Moody’s Changes Pension Solvency Assumptions

Still unappreciated among defenders of public employee pension benefits is the extreme sensitivity of projected rates of return on investments to the amount government payroll departments have to fork over to the pension fund managers every year. Equally unappreciated is the possibility, if not certainty, that the rates of return currently being used by pension funds are significantly overstated. We have explained the reasons for this over and over. Rates of return projections on pension funds are going to drop because:

1 – Economic growth over the last 30 years, and especially during the ten year period up until around 2008, was fueled by a global accumulation of debt. The more borrowing there was, the more cash was being spent, which translated into elevated corporate profits and asset appreciation. Now that the practical borrowing limits have been reached, and economies are painfully confronting debt reduction instead of happily piling on new debt, economic growth is proportionately slower, and rates of return on investment fall apace.

2 – The average age of the population is heading inexorably upwards in every nation on earth, especially in the large industrialized economies. This means there are a higher percentage of retirees within the population than ever, and all of them selling their investments to fund their retirements. This puts additional downward pressure on the value of investments, lowering returns. As pension funds themselves manage a beneficiary population that increasingly is weighted towards retirees drawing the recently enhanced pension benefits, they are increasingly finding themselves selling as much as they are buying; they are contributing to this demographically determined downward pressure on prices.

3 – Pension funds are now far too big to consistently beat the market. To the extent they invest in private hedge funds and engage in program trading and other manipulative tactics, they increase market volatility, decrease liquidity, and basically expropriate returns from small investors who cannot employ these machinations. And eventually, the returns for any pool of investments as large as public employee pension funds must revert to the market average.

Apparently one of the top credit rating agencies in the world, Moody’s Investment Services, agrees with the bears at last.

Moody’s stated in an announcement “Moody’s proposes adjustments to US public sector pension data,” released on July 2nd, that they will now evaluate the solvency of pension funds based on a long-term rate of return of 5.5%. This is the high-grade, long term corporate bond rate – and this is dramatically lower than the current 7.5% that the pension bankers persist in claiming they will earn, year after year, for the next several decades.

How much is this going to cost?

The California Public Policy Center has developed an analytical tool to evaluate the solvency of pensions that provides a result as accurate as the assumptions one inputs (ref. A Pension Analysis Tool for Everyone). If you assume that the average public employee in California receives a pension that is equivalent to 2.5% of their final pay times 30 years working, and enjoys 25 years of retirement, this model will tell you – based on varying rates of return – precisely how much has to be contributed to their pension plan each year as a percent of salary. The model, for this example, also assumes 3.0% annual cost-of-living and 1.0% merit adjustments during years worked, and a 2.0% annual cost-of-living adjustment for retirees. These are representative assumptions that are, if anything, conservative, particularly in California’s many cities where one-third of the workforce are public safety workers whose pension formulas are quite a bit better than this.

Using these assumptions, at a rate of return of 7.5% per year, each employee must contribute an amount equivalent to 17.5% of their salary into their pension fund every year. At a rate of 5.5% per year, this contribution rate goes up to 30% of salary.

Put another way, if you accept Moody’s verdict that pension funds should not expect to earn more than 5.5% per year, and you want to keep pensions solvent, then every state and local employee in California just got a 12.5% raise.

Or you might consider this: If there are 1.5 million state and local government workers in California who make, on average, $70,000 per year (again, these are conservative assumptions), then California’s taxpayers will have to come up with another $13.1 billion per year.

And if only it were as simple as that.

The reality is much worse. Because this simplistic analysis doesn’t include any assumptions for pension spiking, nor for the catastrophic impact of retroactive pension benefit enhancements, which left pensions desperately dependent on sustained high rates of return to remain solvent. This analysis also doesn’t account for the significant retired population of pensioners who can no longer make higher annual contributions to maintain sufficient pension assets – they rely entirely on the rate of return.

In this context, readers are advised to listen to this Bloomberg interview with the City of San Jose’s Police and Fire Retirement Plan Trustee Sean Bill. Apparently Bill thinks that part of the solution may be to invest in hedge funds in order to “de-risk” the plan. Mr. Bill is invited to explain how hedge fund investing and other “professional” management techniques will preserve this 7.5% rate of return – in view of the debt and demographic trends discussed above.

Rather than offering suave and sanguine explanations of how America’s government worker pension funds that now manage approximately $4.0 trillion in assets are going to supposedly beat the market, pension fund managers and public sector union spokespersons ought to provide honest answers to the following questions:

• Why taxpayers should have to cover government worker pension fund losses when annual returns on investment fail to meet expectations?

• Why public employees retire on average 10-15 years earlier than private sector taxpayers, with annual pensions that are 3-4 times greater (or more) than social security?

• Why it’s appropriate that the United States is on track to pay out more each year in pensions to retired public sector workers than they will be paying out in social security to the entire remaining retired population?

• How they’ve gotten away with suggesting voters “blame Wall Street” for the economic mess facing America, when government borrowing and government pension funds are Wall Street’s primary enablers and partners?

• Why it’s ethical for taxpayer funded, government worker pension funds to invest in hedge funds whose purpose is to beat the market, when the inevitable corollary to that is even lower returns for small private investors?

And they might admit that most public employees have themselves contributed, through payroll withholding, only a small fraction of the annual contributions necessary to fund these pensions.