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Home Publications Blogs Beat the Press Bringing Arithmetic to Public Pensions

Bringing Arithmetic to Public Pensions

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Monday, 05 August 2013 04:55

The NYT ran a column by former Los Angeles Mayor Richard Riordan and Tim Rutten which purports to present a plan to "avert the pension crisis." The piece hugely exaggerates the funding problem faced by pensions because of a simple logical error in its assessment of discount rates.

At one point it tells readers:

"America’s state and municipal pensions concede that they are underfunded by more than $1 trillion. If a more realistic expectation of returns on investment is pegged at 5 percent, then that collective liability climbs to $2.7 trillion. Moody’s further estimates that the median state has financed only 48 percent of its future pension liabilities."

The $1 trillion figure is based on return assumptions that are derived from rates of projected economic and profit growth from authoritative sources like the Congressional Budget Office and the Office of Management and Budget. In spite of Moody's assessment (yes, that is the credit rating agency that rated trillions of dollars of mortgage backed securities as investment grade), the pension funds are making realistic assumptions in reaching this figure. (Here is a fuller discussion of the issue.)

It is easy to see the source of Riordan and Rutten's confusion on returns. They write:

"California’s giant state pension fund, the world’s sixth largest, continues to assume it will earn 7.75 percent on its investments, even though its actual returns have been less than half that for a decade. Los Angeles continues to project similar annual yields on its investments, when the actual average returns are closer to 5 percent. As a consequence, the city’s unfunded pension obligations probably will grow to around $15 billion over the next four years."

Their problem is basing future return assumptions on returns in the last decade or a slightly longer past. The key issue here is the return on the stocks in which pensions typically keep close to 70 percent of their assets. Rather than being an indication of future returns, sharp movements in the market (either up or down) will push future returns in the opposite direction.

The logic is simple. Stocks represent a claim to corporate profits. While these vary from year to year, they do not change very much over the long-term as a share of GDP. This means that we can think of shares of stock as providing an amount of profits that grows roughly in step with the economy.

If there is a sharp run-up in the stock market, as was the case in the 1990s, then pension funds and other stock holders must pay lots of money for each dollar of corporate profits. (The ratio of stock prices to trend earnings rose to more than 30 in the 1990s stock bubble.) In this case, their future returns will be low.

On the other hand if stock prices fall, then the price of a dollar of corporate earnings is lower. This means that pension funds can anticipate higher future earnings. Therefore Riordan and Rutten have things completely backward when they imply that pension funds should expect lower returns in the future because stock prices fell in the recent past. (If the recent run-up continues, then return assumptions may have to be re-examined, but this would also mean that pension fund assets are higher.)

The take-away is that there are pension funds that definitely face problems, but this is almost always the result of politicians refusing to make required contributions. This is not a general problem. Many funds did make overly optimistic return assumptions in the 1990s and the last decade when price to earnings ratios were far above historic averages, however their current return assumptions are very much in line with economic realities. 

 

 

Addendum:

Some quick responses to points raised below.

First, pension funds hold a lot private equity (too much for my liking in many cases) so they would come pretty close to the story where they pick up new companies quickly in their holdings. So they should do better than the performance of just the S&P or even publicly traded companies as a group.

On the question of liquidity -- they are not 100 percent in stock. They will have short-term assets providing very low returns and also an inflow of money from current participants. It should very rarely, if ever, be the case that funds would have to sell stock at depressed prices to meet current obligations.

As far as Rithloz's charts, I'm not sure of his data source. (I'm not a subscriber to the service that made the charts.) I can say that the Fed's data shows a somewhat higher ratio of stock prices to nominal GDP than does Ritholz. (Here's my paper giving sources.) We look at roughly a 100 year period and find current ratios are roughly in line with the long-term average. Most other analysts who have looked at long-term stock returns, most notably Ibbotson, have come up with similar numbers. (btw, we always use trend earnings, so it doesn't matter whether the current profit share is inflated.

Comments (15)Add Comment
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written by foosion, August 05, 2013 7:40
A more sophisticated argument is the order of returns argument. It is not the case that you can withdraw 7% per year from a portfolio that averages a 7% per year return. The reason is that prices are variable, which means you can have to sell when prices are depressed. If there's a run of low prices early, subsequent higher returns won't make up the shortfall.

There's also the claim that because pension payments are fixed obligations, they should not be funded with risky assets or, at least, one shouldn't assume a higher return than can be generated by safe assets.

I'd like to see these objections refuted.
2% dilution
written by wkj, August 05, 2013 9:15
You say: "Stocks represent a claim to corporate profits. While these vary from year to year, they do not change very much over the long-term as a share of GDP. This means that we can think of shares of stock as providing an amount of profits that grows roughly in step with the economy."

