“For the first time in the pension fund’s history, we paid out more in retirement benefits than we took in contributions.”
–  Anne Stausboll, Chief Executive Officer, CalPERS, 2014-2015 Comprehensive Annual Financial Report

There are few examples of a seemingly innocuous statement with more significance than Stausboll’s admission, buried within her “CEO’s Letter of Transmittal,” summarizing the performance of CalPERS, the largest public employee retirement system in the United States. Because what’s happening at CalPERS – they now pay more in benefits than they collect in contributions – is happening everywhere.

For the first time in history, America’s public employee pension funds, managing well over $4.0 trillion in assets, are becoming net sellers, not buyers. And as any attentive student of economics will tell you, when there are more sellers than buyers, prices drop. Behind this mega economic trend is a mega demographic trend – across the developed world, certainly including the United States, a relentlessly increasing percentage of the population is retired. The result? An increasing proportion of people who are retired and slowly liquidating their lifetime savings – also driving down asset values and investment returns.

Last week’s sell-off in the markets has immediate causes that get most of the attention. Turmoil in the middle east. A long overdue slowdown to China’s overheated economy. Depressed energy prices. But there are two long-term trends that will keep investment returns down. Demographics is one of them: The more retirees, the more sellers in the market. The other mega-trend, equally troubling to investors, is that debt accumulation, which stimulates spending, has reached its limit. We are at the end of a long-term, decades long credit cycle. The next three charts will illustrate the relationship between interest rates, debt formation, and the stock market during two critical periods – the first one following the stock market peak in December 1999, and the second following the stock market peak in September 2007.

The first chart shows the federal funds rate over the past 30 years. As can be seen, when the stock market peaked in December 1999, the federal funds rate was 6.5%. Within three years, in order to stimulate borrowing which would put cash into the economy, that rate was dropped to 1.0%. Similarly, once the stock market recovered, the rate went back up to 4.25% until the stock market peaked again in the summer of 2007. Then as the market declined precipitously for the next 18 months through February of 2009, the federal funds rate was lowered to 0.15% and has stayed near that low ever since. The point? As the stock market recovered since February of 2009 to the present, unlike during the earlier recoveries, the federal funds rate was never raised. This time, there’s no elbow room left.

Effective Federal Funds Rate – 1985 to 2015
20160111-UW-ER-fedrate

To put these low interest rates in context requires the next chart which shows total U.S. credit market debt as a percent of GDP over the past 30 years. Consumer debt, commercial debt, financial debt, state and federal debt (not including unfunded liabilities, by the way), is now estimated at 340% of U.S. GDP. The last time it was this high was 1929, and we know how that ended. As it is, even though interest rates have stayed at nearly zero for just over seven years, total debt accumulation topped out at 366.5% of GDP in February of 2009 and has slightly declined since then. The point here? Low interest rates, this time at or near zero, no longer stimulate a net increase in total borrowing, which in turn puts cash into the economy.

Total U.S. Credit Market Debt – 1985 to 2015
20160111-UW-ER-debtGDP

Which brings us to the Dow Jones Industrial Average, a stock index that tracks nearly in lockstep with the S&P 500 and the Nasdaq, and is therefore an accurate representation of the historical performance of U.S. equities over the past 30 years. As can be seen from this graph and the preceding graphs, the market downturn between December 1999 and September of 2002 was countered by lowering the federal funds rate from 6.5% to 1.0%. Later in the aughts, the market downturn between September 2007 to February 2009 was countered by lowering the federal funds rate from 5.25% to 0.15%. But during the sustained market rise for the seven years since then, the federal funds lending rate has remained at near zero, and total market debt as a percent of GDP has actually declined slightly.

