American International Group Inc (AIG), Travelers Companies Inc (TRV): The Real Reason Pension Funds Can’t Earn 8%

The view ahead
Of even greater concern for pension funds is that with both stock and bond markets at reasonably high levels, it could be increasingly difficult to earn strong enough returns to meet expectations in the future. Under more normal rate environments, 10-year Treasury bonds have earned between 4% and 6%, contributing a substantial amount of the income necessary for pension funds to meet their payout requirements.

With 10-year bonds near 2.5%, that option isn’t available, and pension funds have stretched for yield the same way that individual investors have. Even high-grade corporate bond fund iShares IBoxx $ Invest Grade Corp Bd Fd (NYSEARCA:LQD) doesn’t provide ample enough spreads over Treasuries to reach above a 3.5% yield; you have to resort to junk bond funds iShares iBoxx $ High Yid Corp Bond (ETF) (NYSEARCA:HYG) or SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK) to get into that traditional range, and that involves higher levels of default risk that many pension funds don’t feel comfortable taking on.

As a result, the fate of public pension funds might rest on the ability of the stock market to keep producing the impressive returns we’ve seen in recent years. Yet with stock already at all-time highs and valuation measures starting to creep higher, betting the future of America’s pensioners on an endless bull market is exactly the trap that pension funds fell into at the end of the 1990s.

Obviously, there’s a chance that pension funds could manage to earn 8%, but the more prudent course is to assume that they won’t. Being safe rather than sorry will require greater funding that could drain scarce financial resources from more pressing concerns, but until governments rein in the outlandish promises they’ve made to workers, any alternative will almost certainly leave some past obligations unmet.

The article The Real Reason Pension Funds Can’t Earn 8% originally appeared on Fool.com is written by Dan Caplinger.

Fool contributor Dan Caplinger owns warrants on AIG. The Motley Fool recommends AIG. The Motley Fool owns shares of AIG and has the following options: long January 2014 $25 calls on AIG.

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