August 05, 2013
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.
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