I don’t have any argument with the investment advice Robert Pozen and Theresa Hamacher gave readers of the Washington Post this past Wednesday. Diversification and investment in high-quality funds seems like common sense.
But the highly politicized trashing of public employee pension plans they indulge in along the way is based less on common sense than ideology. Pozen was an investment banker when George W. Bush appointed him to the President’s Commission to Strengthen Social Security. The commission launched Bush’s plan to privatize Social Security, which would have replaced the security of a guaranteed, regular monthly benefit check by making a large portion of their benefit contingent upon the returns from risky investments in the market. Why? Pozen and his fellow commissioners argued that the stock market historically yields much better returns on investment than the average worker gets from their contributions to Social Security:
“It is relatively straightforward to show that, for a given level of funding, a personal account system can offer higher total expected benefits than the current system.”
To illustrate, the commission helpfully provided a chart showing the average real returns (i.e., returns over and above inflation) of stocks from 1802 to 1997. For 20-year and 30-year holding periods, the real return was 7 percent, a nominal rate of about 10 percent. The implication was, of course, that these returns (having persisted for almost 200 years) would go on forever.
Shortly after the commission issued its report, the stock market crashed (a good lesson for a public that had been seduced by years of skyrocketing market values), and it crashed again, even harder, in 2008. Dean Baker points out that when Pozen was trying to cut public funding for Social Security and reduce benefits, he touted the potential returns of the market even though the price-to-earnings ratio was at historic highs (meaning that stocks were historically expensive to buy and unlikely to provide high returns going forward from that point).
Now, when price-to-earnings ratios are relatively low and stocks might be expected to do well for a few years, Pozen considers the market too risky for public pension plans. This seems contradictory (not to mention economically innumerate), but if one’s real goal is not to improve retirement security but to instead simply reduce benefits in public pension plans, there is no inconsistency.
Pozen argues that public employee pension plans are in crisis, or at least that a crisis is “looming.” He says we know this because even though plan liabilities are only about 4 percent of annual GDP according to standard accounting measures, those measures “rely on the existing, deficient rules for pension accounting” and understate the problem. They depend on the plans getting strong returns on their investments – generally about 8 percent in nominal terms and about 5 or 6 percent in real, inflation-adjusted terms. That of course, is less than the stock market returns Pozen and his fellow commissioners cited as the historic average for all 20 and 30-year periods. Pozen says a rate near 8 percent “seems unrealistic based on recent investment returns. Over the past 10 years, the Standard & Poor’s 500-stock index has achieved only a 1.9 percent annualized return.” Remember, Pozen was arguing the exact opposite about the expected returns from stocks when it was (a) convenient to push his policy preferences, and (b) clearly wrong, as P/E ratios meant that stocks were more expensive (and hence had lower expected returns) back then.
Pozen wants public employee plans to use a discount rate of 4 to 5 percent, lowballing their expected investment returns and magnifying their potential underfunding. He joins Andrew Biggs at the American Enterprise Institute and a host of anti-government, anti-public employee conservative commentators whose twin goals are to reduce compensation for public employees and discredit government.
Whatever one thinks of Pozen’s investment advice, his advice on public policy has a dismal track record and deserves skepticism.