Public Pension Portfolios Double Down
A new study blames GASB policy for spurring state and local governments to make riskier investments.
Many U.S. public pension plans have a propensity to imprudently invest their portfolios more aggressively than private plans or their Canadian and European peers with similar demographics. That's one of the findings documented in a study by an international trio of academics. That paper is potentially the most important research in the public pension arena this decade.
The controversial but carefully constructed findings should be studied and taken to heart by pension boards, plan administrators, investment officials and consultants, and actuaries, as well as the public officials and future taxpayers who will ultimately bear the cost of increasingly higher-risk portfolio strategies if they fail.
Their findings were illustrated in a New York Times story on South Carolina's investment portfolio, which reported that "by the end of 2011, retirement systems with at least $1 billion in assets had raised their stake in real estate, private equity and hedge funds to 18.3 percent, from 10.7 percent in 2007, according to the Wilshire Trust Universe Comparison Service." A separate report in Bloomberg chronicled a similar movement toward higher risk in Texas.
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.
In an effort to manage downward the annual actuarially required contribution and thus defer the reckoning of investment losses, trustees and their hired professionals have let the tail wag the dog, so to speak, when setting their asset allocations. As a result, bonds represented increasingly smaller percentages of the portfolios than private equity and other riskier asset classes -- while the plans' demographic capacity to accept risk actually declined. Sadly, this occurred during a period of dramatic bond price appreciation and pathetic equity underperformance in the past decade, thus impairing portfolio performance and plans' funding ratios. Because public employers are almost universally responsible for bailing out the resultant unfunded liabilities, this policy bias generated a multibillion dollar cost that will now be borne by subsequent taxpayers and not the accountants, actuaries and consultants who collectively led the faltering fiduciaries into this policy trap. (Might make for a heckuva class action lawsuit!) Even worse, "mature" public funds with aging participant populations now suffer increasingly negative cash flows from payouts exceeding new contributions, at the same time they increased their allocations to illiquid investments such as private equity in search of higher, riskier returns. This may not guarantee disaster, but it's a great recipe for one.
Having seen in practice the tendency of pension trustees to ask their investment teams for asset allocation options that help them concoct a predetermined expected return to maintain a given actuarial discount rate, I have no doubt in my mind that the researchers' general assessment of these fiduciaries' behaviors is correct. What's troubling about this tail wagging the dog behavior is that it leads to a much more problematic canine metaphor: the hair of the dog that bit you. In Scottish-English folklore, an alcoholic's remedy for a morning hangover is to have another drink of the same potion that has polluted his system.
For U.S. pension funds, the analogy is the increasing propensity of underfunded plans that failed to meet their previous actuarial assumptions (because of investment underperformance vs. expected returns) to raise their risk profile in order to juice up the expected returns so as to maintain the unachieved discount rate. This practice continues even though bond yields have now reached generational lows that make the perpetuation of previously expected composite returns even less probable and less prudent. On the equity side, there are many professionals who view the intermediate-horizon prospects for investment gains as lower than normal because of global debt overhang and its impairment of economic growth in many developed economies. As their unfunded liabilities mount in each market cycle because of unachieved discount rates, riskier portfolios and increasing levels of intergenerationally deferred contributions, this practice is now doomed to burden future taxpayers with higher and higher costs to pay for benefits of retired employees that served their parents and not the generation paying the taxes.
The report's finding that trustees ramped up their portfolio risk in the face of an aging beneficiary population should send shivers down the spines of the GASB board and staff, as a documented consequence of an accounting policy that has distorted economic behaviors that caused financial harm. That's a no-no when setting accounting standards, which could raise some eyebrows with their international counterparts at the International Public Sector Accounting Standards Board (IPSASB) as well as their domestic corporate cousins on the Financial Accounting Standards Board (FASB). Accounting rules should not allow pension funds to use the expected returns on a portfolio when the plan is materially underfunded and increasingly reliant on riskier portfolio constructions to justify actuarial assumptions about returns on uncollected future contributions.
This research should haunt GASB for its recent acceptance of the public-sector actuarial community's gimmick to avoid blending the discount rate with the employer's cost of capital, which is the general rule that GASB was pursuing until they were sidetracked by the clever public actuaries. Under the latest version of GASB's discount rate methodology (which might hopefully be revised before it becomes final) most public pension plans can continue to unrealistically discount unfunded liabilities financed solely by promised future contributions, using expected rates of return on future investments of these promissory notes rather than the employer's cost of capital in determining the net plan liability.
As readers know, I'm no fan of some academics' "risk free" discount-rate thesis either, because it grossly exaggerates the pension liability and current costs, which would penalize today's taxpayers to eventually produce overfunded plans that would invite even worse mischief. But it makes no sense to me to use expected returns on assets even when the assets aren't there. And it makes even less sense to tolerate this charade when the future bail-out contributions by employers are expected to be made so far into the future that a majority of today's employees will have already retired. When pension plans amortize their unfunded liabilities beyond the expected service lives of employees, the municipal borrowing rate should be used in the calculation. After reading this research report, I'd urge GASB to tweak their blended discount rate convention to address this issue, and hope that this report arrived in time to be considered in their deliberative process as they prepare to publish their new pension accounting standard, which is anticipated at the end of this month.
The report also detected a shortcoming in American public plans' neglect of inflation risk, which I will leave open for further debate. It could be counter-argued that inflation exposure requires higher equity allocations if there is no other asset class that better correlates with inflation (such as TIPS, especially during this study period), but that was not systematically addressed in this study. Thoughtful professionals should nonetheless reflect on the researchers' views of the comparative inflation risks they uncovered in the U.S. plan universe. The inflation risk of U.S. public plans is a topic that warrants a lot more discussion, especially when retirees are trained by Pavlovian conditioning to plead in televised public meetings for additional cost of living increases, as I explained in last week's column.
Investment officers for pension funds should also share this report with their colleagues and board members to stimulate an honest discussion about the alignment of asset allocations and risk tolerances with plan liabilities and the aging of their participant population. The notion that investment horizons of public funds are infinite because the employer is expected to be perpetual must be discarded by the professional community when it violates intergenerational equity, and especially when advocates of pension plans argue that a conversion to defined contribution (DC) plans will carry a transition cost from abandoning that assumption.* (That's logically duplicitous.) As governments reduce headcount in order to offset rising benefits costs, and baby boomers attain retirement age, the ratio of contributing employees to retirees will continue to shrink. If other public employers follow the recent path of San Diego voters to replace their pension plans with a DC successor for new employees, the ratios will shrink even faster. As the Maastricht-Yale-Notre Dame researchers have suggested, that should ordinarily foster higher concentrations of low-risk assets and not the opposite. Although this is a terrible time in the economic cycle to be investing heavily in bonds, the researchers have shown quite clearly that better, lower-risk solutions to the asset allocation process are needed, lest we dig a deeper hole during a decade of highly uncertain, underperforming investment returns that land universally on taxpayers' doorsteps.
*In fact, the public pension actuaries typically raise that objection to pension reforms that would make them obsolete, which is one of the issues discussed in the recent Arnold Foundation report.
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