The Structural Assumptions

Walter Russell Mead complains:

The biggest scam going in American financial life may be the collusive effort by Wall Street, the political class, and public sector unions to use union retirement money to prop up Wall Street speculation.

Step One: state politicians promise big pension and health care benefits to their unionized work forces, but don’t set aside enough money to fund those benefits when the bill comes due. This makes union leaders and unions look good, because they can point to the shiny new benefits they have negotiated with the politicians. Meanwhile, it makes the politicians happy because the unions support them with contributions and volunteers at election time, but because the unions don’t insist on full funding for the benefits, the politicians don’t have to raise costs or otherwise disturb the big majority of voters who don’t work for the government.

Step Two: Make aggressive assumptions about the rate of return on pension investment funds. This has two consequences: it covers the gap between promise and reality (for a while), thereby postponing the day when the politicians have to face the voters and the union leaders have to tell their members that those beautiful benefits were bogus from the start. But the other purpose, equally important, is that it forces America’s public sector pension funds into the deep end of the financial markets, leading pension funds to be major investors in hedge funds, derivatives and various other not-for-the-widows-and-orphans investments. If these work out, great — the funds hit their investment targets and the benefits, or at least some of them, get paid. If they go awry — as many did in the last few years — then the pension problem turns into a crisis.

The scandal is that the structural assumptions of these funds require them to have a 7 or 8% nominal rate of return. In a period, like now, in which real interest rates are negative, in order to accomplish a 7 or 8% nominal rate of return you’ve got to go up the risk ladder. When large domestic companies are sitting on big wads of cash for whatever reason rather than investing them in expanding their operations, developing new products, or making capital investments to reduce their costs of operations, it gets so you aren’t talking about blue chips any more. You start talking about Greek and Spanish bonds. Have a nice day.

The real scandal here is that politicians were allowed to talk about 7 and 8% rates of return without being held accountable for the fraud.

9 comments… add one
  • Icepick Link

    Don’t forget corporate pension funds which also used such rates of return in their assumptions. (And when they got those rates claimed them as profit.)

  • steve Link

    Was this rate of return different than what private pensions were using? Since a lot of what Mead write about is historical, what rate of return are private and public pensions assuming right now?


  • Drew Link

    Heh. There is no structural bias in public vs private return assumptions other than political spin. The people who actually manage the portfolios ain’t dumb. They know the score. What the politicians might say, well, that’s different. They don’t have to manage the portfolio or create the return.

    Dave used the phrase I always use: you have to walk up the risk ladder. That is exactly correct. I can give you an 8% return in a heartbeat. We beat the hell out of that with our eyes closed. That’s not the issue.

    In an academic sense, risk is defined as the statistical variance of return around a mean return. The academics call it beta. But that mean return is a long term measurement. The problem for pension fund managers is that they constantly have to assess inflows and required outflows of capital. And at any given point in time they may need outflows. If the investment in ( risky) assets is temporarily depressed because of their inherent volatility, well you are screwed, because you have to liquidate at the wrong time and accept a substandard return, even if in the long term the return has better prospects. That’s why the older you get, or if you are an endowment or pension fund manager you need to have liquid (read: safe) assets to liquidate all the time.

    Shorter: you can bet it all on red and make a killing, but you’d damned well better be right.

    Nobody is that good. And it is irresponsible to think you are.

    If you could take away all the obvious talents required to be a good investor, and distill things to two points, it would be diversification and risk vs reward. No one in their right mind goes into an investment and thinks its going to go bad. That would just be insanity. But the proverbial shit happens. Business is dynamic. Competitive issues. Regulatory issues. Blah, blah, blah. So no one can give assurances that a particular investment will work. Trust me on this, I know.

    However, disciplined and constant application of sound investment principles in a diversified portfolio – I guarantee- will assure that the portfolio in its entirety will perform. Who’s that chef? I gar-on-tee.

    Add that to a “beta appropriate” portfolio and you have a professional money manager. Can they do that at the state of Illinois? Or any other troubled pension or endowment fund. I don’t think so. I have a personal friend written up in the book titled “New Investment Wizards.”. Even he couldn’t pull this high wire act off.

    As always. The politicians are simply not to be trusted.

  • Drew Link

    Ice pick

    You may know something I don’t, but a supernormal return in a pension fund doesn’t hit a corporate P&L and pass muster with an accounting firm as operating or net profit. It’s a balance sheet item.

    I suppose if you could convince an accounting firm that actuarily you were so ahead you could take the positive balance into income, but I’d be questioning that accounting firm. The actuary rules are pretty stiff.

  • Drew Link

    I just re-read my comment. A couple things will come off as obtuse.

    First, So the sentence that says no one can give assurances that an investment will work……it should be clear, but I don’t think I made it clear, “with all appropriate diligence, experience and collective thinking.”. You just can’t believe the deals you think are home runs vs doubles………..and then 5 years later look back and go WTF?

    Second. ” can they do that at the state of IL?”. My point is they have no hope of an 8% return without undue risk and obvious outflow funding problems. Not that they are incompetent. It’s just that Superman couldn’t pull this off.

  • Drew,

    What does the potential of a decade or more of slow economic growth and employment stagnation do to your assumptions about mean return?

  • Icepick Link

    Drew, I’m referencing the stuff mentioned in this article.

  • Icepick Link

    Perhaps those rules have changed but I don’t think they have. And there IS a good reason for such smoothing methods, although it does allow for abuse.

  • Drew Link


    Returns are calculated for various asset classes by various services and data bases. For example, Ibbottson produces a widely used almost century long data set for public equity returns. There have periods of above and below long term return. Naturally, a decade of slow growth will tug on the long term statistics in a downward fashion.

    The more important point given your query is exactly what I was pointing out, that you wouldn’t want a “portfolio” dominated by, say, public equities and be required to liquidate a large portion at a disadvantageous point in time.

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