The last few years have been hard on pension plans, particularly those for public employees. In this month’s Kellogg Insight, Joshua Rauh, associate profess of finance, says public pension plans liabilities are even higher than currently stated. To make up the difference, states can either raise taxes or hope for higher returns. Given the public’s hostility toward higher taxes, the onus is fund managers to ratchet up returns.
The New York Times is reporting that many state employee pension funds are delving into riskier investments, hoping potentially higher returns will make up for lost ground. I asked Rauh to comment on this unsettling trend.
Both public and corporate pension funds face some accounting pressure to keep expected average returns high by investing in riskier assets. What analysts often fail to recognize is that these higher expected returns come at the expense of greater risk.
In the corporate realm, the expected return on pension plan assets feeds directly into corporate earnings. For states and municipalities, the expected return is used as the discount rate for liabilities, so that riskier investment strategies can be used to justify higher discount rates that produce lower stated liabilities.
Why have corporate funds moved to somewhat safer strategies, while public funds have taken on more risk? The corporate sector faces strong contribution requirements under ERISA [the Employee Retirement Income Security Act] in the event that a company ends up with underfunded pension liabilities. The concern that these contribution requirements will bite when companies need cash produces an incentive for companies to reduce equity investing in pension funds. These cash liquidity concerns may offset the accounting considerations.
Public funds do not face strict mandatory contribution requirements to shore up underfunded plans, which may make them more comfortable with risk taking than corporate plans. Furthermore, for states where balanced budget restrictions are tight, underfunded pension plans are an important means of public sector borrowing, albeit one that under public accounting standards are not properly recognized. If anything it seems that the worse shape the state pension funds are in, the more willing they are to gamble for resurrection.
Photo by Curtis Gregory Perry.