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Victoria, TX 77901

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Damaged Dallas Braces for Bankruptcy

As most of us enjoy the holidays, the City of Dallas, and their pension fund for police and firefighters’ balances on the precipice of bankruptcy.

This is not Detroit. This is Dallas—the city with the fastest economic growth out of the nation’s top 13 largest cities. Despite this growth, Big D is requesting a $1 billion bailout.

How does this happen and what can be learned?

Some historical perspective is helpful. The first impactful decisions were made in 1993. State lawmakers added individual savings accounts to the Dallas pension paying a fixed 8.5% interest per year, guaranteed, for all workers age 50 and older!

The pension managers, and associated consultants, knew the 8.5% figure was aggressive from the beginning. To make the math work they assumed covered payroll would grow 5% every year—which it did not. Furthermore, they assumed their investments would earn an average of 9% per year!

Under the best circumstances, the pension managers knew traditional stock and bond investments would not provide returns necessary to sustain the fund. It also left no room for error. Given this, they reached for returns as they plowed funds into assets that were illiquid and exotic. They accumulated villas in Hawaii, a resort in California, timberland in Uruguay and farmland in Australia. These projects required additional effort, administration and expense.

After the Dallas Morning News published a report questioning the validity of claimed investment returns, retirees cried for a full audit. It revealed the investments were mispriced and the fund was suffering.

This news caused concerned retirees to pull more than $260 million out of the fund setting off a “run on the bank.” However, 23% of the pension’s assets were tied up in illiquid real estate. Additionally, over the last 10 years the fund produced annualized returns of 2%--well below the required 9%. The retirees mad dash for cash only compounded the smoldering problems.

What can the average investor learn from this nightmare?

First, there is a huge difference between liquid and illiquid assets. Converting shares in Pepsi or Exxon can be done any day. Selling an office building or farm may take months.

Illiquid assets are hard to value, have higher than anticipated holding costs and valuations are very subjective. Consultants will often tell you what you want to hear, especially if you are paying for an opinion. It is only once you attempt to turn these assets into cash that you determine their true value.

When making projections, realize things never move in a straight line. If your plan requires perfection to work, you are asking for trouble. If you are overly aggressive early on, you increase the risk of harming long-term purchasing power.

The Dallas pension required average annual returns of at least 9% per year. However, the financial markets deliver very lumpy performance. Since 1929, there have been 10 occasions when the stock market sold off by at least 20%. That is once every eight years. Since 2010 the market has sold off 10% or more on five occasions. In more extreme cases the stock market has sold off by 49% on two separate occasions, just since 2000.

If forced to liquidate when markets are down, you will never earn the averages and it makes it much harder for a portfolio to rebound. Recognizing how volatile the financial markets are, it is foolish to expect returns of 9% per year in a straight line.

Don’t paint yourself into a corner. Bad things happen when you least expect them to occur. Income projections will run below expectations and expenses will run above expectations. Leave yourself plenty of wiggle room.

Given current market valuations and interest rates, we counsel our clients not to expect annual returns above 6% over the next ten years, but recognize they could be less. Although some view this as pessimistic, we think pragmatism helps to prevent people from outliving their funds.

Recognizing returns may be lower, we counsel clients to limit distributions to 3% of assets. This gives a portfolio a decent chance of increasing payouts over decades while offsetting the impact of taxes and inflation.

Much of wise financial management comes from common sense and discipline. Just because some expert tells you they can walk on water does not mean it is reality. As such, plan for the worst and make sure you can survive that. If anything else happens, you will be pleasantly surprised by the increased flexibility.

Dave Sather is a Certified Financial Planner and owner of Sather Financial Group. His column, Money Matters, publishes every other week.