Striking the right balance on risk for state and local pensions

Editor's note:

The papers discussed in this post were presented at the 2017 Municipal Finance Conference on July 17 and 18 at Brookings.

State and local government pension plans invest about $3.8 trillion to provide retirement benefits for millions of teachers, sanitation workers, police officers and bureaucrats. Unlike private pension funds, public pension funds have significantly increased the share of their portfolios in equities over the past couple of decades as they seek to better investment returns at a time when returns on less risky assets, such as government bonds, have been declining.

Two papers presented at the sixth annual Municipal Finance Conference at the Brookings Institution examine the risk that this investment strategy poses for the financial health of pension funds and state and local governments. The bottom line:  The temptation to seek higher returns by investing more heavily in stocks carries larger than often-appreciated possibilities of very pleasant and very unpleasant outcomes.

“The decline in risk free interest rates since the 1980s and 1990s has created a very difficult investment environment for public pension funds,” write Don Boyd and Yimeng Yin of the Rockefeller Institute of Government at the State University of New York.  “Before the decline, the typical plan could have achieved its investment-return assumptions” —an annual return around 7.5 percent—“while taking very little risk. As rates declined, public plans faced a choice: either reduce investment-return assumptions and request much higher contributions from governments, or maintain assumptions, avoiding increasing contributions from governments, and take on more risk.”   Most plans chose the first option – more stocks and fewer bonds.

Equities, however, are generally more volatile than bonds.  Simulating public pension fund finances under various scenarios, Boyd and Yin conclude that the prototypical fund that chooses to invest in riskier assets has a one in six chance that sometime over the next 30 years the value of its assets will fall below 40 percent of promised pensions, a level they describe as “severe underfunding”  because it has been associated with crises in several states, even if the returns over the long term actually average 7.5 percent.  If investment returns turn out be 6 percent instead, the prototypical plan has a more than one in three chance of such severe underfunding.  Of course, assuming a higher rate of return on investments would require much higher employer contributions, as much as three times the current level in some scenarios.

In a similar exercise, James Farrell of Florida Southern College and Daniel Shoag of the Harvard Kennedy School of Government model the potential outcomes of various investment scenarios using the Texas Employment Retirement System as a prototypical example. “The movement toward riskier asset classes that has occurred,” they write, “has had a predictable effect on the distribution of outcomes. While higher risk, higher return allocation improves funding outcomes and reduces total costs at the median, it also greatly increases costs at the tail of the distribution.”

The Farrell and Shoag simulations show that investing more in stocks does generate superior returns “more often than not,” but they say the possibility of things going wrong is not well captured by existing accounting practices.

So, what are the implications of this for pension fund managers? Farrell and Shoag argue that pension funds could do a better job of taking account and reporting the risks and the range of possible outcomes of their investment strategies. Ultimately, they say, the challenge is striking an acceptable balance between investment risk and government contributions to pension funds. “Reducing investment risk would help to shore up plan finances, but at the expense of much higher contributions from governments. Many plans have made small reductions in investment-return risk in recent years, but it remains much higher than in earlier periods,” Boyd and Yin write.