How Rates of Return Affect Pension Contribution Rates

In the post “How Rates of Return Affect Required Pension Assets,” the point is made that depending on the rate of return achievable by the pension fund, there are significant changes to what level of assets are required for that fund to remain solvent. This post takes a slightly different approach; looking at an individual pension participant, how do pension fund rates of return affect how much they will have to contribute into their pension each year?

To make this estimate, the same set of assumptions are used in this post as in the previous post; they are:

  • The participant works for 30 years and they are retired for 30 years.
  • The participant earns a pension equivalent to 66% of their final salary.
  • The participant’s salary, in real (inflation adjusted) dollars, doubles at an even rate between the time they begin working and when they retire.
  • The rate of return and the rate of inflation are held constant throughout the 60 year period under analysis.
  • The rate of inflation is assumed to be 3.0% per year (this is CalPERS official projection, and is consistent with the historical average for the last 90+ years).

Here’s what we get:

There are a lot of takeaways here, but the most important is this:  Even at a return of 7.5% per year, which is actually slightly below CalPERS official long-term projected annual return of 7.75% per year, using these assumptions there is a contribution requirement of 24% of salary per year. This is well above what most cities and state agencies contribute to their employee pension funds each year. But what if pension funds acknowledge they will NOT be earning 7.75% per year any more? What if their earnings merely keep up with inflation?

As shown on the chart, for every 1.0% the real rate of return drops, the annual pension fund contribution as a percent of salary will go up by 10% or more, i.e., if the fund’s real rate of return drops from 3.5% to 2.5%, the amount required to be contributed into the fund as a percent of salary will go from 33% to 43%.

CalPERS spokespersons love to tout the “computer models” and “investment experts” who are confident they can continue to extract a long-term 7.75% return per year. But notwithstanding the fact that these are a lot of the same experts who had computer models that predicted the Dow Jones Average would reach 35,000 by 2005, or that there “might” be a housing bubble,  their confidence ignores several factors:

– The long-term inflation adjusted performance of publicly traded equities in the United States is not quite 3.0% per year, even taking into account dividend reinvestment. The Dow Jones average in 1930 was 286 (ref. Yahoo Finance), and the CPI was 17.1 (ref. Bureau of Labor Statistics). The Dow Jones average at the end of 2010 was 10,856, but the CPI had risen to 216.7. This means the inflation adjusted long-term performance of the Dow Jones average over the past 80 years was a paltry 1.4%. Compare this to CalPERS official long-term, inflation adjusted projection of 4.75% per year.

– Don’t rely on inflation to bail out pensions. The 2.0% annual cap on COLAs automatically lifts when pensioners have lost 20% of their purchasing power – the liability will then remain proportionally intact. This means it remains the fund’s real rate of return, after inflation, that has to be maintained.

– The potential of the U.S. economy to grow over the past 60 years, fueling these higher-than-sustainable historical returns for CalPERS and other pension funds was for two reasons that will not apply today: (1) the U.S. economy 60 years ago was the world’s only intact post-WWII economy, and grew at an extraordinary rate as we exported manufactured goods to the recovering economies elsewhere in the world. Today our manufacturers face formidable competition from developed and emerging economies all over the planet, (2) as the U.S. began to encounter global competition over the more recent decades, the U.S. embarked on a debt binge that is coming to an end.

– In past decades pension funds represented a smaller slice of the economy, meaning that they could beat the market without causing distortions. Today pension funds are the single biggest source of new investment in the U.S. They can no longer expect to beat the market. They are too big.

– A related challenge is the fact that pension funds are now servicing a growing number of retirees. The ratio of retirees to workers is approaching 1-to-1, meaning that fund withdrawals to make pension payments is reducing demand for equities because the pension funds are doing more selling than ever before. This, too, puts downward pressure on equities.

– The recent rise in equity values has to be viewed in the context of the above factors, which means what goes up may be coming down, but also in the context of the strength of the dollar. As the dollar devalues, the real value of U.S. equities shrinks apace. But if the underlying viability of these companies has not changed, their dollar denominated equity value has to adjust upwards in order for their value to stay neutral when compared to foreign currencies. And if the dollar strengthens (since all nations are competing to devalue their currencies these days), the value of U.S. equities – all else being equal – will fall again. And, to complete the thought, if the dollar doesn’t eventually rebound against foreign currencies, domestic inflation will offset any gains in equity values driven by dollar devaluation.

A serious discussion about what rate of return gigantic pension funds can really earn in America in this era, as opposed to previous eras, has not yet taken place. The performances of massive government worker pension funds hold dire implications for taxpayers who are on the hook to cover the difference whenever expectations do not meet reality. For these reasons, it would behoove CalPERS and other pension funds to trot their economists into the limelight to defend their assumptions, instead of hiding behind soundbites uttered by public relations specialists with well-modulated voices.

Require CalPERS to Invest 100% in California?

According to the CalPERS website, in their California Investments section, “as of January 31, 2011, approximately 10.3 percent of CalPERS total assets are invested in California.” This means that out of the $233.5 billion in assets under management by CalPERS (ref. Current Investment Fund Values), $24 billion is invested in California.

