Capitol Weekly, 7/9/12.
by Ed Mendel
In a reporting overhaul proposed last week to give investors a better way to compare pension funding, Moody’s uses an annual earnings forecast based on corporate bonds, 5.5 percent, much lower than the 7.5 to 8.25 percent forecast by pension funds.
Whether pension funds, which often expect to get two-thirds of their revenue from investments, can hit their earnings targets is at the center of the debate over whether public pensions are “sustainable” or will overwhelm state and local government budgets.
Sweeping cost-cutting pension reforms, which face lengthy legal challenges from unions, were approved by voters last month in San Jose and San Diego, where retirement costs are 20 percent or more of the city general fund and projected to continue growing.
In addition to a “lost decade” of low investment earnings, public pensions also are burdened by generous benefits. CalPERS famously said a trendsetting pension increase for state workers, SB 400 in 1999, would be paid for by earnings not taxpayers.
Now critics say unrealistic pension system forecasts hide massive long-term debt, easing pressure for urgently needed cost-cutting reforms such as lower pension benefits and higher payments into the pension fund from employers and employees.
The California Public Employees Retirement System, which lowered its forecast from 7.75 to 7.5 percent in March, says earnings over the last two decades hit the target and will do so again. Unions say alarmists exaggerate debt to weaken pension support.
What the Moody’s proposal, expected to be adopted after comment closes Aug. 31, adds to the debate is an informed view that tighter pension rules adopted by the Governmental Accounting Standards Board last month are inadequate for investors.
The Moody’s proposal not only gives major Wall Street support to the critics of pension fund earnings forecasts, perhaps moving them closer to the mainstream, but Moody’s also cites academic papers by the critics.
“Pension liabilities are widely acknowledged to be understated, and critics are particularly focused on the discount rate (same as earnings forecast: editor‘s note) as the primary reason for the understatement,” said the Moody’s proposal.
A footnote cites Alicia Munnell and others at the Center for Retirement Research at Boston College, Joe Nation at the Stanford Institute for Economic Policy Research and Robert Novy-Marx and Joshua Rauh at the National Bureau of Economic Research.
Nation, a former Democratic assemblyman from San Rafael, led Stanford graduate students who issued a widely publicized report two years ago showing how a lower earnings forecast caused pension debt to balloon.
With a bond-based earnings forecast of 4.1 percent a year, instead of the 7.5 to 8 percent in use at the time, the debt or “unfunded liability” of the three state pension funds increased tenfold, soaring from the reported $55 billion to about $500 billion.
The use of the lower earnings forecast based on U.S. bonds, the Stanford students said, reflected the view of economists such as Novy-Marx and Rauh that risk-free bonds should properly be used to offset risk-free pension debt guaranteed by taxpayers.
An earlier critic of pension earnings forecasts, David Crane, was removed from the California State Teachers Retirement System board in 2006, reportedly for repeatedly questioning whether the earnings target can be hit.
Crane, an investment banker and adviser to former Gov. Arnold Schwarzenegger, has continued to warn about the consequences of unrealistic earnings forecasts. He quoted legendary investor Warren Buffett in an op-ed article last month.
Another multi-billionaire from the financial world, New York Mayor Michael Bloomberg, made a memorable remark about lowering the earnings forecast for city pension funds, opposed by unions fearing higher costs could result in pension cuts.
“The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Bloomberg told the New York Times in May.
“If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”
Among several reasons listed by Moody’s for using a lower earnings forecast based on corporate bonds:
Higher forecasts used by pensions funds are not consistent with recent experience. The S&P 500 index grew at 4 percent a year during the last decade, and a third of pension assets are in “today’s low fixed-income yield environment.”
If pension systems had to borrow to meet obligations, “a high-grade corporate bond index is a reasonable proxy for government’s cost of financing portions of the pension liability with additional bonded debt.”
If pension systems wanted to get out of stocks and other risky and unpredictable investments, “high-grade bonds are an available investment that could be used in a low-risk strategy to ‘match-fund’ pension assets and liabilities.”
California pensions once were limited to bond-like investments with predictable earnings. Proposition 1 in 1966 allowed a quarter of investments to be in blue-chip stocks. Proposition 21 in 1984 lifted the lid, allowing any “prudent” investment.
Moody’s said its earnings forecast is similar to the Financial Accounting Standards Board requirement for the remaining private-sector pension funds. Many companies switched to 401(k) investment plans to avoid long-term pension debt.
The new rules for public pensions adopted by the Governmental Accounting Standards Board last month, after a lengthy process that began in 2006, use a “blended” earnings forecast.
Moody’s said the new GASB rules do not take effect for all governments until 2015, but earlier adoption is encouraged.
The purpose of the new way of reporting by Moody‘s, which began treating pension debt much like bond debt last year, is to apply a standard method of looking at pension fund debt, giving investors a better comparison.
“Our proposed adjustments will improve the comparability and transparency of pension information across governments, enhancing our approach to rating state and local government debt,” Timothy Blake, Moody’s managing director, said in a news release.
Moody’s said inadequate pension funding has already contributed to the downgrading of some states. The new reporting method is not expected to result in more state downgrades, but some local government ratings might be lowered.