California’s pension plans have been front page news for some time now. The first sign of real trouble came when CalPERS saw its assets drop from $253 billion to $183 billion in 2008 as global equity markets plunged. More recently the Little Hoover Commission released this report saying that the “pension plans are dangerously underfunded, the result of overly generous benefit promises, wishful thinking and an unwillingness to plan prudently.” 

For the most part, the Little Hoover Commission report focuses on runaway pension benefits that have become unsustainable. Consider the infamous Senate Bill Number 400 signed by Governor Gray Davis in 1999. The new law allowed California Public Employees, among other things, to have their retirement pay based on the “highest average compensation earnable during a consecutive 12-month period” rather than the “highest average compensation earnable during a consecutive 3-year period.”

I remember that episode well. An old family friend retired in the late 1990s just in time to get the benefit of the bill – an unexpected pop in retirement pay. Pity the poor actuaries who estimated the contributions required to fund his retirement based on one formula only to have it changed in his favor at the last minute. Not surprisingly, the Little Hoover Commission report recommends that “the legislature must prohibit retroactive pension increases.”

Skeptics of the notion of runaway pension benefits should consider the established vocabulary for the various unseemly ways in which employees can enhance their retirement pay. We have pension spiking, “the practice of increasing a member’s retirement allowance by increasing final compensation in the final compensation figure used in benefit calculations, and which has not been considered in prefunding of the benefits,” according to the Commission report. Golden handshakes are early retirement programs that enable members to receive higher retirement benefits than otherwise possible. And there is “air time,” a standing offer to employees to buy additional retirement benefits at pretty much below market rates. Hint: Buy the air time just before you get a raise.

One major aspect of the California public pension system that seems to get less public scrutiny is the portfolio management. Sadly the Total Fund under performed its benchmark by 70 basis points a year over the 10 years ended June 30, 2010. (The average annualized return was 2.6% for the Fund and 3.3% for its benchmark.) You can find this figure on Page 91 of the 2010 CalPERS Comprehensive Annual Financial Report. A 70 basis point shortfall may not seem like much, but we calculate that achieving the benchmark return over the  ten years ended June 30, 2010 would have lifted fund assets by $17.8 billion.

The return series has a “hedge fund that blew up” look to it. For seven years the Fund tracked the benchmark closely and beat the benchmark returns by an average of two-thirds of a percent. Then, bam, the fund under performed by nearly 11 percentage points in the two fiscal years ended 2009.

This assumes the returns reported by CalPERS are correct and there is an oddity about their reporting that makes that assumption questionable. It’s the damndest thing. At the bottom of   Page 3 in Facts at a Glance: Investments published by CalPERS on March 15, 2010 is the following footnote: Beginning 6/30/02 performance figures are reported as gross of fees.

Now this is allowable if it is disclosed, but it just isn’t done. Go to a site like Fidelity’s or Vanguard’s and look for performance figures that do not properly subtract management expenses to arrive at reported fund returns. Meanwhile, this “gross of fees” stuff makes analysis more difficult. Now we have check and find CalPERS paid external consultants $45.1 million and external managers $232.7 million, including performance fees, in fiscal year 2010. The grand total for investment expenses was $393.3 million in that year.

Almost as soon as we estimated performance net of fees, that footnote was gone in the Facts at a Glance: Investments published in February of this year. Figures in the fiscal year column are slightly lower than those reported a year earlier, presumably because they are now net rather than gross of fees. One question remains, however: Why are the performance figures in the calendar year column exactly the same in the new report as they were in the year-earlier report? It looks like calendar year returns were not adjusted to reflect performance after fees.

While we are harping on the management fee issue, does CalPERS include the cost of employees who monitor their active managers in the grand total for investment expenses? Some of the strategies are very complicated and require substantial ongoing due diligence.

All of the above brings us to our first modest proposal: Limit CalPERS investments to publicly traded securities. Such a change could spread the great recession to the finance industry, but the CalPERS portfolio is for public employees, not for finance professionals.

To be sure, the CalPERS staff is full of smart people, but they are not smart enough guide tens of billions of dollars through the dark world of privately held investments, even with the help of consultants. Exhibit One: Witness the sharp downward deviation from the benchmark in 2008 and 2009. And in case you object that those private investments add to expected return, we respond that they also add to expected risk. Exhibit Two: Look at Exhibit One.

