The 8% Solution

by: Cyniconomics

In this article, I'll reveal the third of the seven sins that I introduced in "Seven Deadly Sins of the Government Debt Debate - #1" (sin #1) and continued here (sin #2). And in case you missed the first two installments, I'm channeling my inner elementary school student and doing this word match style. In the diagram below, seven sins are listed in the column on the right, seven topics in the column on the left, and we're playing word match with the two columns. It works like this: you read what I have to say and then I disclose my answer at the end. Okay, I know, you could just skip straight to the end but please don't. The discussion will cover topic #3: Pension fund accounting.

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Pension fund accounting

In the asset bubbles of the last two decades, optimists had a monopoly on big picture themes about our economy. For example: the "new era economy" of the Internet boom … The Great Moderation … The surge of global liquidity that was believed to bring lasting prosperity. We still hear upbeat stories today, such as the revival in the U.S. energy industry and potential revival in housing. But their scope is limited. When it comes to major themes about America's long-term economic future, pessimists have the upper hand. Here are a few of the gloomy ideas competing for attention today (and I'll get around to pension fund accounting in just a moment):

  1. The service-based economy is an unproductive economy. Services contribute an ever-rising percentage of our annual output while manufacturers contribute less and less. At one time, pundits lauded these changes. Service-based economies are at the top of the food chain, the optimists said, and they're less prone to booms and busts than goods-producing economies. On the other hand, evidence suggests that the critical ingredient for economic advancement - rising productivity - is nearly absent from key service sectors such as education, health care and finance. With the economy increasingly tilted toward these relatively stagnant sectors, long-term growth is in decline.
  2. The secular rise in commodity prices imposes a speed limit on most economies. This is another example of a bullish case turned bearish. Rampant growth in the world's emerging markets was once held out as a sign of strength for the global economy. Now, people are asking whether there's enough stuff to go around. Stuff, in this context, is oil, iron ore, wheat, potash, rare earth elements, and so on. For key below-ground commodities, cheap sources of supply are dwindling and forcing extraction costs higher. Above the ground, agricultural production is held back by slowly diminishing amounts of arable land. These pressures seem to push commodity prices up whenever the global economy gathers steam, helping to snuff out the advance and weaken the long-term growth trend.
  3. High government debt means slow growth. While we're still burdened with political leaders and pundits who downplay the risks of government deficits, more sensible perspectives are gaining traction. Researchers like economists Carmen Reinhart and Kenneth Rogoff are making it difficult to ignore ample evidence that we'll eventually pay a steep price for excessive government borrowing. (See here, for example.) And regardless of how we choose to resolve the problem, part of the resolution will be slower growth.
  4. The digital revolution isn't quite as transforming as electricity and indoor plumbing. Experts on innovation are telling us to look at the last thirty or so years of changes in our lives and compare them to the transformations of days past. They're not denying that advances are occurring, just questioning the economic impact. I-gadgets are nice to have, they argue, but they don't measure up to the tremendous innovations that occurred from, say, the mid-19th century through to about the 1970s. And if they're right, the effects will be seen in (once again) diminishing productivity and growth.
  5. The rentier (and retiree) face rough times ahead. Liberal economists once called for policies to lower the returns on capital investments and squeeze out the rentier class - those who live off their wealth. And their wish seems to have been granted. Short-term deposits no longer offer any return at all, while monetary policy is focused on holding down yields on a variety of other fixed income investments. Yields in the stock market have also been pushed lower by policymakers, who acknowledge that propping up stocks is now one of their key objectives. But the collateral damage is more, well, damaging than the old-time economists had envisioned. Today's middle class depends heavily on adequate investment returns to fund their retirements. Standard approaches to calibrating retirement savings and spending amounts have been destroyed by zero interest rates and quantitative easing. And the implication is that our growing numbers of retirees face a difficult future.

All of these themes are relevant to the long-term debt projections discussed in other articles in this series. But their relevance isn't recognized by government analysts any more than they recognize the risk of unexpected events. For example: Alongside warnings that productivity could be in decline, the Congressional Budget Office (CBO) projects the economy forward with the exact productivity growth that's been observed in the past. If we experience any decline at all, debt will rise faster than they project and possibly much faster.

