Tuesday, June 14, 2011

Zero Percent is the New "Killing It"

I have been saying that the return assumptions for pension funds (e.g. 8% annual return) are insane, and that there is no way they will be able to earn those returns on hundred billion dollar amounts of money with mediocre talent and no originality. In fact, I think that big institutions should change their goal to a zero percent real return. They would honestly be saying, "Look, we'll try to preserve purchasing power and not lose any money."

Mebane Faber has a new paper called "What if 8% is Really 0%?" which applies the same thinking

"Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate. In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison - the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years."
Exactly. From the paper, "discounting with the risk-free rate... the 50 U.S. states pension plans have $1.94 trillion in assets versus liabilities of $5.17 trillion, resulting in a funding ratio of only 38% and cumulative unfunded pension liabilities of $3.23 trillion," which is an astonishing amount of debt.

And, consider that these institutions will probably be lucky to earn the risk-free rate, because they are taking so much more risk - the paradox mentioned above.

What is going to happen? There probably will not be any money to pay these pensions.

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