Apparently CalPERS would have us believe that investing 10.3% of their assets in California is a praiseworthy accomplishment, since their disclosure goes on to state “CalPERS is one of the largest investors in California – providing jobs, services, and a financial boost to the State’s economy.” But why shouldn’t CalPERS invest 100% of their funds in California?

Back in 2004 I attended a business forum focusing on the Sacramento region, and listened to a panel of experts discussing California’s economic prospects. One of these experts was an investment manager from CalPERS, who stated with pride that “fully 20% of CalPERS investments are made in California.” (Note: it’s only half that much today) At the time, I asked him why we should be impressed by the fact that 100% of CalPERS funds come from California taxpayers, yet only 20% of those funds go back into California-based investments. His answer was instructive: “We have to invest where we can realize the largest returns.”

The debate over whether or not public employee pension funds are sustainable hinges on one key question: What are the largest sustainable, long-term returns possible? And from that standpoint it is completely rational for CalPERS, and CalSTRS, and the dozens of smaller California-based public employee pension funds to invest their money elsewhere: China, India, Brazil, Texas, Wyoming, wherever. But since public employee pension funds are operated for the benefit of public employees, who, through their unions, virtually control California and are largely responsible for the regulatory environment that has made places like Brazil and Wyoming far more lucrative places to invest, it would be fitting to require 100% of pension fund investments for California’s employees to be invested in California.

This one reform – requiring CalPERS to invest 100% of their funds in California – would have several salutary benefits. First of all, it would force an honest discussion as to what rates of return are truly achievable and sustainable. And, obviously, it would be a tremendous boon to California’s economy. After all, if investing 10.3% of CalPERS funds has provided “jobs, services, and a financial boost to the State’s economy,” imagine what benefit might accrue if ten times as much money was invested in California?

Libertarians and free-market advocates may correctly criticize this proposal as being counter to their principles of open markets and free trade, but these principles might be better applied to private money – CalPERS and the other public sector pension funds are using taxpayer’s money. And by forcing these funds to invest exclusively within the markets where these taxpayer’s live, these taxpayers will at least enjoy the economic stimulus created by these investments, even if they can’t enjoy these generous pensions themselves.

Even more important, by forcing California’s public sector pension funds to invest exclusively in California, an honest conversation will be started at last regarding how California’s business climate has been ruthlessly suppressed. It is more than ironic that the public sector unions – who are largely responsible for California’s hostile regulatory environment – allow their pension funds to turn to Wall Street’s globalized investment apparatus to realize rates of return that they themselves have made impossible to achieve in California.

If public employees and their unions knew that the rates of return their pension funds will earn are going to be based on how healthy the business climate is right here in California, they would be far more likely to advocate a rational recalibration of California’s taxes and regulations. They would also be more likely to accept that an inflation adjusted rate of return of 4.75% (CalPERS official rate) is probably too high, and accept reasonable cuts to their current and future pension benefits accordingly.

How Rates of Return Affect Required Pension Assets

While pension finance is a relatively obscure discipline that requires of its practitioners expertise both in investments and actuarial calculations, it is a mistake to think the fundamentals are beyond the average policymaker or journalist. One policy question of extreme importance to discussions about the future of public worker pensions is how much pension funds can legitimately expect to earn over the long term. The reason this question is critical is because the more the pension fund earns, the lower the annual contribution will have to be. Just how much lower each percentage point gain offers is startling.

In the first table (below), conservative assumptions are offered towards estimating how much the pension funds of California’s state and local workers must earn each year. The number of active state and local government workers is fairly well documented at 1.85 million (including K-12 and higher education). The $68,000 per year annual salary is actually low, since that is the average salary, and pension fund calculations are based on the higher final salary. This means the $68,000 figure is accurate for estimating the money flowing into the pension system, but will understate the amount of money flowing out of the pension system to retirees. Similarly, the 33% average pension fund contribution is on the high side – typically only public safety employees, who are only about 15% of the state and local government workforce, contribute amounts over 30% of their salary into the pension funds. But based on these numbers, each year California’s state and local workers pour $41.5 billion into the state and local government worker pension funds.

The second half of the table (above) estimates how much money comes out of the state and local government pension funds each year. This projection shows a ratio of retirees to active workers of 1-to-1, based on the assumption that – using full-career-equivalent workers and retirees – the average worker is employed for 30 years, and is then retired for 30 years. This is an important concept to linger on, because the concept of “full-career-equivalent” is crucial to understanding why CalPERS spokepeople are accurately able to claim the “average” pension is only $25,000. In reality, that is only true when considering all employees who ever passed through the CalPERS system – even if they only worked for five years and barely vested a pension.

This concept also applies when calculating the “average pension as percent of salary,” where based on existing pension formulas, 67% is on the low side when dealing with full-career-equivalent numbers. Typical government pensions in California accrue between 2.0% and 3.0% per year – teachers, who are 40% of the public workforce, who work 30 years receive 2.5% per year, public safety workers, who are 15% of the workforce, receive 3.0% per year. It is common for public utility workers to receive 2.7% per year. So estimating an average pension of $45K per year, based on 67% of $68K, is almost certainly on the low side. This means California is projected to pay out $83 billion per year to their retired state and local workers. In reality, current formulas and data suggest they will pay out a lot more than that.

