Pensions – There is a distinct cerebral pleasure, relief even, derived from lapsing into a state of suspended disbelief. Click Here to buy Fed Up: An Insider’s Take on the Willful Ignorance and Elitism At the Federal Reserve

Do we care that saw-wielding magicians don’t really cut the girl in two, or that big screen good guys never run out of ammunition? Would the frightening folklore of vampires have survived the ages and still be capable of delivering a captivating bite? Poor Walt Disney would have been just another flash in the pan, and winged porcine platoons never have taken flight. Why love itself might not have survived the rigors of scrutiny without our ability to suspend disbelief. Do I detect a smile on your face?

Federal Reserve To Pensions

Federal Reserve To Pensions

Levity was indeed Samuel Taylor Coleridge’s aim, a just reward for an aesthetic philosopher hitting the zenith of his cognitive prowess at the dawn of the 19th Century. In 1817, Coleridge encouraged those who endeavored to spin tales via the beauty of the written word to marry “human interest and a semblance of truth” thus resulting in a fantastic tale. Contentedly compliant readers would in turn gladly suspend judgement concerning the implausibility of the narrative.

There is of course a caveat. At the risk of inciting deflation, one’s critical faculties can, and well should, only be suspended for finite periods of time. The alternative risks intellectual indigestion, an overdose of fantasy, which carries nasty and lingering side effects. In the words of the actor Edward Norton, “The more you can create the magic bubble, that suspension of disbelief, for a while, the better.” Note Norton only recommends suspension of disbelief for a while.

[drizzle]Chances are, 70 years is a bit much for loitering in the orbit of suspended disbelief. According to Richard Ingram, such an extended stay inevitably leads to disaster. Apologies if you feel you’ve just been sideswiped by a colossal non sequitur. Ingram is the Executive Director of the Teachers’ Retirement System of Illinois. And 70 years is how long it’s been since the great state he calls home has satisfied its annual contribution requirement to the pension he runs today.

Little wonder that Illinois boasts the most underfunded pension in the country. According to Moody’s, the Prairie State’s pension coffers were $193 billion shy of being whole in fiscal year 2015. Given that Ingram has seen through a decrease in the Teachers’ assumed rate of return to seven percent, there could be more red ink in the making.

A smidgen of pension accounting here. The ‘assumed rate of return’ is what pensions use to discount their liabilities, which then dictates sponsors’ required cash contributions. The higher the rate assumed, the less cash required, and vice versa.

For a point of comparison, this rate is capped at 3.5 percent in Great Britain. Encouraging reckless investment behavior on behalf of pensioners is apparently frowned upon in the UK. The irony is, Illinois actually looks pretty conservative in assuming seven percent vis-à-vis its peer average among the other 49 states of 7.5 percent (which has come down from eight since 2012).

Ingram warned in early October that a further reduction in the rate of return assumption to (Heaven forbid, Aunt Pitty Patty!) six percent could be forthcoming. You will recall that California’s actuary quit in protest some four years ago when his recommendation that the Golden State’s assumed rate be dropped by a half percent to 7.25 percent was resolutely rejected by state politicians. Why? A quarter of a percent to 7.5 percent was all that could be squeezed out of the state’s revenues.

In the event I’ve lost you, if you assume your investments are going to return less, you (the state/school district/municipality) have to write bigger checks to ensure the pension has adequate funds to satisfy what retirees and future retirees have been (over)promised. The fact that interest rates have declined precipitously, even using the ridiculously high rates allowed by law, you start to see what’s got all those analysts over at Moody’s so worried.

Add up all our great states and Moody’s math comes up with $1.75 trillion in what will be pension underfunding by the time we’ve said adios to fiscal year 2017. That represents a 40 percent jump from fiscal year end 2015. On a fundamental level, it is poor investment returns and insufficient contributions that have landed pensions in this pickle. “Poor” might be a bit kind considering the median return for state pensions in the last fiscal year was 0.52 percent, again, compared to a 7.5-percent assumption. As for insufficient, half of the states did not contribute enough to stave off further underfunding.

The Moody’s report did contain the mother of all asterisks. Some states that were guilty of writing too small of checks to stem the bleed were fully compliant with their actuary’s stated required contributions. It’s the part about following the rules that will eventually bring pensions down if several things are not done, and soon.

Politicians are of course loath to take any actions that would strengthen pensions in the long run, mainly because their wallets are a bit light these days. Chock that one up to the same sin committed by circa 2005 homebuyers – partying as if the sun would never set, as if home prices would never stop rising, as if tax revenues would not ever be tempered. Why save for a rainy day if your forecast called for no rain? Ever. Disbelief suspended permanently.

At the risk of suggesting politicians are feckless souls at such a juncture, maybe it’s better to steer our collective attention to the politicians’ enablers. Policymakers at the Federal Reserve can claim no immunity to breathing the same air as the rest of us. It follows that they’re fully aware of the inferno burning under the surface of the nation’s public pension system and the direct effect their interest rate policy has had in exacerbating pension underfunding.

Can the Fed directly affect accounting rules? Of course not. But policymakers could long ago have recognized the futility of low interest rates in spurring growth and worse, the moral hazard induced thereof. Go back to the rate of return assumption for a minute and try to appreciate the vise pension managers are in to hit these egregiously high bogeys. Put yourself in their shoes for a minute. Given that relatively conservative stock and bond returns have been punk since the Fed stopped expanding its balance sheet, what choices remain?

In baseball parlance, swinging for the fences. Act I of this play was hedge funds. In a world in which alpha has played dead for years and index funds rule, those hefty hedge fund fees for underperformance got to be a bit rich to stomach. And so the exodus began starting with the Mack daddy of all pensions, the nation’s largest, CalPERS, exiting hedge funds stage left.

What’s replaced hedge funds to achieve that teensy seven percent delta the median pension performance is lacking to meet their nutty actuarial assumptions? If you want to know what’s to come in Act II, go back to the leader of the pack, as in back to CalPERS. The California pension recently smacked

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