Pension Assumptions and Circular Logic

One quarter of one percent.

That’s all it took to set off alarm bells in the state of California. Calpers, the organization that manages the pension plans of the Golden State’s public sector employees and retirees, decided to reduce its estimate of the future rate of return on its investment portfolio by one quarter of one percent.

Calpers asserted that the reduction decision was, in essence, a necessary response to the relatively slow growth environment, with exceedingly low inflationary conditions, that is expected to persist in the United States and around the world for the foreseeable future. But commentators worried that their decision might contribute to the very economic sluggishness that Calpers cited as the justification of its action.

Huh? How can a simple arithmetic decision contribute to its own causal justification? That’s the type of circular logic that makes eyeballs glaze over when conversations gravitate to pension accounting. Nevertheless, the issue is a serious one, with echoes that reverberate throughout the global economic system.

An Arithmetic Necessity

Any pension system can be conceptualized as a collection of promises to pay a fixed annual amount to each employee after (s)he retires and as long as (s)he remains alive. In each year that an active employee is earning (or “vesting”) this benefit, an employer is expected to put aside a sufficient dollar amount to fund this future obligation.

There is uncertainty, of course, over the length of time that any employee will remain alive. With medical technology improving each year, life spans and thus pension obligations are increasing continuously. But average life spans tend to creep up over many decades; thus, although they have placed some pressure on pension funding assumptions, they haven’t wreaked havoc on them.

Rates of return, though, are a different story. As the global investment markets grow increasingly volatile, rates of return grow more volatile as well. If pension systems like Calpers believe that market crashes (such as the decline of more than 50% in the equity markets that slammed investors in 2007 through 2009) are more likely to occur in the future, they will inevitably modify their arithmetic assumptions by reducing their estimates of future returns.

Then why are critics complaining about this arithmetic? And where is the circular logic?

Plugging The Gap

Their concern is, essentially, a function of cause and effect. When Calpers decides to reduce its estimate of future returns, its decision represents an explicit acknowledgment that its current investment portfolio will not be sufficient to cover its future payment obligations.

So what does Calpers do? Well, it must add money to its current investment portfolio to “plug the gap” and compensate for the reduction in future returns. Let’s assume, for instance, that Calpers is obligated to pay $10,000 to a retiree in the year 2013. If the pension plan expects to earn 10% on its investments in the year 2012, it would only invest $9,091 in its portfolio in 2012 with the expectation of earning an additional $909 (i.e. 10% of $9,091) during the year.

But if the pension plan slashes its earnings expectation to 5%, it would need to increase its current investment from $9,091 to $9,524 in 2012 to account for the expected reduction of earnings to $476 (i.e. 5% of $9,524) during the year. In other words, instead of relying on the market to “grow” a $9,091 fund into a $10,000 balance with a robust $909 return, Calpers would only rely on it to grow a $9,524 fund into a $10,000 balance with a meager $476 return.

Okay … but this is still just a matter of simple arithmetic! So where’s the circular logic?

Too Big To Fail

Calpers isn’t a typical pension plan. It’s the California Public Employees’ Retirement System, a gargantuan entity that manages pension and other plans for more than 1.6 million individuals. Its investment portfolio held almost $250 billion as recently as 2007, and rebounded to hold $225 billion at the end of last year.

How does any pension plan, including Calpers, find funds to add to its portfolio when returns are expected to be insufficient? Inevitably, it must turn to its employer sponsor to request the additional funds. At Calpers, the employer is the State of California and its affiliated entities, and the amount that Calpers now requires equals tens of billions of dollars.

So where can the State of California find tens of billions of dollars to give to Calpers? At a time of fiscal austerity, the state must increase taxes or slash government spending to produce such prodigious amounts. And that inevitably slows the economy, thus depressing rates of return, hence causing the future rate reductions that justified Calpers’ decision to begin with!

Like many global banks or European nations that have grown too big to fail, Calpers itself has grown to a size where simple arithmetic business decisions can damage the entire economy. That’s why the critics are worried about its recent decision, and that’s why we should all be concerned as well.

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