Retirees dependent on pension systems for income to maintain their standard of living may be disappointed, according to an analysis by Pricewaterhouse Coopers reported in the Washington Post. The trade-offs of high investment returns with high risk are discussed. Excerpts below.
Individuals whose employer pension is based on a defined benefit plan may want to plan to supplement their retirement income from other sources. The choice of how to save and invest is more complex than ever. These are challenging times for investors and future retirees.
Link: Steep Losses Pose Crisis for Pensions – Washington Post
The financial crisis has blown a hole in the rosy forecasts of pension funds that cover teachers, police officers and other government employees, casting into doubt as never before whether these public systems will be able to keep their promises to future generations of retirees.
The upheaval on Wall Street has deluged public pension systems with losses that government officials and consultants increasingly say are insurmountable unless pension managers fundamentally rethink how they pay out benefits or make money or both.
Within 15 years, public systems on average will have less half the money they need to pay pension benefits, according to an analysis by Pricewaterhouse Coopers. Other analysts say funding levels could hit that low within a decade.
After losing about $1 trillion in the markets, state and local governments are facing a devil’s choice: Either slash retirement benefits or pursue high-return investments that come with high risk.
The urgent need for outsize returns by these vast public pension funds, which must hit high investment targets year after year to keep pace with rising retirement costs, is in turn fueling a renewed appetite for risk on Wall Street.
Before the crisis, many public pension funds had experimented with risky trading techniques or committed more of their money to hedge funds and other nontraditional firms, which in turn invested some of it in complex mortgage securities. When these melted down, pension funds got burned.
Now, facing an even bigger funding gap, some systems are investing in the same securities, betting that a rebound in their value will generate huge returns.
“The amount that needs to be made up is enormous,” said Peter Austin, executive director of BNY Mellon Pension Services. “Frankly, they are forced to continue their allocation in these high-return asset classes because that’s their only hope.”
Some pension experts say the funding gap has become so great that no investment strategy can close it and that taxpayers will have to cover the massive bill.
The problem isn’t limited to public pension funds; many corporate pension funds have lost so much ground that they are also pursuing riskier investments. And they, too, could end up a taxpayer burden if they cannot meet their obligations and are taken over by the federal Pension Benefit Guarantee Corp.
Public systems still have enough to meet their current obligations. If governments take no action, retirees could keep drawing full benefits for the foreseeable future even under the most pessimistic projections.
But already, some funds are seeking to trim benefits to conserve money. Some governments have also proposed increasing the amount of public money paid each year into the funds. In practice, however, some political leaders have begun doing the opposite — cutting annual contributions to pension funds — as a way of balancing state and local budgets buffeted in the recession by falling tax revenue and rising costs.
More Risk or Lower Returns
This is the dilemma confounding pension funds as they emerge from the wreckage of the financial crisis: If they shy away from riskier investments, they would be settling for lower returns that leave future shortfalls unaddressed. But by aggressively pursuing the higher rates of return they need, pension funds increase the chances they will be burned again by investment bets gone bad.
“State pension fund directors face enormous pressure trying to recover their investment losses. It will be tempting for them to consider investments that promise a high rate of return,” said Sue Urahn, managing director of the Pew Center on the States, which plans to release a report on pension losses within weeks.
Traditional investment strategies, which rely on stocks, haven’t fared well in recent years. To meet their obligations to retirees, pension funds tend to assume they will earn an eight percent return on investments each year. The stock market, as measured by the Standard & Poor’s 500-stock index, is actually down 32 percent this decade.
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