Archive for category PERA
This is an extended version of the OpEd that appeared in the Greeley Tribune.
Last week, Colorado legislators considered – and rejected – a plan of dubious legality to shore up the state’s public pensions.
The result of a difficult three-way negotiation among Governor Hickenlooper, Treasurer Stapleton, and PERA, the plan would have circumvented the state Constitution’s limits against issuing general obligation debt without a vote of the people, for gains that would have been largely illusory.
Worse, the changes could have encouraged future legislatures to repeat mistakes that put teachers’ and state employees’ retirements at risk in the first place, while making real reforms more difficult.
HB15-1388 would have authorized the State Treasurer to direct the Colorado Housing and Finance Authority (CHFA) to issue up to $10 billion in bonds on the state’s credit. The proceeds would have been deposited into PERA’s State and School funds, and invested with the rest of PERA’s assets. The investment returns theoretically would shorten PERA’s time to full funding.
The bonds’ interest was to be funded by the supplemental payments that the state and school districts pay into PERA (the AED and SAED), with PERA paying back the principal when the bonds matured. The AED and SAED payments are taxpayer contributions established in 2004 and 2006 to stabilize PERA’s finances. They are escalating percentages of employee salaries.
The complex web of relationships was needed to avoid state constitutional limits on issuing debt. The bill’s language laid out the legal arguments for why the restrictions didn’t apply. Supporters claimed they were revenue bonds that would not obligate general tax dollars, and purported that CHFA is not a state agency.
Passing the buck to the courts, HB 1388 would have required a binding judicial ruling certifying the scheme’s legality before the bonds could have been issued.
Make no mistake: The debt would have been on the state’s credit, and shown up on the state’s balance sheet. These are not revenue bonds; they would have been funded only by general tax revenue.
Whether or not the game of hide-the-pea satisfied the courts, it violated the spirit and purpose of constitutional provisions designed to prevent the legislature from indebting citizens into a long-term fiscal bind. The many state bankruptcies of the 1840s were still fresh in the people’s minds in 1876, when the Constitution was drafted. Those concerns are no less valid now.
The bonds wouldn’t have shown up in PERA’s financial report, except in the footnotes. With no single, authoritative document laying out the full financial picture associated with funding the state’s public pensions, PERA would look better-funded than it was.
Risk-averse legislators could have justified avoiding the difficult decisions needed to provide real retirement security for Colorado’s teachers and state employees. Future legislatures might have been tempted to repeat the mistakes that put that security at risk in the first place. While a full legal analysis awaits, tying the AED and the SAED explicitly to a bonded debt might have complicated any attempts at more sustainable reform.
A comprehensive study by the Center for Retirement Research found that the misuse and mistiming of pension obligation bonds have punished numerous states and municipalities over the last 20 years. The Government Finance Officers Association recommends against their use.
To their credit, the bill’s architects studied past failures and tried to mitigate the risks to Colorado and its schools. The annual interest on the bonds could have been no larger than two-thirds of each year’s anticipated AED and SAED, with a minimum 2 percent spread between the bond interest rate and PERA’s anticipated rate of return. Statutory contributions to PERA – inadequate though they are – would have remained intact, and bond proceeds would have been unavailable for diversion to other spending.
Still, the deal entailed significant risk. Proponents misleadingly argued that it refinanced 7.5 percent debt at 4.5 percent. In an actual refinance, the original obligation is paid off. Here, the pension obligation would have remained, with Colorado taking on additional debt.
Even PERA’s claim that its current debt should be discounted at 7.5 percent is based on an accounting gimmick only available to US public pensions – and no other pensions in the world. (Not coincidentally, without the discipline of correct accounting, US public pensions are also the worst-funded public pensions in the world.)
As contractual promises, they should be discounted at the same interest rate as the bonds. PERA would just be adding 4.5 percent debt to the true 4.5 percent debt of its current contractual obligations, improving its situation only marginally.
The proposal’s safeguards would not have changed the fact that proponents were seeking to close the funding gap by taking on additional debt and risk.
While the governor and the treasurer are to be credited for taking PERA’s underfunding seriously, HB 1388 was the wrong answer to the problem.
