By Julian Guilfoyle
Always be nice to bankers. Always be nice to pension fund managers. Always be nice to the media. In that order. ~John Gotti
Public pension funds continue to experience difficulties maintaining themselves in this turbulent economy. In a recent Wall Street Journal article titled “Pensions Wrestle With Return Rates”, writer Michael Corkery outlines another problem plaguing the public pension system. The issue lies in how pension funds calculate their expected rate of return. In the past, most pension funds assumed, on average, an 8% rate of return on the pension fund’s investment. Though the market fluctuates, generally over the long term these funds were performing at that level. Over the last ten years however, these pensions have fallen well short of their assumed rate of return leaving a gap between the promise made, and what can be delivered.
Pension funds are prepared, in theory, to deal with this shortfall. When the market underperforms the assumed rate of return, public employees and taxpayers are responsible for contributing the difference. This is because the rate of return determines the amount that must be contributed to these funds to assure they are solvent. Prepared does not mean realistic. This system is inherently flawed because it increasingly relies on its contributors as their own financial situations deteriorate. Even worse, as our economy continues to struggle and unrest among our population grows, this system depends on politicians going back to their constituents and asking for a tax incre ase to protect the fund. As increasing taxes is, and always will remain, unpopular, lawmakers are really limited in what they can do to correct the fund’s course.
Lost in all of this is the detriment it causes to our teachers, firefighters, policemen, and other public employees. If it is politically and economically unviable to raise taxes, and the market cannot be counted on to return a necessary rate of return, pension fund managers are increasingly relied upon to deliver the impossible. Their solution is to move these pension funds into more aggressive and risky investments. Jeffrey Friedman, a senior market strategist at MF Global states in the article, “To target 8% means some aggressive trading. Ten-year Treasurys are yielding around 2%, economists say we are headed for a double-dip, and house prices aren’t getting back to 2007 levels for the next decade, maybe.”
What is past is also prologue. Back in 2002, as pension funds began to feel the decline created by the tragedies of 9/11, financial advisors approached pension fund managers pitching a novel new idea known as credit default swaps. While this is a complex issue, these transactions basically relied on the belief and historical evidence that housing values would never decline and most mortgages would not go into default. Essentially they promised high returns for what appeared to be safe investments. No one ever expected these policies to be cashed in, and most did not in vision a scenario where there would be a run on the bank. Just five years later when the housing bubble burst, pension funds were not exempt from the devastation further exasperating the shortfall. Let us hope that as pension fund managers are forced to become more aggressive, they find a safer investment than our homes.
