A report from Ed Mendel from last week’s CalPERS (California Public Employees’ Retirement System) board meeting indicates that the board tentatively approved an employer rate hike of about 50 percent over the next six years. This will replace the current policy which kept rates low during the recession, building up unfunded liabilities in hopes that the plan could be fully funded within 30 years.
“Any addition to the schools (rate) is likely to result in layoffs to employees,” said the board president Rob Feckner. Mr. Feckner requested options for a longer time horizon for phasing in the rate increase, which would soften the blow to employers.
“The proposal for a new actuarial method would show state and local government employers the new rate plan in their next annual valuation report,” Mr. Mendel reports. “But a five-year phase in of the rate increase would not begin until fiscal 2014-15 for state and school employers.”
The rate increase would not to begin to phase in until 2015-16 for local governments such as the city of Davis.
“Contributions that we need for the system really depend on the funded status of the plan and matters that are unrelated to their (employers) financial ability,” Chief Actuary Alan Milligan told Mr. Feckner. “Having said that, I will take a look at what we can do in the way of providing options.”
Mr. Mendel notes that the CalPERS funding level still has yet to recover from the $100 billion in losses during the economic collapse and, under the current policy, would not reach full funding for another 30 years.
Mr. Mendel reports that the investment fund, which provides two-thirds of future pension payments, peaked at $260 billion in the fall of 2007, dropped to $160 billion in March 2009 and was back up to $256 billion last week.
“The total CalPERS fund had 101 percent of the projected assets needed to cover future pensions in 2007. The funding level dropped to 60.8 percent in 2009 and in the last valuation (as of June 30, 2011) was back up to 73.6 percent,” he reports.
“A funding level of 80 percent is adequate, some experts think,” Mr. Mendel continues. “But CalPERS officials, shaken by the huge investment loss five years ago, worry that another deep recession could drop funding low enough to make reaching full funding impractical.”
“Some academicians have said if you go much below 55 (percent) you never can recoup or regain your status,” said board member Henry Jones. “The option of looking at not having that happen is therefore very important.”
Board member George Diehr expressed concern even with the proposed rate increase. He told members that the CalPERS funding level would still have a high probability of dropping below 50 percent in the next 30 years.
“I think falling below 50 percent creates a high risk of political attacks, changes to the defined benefit (pension) system that might be not just what happened, the reform that was just passed, but more likely what happened in San Diego or San Jose,” Mr. Diehr said.
Ed Mendel notes that AB 340, Governor Jerry Brown’s pensions reform plan that took place in January, would give new hires smaller pensions and raise some employee contributions. Even with the new policy, however, the CalPERS funding level has a more than 50 percent chance of dropping below 50 percent funding in the next 30 years.
“They make some significant changes,” Mr. Diehr said, “but I think a fiscal conservative would say they don’t go far enough.”
Ed Mendel reports that he asked Chief Actuary Milligan “for an estimate of rate increases needed to lower the probability of a 50 percent or lower CalPERS funding level during the next 30 years to 40 percent, 30 percent ‘and if it doesn’t crash your software, 20 percent.’ “
Mr. Diehr called CalPERS too protective of employers who raise pension benefits and argued that these “employers should take the responsibility for any sharp increases resulting from higher benefits, whether through reserves or borrowing.”
“In the end, what it might come to, as the head of Human Resources in the city of Palo Alto has suggested, they may need to seek legislation to go after the other lever here that we can’t touch – and that’s the liabilities themselves, the pension benefits which drive the liabilities,” Mr. Diehr said.
CalPERS is considering other changes that could increase rates, Mr. Mendel reports, “Later this year completion of a risk-reduction study that may result in more conservative investments, and next year factoring in longer life spans and a review of the earnings forecast.”
At least one board member, J.J. Jelincic, disagrees with those who argue that the CalPERS earnings forecast, 7.5 percent a year, is too optimistic and deceives the public by concealing large amounts of debt in the form of unfunded liabilities that they attempt to correct over 30-year periods.
He asked Mr. Milligan to assess the probability of reaching 120 percent funding.
Mr. Jelincic cited a 2011 report that the 100 largest corporate pension funds had an average earnings forecast of 8 percent. “Our return assumption is not unreasonable,” he argued.
—David M. Greenwald reporting
S&P 500 up 11% in last 3 months.
[quote]
Mr.Toad
03/26/13 – 09:15 AM
…
S&P 500 up 11% in last 3 months.
[/quote]
What’s going to happen to Calpers and for that matter everyone’s 401K when the Federal Reserve stops its monthly $85 billion infusion into the markets? Crash is coming, it’s just a matter of how soon.
