As blog readers will know, the UC pension's funding plan assumes that the portfolio over the long term will earn 7.5% per annum. Other California public pension plans assume similar earnings. Critics, however, argue that while such earnings might have characterized the past, rates of return will be lower in the future. If you assume a lower rate of return, the liabilities (and unfunded liabilities) of the pension loom larger than official estimates.
However, the returns needed for any given defined-benefit pension plan depend on the assumed outflow of funds which in turn depends in part on future inflation as reflected in the salaries on which future pensions are based and on inflation-linked escalator features, if any, in the plan that adjust benefits for price increases. (The UC plan has a complicated partial price adjustment escalator.) Read on:
From:
http://employmentpolicy.org/page-1775968/3176993#sthash.7oYXAVsF.dpbs
Mitchell's Musings
12-29-14: How Low Can You Go?
Daniel J.B. Mitchell
In past musings, we
have noted that there is a group of monetarist-oriented economists who are
convinced that the fact that the Federal Reserve greatly increased its lending
in various ways during and in the aftermath of the Great Recession means a
Great Inflation is on the way. So far,
however, that inflation has yet to appear, as the chart below indicates. Although inflation has varied, as measured by
the "core" Consumer Price Index (which excludes the volatile food and
energy sectors), no Great Inflation is evident.
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Source: U.S. Bureau of Labor Statistics.
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Some Great Inflationists
have suggested in response to the official numbers that the CPI is being rigged
to hide inflation. There is some irony
in that charge since to the extent there have been modifications of the CPI
methodology, they came largely in response to criticisms by many of the same
folks who argued in the 1990s that the CPI exaggerated the inflation rate. Apart from that historical detail, their
estimate of the exaggeration was around 1 percentage point per annum, so any
estimates of the effect of the modifications are upper-bounded by that
limit. In short, you can't make a case
for a hidden Great Inflation based on recent changes in CPI methodology.
Of course, what has
happened to inflation so far does not
necessarily indicate what could
happen in the future. An interesting
question is what financial markets expect the trend in inflation to be. One measure we have cited in prior musings is
the yield spread between conventional Treasury securities and Treasury
securities that are adjusted to the CPI - so-called TIPS. You can see the yield spreads below and they are
not suggesting any forthcoming Great Inflation. Indeed, for the last six
months, inflation expectations have been diving.
Now there is no guarantee
that the implicit inflation forecast by financial markets will come true. Indeed, the Great Recession was a Great
Illustration of the fallibility of such markets. But what if something like the implicit
forecast turns out to be accurate and the inflation rate – as measured by the
CPI – turns out to be something like, say, 2% per annum over the long term?
There would be implications
of such a development for macroeconomic policy which is partially aimed at
keeping inflation low. But a neglected area in the inflation outlook
is the implication for defined-benefit pension plans, nowadays mainly found in
the public sector. Such plans
provide a pension based on a formula linked to the earnings history of the
employee. A trust fund is supposed to
hold sufficient assets, derived from employer and employee contributions and
past earnings on the portfolio, to pay those benefits. Particularly in the aftermath of the Great
Recession and the related drop in the stock market that accompanied it, those
plans tended to be underfunded.
When actuaries calculate
funding ratios for pension plans, they make assumptions about inflation. Inflation is assumed to affect future wage
growth of employees and thus will affect their eventual pensions, typically
based on some version of end-of-career earnings. In some cases, there may also be partial or
full inflation adjustments to the pensions themselves after retirement. Each plan has its own formulas so the impact
of assuming more or less inflation will vary.
In calculating the funding
ratio of a pension plan, actuaries use an assumption of the expected earnings
over the long term of the trust fund portfolio.
Typically, the assumption is expressed in nominal, not real, terms. A common assumption nowadays is a nominal
return of around 7.5% per annum. Critics
of such assumptions argue that numbers like 7.5% are too high. While portfolios might have seen such
long-term earnings before the Great Recession, we are now, they say, in a “new
normal” of lower returns. Therefore, the
argument goes, estimates of pension underfunding are too low. Maybe the long-term rate of earnings will be
only 6.5% or less and not 7.5%.
The impact of a lower actual
nominal earnings rate on the funding ratio will vary from plan to plan. But to illustrate the impact, consider a
promise to pay $1 per year, adjusted for
future inflation, “forever.”
Suppose, in addition, you thought the inflation rate over the long term
(forever) would be 3%. If you wanted to
set aside enough today to meet that commitment (100% funding) and thought you
could earn 7.5% per annum, you would need to set aside about $23. But if you thought you could earn only 6.5%,
you would need over $29, i.e., roughly a fourth more. The lower the rate you expect to earn in
nominal terms, given an assumed rate of
inflation, the greater is your liability.
(If you could earn only 3% - so your real rate of earnings was zero –
your liability would be infinite since it goes on forever.)
Suppose, however, your
expectation of inflation dropped, say, from the 3% per annum of the previous
example to 2%. Essentially, your
required earning would drop by the same amount in this story. So with 2% inflation, nominal long-term
earnings of 6.5% would produce about the same $23 liability that 7.5% earnings
with 3% inflation gave you before.
The bottom line here is that
even if defined-benefit pension trustees have been over-optimistic about assumed
future nominal earnings, if inflation over the long term will be less than they
expect, they in fact won’t need as high a nominal earnings rate as they have
anticipated. Put another way, if you
argue for lowering the assumed nominal earnings rate for a pension plan because
we are in a “new normal” of lower stock market gains, you have to consider
whether you should also be lowering your assumption of future inflation. A “new normal” of lower inflation tends to
offset a new normal of lower nominal earnings.