Just for fun we looked at the historical return of a public-securities-only portfolio. We noted the  CalPERS target asset allocations over the past ten years and assumed that equity (both U.S. and foreign) and bond allocations were indexed. We put the real estate money into publicly traded REITs and added the funds in private equity and alternative investments into the U.S. equity basket. The hypothetical fund beat actual CalPERS performance over the past eight years but lagged a bit if the past 10 years are counted.

Add some diversifying indexes to our crude experiment and we think a public securities benchmark could rival actual CalPERS returns. So just fire all the analysts, portfolio managers, consultants and lawyers associated with private investments in particular and active portfolio management in general and CalPERS would be a leaner, cleaner and more transparent organization.

Here is modest proposal number two: Revisit the CalPERS Fund asset allocation. The current target calls for 73% of the money to be invested in equities and alternatives and the remaining 27% in bonds. The reliance on risky assets is based on the notion that they provide higher expected returns than bonds.

There is well-known problem with this allocation.  The Fund provides retirement benefits with the typical retiree getting a pension check every month until he or she dies. In the aggregate retirement benefits are a series of fixed income payments, so virtually 100% of the liability side of the CalPERS balance sheet moves around like a bond portfolio.

Now having 73% of the assets in equity-like investments creates a huge mismatch between the assets and liabilities. The mismatch worked against CalPERS in last 10 years when U.S. bonds rose 5.6% annually while stocks rose only 3.6% per year. As a result, liabilities rose more than assets.

So should CalPERS have an all-bond portfolio? Probably not, but 73% in equities seems a little high, considering the asset-liability mismatch risk.

One place we looked for direction on this question is the 2010 Annual Report for the Hartford Financial Services Group. The stock symbol is HIG, if you want to look it up. The lion’s share of the Hartford Group’s business is related to insurance, so you can imagine they spend a lot of computer and brain power to project future liability payments, which, coincidently, look like a big bond portfolio.

The Annual Report is full of talk about asset/liability management, meaning that that they manage their assets so they can meet their future obligations under a wide range of economic and financial scenarios. The Hartford Group has a $131 billion investment portfolio with $95 billion invested in bonds and $36 billion in equities – that’s 73% bonds and 27% stocks, just the opposite of the CalPERS portfolio.

So we conclude that 73% is probably too high for the Fund’s equity exposure, but we are not sure what the right level is. With the benefit of hindsight, however, we think CalPERS promised more in benefits than it prudently should have and then, in a reckless attempt to make good on those promises “reached for yield” by stuffing the portfolio with risky assets.

Now we admit that the CalPERS has many peers in poor financial shape. Just Google “Yale Asset Allocation” or “David Swensen” and you will see the line of thinking used to justify the light-on-bonds approach to fund management. It will be interesting to see if any of the big public pension plans change their asset allocation targets in the coming years.

One last note, if anybody at CalPERS is listening. Bonds are incredibly expensive now and stocks have suffered a rough patch over the last decade. If past is prologue, stocks may well out perform bonds in the coming years. So if there is a decision to increase bond exposure, do it slowly – like over the next ten years or so.

I ask you to refer to the table below and draw a line between each price sector on the left and the correct rate of inflation for that sector on the right. You may not ask the audience nor may you phone a friend. The inflation rates are for the years from 1971 through 2009. 

Ready for the answers? The Consumer Price Index, a broad-based measure of prices, grew at a 4.5% average annual rate from the fourth quarter of  1971 through the fourth quarter of 2009. Energy prices rose 5.5%. The Medical Care Price Index advanced at a 6.4% annual rate and four-year public college tuition rose a whopping 7.7%.

My gosh,  if this keeps up the higher education sector will account for 87% of the economy by the year 2170.

Sources, you ask? Consumer, energy and medical care price indexes are published by the U.S. Labor Department’s Bureau of Labor Statistics. The Bureau’s figures for higher education only go back to 1993, so I used tuition at the University of California.

Now it is true that California students suffered massive tuition increases beginning in the spring of 2009, which arguably would skew the college inflation figure upward. The other side of that argument is that California schools were unsustainably subsidized by the state and the unchecked generosity finally met reality.