Late last week, the redoubtable Andrew Biggs of the American Enterprise Institute published a state-by-state comparison of full-career public pension retirement benefits, in that organization’s monthly Economic Perspectives. While news of PERA’s long-term fiscal problems won’t be a surprise to anyone reading this blog, it may come as a surprise to learn that Colorado ranks among the most generous states when it comes to that measure.
In nominal dollars, Colorado ranks fourth in the country, at just over $60,000 for an employee who spends his entire career in the state civil service. The $60,420 per annum figure ranks just behind California and Alaska, and considerably behind Nevada’s $64,000. When adjusted for the states’ relative cost of living, as calculated by the Council for Community and Economic Research, Colorado jumps well past both California and Alaska, into 2nd place.
Biggs also noted that the present value of these benefits can create “pension millionaires,” whose benefits exceed $1 million in today’s money. When Colorado’s benefit is compounded at the maximum 2.0% COLA, and then discounted using a 3.5% risk-free discount rate, the total comes in at $1.25 million in 2014 dollars, assuming the beneficiary retires at 60 and lives to 82.5 years of age.
As Biggs points out, the need to stay for an entire career in order to collect benefits, at the same time that they forego Social Security benefits for those years, is a serious disincentive to retaining qualified and motivated public employees. Those who leave – or arrive – in the middle of their career get shortchanged the most, since vesting and benefits are not proportional to the years served.
The problem here isn’t that workers are greedy, or that these benefits themselves are unsustainable. It’s that the results are unfair to the majority of workers, who find their own benefits shortchanged in order to fund the retirements of full-career public servants. A conversion to a defined contribution plan, where workers are always fully vested in their own contributions would help to solve this problem, and be much fairer to the majority of workers who do not spend their entire careers with the government.
My introductory at-bat in the Independence Institute’s lineup at the Greeley Tribune:
The assumption of a 7.5 percent return masks considerable risk and volatility. Although catastrophic market years such as 2008 have historically been rare, smaller routine losses are to be expected. Those losses can force an already-underfunded system to eat its seed corn by paying benefits out of assets that should be earning returns.
As a result, considerable risk exists that in the future, the state will still need to cut benefits to those who are already retired, to raise taxes, to cut services, or all three.
There is a way out.
I suggest three reforms that would help solve the problem. We’re no longer in a budget crisis. The Democrats’ passion for spending every last dime that comes in on new programs that will cry poor in the next recession may fix that. In the meantime, though, now would be a good time to fix this.
Today at PERA’s testimony in front of the Colorado legislature’s Joint Budget Committee, the subject of the revisions of GASB’s public pension accounting rules came up. While PERA produced the usual song and dance about discount rates, one portion of the discussion was illuminating.
It turns out that each district that participates in PERA will have to show a pro-rated portion of that fund’s liability on its own balance sheet. PERA makes a couple of comments about this; first, that this is an unusual liability that can’t be brought forward, and second, that there’s nothing that the district can do to reduce it. The first comment is the usual stuff that public pensions always use to justify their higher discount rate. The second requires a little explanation.
You need to remember that the unfunded liability is PERA’s, and it’s only being distributed for accounting reasons to the various districts. The PERA funds are managed by PERA on behalf of the individual members, not on behalf of the districts. The districts have an annual required contribution based on the salaries of the individual PERA members working there, but that’s it. Their contributions go into the appropriate PERA fund, and become the property of PERA. There’s no “JeffCo School Account” at PERA, or “Mesa County Employees” account.
Which means that there’s also no way for the individual district to discharge it own portion of PERA’s unfunded liability, even if PERA were permitted to take additional contributions from employers, which it’s not.
Suppose the School Fund has an unfunded liability of $10 billion. Suppose 5%, or $500 million of that, is attributable to JeffCo School. And suppose JeffCo, in a Herculean effort, raises $500 million in taxes to pay it off, and ensure that they never have to worry about their portion of PERA’s unfunded liability again. JeffCo School cuts a check to PERA for $500 million. And that money goes into the Big Barrel called, “PERA School Fund,” reducing its unfunded liability by 5%, to $9.5 billion. And the next year, JeffCo’s Schools gets a Thank You Note, along with a notice from PERA that they are responsible for 5% of PERA’s School Fund unfunded liability, or $475 million. That’s what PERA means when it says that this is a unique liability for districts – they can’t really do anything about it on their own, but there it sits, on their balance sheets, screwing up their ratios.
