Posted by: Dirk | July 22, 2013

The equity premium puzzle and the default of Detroit

The latest news from Detroit is negative: the city defaulted on its debt. What this means for pension plans was up for discussion, but a gaping hole has come up lately. The NYT reports on a $3.5 billion hole in its pension system:

To calculate a city’s pension liabilities, an actuary instead projects all the contributions the city will probably have to make to the pension fund over time. Many assumptions go into this projection, including an assumption that returns on the investments made by the pension fund will cover most of the plan’s costs. The greater the average annual investment returns, the less the city will presumably have to contribute. Pension plan trustees set the rate of return, usually between 7 percent and 8 percent.

In addition, actuaries “smooth” the numbers, to keep big swings in the financial markets from making the pension contributions gyrate year to year. These methods, actuarial watchdogs say, build a strong bias into the numbers. Not only can they make unsustainable pension plans look fine, they say, but they distort the all-important instructions actuaries give their clients every year on how much money to set aside to pay all benefits in the future.

So the problem is the following: if you build a balance sheet of a pension plan assuming that assets grow “usually between 7 percent and 8 percent” and then you find out they do not you are facing a big gap. If interest rates are basically zero, as they are now and probably will be in the near future, then the 7 or 8 percent of return is impossible. The pension plan was built on a wrong premise. This premise has some academic back-up: it is called the equity premium puzzle. Here is an excerpt from a 2009 paper by Brad DeLong and Konstantin Magin (p. 206):

Our necessarily impressionistic guess, balancing these estimates and factors together, is that the equity premium will continue over the next few decades, but at a lower level—perhaps at 4 percent per year rather than the historical rate of 6 percent. From the perspective of the overall economy, the persistence of an equity premium suggests that the risk-bearing capacity of society is not being fully utilized, and that social welfare gains might be achieved by the design of financial institutions that give financial markets a push toward being more willing to invest in equities long term. What institutions would make long-run buy-and-hold bets on equities easier and more widespread? Mandatory personal retirement or savings
accounts with default investments in equity index funds? Default automatic investment of tax refunds into diversified equity funds via personal savings accounts? Investing the Social Security trust fund balance in equities?
My question is: what if the equity premium puzzle is none because equity prices would have taken a huge hit if central banks and Treasury did not intervene as they did in the financial crisis? The Dow fell by almost half, and that would have wiped out a lot of the premium of the last ten, twenty years. Japan comes to mind, where the NIKKEI stock market index fell from 40,000 to below 10,000, where it still remains. Maybe the return to equity is higher because the risk is higher (that is surely no implausible working hypothesis), but the downward risk has just been “adjusted” by the actions of the Fed.
So, back to Detroit. Did the profession of actuaries by using the equity premium puzzle arrive at a “wrong” rate of return? If so, should not all plans be redesigned? How to do that, without causing an earthquake on financial markets? These must be unnerving questions for pension funds and financial sector firms in general. However, these should be questions to be discussed in the open, in newspapers and journal articles. The manipulation of the US stock market by the Fed might be legal, but as a result it should be clear to everybody that stock market prices are heavily influenced by the central bank and financial market regulation. Should the Fed have a goal for the Dow Jones? Should it just watch it slip down again after quantitative easing failed to increase economic growth and only succeeded in redistributing wealth?
Detroit’s financial problems leave us with urgent questions about the design of pension plans and the role of financial markets.
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