In any case, I checked another source. The College Board says that tuition and fees for public four-year institutions amounted to $376 in 1971 and $7,020 in 2009. The comparable figures for private four-year colleges are $1,820 for 1971 and $26,273 for 2009. The compounding arithmetic works out to an 8.0% average annual increase for public four-year colleges and 7.3% for private four-year colleges.

So there you have it. College costs have skyrocketed over the past four decades but the government and the media squeal most about energy and medical costs. How many times has Congress called energy companies on the carpet? And how did they manage to demonize insurance companies as medical care costs rose two percentage points a year more than prices in general?

Here is my solution. Let’s implore Congress to write a bill (minimum length: 2,500 pages) to take over the higher education industry. Call it the Student Protection and Affordable Education Act. Here are some preferred provisions:

• Bend the education cost curve down by reducing government payments to higher education institutions by 21% and freeze college tuition and fees at 2010 levels
• Establish a pay czar to monitor professor and other professional salaries
• Create a program to encourage schools, textbook manufacturers and the student housing industry to better coordinate the student educational experience
• Require parents to purchase higher education insurance for their children, or pay a tax if they do not purchase higher education insurance
• Establish a program that rewards quality rather than the quantity of education

Yes, let’s make higher education affordable for everybody.

When Meg Whitman was ramping up her campaign last spring I thought: She wants to be elected governor of California? Eliminate sanctuary cities? Ban illegals from admission to California public colleges? Conduct workplace inspections? See for yourself here on page 37. 

Now the Sacramento Bee says Ms. Whitman is pulling “back on immigration inspections.” She might argue that she is clarifying her position. Whatever the case, I find it amazing that she thinks she can carry Los Angeles and San Francisco with positions that are so so so Arizona. 

Whitman of course was CEO of eBay, that massive economics laboratory where the fundamental relationships between supply and demand can be observed in real time. One of those says, roughly speaking, that when supplies rise, prices fall. This explains why wheat prices change according to the annual growing cycle. They tend to be lower at harvest time due to the added supply and higher at planting time when stocks are less abundant. 

So it should not be a surprise that massive illegal immigration over the past two decades has put a damper wages in the United States. But how could 12 million new entrants to the labor market have a substantial effect on wages in country of 300 million? The trick is to understand that illegal immigrants do not compete with all U.S. workers. They do not compete with my father who is retired. They don’t compete with my doctor, either. 

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Illegal immigrants, the vast majority of whom are low skilled, compete with the bottom 30% of our labor force by income, and that group with earnings numbers only 40 million, according to this table published by the U.S. Census Bureau. 

How big is the effect? According to this 1996 paper, “immigration may reduce the wages of the average native in a low-skilled occupation by perhaps 12 percent.” 

All the more surprising: We rarely if ever hear a peep from Black leaders, many of whose rank and file are hurt by illegal immigration, but that’s another story.

A year or so back I ran across the following table published in a Social Security Administration issue paper: 

Table 1.

Social Security’s lifetime shared internal rate of return (IRR) by earnings quintile. 

The first line in the table above shows that “lifetime shared IRRs are higher for persons … with lower lifetime earnings, reflecting the progressivity of the benefit formula.” Source: SSA Issue Paper 2009-02.

So I wondered: What is progressivity worth to someone whose income hovers about the 75^th percentile over his or her working lifetime? What about someone at median earnings?

According to the first line in the table above, the average return for everybody is 2.6% annually on Social Security contributions, whereas someone in the 75th percentile receives a 4.6% annual return.

Based on information appearing in Census Bureau Personal Income Tables, the 75th percentile income for all U.S. workers is about $20,000.

The annual Social Security Contribution is 12.4% of wages up to $106,800 this year — half is paid by the employer and half is paid by the employee. On $20,000 in wages, the annual contribution to Social Security is $2,480.

Now here are some assumptions to get at the benefit of progressivity: Inflation runs at about 2.5% a year and long term interest rates average 4.5% per year. Productivity gains are 2.0% annually, slightly less than the 2.3% average over the past 50 years. Given these assumptions, we can calculate the difference between the worker’s retirement benefits given a 4.6% return on investment versus the 2.6% average return on investment.

