Thursday, March 12, 2009

Public pension funds’ rosy forecasts pose problems

From Capitol Weekly (Sacramento):

Pension funds have been hit hard by the stock market crash, losing about a third of their value in some cases, and there may be another problem.

Before the crash, some financial experts warned that pension funds were making overly optimistic projections of investment earnings in the decades ahead, often assuming about 8 percent a year....

...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.

Beyond raising rates to plug the big hole punched in pension funds by the stock market crash, the problem could get even bigger if forecasters decide that the critics are right, lowering projections of future earnings.

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.”

The plight of the public employee pension funds has drawn a creative proposal from U.S. Rep. Gary Ackerman, D-New York, to shore up two of the nation’s troubled institutions.

Public pension funds would pool some of their money and buy $50 billion to $250 billion worth of stock in banks. In exchange, the federal government would guarantee the pension funds an annual return of about 8.5 percent....MUCH MORE

Slick huh? Offload your state pension obligations to the Federal government under cover of bailing out the banks! By the way, that Buffett quote is from BRK's 2007 Annual Report. Starting on page 18, Warren talks pensions and expected returns.

Relying on memory, some years ago Berkshire froze its Defined Benefit plan and bought an annuity. If I recall correctly the annuity's interest rate was 6%.

Some BRK subsidiaries have DB plans, here are the assumptions (page 44):

...Weighted average interest rate assumptions used in determining projected benefit obligations were as follows. These rates are substantially the same as the weighted average rates used in determining the net periodic pension expense.
Discount rate .......................................................................................................................2007 2006
.................................................................................................................................................. 6.1... 5.7
Expected long-term rate of return on plan assets......................................................................................................................................... 6.9....6.9
Rate of compensation increase...................................................................................................4.4....4.4

Last week we linked to a Bloomberg story "Hidden Pension Fiasco May Foment Another $1 Trillion Bailout", which took public plans to task. Here's CalPERS response via the Sacramento Bee's The State Worker blog:
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

Alrighty then.
Some day I'll get around to the implications of this 1999 Los Angeles Times headline:
CalPERS, Flush With Market Gains, Wants to Boost Retiree Pay
Dot.bomb days.
Try not to mistake a bull market for brains.