April 05, 2012
The Washington Post is always willing to accommodate those who want to make a big issue out of budget deficits. In that spirit it ran a column today by Robert Pozen and Theresa Hamacher warning readers about “public-pension pitfalls.”
The piece begins by decrying the fact that almost 80 percent of state and local government employees are still covered by traditional defined benefit pensions even as these pensions are rapidly disappearing from the private sector. This may seem a bizarre complaint to most people.
After all, few workers have been able to accumulate enough in 401(k)s to guarantee themselves any sort of security in retirement. In 2009, the financial wealth for the median household between the ages of 55-64 was only around $50,000, including all 401(k) assets.
Most public sector workers will have some pension income to support them in addition to just being dependent on Social Security. This might be considered a source of security that we would like to see brought back for private sector workers rather than eliminated for public sector workers. Of course this is the Washington Post.
It is also important to remember that close to a third of state and local employees are not covered by Social Security so their public pension will be their only regular source of retirement income. Somehow, Pozen and Hamacher forgot to mention this fact in their piece.
Next we are told that the unfunded liabilities of these plans are $600 billion. This is supposed to sound very scary, since $600 billion is a big number. To make sense of big numbers we need a context.
The planning period for a pension fund is typically 30 years. Over the next 30 years, GDP is projected to be over $400 trillion in today’s dollars. This means that the unfunded liability is equal to about 0.15 percent of projected GDP over this period. To make another comparison, relative to the size of the economy it is equal to a bit more than 3 percent of what we are currently spending on the military. Are you scared yet?
Next Pozen and Hamacher complain about the rates of return being assumed by these pensions in assessing their liabilities. They tell readers that the pension funds mostly assume 8 percent nominal rates of return but:
“Over the past 10 years, the Standard & Poor’s 500-stock index has achieved only a 1.9 percent annualized return.”
This one should be scary but only because Pozen is identified as a senior lecturer at Harvard Business School and he may be teaching this stuff to young people. What Pozen apparently missed is that we had a huge stock bubble in the late 90s that burst beginning in 2000. It was precisely because stocks were hugely over-valued in the late 90s (price to earnings ratios topped 30 to 1) that we had very low returns.
Some of us noticed this at the time and tried to warn that pension funds were being overly optimistic in assuming 8 percent returns when price to earnings ratios were so high. Unfortunately, Mr. Pozen was not among those issuing such warnings. Instead he sat on President Bush’s Social Security commision, which advocated privatizing Social Security based on the high returns it assumed to be available in the stock market.
However the flip side of this picture is that now that price to earnings ratios have returned to more normal levels, it is safe to assume that stocks will provide historic rates of return. This means that pension funds are being entirely reasonable in assuming 8 percent returns going forward precisely because the return on Standard & Poor’s 500-stock index was so bad over the last decade. In fact, it is almost impossible to construct a scenario in which pension fund returns will be substantially worse than what the pension funds are now assuming.
Pozen should know this, just as he should have been able to recognize that the stock market was hugely over-valued when he wanted workers to put their Social Security money in the market. There is a consistency in Pozen’s seemingly contradictory positions. It is the interests that are being served by his arguments.
Addendum:
I’ll respond quickly to a couple of comments below. First, the 8 percent nominal return for stocks is not based on historic performance. It is a calculation that assumes that firms pay out 60 percent of profits to shareholders (either as dividends or share buybacks), that the price to earnings ratio stays constant and that profits grow at the same rate as the economy. (We adjust for being somewhat above trend now.) If readers check the link to the calculator they will see that you need to make some unusual assumptions to get something much lower than an 8 percent nominal return.
One comment took issue with my comparison to 30 years of GDP. My calculation used a 3 percent real discount rate, it was not simply summing GDP over a 30 year period.
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