By: Mark Glennon*
Nobel Prize winning economists aren’t the hyperbolic type. They usually speak in measured tones, careful to protect the precision of their academic viewpoints. Two of them have spoken openly about public pensions, including one about Illinois pensions. They are uncharacteristically harsh.
First, there’s William F. Sharpe, a Stanford professor who won 1990 Nobel Prize for Economics for his work in developing models to aid investment decisions. The Financial Analysts Journal interviewed him last year. Here’s what he said:
Is this a disaster? You bet…. It’s a crisis of epic proportions…. [Pensions] value liabilities at 7.5% or 8% on the grounds that they are pretty sure they’ll earn that in the long run. This is crazy. It gets even worse. Because they want to minimize the reported value of the liabilities, they want to use a high discount rate, and in order to justify it, they have to build really risky portfolios. Consequently, they believe that one of the great hings to do is put money in private equity, or maybe a hedge fund, because then they can assume an extra 300 or 400 bps of expected return for an illiquidity premium (or just because hedge fund managers are so smart). So, the tail wags the dog.
Idiotic accounting drives even worse investment decisions. This is the classic case of an organization that borrowed money while issuing purportedly guaranteed payment and then used the money to invest in risky securities. Where have we recently heard that this is not a good thing?Of course, you can point to the politics to see why politicians might give benefits that are very large to employees, especially those who may beable to influence elections in various ways. By making sure the benefits are mostly in the future, politicians can pretend that they cost a lot less than they’re going to cost. It’s a very bad situation. [Emphasis added.]
Second, there’s Eugene Fama from the University of Chicago, often called “the father of modern finance.” He won the 2013 Nobel for his work on financial markets. He was interviewed a year and a half ago by Chicago Magazine. When asked specifically about buying Illinois bonds, he said:
Well, in the short term, they’re OK. In the long term, I wouldn’t touch them. The [state’s] pension liability is much worse than [the reported $100 billion that] people think.
States discount their liabilities—I think Illinois uses a discount of 7.5 percent [it’s in fact between 7 and 8]—arguing that’s the expected [annual] return on their portfolio. But the expected return on a portfolio is totally irrelevant. What counts is, How risky are the claims that you have to meet? You’ve made a promise to your employees that you’ll pay them a certain fraction of their income that is usually indexed. Which means it’s a risk-free real outcome. What’s the risk-free real rate? Is it anywhere near 7.5 percent? It isn’t. Historically, it’s like 2 percent. A 2 percent discount rate would approximately triple Illinois’s pension liabilities. [Emphasis added.]
Nobel Prize winning economists aren’t always right. Sometimes they disagree with among themselves. Not on this. Putting more tax dollars into them before they are reformed and properly measured in the way Sharpe and Fama say is pure folly.
*Mark Glennon is founder of WirePoints. Opinions expressed are his own.