After losing about $1 trillion in the markets, state and local governments are facing a devil's choice: Either slash retirement benefits or pursue high-return investments that come with high risk.
The urgent need for outsize returns by these vast public pension funds, which must hit high investment targets year after year to keep pace with rising retirement costs, is in turn fueling a renewed appetite for risk on Wall Street.
Before the crisis, many public pension funds had experimented with risky trading techniques or committed more of their money to hedge funds and other nontraditional firms, which in turn invested some of it in complex mortgage securities. When these melted down, pension funds got burned.
Now, facing an even bigger funding gap, some systems are investing in the same securities, betting that a rebound in their value will generate huge returns.
"The amount that needs to be made up is enormous," said Peter Austin, executive director of BNY Mellon Pension Services. "Frankly, they are forced to continue their allocation in these high-return asset classes because that's their only hope."
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