Friday, June 19, 2009

Markets/Economy: "Paul Krugman's fear for lost decade" and Why the Public Employee Union Pension Plans are Toast

My first thought when seeing that headline was "What does that mean for public employee pension plans?"
(yes, I really, really need to get out more)
Here's the headline story from The Guardian, I'll have the pension angle below:
...Will Hutton: You are warning that what happened to Japan could happen to the whole world. Japan's GDP at the end of this year will be no higher than it was in 1992 - 17 lost years. You are saying that this is an ongoing risk, certainly for the North Atlantic economy - maybe the world economy.

Paul Krugman: Yes. It's not that the risk of the Japan syndrome has receded very much. The risk of a full, all-out Great Depression - utter collapse of everything - has receded a lot in the past few months. But this first year of crisis has been far worse than anything that happened in Japan during the last decade, so in some sense we already have much worse than anything the Japanese went through. The risk for long stagnation is really high.

WH: So what is the heart of your pessimism? The bust banking system? A critic would say: "Hold on, Paul Krugman. Japan is a special case. It had an overblown export sector that had become too large for an American market it had saturated. The yen was very, very overvalued. And this interacted with a credit crunch and bust banking system. Its policy response was consistently behind the curve. That's not the story of the United States or the United Kingdom."

PK: The thing about Japan, as with all of these cases, is how much people claim to know what happened, without having any evidence. What we do know is that recessions normally end everywhere because the monetary authority cuts interest rates a lot, and that gets things moving. And what we know in Japan was that eventually they cut their interest rates to zero and that wasn't enough. And, so far, although we made the cuts faster than they did and cut them all the way to zero, it isn't enough. We've hit that lower bound the same as they did. Now, everything after that is more or less speculation.

For example, were the problems with the Japanese banks the core problem? There are some stories about credit rationing, but they are not overwhelming. Certainly, when we look at the Japanese recovery, there was not a great surge of business investment. There was primarily a surge of exports. But was fixing the banks central to export growth?

In their case, the problems had a lot to do with demography. That made them a natural capital exporter, from older savers, and also made it harder for them to have enough demand. They also had one hell of a bubble in the 1980s and the wreckage left behind by that bubble - in their case a highly leveraged corporate sector - was and is a drag on the economy.

The size of the shock to our systems is going to be much bigger than what happened to Japan in the 1990s. They never had a freefall in their economy - a period when GDP declined by 3%, 4%. It is by no means clear that the underlying differences in the structure of the situation are significant. What we do know is that the zero bound is real. We know that there are situations in which ordinary monetary policy loses all traction. And we know that we're in one now.

WH: So your point is that the crisis in Japan was about excess debt, excess leverage and lack of demand - reinforced by the fallout from the asset bubble collapsing. They didn't have credit contraction on anything like our scale, but even so, zero interest rates were just unable to turn the economy around.

PK: That's right, that's right....MORE

HT: John Mauldin at The Big Picture.

Now the relationship to public employee pensions. In "Public pension funds’ rosy forecasts pose problems" we linked to a story that pointed out:

...Lowering the projection of earnings by even a percentage point or two would create a funding gap of tens of billions of dollars.
CalPERS, an industry leader, warned its 1,500 local government members last fall that their employer contribution rates may increase from 2 to 5 percent of payroll in July 2011 if the stock market does not recover by June 30, the end of the current fiscal year....
Just so we're clear, those local government members are the California towns and cities that entered into contracts with the public employee unions guaranteeing those benefits.
When CalPERS investment returns fail to hit their targets the cities have to raise taxes/cut services to make up the shortfall. The link continued:

...After the big drop in the stock market last fall, the CalPERS investment portfolio, once a high flier, had an average annual return of 3.32 percent for the last 10 years, well below the forecast of 7.75 percent...

...Legendary investor Warren Buffet, in his annual letter to Berkshire Hathaway shareholders in February of last year, questioned the 8 percent earnings forecast common among the pension funds of major corporations.

“How realistic is this expectation?” Buffet said. “Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3 percent when compounded annually.”

The founder of Vanguard mutual funds, John Bogle, told a congressional hearing on retirement security last month that corporate pension funds raised their assumed earnings from 6 percent in 1981 to 8.5 percent by 2007, far above historical norms.

“And the pension plans of our state and local governments seem to be in the worst condition of all,” Bogle said, adding parenthetically: “Because of poor transparency, inadequate disclosure, and non-standardized reporting, we really don’t know the dimension of the shortfall.” ...

Here's the official CalPERS response:

Beware of the anti-pension ideologues who come out of the woodwork during market downturns. Like vultures, they prey on the highly charged and negative investment environment, looking for ways to convince you a temporary performance downturn will be typical for all time!

They know -- but don't tell you so -- that we set our rates based on a fiscal year investment return. They don't tell you that our assumed rate of return is made based on advice from a range of experts within CalPERS and within the industry and that it is regularly evaluated every two to three years in public session. They don't tell you what you would learn from a textbook on pension management: that some years investment returns are as expected; other years, they will be more than expected and yes, some years they will be less than expected.

They don't tell you that over the last 24 years, we have exceed our assumed rate of return 17 times, and eight of those years were more than double the 7 3/4 percent assumed rate of return.

(And here's an interesting fact: For five years after the Great Depression, there were multiple double digit return years.)

We will withstand the market swings, with our goal in mind: to achieve our assumed rate of return averaged over many, many decades. That's what we are designed to do. That's the math that matters.

Patricia K. Macht
Assistant Executive Officer
Office of Public Affairs

To my jaded eye that is nothing but smoke and/or mirrors.

So we are looking at the possibility of ten years with no growth. Why does that matter to the pension funds? In "Californians Eye Carbon Revenues" (And So Do the Public Employee Unions)" we linked to two articles, the first, from New American media: "Is a Carbon Tax Good for the Economy?"

The second, from EcoWorld:

Carbon Taxes & Public Sector Pensions

...Our position on sustainable investment returns, as we document in “Humanity’s Prosperous Destiny” is that it is impossible for a fund as big as CALPERS to earn a sustainable rate of return beyond the real growth rate of the economy in which they invest - and that is about 3.5% per year. Surprise! That’s what CALPERS has earned over the past ten years.

The “math that matters” is indeed how much a large pension fund can earn over the long term, and it is interesting that nowhere in the CALPERS response is a solid rebuttal offered to Evans’ statement they have only earned 3.32% over the past ten years. How high would the preceding 10-20 years of returns have to be, for CALPERS to actually have earned an average rate of return of 7.34%?

To answer this, assume a 30 year timeline, and a fund earning 7.34% on average over these 30 years. Let’s further assume this fund earned 3.32% over the last 10 of those 30 years. An investment that earns 7.34% interest for 30 years will increase in value by a factor of 837%. That is, $100 invested with a return of 7.34% interest per year at the end of 30 years will be worth $837. If in the final 10 years of this period, the rate of return is only 3.32%, then in the first 20 years of the period, the investment would have to earn 9.41% per year. Did CALPERS earn nearly 10% per year on average between 1978 and 1998? Unlikely. Adjusting for inflation - impossible....

The truly horrifying thing is the numbers are right. And the numbers don't care what my emotional response is.