Dow Jones Industrial Average – 1985 to 2015
20160111-UW-ER-DJIA

It doesn’t take a trained economist to understand that the investment landscape has fundamentally changed. The trend is clear. Over the past thirty years debt as a percent of GDP has doubled from 150% to over 350%, then remained flat for the past seven years. At the same time, over the past thirty years the federal lending rate has dropped from high single digits in the 1980’s to pretty much zero by early 2009, and has remained there ever since. The conclusion? Interest rates can no longer be used as a tool to stimulate the economy or the stock market, and the capacity of the American economy to grow through debt accumulation has reached its limit.

For these reasons, achieving annual investment returns of 7.5%, or even 6.5%, for the next several years or more, is much harder, if not impossible. Conditions that stock market growth has relied on over the past 30 years no longer apply. Public employee pension funds, starting with CalPERS, need to face this new reality. Debt and demographics create headwinds that have changed the big picture.

In the case of CalPERS, of course, it isn’t mere demographics that has turned them into a net seller in a market that’s just given up two years of appreciation. It’s the fact that their retiree population is increasingly comprised of people who are retiring with benefits that have been enhanced in the past 10-15 years. This fact accelerates and augments the demographically driven disparity between collections and disbursements. Take a look at the past three years of CalPERS collections and disbursements:

CalPERS Cash Flow (not including investment returns)
2013 to 2015, $=Billions
20160111-UW-ER-CalPERS

These figures, drawn from CalPERS 6-30-2015 CAFR (page 26) and CalPERS 6-30-2014 CAFR (page 24), show the system to be a net seller at a rate of about $5.0 billion per year for the past three years. Interestingly, during that time, employee contributions to CalPERS have actually declined by 4.6%, at the same time as the employer, or taxpayer, contributions have risen by 24.1%.

The idea that CalPERS cannot lobby for equitably reduced pension benefits is a fallacy. Because the financial problems with pensions began when Prop. 21 was narrowly passed in 1984, deleting constitutional restrictions and limitations on the purchase of corporate stock by public retirement systems. The financial problems got worse when California’s legislature passed SB 400 in 1999, which set the precedent for retroactive pension benefit increases. And in both cases, CalPERS was there, lobbying for passage of what were ultimately ruinous decisions.

Now that an aging population delivers millions of sellers into a market already challenged by epic deleveraging, CalPERS can do the right thing, and lobby for meaningful pension reform. They can start by supporting policies that reverse the impact of Prop. 21 and SB 400. If they do this sooner rather than later, they may be able to save the defined benefit. Anne Stausboll, are you prepared to stand up to your union controlled board of directors, and tell them the hard truth?

 *   *   *

Ed Ring is the executive director of the California Policy Center.

18 Responses to Why Investment Realities Will Compel Pension Reform

  1. john m. moore says:

    Clearly, the worst of the deficits and rate increases is ahead of California government entities. You clearly made the case that investmentment returns will decline and deficits will double and then double again. It is a full blown Pension Tsunami with no relief in sight.

    David Crane, make your move to save this state. I realize that means you must tell labor unions that they need pension reform to avoid a Wisconsin. As I see it, you are the only credible candidate to save California. JMM

  2. Equal Time says:

    This is a bit off topic, but I want to recommend seeing the movie “The Big Short” if for no other reason than to help understand why the motives of Wall Street (banks, investment houses and other “deal makers”)are not to be trusted.

    • Rex the Wonder Dog! says:

      This is a bit off topic, but I want to recommend reviewing “SB400” if for no other reason than to help understand why the motives of CalTURDS and trough feeding public employees are not to be trusted.

      🙂

    • SeeSaw says:

      I will second that and urge people to also go back and rent the documentary, “Inside Job” and the drama, “Margin Call”.

      • SeeSaw says:

        I second Equal Time not RWD. RWD is going to whine about the wrongs done to him until the day he dies.

        • Rex the Wonder Dog! says:

          Oh please seesaw, I would only “whine until the day I die” if I was MARRIED to you and your nagging, tormenting and painfully excruciating personality on a 24/7/365 basis! NOW THAT WOULD BE A NIGHTMARE!

