One thing I didn’t touch on in my posts about risk yesterday was that public pension funds have been taking bigger risks with the funds entrusted to them. At City Journal Steven Malanga explains:
Since 2001, the study found, most government pension funds have boosted their share of investments in riskier financial vehicles, from volatile stocks to real estate. During this period, pension funds achieved median annualized returns of just 6.4 percent, well below the goal of 7.5 percent to 8 percent returns. Only one pension system has met its investing goals since 2001. No wonder, then, that the indebtedness of state systems increased from $33 billion to a staggering $1.5 trillion.
The problem stems from politicians squandering the strong investment returns of the 1990s. Rather than banking pension systems’ rising surpluses in those flush years, elected leaders in California, Illinois, New Jersey, South Carolina, and elsewhere expanded worker benefits—promising that financial markets could underwrite the new costs. But economic downturns inevitably ensued, with market crashes in 2001 and 2008. The declines drained the systems of valuable assets, and when the Federal Reserve lowered interest rates, returns languished in safer investments, such as government bonds. The so-called risk-free rate of return—that is, the return that an investor earns from putting money into such instruments—fell from 5 percent in 2001 to just 2 percent today.
Forced to seek bigger gains elsewhere, pension funds have gambled more. Since 2001, the portion of state pension-fund portfolios invested in stocks and alternate financial vehicles rose by 10 points, to 77 percent. Portfolio managers chased these investments even as the pension systems matured, with a growing percentage of members nearing retirement. This approach departed from that of just about every other type of pension fund. As a 2014 study by the Society of Actuaries noted, “Public sector plans in the U.S. are unique in that they have taken additional risk as the plans have become more mature, compared to private sector plans in the U.S. and private and public sector plans in Canada, UK and the Netherlands, which have taken less risk as plans have matured.â€
The stock market isn’t like an annuity. The history of equities tells us that returns come in fits and starts. There can be many years of few if any returns followed by a few spikes of great returns. But that’s not what the assumptions of public pension funds need to meet their goals. They must realize 7.5% – 8% returns every year. All but a very few public pension funds have come anywhere near that so, consequently, they’re chasing greater returns by taking more serious risks.
That’s what will inevitably happen when assumptions are unrealistic and neither those putting the pension plans into effect, the beneficiaries of the pensions, or the managers of the pensions assume any risk. Worst comes to worst they can always fall back on the taxpayer.
Or can they? Illinois’s population is declining in absolute terms and on average those leaving have higher incomes and wealth than those remaining.
What I think should happen is that the pay and pensions of legislators should be contingent on the assumptions they’ve built into the plans they’re created being met. They are, after all, the people who are able to change those assumptions and plans. They need more skin in the game. Maybe even clawbacks. Maybe even clawbacks that exceed the state pay they’ve received—many derive much more income from peddling their contacts and influence than they do at their jobs as state legislators, cf. House Speaker Mike Madigan.
But all of that is a pipedream.
One good reason why we need to go to defined contribution plans for govt employees. Might have to raise salaries a bit to compensate, but well worth it.
Slightly OT, but did you know that federal employees just got a 2.6% raise? His decision to freeze their pay got a lot of coverage, but I didnt know he changed his mind until I talked this weekend with nephew’s friend who does military logistics. Doing everything he (Trump) can to put money in the economy for 2020 isnt he? What’s a little more debt?
Steve
I don’t know about you but my pay is the same as it was five years ago. I have never received a raise from my present employer and I honestly don’t expect to. To get a raise I would need to change employers and the older I get the fewer offers I receive.
It’s one of the reasons I find the demands of the CTU for a 15% raise over five years outrageous.
His figure of 77% allocated to equity and alternatives didn’t seem correct, so I did some digging. (It almost can’t be true due to distribution requirements) I came up with a figure of 68% fixed income pre-2007 vs 52% today. That seems more like it, but is still an eye popping number.
And a technical point. They don’t have to return 7.5-8% every year, but just over time. But that’s what the fixed income allocation is all about: not having to sell equities or alternatives at an inopportune point in time.
In any event, it is clear this was engineered by the Fed and its low interest rate policy. And so you have the nexus of yield chase and politicians who have made promises they cannot keep.
Concerning the notion of performance based legislator pay. Excellent idea, even if a pipe dream. In my business we have to clear a “preferred return” hurdle to investors (8% in the last fund) before we participate in the gains. And if we become over distributed there are formal clawback arrangements.
But once again, that’s the difference between the private and public sector.
It all goes to one question; is there a plurality; a majority; a supermajority that is willing to fix the pension crisis?
Without that; nothing will happen until a bailout or bankruptcy occurs.
At that point; the pain will be deterrent for a long time.
By the way; are the employees in these pensions in social security – if they are not; that is a real problem.
There is “over time” and then there is “over time”. From the late 1960s to the 1990s the DJIA had ZERO growth. In other words if you invested in April 1966 and you had cashed in any time prior to 1996 you would have taken a loss. I doubt the pension funds could survive that.
As the linked article noted, the return in Illinois has been around 5% for most of the last 25 years.
Some are; some aren’t. For example, most teachers do not participate in the Social Security system at all. They do not have FICA deducted from their paychecks; they do not receive SSRI. In theory they’re supposed to contribute to their own pensions but the reality in Illinois is that their employers typically pay the teachers’ pension contribution.
