Omaha is not unique among municipalities across the country – deals cut with workers many years ago have left pension funds well short of money needed for retirement benefits. The shortage has cost Omaha it’s top municipal bond rating and has driven Chicago – the nation’s most egregious offender – to the brink of bankruptcy.

It’s time for the City of Omaha to level with unions and citizens and admit that it’s 8% return projection for the future is a mathematical impossibility.

Today’s World-Herald:

The city expects a return of about 8 percent each year. In 2014, the fire and police pension fund returned 4.9 percent and the civilian fund 5.5 percent, according to annual performance appraisal reports for the funds.

Let’s start out with how the pension fund managers performed over the past two years, because frankly, its hard to fathom. If you try to “back in” to the portfolio allocation, some weird numbers emerge:

First of all, let’s assume that the City of Omaha is smart enough to follow John Bogle’s advice and put its money in low-cost funds that track the indexes. If the City is paying anything more than 1% to have someone manage the portfolio, it is an outlandish fee and further detracts from the struggling performance. That’s an argument for another day. Let’s stick with the passive formula assumption for now…

In order to have generated a 16.2% return in 2013, the fund would have allocated roughly 33.7% of its money in bonds. Let’s say they went with the biggest option and chose the PIMCO total return bond fund. It was a bad year for Bill Gross and prompted his departure to Janus as the fund returned -1.92%. But don’t fret Omahans, the remaining 66.3% of the portfolio invested in the S&P 500 index would have returned 26.39% in 2013. Thus, for the year, the fund still generated an outstanding 16.2% return in 2013.

But if you apply the same asset allocation assumption to 2014’s numbers, the performance breaks down. PIMCO’s broad based bond fund bounced back and delivered a 4.69% return. Meanwhile, the S&P 500 continued its bull run and advanced by 12.39%. Based on the same allocation weighting at 34/66, the pension fund should have easily turned in a gain of 9.8%, not 5.5%. The only way this 5.5% performance could have occurred is if the managers shifted almost 90% to bonds or made the even-worse decision of holding straight cash in a large portion of the portfolio. The pension manager should be called on the carpet.

The questionable 2014 results notwithstanding, reaching an 8% return assumption will be a virtual impossibility going forward:

First, you have the problem of rolling bond maturities. Assuming the pension fund bought some 30 year treasuries back when rates were north of 10% means that as those bonds reach maturity, those funds have no place to go but lowly 2-4% yields.

Second, if bonds are 34% of the portfolio and a PIMCO-esque fund runs at a typical 100 basis points over treasuries, 3.5% is a good year. What would the 66% of the stocck portfolio have to generate to reach an overall return of 8%?

10.35%

Nobel Laureate Robert Shiller has tracked stock market data from 1871 to the present and has shown an average return of about 8.2%.

Aswath Damoradan at NYU has a data series leading back to the late 1800’s showing that stocks have returned approximately 5.74% over the treasury bond. Based on these data points, one will do well to expect a stock return of more than 8% going forward with a Ten Year Treasury yield of 2.15%.

Using the same portfolio weighting noted above, the Omaha’s pension fund expected return should be adjusted to 7% (if not 6.5%!). Denial and compound interest don’t mix well.

If Omaha is looking for a dose of reality, it should look to California where unfunded liabilities are at 50%.  Calpers, the largest pension fund in the US, reduced it’s target rate to 7.5% in 2012. Its own actuary argued for 7.25%.