Thursday, May 31, 2012

Defined Benefit Pension Plans Are Not in Terrible Shape – They are in Worst Than Terrible Shape

How to Solve a Problem – Assume It Away

Everyone has to engage in retirement planning and this largely consists of determining how much money they must save in order to have an investment total at the end of their working life.  A big part of that determination is what will be the rate of return on investments as a person saves and invests every year.  The more one can earn on their savings/investments, the less has to be saved.

State and local governments are the last vestiges of what is called ‘defined benefit pension plans’.  These plan set aside a certain amount of money each year into a pension plan.  The plan then promises to pay a certain level of benefits to the retired state and local investors, regardless of how much money the plan has in it, regardless of how much was contributed to the plan and regardless of the rate of return the plan earns on investing the money.  Sounds like a terrible idea and it is.  But it is what state and local governments have gone out and done.

How much of a rate of return should pension plans assume they are going to make?  Well, let’s see.  Government bonds currently pay about 1.5% to 3.5%.  Corporate bonds maybe a little more, but not much more.  The stock market, possible good long term returns but a lot of risk of zero or negative return.  So what do most state and local pension plans do?

While Americans are typically earning less than 1 percent interest on their savings accounts and watching their401(k) balances yo-yo along with the stock market, most public pension funds are still betting they will earn annual returns of 7 to 8 percent over the long haue. 

Given that part of the portfolio is invested in bonds earning about 3 to 5%, this means the non-bond portfolio must earn 10% or more.  The reaction of Michael Bloomberg, Mayor and financial expert is this.

But to many observers, even 7 percent is too high in today’s market conditions.

“The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Mr. Bloomberg said during a trip to Albany in late February. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”

So why won’t managers use a more realistic number? 

In New York, the city’s chief actuary, Robert North, has proposed lowering the assumed rate of return for the city’s five pension funds to 7 percent from 8 percent, which would be one of the sharpest reductions by a public pension fund in the United States. But that change would mean finding an additional $1.9 billion for the pension system every year, a huge amount for a city already depositing more than a tenth of its budget — $7.3 billion a year — into the funds.

So let’s all play pretend, that the investment fairy will somehow find the return on investment so taxpayers don’t have to make good on all those promises made decades ago.

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