After 38 years the gain is $26,266 in today’s dollars due to the progressivity of the Social Security benefit formula.

What about people who are at the 50th percentile, right in the middle of the income distribution? According to the same Census Bureau table cited above, the median income is about $33,000 and at that income the return on Social Security contributions is 3.5% versus the 2.6% average for everybody in the system. Using the same set of assumptions (but the lower return spread), the benefit of progressivity is $17,118 in today’s dollars.

Many people would not consider these to be a large sums. But there are about 12 million undocumented immigrants in this country. When their children born here are taken into consideration, the population associated with illegal immigration amounts to 15 million people, the majority of whom are from Mexico and Central America.

Now among Hispanics in the United States, 36% earn less than $20,000 and 65% earn less than $33,000, according to Census Bureau data. So let’s guess that illegal immigrants will eventually match the incomes of the Hispanic cohort in the United States. Then they stand to receive at least $228 billion as they become regularized here. Two hundred twenty-eight billion — that’s  one-fourth of Mexico’s annual gross domestic product.

Notice I said “at least” $228 billion. That’s because not all workers pay the full FICA tax associated with their incomes. This of course is due to the Earned Income Tax Credit which “was originally intended to ease the burden of Social Security taxes and provide an incentive to work,” according to this IRS document. A single parent with one child and an income of $20,000 gets a credit of $2,460, slightly less than the $2,480 in FICA taxes normally due on that income. Meanwhile, a single parent with two children and earnings of $33,000 gets an earned income tax credit of $1,530.

Now I come to brouhaha in Arizona. I heard one commentator ask, “How could there be so many undocumented immigrants in Arizona if Arizonans did not want them there?” Well, for one, the average Arizonan has no control over the process. And two, the typical Arizonan is happy to try to help people, whether undocumented or not. But many people are not aware of the external costs of hiring an undocumented worker. On the surface, it looks like a bargain. But when you add the cost education, medical care, law enforcement and yes, the transfer in Social Security benefits, the bargain becomes Faustian. Four or five, fine. Four or five thousand, no problem. Forty or fifty thousand, manageable. But four or five hundred thousand, and people start to notice the aggregate effect.

Some months ago I began a quest to turn my rowing machine into a human powered electric generator to run my office equipment. 

The idea was to transmit the mechanical power of the rowing machine flywheel to an automobile alternator found in cars from the late 1960s well into the 1980s. The alternator is connected to a battery that stores the power. Next along the line is an inverter, which changes the battery’s direct current into household alternating current. Once I was able to produce alternating current, I could run my computer, monitor, router, modem, printer, shredder, radio or pencil sharpener, all of which are within five feet of where I sit writing this post. 

The mechanical part turned out to be easy. I was lucky enough to find some metal benders who spend most of their working hours renovating railroad locomotives for giants like Southern Pacific and BNSF. They fabricated a metal cylinder that connects to the rowing machine flywheel on one side. The other side has a three-quarter inch cylinder that holds a pulley. They also made a mount that holds the alternator securely to the platform on which my human power project sits. So with the flywheel pulley lined up with the alternator pulley a V belt connects the two. 

After this early success I spent at least three months in failure mode. There are a lot of things I do not understand about the Delco Remy 10SI alternator, but I will say this. It produces about 63 amps of current, which at 12 volts amounts to 750 watts of power. The problem is that my body can only produce about 150 watts tops and for the alternator it is pretty much an all or nothing affair. As the alternator spins nothing really happens until a threshold is reached somewhere between 1200 and 2000 revolutions per minute, depending on the alternator. Once the threshold is hit, the alternator wants to produce too much power. I was afraid the stress would break my rowing machine. 

There is another thing about rowing that did not help. When I pull on the chain, the flywheel spins, but when I move forward to start the next stroke, no power is transmitted. So it was hard to maintain the RPMs sufficient to keep the alternator going. 

There is a lot of literature on the Internet about using alternators for human power projects. The more I read the less I understood. I tried a tractor version of the alternator that only produces 22 amps. Did not work. I tried playing with resistors in the circuitry. Did not work. I tried one-wire alternators. Two-wire alternators. Self-exciting alternators. Pretty racy stuff, but I could not get them to work. My wife was in Internet widow as I looked and looked for other ideas to try. 

