The Glass Jaw of Pension Funds is Asset Bubbles

“CalPERS argued that the California constitution’s guarantee of contracts shielded pensions from cuts in bankruptcy. The fund also asserted sovereign immunity and police powers as an ‘arm of the state,’ including a lien on municipal assets.”

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–  Wall Street Journal Editorial, “Calpers Gets Schooled,” February 8, 2015

If you want powerful evidence of crony capitalism at its worst, look no further. In the Stockton bankruptcy trial, the pension fund serving that city’s employees threatened to seize municipal assets to pay pension fund contributions. They’ve made similar threats to other cities that protest against the escalating contribution rates. And they’ve made the cost to exit pension plans confiscatory. It is hard to imagine a bigger or more blatant example of collusion between business interests and government employees at the expense of ordinary private citizens.

In the Stockton bankruptcy case, judge Christopher Klein’s ruling left pensions untouched, but at least the judge was openly disgusted with CalPERS, stating “CalPERS has bullied its way about in this case with an iron fist insisting that it and the municipal pensions it services are inviolable. The bully may have an iron fist, but it also turns out to have a glass jaw” (ref. San Jose Mercury Editorial, February 18, 2015.

Much has been made of the CalPERS’ “glass jaw,” referring to Klein’s contention that cities do have the legal right in bankruptcy to reduce pensions – even though he did not allow pension benefit reductions in this case. But there is another “glass jaw” facing CalPERS and all pension funds, the biggest “glass jaw” of all. They rely on annual returns of 7.5% per year to stay solvent, and as a result, sooner or later, the investment markets are going to deliver these funds a knockout punch.

Professional investors claim they can always beat returns of 7.5% per year, and many of them can. But public sector pension funds control over $4.0 trillion in assets, which makes them too big to beat the market. And the idea, courtesy of pension fund managers, that the investment market can deliver a long-term average return of 7.5% per year implies that 7.5% per year is a “risk free” rate.

For a quick reality check, here are the “risk free” rates of return currently available to investors in the United States:

Even in the cases where cities failed to make some of their annual pension payments, the financial impact was trivial compared to the primary cause of insolvency, which is that pension funds are not required to make “risk free” investments that are actually risk free. Because if they did, they would project low single digit annual rates of return instead of high single digit annual rates of return. It’s that simple.

A little over one year ago, the California Policy Center released a study “Are Annual Contributions Into CalSTRS Adequate?,” which utilized formulas provided by Moody’s investor services for that purpose. Using those formulas, the following table shows how lower rates of return impact CalSTRS:

Impact of Lower Rates of Return on CalSTRS
Based on 6-30-2012 Financial Statements, $ = Billions

CalSTRS chart

Just in case this is all merely abstruse gobbledegook that savvy political consultants recommend politicians avoid since nobody understands it anyway, pay particular attention to the columns on the far left and far right. The left column’s top row shows the official rate of return used by CalSTRS, 7.5%, and the right column’s top row shows how much they should contribute each year based on that official rate of return. Never mind that CalSTRS, like nearly all pension systems, uses creative accounting to avoid making an adequate payment to reduce their unfunded liability. In FYE 6-30-2012, for example, CalSTRS only made an unfunded contribution of $1.1 billion, not $7.0 billion (column five, top row) which would have represented a responsible payment against their unfunded liability.

It’s worth noting that for CalPERS, we can’t even get data on how they break out their normal contributions and their unfunded contributions because doing so would require sifting through the financials of every one of their participating entities. But there is nothing uniquely troubling about CalSTRS. As calculated in a more recent California Policy Center study, released last week “California City Pension Burdens,” in 2014 all state and local government pension funds in California, on average, were only 75% funded.

Imagine what would happen if CalSTRS had to pay $25 billion per year (column six, row five), instead of what they actually paid in 2012, $5.8 billion? Replicate these methods with nearly any pension fund in California, and you will almost always get similar results. And anyone who thinks a rate of return of 3.5% (column one, row five) is overly pessimistic should refer to the actual “risk free” rates of return shown in the previous bullet points. Better yet, consider this:  The federal funds lending rate today, the amount the federal reserve charges to banks, is 0.25% – that’s one-quarter of one percent. This is free money. That money is essentially being given to banks rates to turn around and loan at very low rates to corporations and consumers who use the cheap credit to buy things which, temporarily, stimulates the economy which causes asset values to rise – we are repeating 2008 all over again.

Pension funds depend on continuously expanding debt fueled asset bubbles for solvency. That is how they earn high returns that are anything but “risk free.” That is their glass jaw. Hopefully, when the bubbles pop and the glass jaws shatter, as an “arm of the state,” with “police powers,” CalPERS, CalSTRS, and every other pension fund in California won’t seize every municipal asset we’ve got and impose genuinely punitive taxes, so they can keep on paying those benefits.

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Ed Ring is the executive director of the California Policy Center.

Comments

  1. It’s a House of Cards and when this one collapses, it will be collosal!

    1,000 municipalities will declare bankruptcy and judges everywhere will have to debate whether there is a contractual obligation to provide workers their pensions or a community obligation to provide basic services.

    Judge Klein did Stockton no favors. By not touching the pensions, he sentenced Stockton to 50 years of misery and I guarantee that Stockton will declare bankruptcy again in seven years.

  2. CalPERS has been horribly mismanaged for years, however, Judge Klein followed the law when he made his final decision regarding the City of Stockton. Trust law requires that defined benefit pension payments must be made when they are due according to actuarial demands. The problem here is that an activist politically motivated board of trust has managed CalPERS funds socially, politically and for personal gain. I doubt that the fund could with stand a forensic actuarial survey. Additionally, numerous member plan sponsors have picked up their employees portion of the pension contributions in lieu of wages. In other words they are paying both the employee and the employers contribution rate to CalPERS. They also ‘sweetened’ the pension benefit formulas for employees when they had excess temporary investment earnings. The problem is that the benefits were NOT sustainable over time as CalPERS earnings dipped, however, the law requires that they be paid for regardless. The collapse will be catastrophic.

  3. When the cities and special districts are forced to suspend services because all the tax revenue is going to pension service, their will be mass rioting, and property owners will stop paying there taxes as they abandon that property and leave for other climes.
    If you think Detroit is an isolated case, think again, as there will be “Detroit’s” from one end of CA to the other.

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