Yes, ratios. It turns out that the Colorado Department of Education does a Fiscal Health Analysis on the various school districts, and a key part of that analysis is certain ratios, three of which (Asset Sufficiency, Operating Reserve, and Change in Fund Balance) depend on the districts’ General Fund Balance. CDE hasn’t disclosed yet how they’ll deal with this change, but if it were up to me, I’d more or less ignore it in that analysis. The liability really belongs to PERA, not to the district, and since the legislature will ultimately fix (or not) the problem, it’s almost impossible to know how it relates to any district’s current demographics, employment, or finances.
Last Thursday, Colorado PERA Executive Director Greg Smith gave his annual SMART Act testimony to the Joint Finance Committee of the Colorado General Assembly. Since 2012, all departments of the Colorado state government have been required to testify during the interim concerning their operations, their efficiency, and the degree to which they are fulfilling their mission.
PERA recently changed its assumed long-term rate of return from 8% to 7.5%. In light of that change, its amortization period – the time when PERA will have no unfunded liability, assuming a constant rate of return – has grown from 30 years, probably to something near 40 years.
During the Q&A session, State Rep. Lori Saine (R-Dacono) asked Smith about using a Monte Carlo simulation to test PERA’s long-term soundness. As described in more detail here, averaging a given return over a period of time isn’t the same thing as getting that rate of return every year. PERA’s portfolio might well average 7.5% over 40 years, and still go bust because its returns in the next few years are below average, leaving to try to make up the difference from a lower balance. Rep. Saine was asking if PERA did or could run a simulated 40-year set of returns, and see how often the fund went bust and how often it stayed solvent at the end of that 40-year window.
Mr. Smith replied that yes, they do Monte Carlo simulations, and then proceeded to describe not those, but instead a sensitivity analysis available in the Comprehensive Annual Financial Report (CAFR). The sensitivity analysis is something else altogether. It looks as what happens to PERA if the returns over 40 years are 6.5%, 7.5%, 8%, up to 9.5%, but it still assumes a constant rate of return. This is a completely different analysis, one that admits the possibility of lower-than-expected long-term returns, but ignores the danger in a few years of very low short-term returns, or even a couple of years of severe losses.
Monte Carlo simulations model the year-to-year variability in return that is an inherent function of risk. As a result, even funds that appear to be well-funded, or that appear to have a long-term path to being fully-funded, can show low likelihoods of staying solvent through their amortization periods. Doing such an analysis helps to prevent unpleasant surprises, and is to be preferred to a simple sensitivity analysis such as the type PERA performs and publishes.
Regardless of one’s preference, the two shouldn’t be confused for each other.
You can hear the entire exchange here:
Friday, the PERA Board decided to make two significant changes to their actuarial assumptions. First, they lowered their expected return on their portfolio from 8% to a more realistic 7.5%. Second, they lowered their inflation expectation from 3.5% to 2.8%.
This is being advertised as a more realistic set of assumptions, in effect, an admission against interest that outside players such as Treasurer Walker Stapleton have been agitating for for some time. The lower rate of return will, according to the Denver Post report, raise the unfunded liability from $23 billion to $29 billion.
It’s true that the 7,5% rate is more conservative than 8%, and closer to the average rate of return being assumed by most public pension funds around the country. On that basis, the change is to be welcomed. But for a long time, I’ve felt that the rate of return was very much out of line.
In fact, the lower rate of return should have no effect on the unfunded liability. The only reason that the unfunded liability will grow is that PERA will use the lower rate of return as the new discount rate. Of course, as we’ve discussed before, the discount rate should be independent of the rate of return; it should be the state’s long-term cost of borrowing, or even the risk-free rate of return, the 30-year US Treasury rate.
In addition, many of the benefits of the lower rate of return are more than offset by the lower inflation rate. Before, the real rate of return was 8 – 3.5, or 4.5%; now it’s 7.5 – 2.8, or 4.7%. PERA is decreasing the increase in future liabilities here, by lowering the expected future increase in salaries. This means that the net effect of both changes is to increase the real rate of return.
