The Public Pension Fund Illusion

“Look Ma, no hands!”  Oops!!!!  “Look Ma, no teeth!”

You can make your own paraphrasing to apply to public pension funds.  Most of these are operating on an assumed annual return of 8%.  Dominant components of these funds are stocks and bonds.  For the past 11 years ending with 2009 bonds have kept these funds from losing money.  See the following graph.

Sure gold has done well but how much gold is held in public pension funds?

Bonds are not likely to contribute significant positive returns over the next ten years.  Some believe they will provide negative returns if not held to maturity due to declining market value as interest rates rise.  However, most pension funds should be able to ladder their bond portfolio maturities to match expenditure requirements for benefit payments to retirees.  Thus, bond returns should be roughly in line with interest rates.  Currently these bond allocations would be returning coupon payments averaging 1% to 5%, depending on benefit payment schedules and allocations to Treasuries and AAA corporates.  If we pick a number in the middle, it is reasonable for these pension funds to receive 3% return from bonds going forward.

This means for a portfolio which is 40% bonds, the portfolio gain annually from the bond portion of the portfolio would be 1.2%.  That leaves a 6.8% contribution for the total portfolio or 11.3% for the other 60%.  It is difficult to rationalize the growth necessary to produce that return from stocks over the next several years in view of the weakness of the economic recovery.

If bond returns over the next ten years are similar to the last top in bonds 80 years ago there may be a very broad top in bonds.  See the following graph from David Rosenberg, chief economist at Toronto’s Gluskin Sheff:

The last top in bond markets lasted well over a decade (1938-52).  A similar experience for the current market would drive bond yields below the 3% annual average assumed in the earlier discussion.  This would drive the 8% assumption to push the required return for the non-bond portion of pension plan portfolios above 12%.

How well has this process worked?  Here is a graph from the 5-Min. Forecast:

Yes, the 8% return has been achieved over the past 25 years, but returns fall far short of that level more recently.  You may say that everything should still be okay because the earlier outsized returns should offset the later weak returns.  The key word is emphasized: should.  What actually happened was that many pension plans chose to reduce annual payments during the fat years because high earnings “made them unnecessary”.  This is something like the assumption that the prices of houses could never go down on a national scale.

So the public pension funds cling to the illusion of 8% annual returns even though returns over the past decade have proven that to be a flawed assumption.  Many private pension funds are in better shape, as many have been operating with 5% annual return assumptions.  Even the private sector has fallen short of the 5% assumption over the last decade, but at least not to the same devastating extent.

Where is Houdini when you really need him?

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