Q&A: Dean Baker’s case for the RI pension fund earning 7.5%

March 29th, 2013 at 12:09 pm by under Nesi's Notes, On the Main Site

dean_baker_thumbnailThe iconoclastic liberal economist Dean Baker is famous for discovering the housing bubble years before better-known economists did so. Baker is the co-director of the Center for Economic and Policy Research in Washington. He visited Rhode Island on Thursday to speak at the Economic Progress Institute’s annual budget conference.

Baker sat down with WPRI.com after the event for a wide-ranging interview about the economic issues facing Rhode Island. (A previous excerpt discussed the Superman building and vacant properties.) In this section, Baker discusses why he thinks Rhode Island’s pension return forecasts are reasonable.

The transcript has been lightly edited for length and clarity.

When you testified in New Mexico recently, you said it would be “nearly impossible” for the state’s pension fund not to achieve the 7.75% long-term investment return it’s projecting. Rhode Island’s pension projection is even more conservative at 7.5% – I presume you think that’s even more reasonable. Why?

What most people are doing when they say you can’t get 7.5% is they’re looking back over the past, say, 10 to 15 years, where we’ve had two big tumbles in the stock market, and they go, “See what happens?” But you don’t look at the past; what you look at is the current market valuation – you look at price-to-earnings ratios. And that’s what I’m focused on.

So currently price-to-earnings ratios – I do price against trend earnings, and I look at the economywide numbers, because they invest beyond just equities, like private equity, so you don’t want to just look at publicly traded companies – and that’s roughly 15-to-1. We’ll call it 15-to-1. What that means is that if you assume that stocks grow in step with the economy on average – and you can vary that, it’s not going to change anything, but let’s just assume they grow in step with the economy – well, the economy is projected to grow in nominal terms somewhere around 4% to 5% nominal.

Just so people understand, the nominal rate is before you deduct inflation to get the real rate.

Right.

Then the other component of course is dividends, and typically companies pay out roughly 60% to 70% of their profits as dividends – either directly as dividends or they do it through share buybacks, but from the standpoint of the shareholder it’s the same thing. So if you have a price-to-earnings ratio of 15-to-1, you flip that over – I’m rounding up a little bit, but we’ll make it that earnings are 7% of the share price – if you’re getting paid, say, 60% of that in dividends, that gets you 4.2%. So if you add that to 4% or 5% nominal growth, you’re talking about a 9% or 10% annual return.

If you have 70% of your fund invested in stock, then that by itself is getting you a 6% to 7% nominal return. Then on your other 30% you’re obviously investing in lower earnings, but even if you just get 3% on that, that gets you easily 7.5% and possibly somewhat above that.

In some ways you’re more bullish about the future of the U.S. economy than the conservatives who are saying, no, you’ll never get 7.5%.

Well, I’m not more bullish on the economy – that’s pretty much the consensus forecast. I’m being perhaps more bullish about the stock market because I’m implying what everyone is assuming about the economy to stock prices.

And that’s where I think people are being sloppy – and they were being sloppy the other way in the 1990s, when I was actually out there saying, “You’re being overly optimistic – you won’t get this.” And again, this is where you see the foolishness of people just looking back – you saw people saying, “Well, if we look back over the last three decades, blah blah blah.” And I’d say, “But during the last three decades we didn’t have price-to-earnings ratios of 30-to-1.”

And that’s the point. You have to look at where we are, not what happened yesterday. But people kept looking at what happened yesterday.

Also on pensions, you published a paper about a year ago with a new idea for how governments should calculate their pension contributions over time, which is a huge issue in Rhode Island right now. What’s your idea there?

The idea is that you would look at your current valuations, and then you’d make assumptions on return based on stock prices – so when you have high price-to-earnings ratios you’d have lower return assumptions, and when you have low price-to-earnings ratios you’d make higher return assumptions.

So instead of forecasting 7.5% all the time we’d say, well, the stock market is real bubbly right now, we’d better lower how much we think the future will bring, and vice-versa.

Exactly. And that’s why I’ve been arguing with people who say, “Oh, we would have really been killed if we’d been listening to you back in the blah blah blah,” and I say, “No, if you’d been listening to me back then I’d have been more conservative than these guys, because I’d have said the stock returns are going to be very low.”

So with this you’d adjust your returns in accordance with stock prices. What that would mean is in some cases paying out more and in some cases paying out less, but on average you would have a smoother path than, say, if you always assumed a 7.5% rate of return. In one version of this Christian Weller and I called it “Smoothing the Waves.” And the idea was in principle you say, here’s what we’d like to be our contribution to the pensions – it’s going to be, say, 1% of the state budget or whatever it’s going to end up being – and you don’t want that jumping around suddenly.

Which is why everyone here is freaking out right now.

Yeah, so in principle you want to make a contribution that’s going to be a pretty constant share; it’ll never be exactly constant because you do have unpredictable factors, but a pretty much constant share, and our formula I think would come much closer – and certainly, we did simulations of it and historically that was true, and I’d expect going forward that would be the case as well. So whatever burden we have out there, the idea is we want to have it more or less even through time, so that we’re not sitting around with our hands crossed, saying, “Oh, wow, look, we don’t have to pay anything this year” – and then suddenly the next year we have to pay 5% of the budget for it.