Unfortunately, we won’t know exactly how this plays out until PERA releases its next CAFR – next July, 8 months from now.
This post was originally published on Watchdog Wire Colorado (“Gov. Hickenlooper Admits: Districts Can Use Amendment 66 Money For PERA“).
From the beginning, one of the key concerns surrounding Amendment 66 has been its prospective use to backfill the state’s public pension obligations, rather than aid Colorado students in the classrooms.
It’s a serious worry for Amendment 66 supporters- they even produced a video on this point, claiming that, “There is only one way to read Amendment 66 when it comes to where the new money goes” (visible at 1:38).
“Or, as the group pushing the ballot amendment states on its website, money that will be raised by Amendment 66, ‘is constitutionally and statutorily prohibited from ever being used directly to fund PERA.'”
But that one word, “directly,” is a loophole that even Governor Hickenlooper won’t climb through, and as a result, undercuts this entire claim by proponents.
A Revealing Question
As a result of my membership on the Jewish Community Relations Council of Colorado, I received an invitation to an event on October 8 in support of Amendment 66, hosted by Cherry Hills Village residents David and Laura Merage. The Merages are prominent entrepreneurs and founders of the David and Laura Merage Foundation, which counts education among its primary missions. Gov. John Hickenlooper was a featured speaker and gave some remarks regarding Amendment 66 to the crowd of about 40 people, followed by a question and answer session. I took this opportunity to ask the Governor for clarification on PERA funding. The following is an audio file and transcript of our exchange:
Gov. Hickenlooper: Anything else? What else?
Sharf: OK, so a question about the PERA. So, you had said that it can’t be used to backfill PERA, which is certainly true at the state level.
Gov. Hickenlooper: Yep
Sharf: Well, once the money gets to the districts…now, under SB1, which was supposed to be the fix for PERA, the districts were supposed to split – there was a lot more money going into PERA, there was some increases, some supplemental payments, that were going to go into PERA.
Gov. Hickenlooper: Right
Sharf: And, the districts were supposed to split that increase with the employees, with the unions.
Gov. Hickenlooper: Yep
Sharf: But with the exception maybe of Adams, they haven’t really. Overwhelmingly…
Gov. Hickenlooper: I’m not sure that that’s right –
Sharf: Well, Greg Smith –
Gov. Hickenlooper: They have not split it, they’ve just swallowed it.
Sharf: Right, that’s what I mean, is that they’ve basically just swallowed it.
Gov. Hickenlooper: Well, if you want to fix that, if that’s what’s happening, then we can’t legislate that. There’s a certain amount of money that goes into the districts, and that is the way our education system is structured. If you want to fix that, put it up on our website, how much of that money the district is spending on PERA. And I guarantee you the parents will go nuts.
Sharf: But do you need the tax increase to put it up on the website?
Gov. Hickenlooper: YES! I mean, to have a website like that, $18 million, $20 million, and then to operate it, yeah! You should see – you know what it’s going to cost – I just got the budget today – you know what it’s going to cost to finally have our drivers license system for the state of Colorado, to have a simple system where you go in and you get your driver’s license? And you can do it as you’re coming in, do all the prep work on your handheld device? You know what that’s going to cost? Eighty million dollars. Just so you’re clear; we’ve been working on that for two and a half years, they just told me that today in our budget meeting. That’s just what it is.
Under the terms of SB10-001, passed in 2010 and signed by then-Governor Bill Ritter, school districts are required to make additional payments into PERA in order to help stabilize the program. PERA’s Executive Director, Greg Smith, is on record as saying that the legislature’s intent was that they split the cost of those increased payments with their employees. Smith, in legislative testimony, noted that most school districts have failed to do so.
Sen. Michael Johnston, a prime sponsor of Amendment 66’s implementing legislation, SB13-213, and advocate for Amendment 66, also seemed to believe that SB10-001 required increased employee contributions, and seemed surprised in December of last year to find out that that wasn’t happening:
Question (at 1:21:05): The pushback that I got from our district, and quite honestly, there was no change in the contribution rate for the teachers, for the employees of the district. All the increase, at least in Jefferson County, picked up by the taxpayers and the district. They kept insisting that there was nothing they could do, so please go to the legislature and take care of that, there was nothing they could do about adjusting how much the contributions – the contributions go up really high on the taxpayer side but they haven’t moved for the teachers, at least in JeffCo. Perhaps in other districts…
Sen. Johnston: We should touch base after this, because the bill that I voted for did include increases on employee contributions, so we should talk about that.
