Editors Note: It remains an article of faith among public sector union defenders of defined benefit pensions – as they are – that “the market’s just taken a little beating,” and “the long-term outlook does not merit a crisis mentality.” Even pension fund managers, such as City of San Jose’s Police and Fire Retirement Plan Trustee Sean Bill, quoted in our recent editorial “Moody’s Changes Pension Solvency Assumptions,” still state that these funds can be “de-risked,” and that a 7.5% return as a long-term “bogey” is achievable. It is not. But what if the rate of return that can be safely achieved isn’t even 5.5%, Moody’s new “bogey,” but is more in the range of 2.5%? This is quite likely. In the following post by Mike Shedlock, a regular UnionWatch contributor, these scenarios are explored. When reading this, bear in mind that CalPERS manages roughly one-third of California’s state and local public employee’s pensions, so triple whatever numbers he reports.

The California Public Employees’ Retirement System (CalPERS) manages pension and health benefits for more than 1.6 million California public employees, retirees, and their families. Its pension plan assumes 7.5% annual growth.

For fiscal year ending 2012 CalPERS Reports Preliminary Performance of 1 Percent.

How Underfunded is CalPERS?

Bear in mind that CalPERS was massively underfunded before this report. How underfunded?

Good question. Please consider CalPERS Lies About Equity Returns

CalPERS is both corrupt and incompetent.  If it were a private firm, the lies about return on investments would send executives to jail and billions in lawsuits filed.

“The California Public Employees’ Retirement System (CalPERS) is the biggest public pension in the country. It is also deeply underfunded. Depending on the measure used, they have just 55-75% of money needed for future expenses while 80% is considered the minimum to be safe. Their return is currently less than 99% of big pension funds.

On March 12, CalPERS voted to lower their expected return from 7.75% to 7.5%, ignoring the advice of their own chief actuary that it should be 7.25%. More than a few investment professionals consider a projected rate of 7.75% to be unrealistically high in these times and question whether 7.25% is realistic.”

Now we know that CalPERS is in the lowest 1% of all pension funds—what else would you expect from a California government agency?

“What If” Charts at Various Compounded Rates

Let’s pretend that CalPERS is 100% funded. Already that is one hell of a pretend job, but assuming so, what will CalPERS underfunding look like at various compound plan performance rates?

CalPERS currently has $233 billion in assets.
CalPERS assumes 7.5% annual growth.

What if CalPERS only returns 5%? or 2.5%?

In the following charts the left scale is in billions of dollars.
The bottom scale is in years.

Base assumption is CalPERS is currently fully funded (which it clearly is not)

CalPERS Assets Compounded at 7.5%, 5.0%, 2.5%

CalPERS Underfunding at 5.0% and 2.5%

I believe annualized returns for the next 10 years will be between 0% and 5% at most. I highly doubt they will be as good as 5%.

With that in mind, let’s take a closer look at projections for the next 10 years.

CalPERS 10-Year Asset Growth Projections

CalPERS 10-Year Projected Underfunding at 5.0% and 2.5%

Once again the above charts assume pension plans are fully funded and they ignore effects of drawdowns if exceptionally low returns happen. [Editor’s Note: “Drawdowns” means to pay pension benefits to retirees, the principle assets that need to be retained to earn interest are sold, leaving lower subsequent fund earnings because less money is left invested. This, plus the fact that CalPERS is already underfunded, compound the problem and suggest that Shedlock’s estimates, if anything, are still understating the size of the financial crisis.]

Negative Returns for 10 Years?

I have made the case that Negative Annualized Stock Market Returns for the Next 10 Years or Longer are Far More Likely Than You Think.

For follow-up posts please consider

Assume the Best

Even if you assume negative or near-zero returns are impossible (ignoring Japan for the last 20 years and the S&P 500 since the 2000 peak) clearly low cumulative annual returns over extended periods are possible.

Given boomer demographics, downsizing, student debt suppressing housing, etc., why shouldn’t growth be anemic for quite some time?

Given that pension plans are typically heavily invested in bonds, and the current 10-year treasury rate is 1.48%, it is going to be damn difficult (most likely impossible) for pension plans to come close to the annualized projection of 7.5% made by CalPERS and others.

Furthermore, the more risk pension plans take attempting to meet near-impossible goals, the more likely it is that they will blow sky high in taking that risk.

All things considered, especially with pension plan philosophy to be 100% invested in something 100% of the time, I believe pension plans will not avoid the next huge drawdown, with possibly devastating consequences.

However, let’s for the moment assume positive annual growth of 2.5% to 5%. Let’s further assume plans are not currently underfunded. Finally, let’s assume pension plans avoid the next big drawdown.

Even with those optimistic assumptions (wildly optimistic as pertains to CalPERS being currently fully funded), CalPERS still rates to be deep in the hole 10 years from today.

Lesson in Exponential Math

If that still does not shock you, hopefully the following YouTube video on Exponential Math will.

If you are not familiar with exponential functions such as 7.5% annualized growth assumed perpetually by CalPERS, please play the video above. Perhaps you should play it even if you are.

Those in CalPERS counting on 7.5% annual growth are going to instead see clawbacks, reduced rates, or outright default.

About the author: Mike “Mish” Shedlock is a registered investment advisor representative for Sitka Pacific Capital Management. His top-rated global economics blog Mish’s Global Economic Trend Analysis offers insightful commentary every day of the week. He is also a contributing “professor” on Minyanville, a community site focused on economic and financial education. Every Thursday he does a podcast on HoweStreet and on an ad hoc basis he contributes to many other websites, including UnionWatch.

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