Featured Post

Was it constitutional for Proposition 124 to replace PSPRS' permanent benefit increases with a capped 2% COLA?

In this blog I and multiple commenters have broached the subject of the suspect constitutionality of PSPRS' replacement of the old perma...

Tuesday, December 11, 2012

PSPRS members: Assumed rates of return can make an ass out of you and me

While the Khan Academy is a good starting point for understanding the public pension crisis, those desiring a more detailed explanation should read Andrew Biggs' paper Public Sector Pensions: How Well Funded Are They, Really?

Mr. Biggs' paper concerns how public pensions set their assumed rates of return (ARR).  Also called the expected rate of return, the ARR is probably the most important factor in determining the funding status of a pension.  The ARR is the rate a pension expects to earn on its investment portfolio, so the ARR determines the contribution amounts made by employees and employers.  The higher the ARR the more the pension can expect to earn through its investments.  A higher ARR also means lower contribution rates for employees and employers.  The danger is that if the ARR is too high, the earnings of the pension going forward will be insufficient to meet its future financial obligations..

Mr. Biggs' critical point is that public pensions have erroneously based their ARR's, currently averaging around 8%, on historic market returns.  While this may seem like a sound strategy for long-term investing, it ignores the tradeoff between risk and return.  Mr. Biggs writes that pension obligations are guaranteed obligations, and the expectation that they will be paid is virtually certain.  This means that a pension should invest in as risk-free a portfolio as possible.  This would mean investing in U.S. Treasury securities, or minimally, in high-grade corporate bonds at rates in the 3-5% range.  In order to get an 8% return, a pension has to make riskier investments.  If those higher-risk investments lose money, the pension will not be able to meet its future obligations.  This is where many public pensions are today.

PSPRS maintained an ARR of 9% for 20 years between 1984 and 2004, but the ARR has been incrementally lowered since 2004 and will be at 7.85% for the next fiscal year.  For PSPRS the past dozen years have shown the dangers of having an overly optimistic ARR, along with two market crashes.  I can remember being told, back in 2000 when I came on the job, about the investing genius of PSPRS' then-administrator.  It was true that Jack Cross, the administrator from 1986 to 2004, had produced impressive gains for most of that time, but the end of his tenure was marred by large losses caused by the dot.com bubble bursting.  After Mr. Cross' retirement PSPRS took actions to diversify its holdings more widely and not concentrate so heavily in stocks.

While some have attempted to point the finger at Mr. Cross for PSPRS'current underfunding (Risky investments, poor oversight lead to $1.6B taxpayer bailout of police and fire pension fund), he seems to be just a convenient scapegoat for what appears to be standard practice among the vast majority of public pensions.  Though he was never the investment master that he was made out to be, he was not doing anything out of the ordinary for either public pensions or other knowlegeable investors, both amateur and professional.  This also conveniently ignores the fact that Mr. Cross was long gone when the housing bubble burst, after diversification was supposed to limit the impact of another market crash.  The simple truth is that anyone can be a genius in a bull market, and anyone can be made a fool during a market crash.

This gets us back to Mr. Biggs' central argument.  Government employers and employees like high ARR's because they mean lower contribution rates, and everything had worked fine until reality intruded.  Public pensions simply can not invest like other investment pools because the cost of losses greatly outweighs the potential gains of more risky investments.  If a public pension lowers its ARR to match a risk-free rate, its underfunded liabilities will increase, and employees and employers will need to contribute more to get the pension to fully funded status.  As it stands right now, most public pensions can not and will not use a risk-free ARR and can only hope that the market, which already burned them twice since 2000, will pull them out of this crisis.

No comments:

Post a Comment

Relevant comments are welcome, but please adhere to the following rules:

1. No profanity or vulgarity.
2. No spam or advertising.
3. No copyrighted material may be posted unless you are the copyright owner.
4. Stay on topic.
5. Disagreement is fine, but please avoid ad hominem attacks.

Comments reflect the views of the authors alone, and do not reflect the opinion of this website.