Public sector pension funds are seriously underfunded. That's for sure.
In fact, the credit of Illinois is now ranked as the worst of 50 states primarily due to its underfunded public sector pension fund liabilities. Lots of other states are in similar situations. But it doesn't have to be that way.
There's a relatively simple common sense solution at hand, and it's likely to be a painless one as well.
The funds should sell the bonds they own and stop buying new bonds. They should also stop paying professional managers 1% to 2% of assets for the "privilege" of having their funds managed. Then they should invest 100% of their funds, other than short term cash requirements, in a passively 'managed' S&P 500 Equity Index fund or its equivalent.
If this were done, my opinion is that long term investment returns would improve to at least 8% and perhaps 10% annually, and that overall fund performance would improve by 3% to 5% annually. Contributions would be roughly 50% over time of what they'd otherwise have to be (the twice as expensive status quo 'safe route' assumes the plan's retirement benefits remain unchanged and further assumes that bonds and active investment managers continue to be a part of the investment portfolio).
And by the way, the exact same logic applies to individuals as well. Whatever the actual result, it will be better by a great deal just by taking this "amateurish" self help approach to managing retirement liabilities.
Now let's examine the current funding fiasco and set forth our plan as to how to solve the seemingly insoluble.
If funds keep on following the same investment "playbook they've used unsuccessfully for the past several decades, one of several things has to happen: (1) taxpayers and employees have to increase contributions dramatically, (2) retiree benefits have to be cut dramatically, or (3) annual investment returns have to increase somewhat.
Did you notice the different use of the words "dramatically" and "somewhat" in the preceding sentence?
If so, does that cause you to wonder why the pension officials aren't making the obvious choice to invest differently in order to increase investment returns somewhat over time? As a taxpayer and perhaps even as a public employee, you should be asking that question.
Let's begin with a simple example using the rule of 72. If I want to end up with $4 in 36 years, I can either invest $1 now at a 4% annual rate of return or invest $2 now at a 2% rate of return. Both paths will get me to my chosen destination.
In other words, a 2% different annual rate of return on invested funds over 36 years amounts to a final result of either half as much or twice as much, assuming the same amount is invested at the outset. In other words, if I choose the "safer investment" route and invest in the lower rate of return vehicle, I'll need to increase my contributions by twice as much, or 100%, to arrive at the same result in 36 years.
The math is blindingly obvious, so why is it constantly being ignored by our public officials, pension fund managers and public sector union leaders? Rate of return over time is the biggest elephant in the room, and pretending that it isn't there won't make it disappear.
The elephant to which I'm referring is the habit of pension funds investing in bonds for a considerable portion of their assets instead of putting that same money in stocks, and the machinations the officials then go through to try to make up the shortfall with "alternative investments."
Pensions Bet Big With Private Equity discusses and describes the investment approach being taken by the Teacher Retirement System (TRS) in Texas:
"AUSTIN, Texas—On the 13th floor of a sleek downtown office building here, the trading desks are manned overnight. The chief investment officer favors cowboy boots made of elephant skin. And when a bet pays off, even the secretaries can be entitled to bonuses.
The office's occupant isn't a highflying hedge fund but the Teacher Retirement System of Texas, a public pension fund with 1.3 million members including schoolteachers, bus drivers and cafeteria workers across the state.
It is a sign of the times. Numerous pension funds are still struggling to make up investment losses from the financial crisis. Rather than reduce risks in the wake of those declines, many are getting aggressive. They are loading up on private equity and other nontraditional investments that promise high, steady returns in the face of low interest rates and a volatile stock market.
The $114 billion Texas fund has hit the trend particularly hard. It now boasts some of the splashiest bets in the industry, having committed about $30 billion to private equity, real estate and other so-called alternatives since early 2008. That makes it the biggest such investor among the 10 largest U.S. public pensions, according to data provider Preqin Ltd. Those funds have an average alternatives allocation of 21%.
Not all pension managers are in on the action. Some funds are wary of the high management fees often charged by private-equity and hedge-fund firms. . . .
Even in Texas, there isn't exactly consensus. Critics worry that the teachers' benefits are leaning too heavily on the esoteric investments, which can be less liquid and less transparent than stocks and bonds. Another sticking point is the fund's generous bonus culture—a contrast against the pensioners, who haven't seen a cost-of-living raise in more than a decade. . . .
And yet the strategy has helped to turbocharge the Texas pension, with returns from private equity averaging 4.8% and 15.6% over the past five-year and three-year periods respectively.
