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.

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