I saw this question posted by a municipal employee on a message board and wanted to share it here with a broader audience and give my perspective – and invite thoughts/ideas.
“I have an offer to join a new retirement plan that boils down to a (one time option to join, non-revocable) guaranteed 7.25% annual return on 401K equivalent contributions. I’m not worried about the County being able to fund this rate of return if things get really ugly. I’m also not that financially interested, preferring a “set it and forget it” approach to retiring.”
If there were no risk whatsoever of renegotiation of labor contracts or lack of the municipality’s ability to pay in the future (unlikely a problem since municipalities just raise taxes, kind of like our federal government will have to do when they can no longer print money due to inflation), this is a very good deal.
Here’s why: The risk-free rate of return (Treasuries) is extremely low. You’re getting a 7.25% risk-free return, which is actually a double digit return risk-adjusted.
Why? Stocks carry with them massive volatility and there’s no guarantee that you’ll see a positive return over any particular period. Look at Japan or look at our past 12 years. There are some mildly involved equations I used in B-school for translating between risk-free and risky asset returns, but clearly, a risk-free return over 7% is unheard of, especially in the current low-interest rate environment. As mentioned previously, this now allows you to take some cash on the side and if you’re concerned about missing a major market run in the next few decades, just buy some real cheap out of the money options each year. If the market runs say, 30% one year, you can get a leveraged 200% return for example. On years where the market’s flat, you lose the premium which might only be a few hundred bucks…but you’re guaranteed that 7+% return for a long period of time.
Anyone think this is a bad deal?
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In absolute terms, and given inflation over the last twenty years in developed economies, a 7.25% risk-free return sounds attractive. But over longer periods, and in developing countries, a 7.25% rate would have lost significant (or most of its) purchasing power.
Also, what are the investments in? Anyone can make a promise that a return is risk-free, just as AIG could write an insurance contract for most any “unpredictable” event. Saying it doesn’t make it so. Given your B school analysis and common sense, I have to say that only Bernie Madoff offers 7.25% risk-free returns.
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I have to go on what the employee posted in the forum, but essentially, it’s a government/municipal employee that’s being offered this fixed return through the municipality (i.e. taxpayer funded). We all know the gracious contracts inured to government and municipal employees that until now, have continued to thrive off the public largess. I have yet to see widespread defaults on obligations from these entities, so as long as you have faith that you’ll continue to see full pensions for teachers/police/firemen and as long as those constituents continue to represent a substantial portion of the voting populous (we all know laws and policies are based on what wins the next election), I don’t see the assumption that the municipality will meet their commitment as that far-fetched. The risk cannot be quantified, as it is not “market risk”, but rather, political risk.
Incidentally, Madoff was offering double-digit returns on a fictitious “split-strike” method that seemed to return consistent, market-beating results regardless of what was occurring in equities markets. It was so evident that something was fishy here that multiple prospective investors turned him down and some even approached the SEC, but they refused to act. So, Madoff, Stanford’s CDs and the like are very much different than a municipal obligation commitment.
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