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"One of the few voices of restraint back in 1999 belonged to Ronald Seeling, then CalPERS’ chief actuary. Asked to study differing scenarios for the financial m
by n00b101 10y ago
"One of the few voices of restraint back in 1999 belonged to Ronald Seeling, then CalPERS’ chief actuary. Asked to study differing scenarios for the financial markets, Seeling told the CalPERS board that if the pension fund’s investments grew at about half the projected rate of 8.25% per year on average, the consequences would be “fairly catastrophic."
Who decided on the projected rate of 8.25%, in the first place? Wouldn't that have been the work of the CalPERS’ chief actuary, Ronald Seeling?
The root cause of the problem was the actuarial assumption of an 8.25% rate of return. This is what allowed the new Defined Benefits to appear to be "free," and that is what enabled the board and politicians to ram this through.
Assuming an "average case scenario" of consistent 8.25% annual return on a pension investment portfolio is subjectively irresponsible, even in 1999. But more egregious is the fact that the actuarial profession failed miserably to recognise that the Defined Benefit was a financial guarantee similar to a put option, which means that the value of the put option should have been explicitly calculated - which would have been done by projecting scenarios using the "risk-neutral" rate of return (i.e. the yield on US government bonds) instead of the "real-world" rate (i.e. the super-optimistic assumption of 8.25% annual returns).
The article goes on to explain that the Chief Actuary ran 3 different scenarios: a "pessimistic" scenario of 4.4% returns, "average" scenario of 8.25% and "optimistic scenario" of 12.1%. This is the crux of the problem, and it is not the first time that such actuarial calculations have blown up a pension plan like this. The right thing to do would be to calculate a single "scenario" using the risk-neutral rate, which would have been lower than 4.4% in 1999 and today it would be closer to 0% ... That would have correctly valued the economic cost of pension benefit as a multi-billion dollar expense that no politician would be able to so easily ram through the legislative process.
"Lou Correa, then a freshman Democrat who carried the bill in the Assembly, said he fell victim to inexperience. He remembers seeing actuarial reports and assuming he’d “kicked the tires” and asked the right questions. Correa, now running for Congress in Orange County’s 46th district, said he should have sought independent financial advice."
I think Correa was reasonable in assuming that actuarial reports, signed by the Chief Actuary of CalPERS, would have properly "kicked the tires." That is what the actuarial profession is supposed to do. Just like if an engineer signs off on the construction of major transportation bridge, we can reasonably expect that that the bridge won't be be designed with fundamentally incorrect physics calculations.
- neaden 10y agoAgreed. If I knew someone who was investing for retirement on the assumption of an 8.25% growth I'd be worried about them. The fact that a government agency did it is scary.
- user5994461 10y agoFrom what I recall, 8% returns might have been correct in 1999.
- n00b101 10y agoSee above, the problem does not lie in the subjective question of whether or not 8% return is a reasonable assumption for an investor. The problem lies in how the actuarial liability was (mis)accounted for - specifically, the value of the guarantee was accounted by assigning it zero cost - which is completely incorrect. It is as if an incompetent real estate appraiser were to assign zero value the Golden Gate Bridge, and then your local politician legally transferred ownership of the bridge to some friends for free because the appraisal assigned zero value to the bridge. And then those friends started charging tolls on the bridge, and pocketing the money for themselves. That would normally be considered fraud or embezzlement.
- n00b101 10y agoThis is a routine practice for actuaries. Here's an actuary from 2008 in New York's pension system calling his calculations "voodoo:" "In an interview on Thursday, Jonathan Schwartz, an actuary, called his job “a step above voodoo” and conceded he skewed his work to favor unions. He also admitted to erroneously claiming that a controversial early retirement bill, backed by District Council 37, would have no cost, explaining, “I got a little bit carried away in my formulation.” [1] Again, my point is not just that 8.25% growth is a very optimistic assumption. My point is that we you guarantee a rate of return on investment, then you need to calculate the value of the guarantee explicitly, and the established formulas [2] for calculating the value of such guarantees do not require any assumptions about future growth rates - you are supposed to just use the "risk-neutral rate" rate, which is like the yield on US government bond. An example of the guarantee that I'm talking is this (from the article): "Highway Patrol officers could retire at 50 and receive as much as 90% of their peak pay for as long as they lived" ... So the pensioners are guaranteed to receive X% of their peak pay, regardless of what the actual rate of return turns out to be on the pension investments. This is equivalent to a put option, and the valuation methodology that the Chief Actuary used for this (according the article) is inexcusable - but not surprising. [1] http://cityroom.blogs.nytimes.com/2008/05/16/speaker-tosses-work-of-voodoo-actuary/ http://cityroom.blogs.nytimes.com/2008/05/16/speaker-tosses-... [2] https://en.wikipedia.org/wiki/Black%E2%80%93Scholes_model https://en.wikipedia.org/wiki/Black%E2%80%93Scholes_model