Pensions and partying like it’s 1999

San Diego Union Tribune

Californians questioning why their state budget is in perpetual red ink need look no further than the California Public Employees’ Retirement System’s (CalPERS) implicit forecast in 1999 that the Dow Jones Industrial Average would reach 25,000 by 2009, 595,000 by 2049 and 28 million by 2099 and that its investment earnings would rise alongside.

Based on that projection of robust investment earnings, the 1999 Legislature and governor massively boosted lifetime pensions for government employees without requiring increased pension contributions.

Ten years later, the Dow is at 10,500, 40 percent of that forecast, and because the state must make up for deficiencies in CalPERS’s investment earnings, the most recent state budget diverted $3.3 billion from government programs to pay for pension obligations. Going forward the diverted amounts will be greater and, in the absence of reform, there’s no end in sight.

The problem is that CalPERS is still acting like it’s 1999, recently telling a journalist (Sacramento Bee, Nov. 20) that now it implicitly forecasts the Dow to double in 10 years and hit 7 million by 2099. To put that in perspective, now CalPERS is implicitly forecasting that the Dow will grow nearly four times more than it did in the entire 20th century and do so in nine-tenths of the time.

To learn more about implicit forecasts and pension plan investment-return assumptions, read Warren Buffett’s annual letter published last February. While there, consult the annual report footnotes and you’ll see that Buffett’s implicit forecast for his own employee pension plans needs the Dow to close the century at only one-twentieth of what CalPERS initially projected and one-fifth of the level CalPERS now projects. While CalPERS is a competent investor, does it seem reasonable to assume it will perform five to 20 times better than Buffett and his successors, especially on a much larger (and therefore much harder to grow) amount of money?

More importantly, what happens when CalPERS’s forecast is wrong? Sadly, the damage is done to innocent bystanders down the road, such as the California State University system, parks and every other program that has its funding cut in order to pay for pension promises that weren’t properly funded upfront because of aggressive investment-return assumptions.

The higher the investment-return assumption when a pension promise is made, the lower the required contribution. For corporate CEOs, that offers a way to exaggerate earnings until after the CEO’s retirement. For public pension plans, it offers a way to obscure the true costs of retirement promises at the time they’re made. The difference is in who gets left holding the bag when the investment earnings don’t materialize. In the case of corporations it’s future workers and shareholders. In the case of public pensions, it’s future programs and taxpayers. That’s why California’s universities and other programs today are paying the price for yesterday’s unfunded pension promises and will continue to do so.

This is not just a problem of the recent market collapse. Even if by some miracle the Dow got to 25,000 by the end of this month, the state would still need the Dow to keep growing to 28 million by 2099 and to keep compounding at the same rate for there to be no impact on innocent programs. Simply put, this is what happens when non-cancellable promises are issued based upon mythical assumptions that extraordinary rates of return can be earned on large amounts of money over long periods of time.

Likewise, lowering payments for a year or two is not a way out of this problem. That sort of deferral – termed “super-smoothing,” in CalPERS’s Orwellian terms – is no different than the deceptive pay-option mortgage loans that lulled borrowers into thinking future house price appreciation would take care of accruing interest. Every such deferral is nothing but a high-cost borrowing that results in even greater cost, and the only thing smooth about it is the salesman trying to put it past you.

This is why pension reform means both reducing the size of pension promises for new employees and limiting investment-return assumptions so that governments are forced to properly fund pension promises.

Next time a public pension fund manager says not to worry about investment-return assumptions, ask them to repeat that same assertion to a child. After all, that’s whose money and future they’re risking. Better yet, schedule a school field trip to the next CalPERS board meeting at which investment-return assumptions are on the agenda.

Crane is special adviser for jobs and economic growth to Gov. Arnold Schwarzenegger.