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Reality check

23 November 2011 By Richard Beales, Agnes T. Crane

U.S. public pension funds are in a pickle. Lackluster returns and underfunding have left their $2.3 trillion of assets inadequate to cover future obligations in many cases. In addition, pension fund managers can no longer count on the 8 percent annual return they typically assume for the future. They need to bring expectations down to earth. But instead, some are considering borrowing to juice returns.

A new Breakingviews calculator shows how untenable the 8 percent assumption is. Using an asset allocation mix typical of big pension funds and assuming the continuation of the average returns on each type of asset in the five years to 2010, a more reasonable target would be around 4 percent. But without big extra contributions, that’s going to make funding shortfalls even worse.

That is leading some managers to explore the dangerous idea of borrowing to juice returns. One strategy making the rounds would shift funds out of the usual stock allocation of just over 50 percent and into a new bucket of supposedly safe fixed income assets. Managers would then lever up this allocation, borrowing say $3 for every dollar of the fund’s money to buy more assets and thereby turbo-charge returns.

Suppose they take about half the typical existing equity allocation and treat it in this way. The difference between a traditional fixed-income annual return of say 6.7 percent and a (relatively high) cost of borrowing of just under 3 percent allows this part of the portfolio to deliver annual returns north of 15 percent to the fund. Bingo! The potential return suddenly tops the 8 percent hurdle.

Yet recent events in Europe suggest borrowing to buy even highly rated sovereign bonds is riskier than it looks – and with leverage, any losses make a bigger hole in the underlying fund. Moreover, if pension funds go this way, they will be more vulnerable to rising interest rates, which would bring bond values down and funding costs up. Also, bets with borrowed money are simply not what pension fund managers are good at. Sure, they invest in leveraged private equity and hedge funds. But that’s probably already enough underlying debt for what should be ultra-safe repositories of retirement funds.

If fund managers admit an 8 percent return is no longer doable, cash-strapped states and employees will have to make up the difference. That would be unpopular, and in some instances very challenging. But playing with leverage could easily turn out worse.


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