A recent Pew report shows a systematic shift of public pension plans away from fixed-income investments towards equities and alternative investments in the last 30 years. Using investment data on public pensions from 1952 to 2012, Pew found that public plans “significantly increased their reliance on stocks” during the 1980s and 1990s. The data reveals that fixed-income investments and cash constituted nearly 96% of public pension assets in 1952. The proportion decreased to 47% by 1992, and had dropped to 27% by 2012. And during the past decade, public pension funds have allocated an increasing share of their assets to alternative investments, which include private equity, hedge funds, real estate, and commodities. From 2006 to 2012, the share of pension assets in these alternatives had more than doubled, from 11% to 23%.
Unrealistically high assumed rates of return are the cause behind this shift. From 1992 to 2012, while the average annual yield on 30-year Treasury bonds declined by 4.75 percentage points, from 7.67% to 2.92%, the medium pension fund’s assumed rate of return decreased by only 0.25 percentage points, from 8% to 7.75% during the same period. This means pension funds have to be much more aggressive than in the past to earn their assumed rates of return, hence the shift towards equities and alternative investments.
While moving away from fixed-income securities allows pension funds to keep up with the high assumed rates of return, it also entails substantial risk. Higher risk means higher volatility, which implies higher chances of incurring losses. Pension expert Andrew Biggs made the same point not long ago. Biggs estimated that a portfolio in 1975 could earn an annual expected return of 8% with a standard deviation of 3.7%, losing money on average only once every 65 years. By contrast, a portfolio today must have a standard deviation of 14% to get the same expected return, suffering losses about once every four years. Larger pensions and riskier investments therefore create a substantial threat to state and local budgets. In 1975, the standard deviation of public pension investments amounted to only 1.8% of state and local budgets, while it has increased tenfold to a whopping 19.8% today.
Higher risk, however, is not only about higher volatility. It is also about higher responsiveness to market movements (in financial terms, it means a higher “Beta”). The implication is that riskier investments such as equities and alternative investments tend to move more in tandem with the market, and their change in values is more magnified by market change. In other words, when the market performs well, these investments can earn large returns; but when the market falls, the investments dive even deeper than the market, risking large unfunded liabilities.
Unfortunately, state and local governments’ revenues typically plunge during market downturns, meaning pension unfunded gaps balloon when government budgets are most constrained, and thus least able to make up for the shortfalls. This potentially creates a vicious cycle: pension plans that suffer substantial losses during recessions lack money to reduce funding gaps, thereby have an incentive to invest more in risky assets with a hope of earning larger returns to reduce the debts, and thus expose government budgets to even more risk.
The use of unrealistic rates of return stems from a flawed approach to liability valuation. Instead of using a near risk-free rate to value pension liabilities, public pensions rely on the expected rates of return of pension assets, which can be easily manipulated to artificially reduce the required contributions and conceal the real funding gap.
 In finance, standard deviation is a measure of how much an investment’s returns can vary from its average return, or in other words, how “spread out” these returns are. It is, therefore, a measure of volatility. The higher the standard deviation, the greater the volatility, and thus the riskier the investment.
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