America’s public pension plans make over-optimistic return assumptions
PROMISING A PENSION is a long-term and expensive business, especially if the payout is linked to earnings. But whether the employer is private or public, the cost ought to be the same in the long run and so, you might assume, would be the investment approach. Until 2008 that was true for American pension plans: private and public-sector schemes had roughly the same asset allocation.
But a new report by Jean-Pierre Aubry and Caroline Crawford of the Centre for Retirement Research (CRR) at Boston College shows that things have changed. Public plans have 72% of their portfolios in risky assets (equities and alternatives such as hedge funds), and private plans just 62%. Since private plans have more scheme members who are retired, they should have a less risky approach, because they must focus on paying benefits immediately rather than on long-term growth. However, even allowing for this and other factors such as plan size, public-sector schemes are taking more risk.
The cost of paying pensions stretches far into the future; a 25-year-old today could still be receiving an income in the 2080s. So employers must discount future payments by some rate to calculate the current cost. Since a pension is, in effect, a long-term debt, private-sector schemes must use a bond yield as the discount rate, according to accounting rules. But public-sector plans can use the expected rate of return on their investments. The higher the assumed return, the higher the discount rate and the lower the current cost appears. Public-sector plans assume, on average, 7.4%.
In effect, then, public-sector plans have riskier portfolios because they must, in order to justify their return assumptions. In turn, this allows them to keep down annual contributions, and thus reduce the burden on today’s taxpayers. But the report finds that, even allowing for asset allocation, public pension plans make optimistic assumptions about future returns, compared with those of professional investors.
All this might not matter if public pension plans were right. They would be widely applauded for funding pensions in a cost-effective manner. But the average public pension was 72% funded at the end of 2017, according to CRR data, even using the optimistic accounting approach—down from full funding in 2001. Dismal market returns in 2018 mean the problem will only have worsened. The gamble isn’t working.