THE BLOG
04/28/2010 05:12 am ET Updated May 25, 2011

It's the Assumptions, Stupid!

"I'd like to get your perspective on what your assumptions are, because obviously things could get a lot worse here."

That was the question put to the CEO of Fannie Mae, the huge government-sponsored mortgage lender, in November 2007 about mortgage assumptions.

The CEO's response:"[T] here's a fundamentally sound business model here."

The assumptions proved wrong, and just ten months later the federal government seized a dangerously underfunded Fannie Mae and its sister enterprise, Freddie Mac, at a cost so far of $110 billion.

Today, state-sponsored pension funds are being asked about their assumptions. But so far, California's pension funds (CalPERS and CalSTRS) aren't answering, and that's bad news for Californians.

Pensions payments are supposed to be funded by the combination of contributions during the employee's work years and investment earnings on those contributions. Because contributions must be made before investment profits are earned, contributions are based upon assumed investment returns. The higher the assumed return, the lower the contribution. Because of compounding, a tiny difference in assumption makes a huge difference in contribution. For example, an investment assumption just 10% lower than CalSTRS's assumption boosts the upfront contribution for a pension payment due in 45 years by 40%.

Now, there's no problem if investment profits end up equaling those assumed. But if not, budgets down the road are invaded to make up the difference. Under the previous example, if the upfront contribution is based on CalSTRS's higher assumption but the lower assumption ends up on target, then the budget in the year the pension is due will be invaded for 28% of the pension payment.

This is why CalPERS invaded the state budget this year for $3 billion, five times more than projected. But even that huge figure optimistically assumed CalPERS would earn at a high rate going forward. CalPERS is already projecting pension costs growing to more than $10 billion per year, but if its earnings are off by just a little, the costs will be billions greater. But by how much greater isn't known because CalPERS doesn't disclose those consequences.

Worse, in 1999 CalPERS lobbied to boost pensions without boosting contributions, saying the enhanced promises could be issued "without it costing a dime" because of future investment returns. (One can only imagine the lawsuits had a private company given the same assurances without disclosing the risks. Even most mortgage lenders during the recent real estate bubble provided more disclosure.) But over the past ten years the state budget was invaded for $20 billion, four times more than the $5 billion CalPERS projected, squeezing out funding for higher education, parks and other current programs.

As a result of underfunding due to high assumptions, the two pension funds have built up over $100 billion of debt that's growing 7.75-8% per year. But even that titanic amount, which exceeds the state's infrastructure debt, is based on assumptions. For example, CalSTRS reports a debt of $43 billion, but that figure implicitly forecasts the market to double every 11 years. If not, the debt is greater. For example, the debt more than triples if the market doubles only every 16 years. The greater the debt, the greater the future invasions.

This isn't rocket science. Pension funding is like saving for college, yet pension funds don't disclose what every college saving parent knows, namely the consequences if investment accounts don't grow at assumed rates. The similarity ends there, however, because college-savers and their children suffer those consequences while in the case of pension funds, the consequences fall on citizens down the road who must pay for past pension costs at the same time as they need to pay for their own costs. This explains why college-savers have an incentive to employ reasonable assumptions, even if it means having to contribute more up front, and why inadequate pension funding is the moral equivalent of leaving one's debts to one's children.

Pension funds may well earn at their assumed rates, and we should all hope they do. But if and when they don't, the consequences for innocent parties are severe. That's why Governor Schwarzenegger has proposed that pension funds be required to disclose these risks. Simply put, government-sponsored pension funds should practice the highest standards of disclosure.