“These pension funds are gambling. They are not being hedged,” says George Pennacchi, a University of Illinois finance professor, about many public pension plans. In a recent study of public pension funds’ portfolio-risk choices, Pennacchi and co-author Mahdi Rastad looked at 125 state pension funds’ annual data on their portfolio allocations and plan characteristics from 2000 to 2009. “Hedging risk from changes in the market value of the pension fund’s liabilities is likely to be the socially optimal policy,” concludes the report, “Portfolio Allocation for Public Pension Funds.”
And yet, public pensions often respond to deteriorating performance by increasing portfolio risk, the study finds. “It is like doubling down on your bet,” Pennacchi says in an interview. “The investments will lose value when the stock market declines, and that is exactly the time when most state and local governments are cash-strapped.”
These plans need to be run with a different strategy, Pennacchi says. He likens state and local pension funds’ liabilities to fixed-income liabilities such as a corporate bond that also promises to pay a specified amount in the future.
“What would be the best way for pension funds to put money aside today? Invest in a bond,” he says. “If interest rates fall, the value of the liability goes up, but at the same time, your bond investments go up. So they move together. As long as the duration is matched, you are pretty much hedged.”
And yet, state and local government pension funds invest just over 30 percent of assets in fixed income, the study says. “If you start moving out of fixed income into equities, then you start increasing tracking error,” Pennacchi says. Adds co-author Rastad, a University of Illinois economics Ph.D student, “The ones that minimize tracking error are very far from the other group of pension funds’ portfolios.”
Some plans also may need to change the way they judge their staff. “The traditional practice now is to measure the performance of pension fund managers by the rate of return relative to their peer pension fund managers, rather than rate performance as to how closely they hedged the liabilities,” Pennacchi says. “That creates an incentive to ignore the liabilities and focus on investment returns.”
Public plans that use a relatively high discount rate also tend to choose riskier portfolios, the study finds. “They are making bets based on an expectation of earning 7 percent or 8 percent,” Pennacchi says. “Those returns are perhaps consistent with historical returns over the past 75 to 100 years, but we have not seen that in awhile. They are just gambling on a good stock market in the future. Those gambles will pay off when the economy is doing well already. They will lose big when the economy is not doing well.”
And in a gamble for higher benefits, public plans also assume greater risk when they have more plan participants on their board of trustees, the study finds. “In designing the allocation of the portfolio, they have an incentive to take more risk, because they will share in the upside if the pension fund gains, and they do not share in the downside if it loses,” Rastad says. “There is no risk that they will lose their pension, even if the pension fund does badly.” And when pension funds do well and are overfunded, unions often can negotiate for higher benefits, Pennacchi says. “They could gain some upside benefits if they gamble,” he says. “Their incentives may not always be aligned with taxpayers.”
