The Risks of Public Pension Systems Reaching for Higher Investment Returns

In the current political and economic environment, where public pension plans are commonly underfunded and investment outlooks are becoming less optimistic, stakeholders frequently face the difficult challenge of somehow increasing the funding flowing into pension funds.

A possible answer for policymakers to consider is restructuring a pension plan’s portfolio in ways that would guarantee a higher investment return, but it’s important to consider the latest research on how plans tackle portfolio choices, the logic behind such choices and their consequences.

State and municipal pension funds are typically structured so that their participants are guaranteed a certain amount of benefits upon their retirements, with the level of benefits established by a predefined formula—hence the term “defined-benefit pension.” In order to provide these benefits, employers (or plan sponsors) invest pension fund assets into a portfolio they believe is most likely to generate sufficient investment returns to cover the pension benefits that have been promised to plan participants. Complex, inherent challenges come with the long-term economic forecasting, the expected rate of return on investments, and the mix of assets needed to achieve the pension system’s goals over multiple decades.

In a defined benefit pension system, the employer is responsible for paying out retirement income to retirees, regardless of how the investment portfolio actually performs. The benefit is predefined in law and that benefit is protected from nearly all retroactive impairment by the contract’s clauses in the federal and state constitutions. Therefore, the risk of investment underperformance—and the responsibility for making up for any lost income that is needed to fund the retirement benefits—typically falls on the plan sponsor (unless the pension plan was specifically built with cost-sharing provisions related to unfunded liabilities).

When a pension plan’s value of assets is less than the value of its liabilities, it is considered underfunded because there are not enough funds to cover all of the existing lifetime retirement benefits that have been promised to its members. Sponsors of underfunded pension plans face a pressing dilemma— they need to either lower their liabilities or increase their assets in order to balance the books. Reducing the amount of liabilities would likely require going back on promises already made to current workers, which would be neither legal, moral, nor fair.

When it comes to increasing the amount they have in assets, pension fund managers have a few options. The two most obvious: they could invest in assets that could be expected to generate higher rates of investment returns or they could require greater contributions from the beneficiaries or the sponsor (government), or both.

All of these options have political implications, but some less than the others. Requiring greater contributions from active workers means that they would have to pay more into the retirement system. This is essentially viewed as a cut in pay (unless offset by other increases) by workers. Having the government/employer contribute more to the plan means that the larger payments to the pension plan would have to be done at the expense of cutting other government programs or alternative methods like pay decreases or tax increases. Thus it is easy to see why investing in assets with higher expected returns is the least politically costly method since it does not require immediate action from either the government, workers or taxpayers. It does, however, increase the level of assets estimated by the fund—at least on paper—and that is what plan managers want to see.

In a recent research paper, researchers from the Federal Reserve Board examined the motivation and consequences of risk-taking behavior among public pension funds. The paper explored how plans with varying asset to liabilities ratios and state public financial health balance risk in their investment portfolios. Overall, they see a pattern of riskier behavior among plans that have a relatively low asset to liabilities ratio, as well as those that have weaker public finances.

Several of the authors’ observations merit a closer look:

1. In the situation when both the funded ratios and the returns on safe (risk-free) assets are low, plans are willing to take more risk.

As we have noted above, when the assets-to-liabilities ratio (in other words, the funded ratio) is low, the pension funds do not have enough money to pay out all promised liabilities. The only way out of this, without either having the employer or employees contributing more to the pension plan, is to generate more income. But, if, at the same time, the return rate on safe (risk-free) investment assets, such as Treasury bills, is low, the seemingly plausible alternative for the plan is to invest in higher-yield, riskier assets.

This creates an issue of its own, however, because risky assets have greater uncertainty associated with their returns. In other words, these pension funds become more volatile and their return can fluctuate more significantly. This is a problem because a period of low returns on risky assets can damage the financial health of the plan significantly. If risky assets underperform, then the pension fund won’t accumulate its target amount of assets, leading to a further drop in its funded ratio.

2. The risk-taking is even more pronounced when the investment returns are relatively low.

When investment returns are relatively low, a pension plan may perceive that it is not getting enough income from its portfolio. By taking on riskier assets, plan managers are attempting to make up for the lost income. As a result, the plans financial projections are boosted by saying it expects higher future investment returns. This motivation is particularly strong in low returns years because higher future returns make it look less damaging for current year investment returns to be lower. Politically, if the plan has higher returns in the future, fewer adjustments are immediately needed.

3. Sponsors with weaker public finances take more risk.

The authors observe that “funds sponsored by states with higher debt-to-income ratios or worse bond ratings engaged in more risk-taking behavior.” Here, weak public finances are reflected by higher levels of public (including non-pension) debt or worse credit ratings of the state. This means that credit ratings agencies have found plan sponsors to already have high amounts of borrowing or a low ability to pay debts or generate wealth, and by taking on risky assets, they put themselves in danger of further weakening their poor fiscal condition.

As plans are being exposed to even more risk, they could further exacerbate their debt levels, because of the possibility of extreme variability in riskier assets. What is striking here, is governments or pension systems that are already in bad shape (those with weaker public finances), are even more willing to gamble. Moreover, as we have discussed elsewhere, de-risking pension plans could go a long way toward improving government credit ratings in the long-term.

4. States that could default on non-pension debt also chose higher risks.

“Our modeling of state finances suggests that if states can default on their non-pension debt, states with high debt-to-income ratios may choose to take higher risk in their pension funds because they can shift the risk of poor fund performance away from taxpayers and toward state debt holders. On the other hand, our model also implies that states may choose to take less risk if state debt is high but they cannot default on it, or if the penalties for defaulting are large,” the authors, Lina Lu, Matthew Pritsker, Andrei Zlate, Kenechukwu Anadu, and James Bohn, write.

In the new normal environment for investment returns, gains are not likely to be as high as they used to be. For US and Western equities, examples of what’s considered safe assets, expected rates of investment returns are between 4 percent and 6.5 percent over the next 20 years. This means that pension plans that are expecting higher investment returns than that could be structurally underfunded. The National Association of State Retirement Administrators found that public pension funds have an average return assumption of 7.27 percent, which, following the logic of the research discussed above, is likely to motivate them to take on riskier assets. Pension plans trying to overreach for higher yields could end up exposing their retirement systems to greater risks and unfunded liabilities.

To better secure pension benefits for plan participants, pension plan managers should reconsider overly-high investment rate targets and they should be careful with methods of achieving high return goals. Restructuring a pension plan’s portfolio in ways that promise higher returns might be tempting, but it’s important to consider the amount of uncertainty and potential downsides that risky assets bring.

State and municipal retirement systems, as well as an employer offering a defined benefit plan, need to consider the long-term consequences of exposing their pension funds, and taxpayers, to greater risk.