On a per-pupil basis, this becomes clear. Statewide, the overall increase in PERA contributions (left axis) strongly parallels the increase per-student contribution to PERA from the districts, while the per-pupil contribution from the employees has barely budged (per-student on right axis):
Source: PERA CAFRs and Colorado Department of Education
District Versus State Rules
Because teachers are employees of the school districts and not the state, the overwhelming portion of the employer’s PERA contribution to the School Fund comes from the districts to begin with.
(One major exception is Denver teachers, whose retirement plan recently merged with PERA and has its own fund. Under the terms of the merger, DPS payments are currently offset by the interest payments on the debt DPS floated in 1997 and 2008 to fund their pension obligations.)
The governor’s candid admission that once the money leaves for the districts, the state has no real control over how it’s spent, severely undercuts one of Amendment 66’s supporters’ key claims about how much of the $1 billion in additional tax money is required to make it to the classroom, and how much will be diverted to the pension fund.
And the districts’ recent behavior gives taxpayers little cause for optimism, either.
Another month, another report showing the country’s pension problem to be worse than we thought, Colorado’s pension problem to be among the nation’s worst. This time, it’s a report from the non-partisan State Budget Solutions, “Promises Made, Promises Broken – The Betrayal of Pensioners and Taxpayers.”
In three significant measures, Colorado ranks in the bottom third of the nation’s public pensions: Its funded ratio is the 11th-lowest in the country, at 32.8%; the per capita unfunded liability is 15th-worst, at $16,158 per head; and as a percentage of the state’s GDP, Colorado is 16th-highest, at just over 31%. These dire rankings corroborate a recent Moody’s study that had Colorado’s unfunded pension liability in the bottom 10 as a percentage of state government revenues, another measure of the state’s ability to cover these debts.
They calculate the actual unfunded liability at just under $84 billion, nearly four times what PERA admits to, and $27 billion more than is estimated in an upcoming Independence Institute report. It should be noted, however, that the authors include five plans managed by the state’s Fire and Police Pension Association, much smaller plans which are not part of PERA.
The report takes issue with most public pensions’ investment return expectations, which usually vary between 7% and 9%, and the aggressive discounting oliabilities that most plans engage in. Instead of the optimistic – some would say wildly optimistic – return assumptions, the report’s authors use 3.225%, the 15-year Treasury rate. They also use that number to discount plans’ liabilities, arguing correctly that the discount rate should reflect a plan’s risk to its investors, not its returns on its investments. They argue that since these plans approach being risk-free investments, they should be discounted as such.
Personally, I think both the return assumption and the discount rate are too low. Even if 8% is unrealistic, and I’m not sure that it is, funds tend to have their money in diversified portfolios which will average returns higher than Treasuries. In addition, the plans are covered by state obligations, not federal ones. Investors have long recognized that state obligations carry more risk than do federal “risk-free” obligations, a fact reflected in the higher interest rates carried by state debt.
That said, the study makes two useful contributions to the debate. By making the return and discount assumptions it has, the report effectively sets an upper bound on the problem; surely no lower interest or discount rates could reasonably be chosen.
More concretely, by showing us to occupy the same neighborhood as such well-known pension basket cases as New Jersey and California, the report shows the foolishness of the approach of Amendment 66 – raising taxes, while appropriating all of the increased short-term revenue to ongoing operations.
Stapleton, a Republican, is a vociferous critic of the current PERA structure. The state treasurer is automatically a member of the 16-member PERA board. First elected in 2010, Stapleton in 2011 asked the board for access to individual records (without names) of the top 20 percent of PERA retirees, based on pension amounts.
High-dollar pensions have been something of a fixation for GOP critics of PERA, even though the average monthly benefit paid by the system is $3,020. Most PERA members aren’t eligible for Social Security. The PERA system covers all Colorado teachers and many higher education employees.
That last paragraph requires some rebuttal. High-dollar pensions are a fixation in large part because the rest of the PERA board decided to go to the mattresses to keep the information from being released. One might just as easily ask why keeping high-dollar pensions secret is something of an obsession for PERA.
