Systematic Relative Strength

According to the article Public Pension Funds Are Adding Risk to Raise Returns in today’s New York Times:

States and companies have started investing very differently when it comes to the billions of dollars they are safeguarding for workers’ retirement.  Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

Besides bonds, where else are they going?

Though they generally say that their strategies are aimed at diversification and are not riskier, public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.

What type of return do they need?

A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.

Why pensions don’t want to lower their return assumptions:

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions.  But plan officials say they cannot.  “Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.

Why not increase contributions?

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

This is insanity!  It is time for public pension plans to face the music.  They need a better investment approach.  It’s after reading articles like this that I become even more grateful that we adhere to a dynamic approach to investing that doesn’t have any bias about where returns will come from in the future.  We simply allow relative strength to dictate how we will be allocated.  They have sworn off US equities because of their volatility and of their underperformance relative to other asset classes over the last ten years.  However, it is entirely possible that US equities could be the very best performing asset class over the next ten years.

They need to realize that nobody is entitled to 8% per year.  I think 8% a year, and even better, is very possible over time, but you have to earn it by adhering to an effective investment plan.  Furthermore, there is no way to get that year in and year out unless you are one of Bernie Madoff’s clients.

They need to quit promising guaranteed benefits that are completely out of line with reality.  Rather, they should pay out benefits that fluctuate according to how the pension performs.  That is how the rest of us live.

Finally, funding the pension cannot be optional.  It must be funded each year, regardless of the opposition.

There, I’m done.

Source: The Economist, via Greg Mankiw.

Americans, as well as citizens of many other advanced nations, now spend about twice as many years in retirement as they did a generation or two ago.  Aggressive saving and adherence to a well-thought-out investment plan are more important today than they have ever been.  It is a big mistake for today’s 65-year olds to no longer consider themselves to be “long-term investors.”