So now’s a good time to take a fresh look at the retirement systems for public employees and whether they are prepared for such financial drama — and how they might be better prepared to serve retirees.
There are two types of systems to assess here: traditional defined-benefit (DB) pension plans and various forms of defined-contribution (DC) plans that include voluntary savings in 457 and 403(b) supplemental plans as well as employer-funded 401(a) plans that sometimes replace traditional pensions with individual accounts similar to private-sector 401(k)s. Traditional DB pension systems invest in a common trust fund overseen by pension trustees, while DC plans typically offer participating employees a menu of investment selections. For most baby boomers in public service, it’s common to have accumulated benefits in both types of systems.
For traditional pension systems, investment risk from market and portfolio underperformance falls on the public employers. Retirees and near-retirees can count on a fixed benefit based on their retirement age, salary history and length of service. The opposite is true for DC plans: Employee-participant-retirees are on the hook entirely if investments turn sour. After systemwide developments of the past two decades, the lessons to be learned from recent experience are quite different for these two types of plans.
For defined-benefit pensions, the two major developments of this century have been a movement toward broader portfolio diversification through so-called alternative investments and a sensible but slow movement toward lower actuarial return assumptions after the pensions ate humble pie following the Great Recession and bear market of 2008. The alternative investments have largely featured private equity and private credit (the catchall term for non-bank lending) but also include commodities and hedge funds. Combined, those various categories now comprise some 26 percent of the average public pension fund’s portfolio, not counting real estate.
Each of those asset classes makes a different contribution to the overall portfolio’s return risk profile, and in various economic situations they move in different directions, or at least at different rates. In the case of private equity and private credit in particular, the argument in their favor has been that only about half of investable American business is owned by public corporations, while private lending has unlocked new off-market sources of lucrative interest income previously confined to marketable bonds.
The knock on these alternative assets in general is mostly about their fees, which are exorbitant when compared with the cost of owning public market assets, especially when compared with index funds. The money managers of these funds can reap fees and carried interest that altogether can range from 2 to 4 percent of the assets they collectively manage, depending on their performance and the negotiating power of the pension system, which is usually a function of its size.
Only time will tell whether the advent of artificial intelligence ultimately drives down the cost of this asset class by disintermediating the high-fee managers. In the meantime, public pension consultants and staffers still have their work cut out for them in whittling away at fee drag. There’s also nagging issues still to be resolved regarding the allegedly “fairy tale” inferential methods used to value those assets and their overstated diversification properties, which may both be too optimistic. (Try to sell private equity holdings in a recession and see what they’re actually worth.) So the “alts” strategy still has its skeptics.
An Actuarial Dream
A clearly positive trend worth noting in pension-land has been the gradual drift downward in these systems’ actuarial assumptions for investment returns. At the turn of the century, it was commonplace for public pensions to assume that they would forever generate 8 percent in compounded returns. That enabled them to minimize contribution rates using plausible but risky methods peculiar to governmental accounting rules, and when they fell short so dramatically in 2001 and 2008-09, the pension hawks came out in droves and challenged those assumptions.
The good news is that since then these actuarial assumptions have been shaved down by a full percentage point. Data from the National Association of State Retirement Administrators shows clear progress, although prevailing assumptions for the real rate of return (net of inflation) have largely remained unchanged over 20 years. Unsustainable assumptions simply burden the employers and taxpayers with mounting unfunded liabilities each time we hit a recession. If a tax-cutting Congress approves massive, endless federal budget deficits this year, the actuarial dream of low inflation, high real returns and profitable bond portfolios looks increasingly wishful. That alone requires a reality check.
Despite the progress on investment assumptions, the worst shortcoming of public DB plans remains their chronically anemic actuarial funding — at least on average. After plummeting by 25 percent from full funding in the first decade of this century, average public system funding ratios have continued to scrape along at the 75 percent level or a bit more for the last 12 years with very little improvement — even though public employers’ payroll contribution rates have doubled over 20 years.
With the baby boomer generation of public workers now almost entirely retired, that means there are figuratively only three overworn quarters in the funds overall today for every IOU dollar that the boomers and others have already earned — even if the funds’ future investments do produce their assumed rates of return. Some blame it on the actuaries, who “smoothed” unpleasant investment returns and preached “contribution rate stability” instead of “intergenerational equity,” artfully dodging the full cost of prudently prefunding the boomers’ pensions before they retired. The can has been kicked to a new generation.
