The public pension debacle is attributed mostly to the failure of politicians to reign in public union demands in favor of courting their votes with over-generous contracts. But one of the hidden risks of the Fed’s Zero Interest Rate Policy is to greatly increase the risks of municipal and state budget crises as pension investments fall far short of their required returns and are forced to bear far more risk than is prudent. (This also applies to private pension plans.) This analyst calculates that these risks have increased ten-fold. The financial casino we’ve created hides a ticking time bomb.
From the WSJ:
The Hidden Danger in Public Pension Funds
Their investments expose government budgets and taxpayers to 10 times more risk than in 1975.
In 1975, state and local pension assets were equal to 49% of annual government expenditures, according to my analysis of Federal Reserve data. Pension assets have nearly tripled to 143% of government outlays today. That’s not because plans are better funded—today’s plans are no better funded than in 1980—but mostly because pension plans have grown as public workforces have aged.
The ratio of active public employees to retirees has fallen drastically, according to the State Budget Crisis Task Force. Today it is 1.75 to 1; in 1950, it was 7 to 1. This means that a loss in pension investments has three times the impact on state and local budgets than 40 years ago.
And pensions can expect to take losses more often because of increased investment risk. Public plans have historically assumed roughly an 8% rate of return. But thanks to falling yields on safe assets, pensions must invest in riskier assets to have any hope of getting 8% returns. A one-year Treasury bond in 1975 yielded a 5.9% return. In 1980, it offered 14.8%, and in 1985 an investor could expect 6.5%. Today, the Treasury yield hovers at 0.1%.
Meager yields leave America’s enterprising public-pension plan managers with a choice: Accept a lower return—forcing higher taxpayer contributions—or take on more risk to keep 8% returns flowing. My estimate, based on Treasury yields and analysis from economists at the Office of the Comptroller of the Currency, is that a pension today must build a portfolio with a standard deviation—how much returns vary from year-to-year—of 14%. Such high volatility means that a fund would suffer losses roughly one out of every four years.
By contrast, in 1975 a plan could achieve 8% expected returns with a standard deviation of just 3.7%. Those portfolios would lose money once every 65 years. This level of risk varied little through the 1980s and 1990s: An 8% return portfolio in 1985 would require a standard deviation of 2.7%, and 4.3% in 1995. Risk began inching upward after 2000 and has increased rapidly since the recession as low-risk assets continue to fall.
These figures aren’t theoretical. They represent public pensions’ decades-long shift from safe bonds to risky stocks, along with the recent growth of “alternative investments” such as hedge funds and private equity. These alternatives are, according to Wilshire Consulting, 60% riskier than U.S. stocks and more than five times riskier than bonds.
Larger pensions and riskier investments combine to increase risk to state and local budgets. The standard deviation of public pension investments equaled 1.8% of state and local budgets in 1975. That figure crept upward to 2.2% in 1985, and reached 5.8% in 1995. Today it stands at 19.8%. Pension investment risk to budgets has risen roughly tenfold over the past four decades.
As pension plan managers in Detroit, California and elsewhere can attest, there aren’t easy solutions. Mature pensions should move their investments away from risky assets, but many plan managers are doing the opposite in a double-or-nothing attempt to dig out of multitrillion-dollar funding shortfalls. In most instances, significant benefit cuts for current retirees who made the contributions asked of them is difficult to justify and legally problematic.
The only real option, then, is to make structural changes, including more modest benefits and increased risk-sharing between plan sponsors and public employees. But that will only happen if elected officials accept that they can’t continue with business as usual without accumulating tremendous risk.
Mr. Biggs is a resident scholar at the American Enterprise Institute.