The sharp increase in consumer prices this Spring may be a blip but may also be a sign that inflation is returning as a chronic problem. For those of us who can accurately recall the 1970s economy, it is a frightening prospect. Everyone else would benefit from reading contemporaneous news coverage.
Recent events call into question pronouncements of the leading Modern Monetary Theorists who thought that the U.S. could sustain much larger deficits without triggering major hikes in the cost of living. Instead, it appears that the traditional rules of public finance still hold: deficit spending financed by Federal Reserve money creation is inflationary.
Analogies between today’s situation and the 1970s are not quite on target. By the early 70s, inflation was well underway. Instead, we should be drawing lessons from the year 1965, when price inflation began to take off. Prior to that year, inflation seemed to be under control with annual CPI growth ranging from 1.1 percent to 1.5 percent annually between 1960 and 1964 — not unlike the years prior to this one.
Private equity investments underperformed broad US stock indexes for the fiscal year that ended June 30, 2020. Importantly for taxpayers and governments, this underperformance of private equity weighed down public pension system asset returns during a particularly difficult year for investments.
These investment results may mark the beginning of the end of superior private equity returns that have characterized early 21st century institutional investing. If private equity returns have now fallen “back to earth,” many public pension systems can expect heightened scrutiny over their allocations to this asset class and the high investment costs that go with it.
In some cases, state and local governments show net OPEB liabilities, which is the total amount of benefits already promised to retirees, as large or larger than their net pension liabilities. Although the total future cost of retiree health care benefits is smaller than pension benefits, which are intended to replace income, most governments have at least partially prefunded their pension benefits while setting aside little or no money to cover their future OPEB costs. This is often attributable to the strong legal protections granted to public pensions but that largely do not extend to OPEB benefit promises made to workers in most places. Nonetheless, by failing to set aside funds for retiree health benefits as employees accrue them, government employers are burdening future taxpayers with growing debt. The size of the problem is also raising doubts among prospective retirees about whether the benefits promised to them will really be there when they retire.
In this post, I consider two potential strategies for using the temporary increase in governments’ fiscal capacity to address unfunded other post-employment benefit liabilities: (1) prefunding and reforming defined retiree healthcare benefits, and (2) switching employees to defined contribution retiree health care benefits.
The extended period of low interest rates we’re in is not only creating challenges for public pension systems across the nation, but it is also negatively impacting people who are relying on their own savings to fund their retirements.
A common strategy for generating retirement income is to invest savings from an individual retirement account (IRA) or 401(k) into income-producing assets such as corporate bonds. But interest rates on corporate bonds have been falling in recent decades, reaching multi-decade lows in 2020.
However, there are reasons to be skeptical of public pension investment in private equity. While it is true that most private equity benchmarks outperformed the S&P 500 during the 2010s, it appears that public pension system investors did not benefit from this outperformance: their returns on public and private equity holdings were similar. Furthermore, it appears that private equity underperformed in 2020 and may not recover its edge in the decade ahead.
Over a long time period, annual returns on leveraged buyout funds are highly correlated with those of the S&P 500, raising questions as to whether private equity meaningfully adds to the diversification of pension system portfolios.
Pension systems should thoroughly evaluate the downsides of private equity investing before increasing their allocations to this asset class. These disadvantages include illiquidity, challenges in obtaining timely and accurate valuations, high investment costs, and lack of transparency.