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Pension Cutter Confuses Stock Market With Las Vegas

Dan Braun

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“Public Pensions Need Gamblers Anonymous,” blared the op-ed by the American Enterprise Institute’s Andrew Biggs in the Wall Street Journal last week.

Can it be true? Did the trustees of CalPERS just take retirement funds for 1.7 million Californians – backed up by our tax dollars – to Las Vegas and put it all on black?

Of course not. Biggs is probably talking about speculating through black box investments and shadowy hedge funds, right?

Wrong again. The risky investing strategy we are warned against: the stock market.

As a measuring stick, Biggs trots out the “100 minus age rule,” which says that an individual should invest no more than that percentage amount in stocks and other so-called risky assets. (So a 30-year-old might have 70 percent of his or her investments in stocks and 30-percent in things like bonds, while a 60-year-old nearing retirement should put no more than 40 percent in stocks.)

Biggs takes California’s largest pension system as his example. In CalPERS (California Public Employees’ Retirement System), “The typical participant is around age 62, so a ‘100 minus age’ rule would recommend that CalPERS hold about 38 percent risky assets. In reality, CalPERS holds about 75 percent of its portfolio in stocks and other risky assets.”

This represents either a complete mischaracterization or a willful misrepresentation of the forces at play in a pension system.

The dynamics of pension funds are different than an individual’s retirement fund or 401(k). Not only that, they are different in exactly the ways that are important here.

For an individual, having a healthy mix of stocks in the portfolio is the best way to build funds long term. As the individual nears retirement, a much more conservative mix is recommended, because there is less time to make up potential losses or weak market years before retirement. The individual then retires, at which point his relationship to his retirement fund changes entirely. He switches from (ideally) contributing into the account on a regular basis, to withdrawing from it in order to live off of the funds.

For pension funds, there is no such retirement date at which everything switches. As of the most recent reports, CalPERS’ main fund was paying out monthly benefits to about 575,000 recipients (retirees, survivors and beneficiaries). Another 1.1 million members are in the system, the majority of them employed and paying into the system each month along with their employers. Those numbers will be largely similar for each following year, as about 30,000 participants retire annually. The system will not retire en masse, as Biggs’ setup implies.

If the average participant’s age is 62, it will be about 62 next year as well. (Some people pass away, lowering the average; others are hired, usually in their 20s and 30s, also lowering the average; while everyone else ages one year.) Evaluating the system as you would evaluate a 62-year-old just doesn’t make sense.

Age dynamics aside, are stocks just too risky for pension funds to invest in? Again, the wisdom behind investing in a higher ratio of stocks as a young individual is based on that being the best way to grow a retirement fund – far outpacing ultraconservative investments such as bonds and savings accounts. This is coupled with the understanding that, unlike with older individuals, there are many years to make up any short-term losses, both through better investment years and setting aside a little more to invest, if need be.

The dynamics of pension funds are different than an individual’s retirement fund or 401(k). Not only that, they are different in exactly the ways that are important here.

Pension funds similarly have a longer-term horizon and can be confident that they will not need to massively draw down their investments to pay retirement benefits at any specific point in time. The risk is that major losses will have to be made up in part by increased contributions from employers into the pension system. That means money coming out of public budgets, at the expense of other things we, as taxpayers, value. Indeed, we have seen employer contributions rise following the great downturn of 2007-08. This is largely the danger from which Biggs wishes to save us by investing conservatively.

However, to avoid the losses of those investments, we would also have to give up the gains they bring during other years. The most recent net rate of return for CalPERS funds was seven percent for the 10 years ending September 30, 2014. This includes the historic downturn of 2007-08, with its two fiscal years of negative returns, as well as a year that was all but flat (one percent in 2012). By any reckoning, this is a decade that includes a major dose of what-could-go-wrong. And it still came out at seven percent. Less than the 7.5 percent CalPERS planned for, but not by much. CalPERS’s 20-year investment return is 8.5 percent.

Biggs puts his conservative, mostly-bond investment mix at a safe five percent yield. If we go back a decade with CalPERS investments, what difference would that have made? The chart below shows three scenarios over nine years, starting from the $189.7 billion that CalPERS fund had on June 30, 2005: a smooth seven-percent return, a five-percent return and the actual rocky road of annual returns that the fund experienced. (Note that this is a thought exercise — the actual CalPERS fund doesn’t track perfectly with investment returns due to contributions and payments.)

calpers returns2

The ultraconservative five-percent returns would have left CalPERS about $43 billion short of its actual investment mix – that would have been the rough cost to our taxpayer-funded public budgets. All to supposedly save us from taxpayer costs. Biggs’ explanation:

. . . the fundamental misunderstanding afflicting practically the entire public-pension community is that taking more investment risk does not make a plan less expensive. It merely makes it less expensive today, by reducing contributions on the assumption that high investment returns will make up the difference. Risky investments shift the costs onto future generations who must make up for shortfalls if investments don’t pay off as assumed.

Biggs’ ultraconservative investment mix would protect us (and our future generations) from the cost of shortfalls if actual returns turned out to be below his five-percent annual return. This is a return below which the stock market has only fallen over an extended period three times in the past 100 years: during the Great Depression, during the late ’60s-to-early ’70s (quickly recovered in the ’80s) and in the twin recessions of the 2000s (quickly recovered in the last few years).

Again, the cost of insuring ourselves against an historic downturn with a conservative five-percent plan would have been $43 billion over a nine-year period that included a significant part of an historic downturn.

Looking back a little farther, that 8.5 percent annualized return of the last 20 years means CalPERS has nearly doubled the funds it would have made with a five-percent return. That’s the steep cost we would have paid for an ultraconservative approach.

It’s important to note that the discussion here is not about changing assumed rates of return, a policy discussion that many pension systems and their sponsors have engaged in lately. That discussion centers on how much investment income to assume looking forward, and consequently how much to adjust current contributions. (CalPERS, as mentioned, assumes 7.5 percent. The City of Los Angeles recently saw its three major pension funds reduce their assumptions from 7.75 to 7.5 percent.) Biggs’ plan would not only lower the assumption, it would all but guarantee that fund fell short of all but the most pessimistic of outlooks.

Over the past few decades, pension funds have made about 60 percent of their revenues through investment returns, on average, with 13 percent from employees’ own contributions and the remaining 27 percent from employer contributions – in this case our taxpayer-funded state and local agencies. It is certainly possible that future returns won’t be as good as they’ve been historically, and we the public might have to pay a little more out of our public budgets and pockets than we have before. But we shouldn’t let the chance that we could fall a little short of past returns scare us into guaranteeing that we fall short.

As any investor with a longer-term horizon will tell you, the best answer isn’t to avoid all risk; it’s to balance risk wisely – not at the roulette table, but in the market.

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