Finally I came upon a solution that in my mind changed the character of the alternator so that it acts more like a generator. But I could be wrong here. I replaced the rotor — a coil of wire wrapped around an iron core — with a permanent magnet rotor. Now I can produce very small amounts of electricity at alternator speeds as low as 300 RPMs and as the speed increases the electrical output increases more or less linearly. So the final trick was to pick the right combination of pulleys for my range of output while rowing. 

Here is a final note. If you fancy the power production side of a project like this one, stay away. That’s because it has to be the least efficient way of generating electricity. My original goal was to produce one kilowatt of power per day. I have photovoltaic cells on my roof which produce 30 kilowatts on a sunny day. So producing one kilowatt seemed like a meaningful contribution. Sadly, my production is only about 15% of my original goal. 

There was a major plus, however, beyond the fun of keeping my computer monitor going. The project gave me a deeper appreciation of our electrical power that is too easy to take for granted. 

For alternative power geeks, here’s a bonus: pictures of the project.

I watched with interest a recent O’Reilly Factor interview with Time Magazine Senior Political Analyst Mark Halperin about President Obama’s limited allowable emotional range. 

Said Halperin:

“He can show a range of emotion. One of them though is not anger unless he wants to deal with political implications of that. ”

“With some of the anti-Obama sentiment in the country, not all of it, I want to be totally clear, not all of it, but as I’ve travelled around the country and sampled anti-Obama opinion, some of it is racial, hinged at least by racism, some driven by racism.”

Now I ask if Colin Powell had been elected president and was under heavy criticism, would Halperin claim that it was driven by racism? Probably not. 

So there’s something else going on here with Obama and it has more to do with his performance as President of the United States than his race.

Now that that the bloom is off Barack Obama’s presidency and even David Broder seems concerned that the President’s tenure may look more and more like Jimmy Carter’s, a wonderful 1971 novella comes to mind. I know it is a bit of a stretch, but Jerzy Kosiński’s Being There, if nothing else, tells us that soaring rhetoric is not a sign of leadership and competency. In the 1979 movie Peter Sellers plays Chauncey Gardner, who most improbably rises to the level of presidential candidate. (Photo from the 1979 movie Being There.)

A few months back the United States Postal Service proposed a five-day delivery plan. Nicely summarized here, the plan would eliminate street address delivery on Saturdays, except Express Mail. The reason for the proposed cut back, of course, is that the Postal Service is not doing well financially.

 As long as the Postal Service has a little restructuring in mind, why not go for broke? My modest proposal: Deliver mail to half the street addresses on Mondays, Wednesdays and Fridays and to the other half on Tuesdays, Thursdays and Saturdays.

 I invite all operations research types with knowledge of the Postal Service to comment on feasibility. Assuming mail is distributed evenly by address, a typical postal truck would carry the same amount of mail each day, but it would make only half of the stops. So the work could be done with a smaller fleet of trucks and mail carriers. Being competitive is obviously an issue, but I will leave that aside for now.

 I know merchants who depend on the mail would scream for the usual reasons. But really, for most people this would hardly be a life changer. Seventy percent of my mail is made up of advertisements from local stores, catalogs and unsolicited credit card applications. Most of the rest is business related, bills or an occasional greeting card from my mother-in-law.

 As a final pitch for my idea, I note that once behemoth General Motors applied bandages here and there for more than twenty years. Look where it got them.

There was a time when I lived in New York City and loved running around what is now called the Jacqueline Kennedy Onassis Reservoir in Central Park. By late morning on a Saturday or Sunday I would take the Lexington Avenue Line to the Upper East Side and walk to the park entrance on Fifth Avenue.

Carsten Kessler

On one of my runs I made a small discovery. There were more women running around the park than men! I confirmed this on subsequent visits. All during the summer, more women than men.

Then one Saturday afternoon I sat down on a bench on the north side of the reservoir. I counted the runners as they passed by. To my surprise, they were about equally divided between men and women.

Is the point here obvious? Is it possible that a frame of mind can distort one’s view of the world? If one is looking for something, how often will it be seen to the exclusion of other things in plain sight?