      • Rex the Wonder Dog! says:

        I will second that and urge people to also go back and rent the documentary, “Inside Job” and the drama, “Margin Call”.

        I will second the urge for honest people to go back and read “SB400” and the shake your head in astonishment at the blabber from the drama queen known as “SeeSaw” 🙂

    • john m. moore says:

      Browse “Brooksley Born.” She was in the class behind me in law school. In 1996, Clinton appointed her to head the Options agency. She had evidence that the entities selling derivatives known as “swaps” were not regulated and often had no capital to pay claims(such as the “swaps” sold by AIG to insure the risks of mortage backed securities). She proposed legislation to make the “swaps” market responsible. Greenspan,Rubin, Levitt(SEC head) and L. Summers all testified against and defeated her proposals. Instead, congress passed legislation allowing banks to enter the securities business. Next came the 1998 Long Term Capital fiasco($1B created hundreds of billions of risk that went upside down, but still no reform. We all recall the 2008-9 crash as depicted in “The Big Short.” Since then, the country has lived off the backs of those with savings, but that pot has sprung a leak. Pigging out on large salaries(Richmond: 10 fire off. draw over $400K a year) and million dollar pensions pensions is rubbing our noses in IT.

      • Rex the Wonder Dog! says:

        Wall Street OWNS the Congress, just as public unions OWN the CA legislature. Nothing new, and will probably not change until the public is completely underwater and a true REFORMER RUNS FOR OFFICE, like Teddy Roosevelt and FDR. And well ALL know Teddy came into office by pure luck and accident, but he did what Big Business HATED, took them down.

        Until this happens we are doomed b/c $$$$ rules the day.

        BTW SEC attorney Gary Aguirre ALSO took on Wall Street and hedge fund billionaires and was shut down by superiors. Banana republic.

      • Sean says:

        Speaking of Brooksley Born, PBS had a great documentary called “The Warning” which chronicled Born’s attempts to call attention to the derivatives problem back in 1998. Remember the collapse of Long Term Capital? That was 1998. Ten years later, we had the 2008 collapse. The Warning is well worth watching.

        That said, I love it when public sector types go on and on about Wall Street corruption. It shows how ignorant they are about their own ties to Wall Street, and their own likeness to the wrongs they see in Wall Street.

    • Ken Churchill says:

      After watching the Big Short and looking at the tremendous bond debt of tiny Puerto Rico ($72 billion, only New York and California have more), it occurred to me that the banks may have turned to municipal bond debt as a way to make huge fees to replace CDO’s.

      With government financial statements not required to list either pension or OPEB unfunded liabilities on their balance sheet, Puerto Rico may have looked solvent when they were actually balance sheet insolvent. And we all know how the ratings agencies operate from the movie. They essentially give the banks the rating they want.

      So I wonder if the bonds were rated as if pension and OPEB liabilities did not exist. Puerto Rico has $30 billion in unfunded pension debt and were probably using the bond proceeds to prop up their pension fund. But I doubt the banks cared about that because as with CDO’s they did not care because they also sold off the risk and kept their fees.

  3. William Monnet says:

    Very thought-provoking article. Another interesting way to view this problem is noting the spread between CalPERS’ Target Investment ROR and the yield on riskless 10 Year Treasuries. In summary, in 1994 the 10 Year Treasury Yield was 7.5% and the CalPERS Target ROR was 8.5% so that they could achieve their investment target with very little risk. Today, CalPERS Target ROR has dropped by 1 point to 7.5% but the 10 Year Treasury Yield has dropped by 5 points to 2.5%. CalPERS is taking-on more risk even as their actual investment ROR declines. CalPERS will be bleeding our local governments like a blackmailer.

  4. john m. moore says:

    At the local entity, there is a way out, but it will take heros and money. At the state level, both parties are owned by the unions. Until candidates running for state offices run on a platform of true pension reform, the voters have little say. In a sense, reform of the pension tsunami at the state level is incomprehensible. Where are the journalists?

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