Chicago police officers, firefighters, city employees, and Cook County employees do not participate in Social Security.
At least in Chicago teachers’ pay is unrealistically high. Today the starting pay for a Chicago teacher for a nine month job is over $50,000 per year, bachelors only (most hold degrees from third rate colleges). Median pay is over $80,000. When their new contract is approved unless something drastic occurs starting pay will be over $60,000 and median will be over $90,000. When they retire they retire at 75% pay with a guaranteed 3% increment.
“There is “over time…”
That’s correct. Which is why the allocation to fixed income must be sufficiently large. I don’t think people who don’t have some facility with the basic concepts really understand how risky and structurally unbalanced the over-allocation/yield chase strategy is. And its why I say with a high degree of confidence that these pensions are simply waiting for disaster. Whether the portfolio returns 6% or 8% will be a second order issue compared with what will be a huge liquidity crisis as redemption requirements overwhelm available liquid funds.
This situation is Enron squared. In a just world screw the clawbacks; let’s talk jail time.
“As the linked article noted, the return in Illinois has been around 5% for most of the last 25 years.”
As a follow on, the way you get there is important. If fixed income returns 4%-5% (like pre-2007) you can look at equities and alternatives as an “equity kicker” that enhances yields. But the portfolio is not reliant on outsized returns or at risk due to fallow periods. More recently its been a reversal. Add on to that the giveaway during the heyday of equity returns and, well, you know.
Go long torches and pitchforks.
“As the linked article noted, the return in Illinois has been around 5% for most of the last 25 years.”
My wife and I met with our financial planner last week, and ~5% (before inflation) was what he said we should plan for as a year-to-year average.
As Mr. Micawber said, “Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” The assumption for Illinois’s public pension plans is 7.5% return.
The Madigans are hoping to deliver Illinois to a victorious Democratic Presidential candidate in 2020, who in boundless gratitude upon assuming office will make all their pension deficits go away, courtesy of a complaisant Congress and paid for by you, me, those filthy rich people who don’t contribute to Democrats, and the man behind the tree.
Andy – just my opinion, but an informed one. Have him run the numbers at 4. And depending on how old you are, hear Dave’s remark about an extended period of poor equity returns. Just run a scenario. I instructed my wealth manager: “I’ve already won the war. Don’t expose me to too much equity risk, I don’t need the return.†You also have a major decision to make on inflation. DFU.
Dave – they will achieve 7.5% with the same probability I go on the PGA Tour.
I think Tars is correct. They expected Big Hearted Hillary to win and bail them out.
My comment on social security is if these pension plans are (will?) ever unable to payout — some of these worker/retirees will have no other source of income.
The incentive to shoot those responsible AND bailout will be immense at that point.
It’s not quite that bad. You’re correct that the inflation-adjusted price of the DJIA didn’t return to April 1966 levels until late 1995, but that doesn’t take into account dividends. If you reinvested dividends over that same time period, your total return after inflation would be around a 300% gain, or about 4.8% annually.
That said, there are some bad protracted time periods in the history, even if you factor in dividends. For example, if you bought in April 1966 and reinvested dividends, you’ll have right around zero total gain (after inflation) until after May 1985. A 19 year span of zero growth is still pretty hard for any but the most conservative pension plan to weather.
You can play around with the dates here.
“And its why I say with a high degree of confidence that these pensions are simply waiting for disaster. ”
In the past this was usually followed by a polemic on your part about rates being kept too low and people taking on too much risk to chase yield. Now you dont say anything about keeping rates low. What changed?
“I don’t know about you but my pay is the same as it was five years ago.”
No raise from 2007-2017. Two since then since our labor market got tight. (The “experts” kept predicting that the total number of OR and related procedures would go down, but they actually increased. We also have a lot of demand in critical care so I now have a dozen ICU docs.)
Steve
As I’ve mentioned before, for a couple of decades I struggled to build my own company, taking a poverty-level salary in the process. Five years ago I gave up, closed my doors completely, and took a job working for someone else. I got a big raise in the process. But that was the last raise I’ve gotten.
I’m not quite back to where I would have been if I hadn’t started my own company.
You certainly do have a knack for saying some of the dumbest things, steve. The “correct” rate is the market rate. However, the Fed has engineered an easy credit environment. Recently they started raising rates rapidly, then shifted back. They just aren’t very good at this game. You wouldn’t take a profound alcoholic and have them go cold turkey withdrawal would you?
And since you seem to be having trouble following the points in the thread, that low rate environment, combined with politically driven sugary pension promises, has caused a dramatic shift in asset allocations in an attempt to make the cash in – cash out dynamics converge. Those allocations are risky, in that they are not consistent with the ability to liquidate positions to fund payouts without the potential for (in the case of illiquid alternatives) either fire sales into the secondary market, or just plain and simple temporary declines in equity asset values.
I will make it easier for you Drew. Just say “I am ok with the Fed targeting lower rates if it is what Trump wants.” When Trump champions higher Fed targets you will support that also. The “correct rate” is whatever Trump wants. (Note that I did not say “correct rates”, that was your term. I simply noted that in the past you criticized the Fed for targeting low rates but that stopped once Trump became POTUS.)
Steve