Tuesday, March 9, 2010

States Doubling Down To Make Pensions Solvent

There's a betting strategy that is especially common to blackjack players: when you lose a hand, keep doubling your bet until you win. In theory, you are assured of not losing anything. This theory depends on two factors: 1) having enough money to afford to keep doubling until you hit a hand, and 2) not running into a hot dealer. The other problem with this theory is that it begins with the assumption that you are going to lose and sets as a target "getting back to even". It appears that some states are subscribing to this strategy to try and "get back to even" when it comes to funding their public pensions. As private companies continue to move assets out of the stock market and into other vehicles like bonds, t-bills and cash, states that are watching their pension funds evaporate are instead buying into riskier high-return stocks.
“In effect, they’re going to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. “Double up to catch up.”

Though they generally say that their strategies are aimed at diversification and are not riskier, public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.
This is the same sort of behavior that caused banks and mortgage brokers to suffer the wrath of the President and the "banks are evil" crowd. That state governments are willing to do this is not only hypocritical, it's inane. After all, they have the recent memory of collapsing stock markets to show them why this is a bad idea.

Don't misunderstand; investing in the stock market is a good thing. Stocks are a great way to build wealth when you understand that results aren't guaranteed. I set aside a small bit each month to dabble with the understanding that it could be lost. What the states are doing is different; they're trying to cheat death in a sense. Public pensions all over the country are failing. The obvious answer is the cut payouts where practicable. Perhaps increase the retirement age. These are hugely unpopular with the benficiaries however and invoke the wrath of the unions. The other possibility is to raise taxes. This is hugely unpopular with the taxpayer and, with the rise of the Tea Party, this is not a good time to do that. That leaves cutting other programs and services to cover the shortfall. Instead, these states are opting for a fourth way: investing what's left into high risk/high reward stocks in an effort to snatch victory from the jaws of insolvency. It's the equivalent of letting it ride.

Perhaps I'm going to expose my lack of understanding of how fund management works and if so, I apologize. But it seems to me that pension funds should be handled the same way as a retirement fund for an individual. Earlier in a person's working life, monies are more heavily invested in stocks and other higher-risk investments. The purpose is to ride the market for years, surviving the dips under the belief that in the long run, the market will be ahead of where it was when you started. As you near retirement age, the balance of the investment moves ever more towards safer vehicles like bonds. This is to protect the gains made from the market and ensure a steady income once retirement is reached.

Pension fund managers should be able to determine where the payees are in that cycle and manage the funds similarly. In other words, if a large percentage of the workers to benefit from the pension are younger, more of the available funds would be in stocks. As the workforce begins to skew older, the funds are shifted to bonds and the like. That should provide a hedge against dips in the market and ensure that the older workers are taken care of. Again, forgive me if this sounds naive. I certainly bow to the expertise of any profession fund managers out there.

Of course. the role of unions can't be overlooked in this. Pension fund managers are loathe to revise the models on which the pensions are built, as revising the expected rate of return downward in a down market can have far-reaching effects on the budget and prompt a backlash from the unions.
The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report.

But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace.

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.
One or two of these states could certainly hit it big; I've seen blackjack players hit their hand with the double down method before. But most of the time it doesn't work. You just run out of money too fast or you find yourself playing against a hot dealer. Most of these states are going to end up gambling their pensions away completely.

(Crossposted at Say Anything)

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