December 07, 2014
Andrew Biggs had a column in the Wall Street Journal last week complaining that public pension funds were taking excessive risk by having 70 percent to 80 percent of their holdings in risky assets, such as stocks and various alternative investment vehicles. In a few cases, holdings of risky assets apparently cross 80 percent. Biggs argues that this is far too high and that underfunded pension plans are now taking big gambles in the hope of closing their funding gap.
Bigg’s basic argument stems largely from an inappropriate comparison of pension investment patterns to individual investment. Biggs tells readers:
“Many individuals follow a rough ‘100 minus your age’ rule to determine how much risk to take with their retirement savings. A 25-year-old might put 75% of his savings in stocks or other risky assets, the remaining 25% in bonds and other safer investments. A 45-year-old would hold 55% in stocks, and a 65-year-old 35%. Individuals take this risk knowing that the end balance of their IRA or 401(k) account will vary with market returns.
“Now consider the California Public Employees’ Retirement System (Calpers), the largest U.S. public plan and a trendsetter for others. The typical participant is around age 62, so a ‘100 minus age’ rule would recommend that Calpers hold about 38% risky assets.”
The logic of an individual following this rule is that some point individuals will retire and basically be dependent on their savings and Social Security for all their income. Retirement is usually a pretty sharp break. If the stock market happens to be down at that point, they will be in trouble if they hold lots ot stock, especially if their intention had been to buy an annuity to support themselves in retirement. They will be forced to sell their stock at a depressed value since they won’t have the option to wait for the price to recover.
How does this work with Calpers and other public pensions. Ignoring the fact that age 62 for the typical participant seems a bit high, what would happen if the stock market plunged again, as it actually did in 2008-2009? The fund would still have large amounts of revenue coming in and would still have an amount equal to 25 percent of its prior holdings in more liquid assets to pay out to current beneficiaries. It is almost inconceivable that it would have to liquidate any of its assets at a depressed price to pay current benefits.
In fact, if Calpers was to rebalance its portfolio following a sharp drop in the stock market, it would likely be buying rather than selling stock. (If the value of Calpers holdings fell by 50 percent, then it would have just 60 percent of its holdings in stock and other risky assets.)
Biggs also complains:
“volatile pension investments translate into volatile contribution requirements that can and have destabilized government budgets.”
Volatile contribution patterns can be a problem, but the asset smoothing practiced by most pension funds and also calculating contributions based on expected rates of return minimizes the problem. By contrast, a pattern of marking assets immediately to market prices, and using a risk-free rate of return as practiced by the Netherlands, one of the countries Biggs holds up as a model, would lead to volatile contribution patterns. In the Netherlands, pensions cut benefits and raised contribution requirements in the middle of the recession, making the downturn worse and raising the country’s unemployment rate.
There are some legitimate points that should be considered. First, pension plans can take too much risk, especially when they get into non-traditional assets like hedge funds and private equity funds. In this respect, it is very important to have more transparency about the nature of these investments, both so that the risks can be better understood and the public can be assured that the intermediaries are not drawing excessive fees.
Disclsosure requirements may keep some private equity or hedge funds from doing business with a pension, but in most cases this will not be a loss. In some rare cases a public pension may be losing the opportunity to invest with a Warren Buffett-type market whiz, but the vast majority of fund managers are not Warren Buffet-type whizzes. Most of them do not beat the market after netting out fees, so pensions will not be suffering if disclosure requirements scare them away.
The other point is that the recent run-up in stock prices should be causing funds to adjust their projected earnings downward. Historically the stock market was able to give 10 percent nominal returns (7.0 percent real) because the price-to-earnings ratios were around 14.5. With the current ratio of price to trend earnings around 20, a real return of 5.0 percent (nominal of 7.0 percent ot 8.0 percent, depending on the inflation assumptions) would be more realistic.
Many pensions originally started facing shortfalls because they assumed in the 1990s that the stock market would provide its historic rates of return even as price to earnings ratios crossed 30. They should not repeat this mistake.
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