The Hidden Danger in Public Pension Funds

December 30, 2013

Public-employee pensions are larger and their investments riskier than at any point since public employees began unionizing in earnest nearly half a century ago, says Andrew Biggs, a resident scholar at the American Enterprise Institute.

How much riskier are public pensions now?

  • Public pensions pose roughly 10 times more risk to taxpayers and government budgets than in 1975.
  • In 1975, state and local pension assets were equal to 49 percent of annual government expenditures, according to Biggs' analysis of Federal Reserve data.
  • Pension assets have nearly tripled to 143 percent 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.

And pensions can expect to take losses more often because of increased investment risk. Public plans have historically assumed roughly an 8 percent rate of return. But thanks to falling yields on safe assets, pensions must invest in riskier assets to have any hope of getting 8 percent returns.

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 percent returns flowing.

  • Biggs' 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 percent.
  • 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 percent expected returns with a standard deviation of just 3.7 percent.
  • Those portfolios would lose money once every 65 years.

This level of risk varied little through the 1980s and 1990s: An 8 percent return portfolio in 1985 would require a standard deviation of 2.7 percent, and 4.3 percent in 1995. Risk began inching upward after 2000 and has increased rapidly since the recession as low-risk assets continue to fall.

Larger pensions and riskier investments combine to increase risk to state and local budgets. The standard deviation of public pension investments equaled 1.8 percent of state and local budgets in 1975. That figure crept upward to 2.2 percent in 1985, and reached 5.8 percent in 1995. Today it stands at 19.8 percent. Pension investment risk to budgets has risen roughly tenfold over the past four decades.

Source: Andrew G. Biggs, "The Hidden Danger in Public Pension Funds," Wall Street Journal, December 15, 2013.

 

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