Last Updated Feb 2, 2010 10:19 PM EST
The Problem. You may know that many state and local public pension plans are severely underfunded. This basically means that they don't have enough money to pay all of the promised benefits.
If you ask a "non-financial" person what should be done if a plan is underfunded, the answer you'll probably get from most people is "add more money". That's common sense and a pretty prudent approach.
But many state pensions are not in a position to add more money, or don't have the political will to require participants to increase their contributions. So some have decided to increase the investment risks they're taking, hoping to get big returns and thus solve their underfunding problems.
The Risks. There was a very good article in the Wall Street Journal last week about the types of risks public pension plans are taking to try to juice their returns. While you might find it hard to believe, some public pensions plans have decided to borrow money to invest in the financial markets. This is the same type of strategy that just destroyed many major investment banks, and it might apply to your retirement money.
How It Works. You see, if you can't add real money to an investment portfolio, the next best thing is to borrow money. You add the borrowed money to the portfolio and hope that the return you get from investing that money is more than the interest it costs you to borrow that money. This then produces a sort of magical return, where you're making money on money that was never yours in the first place.
Here is a simplified example of how it works:
- Assume you borrow $1,000,000 and only have to pay 2% interest to borrow it. So that costs you $20,000 a year in interest. Now, you take that borrowed $1,000,000 and invest it in a bond that pays you 4% interest, which means you're getting $40,000 a year in interest. Once you deduct the $20,000 of interest you have to pay to borrow the money, you have made $20,000 of interest by investing the borrowed money. Sounds pretty easy.
- The more you borrow, the more you make, so why not keep borrowing more money?
- Well, the problem is when you borrow $1,000,000 and invest it in bonds, what happens if those bonds fall in value to $800,000? You might think, well I can just wait it out until the market recovers. But the problem is the $1,000,000 is borrowed on a short term basis and you have to pay it back right away. But you only have $800,000 available to do it, so now you've got a big problem.
- You see, in order to make the numbers work, you have to borrow short term and then invest those borrowed funds in longer term bonds. And if your long term bonds decline in value, you won't have enough money available to repay your short term loan. This is what happened to many investors in the mortgage markets over the last few years. The mortgages (which are long term assets) fell in value, and the investors didn't have enough money available to pay back the short term loans they used to buy the mortgages.
- And bond values can fall for all sorts of reasons, such as credit concerns or rising interest rates or inflation. So there can be significant risks associated with these strategies. And the more your borrow, the bigger the risk.
What To Do. If you have a government pension, you need to stay informed about the plan's funding status and how the plan is investing your money.
- Most of this information is included in the plan's annual report or on the website for the plan. If it isn't there, then make a call and ask for it.
- If you're concerned about how your money is being handled, then make your concerns known to the managers of the plan.
- And if you're really uncomfortable, explore your rights to roll your money out of the plan and into your own IRA. That way, you can handle it yourself. Some plans may allow this option.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.