June 02, 2015
American Enterprise economist Andrew Biggs again warned about public pension funding in a Wall Street Journal piece. He’s not altogether wrong. Biggs points out that many states continue to badly underfund their pensions. He also cautions against pension funds taking too much risk with their investments. These points are well taken, but I would raise a few issues about Bigg’s argument.
First, it’s good to see that Kansas is Bigg’s poster child as one of the states with a poorly funded pension plan looking for higher market returns rather than making its required contributions. This is worth noting because Kansas is one of the most Republican states in the country, with a very conservative governor. It certainly it is not a hotbed of public sector unionism. This point is important. It was not public sector unions that caused states to have problems with pension funding, it was bad management by elected officials, both Democrats and Republicans.
Second, Biggs somewhat misrepresents the issues on returns. He argues the return assumptions used by public pension plans are considerably higher than the recommendations of a group of investment consultants and asset managers. However the asset mix for which this group made their projections was a portfolio of 70 percent equities and 30 percent bonds. The mix of assets held by pensions tends to be oriented towards somewhat higher return assets, with holdings in private equity and venture capital. The returns assumed by the pension funds are much closer the returns recently recommended in a report by the Pension Consulting Alliance.
It is also worth noting one source of confusion in these comparisons. Many pension funds assume higher rates of inflation than we have been seeing recently or are expected in the future. For example, the Kansas plan cited by Biggs assumes a 3.0 percent average rate of inflation over its planning horizon. The Congressional Budget Office and most other forecasters assume a 2.0 percent inflation rate. The difference in inflation assumptions should translate one to one into differences in returns. In other words, a 6.0 percent return assumption with a 2.0 percent inflation rate translates into a 7.0 percent return assumption with a 3.0 percent inflation rate.
However Biggs is right to raise a flag about some of the risky investments being pursued by pension funds. Private equity and venture capital can both be very risky. In the past these investments have provided a better return than the overall market, but pension funds would be wise to exercise caution if they are relying on this continuing in the future.
Finally, it is worth noting that pensions certainly are not the only ones that can be accused of making excessively optimistic assumptions about market returns. Back in the 1990s, there were many economists, both liberal and conservative, who wanted to put Social Security funds into the stock market. The liberals wanted to put a portion of the trust fund directly into the market. The conservatives wanted to do it through individual accounts.
In both cases, they assumed that the stock market would give 7.0 percent real returns (10.0 percent nominal) in spite of the fact that price to earnings ratios exceeded 30 to 1 at the time. The list of economists in this camp was quite impressive. It included folks like Larry Summers, Martin Feldstein, and Andrew Biggs. (Hey, we all make mistakes.)
Anyhow, caution is warranted on return assumptions. With the recent run-up in stock prices, funds should be dialing down their projections of returns, but most are not hugely unrealistic where they stand now.
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