California’s Misleading Pension ’Losses’

BLOOMBERG -- The executive of Sacramento County in California recently attributed the increase in his county’s pension costs to “investment losses during the recession.”

The official, Brad Hudson, is right that public pension costs are growing, but not that investment losses are to blame. To the contrary, these expenses are rising despite gains in pension-fund investments.

If not because of investment losses, what’s the reason?

Let’s start by assuming you left the Earth on Dec. 31, 2007, returned June 3, 2013, and had no news in the interim five-plus years.

When you left, the Dow Jones Industrial Average stood at 13,264. On your return it was 15,252, up 15 percent. Dividends provided an additional 2 percent each year. Fixed-income investments did even better because interest rates declined while you were away, with AA corporate bonds producing returns bettering 8 percent per annum.

From your perspective, it looks as if investments did just fine during your trip. And for long-term investors, you would be right. For example, the assets reported by the largest U.S. public pension fund, the California Public Employees’ Retirement System, are greater today than in 2007. So to whom is Sacramento County’s executive referring?

He’s referring to short-term investors who were forced to sell at the wrong time. Handed a newspaper from 2009, you learn that the country suffered a recession while you were away and that at one point the stock market dropped below 7,000. When that happened, short-term or leveraged investors who had borrowed money to buy stocks suffered investment losses when they were forced to sell equities at low prices.

LONG-TERM INVESTORS

That category of investor doesn’t include public pension funds. They don’t have short-term liabilities and aren’t forced to sell at the wrong time. Instead, they are invested for the very long term -- decades -- and are run by professional investors with the expertise to take advantage of market volatility. They are more like Warren Buffett’s Berkshire Hathaway Inc., another long-term investor that isn’t forced to sell when prices decline and has the resources to take advantage when prices fall.

The reason for rising pension costs has nothing to do with the recession or short-term declines on Wall Street. Public pension costs are increasing simply because liabilities are growing faster than assets.

Calpers is a good example. As an intermediary that administers pension promises made by the state of California and other public-sector employers to their employees, it collects contributions from employers and employees, invests those funds to generate earnings, and uses the proceeds to pay benefits to retired employees.

In 2007, Calpers reported that the pension liabilities of its largest pool of employers totaled $248 billion. By 2011, just four years later, those liabilities had grown 32 percent, to $328 billion. That rapid growth happens because pension liabilities grow (“accrete”) at the rate used to discount those obligations to present value, which at Calpers is a very high 7.5 percent per year. Pension assets must grow at that “hurdle” rate or pension costs rise. For example, to meet the rate at which pension liabilities were increasing in 2007, Calpers needed the Dow to reach 20,000 by now. Because it is at 75 percent of that level, pension costs must rise to make up the difference.

This isn’t a new phenomenon. To meet the rate at which pension liabilities were growing in 1999, Calpers needed the Dow to reach 30,000 by now. Because it is half that level, California has spent $20 billion more on public pensions than would have been the case had pension assets grown at the hurdle rate.

HURDLE RATES

It’s very hard for Calpers, or any other professional investor, to grow at such a high rate, which is almost double the rate at which Buffett’s pension liabilities accrete. Looked at another way, the Calpers hurdle rate is almost 15 percent greater than that at which the typical portfolio of pension investments grew in the 20th century. Calpers is a good investor, but the odds are against outperforming markets for decades, especially for very large investors.

Because public pension liabilities continue to grow faster than assets, Calpers recently announced a 50 percent increase in pension costs for governments, starting in 2015. For the same reason, Sacramento County needs to spend more on pensions to keep up with the growth of its liabilities.

Public officials need to be clear with their constituents that pension costs rise whenever pension funds fail to earn their hurdle rates. They should also acknowledge that total costs would be lower if the funds reduced their hurdle rates and required larger upfront contributions when pension promises are made.

That way, more money would be invested earlier, reducing the need to outperform markets. That shift would also be fairer to future taxpayers, who get no benefit from the services provided by past employees but have to cover pension deficiencies when hurdle rates aren’t met.