Swedroe: What Hampers Pension Plans

Some requirements can lead plans into dangerous territory when it comes to asset allocation.

It is no secret that many public and private pension plans are significantly underfunded. A combination of changing demographics, lackluster investment performance and low interest rates have all played a part. The long-term solvency, regulation and investment performance of these plans are all being questioned. This is particularly so for taxpayer-funded U.S. public pension plans.

Regulatory guidelines for U.S. public pension funds allow for considerably more discretion in setting liability discount rates compared with guidelines for other pension funds. They follow the Government Account Standards Board (GASB) guidelines for computing discount rates, which allow them to base liability discount rates on the expected return of assets held by the plan.

This contrasts to other types of pension plans, like U.S. private plans and Canadian and European private and public plans, which require the use of some type of high-credit-quality interest rate as a discount rate.

Given the many important implications of this dichotomy for public pension recipients, my colleague, Tim Jost, an institutional services advisor with my firm, Buckingham Strategic Wealth, supplied the following analysis of recent research into regulatory incentives, asset allocation and the performance of pension plans.

Recent Research

In the February 2017 paper, “Pension Fund Asset Allocation and Liability Discount Rates,” Aleksandar Andonov, Rob Bauer and Martijn Cremers examined whether the asset allocations and performance of U.S. public pension funds (those offered to federal, state and local government employees) were related to the unique regulatory framework that defines how liability discount rates are determined.

The authors also explored the role that regulatory incentives play in different asset allocations among types of plans, and how these incentives impact performance. Their data set included more than 850 U.S., Canadian and European pensions, and covered the period 1990 through 2012.

Andonov, Bauer and Cremers investigate a “regulatory incentives hypothesis,” implying there is an incentive for U.S. public pension plan stakeholders to increase allocations to risky assets. They found that when comparing public and private pension funds in the U.S., Canada and Europe, U.S. public pension funds act on their regulatory incentives and tend to take more risk—their asset allocations reflected the highest levels of risk among funds analyzed in the paper.

By increasing allocations to risky assets, U.S. public plans are able to increase expected returns and discount rates, having two primary positive effects: 1) the present value of liabilities goes down; and 2) the plan funding level goes up.

These twin effects allow states and municipalities to make fewer contributions to their public pension plans in the near term. Thus, it can be said that GASB guidelines encourage the funding of future liabilities with investment gains as opposed to contributions.

Stakeholders in U.S. public pension funds, as well as taxpayers, need to ask an important question: In the absence of unique GASB guidelines, should these funds be taking the amount of risk that they are?

Plan Maturity & Risk Taking

The collective allocation to risky assets for public pension funds across the U.S., Canada and Europe increased from 56.1% in 1993 to 72.4% in 2012, mainly due to U.S. public pension funds. Private pension plans actually decreased their allocation to risky assets from 63% in 1993 to 60.2% in 2012.

Taking more investment risk, as U.S. public pension funds have done, isn’t necessarily a bad thing—as long as it is within appropriate levels of risk tolerance and is being adequately compensated.

Conventional wisdom regarding the management of pension funds suggests lowering the allocation to risky assets as the plan matures—as the collective group of participants ages, the duration of liabilities gets shorter and less uncertain, suggesting a lower discount rate. Thus, if a workforce is actually getting younger, a higher allocation to risky assets is likely appropriate.

However, pension plans as a whole, and U.S. private plans especially, have been getting more mature. (Many corporations have decided to freeze existing plans for other options, such as defined contribution plans.) According to the study, retired members of private plans increased from 31.1% in 1993 to 56.7% in 2012, while retired members of public funds increased from 27.3% to 42.1% over the same period. With an aging population, it would seem U.S. public pension plans should have been backing down risk, not increasing it.

For all funds other than U.S. public plans, the authors show that a 10% increase in the percentage of retired members is associated with a 1.7% lower allocation to risky assets. In other words, as cash flows become more certain, these plans take less investment risk. However, for U.S. public plans, a 10% increase in retired members is associated with a 5.9% increase in risky assets—the opposite of what should be expected based on plan maturity and risk.

The authors posit that the added risk taken by U.S. public pension plans as they mature stems from regulatory incentives. More mature funds are generally more likely to face worsening funding status prospects, especially in a low-interest-rate environment. This suggests that more mature funds will have an incentive, under GASB guidelines, to increase allocations to risky assets to keep discount rates higher, reducing their funding requirement.

Importance Of Expected Returns

U.S. public plans have kept expected returns relatively constant over the past few decades, even as interest rates have declined, by increasing allocations to risky asset classes such as equities and alternatives. According to the study, over the period 1993 through 2012, U.S. public plans maintained discount rates (expected returns) of about 7.5% to 8.0%. Contrast this with U.S. private plans, which lowered discount rates from 8.2% to 4.4% during that period.

Andonov, Bauer and Cremers found that public plans in Europe and Canada made allocation decisions similar to their private counterparts, while U.S. public plans make distinct investment decisions from U.S. private plans.

Current forward-looking return expectations are muted for stocks and bonds compared with historical averages. This unfortunate reality is due to today’s historically low-interest-rate environment, coupled with elevated equity market valuations. Lower return expectations make it natural for investors who require a certain long-term investment return, such as most institutions, to increase allocations to risky asset classes to better align portfolios with return goals.

For example, a university spending 4% of its endowment per year will need to achieve a return that covers this 4% spending rate, plus inflation, and also any additional costs, such as investment management.

