Skip to comments.Why Government Pension Funds Became Addicted to Risk
Posted on 06/25/2014 5:29:39 PM PDT by Lorianne
A public pension fund works like this: The government promises to make payments to its employees after they retire; it invests money now and uses those investments, and the returns on them, to make those promised payments later.
Back when interest rates were high, this was fairly simple to do. Pension funds could buy bonds ideally bonds that would mature around the time they would need the money to pay pensioners and use the interest on those bonds to fund the payouts. In 1972, more than 70 percent of pension fund investment portfolios consisted of bonds and cash, according to a new analysis from the Pew Charitable Trusts and the Laura and John Arnold Foundation.
But as interest rates began their long fall, pension funds faced a dilemma. Staying heavily invested in bonds would force governments either to set aside more cash upfront or to cut pension promises. So instead, pension funds radically changed their investment strategies, embracing investments that produce higher returns but also involve more risk. This shift has replaced an explicit cost with a hidden one: that lawmakers will have to divert more tax dollars into pension funds, cut back on benefits or both when stock market crashes cause pension fund asset values to decline.
(Excerpt) Read more at nytimes.com ...
The same thing is happening to private sector.
But we ca’t demand more tax dollars to fill the gap....
No risk for federal pensions. The taxpayers foot the bill.
If they make money, they get fat bonuses.
If they lose money - well we can’t let these poor pensioners suffer, so the taxpayers will take it in the backside, again.
Just another type of financial bubble everyone thought the government will bail out on the dirt hits the fan.
1. Pay up. Contribute what is necessary to meet promised benefits.
2. Right-size (reduce) benefits to what the employer is willing to pay.
3. ... or most likely, a little of both of the two above choices.
In 1972, more than 70 percent of pension fund investment portfolios consisted of bonds and cash, according to a new analysis from the Pew Charitable Trusts and the Laura and John Arnold Foundation.
But as interest rates began their long fall, pension funds faced a dilemma. Staying heavily invested in bonds would force governments either to set aside more cash upfront or to cut pension promises.
This makes no sense at all. Interest rates actually rose considerably in the late 1970s and early 1980s. Why would pension funds reduce their bond exposure when interest rates were rising?
The answer -- which the author didn't even mention -- is that the 1970s and 1980s also saw a shift in the whole approach to bond investing. Instead of buying a bond and sitting on it until it reached maturity, astute investors began to buy and sell bonds at various points before they matured. This meant that a bond could rise and fall in value depending on how interest rates changed. If a pension fund owned a bond paying 8% interest in 1972, that "old" bond lost a lot of value if interest rates on new issues were 12% or even 16% by the late 1970s. Who would want to own a bond paying 8% when they can instead buy one paying 12% or 16%? When interest rates rise, the value of "old" bonds drops, and vice versa. The guy who made out like a bandit was the one who bought a new long-term bond paying 12% just before interest rates began to decline in the mid-1980s. Five years later he was getting his 12% return while new bond investors were buying bonds paying interest rates of 6% or 8%. That investor could sell his 12% bond for a lot more than face value in that kind of environment.
As bonds changed from "buy and hold" instruments to traded securities, they became much more risky investments because the owner of the bond had to consider the risks associated with rising and falling interest rates.
It's not a coincidence that this transition from pension funds investing in bonds to investing in stocks occurred at the same time some of the most brilliant minds in the investment banking business began figuring out ways to turn bonds into investment instruments that could be manipulated -- through legal and borderline-illegal means. The life story of Michael Milken, the junk bond king of Drexel Burnham, offers some fascinating insight into this.
And some of those funds are in energy companies. Study, plan, design and build alternative heating sytems for your homes, because home heating energy prices will probably go up much more.
And remember that there are also many local government pension funds (see local regulations, ties with federal, etc.).
All these suggestions are correct. However it is difficult to do when only two out of three parties are represented at the negotiating tables. The politIcians and the pension beneficiaries have a lot of input but current and future taxpayers are rarely represented.