But let's leave the CBO alone for a moment. What about government pension calculations? At state and local levels, gaping pension shortfalls are perhaps today's greatest challenge. And pension valuation depends critically on assumptions for future investment returns, which are affected by every one of the themes above. With investment yields at levels that would have been unfathomable just a few years ago - and policymakers promising to keep them that way - surely the investment return assumptions have been lowered? Let's have a look. Here's a comparison of various market-based yields to the median investment return assumption in a database of over a hundred state and local government pension plans (which is maintained by Boston College's Center for Retirement Research):

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If this article were a print version of The Daily Show, I'd cue up the full repertoire of Jon Stewart's expressions of confusion. The chart makes you wonder if the people who set return assumptions answer all questions with "8%". "Hi, how are you today?" "Oh, I'm about 8%." "What's the capital of North Dakota?" "8%." Their 8% fixation is troubling because even a small reduction in this assumption can significantly increase reported pension liabilities. Boston College's retirement specialists recently tested such a reduction, based on a methodological change recommended in the Government Accounting Standards Board's (GASB) Statement No. 68, approved in June of last year. Although the new methodology only changes the return assumption for a small portion of the pension liability, Boston College estimates that unfunded liabilities would increase by about 30%. And together with another new GASB standard with a similar sized effect, the aggregate 2010 funded ratio of 76% would be 57% under the new accounting guidelines - an increase in unfunded liabilities of almost 80%.[1]

Clearly, our pension predicament would look worse if those who set the assumptions acknowledged that the world sometimes changes. Or, the issue may have less to do with acknowledgement than with individual incentives, recognizing that actuarial assumptions can be highly politicized. In either case, I'll take my word selection from Sigmund Freud and match pension fund accounting to denial.

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Check back next Wednesday (if not before) for word match topic #4: "Entitlement program accounting."

Data links and reading recommendations

Long-term economic challenges

  • Tyler Cowen, The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better (New York: Dutton, 2011).
  • Zerohedge post on November 20, 2012 and link to Jeremy Grantham's November 2012 GMO quarterly letter, "Jeremy Grantham Looks at the Future of America: 'On the Road to Zero Growth," November 20, 2012.
  • Robert J. Gordon, "Is Economic Growth Over? Faltering Innovation Confronts the Six Headwinds," NBER Working Paper No. 18315, August 2012..
  • Carmen M. Reinhart and Kenneth S. Rogoff, "Growth in a Time of Debt," American Economic Review 100 (2010): 573-78. Also: Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff, "Debt Overhangs: Past and Present," Journal of Economic Perspectives (forthcoming). And the bestseller: Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009).
  • Chris Martenson, The Crash Course: The Unsustainable Future of Our Economy, Energy, and Environment (Hoboken, NJ: John Wiley & Sons, 2011).
  • Matthew R. Simmons, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy (Hoboken, NJ: John Wiley & Sons, 2005).
  • Jared Diamond, Collapse: How Societies Choose to Fail or Succeed (New York: Penguin, 2005).
  • John Maudlin and Jonathon Tepper, Endgame: The End of the Debt Supercycle and How It Changes Everything, (Hoboken, NJ: John Wiley & Sons, 2011).
  • Mancur Olson, The Rise and Decline of Nations: Economic Growth, Stagflation and Social Rigidities (New Haven, CT: Yale University Press, 1982).

Boston College database and analysis

  • Alicia H. Munnell, Jean-Pierre Aubry, Josh Hurwitz, and Laura Quinby, "How Would GASB Proposals Affect State and Local Pension Reporting," Center for Retirement Research at Boston College, Updated September 2012.

Image of truck (and Goldbug)

  • Richard Scarry, Cars and Trucks and Things that Go (New York: Random House, 1974).

[1] For technical readers, here's my math (which gets complicated when calculating percentage changes of percentages): The actual aggregate funded ratio of 76% would have been 67% if pension assets were marked-to-market instead of smoothed over five years (the other change recommended in Statement #68). It would have been 57% with the additional change of slightly lowering the investment return assumptions. The corresponding figures for unfunded liabilities are calculated by subtracting the funded ratios from 100%, meaning that the reported shortfall of 24% would have been 33% with marking-to-market and 43% with both changes. And the figures noted above for the percentage increases in unfunded liabilities (30% for the new investment return assumption and 80% for both changes together) are based on the jumps from 33% to 43% in the first case and 24% to 43% in the second.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.