That said, there are some excellent reasons for wanting to examine PERA’s high-dollar pensions.
First, at least some of those pensions come from teachers’ union reps, who are frequently no longer doing work for their school district, and instead are working exclusively for the union. The status of the Douglas County Federation of Teachers (DCFT) union rep became a major point of contention during open negotiations, mostly because she would have continued to accrue PERA benefits, even though the union offered to pay both her salary and her personal PERA contribution. With a $1 billion tax increase likely to be on the ballot this fall, and with much of the opposition to that tax increase based on the fact that about half of it would go to fund teachers pensions rather than classrooms, non-teaching union reps receiving outsized pension benefits would be embarrassing both for PERA and for tax increase supporters.
The other reason for concern over high-dollar pensions is the agency problem surrounding the PERA board itself. Most of the board are PERA members, and many receive high salaries, and so will be eligible for high-dollar pensions when they retire. With the PERA board having opposed recent attempts at reorganization, so that fewer board members are voting on their own benefits, the last thing they want is for attention to be focused on those benefits.
From a political point of view, it also makes sense for Treasurer Stapleton to try to split PERA beneficiaries between the average member and the high dollar recipient. While the PERA board and its allies have a history of resisting attempts to limit benefits overall, or to change the benefit calculation formula, a graphic demonstration of the actual distribution of benefits could lead many average PERA recipients to rebel against leadership, and accept limits at the high end of the scale. From the board’s point of view, that would be an ominous development.
While the Appeals Court has decided that Colorado taxpayers are not entitled to this information about their senior government employees, there is yet hope that the State Supreme Court will decide differently.
UPDATE: An earlier version of this post mistakenly attributed the ruling to the State Supreme Court.
One of the biggest problems with the way that pension plans report their solvency numbers is the assumption of constant returns over the life of the plan. By assuming constant returns, plans end up hiding the single biggest factor in why they’re likely to go bust: risk. This post will try, with a hugely (and unrealistically) simplified example, to illustrate the problem this poses when trying to figure out whether a plan has enough money to cover its liabilities.
For this first cut, the aspect I want to capture is that with mandatory annual outflows, a pension fund puts itself at risk of falling behind, and never being able to catch up.
Let’s take this example: a $1,000,000 liability, timed to last 30 years, with $250,000 annual payouts, and payments into the fund that are calculated based on the expected return on assets. Here’s what the fund balance will look like if we assume a constant 8% return on assets:
Payments into the fund each year are calculated to be a little over $161,000 a year in order to make this happen. Also note that all this is being conducted in real dollars; we’re ignoring inflation, which is going to drive some people up the wall, but 1) we can always make a calculation in real dollars, 2) there’s really no good way of predicting inflation over a 30-year span, and 3) this is a thought exercise.
Where can I get an 8% a year return for 30 years? Well, I could put it in bonds that return 8%, but those may not always exist. Right now, we have a low-interest rate environment, and even corporate bonds that are highly-rated don’t necessarily return 8%. Surely investment-grade municipal bonds don’t get me 8% at 30 years. And remember, I need to find a place to put each year’s inflow, so by the end of the 30 years, I’m unlikely to find a 1-year corporate or municipal bond that pays me 8%, absent a pretty severe inflationary environment.
One investment that is liquid, that also provides reliable 30-year returns over 8%, is the S&P 500 index of large-cap US stocks. The S&P has been around since 1926. So starting in 1955, we have 30-year return profiles for it. Here’s the distribution of annualized 30-year returns for the S&P 500, from 1955 – 2011:
The thing has never returned less than 8.5% over that time, and averages 11.76% (although the median is lower). This is a period of time that covers a World War, a Depression, inflation, the Korean and Vietnam Wars, the 2000 Tech Bubble Burst, and the 2008 Real Estate Bubble Burst. That’s a pretty good track record.
Here’s the rub. Here are the annual S&P 500 returns over that time:
Not so good. You have a pretty good chance of losing money; in 11 years out of 85 you’d be down 10% or more, and in 6 of those years, down 20% or more. In three of those years, you’d lose 35% or more of your total investment. You can see the problem: the risk of running one really bad year, or a couple of moderately bad years, early on, where you might have to spend your seed corn, is high enough to be worrisome, even if the total 30-year return is comfortably higher than your planning.
