The Phaserl


Here’s Why All Pension Funds Are Doomed, Doomed, Doomed

by Charles Hugh Smith, Of Two Minds:

There are limits on what the Fed can do when this bubble bursts, as it inevitably will, as surely as night follows day.

It’s no secret that virtually every pension fund is dead man walking, doomed by central banks’ imposition of low yields on safe investments, i.e. Zero Interest Rate Policy (ZIRP).

Given that both The Economist and The Wall Street Journal have covered the impossibility of pension funds achieving their expected returns, this reality cannot be a surprise to anyone in a leadership role.

Many unhappy returns: Pension funds and endowments are too optimistic

Public Pension Funds Roll Back Return Targets: Few managers count on returns of 8%-plus a year anymore; governments scramble to make up funding

Here’s problem #1 in a nutshell: the average public pension fund still expects to earn an average annual return of 7.69%, year after year, decade after decade.

This is roughly triple the nominal (not adjusted for inflation) yield on a 30-year Treasury bond (about 2.65%). The only way any fund manager can earn 7.7% or more in a low-yield environment is to make extremely high risk bets that consistently pay off.

This is like playing one hand after another in a casino and never losing. Sorry, but high risk gambling doesn’t work that way: the higher the risk, the bigger the gains; but equally important, the bigger the losses when the hot hand turns cold.

Here’s problem #2 in a nutshell: in the good old days before the economy (and pension funds) became dependent on debt-fueled asset bubbles for their survival, pension fund managers expected an average annual return of 3.8%–less than half the current expected returns.

In the good old days, the needed returns could be generated by investing in safe income-producing assets–high-quality corporate bonds, Treasury bonds, etc. The risk of losing any of the fund’s capital was extremely low.

Now that the expected returns have more than doubled while the yield on safe investments has plummeted, fund managers must take risks (i.e. chase yield) that can easily wipe out major chunks of the fund’s capital if the bubble du jour bursts.

Here’s problem #3 in a nutshell: everyone who rode the great bubble of 1994 – 2000 (including pension funds) soon reckoned 10%+ annual returns on equities was The New Normal, so expecting 7.5% – 8% annual returns seemed downright prudent.

When that bubble burst, decimating everyone still holding equities, the Federal Reserve promptly inflated two new bubbles: one in stocks and another in housing. Once again, everyone who rode these two bubbles up (including pension funds) minted hefty profits year after year.

This seemed to confirm that The New Normal included the occasional spot of bother (a.k.a. a severe market crash), but the Federal Reserve would quickly ride to the rescue and inflate a new bubble.

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1 comment to Here’s Why All Pension Funds Are Doomed, Doomed, Doomed

  • rich

    The legal technicality that let BofA skate on an alleged billion-dollar mortgage fraud

    If I’m ever dragged into court for a financial fraud, I want to throw myself on the mercy of Judge Richard C. Wesley.

    Wesley is the U.S. appeals court judge in New York who, with his colleagues Reena Raggi and Christopher F. Droney, found a loophole in federal fraud law big enough for the nation’s second-largest bank to fit through without even scratching a fender. In a ruling written by Wesley and issued Monday, the three judges tossed out a $1.3-billion judgment against Bank of America for stuffing thousands of lousy mortgages into the portfolios of Fannie Mae and Freddie Mac in 2007 and 2008 by pretending they were high-quality loans. Their ruling turned on the curious question: “When is a fraud not a fraud, but just, sort of, a lie?”
    (Countrywide’s ‘Hustle’ program) was…the vehicle for a brazen fraud…driven by a hunger for profits and oblivious to the harms. — U.S. District Judge Jed S. Rakoff

    Anyone concerned about white-collar crime should be find the appellate court’s logic appalling. One who does is Dennis Kelleher, a former corporate lawyer who is now CEO of the financial watchdog group Better Markets. “You wonder why the American people are so cynical,” he told me after the decision came down. “It’s because there’s an endless reservoir of ways to figure out how to hold no one accountable for illegal conduct.”

    The biggest danger with the court’s exoneration of the bank, however, is that it provides a road map for white-collar wrongdoers to evade responsibility. Breach-of-contract damages, as Kelleher says, have “zero deterrent effect — there’s no downside for committing the fraud.” You either get away with it and pocket the gains, or you get caught, and have to give back the money. The way to stamp out fraud, however, is to make punishment greater than the potential gains.

    That course was closed off by the appeals judges. Wrongdoing executive now know they only have to dredge up a preexisting contract “breached” by their behavior–since few businesses enter into contract plotting in advance to make it the vehicle for fraud,

    this becomes an all-purpose get-out-of-jail-free card.

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