Arnold Kling  

Paging the Left

Diamonds in the Rough... Payday Lending...

Megan McArdle points to this analysis of why public worker pensions are underfunded. Basically, seemingly innocuous assumptions about the rate of return are very unrealistic, and this leads to massive underfunding.

Back in 2003, when many Republicans were pushing private social security accounts, I called them out on what I called the "stock market scenario," which uses an unrealistically high return to make privatization seem like a free lunch. State and local pensions are underfunded because of similarly unrealistic assumptions.

The reason I title this post "paging the left" is that I think it is time for someone other than a right-leaning economist to call the states and cities out on this. Brad DeLong? Mark Thoma? Dean Baker?

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COMMENTS (12 to date)
Yancey Ward writes:

Good luck with that.

thruth writes:

I think, at best, you'll hear crickets from the left. Or you'll get Dean "The Equity Premium Is a Free Lunch" Baker:

The argument that pension funds should only assume a risk-free rate of return in assessing
pension fund adequacy ignores the distinction between governmental units, which need be
little concerned over the timing of market fluctuations, and individual investors, who must
be very sensitive to market timing.

Krugman cited this approvingly a few months back.

thuth writes:

The Dean Baker link didn't work:

azmyth writes:

I was surprised to find out that the long run real growth of the stock market cannot exceed the long run growth of the economy as a whole.

The price of a stock is the present value of the future expected dividends. The percent of the economy that goes to capital has been relatively stable, so the only thing that can adjust is the interest rate. Thus, real stock market returns shouldn't exceed 3% or so in the very long run.

There are advantages to privatizing social security, but increasing returns is not one of them.

Don Levit writes:

One advantage to privatizing Spocial Security is so that the trust fund will be comprised of assets that can be liquidated without drawing down general revenues from the Treasury.
Of course, keeping the contributions needed to pay current benefits should remain on a pay-as-you-go basis.
Even if the return is less than expected, any positive return is better than zero.
Don Levit

coupon clipper writes:

Not sure why this myth persists that stock returns can't exceed gdp growth. Les Antman debunked this a while back. I don't have the link handy, but it came down to the fact that society as a whole does not reinvest all its dividends.

None of this is to say that gov'ts don't wildly overstimate returns. They also invoke the fallacy of time diversification, but that's a topic for another time.

R Richard Schweitzer writes:

In our current stage of "capitalism" most of the surplus is locked up in "retained earnings."

This puts the control of capital requirements in the hands of "managers." who have quite different objectives from investors or financial bankers.

The attempts by the financial bankers to offset that "lock-up" through credit expansions (there have been more than one), principally for consumption, have only increased managerial zeal to increase the surplus accounts of businesses.

mike shupp writes:

Memory says de Long or Krugman actually addressed this issue, some time ago, maybe a year back. They didn't see it as quite as large an issue as Megan McArdle does.

Anyhow, the thing is historically the stock market goes up 4-5 % a year and generally the sorts of stocks pension funds invest in pay dividends of 3-4 %. So if the dividends are reinvested, the value of the stocks goes up about 8% per year, which is about the sort of payoff assumed by most people running municipal pensions.

Yeah, in recessions, the stock market falls back a bit and the dividends drop off. But again, historically, recessions don't last long and the market recovers. Entities the size of cities and states can generally shrug them off -- 48 years out of 50. What REALLY gets a government pension plan in trouble is when the clever politicians decide to skip the regular payments for a year or two, on the grounds that they can easily be made up later on.

Jason writes:

Arnold, you keep making this logical fallacy about long run rates of return not being higher than GDP. It is an elementary finance mistake and it is clearly wrong and I think you should make a correction. It appeals to people until they understand what an interest rate is.

I'll prove your example wrong in a silly example. Let's take a hypothetical economy with no risk and price a stream of future dividends or output. If everyone has power utility, the interest rate is just a function of the time discount factor and expected growth. This interest rate can be anything depending on preferences. Why do people not reinvest the dividends and take over the economy when the rate of return is 50% or 100% or 1000%?

Well, what is an interest rate? Its exactly the rate of return that makes people, in equilibrium, consume everything that is produced and not invested. It can be greater than the growth rate of the economy forever, no problem.

If you realize that equilibrium interest rates are not constrained by the growth rate of the economy, then you must recognize the same is true for risky assets. Their returns are precisely the risk adjusted returns necessary to make people exactly consume all of the dividends the stocks produce.

azmyth writes:

Ok, I think I got it now. Returns from an investment can exceed GDP growth so long as those returns are not reinvested. The total returns of the stock market cannot grow faster than GDP, but the returns from an investment can be.

Capital income = capital * (average return on capital)

Capital income can be on a fixed growth trend, and as long as the stock of capital does not grow faster than GDP, the average return can be anything you like.

kebko writes:

Arnold, I don't know if you read the comments, but I want to let you know that your insistence that stock market returns can't exceed the growth rate of the economy has hurt your credibility in my book - which is a shame because I've learned a lot of insights from you. I think you need to address it.
This seems like an elementary mistake.

Old Whig writes:

The unanswered question both in privatizing Social Security and Public Sector Pension is:

Who should carry the risk for underfunding?

1. The taxpayer in general and future tax payers in particular

2. The individual that gets the benefit

I come from Sweden and now live in the US. In Sweden, the first post-industrial and first post baby boomer society, answered the question in the late 80s when our pension systems went broke i.e. the assumed BNP growth of plus 4% turned to below 2 % and the assumed 4 workers per retired turned to 2:1 was very simple.

The retiree takes the risk both on the GDP growth side as well as the ratio. Sweden went from a PAYGO system to a fully funded system with individual privatized 401k like accounts as well as an automatic cut in benefits if GDP growth goes below 2 % and the ratio goes below 2:1.

My already earned SS was cut by 33 %. However if not changed I would have as in the US today recieved 10 cents on the dollar. Now I will receive 70 % on the dollar plus my 401k part will recover the lost portion since I've since the year implemented 2000 have an annual rate of retun of 10%.

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