Tuesday, July 17, 2012

Quote of the Week

This week's Quote of the Week was a bit of a tough choice. I first wanted to reward fellow Harvard grad Teresa Hsiao (a writer for Family Guy) for her anecdote about Harvard passed along in this article—"asymptotic strippers" is seriously the clubhouse leader for phrase of the year. Slow clap.

But it's not your Quote of the Week, and that's because of Stockton, California. If you don't know anything about Stockton, here's an enormous infographic to get you up to speed—if you just want the basics, it's a city in California that recently went bankrupt, making it the largest municipal bankruptcy in American history. Wanna know how it happened? Let's go to the mayor for a quick overview (original WSJ article can be found here).


"We didn't have projections into the future what the costs might be. I learned that you don't make decisions without looking into the future."
                                        - Ann Johnston, Mayor of Stockton, CA

Jesus, what is this, an Onion article? And yet, scoff as we might at the people of Stockton, the reality is that this kind of brutally short-sighted financial planning is far closer to the norm than the exception in our country.

For proof, check out this post from Mish Shedlock, which shows that CalPERS—the fund that manages pension benefits for more than 1.6 million California public employees—returned only 1% on its investments last year, despite operating with a (ridiculous) 7.5% return assumption. That assumption, incidentally, is the amount CalPERS needs to achieve on an annual basis in order to remain anywhere near solvent.

Lest you think one year of underperformance doesn't matter, this year's 1% return means that CalPERS will need to earn a 14.5% return next year just to get back to where it needs to be. And if it returns the same 1% again next year, which is entirely possible? Then it'll need a 21.8% return in year 3 to get its head back above water.

You see, the problem with this kind of pension math is that even a relatively small amount of underperformance (not even something as drastic as this year's 1% return) can have a significant impact on long-term solvency of the pension fund, if it persists for long enough. For example, if a fund with a 7.5% return assumption were to earn 5% per year over the next 5 years—which would honestly be a pretty solid performance, given prevailing interest rates—it would still need a 20.9% return in year 6 (or, alternatively, an equally long period of equivalent outperformance, which seems doubtful) in order to get back to even.

So when it comes to projecting the future, is projecting an unrealistically rosy future—like CalPERS is doing—really any different from not projecting the future at all like Stockton? I'd suggest not, and I'd also suggest that anyone who relies on CalPERS for their retirement plans should start looking elsewhere. Soon.


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