Sunday, October 11, 2009

Pensions chasing returns at the end of the rainbow

One of the more startling and frankly, under reported stories of the financial crisis is what has happened to the nations public (and private) pension funds. In the mid-90's it became apparent to me that pension funds were using increasingly aggressive assumptions for market returns in order to put off the day of reckoning. This worked while the market roared through the 90's and most pension funds easily beat their assumptions. Over the past decade, this trend continued as funds sought more diversification of their assets in the hopes of increasing returns and lowering risk.

Unfortunately, that plan backfired when all asset classes (except government bonds) moved in the same direction. Now, many of these investments -- stocks, hedge funds, real estate, private equity have all made strong rebounds off their bottoms, but pension funds assume it will continue like this for the foreseeable future.

According to the Washington Post....

"The upheaval on Wall Street has deluged public pension systems with losses that government officials and consultants increasingly say are insurmountable unless pension managers fundamentally rethink how they pay out benefits or make money or both.

Within 15 years, public systems on average will have less half the money they need to pay pension benefits, according to an analysis by Pricewaterhouse Coopers. Other analysts say funding levels could hit that low within a decade.

After losing about $1 trillion in the markets, state and local governments are facing a devil's choice: Either slash retirement benefits or pursue high-return investments that come with high risk.

"The amount that needs to be made up is enormous," said Peter Austin, executive director of BNY Mellon Pension Services. "Frankly, they are forced to continue their allocation in these high-return asset classes because that's their only hope."

Despite this situation many local governments are taking the easy (and wrong) road by suspending contributions at a time when they probably should be hiking contributions (expect this to be a huge issue in 2010 when local school budgets are facing big tax hikes to make up for investment performance of the teachers pension).

"And like their counterparts across the country, state officials assumed they would earn around 8 percent a year from investing in financial markets for years to come given the outstanding performance of stocks in the 1980s and 1990s.

But officials in Virginia and elsewhere soon began to wonder whether those two decades were a fluke. As pension deficits began to rise, officials questioned whether the investment assumptions were too optimistic. In 2006, Virginia's pension officials suggested scaling back benefits or requiring current employees to begin paying into the pension fund. The state's lawmakers took no action. (My comment: Again because a hard decision had to be made, the politicians decided to take no action)

Then the crisis hit. Virginia lost 21 percent of the value of its portfolio, or about $11.5 billion. Maryland and the District, meantime, suffered drops of 20 percent.

The losses were typical of what pension funds suffered around the country. State and local government officials had predicted before the crisis they would have $3.6 trillion in their accounts by now, according to the Center for Retirement Research at Boston College. Today, they are $1.2 trillion short of that mark.

Here's the big idea that we all need to remember....

"Even if public pension funds were to hit their 8 percent investment targets every year (my comment: highly unlikely), Nicholl calculated they would have less than half of what they need by 2025. This is because a greater share of the population will be retired and those who are (retired) will live longer, thus collecting benefits longer, she said."

In Ohio, for instance, the teachers pension system reported that it would take 41 years for its investments to catch up with the costs of meeting its obligations to retirees. That was before the worst of the financial crisis.

During the last fiscal year, Ohio's fund lost 31 percent. Its most recent annual report detailed how long it would now take for its investments to put the fund back on track. Officials simply said: "Infinity."

Sometimes I wonder if I was meant to live in Ohio -- they are pessimistic enough to make me look optimistic at times :)

I've said this before but it is worth repeating. A retirement age of 65 may have been appropriate when the bulk of you job involved physically demanding tasks and the average life expectancy was 70 years. However --- hold on a second.... Mom, please avert your eyes....
we can't continue to allow people to retire in their early 60's with life expectancies touching 80 while population growth and immigration levels slow. The math just doesn't work out.

This is the third rail of politics (did you see the reaction to the one county possibly reducing headcount in CNY?) but it needs to be addressed. Again, this is one of those big picture financial issues that should be settled by a non-partisan oversight panel that is not staring down the barrel of an election every 2 years. Wishful thinking, I know.


The Hermit said...

How about we let the market take over social security? The government lumps the money in the general fund anyway(read bankrupt).
We don't really need pensions. heck, I just know congress will take care of us.
Look, their fixing health care right now as we speak. Finance committee just ok'ed it. Its for our own good, right?? huh??

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