Tuesday, June 29, 2010

Dow Jones: 28,000,000

Cali Gov. Arnold S.'s tentative deal with four public-sector unions to scale back future pension benefits is considered "historic" by The Economist:

"This is because it would begin the undoing of a policy disaster dating back to 1999. That was when the Democratic legislature and the then governor, Gray Davis, a Democrat elected with union support, thanked the unions by giving state workers pension increases of between 20% and 50%. Many highway-patrol officers, for example, were allowed to retire at 50 with 90% of their final salary. All told, California now has probably the most generous public-sector benefits in the country.

That, however, is not what outrages Mr Schwarzenegger, a Republican, or his brainy economic adviser David Crane, a Democrat. Rather, it is that the pension plans—above all the California Public Employees’ Retirement System (CalPERS), the largest such scheme in America—pretended that this generosity would not cost anything. In 1999 the dotcom bubble was still inflating, and the plans’ actuaries predicted that their retirement funds would gain enough value to pay the increased pensions. By implication, they assumed that the Dow Jones Industrial Average would reach 25,000 in 2009 and 28m in 2099. It is currently at around 10,300."

Who were these actuaries and were they high when conducting these calculations?

Wait, is this hindsight bias on my part? I can't be sure it's not, but all the same, these actuaries appeared to commit a pretty obvious extrapolation error. (Of course, they were not alone in their irrational exuberance / incompetence.)

...And to be fair, they haven't been proven wrong on the 28,000,000 thing yet.

3 comments:

rvman said...

The rate of return implied by those numbers is about 7.8%-8.2%, give or take. The article doesn't say whether these numbers account for dividend yield, which is about 3-4%. If they do, the forecast was for about a 12% total annual return, which, though too high objectively, matches the dividend-included return on the Dow from 1932-1999.

These numbers (25k in 2009, 25M in 2099) look ridiculous mostly because the actual pre-dividend return on the Dow over the 1999-current time period has been about -1%. A 12% return would have been closer to the expert's 'expected' 8% than the actual 3% return was. Had the Dow performed after 1999 the same way it did from 1945 to 1999, 20M would be about right for 2099.

Most personal finance advice tells people to assume a nominal return of about 8% for retirement investing. So if you started funding your 401k based on expert advice with equal deposits starting in 1999, you would be about 20% behind right now, and the current balance derived from your 1999 principle would be about 40% lower than anticipated.

Sally said...

12% is closer to 8% than 3% is, but 12% is 50% higher than 8%. That's a pretty big gap.

No doubt this error was offset by the planners of some light rail system in Cali who had a cost estimate that was 50% too low...

jen said...

I started contributing to my first 401k in 1999. I have definitely not seen the results everyone was preaching about.