This isn't just about pensions and Detroit, this is about funding retirement in general. Let me cut to the chase:
That's the connection with the concept of "stocks for the long run."Much of the theoretical argument for retaining current methods is based on the belief that states and cities, unlike companies, cannot go out of business. That means public pension systems have an infinite investment horizon and can pull out of down markets if given enough time.
"It might seem?" Good heavens. It would never have occurred to me that they would do anything else.For several years, little noticed in the rest of the world, [actuaries have] been fighting over how to calculate the value, in today’s dollars, of pensions that will be paid in the future.... [There is a possibility] that a fundamental error has for decades been ingrained into actuarial standards of practice so that certain calculations are always done incorrectly....
When a lender calculates the value of a mortgage, or a trader sets the price of a bond, each looks at the payments scheduled in the future and translates them into today’s dollars, using a commonplace calculation called discounting. By extension, it might seem that an actuary calculating a city’s pension obligations would look at the scheduled future payments to retirees and discount them to today’s dollars.
The great divide. Plan on the basis of liability matching, or plan on the basis of guesses about future investment returns, meeting liabilities that will come due in finite time using a methodology based on an infinite planning horizon.But that is not what happens. To calculate a city’s pension liabilities, an actuary instead projects all the contributions the city will probably have to make to the pension fund over time. Many assumptions go into this projection, including an assumption that returns on the investments made by the pension fund will cover most of the plan’s costs. The greater the average annual investment returns, the less the city will presumably have to contribute. Pension plan trustees set the rate of return, usually between 7 percent and 8 percent. In addition, actuaries “smooth” the numbers, to keep big swings in the financial markets from making the pension contributions gyrate year to year....
If the critics are right... even the cities that diligently follow their actuaries’ instructions, contributing the required amounts each year, are falling behind, and they don’t even know it.
These critics advocate discounting pension liabilities based on a low-risk rate of return, akin to one for a very safe bond.
If you personally are planning on 7-8% returns in your portfolio, and a belief that you can always "pull out of down markets, given enough time," then you are planning the same way these pension funds have been planning. And I am confident that some will reply to this post by saying that this methodology is valid and that the pension funds doing it are sound.
A few years ago... the Society of Actuaries, gathered expert opinion and realized that public pension plans had come to pose the single largest reputational risk to the profession.