Sharp increases in equity prices since last summer have sparked a debate on whether we have a bull market driven by economic fundamentals, or another bubble about to burst. Regardless of which side of the debate you take, only the most optimistic market watchers would predict a Dow Jones Industrial Average of 50,000 or more in a decade.
Yet, this is the assumption of many defined benefit pension plans, including a large number of state and local plans for government employees. To understand the crisis of these systems, you need only grasp the market targets necessary to keep them healthy, not just by 2023, but on and on. If, for instance, the Dow does reach 50,000 in a decade, most pension plan assumptions require the index would have to be above 90,000 in 2030 for them to continue being adequately funded.
When you stop laughing, pause and consider where you live and whether you are going to be asked through your tax dollars to make up for investments that fail to match those projections.
Many Wall Street professionals, for instance, reside across the Hudson River in New Jersey, with one of the nations worst-funded pension systems. A few years ago the states actuaries began warning the system could soon run out of money. So Jerseys government passed reforms that required greater contributions from the state (that is, taxpayers) and workers. The state also lowered its future investment assumptions from a heady 8.2 percent annually to a still lofty 7.9 percent. It couldnt go any lower because that would have exposed even greater liabilities and required the state (the taxpayer, again) to contribute even more. But someday the Jersey pension system will need that money. The states portfolio managers have missed their high investment targets so consistently over the last decade that theyd need a Dow of about 26,000 right now for the pension system to be decently funded, and will require Dow 200,000 (more or less) by 2040.
Warren Buffett warned about this in a 2007 letter to shareholders pointing out the unrealistic investment assumptions upon which most defined benefit pension plans, which promise a worker a percentage of his salary in retirement regardless of how much his employer can save for him, are based. As Buffett noted, the Dow seemed to do very, very well throughout the 20th century, but expressed as a compound annual return, the market averaged 5.3 percent growth, substantially less than the lofty assumptions most pension systems now boast.
In many places politicians have seized on investment gains that occurred over a compressed time to justify boosting pension payouts to government workers, under the assumption those gains would continue. In California, for instance, the state legislature in 2000 rewarded public employees with enhanced benefits based on the gains of technology stocks in the 1990s. As California venture capitalist David Crane has pointed out, the assumptions that the California legislature operated under required that the Dow be at the equivalent of 29,000 by 2009, and at 23 million by the end of this century. Municipalities around California which signed up for the enhanced benefits, often under pressure from government unions, are now groaning under demands from the pension system for more taxpayer dollars.
It wasnt always like this. Initially, states designed government retirement systems to provide modest pensions through reasonable contribution rates. Californias pension system for public workers, created in the early 1930s, promised a little more than half of someones final salary in a retirement that started sometime in a persons mid-sixties. To achieve that the system relied on investments based on conservative market principles.
All of this changed starting in the 1960s, as government workers gained more power and politicians found that they could reward this interest group with higher pensions justified largely with hefty investment assumptions. California, for instance, lifted the prohibition against its pension system investing in stocks in the early 1960s, and raised the percentage of the funds portfolio that could be devoted to equities in 1984. By the middle of that decade, Californias retirement system passed a milestone as the growth in assets thanks to investment gains began surpassing contributions by workers and taxpayers into the system. But to achieve those gains portfolio managers increased risk, too. Today, many pension systems rely on getting two-thirds of their income from investment gains with projected rates of return worthy of Bernie Madoff.
Defenders of the current system argue that government pensions are modest. But they often make this claim by misleading us about the true extent of benefits. Back in 2011, for instance, California State Treasurer Bill Lockyer attempted to squash talk of lowering benefits by pointing out the average retirement paycheck in California was just $2,500 a month for state employees. Skeptical reporters dug a little and discovered that was the average of all pensions in the system, including those for people who retired with only a few years of service. The typical pension for those who worked a full career of 30 years or more and were just retiring at the time was $67,000 a year, plus Social Security benefits, which for California state workers raised the average to $86,000.
Regardless of the level of benefits, a system based on hard-to-imagine returns is unsustainable. Recently former hedge fund manager Andy Kessler predicted in the Wall Street Journal that government pensions would soon have to go the way of corporate retirement systems toward defined contribution plans. But politicians generally wait for a crisis before reforming perks enjoyed by special interests. Although more than 40 states claim pension reform in the last four years, few have made the switch to 401(k)-style plans. Most states have kept in place high assumed rates of investment returns as the anchor of defined benefit plans. This is one reason why states and municipalities continue accumulating a mountain of debt that the States Project, a joint venture of Harvard and the University of Pennsylvania, recently estimated at $7.3 trillion.
A recent news item on NewJerseyWatchdog.org noted that despite pension reform, the states elite club of public employees retiring with pensions of more than $100,000 annually has increased 50 percent in two years.
If only the equity markets grew like that, Jersey and other states wouldnt face the retirement debt problems now plaguing them.
Original Source: http://www.realclearmarkets.com/articles/2013/04/17/is_your_10-year_target_for_the_dow_50000_100267.html