Unsustainable Risk Taking by Public Pensions

In a recent article in the Wall Street Journal, Andrew Biggs shows the bleak picture of public pensions’ risk taking. Biggs points out that many major public pension plans hold substantially more risky assets than they should. For example, California Public Employees’ Retirement System (CalPERS) invests 75 percent of its portfolio in stocks and other risky assets, while a typical participant of the plan is supposed to hold only about 38 percent risky assets. Public plans in other states are not too different: Illinois holds 75 percent in risky assets; New York state and local plan 72 percent; Pennsylvania 82 percent; New Mexico 85 percent.

Defenders of this practice often argue that public plans can afford to take more risks because they have longer investment horizons. This is called “time diversification”: the idea that time itself can diversify risks because in the long run investment losses tend to be made up by inevitable gains. The idea however is widely rejected by economists, and most economists agree that investment risks increase, not decrease, with time. Biggs has already discussed this myth in a separate paper here. Besides, many public plan managers take more risks as they believe doing so reduces pension costs by decreasing required contributions. This is again fundamentally flawed, since more risk taking merely shifts the costs to future taxpayers through contingent liabilities.

Investment practices by public pension plans in the United States, as noted by the Society of Actuaries, go “against basic risk management principles” and are unique compared to not only private pension plans in the US, but also public sector plans in Canada, UK, and Netherlands. Since few people inside the system have the incentive to change it, Biggs suggests more tightening standards for public-plan actuaries, requiring additional disclosures and allowing less discretion.

To read the article, go here.