“Public pensions are addicted to risk and, because they are effectively “too big to fail,” require an intervention….Calpers, the largest public pension plan, holds about 75% of its portfolio in stocks and other risky assets, such as real estate, private equity…
…and, until recently, hedge funds, despite offering benefits that, unlike IRAs or 401(k)s, it guarantees against market risk.”, Andrew G. Biggs, American Enterprise Institute
“Besides the financial risks to public pensions plans and state and local governments, I know of another problem. When these public pension plan’s risky investments don’t work out; they have sought to blame others, for their decisions, by making false claims of securities fraud (“the risk wasn’t disclosed”, “we didn’t understand”, “they knew we didn’t have the authority to invest/borrow”, etc.). These types of false claims, especially by government pension plan administrators and the politicians backing them, I believe has an insidious, destructive effect on U.S. capital markets and American’s appetite for risk taking (Why take the risk, we will be sued if it doesn’t work out and we fail?). I believe this is exactly what happened in the after-math of the 2008 financial crisis and I believe it is negatively affecting our economy.”, Mike Perry, former Chairman and CEO, IndyMac Bank
Public Pensions Need Gamblers Anonymous
Retirement funds for Illinois and California hold 75% risky investments. The Texas teachers’ plan: 81%.
By Andrew G. Biggs
State and local pension plans invest roughly twice as much in risky assets as would a prudent individual saving for retirement. Indeed, the Society of Actuaries, which represents the actuarial profession, recently pointed to public-pension investment practices “that go against basic risk management principles.” With $3.7 trillion on the line, risk-addicted pensions need an intervention. The question is who can do it.
Many individuals follow a rough “100 minus your age” rule to determine how much risk to take with their retirement savings. A 25-year-old might put 75% of his savings in stocks or other risky assets, the remaining 25% in bonds and other safer investments. A 45-year-old would hold 55% in stocks, and a 65-year-old 35%. Individuals take this risk knowing that the end balance of their IRA or 401(k) account will vary with market returns.
Now consider the California Public Employees’ Retirement System (Calpers), the largest U.S. public plan and a trendsetter for others. The typical participant is around age 62, so a “100 minus age” rule would recommend that Calpers hold about 38% risky assets. In reality, Calpers holds about 75% of its portfolio in stocks and other risky assets, such as real estate, private equity and, until recently, hedge funds, despite offering benefits that, unlike IRAs or 401(k)s, it guarantees against market risk. Most other states are little different: Illinois holds 75% in risky assets; the Texas teachers’ plan holds 81%; the New York state and local plan 72%; Pennsylvania 82%; New Mexico 85%.
Managers of government pension plans counter that they have longer investment horizons and can take greater risks. But most financial economists believe that the risks of stock investments grow, not shrink, with time. Moreover, while governments may exist forever, pensions cannot take forever to pay off their losses: New accounting rules promulgated by the Governmental Accounting Standards Board (GASB) and taking effect this year will push plans to amortize unfunded liabilities over roughly 15 years. Even without these rules, volatile pension investments translate into volatile contribution requirements that can and have destabilized government budgets.
Yet public-plan managers may see little option other than to double down on risk. In 2013 nearly half of state and local plan sponsors failed to make their full pension contribution. Moving from the 7.5% return currently assumed by Calpers to the roughly 5% yield on a 38%-62% stock-bond portfolio would increase annual contributions by around 50%—an additional $4 billion—making funding even more challenging.
But the fundamental misunderstanding afflicting practically the entire public-pension community is that taking more investment risk does not make a plan less expensive. It merely makes it less expensive today, by reducing contributions on the assumption that high investment returns will make up the difference. Risky investments shift the costs onto future generations who must make up for shortfalls if investments don’t pay off as assumed.
In November the Society of Actuaries noted that “public sector plans in the U.S. are unique in that they have taken additional risk as the plans have become more mature, compared to private sector plans in the U.S. and private and public sector plans in Canada, UK and the Netherlands, which have taken less risk as plans have matured.” The reason: GASB accounting rules let U.S. public plans credit themselves with the higher returns on risky assets before those returns are earned, creating an artificial incentive to take risk. U.S. corporate pensions and public plans overseas may credit themselves only after investment risks pay off, and thus better balance risk and return.
Public pensions are addicted to risk and, because they are effectively “too big to fail,” require an intervention. There are few actors who can do it. The GASB blinked in 2012 when, while tightening some aspects of pension accounting, it maintained the fiction that a plan that takes greater investment risk automatically becomes “better funded.” Public-pension actuaries, likewise, are conflicted, as their livelihood is derived from public plans that clearly don’t want any back talk. State treasurers of both political parties have resisted tougher accounting rules that might pressure them to reduce risk and raise contributions. Unions have an interest in better pension funding, but justifiably fear that higher employer contributions would be offset against salary increases.
One step is for the broader actuarial profession to tighten standards of practice for public-plan actuaries, requiring additional disclosures and allowing less discretion. Tying actuaries’ hands may be the best protection against pressure from plans. Another possibility: The Securities and Exchange Commission could be empowered to demand accurate disclosures of pension liabilities that don’t artificially credit plans for taking investment risk. The political challenges to pension reform are daunting, but the economic risks of failure are no less so.
Mr. Biggs is a resident scholar at the American Enterprise Institute.