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Public pension plan portfolios: pursuing higher risk at what cost?

How should a public sector pension plan invest its assets? A trend since the 2007 financial crisis is public pension funds making up for losses by seeking higher returns in riskier portfolios. Michael Corkery at The  [1]Wall Street Journal [1] takes a look at the Texas Teachers’ Retirement Fund [2] which is placing more of its assets in private equity in an attempt to “hit its target” of 8 percent annual returns. Therein lies the problem.

Due to how public pension liabilities (i.e. the benefits owed to retirees) are valued (based on the expected return on plan assets), there is pressure to invest plan assets to achieve a targeted return that is linked to how the liability is valued. This approach is deeply flawed and been criticized often [3]. Instead, plan assets should be invested in a way that hedges the risks inherent in the liability. These risks include changes in wages and interest rates since the value of the retiree’s benefits is affected by changes to wages and are usually indexed to inflation.

In a recent paper in the Journal of Pension Economics and Finance entitled Portfolio Allocation for Public Pension Funds [4], George Pennachhi and Mahdi Rastad find that a “benchmark” portfolio for public pensions would consist of 160 percent fixed income, with a 9 percent short position [5] in equities, a 67 percent short position in hedge funds and a 24 percent investment in private equity. A short position implies the fund should borrow in other asset categories to increase its holdings in fixed income. Where short selling isn’t feasible or permitted  one would take a 100 percent position in fixed income.

Instead public plans tend to invest assets with a view towards meeting a numerical goal [6]. Over time, this has led plans to increase their exposure to higher risk investments, changing the composition of pubic sector plan portfolios from being more heavily invested in bonds (almost exclusively so in 1952 [7]) to more heavily invested in high-return, high-risk investments like real estate, with the average plan exposed to a 21 percent investment in alternatives.

There are two inter-related problems here. Firstly, the liability is undervalued based on high-risk discount rates and secondly, the asset investment strategy is focused on targeting returns rather than hedging risks in the liability. An unfortunate but predictable result of this flawed linkage between liability valuation and asset investments is that during a downturn, plans have opted to “double-down” on risk and expose plans to potentially bigger losses down the road.

Indeed, as plans continue to fall short of return expectations many are turning to alternative investments including “exotics [8],” a strategy  that shows no sign of abating, according to Pensions & Investments [9].