Let say you are in charge of running a pension fund, and it consists entirely of one paper asset that cost $20 to acquire and entitles the fund to a payment of $1 per year, which can be used to pay benefits. How much money is in your pension fund? Twenty dollars. And what is your expected future rate of return on your investment? Five percent, because $1 is 5.0% of $20. But let’s say that as a result of a speculative bubble, people start buying and selling pieces of paper identical to yours – and still only paying $1 per year – for $100? Then how much is in your pension fund? You probably shouldn’t, but you might say $100. But then, how much is your expected future rate of return? If you were honest you might say one percent, because $1 is 1.0% of $100.
But if you were the typical public employee pension fund manager of the past 15 years, and the typical actuary such funds were willing to hire, you would probably say the future rate of return was still five percent — even though you were only getting one dollar, not five dollars, in cash return, and even though 5.0% of $100 is $5, not $1. Because, it would be assumed, the trading price the piece of paper would keep going up and up. Or you might say that the future return would be ten percent, even though you were only getting one dollar and not ten dollars. Because it would go up even faster. That would allow you to hand out retroactive pension increases for politically powerful public employee unions, even though no money had been set aside for the added benefits during most or all of their career, and claim it would cost nothing. And/or underfund the pension fund, to divert money to other more politically powerful priorities. The nature of the pension lie was double counting: counting both the inflated asset values and the same, or a higher, rate of return from those inflated values. That lie is still being told today. Ordinary people not in on the deals, particularly in younger generations, will pay for the consequences of that lie for decades.
It isn’t really the case that we will have an ongoing pension crisis because of a technical issue regarding the expected rate of return. It is more the case that the public employee unions and politicians decided to steal some of our future, and the technical details were worked out later. For the most part the broader public was never told that pensions were being underfunded, or that they were being increased, since the deals were done in secret and no announcement was generally made. News coverage was very limited at the time, given the consequences.
Because there are various legal requirements around pension funds and public accounting, however, Comptrollers and pension actuaries were required to fudge the numbers after the fact. In the dry reports, bond offering statements and other documents cities and states are required to produce. Just as accountants were required to sign off on inflated estimates of profits, bond raters were required to sign off on inflated ratings of mortgage bonds, real estate appraisers were required to sign off on inflated appraisals, and executive pay consultants were required to sign off on inflated estimates of the going rate for executive pay. Go along with the deal, or you don’t get the job, and you are left on the outside with the serfs. And, they could promise, no one will go to jail, although some people probably should.
In fact, the very same double counting of inflated asset values and high future returns that has been used to justify retroactive increases in pensions for politically powerful public employee unions, was also used to justify the explosion of executive pay, as I wrote here.
In the 1990s stock market bubble, greater “shareholder value,” was used to justify higher executive pay. Some of that false shareholder value disappeared twice, in 2003 and 2008, before re-appearing with the help of zero percent interest rates from the Federal Reserve. But while stock prices are slowly regressing to the mean, over a series of cycles, executive pay was never cut back to what it had been. Now it is justified by the fact that top executives deserve to get what they have gotten, and nothing less. We deserve to get it because we have got it.
Speaking of stock prices regressing to the mean, imagine that the recent trading price of the one paper asset in our fictional pension fund were to fall by half, to $50? How much money would be in the pension fund then? If you said $50, then clearly you aren’t qualified to be a city or state Comptroller. Because after doing “market value restarts” when the stock market is up, asserting that the temporary asset price increases were both justified and permanent, pension actuaries, comptrollers and legislators have repeatedly elected to “smooth” the decreases when the stock market was down, on the grounds that the decrease was temporary and likely to be reversed. So the single asset that used to trade for $20 and then $100 but is now trading for $50 is reported on the books of public pension funds to be worth $90.
And what is the rate of return? Well that fictional asset is still paying out just $1, which is a just 2.0% of $50, and 1.1% of $90. What the unions, politicians and actuaries have done, however, is either keep the expected rate of return at 10.0% or claim they are conservative and reduce it back to 5.0%. But how can you have a 5.0% rate or return on $90, which would be $4.50, when you have a single paper asset that is probably only worth $20 at normal interest rates, and is currently trading just $50? Our public pension funds are not only assuming inflated future returns. They are assuming inflated future returns on money that does not in fact exist anymore, if it ever did.
The lie is backed by propaganda. Let’s say the latest stock market bubble does not deflate before the fiscal year of New York City’s pension funds ends in June. Then I’m sure you’ll hear announcements of how well the funds are doing based on market values. But if there is a correction, then I’m sure you’ll hear an announcement of how well the funds are doing based on actuarial values. Market values on the way up, “smoothed” values on the way down, with city residents 20 years from now paying public employees extra for work that they did 20 years ago based on pension deals that were cut five to 15 years ago and lied about ever since.
As I wrote a few years ago, the expected rate of return should be a rule and not a number. As asset values temporarily bubble up, the expected rate of return from those inflated values should be cut down. On the other hand, a market crash usually means better returns going forward. Although this has always been common sense to me, I didn’t see it mentioned elsewhere. Since powerful people – from Wall Street to top executive in general to politicians to mutual fund companies to public employee unions, have all taken more and more, and justified it based on the lie that trees grow to the sky. They have taken money off the top, leaving the serfs to deal with the distribution of the losses later.
Until recently. The Buttonwood blog of The Economist magazine has in recent years had a number of posts with rule-based estimates of a reasonable expected rate of return. Here is the most recent.
