“But as interest rates began their long fall, pension funds faced a dilemma. Staying heavily invested in bonds would force governments either to set aside more cash upfront or to cut pension promises. So instead, pension funds radically changed their investment strategies, embracing investments that produce higher returns but also involve more risk. This shift has replaced an explicit cost with a hidden one…
…that lawmakers will have to divert more tax dollars into pension funds, cut back on benefits or both when stock market crashes cause pension fund asset values to decline……Plunging returns on safe investments over the last few years are a sign of broadly increased investment risk and tepid prospects for economic growth. It won’t be impossible for pension funds to meet a return target of 7 to 8 percent in that environment, but doing so will involve taking on a lot of risk — which means the next stock market crash is likely to also bring another round of exacerbated state fiscal crises and cuts to pension benefits. It’s the way we’re paying for what looks like a free lunch of high investment returns on stocks. A return to boring pension funds that invest mostly in bonds would make the cost of pensions explicit and upfront, and would not subject governments to pension crises when the economy goes bad.”, Josh Barro, “Why Government Pension Funds Became Addicted to Risk”, New York Times
“Again, this NYT’s article makes clear that investors…whether they are private, for-profit institutional investors or public pension funds….are knowingly taking on significant risks to meet either investor expectations for higher returns or to avoid painful actions (like cutting pension benefits or increasing pension plan contributions). These economic and political decisions fuel demand for riskier, higher-yielding assets. Just like they fueled demand for trillions of dollars in private MBS and other higher-yielding, but riskier securities in the period before the 2008 financial crisis. These investors have never been fooled by the increased risks inherent in these securities (as some claim). I believe that the important risks are and were (pre-crisis), for the most part, fairly and properly disclosed. I also believe that for securities markets to work, private and public investors have to be responsible for the consequences of their own decisions (to significantly increase their investment risk appetite in order to earn superior returns). Private securities markets won’t work in the long run if these investors claim (and are lauded for) the superior profits of increased risk-taking during good economic times, but disown the extraordinary losses that occur during bad economic times as a result of their increased risk-taking. And even worse, they and the securities regulators like the SEC inappropriately blame others (the lenders and securities issuers and underwriters) for their own decisions and losses. (I believe this also has resulted in a poor understanding of the root, economic and political causes of the financial crisis.)” Mike Perry, former Chairman and CEO, IndyMac Bank
Why Government Pension Funds Became Addicted to Risk
By Josh Barro
A public pension fund works like this: The government promises to make payments to its employees after they retire; it invests money now and uses those investments, and the returns on them, to make those promised payments later.
Back when interest rates were high, this was fairly simple to do. Pension funds could buy bonds — ideally bonds that would mature around the time they would need the money to pay pensioners — and use the interest on those bonds to fund the payouts. In 1972, more than 70 percent of pension fund investment portfolios consisted of bonds and cash, according to a new analysis from the Pew Charitable Trusts and the Laura and John Arnold Foundation.
But as interest rates began their long fall, pension funds faced a dilemma. Staying heavily invested in bonds would force governments either to set aside more cash upfront or to cut pension promises. So instead, pension funds radically changed their investment strategies, embracing investments that produce higher returns but also involve more risk. This shift has replaced an explicit cost with a hidden one: that lawmakers will have to divert more tax dollars into pension funds, cut back on benefits or both when stock market crashes cause pension fund asset values to decline.
The shift began with pension funds’ adoption of portfolios consisting mostly of stocks, with only about a quarter of their investments in bonds. Then, in the last few years, they rapidly expanded their use of “alternative” asset classes like hedge funds, private equity, commodities and real estate. As of 2012, the typical pension fund investment portfolio was about half stocks, a quarter bonds and cash, and a quarter alternative investments.
The shift has allowed public pension funds to adjust to a sharp drop in bond interest rates. Between 1992 and 2012, the yield on 30-year Treasury bonds fell 4.75 percentage points; on average, large government pension funds cut their investment return targets by just 0.7 of a percentage point over that period.
And the shift has been, in one sense, a success: Pension funds continue to hit their target returns, on average. After the stock market crash of 2008-9, pension funds’ typical goals of annual returns around 8 percent were often criticized as unrealistic, but the National Association of State Retirement Administrators notes that public pension funds have earned annual returns of 9 percent on average over the last 25 years, despite falling interest rates and gyrating stock prices.
