Tuesday, March 3, 2009

Poor Assumptions

Baseline Scenario is linking to a story about underfunded government pensions. The short story starts off this way:
  1. Of the next cohort of retirees, only 61% have IRA's,
  2. The average balance in that group's IRA was $98K,
  3. Due to drops in stock values, that balance has probably fallen recently.

Ok, that's just awful. Luckily, there are state and government pensioners who are in better shape, right? Here is what BS says,

  1. Pensions are usually paid using bonds taken out by the respective government entity,
  2. Pension funds are allowed to assess their long-term solvency using assumed annual rates of return, generally around 8% per year.
  3. As long as the bond repayment rate is lower than the assumed rate, the government comes out ahead.

Let me repeat the key point...rates of return are assumed to be higher than the bond rate.

"In the long term, of course, it’s a crazy investment strategy (and a mistake many people make - comparing a risk-free interest rate you borrow money at with a risky expected rate you hope to earn). And the results in the future are predictable: either higher taxes, or yet more value-destroying pension obligation bonds. Sometimes people get caught saying stupid things, like Christine Whitman saying, “You’d be crazy not to have done this. It’s not a gimmick. This is an ongoing benefit to taxpayers,” but it’s really a systemic problem."

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