California’s Bad Bet Makes JPMorgan’s Look Minor

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

Crossposted on Bloomberg Congress ordered JPMorgan Chase & Co. (JPM)’s chief executive officer, Jamie Dimon, to testify about $2 billion that his bank lost on an investment bet. Worrisome as that gamble was — after all, the banking crisis was largely due to bad bets by banks — it is unfortunate that Congress has never […]

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When You Hate Your Taxes but Can’t Name Your Legislator

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

Crossposted on Bloomberg Who do you think has more influence over the education, safety, health, welfare, transportation, justice, recreation and economic well-being of 40 million Californians? U.S. Senator Dianne Feinstein or California State Senator Loni Hancock? That’s easy: Loni Hancock. How can it be that someone so powerful is so unknown? The answer is that few […]

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New California Taxes Pay for Pensions, Not Schools

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

Crossposted on Bloomberg Most Californians would be surprised to learn that 100 percent of education’s share of the tax increase proposed by Governor Jerry Brown will go to pensions instead of classrooms. But that would be no surprise to longtime observers of the California State Teachers’ Retirement System, which administers teacher pensions. Here’s why: After retirement, […]

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California must Address Leaks in Budget before Raising Taxes

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

Crossposted on Sacramento Bee In an effort topreserve existing services, Gov. Jerry Brown has proposed a temporary tax increase to generate new revenue of $9 billion per year for seven years. The Legislative Analyst’s Office says the proposed tax increase will yield less. Either way, little of the new money will help existing services for […]

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How About a Race to Reform State Pensions?

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

Originally Published in the Washington Post President Obama has proposed that the federal government provide $35 billion to assist state budgets. It’s a fine idea — provided there’s a carrot. Many states have been hit hard by fast-rising retirement costs for public-sector employees, forcing those states to divert money from services such as education and […]

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Hiding Their Books

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

In their magnificent study about eight centuries of financial folly
("This Time Is Different"), economists Ken Rogoff and Carmen Reinhart
lampoon the low level of accuracy with which governments maintain their
books: ""Think of the implicit guarantees given to the massive mortgage
lenders that ultimately added trillions to the effective size of
national debt, the trillions in dollars in off-balance sheet
transactions engaged in by the Federal Reserve . . . not to mention
unfunded pension and medical liabilities. Lack of transparency . . . is
almost comical."

It’s also expensive. In a recent study, Alicia Munnell, a member of
President Clinton’s Council of Economic Advisors and now director of
the Center for Retirement Research at Boston College cited one example:

"In 1999, the California Public Employees’
Retirement System (CalPERS) reported that assets equaled 128 percent of
liabilities, [after which] the California legislature enhanced the
benefits of both current and future employees. If CalPERS liabilities
had been valued at the riskless rate, the plan would have been only 88
percent funded. An accurate reporting of benefits to liabilities would
avoid this type of expansion . . .."

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CalSTRS’s Extra Hurdle

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

In May 2008, Federal Reserve Vice Chairman Donald Kohn
delivered important remarks about an obscure but
consequential issue:

"Public pension benefits are essentially bulletproof promises
to pay. The only appropriate way to
calculate the present value of a very-low-risk liability is to use a
very-low-risk discount rate.  However,
most public pension funds calculate the present value of their liabilities
using the projected rate of return on the portfolio of assets as the discount
rate. This practice makes little sense from an economic perspective [and] pushes
the burden of financing today’s pension benefits onto future taxpayers, who
will be called upon to fund the true cost of existing pension promises."

To the vast
majority of Americans those remarks were hardly understandable, much less relevant.  But not to some public pension fund
officials.  Later, the CEO of the California
State Teachers Retirement System (CalSTRS) labeled as deserving of a "letter
grade of F" a study from Stanford University that adopted the Kohn methodology
for measuring California’s pension liabilities.  

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Lights, Camera, Inaction

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

Some politicians must think Californians are fools. Either that or they
must believe the Titanic wouldn’t have sunk had just the tip of the
iceberg been removed while the rest of it stayed hidden below the
surface.

The politicians I’m referring to are those engaged in vigorous
grandstanding about the city of Bell’s compensation abuses.

So far
we’ve heard calls to publish every government employee salary and to
make Bell give its citizens refunds. But we haven’t heard anything that
would actually make a difference in solving our state’s financial woes.

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Setting the Record Straight

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

Some public pension funds like to blame the 2008 stock market crash for the pension cost crisis but as the chart below shows, pension costs started rising well before the 2008 stock market crash.

In fact, those pension costs increased sharply through the decade even though CalPERS and other public pension funds earned money for the period including the 2008 crash. This is because public pension costs rise whenever public pension funds earn less than they expect to earn. Put another way, when it comes to pension costs, what matters is the "spread" between expected returns and actual returns.

When pension promises are made, employers and employees make contributions into pension funds.  The size of those contributions is based upon an expected return from investment of those contributions so that, together, the contributions and investment earnings on those contributions are supposed to be enough to pay the pension when it’s due. The higher the expected investment return, the lower the contributions when the promises are made. But if the actual investment return falls short of the expected return, the employer must make up all the difference.

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Great Expectations

David Crane
Lecturer and Research Scholar at Stanford University and President of Govern for California

During a recent
public discussion about expected investment returns, the Chief
Investment Officer of a California public pension fund was quoted as
saying that "I would argue, and I have, with people who said it’s going
to be 6 percent or lower that they are basically saying the United
States is going to go in the drain in the next 100 years. I’m not
willing to go there."

By all accounts this CIO is a very smart fellow.  However, in making
that statement he’s up against some tough math because, for the 100
years of the 20th century – not exactly "in the drain" for the USA – an
investor with assets allocated like the typical pension fund would have
earned (you guessed it) around 6 percent.  

Somehow a perfectly good return in the 20th century has become a poor
expected return for the 21st century. How did that happen? As Warren
Buffett explained in a remarkably prescient article
in 1999, sometimes people extrapolate from statistically insignificant
periods to draw invalid inferences about future long-term performance.
For example, many people today came of age during the 17-year
investment boom from 1982 – 1999, but as Buffett pointed out, "The
increase in equity values [from 1982 to 1999] beats anything you can
find in history."

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