domingo, 10 de septiembre de 2017

domingo, septiembre 10, 2017

They’re Using Bernie Madoff Math to Hide a Crisis

by Nick Giambruno




Politicians are always generous with other people’s money… until it runs out.

Near the peak of the late-’90s tech bubble, California’s legislature passed the largest pension increase in its history.

Today, with as much as $750 billion in unfunded public pension debt, California has one of the worst pension situations in the country. But it’s far from alone.

Illinois has a staggering $250 billion in unfunded pension obligations. State pension plans in Connecticut, Pennsylvania, New Jersey, and many other states are taking on water, too.

Unfunded public pension liabilities in the US have surpassed $5 trillion.

Taxpayers Are Stuck With the Bill

There used to be a simple formula for a secure retirement. American workers would work for a big company for decades. Then, at a certain age, they were eligible for a monthly pension check… for life.

Once common, pensions have virtually disappeared from the private sector. Today, less than 4% of companies offer them. It’s another vector in the devalued standard of living of the average American.
Essentially, only government employees get pensions now.

The government isn’t subject to the same constraints as the private sector. So it has no problem promising benefits it can’t afford to pay.

That’s because government revenue doesn’t come from the voluntary exchange of goods or services.

It comes from taxes, which it extracts via coercion.

Politicians only care about the next election. So there’s no way to hold them accountable in the long term.

They automatically do the most expedient thing in the short term, like promising extravagant pension benefits. In the long term, their successors have to deal with the consequences.

Naturally, not one of the politicians who voted for California’s record pension increase is still in office.

It’s bad enough that politicians give themselves and other state employees extravagant retirement benefits and stick the taxpayers with the bill.

But the story gets worse…

Government pension plans use all sorts of accounting wizardry that would land someone in the private sector in prison.

Bernie Madoff Math

The single most important number for a pension plan is its assumed rate of return. This is the rate the plan’s investments are expected to make.

As in other areas of life, the government takes special privileges here. It uses accounting practices that the private sector can’t—not legally, anyway.

Essentially, government pension plans choose whatever rate of return they’d like.

Lawrence McQuillan—a senior fellow at the Independent Institute—says that government pension plans “work on the assumption that they’re going to generate returns 25% higher than Warren Buffett every single year into perpetuity.”

These assumptions are totally disconnected from reality.

Government pension plans overestimate investment returns using unrealistically high rates of return.

They routinely pull numbers out of thin air.

The results they come up with are insane.

In effect, this artificially shrinks a pension fund’s liabilities, making it look more solvent than it really is.

In other words, the government is using Bernie Madoff math.

This lets politicians contribute less money than the fund needs to be truly solvent. That, in turn, frees up money to bribe constituents for votes, or do whatever else the politicians want.

On average, government pension plans assume about a 7–8% rate of return (even after years of underperformance).

False Assumptions

A recent study found that the average 2016 return for a public pension was an awful 0.6%, compared to an average assumed return of 7.6%.

At those assumed rates, a dollar invested today would double in around nine years. This rosy assumption allows a pension plan to say, for example, that $25,000 in the fund today will cover a $50,000 obligation in 2026.

California’s public employee pension plan is the largest pension plan in the US. It recently voted to reduce its assumed rate of return from 7.5 to 7% over three years.

The move—which doesn’t go nearly far enough—generated enormous political controversy.

Lowering the rate of return to a more realistic number, if even slightly, means politicians would need to contribute more to a pension fund. That means drastic spending cuts or higher taxes elsewhere.

This is why, in most cases, it’s politically impossible for a government pension plan to stick with anything close to realistic assumptions.

The Biggest Financial Bubble in World History… and Pensions Are Still Broke

In the ’50s and ’60s, government pension funds were, on average, over 90% invested in bonds and cash.

Most importantly, they were structured so that assets matched future liabilities. It was conservative, and it made sense.

That’s not how public pensions look today.

Matching liabilities with safe fixed income investments has become impractical, thanks to the Federal Reserve and the historic bubble it’s created in the bond market.

The economy has been on life support since the 2008 financial crisis. The Fed has pumped it up with unprecedented amounts of “stimulus.” This has created enormous distortions and misallocations of capital, especially in the bond market.

Think of the trillions of dollars in money printing programs—euphemistically called quantitative easing (QE) 1, 2, and 3. In short, the Fed created trillions of dollars out of thin air and used them to buy up bonds, creating an epic bubble.

Meanwhile, with zero and even negative interest rates in many countries, rates are the lowest they’ve been in 5,000 years of recorded human history.

What’s happening in the bond market could not happen in a free market. It’s only possible in the current “Alice in Wonderland” economy created by central bankers.

This is not hyperbole. We’re really in uncharted territory. (Interest rates were never lower than 6% in ancient Greece and ranged from 4 to over 12% in ancient Rome.)

Allegedly, the Fed has done all of this to save the economy.

In truth, it’s warped the economy and turned the bond market into the largest financial bubble in human history.

This, of course, affects pensions.

First, today’s artificially low interest rates make it very difficult to match future liabilities with income from bonds at a reasonable cost. So pensions have had to turn to riskier assets like stocks, real estate, and alternative investments.

With interest rates near all-time lows, bond prices are at an all-time high. That benefits pension plans because it pumps up asset values and makes the funds look more solvent.

But, even with the bond market in a historic bubble…

Even with the stock market at all-time highs and more overvalued than almost ever…

And even with the Bernie Madoff math…

Public pensions are still insolvent.

Despite the eye-watering returns in the bond and stock markets over the past 10 years, pension liabilities have still gone up.

According to Moody’s:

The optimistic "best case" of cumulative 25% investment return would reduce net pension liabilities by just 1% through 2019 year-end because of past bad investment returns and weak contributions.

Meanwhile, the "base case" scenario of 19% returns would see net pension liabilities rise by 15%.

This is an unsolvable problem.

Many public pensions are hopelessly insolvent. It will all be apparent in the next market downturn, which probably isn’t far off.

I think we’re headed into an enormous crisis.

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