# traditional pension plans in the US: trouble (ii)

CalPERS

The California Public Employees’ Retirement System (CalPERS) is a bellwether for government employee pension plans around the US.

not fully funded

By its own calculations, CalPERS is not fully funded, meaning that it does not have enough money on hand today to meet the future pension obligations of its members.  That’s even assuming, as it officially does at the moment, that it can earn on average 7.5% on its investments yearly.

assuming a 7.5% annual return

How reasonable is it, though, to think that CalPERS–or anyone else in a similar situation–can earn 7.5% on a diversified portfolio of stocks and bonds?

reasonable?

Let’s assume an asset allocation of 50% stocks and 50% bonds, just to make the arithmetic simple.

bonds first.  Let’s say that the yield on Treasure bonds rises to 4% over the next several years and stays steady at that level from that point on.  When we’re there, CalPERS can earn the coupon each year by holding them, or 4%.  A 4% return on half the portfolio is a contribution of 2% to the entire portfolio   Note:  we already know that the return will be less than that over the time it takes for interest rates rise back to normal.

stocks.  To achieve a 7.5% return on the entire portfolio, assuming bonds deliver 2%, stocks will have to chip in 5.5% per year to the total.  This means achieving an average 11% annual return on the stock half.  How reasonable is this?  Well, over the past ten years the S&P has risen by 58%, or on average by a little less than 5% per year.  If we assume that inflation will remain contained at around 2%, an 11% return would be a whopping 9% real annual return.  Over long periods of time, stock markets around the world have averaged at best a 6% real annual return.

change the asset allocation?

Yes, we could up the overall return by shifting the asset allocation away from bonds and toward stocks.  But the stock portion would have to be above 90%–making calPERS’ assets vulnerable to wide business cycle swings in their value–before it could achieve a 7.5% annual return, assuming a 6% real return on stocks.

In short, the numbers don’t add up.  The biggest issue isn’t CalPERS’ ability, or lack of it, to manage money well.  It’s that the actuarial assumption of future returns is too high.

Over the recent decade or more, pension plans like CalPERS have tried the “magic” solution of alternative investments–hedge funds and private equity–to try to square the circle.  But most hedge funds continually produce returns to clients that are below the S&P 500.  And, again, the allocation to such dubious, and illiquid, vehicles has got to be very large to move the total return needle, even if one believed the promoters’ marketing claims.

changing the actuarial assumption

Interestingly, California has just announced that it is going to accelerate the process of lowering the assumed return on CalPERS investments to what sounds like a target of 6.5%.  To me, this is clearly the right thing to do, and the sooner the better.  But it will also show that CalPERS is more deeply underfunded than today’s official figures suggest.  It will likely mean that state and local governments will have to up their contributions to the fund.

That’s doable for California.  But what about the country’s government pension fund basket cases, like Illinois and New Jersey?  Following suit will show voters for the first timethe reality of how bad the situation is there.

# Calpers: one pension, two sets of books

For some time, the Los Angeles Times has been running articles aleerting readers to the troubles that California’s famous Calpers retirement system is having.  In a nutshell, the assets Calpers has on hand to meet future municipal employee pension benefits fall far short of what it will likely need.

The New York Times chimed in last week with a story about the troubles that individual cities, worried about their future and seeking to extract themselves from Calpers, are experiencing.

There are two parts to the latter:

–the “official” Calpers books give a relatively rosy picture of the current situation for each municipality.  They do this essentially by assuming the pension plan will eventually grow itself out of the problem.  The issue here is that their actuarial assumptions have lnot been adjusted down enough to account for today’s low-inflation, near-zero interest rate world.  In a sense, that pie-in-the-sky attitude would be ok with cities that want to leave Calpers   …except that Calpers presents potential leavers with a far different–and much higher–bill to bring their accounts up to full funding so they can depart.

–The Stanford Institute for Economic Policy Research has developed a Pension Tracker website where Californians in many areas can quickly look up how deeply in the hole their cities are.

Irwindale, a small town in the San Gabriel Valley of Los Angeles County, has the dubious honor of being #1 on the Stanford list of most exposed to pension shortfalls.  Irwindale’s Calpers account is short by \$134, 907 per household of having its municipal pension funded.  Irwindale has other woes–Huy Fong Srirscha, for example.  But with the Stanford pension info a mouse click away, who is likely to move to Irwindale?    …or to other cities high on the unfunded list?

Worse than that, I’d certainly be thinking of moving elsewhere.

California may be the most high profile instance of municipal pension underfunding, but it’s certainly not the only one.