That is not quite true. Assume on 1/1/2013 a pension plan owned .01% of every public company. Some of those companies will fail during the year and some new companies will be created. Unless the pension plan buys a piece of each new public company then at the end of 2013, the pension plan;s share of the public corporate sector will have been diluted.

If it does reinvest, its spendable return will be diluted. William Bernstein calculated this dilution as approximately 2% per year:

http://www.efficientfrontier.com/ef/702/2percent.htm
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written by skeptonomist, August 05, 2013 10:11
I think Dean ignores some potentially serious problems in long-term stock valuation. Both PE ratios and market capitalization

http://www.ritholtz.com/blog/2013/02/market-capitalization-as-a-percentage-of-gdp-4/

are still way above the pre-1995 averages. If stock prices go back to these older norms there will be big losses for any stock owners. If they do not, it will mean that stockholders are satisfied with returns which are lower than those pre-1995 averages - does that make sense? There is also the effect of current historical-high corporate profits which inflate the P/E ratio - are these going to continue? Because prices have been so high for the last 18 years, stock-market returns are just less predictable than either side thinks.

What is needed is expansion of the pension program (Social Security) that is tied more directly to national output. Pensions have been moving in the wrong direction - toward private investment accounts - for years.
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written by ltr, August 05, 2013 11:42
Dean Baker, your price earnings ratios differ greatly from those used by Robert Shiller and I would suggest Shiller is right and this stock market is highly priced indeed which makes future returns questionable unless the market stays historically overpriced indefinitely.

Shiller is the expert here and needs to be credited at least.
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written by foosion, August 05, 2013 11:52
Shiller uses 10 year p/e, Dean is most likely using normal p/e. There's no good evidence PE10 is any better at predicting returns (Vanguard has a recent paper showing neither method is great and one is generally as good as the other).

PE10 includes the effects of the recent recession, etc., from which business seems to have emerged. Therefore, normal p/e is likely better under current conditions.
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written by ltr, August 05, 2013 12:17
Just as with the historical data Shiller has on real home prices, Shiller has price earnings data extending to the 1880s and the data has been stunningly accurate on predicting long term stock market returns.

Looking at Shiller's data and absurdly low dividend yields for stocks, this market looks quite expensive.

Dean Baker has an intellection obligation to pay attention to the work of Shiller even if deciding to reject the work after explaining.
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written by ltr, August 05, 2013 12:21
"There's no good evidence PE10 is any better at predicting returns...."

I have no idea what this means, but I do know stocks and I know even the last 4 quarters for valuations this stock market is expensive.

Again, Dean Baker has an obligation to explain in detail why his valuation figures are better than Shiller's. I hope Baker is right, since I am pleased as can be with my stock portfolio, but Baker needs to argue fully.
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written by foosion, August 05, 2013 12:23
"P/E ratios have “explained” only about 40% of the time variation in net-of-inflation returns. Our results are similar whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller’s popular P/E10 ratio)."

https://personal.vanguard.com/pdf/s338.pdf
Those are some smart pensions
written by Mark Brucker, August 05, 2013 12:42
I'm curious how it is that the NYT ascertained that the pensions had "conceded" a $1T gap. Do the pensions have a spokesperson? A blog? That is bizarre language. Is the NYT really that clueless about logic????
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written by ltr, August 05, 2013 1:59
Foosion,

I will read the Vanguard study carefully and comment, and I am grateful the link.
Missing the elephant in the room
written by Jay, August 05, 2013 6:53
Why are you only focusing on pensions? At least ERISA forces governments to partially fund them. Government agencies are not forced (and typically pull a Detroit and don't fund at all) employee post-retirement health insurance benefits. $1 in cash paid to a retiree is no different than $1 in health insurance benefits, yet the accounting is different. Well one big difference, part of your pension is federally guaranteed. That cannot be said for post-retirement health insurance benefits.
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written by ltr, August 05, 2013 8:02
Dean Baker, I have read all the references through carefully but I dearly ask you to look at the work of Robert Shiller and explain why his market valuation differs so markedly from yours. This is a serious matter, and Shiller's work needs to be confronted.
Shiller focuses on the S&P, i look at all corporate stock
written by Dean, August 05, 2013 8:35
LTR,

here's a paper with exact references (Table numbers and lines) that gives the derivation of my projections http://www.cepr.net/index.php?...ew=article
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written by ltr, August 05, 2013 9:03
Dean, I am really grateful for the response and will carefully work through the paper now.
http://edmerls.com/blogs/post/977
written by http://edmerls.com/blogs/post/977, August 05, 2013 11:53

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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