The key caveat in that statement is “on average.” While the old bond-heavy investment strategy produced steady, stable returns, a pension fund that is full of risky investments will swing heavily, soaring in value when the economy is strong and tanking when it is weak. The recent fashion for investing in managed investment funds, like private equity funds, has also put taxpayers in the position of paying management fees for services of dubious value.
Advocates of public pension funds typically say state and local governments are in a good position to absorb investment risk and can effectively create value by investing in high-return stocks and using the expected returns to make bondlike promises. “A pension fund, unlike individuals, does not need to be concerned about the stock market’s short-term fluctuations,” according to Dean Baker, co-director for the Center for Economic and Policy Research.
But if this were true — if governments were indifferent, or nearly indifferent, to investment risk — then they would have an enormous arbitrage opportunity on their hands. They could borrow money on the bond market at low rates and invest it in the stock market for high expected returns, using the proceeds to finance not just pension payouts but all kinds of government operations.
The reason governments don’t do this is that they are not actually indifferent to investment volatility. When asset values fall, governments come under pressure (and, in some states, court order) to increase their annual contributions to pension funds to shore them up. Typically, those stock price declines come at the same time that a weak economy is pushing tax receipts down and demand for government services up. A government that does not make those shoring-up contributions can end up in a downward spiral, where the pension fund’s investment projections rely on investments that do not exist, and the pension system’s funding gap continues to grow indefinitely.
In the last few years, the need to shore up pension funds has been a key stressor on state and local budgets. In some places this has led lawmakers to cut back on pension benefits, while in others, the benefits are protected by constitutional provisions or the political power of public employees. On the other hand, periods of excellent returns on pension fund stock investments can create political pressure for pension benefit increases, which many jurisdictions handed out as stock prices soared in the late 1990s — and then came to regret as the tech stock bubble burst.
The volatility of stock returns is why pension funds invested in bonds in the first place. And it’s most likely a driver of the recent rush toward alternative investments, which went from 11 percent of pension portfolios in 2006 to 23 percent in 2012, according to Pew; nearly the entire shift has come at the expense of stocks.
The theory with alternatives is that they earn a premium return in exchange for the difficulty of investing in them. Small investors lack easy access to these asset classes, and the investments are often illiquid: You can’t call up your broker and sell an office building in 15 minutes to raise cash. As a result, by investing in alternatives, pension funds should be able to get either returns similar to those of equities at a lower risk, or higher returns at a similar level of risk.
That’s the theory. The evidence on alternative investments is considerably more mixed. Hedge funds are supposed to pursue equity-like returns with lower levels of risk. But as Antti Ilmanen of the investment manager AQR Capital Management describes in his guide “Expected Returns on Major Asset Classes,” the historical returns of hedge funds are most likely overstated because of reporting biases. Hedge funds don’t have to report their performance to public databases, and are more likely to do so when returns are good.
They often engage in strategies that produce modest regular returns at the expense of rare catastrophic losses, which may make their track records look misleadingly strong. And though skilled fund managers can identify opportunities for above-normal returns without increased risk, a rush of investment capital into hedge funds has pushed those average “alpha” returns (that is, returns after adjustment for risk) down over time.
While Mr. Ilmanen provides a mixed verdict on hedge funds, his verdict on private equity is negative. “The typical PE manager is skillful enough to outperform public indices on a gross basis, but the benefits of these skills accrue primarily to the manager and not to the investor,” he writes, because management fees exceed the excess gross returns generated by private equity funds.
Big management fees are something that private equity and hedge funds have in common, unlike stocks and bonds, which pension systems can generally manage on their own. So it’s no surprise that, as pension funds doubled their allocation to alternatives between 2006 and 2012, their spending on management fees also rose sharply, from 0.28 percent of assets to 0.37 percent, again according to Pew.
A rise of 0.09 of a percentage point may not sound like much, but since public pension funds manage approximately $3 trillion in investments, that means an additional $3 billion a year being spent on management fees — in the case of fees to private equity managers, probably not in exchange for much.
Plunging returns on safe investments over the last few years are a sign of broadly increased investment risk and tepid prospects for economic growth. It won’t be impossible for pension funds to meet a return target of 7 to 8 percent in that environment, but doing so will involve taking on a lot of risk — which means the next stock market crash is likely to also bring another round of exacerbated state fiscal crises and cuts to pension benefits.
It’s the way we’re paying for what looks like a free lunch of high investment returns on stocks. A return to boring pension funds that invest mostly in bonds would make the cost of pensions explicit and upfront, and would not subject governments to pension crises when the economy goes bad.The Upshot provides news, analysis and graphics about politics, policy and everyday life.