Could a state or locality put that in place, or are there Government Accounting Standard Board [GASB] reasons they’d have trouble with that?

They would have no problem with GASB. I’m familiar enough with the rules, they allow discretion. Certainly this would be warranted. You have different assumptions – you mentioned New Mexico is at 7.75%, you’re at 7.5% -

Providence is at 8.25%.

Yeah, so you have some discretion. And this is well-founded, so you’d have a theory you’re basing it on – it’s not just, like, “Oh, well, we’ve decided to make it 10% this year” – no, you have a formula that’s written down, here’s what we’re basing it on. I can’t imagine it having an issue with GASB.

Just to be clear, you don’t support big shortfalls in pension funds, right? You don’t support overfunding, either, but you’re not saying it’s good when Rhode Island is at 48% funded.

No, no. We want properly funded pensions. But this idea – I was talking to some people in New Mexico and they said, “Oh, well, we should fully fund it.” Well, you don’t want to do that tomorrow – there’s no obvious virtue because in effect you’d say, “OK, we’re going to take two years and get to 100% and then we can reduce our funding dramatically.” Well then what we’ve done in effect is we’ve overtaxed people today so that we can under-tax people in the future, and we don’t think of any other thing like that; we don’t say, “Oh, why don’t we put all this money in the bank for our schools, then after 10 years we’ll have all this money in the bank and then we won’t have to pay for schools.”

We could do that, but everyone would go, “That’s crazy,” because obviously we’d have negative economic effects from the taxes, with reduced output as people in these years are going to have this really big tax burden, and it doesn’t make any sense. So we say, OK, we want funding for schools to be level and more or less in step with the economy, and we should treat pensions the same way.

It’s not an argument for underfunding at all. I take pension funding very seriously – we should make sure that that money’s there when it’s needed, because it’s an important commitment from the state or the city or whoever’s doing it, and you don’t want to tell workers, “Hey, oh, we messed up.” You do not want to be in that situation. I take it very seriously that you want proper funding. But there’s no virtue in saying, OK, we want this huge over-funding. That’s crazy.

Check back for more from the Nesi’s Notes interview with Dean Baker. •

• Related: Q&A: Dean Baker calls tax deal for Superman building ‘crazy’ (March 28)

Ted Nesi ( tnesi@wpri.com ) covers politics and the economy for WPRI.com and writes the Nesi’s Notes blog. Follow him on Twitter: @tednesi

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4 Responses to “Q&A: Dean Baker’s case for the RI pension fund earning 7.5%”

  1. Mario says:

    He’s not wrong, and I really like tying the funding level to PE ratios* (as long as they are computed generally, and not based on the funds current investments), it makes sense. You can’t time the market, but this seems like it would work, but since you have to assume that PE ratios vary around a mean (so short-term changes wouldn’t effect long-term returns), I’m not sure it would have a strong effect in any given year.**

    But to suggest that, if you are going with a level expectation, 7.5% is perfectly reasonable, that’s crazy. Historically, both the politicians and unions have sought short-term gains by underfunding, and there’s no reason to think that they won’t continue down that road when the political winds shift in their favor. We are certainly at no risk of overfunding, so concerns about that possibility shouldn’t even enter into the discussion when choosing a number, its just not a realistic fear.

    * I never like to say this without also mentioning that I am against the idea of public pensions regardless, for the same reason that I am against any use of unauthorized public debt to defer operating costs.

    ** For instance, if the average PE ratio drops to 10 this year, you would expect larger than average gains for a little while. But what is your expectation for PE ratios next year? I would have to say somewhere closer to the historical average, just like you would expect in any year. So your long-term growth assumption changes only a little, with slightly higher gains in Y1, but otherwise remains the same, no?

    1. Mario says:

      Having skimmed the paper now, I’m even less convinced. The paper talks about how to smooth out y/y funding for a fully funded pension system — a situation not entirely germane to this state. What’s more, it seems like (and maybe I have it all wrong) by increasing funding when PE ratios are historically high you may be compensating for lower expected returns, but you are also increasing your exposure to downside risk (since, if stocks are overvalued, you would have to expect them to fall). The system makes sense when your goal is to keep a pension level-funded, so y/y swings are more important, but that’s an unachievable ideal at the moment. In fact, if your pension system is severely underfunded, it would seem like you would be better off increasing your contributions if you can identify when stocks are undervalued. That, and switching the asset mix toward bonds when PE ratios are high, but that’s just good fund management.

      As long as pensions are underfunded, a stable estimated ror with a sufficiently long catch-up horizon shouldn’t be subject to large funding swings based on asset bubbles anyway.

  2. B says:

    Is all of this Moot now that Gina in her wisdom has invested the fund at 1%–?

  3. Ed says:

    I am glad I have a 401K, a Roth IRA, a traditional IRA, and a non deductible IRA. For the last few years I have been averaging 17% return in a diverisfied portfolio. At least I can retire and KNOW there is money in my retirement account. Public sector employees in Rhode Island especially at the municipal level have to worry about Chapter 9. Too bad these people never learned to be financial independent and responsible for themselves.
    BTW when I retire I am moving to a state that does not have income tax or estate tax.