Including all assets, the pension's annual return from Dec. 31, 2007, to Dec. 31, 2012, was 3.1%—better than the median preliminary return of 2.46% among large public funds, according to Wilshire Trust Universe Comparison Service.
Texas pension officials say private equity helped offset declines in its other investments. Britt Harris, the pension's chief investment officer, says he aims to "smash" the stereotype that government pension funds are on the losing end of most investments. . . .
For the fiscal year ended Aug. 31, the Texas teachers fund had a 7.6% return, and pension officials say they expect their bet on alternatives can help the fund hit its 8% annual target return over the long term. Over a ten-year period ending Aug. 31, 2012, the fund has had an annual fiscal year return of 7.4%.
Other large pension funds aren't so optimistic. Sticking to a return of 8% or more is "taking a big risk with one's ability to pay for benefits,'' says Richard Ravitch, co-chair of the State Budget Crisis Task Force, a nonpartisan research group. Since 2009, one-third of state pension plans have scaled back their return goals, according to the National Association of State Retirement Administrators.
The reason: In some states, like California, failure to hit the target return puts taxpayers on the line to make up the difference.
California's giant public employee pension fund, Calpers, had made an aggressive push into alternative investments such as real estate, representing about one-tenth of its assets. But many of those real-estate holdings, particularly in housing, suffered big losses during the financial crisis.
If Texas misses its mark, state officials could seek to cut benefits or switch newly hired teachers from traditional pensions to less generous 401(k)-type plans. Similar proposals in other states have met with stiff resistance from labor unions.
Retired education workers in Texas, on average, receive an annual pension of $21,730. Most former educators don't receive Social Security, making their total retirement benefits among the lowest of the big public pension systems.
"If new teachers are forced to switch to 401(k)s," says Tim Lee, head of the retired teachers association, "they will end up in poverty.". . .
Unlike many state pensions, the Texas teachers fund is in relatively solid shape. It is 82% funded, meaning there are 82 cents of assets covering $1 of liabilities, up from a low of 68% in February 2009, during the depths of the financial crisis. The average funding level among large public pension systems nationally is about 76%. Contributions from teachers and the state are identical, at 6.4% of employee salaries. The balance comes from investment earnings.
Still, the pension had a $26 billion shortfall, as measured at the end of August, caused in large part by big stock market losses during the financial crisis and increases to benefits for future retirees.
Mr. Harris, the pension's CIO since late 2006, says over the long term the fund can keep hitting its target, but "getting to [the 8% target level] over the next five to 10 years is going to be tough," he acknowledges. . . .
Despite that particular coup, doubters wonder if the strategy is sustainable. "They may think they are the smartest and best investors, but this system cannot work in the long term," says former Rep. Warren Chisum, who in the last legislative session proposed switching new teachers to 401(k) plans.
Pensions officials, such as Mr. Harris, say the risks of the alternatives are manageable because the pension fund has ample liquidity to keep paying benefits in the event of big losses.
Texas educators have little choice but to support the pension fund's aggressive investment strategy and Wall Street-style bonuses. But retiree raises can't materialize until the system's funding level improves—to an estimated 90% from its current 82%. One solution, not popular with educators, is to increase the retirement age for teachers to help make up the fund's shortfall.
In the meantime, educators like Vella Pallette, a retired elementary-schoolteacher from the tiny Central Texas town of May, are in limbo. The 78-year-old's $2,000 monthly pension check is her sole source of income. "A little more money," she says, "sure would help."
The solution to all this unnecessary handwringing and needless name calling is actually quite simple.
Keep the rate of return assumption at 8% annually, extend the normal retirement age to the equivalent age as that in private industry (about 65), convert to a 401(k) plan for new employees, invest in blue chip stocks for the long haul, and perhaps even use a simple passive S&P 500 Equity index fund instead of paying a "professional manager" commissions to manage the funds.
Then allow existing employees to convert their future contributions to a 401(k) plan instead of the existing pension benefit plan if that's their choice. If employees are properly informed, they will come to know that the upside attached to the 401(k) plan benefits will work to their advantage rather than seeing them "end up in poverty," as the IGNORANT head of the retired teachers association in Texas says would be the case.
There is a whole lot of "expert" misinformation floating around about this entire public sector pension issue. And investments generally.
The common sense solution is that pension officials can choose to invest wholly in stocks over the long haul and take what the market gives them, which wil be sufficient to satisfy their liabilities.
Otherwise they can choose to increase contributions dramatically or cut benefits dramatically, and each side can continue to call the other side names and keep kicking the proverbial pension plan can down the road to nowhere.
And name calling won't put the necessary money in the public sector's retirement pot.
KISS works for me. How about you?