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Longboat Key Wednesday, Jun. 13, 2012 5 years ago

My View: Pension plan: Rainbows and butterflies or logic?

by: Mitchell Levin

“Fiscally sound” is not how the pension board behaves. This issue continues to vex. The pension nightmares for the town are likely to grow even worse. Joe Carter, of Morgan Stanley Smith Barney, the Firefighter Pension Board actuary, is woefully misinformed or misaligned. The reader can decide which is worse. 

Expecting an “8% assumed rates of return” is unrealistic, at best — excessively risky in its attempt and self-serving at its core. 

Research shows, that for the 16 countries where markets have existed for stock trading over the last 230 years, the average return is 3.5% above inflation. Using that same periods average inflation of 3.3%, means the most a complete stock portfolio can return is only 6.7%. Let’s just round up to 7%.

True — that does not include dividends; however, for the sake of argument, I purposely excluded those additional 2% of dividend returns because of the fees, costs, expenses and taxes (which on average far exceed 2% to 3%) not also included in the calculations.

To diversify and to reduce the fluctuations in account values (that is to lower short term risk), we also will allot some money into bonds. This also enables some ongoing cash outlays from the income. Usually a pension has between 30% and 60% of the fund, in bonds. The bond average rates of return exceed inflation by only 0.5-1.5%. So that allocation may only expect to return, say 4.5%

If the pension is half bond and half stock the best expected return is only half of 4.5% (bond) and half of 7% (stock). That is 5.75% expected return. Before Mr. Carter and MSSB take their cut.

Even worse, math is not money. Average returns are not effective returns. The broad U.S. stock market average returns for the previous 30 years is 10%. But the effective returns were only 7%. Why? 

Here is an example. Let’s assume we can get a guaranteed return of 20% for two years. The first year we go up 100%. The second year we go down 60%. Therefore we have an average return of 40%. Divide that by the 2 years and it leaves a 20% return. Pretty good. 

Just not for money. We start, in this same example with $1 million. The first year we go up 100% so we go up $1 million. Now we have $2 million. The second year we go down 60%. 60% of $2 million is $1,200,000. That is a loss of $1.2 million. So we now have only $800,000. We experienced a $200,000 loss yet have a 20% gain. 

Expecting average returns is like expecting rainbows and butterflies everywhere, trees to grow to the sky and a bridge for sale in Brooklyn.

The only fiscally-sound approach is to reduce promised benefits for future recipients; reduce expected rates of return to reality; increase contributions from employees; oh, and completely re-structure the board and the pensions’ investment policy statement. Period.

Mitchell Levin is CEO and managing director of Summit Wealth Management in Orlando.


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