&P 500’s long-term returns (and investor patience) in today’s New York Times. You can read it here ([url]http://www.nytimes.com/2009/12/27/business/economy/27fund.html?_r=1&ref=business[/url]).
One bit it notes is how dramatic the stock market has swung the last two years. 2009 is going to end up one of the single best years ever, on the heals of 2008 being one of the worst: [quote] The Standard & Poor’s 500-stock index has climbed more than 24 percent in 2009 — after falling 37 percent the previous year — putting stocks on pace for one of the greatest reversals of fortune in market history. Assuming that stock prices essentially stay put for the next four trading days, this would be the biggest two-year swing in stock returns since the S.& P. 500 lost 26.5 percent in 1974 and then surged 37.2 percent the next year. …
History shows that market rebounds can be so quick that they are easy to miss. Not only are much of a bull market’s gains achieved in the first year, but a good chunk of those first-year gains occurs very early on.
This year offers a perfect example. From March 9, when the rally began, to Dec. 17, the S.& P. advanced nearly 65 percent. But if you sold out of your stocks during the 2008 downturn and came back into the market less than a month after the rally started — say, on April 1 — you would have earned a 37 percent return. [/quote]
Why should my tax money ever be used to save someone elses pension when if my self-created-and-directed pension goes under I receive no help, period.
Homeless – your question gets to the heart of the ideological debate boiling in this country today. We are a nation derived from the celebration of individual freedom to pursue self interest, and protection for the property and wealth we acquire through the sweat of our own brow. Our brilliant founders conceived of unobtrusive and light-in-touch governance design. But today our government is a growing behemoth of inestimable meddling. Combined with our media-industrial-complex, it effectively demonizes self-sufficiency and sanctifies victims in ever increasing numbers. Meanwhile, our earned property and wealth is assaulted with perpetually augmented taxation, and our individual freedoms are increasingly subjugated. As you and I know, this is a path to total system collapse as more and more people begin to fall below the line of self-sufficiency and sufficient opportunity.
After you are no longer able to pay your own way, if you are lucky, you will grab a good-paying government job with union-protected retirement benefits. However, eventually you have that taken away too as government runs out of people to tax. That is the problem with socialism: eventually it runs out of other people’s money.