According to experts quoted by this source, “fair value for the S&P 500 is 1100 (as opposed to its level of around 1800) and the expected return is -1.3% per year for the next seven years after inflation. This is based on the market returning to normal valuation levels (in terms of price-to-book, returns on sales etc) over a seven-year period.” That’s right, minus when adjusted for inflation, including the current dividend yield of around 2.0%, which less than half its historic average (but double the 1.0% in 2000). “News Release: November 20, 2013: The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.72 percent.” That would put the nominal gain in stock prices at an expected plus 0.4% per year, which would be minus 1.3% adjusted for inflation.
After the seven years, perhaps stock values would be back to normal, and from that point one might assume historically average returns going forward. But by then many pension funds would be insolvent. That could happen sooner if there were an overshoot on the downside some time in the next decade, which is just as possible as the overshoots on the upside we have recently had. But there is no way anyone can expected historically average investment gains from today’s inflated asset values. That’s even more clear in the case of bonds, where any money the pension funds invest today gets locked in at historically low interest rates – with a massive decrease in bond value baked in if an when interest rates return to normal. But just about every pension fund is assuming inflated returns from inflated asset values.
With low interest rates, low inflation, low stock market returns since the peak of the bubble in 2000, and record high corporate profits as a share of the economy, how do the liars in chief keep lying? That’s what state Comptroller Tom (Mr. Smooth) DiNapoli, NYC actuary Robert North, and the new local liar in chief City Comptroller Scott Stringer get paid to figure out.
One recent innovation is to pay far more to Wall Street, and make the claim that this will allow higher returns than are available on stocks and bonds, thus justifying the inflated predicted rate of return. According to Crain’s New York Business investment fees paid by the city’s pension funds “climbed to $472.5 million in the year ended June 30, enough to pay the salaries of 6,440 teachers, a city report shows. The 28% gain is more than double the return on the $137.4 billion retirement system’s assets in the same period. In the past seven years, investment expenses for the pensions, which are overseen by the comptroller’s office, surged by $280 million.”
New York City’s push into high-cost hedge fund and private equity deals was the brainchild of union-backed controllers Bill Thompson and John Liu with the backing of the union controlled pension boards. Which is why you haven’t heard much about it here. Up in Rhode Island, a similar push was made by a State Treasurer who was elected on a pension reform platform, and was a former hedge fund manager. There, the public employee unions are claiming that the same policies are a pension raid by Wall Street. Are they?
We’ll probably know if, and to what extent, we’ve been robbed by Wall Street, when the stock market next plunges. If the hedge funds have in fact hedged, perhaps the market value of our pension funds assets wouldn’t go down as much. If they have just leveraged up, the losses will be massive. Either way, it will be hard for any alternative investment company to earn enough to justify all the extra money they pay themselves. California’s massive pension fund, CALPERS, tried to get more by shoving rent regulated tenants out of Stuyvesant Town. That didn’t work out too well for them. I, of course, believe that the public employee unions and Wall Street are looting less powerful people together. In New York, since those who don’t even get pensions will be forced to make up whatever is lost, the unions consider the alternative investments a “heads we win, tails you lose” gamble.
There is one pension lie that is even greater than double counting a normal long term rate of return from inflated asset values. Silence. Rob people, but don’t let them know they have been robbed. Let them get more and more dissatisfied with what they pay for public services and what they get in return, but never let them know why they are paying more for less. That’s really what Scott Stringer and Tom DiNapoli were put in those Comptroller’s chairs by the public employee unions and Wall Street to do. To not say anything that tells anyone what has really happened.
Here is an example of what is acceptable in public discourse, an overview of the fiscal legacy of the Bloomberg Administration published by Gotham Gazette. It runs for 4,329 words, but even though the greatest change in the city’s spending priorities over the past 12 years has been the increase in funding for retirement benefits, the word “pension” is not mentioned once. Not once.
The article contains, in fact, no facts about what categories of spending went up or down – as a share of the income of us city residents – at all. Nor any tabulation of how our local government spending and employment levels compare with other places. Nor any facts about how the total compensation of city employees has changed RELATIVE to the income of other city residents over the past five or ten years. Nor any facts on how New York City’s local government employment compared with other places by category, adjusted for the level of population. Just an assertion of how many $billions unionized public employees are owed based on an assumption that their pay should have done up relative to inflation back in 2008 and 2009 and stayed even since – even if the income of the average city resident has plunged relative to inflation.
One thing the author of this analysis was not going to do was look up American Community Survey data on how the income of city residents has fared during the same period. Which I did. Nope, facts are inconvenient for those taking money off the top, so they are unacceptable.
A couple of months ago I had a thought. Someday, someone might try to find out how we got into this pension mess. Perhaps as a part of some “Truth and Reconciliation Commission.” Chances are the city and state pension funds themselves will eventually burn or destroy all past records of their financial situation over the years, if such an investigation ever appears likely. But over the years, the pension funds have provided data to the Governments Division of the U.S. Census Bureau, and this detailed data is available on an “individual unit” basis for individual pension funds.
It occurred to me that someone ought to gather all that information that the Census Bureau has together for the currently active pension funds in New York and New Jersey for all the years available. The New York City teachers fund compared with the New York State teachers fund (which covers teachers in the rest of the state) and the New Jersey Teacher’s fund. The different police and fire pension funds. The funds for general employees.
And then it occurred to me that since doing so would require a massive amount of grunt-work, the only person likely to do it was me. Certainly, no one would be paid to produce this information – people are paid to NOT produce this information. So I did it, downloading the data for individual pension plans for individual years, sorting it, and copying and pasting it into a usable from. That rather large spreadsheet with a series of spreadsheets is attached here.