Public pension funds’ rosy forecasts pose problems

Pension funds have been hit hard by the stock market crash, losing about a third of their value in some cases, and there may be another problem.

Before the crash, some financial experts warned that pension funds were making overly optimistic projections of investment earnings in the decades ahead, often assuming about 8 percent a year.

Investment earnings, the heart of a modern pension system, are usually expected to provide two-thirds or more of the revenue needed to pay retiree benefits in the future.

In public employee retirement systems, a rosy forecast of future earnings means that fewer taxpayer dollars have to be spent to provide generous retirement benefits.

The giant California Public Employees Retirement System assumes annual earnings averaging 7.75 percent in the decades ahead. The California State Teachers Retirement System assumes 8 percent.

Lowering the projection of earnings by even a percentage point or two would create a funding gap of tens of billions of dollars.
CalPERS, an industry leader, warned its 1,500 local government members last fall that their employer contribution rates may increase from 2 to 5 percent of payroll in July 2011 if the stock market does not recover by June 30, the end of the current fiscal year.

Beyond raising rates to plug the big hole punched in pension funds by the stock market crash, the problem could get even bigger if forecasters decide that the critics are right, lowering projections of future earnings.

After the big drop in the stock market last fall, the CalPERS investment portfolio, once a high flier, had an average annual return of 3.32 percent for the last 10 years, well below the forecast of 7.75 percent.

A prominent critic of the high earnings forecasts, David Crane, was a rare appointee to a pension system board, CalSTRS, with a big-league background in investments.

Crane, an adviser to Gov. Arnold Schwarzenegger, helped build a small San Francisco business, Babcock & Brown, into a global investment firm, becoming personally wealthy along the way.

After the governor put Crane on the CalSTRS board and he had served almost a year, the Senate refused to confirm the appointment in June 2006, ousting a board member who had repeatedly questioned the 8 percent earnings forecast.

Legendary investor Warren Buffet, in his annual letter to Berkshire Hathaway shareholders in February of last year, questioned the 8 percent earnings forecast common among the pension funds of major corporations.

“How realistic is this expectation?” Buffet said. “Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3 percent when compounded annually.”

The founder of Vanguard mutual funds, John Bogle, told a congressional hearing on retirement security last month that corporate pension funds raised their assumed earnings from 6 percent in 1981 to 8.5 percent by 2007, far above historical norms.

“And the pension plans of our state and local governments seem to be in the worst condition of all,” Bogle said, adding parenthetically: “Because of poor transparency, inadequate disclosure, and non-standardized reporting, we really don’t know the dimension of the shortfall.”

The plight of the public employee pension funds has drawn a creative proposal from U.S. Rep. Gary Ackerman, D-New York, to shore up two of the nation’s troubled institutions.

Public pension funds would pool some of their money and buy $50 billion to $250 billion worth of stock in banks. In exchange, the federal government would guarantee the pension funds an annual return of about 8.5 percent.

Earnings forecasts were not a problem in the early days of California public employee pension funds, when investments were limited to fixed-income bonds and mortgages.

In 1966, a ballot measure, Proposition 1, allowed the pension systems to put 25 percent of their funds into blue-chip stocks. Advocates said the change would enable increased retirement benefits and lower employee and taxpayer contributions.

A measure to allow 60 percent of pension funds to be invested in stocks, Proposition 6, was rejected by voters in 1982. But two years later voters approved a far broader measure, Proposition 21, simply requiring that investments be “prudent.”

The ballot pamphlet argument said the measure, still in effect today, is similar to federal law covering private pension funds and is needed to prevent inflation from eroding the value of pension funds.

The ballot argument said pension fund trustees are “personally liable” if they invest funds without “the degree of care expected of a prudent person, who is knowledgeable in investment matters.”

The lifting of the restrictions on investing in stocks in 1984 came a few years after legislation allowed public employees to form unions and bargain collectively for labor contracts, which usually include retirement benefits.

A state labor law in 1968 covered local government employees. Teachers were added in 1975 under the Educational Employment Relations Act, state employees in 1977, and University of California and California State University employees in 1978.

Many public employee labor unions went on to negotiate contracts providing generous benefits — up to 90 percent of the final salary at age 50 for some police and firemen — that are expected to be paid mainly by pension fund investment earnings.

Retirement benefits provided by a labor contract have strong legal protection. In a widely watched test case, the City of Vallejo declared bankruptcy last year and asked a federal bankruptcy judge to overturn its labor contracts.

In hindsight, after a historic market crash that may force taxpayers to bail out pension funds, was it prudent to lift the restrictions on investing in stocks?

Calpensions asked an expert, Alicia Munnell, director of the Center for Retirement Research at Boston College.
“In the old days (before the mid 1980s), many public plans had limitations on equity investments,” Munnell replied by e-mail. “Virtually all have eliminated those constraints. Allowing more freedom to the investment managers is probably a positive development.

“The controversial area is the rate of return assumed in the actuarial valuation of pension plans. Public sector sponsors tend to assume high returns (8 percent or more), which makes the taxpayers’ commitment for future benefits seem small and encourages major expansion.

“Bottom line: a free hand for investment managers is a good idea; more cautious assumed rates of return would help check major benefit expansions.”

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. He now writes about public pensions at http://calpensions.com .