Undone by our assumptions
James Saft is a Reuters columnist. The opinions expressed are his own.
As the people of the great state of California are finding out, very small changes in our assumptions about the world can have very large consequences.
The $230 billion California Public Employees’ Retirement System (CalPERS) will likely cut its expectation this week about how much the pension fund will earn in future years, reducing its “discount rate assumption” to 7.5 percent from 7.75 percent.
That is going to land the State and other employers with workers in the fund with a bill to make up the shortfall that could total upwards of $200 million.
And let’s not just pick on California; this is, or should be, happening all over the U.S. as government and private pension plans come to terms with the reality of a low-growth, low-return world. The median discount rate for leading U.S. public pension plans is 8 percent, according to the National Association of State Retirement Administrators, while consultants Milliman say the largest defined benefit corporate pension plans are banking on 8.1 percent.
Those figures are not only far higher than recent returns, they are very likely far higher than what it is reasonable to expect going forward.
As those assumptions fall, there will be intense pressure for higher contributions, lower benefits and — and here is where it could get really ugly — higher risk investments.
Here is what to expect as a result:
- More Wisconsin-style political conflict, as workers and employers clash over who will pay what to whom.
- More corporate earnings hits, as the recognition dawns that too many companies are hedge funds with businesses attached (Does anyone remember General Motors?).
- More risk-taking by pension funds as the intense pressure from the first two prompts pension funds to swing for the fences to avoid having to make painful choices. If you manage a hedge, private equity or emerging markets fund this will be very good news for you.
- This will not be a sudden process, it will be slow and grinding and will be made worse (or better if you like) as life expectancy assumptions improve.
“GREAT MODERATION” FALLOUT
While it is true that the current level of pension underfunding is caused in part by the atrocious returns on equities over the past decade, it may well be that this is not simply a cyclical problem which will come right as returns improve, but a structural one driven by much larger assumptions.
Returns over the past 30 to 40 years were driven by a number of factors that may prove to be either one-time benefits, pendulum swings that are in the process of coming back the wrong way, or illusions.
The conquering of inflation that began in the early 1980s allowed for higher prices of financial assets, particularly stocks. Having come all the way down, there is no more expansion of multiples possible from that source.
Secondly, deregulation and globalization allowed the percentage of GDP that flowed to profits to rise and rise. That flattered returns on stocks and corporate bonds. If that trend reverses, as well it might, and wages rise relative to profits, stock valuations will have to fall.
Thirdly, and this is crucial, the illusion otherwise known as the “Great Moderation,” a theory of ever shorter and milder recessions due to clever central banking, has been burst. Part of what the Great Moderation did was to lull investors, regulators and policy members alike into a false sense of security about how volatile growth and conditions may be.
That illusion of moderation encouraged risk taking, borrowing and speculation, all of which drove up the price of financial assets, notably stocks. Risk premia are being artificially suppressed now by easy monetary policy and willful blindness by regulators but that will unravel sooner or later, either via a spike in inflation or some other unexpected force. When it does, we face a few years of very poor returns in most of the things pension funds invest in.
As all of this unfolds, governments, corporations and individuals will face painful and divisive fights involving promises, taxes and expectations. Here is where we can expect the financial services industry to step in with its magic beans. After all, it is far more pleasant to earn a higher rate of return through “shrewd” investment than it is to save more, work longer and pay more in taxes.
This is already happening in New Jersey, which faces a huge pension fund problem and is in the midst of a political dogfight over who will bear the costs. The New Jersey Division of Investment, for example, recently hiked its upper limits on alternative investments such as hedge funds to 38 percent from 28 percent and for private equity to 12 percent from 7 percent.
Wish New Jersey, and California, luck. They are going to need it.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)