One Inflation Threat You Haven't Thought Of

Ready for the next kick to your retirement?

You should be, because managers at America's public pensions are making a series of egregious financial decisions that will jeopardize your retirement income. But it's a problem that you can address now.

It's a tearjerker
Here's what's happening, according to a recent article in the Wall Street Journal.

Pensions are supposed to be among the most conservatively managed portfolios, since millions of retirees rely on income produced from them. But because managers at public pensions are frustrated with the returns of hedge funds and private-equity investments, they're turning to a classic, but nonetheless risky, tactic to juice returns. The pensions are borrowing against their high-quality bonds, especially government or corporate debt, and reducing their exposure to stocks.

The State of Wisconsin Investment Board was among the first to jump on the bandwagon earlier this year. The fund manages some $78 billion, and will borrow 4% of assets this year, a figure that will increase to 20% over the coming three years. More terrifying, though, is that under this scheme, the fund theoretically could borrow as much as 100% of its assets in order to boost returns.

Sure, the fund's chief investment officer pooh-poohs the idea that it would ever use 100% leverage, but the use of debt to boost returns can be much too seductive for a manager, especially in a period when returns have fallen. But, after all, that's exactly the situation right now: Pension returns have declined, and now managers are already looking for ways to make up lost ground by turning to a risky strategy.

Can we reasonably expect fund managers to know "when to say when" to leverage? And that goes double if incentives actually encourage them to engage in risky investments. We know how this film ends: It's a tearjerker for Bank of America (NYSE: BAC), Bear Stearns, Lehman Brothers, Citigroup (NYSE: C), and their highly leveraged ilk.

Because financial companies normally rely so heavily on debt for their operations, even a hiccup in their markets could unsettle them and quickly destroy profitability.

The Wall Street Journal recently reported that Bank of America and Citigroup have been hiding billions of their debt from investors by classifying some borrowings, or "repos," as sales. They undertake such behavior right before they report results to investors, which makes their balance sheets appear cleaner than they typically are. While in this case, the impact to their balances sheets wasn't material, it's a reminder of how opaque and combustible leverage can be.

But it gets worse.

Really? Really.
The pension funds' use of leverage cuts both ways: You can't borrow in order to enjoy magnified returns unless you take on the risk of magnified downside. Public pensions that engage in this kind of financial engineering are potentially exposing themselves to massive losses, and sooner than many might expect. In an era when everyone should be anticipating massive inflation leading to higher interest rates as soon as the economy turns the corner, the price of bonds, especially low-yielding debt, will get crushed.

Superinvestor Seth Klarman, founder of Baupost Group, critiqued the strategy as well: "No one who was paying attention in 2008 would possibly think this is a good idea." Despite such well-reasoned criticism from cooler heads, advocates of the pension plan push heatedly on.

Because the funds are borrowing against their bonds, they rely heavily on the prices of bonds remaining high. If prices decline, managers will be forced to make a tough decision: Close the positions they created with their borrowing, or put up more capital, probably by borrowing against other shrunken bonds. You can see that managers who have no intention of borrowing 100% of their capital might quickly have no choice but to do so, if only in order to keep the entire fund from being wiped out.

Public pensions engaging in this practice will get burned. Higher interest rates may not return today or tomorrow, but they will return. And when the funds can no longer put up capital, because their bonds have shrunk too much, they will go bust, and so will the retirements of those who relied exclusively on their public pensions.

One up on the public pensions
According to many experts, public pensions are being unrealistic in going after a targeted return of 7.5% to 8%. That level of return might be difficult for institutions, with all their efficiency-destroying mandates, but it's an eminently achievable goal for individuals, especially those who focus on high-quality dividend-paying companies, like those recommended by Motley Fool Income Investor.

As I've argued elsewhere, dividend-paying stocks are the best way to secure your future forever. The best companies, like those below, grow their dividends over time, and unlike institutions, you're not forced to reallocate your assets every time a manager retires.

Source: Capital IQ, as of March 4, 2010.

The beauty of the dividend approach is the stream of cash paid by stable, high-quality companies. Stalwarts like Procter & Gamble have been upping their payouts by 12% annually over the last half-decade. That's the type of dividend growth that makes P&G and others such as PepsiCo stocks that you can retire on.

And you can rest secure in the knowledge that resilient franchises are behind these increasing payouts. Coca-Cola's recognized brand and asset-light business model allow it to spin excess cash to shareholders. Chevron has the benefit of providing always-in-demand energy, as does utility company Exelon. Procter & Gamble provides indispensable consumer products such as detergents, while it's hard to imagine turning on a PC without seeing a Microsoft logo.

Two of the companies above are recommendations of Income Investor, and one is a Best Buy Now (hint: think fizzy). To find out what other stocks Income Investor has recommended, including all its picks for Best Buys Now, click here to join as our free guest for 30 days. Advisor James Early looks for companies offering a yield of 3% or better and that are primed to increase their payouts for the long term.

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Jim Royal, Ph.D., owns shares in Procter & Gamble, Microsoft, and Bank of America. Exelon, Coca-Cola, and Microsoft are Inside Value recommendations. Coca-Cola and Procter & Gamble are Income Investor selections. Motley Fool Options has recommended a write puts position on Exelon. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Coca-Cola and Procter & Gamble. The Fool has a disclosure policy.