TW: The crash in the markets has many implications. One not yet often discussed is how the assumptions underlying the various public and private pension schemes are being torn asunder. This piece focuses on public pensions which are in fact a looming disaster but many of the same problems exist for private obligations. The net net is folks need to understand their pension benefits are at risk and should come down. Folks do not want to hear this which is why the problem just gets worse and worse. Governments are over promising on public pensions, private companies are moving rapidly away from defined benefit schemes but the existing programs have looming problems as well.
The emerging current problem (putting aside governments providing excessive benefits to start with) is that the funds are significantly overestimating the returns they can achieve on their pension funds. (obviously if I assume I can make 8% instead of 6% over a long period I will need fewer $ to start with to pay out given amount in say 20 years). Pension funds used to limit their investments to bonds and other lower risk items, this changed over the past 20-25 years as pension funds began investing in stocks and other riskier assets. In doing so they hoped to achieve higher returns which would reduce the amount of money required upfront to meet future obligations. Certainly nirvana to any politician (or private company CEO wanting to please Wall Street).
Unfortunately the higher returns are obviously turning out to be chimerical but the obligations remain. Pension funds were not particularly well funded to before the crash, they are know really poorly funded and the assumed rates of return now seem almost certainly too high.
The public funds have a choice, cut benefits (if they can) or raise taxes...alot. The pursuit of higher returns has permeated all aspects of our society, which is fine if one understands that higher returns come with higher risks. This rather fundamental attribute of finance has not been well understood by many if not most.
From Pension Pulse blog:
"Pension funds have been hit hard by the stock market crash, losing about a third of their value in some cases, and there may be another problem. Before the crash, some financial experts warned that pension funds were making overly optimistic projections of investment earnings in the decades ahead, often assuming about 8 percent a year.
Investment earnings, the heart of a modern pension system, are usually expected to provide two-thirds or more of the revenue needed to pay retiree benefits in the future. In public employee retirement systems, a rosy forecast of future earnings means that fewer taxpayer dollars have to be spent to provide generous retirement benefits.
...Lowering the projection of earnings by even a percentage point or two would create a funding gap of tens of billions of dollars.
...After the big drop in the stock market last fall, the CalPERS [CA pension fund] investment portfolio, once a high flier, had an average annual return of 3.32 percent for the last 10 years, well below the forecast of 7.75 percent.
A prominent critic of the high earnings forecasts, David Crane, was a rare appointee to a pension system board, CalSTRS, with a big-league background in investments.
...After the governor put Crane on the CalSTRS board and he had served almost a year, the Senate refused to confirm the appointment in June 2006, ousting a board member who had repeatedly questioned the 8 percent earnings forecast.
Legendary investor Warren Buffet, in his annual letter to Berkshire Hathaway shareholders in February of last year, questioned the 8 percent earnings forecast common among the pension funds of major corporations.
The founder of Vanguard mutual funds, John Bogle, told a congressional hearing on retirement security last month that corporate pension funds raised their assumed earnings from 6 percent in 1981 to 8.5 percent by 2007, far above historical norms.
“And the pension plans of our state and local governments seem to be in the worst condition of all,” Bogle said, adding parenthetically: “Because of poor transparency, inadequate disclosure, and non-standardized reporting, we really don’t know the dimension of the shortfall.”
....Earnings forecasts were not a problem in the early days of California public employee pension funds, when investments were limited to fixed-income bonds and mortgages.
In 1966, a ballot measure, Proposition 1, allowed the pension systems to put 25 percent of their funds into blue-chip stocks. Advocates said the change would enable increased retirement benefits and lower employee and taxpayer contributions.
A measure to allow 60 percent of pension funds to be invested in stocks, Proposition 6, was rejected by voters in 1982. But two years later voters approved a far broader measure, Proposition 21, simply requiring that investments be “prudent.”
...The lifting of the restrictions on investing in stocks in 1984 came a few years after legislation allowed public employees to form unions and bargain collectively for labor contracts, which usually include retirement benefits.
...Many public employee labor unions went on to negotiate contracts providing generous benefits — up to 90 percent of the final salary at age 50 for some police and firemen — that are expected to be paid mainly by pension fund investment earnings.
...“In the old days (before the mid 1980s), many public plans had limitations on equity investments,” Munnell replied by e-mail. “Virtually all have eliminated those constraints. Allowing more freedom to the investment managers is probably a positive development.
“The controversial area is the rate of return assumed in the actuarial valuation of pension plans. Public sector sponsors tend to assume high returns (8 percent or more), which makes the taxpayers’ commitment for future benefits seem small and encourages major expansion.
“Bottom line: a free hand for investment managers is a good idea; more cautious assumed rates of return would help check major benefit expansions.”
....But that 8% projection of investment earnings needs to come down. Pension funds and their stakeholders need to reassess their growth projections and realize that overly optimistic projections will only aggravate their pension deficits."
http://pensionpulse.blogspot.com/2009/03/rosy-projections-of-pensions-investment.html
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