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The Detroit bankruptcy filing has raised concerns not just about workers and retirees within the city's pension system but about public pensions across the nation. With states like Illinois facing pension shortfalls numbering in the tens of billions of dollars, it's clear that governments need to match up their resources with their promised benefits more closely and will have to boost pension funding to meet their past obligations.
Yet even with the magnitude of those shortfall estimates, the scariest part of the public pension crisis is that too many pension funds have unrealistic ideas of how much they'll be able to earn in long-term returns. With cities and states having failed to update their return assumptions to reflect the current investment environment, the problem is probably even worse than people realize, and the reason has as much to do with low interest rates as high stock valuations.
Old expectations in a new market
Many pension funds still expect to earn 8% or more on their investments over the long run, and although funds have gotten somewhat more conservative in their return estimates, the declines have been slow in coming. In the most recent year available, average return estimates among the top 100 public pensions fell from 7.92% to 7.84% in 2011, according to Pensions & Investments, but that's only an eighth of a percentage point below its 2007 high.
Yet funds have had a big problem meeting those expectations, with half of all pension funds falling short by at least 2.25 percentage points annually over the preceding decade. Only three of the plans that the survey looked at managed to top the 7% mark.
What's the big deal about 8%?
Two potential problems with an 8% figure show the balancing act that pension plans face. On one hand, given that pension funds have perpetual existence, it makes sense for them to invest aggressively in order to maximize returns. The experience of the 2000s shows the difficulty in pursuing that strategy, as moves that pension funds made during the boom years of the 1990s backfired on stock-heavy investment portfolios during the so-called Lost Decade.
On the other hand, pension funds also have continuing obligations to provide income to current recipients, and that has led many pension plans heavily into the fixed-income market. In past years, the bond side of pension-fund portfolios has actually been a saving grace given the turbulence in the stock market. But now, interest rates have already risen sharply, causing massive losses in bond portfolios. We've seen bond-rich insurance companies AIG (NYSE: AIG ) and Travelers (NYSE: TRV ) both report substantial book-value drops in the second quarter because of their fixed-income exposure, and with pensions having made big bets on fixed income recently, they too could take a big hit.
The view ahead
Of even greater concern for pension funds is that with both stock and bond markets at reasonably high levels, it could be increasingly difficult to earn strong enough returns to meet expectations in the future. Under more normal rate environments, 10-year Treasury bonds have earned between 4% and 6%, contributing a substantial amount of the income necessary for pension funds to meet their payout requirements.
With 10-year bonds near 2.5%, that option isn't available, and pension funds have stretched for yield the same way that individual investors have. Even high-grade corporate bond fund iShares iBoxx Investment Grade (NYSEMKT: LQD ) doesn't provide ample enough spreads over Treasuries to reach above a 3.5% yield; you have to resort to junk bond funds iShares iBoxx High Yield Corporate (NYSEMKT: HYG ) or SPDR Barclays High Yield Bond (NYSEMKT: JNK ) to get into that traditional range, and that involves higher levels of default risk that many pension funds don't feel comfortable taking on.
As a result, the fate of public pension funds might rest on the ability of the stock market to keep producing the impressive returns we've seen in recent years. Yet with stock already at all-time highs and valuation measures starting to creep higher, betting the future of America's pensioners on an endless bull market is exactly the trap that pension funds fell into at the end of the 1990s.
Obviously, there's a chance that pension funds could manage to earn 8%, but the more prudent course is to assume that they won't. Being safe rather than sorry will require greater funding that could drain scarce financial resources from more pressing concerns, but until governments rein in the outlandish promises they've made to workers, any alternative will almost certainly leave some past obligations unmet.
With pension funds in tough shape, you really need to take matters into your own hands and boost your own investing. Your best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.