The Metamorphosis of DC Plans
For defined-contribution plans, the investment portfolio problem long ago was the complete opposite. Most of these deferred-compensation plans were initially served by insurance companies or enrollment agents who collected upfront commissions from selling guaranteed-interest products. Risk-averse teachers and other public employees, shell-shocked from the 1973-74 bear market and high inflation, were terrified of stocks and flocked into “introductory” 7 or 8 percent stagflation-era interest rate products. In retrospect, they were too conservative throughout the 1980s and 1990s. Over time, participant education efforts helped to steer them toward a more diversified portfolio mix.
Left to their own devices, however, most public employees suffer from inertia, still fear stock volatility and tend to leave too much of their DC money where it was first invested, so their portfolio mix over time tends to become suboptimal. Fortunately the DC industry came up with a remedy: the target-date fund platform, which enables participants to put money into a single set-it-and-forget-it investment product designed to start with a growth bias in their youth and gradually de-risk the portfolios toward more fixed income as they near retirement — typically about 50/50 in stocks and bonds by then.
These diversified multi-asset funds are hardly perfect, but they have made a big difference in the DC asset allocations of millions of public employees. Some two-thirds of participants are now using these vehicles along with old-school balanced funds. For that, the industry should be congratulated, although a few of the players still try to bury or camouflage their fees in these funds. So oversight committees need to read the fine print before approving a proprietary package of such funds.
For some insights into how public employee DC plan participants have been managing their own funds, the National Association of Government Defined Contribution Administrators has teamed up with the Employee Benefit Research Institute to produce some insightful reports by the Public Retirement Research Lab that are worth a look. Updated data for 2023 and 2024 are expected soon.
Don’t be surprised if advanced AI robo-advisers eventually provide individual participants with customized portfolios that suit their life stages, risk tolerances and personal financial situations (including DB pension fund accruals) with greater precision than today’s target-date funds, but that’s unlikely to overtake the industry before the end of this decade. And expect to see proponents of alternative investments seek to wangle in a piece of the pie within target-date funds built for midlife employees. Some are now launching specialized retail products with potentially lower fees than many pension funds have been paying for standalone private lending.
Opportunities for Improvement
For public employers that have replaced traditional DB pensions with DC plans for new hires, there’s also an issue as to whether they are requiring or at least steering DC participants toward ample contributions by offering employer matches adequate to assure a sufficient retirement nest egg. Many of the DB-to-DC conversions were undertaken to limit or reduce employer contributions, so the gap between payroll contribution percentages in the two rival systems has widened over time. As with pension plans, there’s reason to question the investment return assumptions that employees are provided in formulating their own projected portfolio growth. Those are clear opportunities for a 20,000-mile checkup.
The missing bridge between these two systems would be an option for DC participants to cash in part of their nest eggs at retirement in exchange for a supplemental fixed-income public pension at fair actuarial rates. In a way, California tried a version of that 20 years ago with what was then called “air time” — allowing employees to purchase additional years of service credit toward retirement. It became a financial fiasco because the benefits design was unsound actuarially; it seemed too good to be true, and it was.
But the original underlying concept still has merit, if the retirement community can work together to build a better mousetrap using sensible, achievable, lower-risk actuarial assumptions. Insurance companies that now underwrite life annuities won’t like the competition, but that doesn’t mean it’s a bad idea — just a project that requires skilled design and implementation.
Finally, to circle back to fine-tuning retirement portfolios after the recent stock market swoon, there’s a new professional study suggesting that both traditional DB pension funds and DC-style target-date funds are leaving billions on the table with their quarterly rebalancing rituals, whereby they reshuffle their holdings to match target ratios after disparate market moves between asset classes. Turns out they’re losing money to hedge funds and others who front-run them. Clearly there must be smarter ways to do this.
Overall, the good news is that there is no major crisis imminent in either system at this point, as long as the global economy is not pushed over the brink by reckless politicians, taking markets deeply down with them to the demise of all diversified portfolios. For investment practices, I’d rate both systems a B-plus for now, but they both deserve only a B-minus for their funding insufficiencies. To be fair, I’d rate most private-sector plans with a B and a C-minus on the same criteria, and the average retail trader a D. So there’s ample room for improvement industrywide.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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