“A Slow Speed Train Wreck”
The Los Angeles Times published an excellent long form series last week on the root causes of California’s burgeoning public pension funding gap. It is an interesting backstory characterized by financial myopia, cognitive bias, and endemic conflicts of interest.
The LAT traces much of the problem to SB 400, a law passed in 1999 which significantly expanded pension benefits for more than 200,000 state workers, while also reducing the minimum age for full retirement benefits to 55 (50 for CA Highway Patrol officers). At the time, the California Public Employee Pension Fund (CalPERS) was operating at a surplus thanks to a decade-long bull market which had more than tripled the fund’s assets between 1990 and 1999 (making it the largest pension fund in the country). Proponents of the legislation extrapolated the fund’s recent returns into the future, and reasoned that benefits could be safely expanded without raising taxes.
This “free lunch” was a tempting siren song for public employee unions and the legislators who counted them as important contributors to their campaigns. What few acknowledged at the time was that the long-term solvency of the plan was highly sensitive to assumptions for investment returns. In 1999 (after several years of above-average market returns), the CalPERS’ return assumption was 8.25% per year. However, the fund’s chief actuary at the time noted that if actual returns were only 4.4%, the impact on the plan’s finances would be “fairly catastrophic.” The CalPERS board, heavily represented by union leaders looking to expand benefits for their members, took no apparent heed of this warning.
As it turned out, SB 400 was passed very near an all-time peak in the stock market. Within the next decade, the bursting of successive bubbles in technology and housing led the fund’s investment returns to lag the 1999 projection. Meanwhile, persistently low interest rates over the last 9 years mean that pension liabilities are discounted at a lower rate (increasing their value in today’s dollars).
Further confusing matters is that pension accounting rules already permit a multi-year “smoothing” of actuarial assumptions, an accounting liberty which more often than not causes reported figures to over-estimate the true solvency of the plan, relative to a snapshot of actual market values. The New York Times recently published a profile of one small California agency which sought to remove itself from CalPERS only to discover an uncomfortably wide chasm between its “actuarial” solvency (a modest surplus) and that based on current market values (a significant deficit).
More than anything, the study of pension funding shortfalls illustrates several frailties of human nature. Among them: a tendency to defer or understate obligations; the temptation for self-dealing; susceptibility to cognitive bias; and difficulty forecasting the future. The lesson we draw from it as investors is to be mindful of our own limitations. We regularly scrutinize and challenge our assumptions, and prefer to incorporate a healthy margin of safety in our forecasts, particularly when helping our clients plan for their own retirement.
Planet Money Buys Oil
For those who are not regular listeners to NPR’s “Planet Money” podcast, we thought we would pass along the link to their recent 5-part series on the history and evolution of the oil industry. In this series, NPR’s reporters track the journey of a typical barrel of crude oil from a well in the ground, through various trading, transport, and refining intermediaries, an on to its eventual end use (fuel, fertilizer, plastics, etc). The series thoughtfully weighs both the benefits and costs of this historically important resource.
The Road Ahead
For a thought-provoking treatise on the future of mobility and urban planning, we recommend this blog post from John Zimmer, co-founder of the ride-sharing company Lyft. Zimmer offers bold predictions for the pace of autonomous vehicle adoption, but also an inspiring blueprint for how that eventual adoption could drastically reduce the amount of public infrastructure devoted to cars, freeing it to be repurposed into more “people friendly” uses.