January 27, 2012

The Market Undoes Pension Reform

Justin Katz

Remember the hoopla when General Treasurer and the state Retirement Board lowered the expected rate of investment return from 8.25% to 7.5%, thus throwing the system into underfunded panic? (Of course, the system should have already been in underfunded panic, but we needn't rehash all that, just now.)

Well, according to Ted Nesi, the return for 2011 was 1.4%:

Rhode Island's state pension fund earned a paltry 1.4% return on its investment portfolio last year, far below its target of a 7.5% annual return, WPRI.com has confirmed.

Treasurer Gina Raimondo's office disclosed the figure for 2011, which is after expenses, in response to an inquiry on Thursday. The pension fund earned 12.5% in 2010, according to the House Fiscal Office.

Raimondo told Nesi that "it's really hard to manage money right now," and the current expected rate of return "is a tall order." Unfortunately, Nesi's number is for calendar 2011 (January through December), while all the pension fund projections align with fiscal years (ending in June). That brings the frightening observation that the return for FY11 was 20%, so either the latter half of calendar 2010 was really amazing, or the latter half of calendar 2011 was even more pitiful than the 1.4% suggests.

Either way, assuming 7.5% from here on out, if the 1.4% carries for the whole of FY12, it will leave the pension system $2.4 billion short by 2035, the year it's supposed to be fully funded, under the pension reform. It's difficult to calculate the effects of such changes on the actuaries' numbers, which are layered with assumptions, but if my analysis is correct, this one bad year means that the annual rate of return will have to be 8.0% to make up the difference.

We could be seeing the Retirement Board exercising its new dictatorial powers sooner than expected.

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What do you expect, Justin? RI Republicans and "Blue Dog" Democrats have cut state government to the bone so they don't have the manpower or ability to attract the necessary economic talent to accurately make market predictions years in advance. They also fail to invest in hot new, green technologies and sustainable local agriculture against their own best interests. Central economic planning will always be more efficient than diverse investment through local actors with dispersed, specialized, up-to-date knowledge, so clearly there is not enough centralized authority to make the hard decisions for everyone to get stable returns on these socialized state-run systems.

For any of our RIFuture guests, that was sarcasm, by the way.

Posted by: Dan at January 27, 2012 8:21 AM

Uh oh, looks like J. Michael Downey was right - the G.T. is cooking the books...

Posted by: Monique at January 27, 2012 8:32 AM

"Either way, assuming 7.5% from here on out..."

This also in, it's 14 degrees warmer today than it was yesterday. Assuming daily 14 degree changes for the rest of the month... time to fill up the pool, Justin!

Posted by: Russ at January 27, 2012 10:57 AM

Russ is arguing *against* economic forecasting now? Don't tell his economics idol, Krugman, or the RIFuture crowd for that matter.

A very Hayekian observation, Russ. Maybe there's hope for you yet. Free market libertarian philosopher Nassim Taleb would be proud.

Posted by: Dan at January 27, 2012 12:09 PM

Russ's comment doesn't even deserve that much credit, Dan. He surely knows that I'm skeptical of the 7.5% investment return. But that's the number the actuaries are using to make it look like the reform has a chance of working. So, either we'll be short the amount that I described, or we'll get even farther from our goal.

Posted by: Justin Katz at January 27, 2012 12:20 PM

Justin - To be clear, I was not applauding his comment as a criticism of your statements, which I found to be properly framed. I was applauding it as a first step toward the realization that many of the government forecasting practices that progressives routinely rely upon to justify their economic designs are fundamentally unsound and prove to be wrong time and time again with severe consequences.

One illustrative example, discussed in Taleb's The Black Swan, is the following memorandum signed by the U.S. Secretaries of the Treasury, State, Interior, and Defense in 1970:
"The standard price of foreign crude oil by 1980 may well decline and will in any event not experience a substantial increase."
In fact, the price of foreign crude oil increased 10-fold by 1980. The result was not that these government planners realized the futility of their methodology, but instead they revised their earlier estimates and started all over again. The book also describes an agency forecasting the price of oil 25 years out in January 2004 at $27 a barrel. 6 months later, the price of oil had increased to $54 a barrel. Again, they did not discontinue the practice, but instead simply revised the forecast based on the new data and started again.

Posted by: Dan at January 27, 2012 2:07 PM

"Russ is arguing *against* economic forecasting now?"

No, I'm against the idea that you can couple a single years' return with the average rate forecast for the entire period as "proof" that the model is incorrect. Economic forecasting done by someone with the credentials of Raimondo surely includes assumptions of years with average, above average, and below average performance. Just as sure that some days in January will be warmer but many, many won't.

Posted by: Russ at January 27, 2012 3:43 PM

Yes, Russ, but each year one can figure out what the results experienced will require in order for the future returns to balance it out. That's what I'm saying: Effectively, the rate of return will have to be 8% for the remainder of the amortization period. If next year returns around 14%, we go back to 7.5% for the remainder of the period. If it's higher, the requirement will be lower; if it's lower, the requirement will be higher.

I'm merely noting, here, that Raimondo acknowledges that 7.5% is tough. 8.25% was considered too high. And we need 8% from here on out, barring additional deltas between reality and forecasts.

Posted by: Justin Katz at January 27, 2012 4:36 PM

Notably the article mentions that the "fund earned 12.5% in 2010, according to the House Fiscal Office." Hardly proof that the "market [has] undone pension reform" as you'd have us believe and proof that in at least some years the fund can expect to do significantly better than average.

Posted by: Russ at January 27, 2012 4:47 PM

Keep striving, Russ, but it'd be easier just to admit that you respond to everything we say as if those of us who disagree with you are just a bunch of vicious idiots, making you that which you find offensive in us.

The return was 12.5% for CY10. It was 20% for FY11 (which includes half of CY10). That was all incorporated into the numbers for pension reform. FY12 has to return 7.5% to keep up.

So, yes, low returns thwart the reform. In particular, the reform itself (absent reamortization) saved something like $3 billion. If a bad investment year removes $2.4 billion of that, then, yes, it has largely undone the reform.

(It'd be so nice if you'd drop the attitude and allow us all to have productive conversations.)

Posted by: Justin Katz at January 27, 2012 5:32 PM

Justin - Russ simply doesn't understand the point you are making about what Taleb calls scalable randomness. But most people don't understand how probability works - it's very counterintuitive. For example, if somebody's life expectancy is 80 and they live to 79, probability doesn't mean that they will die next year. In fact, it indicates that they will most likely not die next year or in the next few years. Russ commits the same error in his statement about averages and what the state can expect.

Posted by: Dan at January 27, 2012 5:42 PM
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