Hypothetically, assuming 2% expected inflation and 0.5% investment management costs, the university will need a 6.5% annual return to preserve the purchasing power of its portfolio over time. In the past, a simple 60% equity and 40% fixed-income portfolio would have had a high likelihood of meeting this 6.5% return goal. However, using current forward-looking return expectations, this is not the case today (due to higher equity valuations and lower interest rates).

While taking more investment risk may be an appropriate decision for some institutions, doing so widens the distribution of potential returns and increases left-tail risk. This creates added uncertainty around the annual distribution amount that the university in our example will be able to take from its endowment to support operations—which may not be acceptable. Thus, both risk and return must be factored into asset allocation decisions.

By taking more risk, pension funds are able to appear better funded. However, added risk comes with a cost, in the form of the aforementioned wider distribution of potential returns. Should a large drawdown in risky assets occur, perhaps like the one we saw during the 2008-2009 global financial crisis, the funding level of many U.S. public pension funds would deteriorate significantly. Such a deterioration in funding would likely occur at an undesirable time because its probable state and local budgets would simultaneously come under strain from lower revenues.

Dangerous Game

Ultimately, the trustees of many U.S. public pension funds are playing a dangerous game with taxpayer dollars and plan participant benefits—increasing investment risk. Instead of proposing larger contributions, or attempting to restructure plans, trustees are seeking higher investment returns to improve funding levels.

This behavior shouldn’t come as a surprise, given that it’s the path of least resistance. Should returns not meet expectations over the coming years, many states and municipalities are going to face much tougher budgetary challenges, with the burden likely falling on younger generations for years to come.

Risk & Return

Unfortunately, the increased level of risk taken by U.S. public pension funds over the past few decades has not been rewarded. In fact, risk-adjusted performance has suffered a negative impact.

To allow for the comparison of performance across plans with different allocations and risks, Andonov, Bauer and Cremers adjusted returns for each asset class to reflect the net of self-reported benchmark return specific to that asset class.

The authors confirm that these self-reported benchmarks are appropriate and do not differ between plan types. After adjusting returns, U.S. public plans collectively have underperformed benchmarks by about 0.5% per year. This underperformance is particularly strong for more mature plans with higher allocations to equities and alternatives. None of the other types of plans the authors studied tended to show any sign of underperformance.

The authors show that U.S. public pension funds underperformed other types of pension funds against benchmarks in public equity by 0.24% a year, though they did not underperform in non-risky fixed income. However, U.S. public plans underperformed other types of plans by a sizable 2.41% per year against benchmarks in alternatives.

Given the abundance of index funds available today, U.S. public plans could easily reduce underperformance against equity benchmarks simply by owning low-cost index funds. However, collectively pension funds use active managers for about 80% of their assets. Thus, it is likely the use of high-cost, actively managed investment vehicles in risky asset classes like equities and alternatives contribute to this negative tracking variance.

Not All Alternatives Created Equal

While U.S. public pension funds invest more in risky asset classes, in particular, they have increased holdings in alternatives. Even though U.S. public pension funds have significantly underperformed relevant alternative benchmarks, investors shouldn’t necessarily rule out this asset class.

Unlike public equity, there is generally no ability for investors in alternatives to passively own most alternative indexes. However, there are now alternative strategies that are passive in their management style, meaning they seek to capture systematic sources of return.

What’s more, they are available in liquid structures at reasonable costs. Two fund companies that offer these types of strategies are AQR and Stone Ridge. My firm, Buckingham Strategic Wealth, recommends strategies from both of these fund companies in constructing client portfolios.

These strategies are backed by peer-reviewed research showing attractive risk premiums expected to be relatively uncorrelated to public equity and fixed-income markets. While none of these strategies (such as reinsurance, the variance risk premium, alternative lending and long/short factors) are new (they have been residing on the balance sheets of endowments and hedge funds for in some cases decades), they can now be accessed using publicly available interval and mutual funds regulated by the SEC.

In addition, they come without the typical 2/20 fee structures associated with most hedge funds. Adding alternative sources of risk and return to a portfolio can be beneficial for investors, especially in today’s environment of muted capital market assumptions. However, investors need to be cautious, as not all alternative strategies are created equal.

Summary

Every individual and institutional investor has unique investment goals and risk tolerance. The level of risk taken in a portfolio should ultimately align with those goals and risk tolerance. This is no different for U.S. public pension funds. However, Andonov, Bauer and Cremers show that the investment decisions made by U.S. public pension funds largely have been influenced by regulations specific to those plans, as opposed to risk tolerance and the duration of liabilities.

Given that U.S. public pension benefits appear legally well protected, as highlighted by recent legal action, U.S. public pension fund trustees face an uphill battle in attempting to restructure plans. Thus, they have two options to shore up plan funding: increase contributions or increase investment risk.

The authors show they’ve generally opted for the latter, which shouldn’t be much of a surprise, because any increase in contributions would likely come from higher taxes, or cuts to other state and local programs. These options obviously are not attractive to elected officials.

Ultimately, stakeholders of U.S. public pension funds are attempting to earn their way out of underfunding by taking greater investment risk. However, with added risk comes a wider distribution of potential outcomes. This added risk is also being taken at a sobering point in time from a capital market assumptions outlook.

Time will tell how things play out, but signs certainly seem to point to U.S. public pension funds becoming even more of a hot topic in the future.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.