In order to see our imaginary fund’s chances of making to 30 years solvent, we need to put in not a constant 8% return, but a random variable that looks like the S&P 500 annual return. Surprisingly, there’s considerable debate over whether or not such a variable is even possible to construct. The returns are clearly not normally distributed, and adding more moments (skewness, how fat the tails are, etc.), doesn’t produce unique random variables. When you look at the returns, it also looks as though the year-to-year returns may not really be independent, either; that is, a losing year seems to follow another losing year.
Given all this debate, I just figured that, with 57 separate 30-year runs available to us, the easiest thing to do would be to use those 30-year runs themselves. I.e, 1956 – 1985, 1957 – 1986, etc. Here’s a pretty typical return profile:
One really bad year, a couple of downers soon after, but positive almost all the time, and a number of eye-popping returns of over 40% to make up for it. Should work out, ok, right?
Not so much:
The actual balance in the account falls below the projection in Year 9, and never really is able to gain altitude again. By Year 20, the fund is bust, and has to either get bailed out or stop making payments.
What’s interesting is that it’s not the Year 6 Catastrophe that does the fund in. Given the good years that preceded it, the balance after Year 6 is right at the projected levels. A fund manager could easily persuade himself that everything’s going to be ok. What really causes the problem is the two bad-but-not-disastrous Years 9 and 10 consecutively. The S&P comes back in consecutive years with 20%, 25%, 20%, 35%, and it’s still not enough to put any real air between the balance and the ground. So by Year 15, when the S&P loses less than 10% – less than it had lost in any of the previous losing sessions – it’s effectively all over.
How often does this happen? Well, here are the failure rates for various return assumptions, starting with the average of 11.76% that the S&P actually returns, and going to 7%, for the ultra-conservative fund manager:
The manager who doesn’t leaving himself any breathing room cashes out over 60% of the time, which might be a little surprising. It’s not until we assume a 10% return (corresponding to annual pay-ins of $143,000), that we get to a 50-50- chance of seeing 30 years. Our 8% manager still fails over a quarter of the time, and it’s not until we get past a 7% assumed return (pay-ins of $169,000) – where we’re effectively giving up 40% of the actual S&P historical return in our planning, that we almost get to an 80% chance of solvency in Year 30.
Now, to be clear, you don’t end up in such bad shape most of the time that you don’t go bust. You’re often well in the black. For the fund manager who’s planning on 7%, he ends up over $10,000,000 in the black over a third of the time. So often, when you win, you win really big.
But in pensions as in baseball, you can’t spend those winnings from other timelines. The Cardinals beat the Reds 15-2 today, but tomorrow, it’s 0-0 when the pitcher takes the mound. My concern as a pensioner is being able to plan on a certain amount of money coming my way after I retire. If the plan goes bust when I’m 75, it’s too late for me to make other plans. And if the plan ends up with an extra $9,000,000 on-hand when I’m 80, there’s not much benefit in that, either. The cost of losing is very, very high; the unlikely rewards from extra winnings don’t make up for that, which is why I put my money into a “safe” pension plan in the first place.
Understand, as stated at the outset, this is a hugely simplified example, on about 100 different levels. Real pension plans don’t consist of a single individual. They generally don’t make payouts at the same time they’re collecting contributions. The lifetime of the plan for an individual is longer than 30 years. Their portfolio is more diversified than putting everything in US stocks. Inflation actually matters to pensions, possibly for benefits, certainly for wage calculations.
But the basic point – that the actuarial assumptions of flat returns, assumptions that fail to take into account risk as well as reward – are serious planning flaws that can ultimately lead to a plan’s demise.
My hope is, over time, to make these models more complex, remove some of the simplifications, give something approaching actual likelihoods of Colorado’s PERA going bust, and ultimately, create an online model where you, the reader, can enter your own assumptions and see what happens to PERA’s long-term prospects. That’s a big project, and it’s going to take a long time to complete. But there’s nothing in the finish product that isn’t here in the basic principles: returns move around all over the place, and the cost of providing ownership in a liability rather than an asset can be ruinous.