Combining Solid Analysis With Wishful Thinking on Pensions

At National Affairs Josh B. McGee combines solid analysis with wishful thinking in a piece on public pensions. Here’s an instance of the solid analysis:

In the background, as plans reaped the market gains of the 1980s and ’90s, the economy was shifting, changing the calculus of pension financing. Interest rates, which had reached new heights in the preceding decade, began to fall consistently through the 1990s and into the 2000s. Meanwhile, pension plans’ investment-return assumptions, which had followed interest rates up, did not follow them back down. As a result, plans were expecting the return on their investments to exceed the “risk-free” rate (the return on the relatively safe bet on United States government bonds) by a growing margin over time. To achieve the same return, plans needed to take on more risk or give up some liquidity — and they did both.

Researchers estimate that, to get the same 7.5% to 8% return, pension plans need to take three to four times more risk today than they did 20 to 30 years ago. As risk increases, pension assets become more volatile. As a partial solution to this problem, pension plans began shifting into less liquid, alternative investments like private equity, hedge funds, and real estate. In theory, giving up some liquidity and diversifying will somewhat reduce risk for any given return target. Since 2001, public pensions have tripled the share of their portfolios devoted to alternative investments from 9% to 27%. But based on the available evidence, it’s doubtful that this shift into alternatives has delivered on its promise: Returns have fallen well short of targets, fees are up, and volatility is still a problem.

and here’s one of wishful thinking:

Many governments face daunting amounts of pension debt that can make full funding appear out of reach. Fixing public-pension funding is not technically difficult, but in most jurisdictions, fully funding pensions at this point would require significantly higher contributions or reduced benefits (or both), making a solution politically challenging to achieve. However, failing to take meaningful action to close the funding gap will only make the problem more challenging and painful to fix in the future. No matter the scale of the problem, governments that work with their plans to craft workable solutions and begin down the path to full funding will be better positioned to weather the next downturn.

The recommendations of the Society of Actuaries Blue Ribbon Panel on Public Pension Plan Funding (SOA BRP) make a great starting point for policymakers who wish to tackle the challenge of pension reform. The SOA BRP’s most important recommendations involve investment-return assumptions and pension-debt amortization. The assumption plays a critical role in calculating the current value of promised benefit payments, and thus the adequacy of annual contributions to cover the cost of those benefits. The amortization schedule determines how quickly pension debt is paid off. Together with mortality estimates, the investment-return assumption and amortization policy are the most important elements of pension funding policy. Tightening rules around these three elements would dramatically improve the accuracy of public-pension cost estimates and help ensure the adequacy of annual contributions.

The sine qua non of public pensions is that they must, like private pension plans, be converted from defined benefit plans to defined contribution plans with the attendant political costs that will entail. In Illinois, at least, it is no longer possible to avert a crisis. As people flee Illinois’s taxes, corruption, and high homicide rates (at least on the South Side of Chicago), fewer people will be paying the pensions agreed upon 30 years ago when the assumptions were very, very different and the situation cannot be changed without amending Illinois’s constitution, something that Illinois’s politicians refuse to do. They are presently striving to amend the constitution to allow them to raise taxes but not to reduce expenses.

4 comments… add one
  • Guarneri Link

    I’ve been commenting on this general phenomenon for years here. Although Mr McGee’s writing indicates a rather tenuous grasp on how things really work, the overall thrust of the history of the issue presented in his article is correct.

    However, as Dave correctly points out, the notion of shoring up the actuarial assumptions as a solution is just flapping of lips. In a turn on an old saw, you can’t get there from here. That is, the obligations and funding under realistic taxing or return assumptions simply cannot converge for any number of states and cities, including Chicago and Il. The politics won’t allow it. The financial reality cannot be wished away.

    Conversion to defined contribution is a first step towards future structural integrity. But it doesn’t resolve the existing problem. That problem appears intractable. Sound analytics are not that difficult to perform. So the politicians, pension managers and sober pension recipients all understand the issue. They are simply riding the train until the end, jockeying for position.

    As for the politicians, they remind me of a cartoon I once saw. The pilot and co-pilot of an airplane, with parachutes on as they prepare to jump out of the plane, turn to the passengers and say, “remember folks, head between the knees.”


    Our corrupt Ruling Class is driving us over the cliff: pensions, de-industrialization, identity politics, government debt, military adventurism, … Anyone of these, and others, could drive an economic collapse, or worse.

    I am an extreme pessimist. I think collapse is unavoidable.

    Both my wife and I are retired. I have a defined state pension, and she has TIAA. We lived modestly and saved as much as we could. Yesterday, we had paper losses of around $100,000. Fortunately, it’s only paper, and one day either way doesn’t matter. But, a major, long-lasting stock market crash will impoverish us.

  • Grey Shambler Link

    On the bright side, we won’t live forever.
    Actually, dying in poverty of a preventable disease is something we don’t like to think about, but is common as weeds around the world. Might be we should contemplate that as a dignified possible outcome.

  • Guarneri Link

    At the risk of some unsolicited advice, Robert….

    A $100,000 loss implies something like a $3MM equity portfolio, unless your holdings are concentrated in a few stocks that experienced disproportionately poor performance.

    If you diversify, and hold an appropriate mix of assets (not just equities or alternatives), you will not become impoverished. Don’t make the same mistake that the pension funds are making, pursuing yield at the expense of improper retiree risk tolerance.

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