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Public pension funds hammered by a perfect storm

As hard as the economic downturn and volatile stock market have been on ordinary investors, public pension funds have fared much worse.

The Pew Center on the States estimates public pension funds are collectively short by $1 trillion. Some economists think that's an overly rosy picture and say the shortfall could be as much as $3 trillion. Unfortunately for the managers of these funds -- as well as the millions of public employees depending on them for retirement income -- the Fed's initiative intended to lower long-term interest rates will only widen that chasm.

"They've been exposing themselves to equity market underperformance, and they've been exposing themselves to a secular down trend in interest rates," says Jeremy Gold, a pension consulting actuary. With the Fed's new plan piled on top, he says that $3 trillion shortfall could grow by as much as an additional trillion dollars. 

"This is probably going to hurt pension funds even more," concurs Pamela Villarreal, senior fellow at the National Center for Policy Analysis. "Now that the Fed has tinkered with their portfolio allocation, that means these pension funds are going to have to come up with a lot more money" to maintain their current rate of return, she says.

Much of public pension funds' troubles are self-inflicted: When states face a budget shortfall, funding obligations can get the short shrift. Some fall into the trap of believing a few banner years are representative of long-term gains, and some have dabbled in risky investments that turned out to be losers. They can also succumb to the same kind of emotion-driven, irrational decision-making that financial advisers warn individual investors not to do. 

The other big hitch is the way these funds do their math. Although public pensions are guaranteed, risk-free to retirees, funds are allowed to assume returns of 8 percent — a number that's not representative of low- or no-risk investing. It's a discrepancy that's currently being examined by the body that oversees public pension funds.

"The Governmental Accounting Standards Board has been undertaking a review of accounting standards and there's been a very heated debate," says Girard Miller, senior strategist at the PFM Group. "It will tend to raise the visibility of this issue."

For public pension fund managers, a regulatory mandate to take off the rose-colored glasses is going to mean crunching some tough numbers and coming to grips with the need for much more capital.

States and cities have already begun altering their pensions to try and staunch the red ink, requiring employees to pay more into the system, delaying retirement age and cutting benefits for new workers. Villarreal says public defined-benefit pensions will give way to the defined-contribution plans that are now the de facto retirement plan in the private sector.

But these changes may not be enough. "To the extent that the long-term Treasury bond yield is falling, there's an impact on both public and private funds," Miller says.

 One silver lining is that the longer-term descent of interest rates had already motivated fund managers to move some assets out of Treasuries and into higher-earning investments. But two other major components — stocks and corporate bonds — are much more vulnerable to a poor economy. Combined, economists fear these factors could create the perfect storm for public pension funds.