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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Glass Houses

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

Recently the Wall Street Journal reported that CalPERS, the country’s largest public pension fund, is recruiting executives for seats on poorly performing corporate boards.

Apparently, CalPERS places blame for much of the financial crisis on lax cultures inside corporate boards and a failure to hold directors accountable. As a CalPERS spokesperson put it: "If boards live in a world of no consequences and can let a company go to wrack and ruin, what are we to do?"

CalPERS is right to pursue better governance. Boards sometimes do allow practices that can lead to failure of enterprises and disaster for our economy. As starkly illustrated in the financial crisis, one glaring example took the form of misleading financial reporting.

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The Role of the Investment Return Assumption

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

As
California’s public pension funds consider changes to their investment return
assumptions, it’s helpful to review that assumption’s role and whom it impacts.

The
investment return assumption determines who pays for pension costs. This
is because it determines how much money must be set aside (contributed) by the
generation that got the benefit of the services to which the pension relates.

If the right amount of money is set aside when the promise is made, then the
generation that got the benefit of the services to which the pension relates
rightly bears the full cost, and only that cost. If too little is set aside, a
future generation has to cover some of the cost even though it did not get the
benefit of the employee’s services. If too much is set aside, the generation
that got the benefit of the services bears too much of the cost.

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CalPERS Making Strides to Meet Pension Costs

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

Later this week, CalPERS’s board is expected to approve a staff
recommendation to require more money from the state in order to meet
pension costs, a decision it had earlier postponed.  The board should
be commended for breaking a troubling trend and lowering total pension
costs to boot.

The troubling trend is "cost shifting," a technique by which a
generation issues debt to cover operating expenses and then shifts the
obligation to service that debt to future generations.  

For years, the
state has been doing just that by making promises of lifetime pensions
and healthcare after retirement but then not contributing enough money
to meet those promises.

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Crane’s Testimony on Pension Reform

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

Reprinted here is David Crane’s testimony yesterday before the Senate Public Employees and Retirement Committee on pension reform, SB 919, (Hollingsworth, R- Murrieta)

Good afternoon, Mr. Chairman, and thank you for allowing me to appear before the committee today on this important matter.

I will divide my remarks into five categories:

  • The nature of pension promises
  • The rising costs of meeting those promises
  • The consequences of those costs
  • The causes behind those costs
  • What the state can do about it
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Fuel Price Reality Leads to Low Carbon Fuel Standard

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

In his February 8, 2010 column, Joel Fox wrote, “we have to be realistic about pricing [of alternative fuels].” Is that because we’re so realistic about the pricing of incumbent fuels?

On the day Joel wrote that column, oil was trading at $71 per barrel. One year before, it was at $40. Today it hovers near $80, more than 10% higher than it was when he wrote that column less than three weeks ago.

On America’s so-called “Independence Day” in 2008, oil hit $145, double what it was just the year before and nearly five times its price five years before. In response, our country showed its utter lack of independence by moving deeper into a recession. Indeed, forgotten in the current discussion about the current recession is the role played by volatile oil prices. With that commodity providing 97% of our transportation fuels and the state dependent on transportation for economic growth, a doubling in price in twelve months and a near quintupling in five years was catastrophic.

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The Bet Here is Oil Prices will Rise

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

Joel Fox is offering a guarantee against rising oil prices!

Well, he didn’t explicitly offer that guarantee, but that’s the inference I drew from his recent column in which he worries that alternative fuels elicited by Governor Schwarzenegger’s Low Carbon Fuel Standard could raise transportation costs for California consumers. Apparently Joel is so certain that gas prices won’t rise that he’d rather California remain reliant on that product for 97% of its transportation fuels than seek alternatives.

I’m glad he’s offering that guarantee because I’m not comfortable with that bet. Instead, I’m betting Saudi Arabia, Iran, Russia and Venezuela want oil prices to rise, and I’m betting that gasoline demand by the three billion new drivers in China, India and other rapidly-developing countries is likely to make that happen. So I would like alternatives.

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Attacking AB32 Won’t Lower Unemployment

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

Recently a State Assemblyman proposed suspending AB 32 until
California’s unemployment rate reaches 5.5%.

Putting aside for the moment that AB 32 is not yet in effect and
therefore not responsible for our current unemployment and that
there’s no support for the view that an AB 32 implemented
intelligently would constrain job growth (indeed, there’s evidence
that many of AB 32’s efficiency measures in particular would likely
boost rather than retard profits and jobs), let’s first ask a
fundamental question:

Why has California’s unemployment rate exceeded the national
unemployment rate since 1991?

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Public Employee Gain Reason for Higher Ed Loss

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

This Thanksgiving I gave special thanks for the University of California and California State University systems. In California, jobs and economic growth are inextricably linked to the well being of higher education. With their 33 campuses and 670,000 students, UC and CSU play central roles in providing opportunity to students, preparing California’s workforce, and powering our diverse and entrepreneurial economic growth. Put simply, a healthy California economy requires a healthy university system.

Yet, despite its essential importance, higher education’s share of the state budget has been reduced by 30% over the past thirty years, largely to make room for more compensation for state government employees. In the last ten years, cash expenses relating to state employee compensation (just for direct employees only) have more than doubled and now total more than $20 billion per year, in excess of three times what the state provides to higher education. On an accrual basis it’s more like four times.

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Stop Blaming and Start Praising AB32

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

In 1973, the president of Ford testified against pollution-reducing catalytic converters on cars on the grounds that such a requirement risked “a complete shutdown of the US auto industry.”

Of course, no such shutdown occurred and pollution was greatly reduced. But 35 years later, Meg Whitman, a candidate for the Republican nomination for governor, is raising similar fears about California’s Global Warming Solutions Act, signed into law by Governor Schwarzenegger in 2006 (AB32). In doing so she betrays an apparent lack of understanding about how AB32 will be implemented, the opportunities arising from that implementation, and an indifference to the risks of suspending the law.

Ms. Whitman says that AB32’s implementation can only result in reduced economic growth, but as California demonstrated in the 1970’s when it launched its energy efficiency effort using performance standards, that does not have to be the outcome — provided we harness the power of capitalism and competition. Back then, refrigerator makers claimed performance standards would curtail consumer choice and raise prices, but instead, choices weren’t reduced, energy consumption per unit dropped 75%, and prices fell nearly 50%. In fact, relative to a 1974 model, energy savings have put $15 billion in Californians’ pockets.

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