Pensions Are Stuck, But You Don't Need to Be

A recent report painted a bleak picture for the future of American pension funds, which are underfunded because of investment losses and the sometimes desperate measures taken as a response.

According to the report, the Chicago Transit Authority was underfunded by $1.5 billion until it floated a bond to make up the difference. Of course, the fund's returns must exceed the interest paid to bondholders or the pension will be in an even bigger hole. Elsewhere, the Teacher Retirement System of Texas expects an average annual return of 8%, but for the past 10 years, it has only been averaging 2.6%. And there are similar stories.

Pension funds know how much they must pay out in a given year and can get a sense of obligations in the years ahead. Because of that, a fund needs to predict stock market returns, which are lumpier than their average increase would suggest. Stocks average about 9% a year but rarely return that amount in a given 12-month period.

The recently ended bull market is a good microcosm. From 2003 to 2007, the S&P 500 returned a sequential 26%, 9%, 3%, 13% and 3%, excluding dividends. Targeting 8%, or some other "reasonable" number, would have worked in one out of five years. It would be reasonable to think that an equity portfolio manager who returned 8% in 2003 would have had his work cut out in justifying why he should not be fired. Additionally, getting 8% in a 3% year would possibly involve taking risks unsuitable for a pension fund.

Pension funds must meet their obligations, period. A do-it-yourself investor has the luxury, from a portfolio perspective, of taking out less to live on during a bear market. Giving back 12 years' worth of stock-market gains, as many people have done, is a rare event and has turned a lot of financial plans upside down. A retiree taking what may have been a prudent $50,000 out of his portfolio every year currently faces a greater risk of outliving his portfolio because of the massive declines in the equity market. Someone facing this reality has an easy solution: withdraw less of the portfolio. That is easier said than done, but doing so is the answer. The variable is how to make up the difference. The easiest answer to that might be to spend less.

There have been studies calculating the ideal withdrawal rate -- "ideal" in terms of covering expenses and avoiding the depletion of the fund too early. Many conclude the withdrawal rate ought to be a maximum of 4% to 5%. During a huge setback in the market (or some other life event), simply cutting the withdrawal rate for a year or two can be the difference between success and failure. A pension fund cannot do this, which is why many find themselves underfunded and resort to what might be described as going for broke by floating a bond yielding 6% with the hope of earning 8% in the stock market, as the Chicago Transit Authority has done.

As Baby Boomers begin to draw on savings, they will become net sellers of stocks, hurting the equity market. In this light, even the 4% to 5% assumption may not be safe. This could mean bigger problems for pension funds. But individuals can be more adaptive to this ominous outlook.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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