The point of the first chart is that the money going into the government worker pension funds in California is estimated to be $41.5 billion per year, and the amount of money being paid out of these pension funds to retired state and local government workers is projected to be $83.8 billion per year. This means $42.3 billion per year will have to be earned on the market through investment returns.

The second chart (below) shows what the necessary asset balance is based on various rates of return. The calculation is extremely straightforward – take the amount that has to be earned each year, and divide that amount by the rate of return the fund is going to deliver:

As can be seen, at a rate of return of 7.75%, which is CalPERS (and most other government worker pension funds) official long-term projected rate of return, “only” $545 billion in assets are necessary for these funds to be “fully funded.” But if this rate of return is dropped by a few percentage points, the necessary assets mushroom. What if pension funds were required to stop making risky investments and instead had to buy treasury bills? Don’t be surprised if that is necessary someday – for example when nobody else will buy T-bills… What an elegant solution to the challenges posed by quantitative easing. But California’s pension funds would go from being fully funded at $545 billion to being only 39% funded – and the necessary asset balance would increase by $864 billion to $1.4 trillion.

The reason we don’t hear more about the serious discussions over what the real long-term rate of return should be for these massive funds is because they are occurring behind closed doors, and the reason for that should be clear by studying the above table. How on earth would Californian taxpayers cough up $864 billion? How and when will the actuaries and investment experts deliver this shock to the system?

Because current pension benefits have a cost-of-living-adjustment cap of 2% that is lifted as soon as the purchasing power of the pension benefit erodes to between 75% and 80% of the original award, don’t expect inflation to bail out the government worker pension system. Even more alarming than the nominal projection of 7.75% used by CalPERS is their real rate of return – they assume 3.0% inflation and expect an inflation-adjusted return of 4.75%. That may have been possible in the days when asset bubbles were inflating which collateralized what is now $50 trillion in debt (commercial, household and government combined) in the U.S., but those days are done.

Even if pension funds – that in aggregate in the U.S. currently manage about $3.0 trillion in assets – could earn a 4.75% (long-term, after inflation) return, they would do so by beating the market. This means other market participants, i.e., individual small investors with their 401Ks, would lose. This predatory relationship between large public sector pension funds and the small investors is ignored by apologists for public sector pension funds, who both claim “Wall Street” is to blame for the 2007 market crash, yet rely on Wall Street to deliver for them, decade after decade, higher than market rates of return.

Finally, if taxpayers are to fund market investments for the purposes of augmenting the retirement assets available to workers in the United States, it should be for ALL workers, not just government workers. As it is, however, the existence of gigantic, aggressively managed funds whose entire risk is borne by taxpayers creates a dangerous distortion in the investment market. It is ridiculous that in an era of unavoidable debt reduction, when the federal composite borrowing rate is less than 1% per year, taxpayer supported Wall Street entities – i.e., government worker pension funds – are claiming they can earn 7.75% per year. The longer they cling to this fiction, elevating their portfolio risk to achieve the unachievable, the more volatile the entire market will become.

Policymakers have to face the fact that when these projected rates of return come down, and they will, government worker pensions as they are currently formulated will disappear. Hiding behind the “complexity” of this issue, and instead echoing the sanguine talking points of CalPERS spokespersons who have not sat in the closed door meetings, is simply irresponsible.

Which Special Interests Are Partisan?

A commenter to the previous post, “Is Union Reform Partisan,” took issue with the observation therein that corporate political spending is less partisan than union political spending. The commenter requested evidence to back up that claim, and suggested that not only is corporate spending equally skewed in favor of Republicans, but that corporate political spending far outweighs political spending by unions. These are fair questions, and the data that follows draws from the same source used in that post, which documented that 95% of union spending goes to Democrats.

Parsing data from OpenSecrets.org, again, “a nonpartisan, independent and nonprofit research group tracking money in U.S. politics,” this time I will present information on all of the top 100 political spenders during the eleven election cycles between 1990 through 2010. These top 100 are divided into four categories; corporate, financial, union, and grassroots. The results were quite surprising, as summarized on the chart below:

The data used to generate these numbers comes from OpenSecrets.org’s “Top All-Time Donors, 1990-2010” table, which I downloaded onto spreadsheets and sorted into the four categories noted, while retaining in the far left column the rank of each contributor within the top 100. So the reader may view my assumptions, all four of these tables constitute the remainder of this post.

Readers are invited to mull the implications of these findings regarding the top 100 political spenders of the last 20 years in America:

1 – The corporate and financial sectors combined did outspend unions, by a ratio of almost exactly 2-to-1.

2 – Unions spent 95% of their contributions on Democrats.

3 – The corporate sector spent 56% of their contributions on Republicans, and the financial sector spent 53% of their contributions on Republicans. Their spending between the two parties was essentially nonpartisan.

4 – Overall, among the top 100 political spenders of the last 20 years, Democrats collected 62% of the takings, and Republicans only collected 38%.

It remains open to interpretation which party might be more beholden to special interests…

Here is the data:

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