Many public pension plans in the United States make riskier investments than plans in Canada and Europe, according to a new study by researchers from Maastricht University and the University of Notre Dame. This should raise concerns among state and local government officials who are trying to bring their jurisdictions’ finances under control. Many U.S. public pension funds are severely underfunded, and overly risky investment strategies threaten to make the situation worse.
So what can be done? One possible reform suggested by the study would be to require Governmental Accounting Standards Board (GASB) standards to better reflect risk. As Girard Miller, the Public Money columnist at Governing magazine, notes:
In one of the key observations in the academic paper, the researchers found that state and local government public pension plans in the U.S. allocated higher percentages of their portfolios to risky assets as their plans’ retirees/actives ratio increased, which is exactly opposite of what prudent fiduciaries would do if concerned solely for the interests of beneficiaries. (Their multiple-regression analysis controlled for accounting policy, public/private sector variations and the ratio of actives to retirees.) The researchers posit that this behavior results from American Governmental Accounting Standards Board (GASB) policies that allow state and local pension plans to discount liabilities using the expected rate of future investment returns. This is unlike private plans and their peers in other countries which cannot use imaginary numbers, especially when they are underfunded.
Indeed, as I noted recently in The American:
Many state pension managers base their funding projections on overly optimistic expectations of investment returns, resulting in too little being set aside for future beneficiaries. This has been allowed to happen under rules set out by the Government Accounting Standards Board (GASB), which governs public pensions. GASB rules allow public pension funds to set their liability discount rate based solely on their expected rate of return. For most pension funds, this lies in the 7.5 to 8.5 percent range.
However, while pension funds can achieve such rates of return in some years, they are extremely unlikely to replicate such performance in the long run and without taking a lot of risk.
Establishing a more realistic discount rate is necessary, but such a policy change can be undone at a later date. As long as large segments of the government workforce remains on defined benefit pensions, taxpayers will continue to be exposed to the hazards they often bring — politicized pension boards stacked with union cronies and gaming of the system to increase final payouts — due to government employee unions’ political clout. A long-term solution would very likely have to entail depoliticizing the system by adopting some sort of 401(k)-style defined contribution plan, such as those becoming increasingly prevalent in the private sector.