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CTA Pension Debacle – What Does This Teach Us? : Inthon

Amazing piece by Bloomberg on the pension crisis which will soon be front page news.  This article is filled with excellent research, insight and analysis.  Bloomberg.com is a great resource for in-depth journalism.  Their Recipe for Famine series last December provided great insight on the economics (facts) behind global food shortages.

Like most problems left to politicians, the pension crisis has been avoided as long as possible.  As the market has declined and evaporated trillions of dollars of wealth for everyone, this issue has now been dragged out of the closet, naked and shivering for all the world to see.

Some of my favorite excerpts are:

Fund accountants resort to a grab bag of tricks to get by. They set unrealistically high expected rates of return to reduce governments’ annual contributions. And they use smoothing techniques to paper over investment reverses so they make losing years look like winners.

Accountants do that by averaging gains and losses, usually over a five-year period — sometimes for as long as 15 years of investment returns.

That means actual results of any one year aren’t used to calculate how much a state legislature contributes, which can delay governments catching up with losses for more than a decade.

Fund accountants using “smoothing” to distort reality.  It is this type of deliberate, fine-print deceit which all investors and taxpayers must be vigilant against.  This type of smoothing occurs even in “earnings” announcements by companies like GE, which is a major reason why companies “beating earnings” should always be taken with a grain of salt.

“What appears to be a riskless strategy is actually very risky,” says David Zion, director of accounting research for New York-based Credit Suisse Holdings USA Inc. “If the returns on the pension bond-financed assets don’t exceed the cost of servicing the debt, the taxpayers bear the brunt.”

As always, the taxpayer bears the cost of unrealistic government promises.

Finally, flat out stupidity by those “in charge”

The CTA concluded it could borrow $1.9 billion, paying an interest rate of 6 percent to bondholders, and invest the proceeds to receive its expected rate of return of 8.75 percent. Such an annual return would add $52 million a year to bolster the fund.

The CTA chose to ignore not only Illinois’s auditor general but also its own actuarial firm, Detroit-based Gabriel Roeder Smith & Co. The company had determined there was just a 30 percent chance of earning 8.75 percent.

“We executed the best transaction we could, given the legislative and political restraints,” says CTA Chairman Brown, who is also co-head of municipal finance at Chicago-based Mesirow Financial Inc.

Takeaway:  Everyone has an incentive for the market to go higher and let the good times roll.  This attitude manifests in numerous levels of opacity.  This opacity ranges from the fund manager who smooths earnings, to the politician making outrageous promises, to Joe Taxpayer who complacently watches and does nothing.  Only during a market downturn do these instabilities and crises manifest.  As a grown man or woman, arming yourself with An Accurate Model of Reality is paramount to developing a healthy sense of skepticism and uncovering the truth before it is too late.

Kudos again to Bloomberg for shedding more light on this future front-page story.

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