Why Investing In Pension Funds "With Fingers Crossed And Eyes Closed" Is A Bad Strategy

fingers crossed

Photo: Flickr confusedbee

It is well known that America’s public pension funds are in serious trouble.A study by the centre for Retirement Research at Boston College recently estimated the funding gap at state and local pension funds is nearly $700 billion, or roughly 80 per cent of current liabilities.

Compare that to 1999, when state pension funding stood at 102 per cent.

It is also well known that the universally assumed rate of return of 8 per cent a year for pension fund investments is far too high.

These return rates are important because they are key to calculating how much money the fund needs to meet its future obligations to retirees. If a more conservative return is considered, such as the risk-free rate on government bonds, the average funding ratio at public pension funds plummets to 45 per cent, causing liabilities to explode by trillions of dollars.

What is not well understood is that pension fund managers, in an attempt to climb out of the funding hole, are chasing higher returns by placing riskier bets. Problem is, this strategy, which could be called “fingers crossed and eyes closed,” could backfire dramatically, putting pension funds in an even deeper hole.

In short, with government bonds returning about 4 per cent, pension fund managers must invest in other outperforming assets to meet their rosy 8 per cent return assumptions. The problem with shifting assets away from the risk-free rate is that they are, by definition, risky and uncertain. If a pension manager is employing the typical split of 40 per cent bonds and 60 per cent equities, the equity portion has to return about 11 per cent to achieve the targeted 8 per cent annual return.

Seeing the difficulty in the above maths, fund managers have explored other solutions to achieve the almighty 8 per cent. After the dot-com bubble, many turned to Yale University’s portfolio management model, or the “Endowment Model,” which focused on illiquid assets, such as private equity, venture capital, and timberland investments. But, as real money investors sought diversification through the same strategy, their portfolios achieved lower returns over time while the amount of risk they took on skyrocketed.

Pension fund managers have assumed 8 per cent annual returns because that’s indeed where they’ve been over the past few decades. But, as most investors know by now, things have changed dramatically.

20-five years ago, long-term interest rates in the Unites States were around 10 per cent and the P/E Ratio for U.S. stocks was around 10. Both were at the early stages of long bull markets. In 2011,the backdrop is dramatically different. Long-term interest rates stand at approximately 4 per cent, and the P/E Ratio for U.S. stocks is more than 20—an environment that historically has produced substandard returns.

The potential for subpar returns can last for decades. Having just experienced one lost decade in the U.S., it is entirely possible we could experience another one.

Unfortunately, most pension funds are not prepared for lengthy bear markets because they are seen as extraordinary and beyond the scope of either feasible response or possibility. But we only need to look at post 1980’s Japan to see that long-running bear markets can occur in even the most sophisticated economies.

Over the past two decades, a Japanese pension fund manager who chose an endowment-style strategy would have returned just 1.42 per cent per year—far less than the Japanese government bond return of 4.36 per cent per year. The fund would have lost a whopping 4.62 per cent per year had the manager chased higher returns by investing in equities over the same time period.

What these returns show is that by diversifying away from bonds and into risky assets, the endowment style portfolio has the potential to perform better, but also worse than the risk-free rate in a perpetual bear market. Paradoxically, in an effort to meet the universal 8 per cent assumed rate, pension funds may be laying the groundwork for returns even lower than the risk free rate.

The result is that millions of Americans could suffer higher contribution requirements, lower benefits, and an increased retirement age. To fully fund their obligations, pensions need higher contributions now and more realistic return assumptions.

It’s safe to assume that “fingers crossed and eyes closed” is not what public pension beneficiaries signed up for. They deserve better.

This post originally appeared at CNBC.com.

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