It is normal, over the long run, for large indexed equities (like the S&P 500) to achieve returns of greater than 8% per year (assuming no taxes on dividends and assuming dividends are fully reinvested).
Using today’s price for the close, here are the historic annualized S&P 500 Return (dividends reinvested) over the last 10, 20, 30, 40 and 50 years:
March 2003 – March 2013: 8.314%
March 1993 – March 2013: 8.414%
March 1983 – March 2013: 9.660%
March 1973 – March 2013: 10.024%
March 1963 – March 2013: 9.797%
It should be noted, however, that there are a few problems with thinking a fund like CalPERS can fully achieve those rates of return. One, like all investors, CalPERS has some trading costs, which reduce its returns; second, CalPERS (incorrectly in my opinion*) pays a full-time staff to research the companies it invests in and follows the advice of those stock pickers. That advice costs a lot of money, and thus further reduces the total return.
(*Incorrectly? Yes. CalPERS would do [i]better[/i] simply buying unmanaged indexed funds and never trying to pick winners they believe are underpriced. Don’t believe me? Read ‘A Random Walk Down Wall Street.’)
Costs are not the major problem in the regard. The real challenge is that CalPERS has monthly cash needs–to pay their pensioners the cash owed them every month. It’s not the case that PERS can just sit and hold equities. As a result, PERS must hold at least three types of assets which return much less than stocks: cash; bonds; and real estate. Those assets are needed because they produce the cash flow that a pension fund needs.
The worst of these is cash itself. Typically a cash account (for a very large fund) will return about 1.5% to 2% less than the rate of inflation. Our current inflation rate is running at about 2%. Thus, cash accounts are paying approximately nothing. Bonds vary, depending on risk. But a broad bond portfolio (including high-grade corporate bonds, T-bonds and munis) will likely only return about 1% to 1.5% more than the rate of inflation. So at best, PERS can achieve a 3% return on its bond portfolio in today’s climate. The expected long-term return on real estate**–that is, the cash payments that PERS gets from renters of the residences, offices and commercial buildings it owns and manages–is generally equal to the long-term growth in nominal income. That is, the more money workers make, the more they will pay in rent. That number is typically about 2% more than the annual rate of inflation (over the long run).
I still think a 7.5% total fund return is reasonable for the long term. However, in a low-inflation climate, that is harder to achieve, because those non-equity classes of assets will be depressed. And, of course, when we are in an economic tailspin, as we were from 2007-2011, the total market value of a pension fund is going to lose value, as stocks decline.
**Save people who are extremely lucky–that is, they timed the real estate market just right–[b]no one makes big money in real estate by buying and holding for the long run[/b]. Real estate returns are just not that good. Real estate returns in the long-run are never as good as stock returns.
The main ways most real estate gazillionaires make their riches are: 1) They add value over and over. For example, they buy for little a run-down hotel in a good location, demolish it, and construct a shiny new office tower on the same spot. The value of their land will thus greatly increase. They then pull off this trick in a new location, again and again; 2) They make management and leasing fees. This is possible when some or most of the equity investors in a real estate development are not also managing the property; and 3) Taxes. Some value in real estate development is due to government policies which benefit wealthy investors.
There is actually one other way real estate gazillionaires make big money: They buy influence with government.
For example, they buy a cheap piece of farm land worth $2,000 per acre. They then use campaign donations and other bribes to convince politicians to change the zoning on that farm land to residential. In a stroke of the pen, their land is now woth $20,000 an acre. The “investor” can then sell the land, having never built a house or improved it in any way and still will make a killing.
Another example is where real estate developers will buy government land for much less than market value and then redevelop it into something worth a lot. The only corruption in this is when the buyer of the land uses his money to make sure he is the only one who knew that land was available for sale and then he gets it for much less than an auction price would have achieved.
A third example is where a real estate developer buys an obsolete property in a marginal neighborhood for very little money. He then promises to develop something shiny and new on his parcel, with the caveat that the city will then massively upgrade its infrastructure all around him, making his investment worth much more money. This sort of thing happens all the time. A variant of this is where cities agree to build large parking garages on land they own, which has the effect of making the proximate private property worth a lot more money. I saw Walter Shorenstein pull this off many times in San Francisco with his high=rise office buildings, which he never had to construct any parking for.
Rich wrote:
> CalPERS would do better simply buying unmanaged
> indexed funds and never trying to pick winners
> they believe are underpriced.
CalPERS main goal is to get money in the hands of politically powerful people and make them even richer (so they can kick back even more money to the people that made them richer), funding the retirement of public workers is a secondary goal (that they are not doing very well at)…
> **Save people who are extremely lucky–that is,
> they timed the real estate market just right–no
> one makes big money in real estate by buying and
> holding for the long run.
