America’s public pension funds are in trouble because sketchy Mr. Wall Street sold some slack-jawed pension fund managers on risky investments with promises of high returns that may never materialize. Or so Matt Taibbi seems to believe.
In a recent piece in Rolling Stone, Taibbi blames public pensions’ current woes on “Gordon Gekko wanna-be’s” (sic), “scorched-earth takeover artists like Bain Capital,” and “Wall Street,” who used the financial crisis to lure weakened pension funds into investing in “alternatives.” Alternatives are investment vehicles that are different from stocks, bonds, and commodities in that they are typically traded by individuals without the benefit of an exchange — a “one price” that indicates how the rest of the market values the asset.
Assignment of motive aside, there is some truth to Taibbi’s story. Wall Street (for lack of a better term) wants to sell alternative investments to pension funds. And pension funds are often decidedly eager to invest. One of the few remaining states to ban investing pension money in alternatives, Georgia, finally succumbed last year to the requests of lawmakers and fund managers to allow its smaller pension funds to dip their toes into private equity.
But public pension funds have been flocking to alternatives because fund officials want to believe the bold promises of hedge fund managers. They are in a frantic search for high returns, having been led to a desperate state by the actions of politicians and the rules that typically govern public pension actuarial methods. And the demographics of the populations they are supposed to serve don’t help either.
Most public pension funds across the United States were on an unsustainable course long before the financial crisis hit.
For example, prior to the crisis, in my home state of Kentucky, the share of pension fund assets flowing from the pension fund to retirees went from less than 5 percent to more than 9 percent between 2001 and 2007, just before the financial crisis began to cascade. That means that however quickly the pension fund grew, payments to pensioners grew considerably faster — during good times. All well before Taibbi’s supposed “legend of pension unsustainability” got started.
Furthermore, while the shift by public pension funds away from secure fixed income and into riskier investments accelerated after the financial crisis, it was actually decades in the making. Between 1984 and 1994, U.S. public pension funds in total held just 5 percent of assets in alternatives and 50 percent in fixed income, reports Pensions and Investments. By 2007, alternatives had doubled to comprise 10 percent of all pension fund holdings. Since the financial crisis, alternatives have nearly doubled again to 19 percent of total assets. By contrast, fixed income holdings have fallen nearly in half to 27 percent of total assets.
Clearly, pension funds have been chasing returns. Part of the cause is that politicians, during the reasonably good economic times before the financial crisis, were loath to make the full contributions recommended by actuaries — the people who tell lawmakers how much to contribute to keep pensions funds functioning into perpetuity.
Unfortunately, public pension advisors and many plan actuaries made many recommendations based on faulty assumptions about the nature of pension promises, the risks inherent in financial markets, the challenge of funding pensions in down markets, and politicians’ incentives for following through on all those generous pension promises. In short, pension fund managers and actuaries have been getting the accounting wrong for years.
Many public pension plans discount their pension liabilities at high interest rates under the assumption that the plans will achieve high returns on their investments. But discounting is supposed to reflect the likelihood of a liability being paid. If a debtor knows for a fact that a payment will come due at a specific time in the future, he will put away the full amount needed to pay that obligation. His discount rate will be nothing more than the Treasury bond rate. However, if he has reason to believe that the payment may not come due, he may put away a smaller amount and hope he can cover the rest when the bill comes due . . . if it does.
In the case of pensions, however, payments are often guaranteed by law, so it is inappropriate to discount them at a high rate. But, to the general puzzlement of the rest of the financial world, that is exactly what public pension funds have done for years.
As a result, for years many state and local governments have been understating their pension liabilities and the costs of providing pensions to public sector workers. Among economists, it is broadly agreed that 7 to 8 percent, the typical range of discount rates used by public pension plans, is inappropriate for a secure stream of payments.
By discounting at high rates, pension fund managers are essentially acting as if these payments do not demand risk management. To make matters worse, high discount rates let politicians off the hook by lowering today’s payments on behalf of tomorrow’s retirees.
Discounting liabilities to reflect the risks inherent in guaranteed payments would require a discount rate that is relatively risk-free, like the Treasury bond rate of 3 to 4 percent — in other words, matching the investment risk to the risk associated with the liability.
A University of Chicago Booth School survey of economists found near-unanimous agreement with this statement: “By discounting pension liabilities at high interest rates under government accounting standards, many U.S. state and local governments understate their pension liabilities and the costs of providing pensions to public-sector workers.”
Taibbi seems to interpret this broad agreement as a desperate call for higher returns on that same pile of cash, but there he has it precisely backwards. Financial economists have long argued that too-high discounting has been used to push pension funds into riskier investments. With a properly discounted pension liability, the move by pension funds into alternatives makes even less sense.
Taibbi’s main source for answers about pension fund risks and returns is economist Dean Baker, who argues (in the same 2011 report Taibbi quotes) that governments need not worry about the timing of market fluctuations and that they should continue investing in the relatively risky stock market. Baker’s analysis is rooted in his own expectations about future stock market returns, not an attempt to match a portfolio’s risk with the uncertainty of the liability. In the case of pension funds, it can’t be overstated that the funds are supposed to operate into perpetuity. Baker’s analysis may turn out to have been correct about the direction of the stocks versus bonds, but it’s not how pension fund managers should work to manage risks associated with securing government workers’ retirements.
The financial crisis was a contributing factor to a problem that would have existed anyway. That problem is lawmakers effectively telling pension fund managers that they need to aspire to get higher returns so fewer present state resources have to be devoted to fund generous pension promises. Unfortunately, as is often the case in politics, the potential for malfeasance arises anytime someone is allowed to avoid responsibility tomorrow for promises they make today.
That’s the real lesson from the real crisis in public pensions.