Allison's ode to

Newsletter 26


Welcome to the 26th issue of Allison’s Ode to the Second Moment, a newsletter that answers the big existential questions like is the past really our future and what’s the right pension discount rate?

Even the discretionary budget is full of entitlements

You may have heard about the new budget proposal. It cuts discretionary spending in many areas, with the notable exception of the Department of Defense’s budget. This is not necessarily how I would tackle the budget, but as Philip Coogan points out, in this climate, increasing taxes is a non-starter (entitlements, too), so that leaves discretionary spending on the chopping block.

But while we are looking at discretionary spending, it is worth asking, calmly and rationally, what’s the most efficient way to spend our scarce resources?

I was surprised to learn how expensive military pensions are. Service members can retire after 20 years. This means people retire around the age of 40 and collect benefits for the rest of their (and their spouses) lives as they go on to second careers—that’s not cheap. The expense not only comes from paying benefits for many decades, but also bearing all the longevity and asset risk involved. The pension fund is invested mostly in TIPS, but the fund is, to put it mildly, short duration and earned 1.8% in 2015, well short of the assumed 5.5% return.

These pensions also exacerbate inequality within the military. About 50% of officers and only 17% of enlisted service members end up collecting any retirement benefits. Considering officers are more educated and skilled, and have better post-military career prospects, it seems this isn’t an efficient way to construct compensation.

This pension structure creates all sorts of interesting incentives. Attrition is high up until the 10-year mark. But the odds are if you make it to 10 years of service, you’ll stay another 10. The military knows this and tends to send long-time service members to less desirable locations like Korea or Louisiana (nothing against either of these places, they sound nice to me, I am told they are 'undesirable' from a service point of view).

Partly in response to millennials demanding more flexibility (turns out even military millennials aren’t afraid to speak up about their needs), there have been some reforms. They include small cuts to the DB plan and adding a DC plan with a match. Even these small changes have increased uncertainty about how long people will stay in the military now.

Puerto Rico still on the brink

Speaking of expensive pension inequity, Mary Walsh had a great story in the Times about Puerto Rican pensions. The Puerto Rican pension fund is due to run out of money next year and like many DB plans it favors older workers over younger ones. Imagine working for the Puerto Rican school system where the future is so uncertain and a large share of your compensation goes toward what has become a pay-as-you-go pension with a long vesting and smaller benefits for younger teachers.

It seems like you can never cut an existing benefit. However, the control board estimates pensions must be cut 10%, they must eliminate Christmas bonuses, and they must furlough teachers in order to pay for other basic services. It is hard to see how Puerto Rico will grow out of this one when it requires so much austerity.

Is Connecticut next?

Speaking of under-estimating risk causing fiscal stress, several cities in Connecticut are on the verge of bankruptcy. Things aren’t much better statewide. Pension costs are out of control, and the funding ratio of the state plan is just about 35% (assuming a 7%+ discount rate).

Connecticut is in a tough spot. I never realized people associated the state with prosperity until I lived in New York. Many of the factory jobs, in textiles and metals, left in the 1970s and 1980s. Parts of the state were early victims of the heroin epidemic, and now Connecticut suffers from some of the highest rates of heroin overdoses in the country.

Now even the richer towns are losing large employers in part because of the high tax burden, but also because young, talented people want to be in big cities. Connecticut’s strength has always been its suburbs. This report argues Connecticut plans to boost growth through urban revitalization, and sticking the cost to the suburbs, is hopelessly misguided.

It doesn’t have to be this way. Rhode Island certainly has its problems, but it is doing comparatively better.

Is it too soon to use the C-word?

So what can the states do? It is nearly impossible to cut pensions even in the private sector. Just look at the saga of Central States. Woefully under-funded, they got permission to cut their DB benefits, but this never materialized. Now it’s getting political attention and some speculate this will sink President Trump.

Others speculate pensions will sink all of us. I guess that’s why it is important to account for risk in your pension discount rate. Time to update the score of the nerdiest rivalry in the world, the one between actuaries you think you can use the expect rate of return as your discount rate, and financial economists who prefer a risk-based measure:

Actuaries: -100
Financial economists: +50,000

But who knows? Low interest rates are partially to blame for this situation. Rates could increase and offer pension funds some relief. The whole point is you need to account for risk, sometimes risk works out in your favor.

Higher rates to the rescue

Speak of the devil, this week the Fed increased interest rates and more rate hikes are likely in 2017. If you read most of the coverage, you’d think high rates, by discouraging investment and hurting debt-laden consumers, only pose costs to the economy. All policies have costs and benefits and increasing interest rates is no different. I don’t just mean inflation credibility. Keeping rates too low for too long can create distortions and undermine financial stability.

The Bank of International Settlements welcomes higher rates. They have an interesting take on low rates and financial stability. Policy makers and commentators, who don’t have much experience in financial markets, tend to assume that long rates are a perfect reflection of expectations of future short rates. When they defend keeping rates low, they tend to assume that low long-term rates indicate poor growth prospects and that the natural short rate is low too.

But as we pension geeks know all too well, it’s not that simple. Some people (pensions and insurance companies) like duration or face regulations that require them to hold long-duration assets. This means there’s a natural demand for long-term assets and the low long rates reflect their need to hedge long-term liabilities and risk preferences.

Myron Scholes has a fun column on how derivatives’ prices indicate that now is a good time to increase rates. Perhaps it means the Fed should have increased rates earlier. Matt Levine has become woke to the fact that the VIX, a measure of future risk based on derivatives prices, is really backward looking. After all, the volatility used to price derivatives tends to be estimated from historical data. So future expectations are necessarily backward looking and maybe don’t tell us much about future risk. It’s just like the movie Memento and so many things in life; pretty deep stuff.

Higher rates also can benefit savers. Things are getting spare for future retirees. Diane Garnick points out they need low-risk assets (annuities, long-term bonds) to finance their essential expenses. This will be a lot cheaper if rates are higher.

Guess life is more complicated than those static, deterministic, Keynesian models we learned as undergraduates.

Until next time, Pension Geeks!