You are forgetting that just about everyone (even CalPERS) uses leverage to invest in real estate, and that almost all real estate has annual cash flow above and beyond the annual appreciation” so just about everyone that buys and holds for the long term makes “big money” aka a huge return on their initial investment…
> Real estate returns in the long-run are never as
> good as stock returns.
Let’s forget about the $3K my Dad invested to buy a Bay Area rental home in 1975 for $35K that is now worth $1.2mm and rents for $48K a year (giving him over $40K of cash flow a year after expenses) and focus on a typical East Davis home that would have sold for $25K in 1975. Making a $10K/20% down payment the East Davis home would have cash flowed from day one and today the home would be debt free worth about $500K and churning off about $20K a year in cash flow after expenses. Can you name a stock index that has returns even close to that?
Dow Jones Industrial Average December 6, 1974 was 577.
Dow jones industrial Average today 14559.
Return 2523%. A better investment than even a house in Davis.
[i]”… focus on a typical East Davis home that would have sold for $25K in 1975.”[/i]
I don’t believe that price actually existed that year. Your suggested sales price is more typical of 1965, not 1975. A 1,000 sf, 3-bedroom 1-bath in East Davis would have gone for $40,000 in 1975.
[i]”Making a $10K/20% down payment the East Davis home would have cash flowed from day one and …”[/i]
In order to have achieved a positive cash-flow from day one, you would have had to put down about $30,000, in order to cover property tax costs, repairs, homeowners insurance, parcel taxes, interest and principal payments.
Loans in 1975 carried an interest rate of about 11.5% APR (and rose substantially in the subsequent years).
A 3-bed, 1-bath East Davis home back in 1975 would have had a rent of under $200/month.
[i]”… today the home would be debt free worth about $500K and churning off about $20K a year in cash flow after expenses.”[/i]
There is a 960 sf, 3-bedroom, 1-bath home in East Davis (622 J Street) which is listed for $320,000 right now. A house like that rents for $900 to $1,000 a month, today, less property taxes, parcel taxes, insurance, repairs, etc. The net income (before income tax) is closer to $570/month on that house.
Your home’s average annual appreciation over 38 years was 5.62%. However, due to your positive cash flow, your annual return on investment on that house would be roughly 5.94%, less if you hired a property manager.
[i]”Can you name a stock index that has returns even close to that?”[/i]
Yes. The S&P 500. It was over 10% per year over the same period, assuming no taxes on income (as I assume in the E. Davis house case, too), no costs of reinvesting dividends, no fees, etc. Realistically, even with no income taxes (such as with a pension fund), costs would bring down that ROI to about 9%/year.
Mr. Toad wrote:
> Dow Jones Industrial Average December 6, 1974 was 577.
> Dow jones Industrial Average today 14559.
Sure the numbers have gone up, but since only about a half dozen of the 30+ stocks in the Dow back in 1974 are still in Dow today.
The Dow is a big scam that tricks people in to thinking that stocks always go up. If Kodak or GM go BK they just take them out of the Dow index and add stocks that are going up Cisco or Wal Mart, but the people that owned since 1974 took the loss.
Then Rich wrote:
> A 1,000 sf, 3-bedroom 1-bath in East Davis would
> have gone for $40,000 in 1975.
Can you dig in to the Enterprise microfilm for actual sale prices? I don’t think he was lying when an older guy I know in town told me he bought a “new” (~1,500 3×2) East Davis “Streng” home for $30K in 1974 (that he still lives in) after he sold his older and smaller (~1,100 3×1)East Davis home for $25K.
> There is a 960 sf, 3-bedroom, 1-bath home in East Davis
> (622 J Street) which is listed for $320,000 right now.
That is a forclosure sale and 621 J (just across the street) sold for $415K in 2011 and 602 J sold for $455K in 2012 and just about everything is higher this year:
http://www.sacbee.com/2013/03/26/5292593/bidding-wars-breaking-out-in-sacramentos.html
I’m not a real estate cheerleader, but knowing multiple people looking to buy in Davis right now I can tell you (and I’m sure that any real estate agent can confirm) that just about everything in town is selling for more than in 2011 and 2012 (and that a foreclosure that is thrashed and needs $100K to make it livable will sell for a lot less than average)…
> A house like that rents for $900 to $1,000 a month.
The average one bedroom APARTMENT in Davis is close to $1,000 a month today (it was $946 in 2011), a decent home will rent for double that:
http://housing.ucdavis.edu/_pdownloads/2011_vacancy_report.pdf