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IU: Is this something that has been exacerbated by recent events? Ryan: It's a long story, but bad rules lead to bad decisions. Because pensions never priced their liabilities at the market value - instead, it's some accounting rule that smoothed or amortized or created some actuarial value instead of a market value - the client never really knew the true valuation of their liabilities. In some cases, they didn't even know the valuation for the assets, because the assets tended to be smoothed. Imagine a bank that can't tell you your current balance but can tell you the average balance for the last five years. I don't think that would help you write a check. It's the same thing here: We have a problem with the clarity of values. Most pension funds really are confused as to the true valuation of their assets and liabilities so they don't know the true funded ratio. If somebody told you that you had a deficit, hopefully you would behave differently than if you had a surplus.
Here's a cute story: When the stock market was going crazy in the late 1990s and having 20% to 30% returns almost every year, Greenspan saw this overvaluation and he disclosed the Fed model for the stock market, which compared the S&P 500 to the ten-year Treasury and showed that it was about 62% overvalued on a 40- or 50-year basis. Well, guess what the stock market did: It tanked. He didn't want it to go down too fast; he just wanted it to correct itself. So as the stock market was going down too fast, what did he do? He decided to lower the interest rate, and he lowered it and lowered it and lowered it for three years to help the stock market not crash but come to a safe landing. It really didn't work, but it killed pensions.
Those three years, 2000 to 2002, it's amazing what happened to pensions, and we had a rash of bankruptcies in corporations, most of which most people never heard of, where they turned over their pensions to the Pension Benefit Guaranty Corporation (PBGC). Greenspan also created this budget crisis for cities and states, and because they amortized over 30 years, this thing is really out of whack. It's the big thing you're going to be hearing about, that cities and states have this humongous budget explosion mainly due to pensions and they don't know what to do about it. So they're selling assets and borrowing money. They're trying everything under the sun not to tax people, and it's kind of scary.
Lowering interest rates dramatically, I believe, is the cause of the pension crisis and the cause of the market's problem, where people went and bought inflated houses at supposedly cheap money, but since it was an adjustable rate when those things reset they got clobbered. So they're just buying time, but they still have the problem of buying an inflated house at a mortgage that they can't afford.
IU: How is the practice of amortizing adding to the problem?
Ryan: That's what the public side does - they amortize everything over 30 years. They stretch it out, which kind of buys time, but what it means is their contributions will be going up for 30 years unless they can find a miracle solution. If lower interest rates cause the problem, you would think that higher interest rates would be the solution, but that's not what they're doing. They're reaching out to find assets that can give them better returns. So they're going into assets and strategies that they never did before --- very risky assets, very risky strategies to try and enhance their returns --- alternative investments, leverage, 130/30 strategies and the like. That was never allowed in pensions. So now we have this new wave of strategies that are very risky to supposedly get a better return. It might work, but the better solution is that interest rates need to go up.
The Fed is the major operator of the yield curve on the short end. You can see the long end doesn't believe it, so the long end hasn't gone down in yield like the short end, and it has created this tremendous slope. At the same time inflation looks like it's becoming more pronounced, so we just need interest rates to go up gradually, nothing dramatic. If they would go up gradually for the next five years, then pension funds could get out of their hole. It's hard to say about mortgages, but if inflation and interest rates go up, usually the value of your house goes up. That might help housing. You just need a gradual movement here.
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