“The six-year bull market is admittedly long in the tooth.”
CalSTRS Chief Investment Officer Chris Ailman, Sacramento Bee, July 17, 2015
If what Mr. Ailman really means is equity investments may not be turning in double digit returns any more, that makes the recent performance of CalSTRS and CalPERS all the more troubling. Because according to their most recent financial statements, CalSTRS only earned 4.8% last year, and CalPERS only earned 2.4%. That leaves CalSTRS 68.5% funded, and CalPERS 77% funded.
Are we at the top of a bull market? Take a look at this chart:
S&P 500, Last Twenty Years Through June 21, 2015
The S&P index, which reflects U.S. equity trends reasonably well, enjoyed a five year bull market that crested in mid-2000, then another one that ran five years from September 2002 to October 2007, then this current bull market, which began 6.5 years ago. The bull market ending in September 2000 saw a 170% rise in the S&P, the one that peaked in October 2007 rose 90%, and this current one has yielded a 188% rise. So far.
Is today’s bull market “long in the tooth”? It sure looks that way.
There’s more to this, however, than the new reality of globalized, largely automated equity trading that condemns stock indexes to unprecedented volatility – or the graphically obvious fact that we’re at another peak.
There’s something stock traders call “fundamentals,” in this case creating economic headwinds that all the high-frequency trading and hedges in the world can’t avoid. About the same time that CalSTRS and CalPERS announced they missed their earnings targets, Reuters published this: “Calpers chief looks to cut volatility as fund enters negative cash-flow era.”
In plain English, this “negative cash-flow era” means that CalPERS has crossed a big line financially. They are now going to be selling more investments each year than they buy. They are going to be net sellers in the markets. While the superficial explanation for this is “baby boomer retirements,” that is incorrect. Government staffing is not directly driven by population demographics. In government, new hires replace retirees and headcounts trend upward. The real reason CalPERS is entering a negative cash flow era is because the retroactive pension benefit enhancements that started in 1999 and rolled through agency after agency for the next six years or so are now translating into large numbers of people retiring with these enhanced pensions, replacing earlier retirees who had modest pensions. Meanwhile, new hires are, increasingly, accepting more realistic reduced retirement promises, and paying proportionately less into the funds.
If CalPERS were the only pension fund becoming a net seller in the market, it wouldn’t really matter. But all the major pension funds, everywhere, are becoming net sellers. That’s nearly $4.0 trillion in assets under management in the U.S. that suddenly are shedding assets faster than they’re acquiring them. When supply rises, prices drop. This is a headwind.
There are other headwinds. If government staffing doesn’t directly reflect population demographics, the general population obviously does. Between 1980 and 2030 the percentage of Americans over 65 will rise from 11% to 22% of the total population. And ALL of these seniors will be net sellers of assets.
If that weren’t enough, there is the small matter of the United States – along with most of the rest of the world – arguably in the terminal phase of a long-term credit cycle. Total market debt as a percentage of GDP in the United States is over 300%, higher than it was in 1929. When interest rates fall to zero, playing the debt card to stimulate economic growth doesn’t work anymore. And when interest rates rise, asset values fall and debt service becomes untenable. We’ve painted ourselves into an economic corner.
In the face of this reality, unconcerned and all-powerful, the government union band plays on. Today the Los Angeles based City Watch published an early version of what will become an irresistible torrent of propaganda opposing the proposed Reed/DeMaio pension reform initiative. The title says it all “Measure of Deception: Initiative Would Gut Retirement Benefits for Millions of Californians.”
Take a look at the average full career CalPERS pension per former employer. Bear in mind the average public sector retirement age is 61, and that the average Social Security benefit is around $15,000 per year. Is there no middle ground between “gutting” and restoring financial sustainability?
Restoring pension systems to financial sustainability in the face of economic headwinds will require two major changes in policy. First, pension benefit plans would need to change in the following ways: (1) Increase employee contributions, (2) Lower benefit formulas, (3) Increase the age of eligibility, (4) Calculate the benefit based on lifetime average earnings instead of the final few years, and (5) Structure progressive formulas so the more participants make, the lower their actual return on investment is in the form of a pension benefit. Finally, enroll all active public employees in Social Security, which would not only improve the financial health of the Social Security System, but would begin to align public and private workers to share the same sets of incentives. Taking these steps will repair the damage caused by SB 400 in 1999, which set the precedent for retroactive pension benefit increases.
Second, completely change the investment strategy of public pension systems to return to lower risk investments. Along with choosing, say, high-grade corporate bonds over global hedge funds, these lower risk investments could include investment in revenue producing civil infrastructure. A thoughtful article recently published in Governing, “How Public Pensions Are Getting Smart About Infrastructure,” explores this possibility. Not only would massive investment by pension funds in revenue producing infrastructure create millions of jobs, repair neglected public assets, and constitute a low risk investment, over their life-cycle many of these projects actually produce excellent returns. Moving to lower risk investments will repair the damage caused by Prop. 21, narrowly passed in 1984, that “deleted constitutional restrictions and limitations on the purchase of corporate stock by public retirement systems.”
Given the financial headwinds they face, it is going to take courage and creativity to save defined benefits for public sector workers. But depending on what direction these reforms take, they have the potential to greatly benefit the overall economy.
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CALIFORNIA POLICY CENTER PENSION STUDIES
California City Pension Burdens, February 2015
Evaluating Public Safety Pensions in California, April 25, 2014
How Much Do CalSTRS Retirees Really Make?, March 2014
Comparing CalSTRS Pensions to Social Security Retirement Benefits, February 27, 2014
How Much Do CalPERS Retirees Really Make?, February 2014
Are Annual Contributions Into CalSTRS Adequate?, November 2013
A Pension Analysis Tool for Everyone, April 2012