Do Public Pensions Bet Against the Odds and Let Politicians off the Hook?

What’s one reason for the nation’s public pension crisis? It may have to do with placing false hopes in risky investments and making pensions look better off than they really are.

Policy analyst Caleb Brown recently gave his take on “The Real Reason We Have a Public Pension Crisis.”

He notes that “Wall Street” has wanted public pensions to invest in “alternatives,” a typically riskier type of investment, and that public pensions are eager to take up the offer because they are looking for higher returns. This was a trend that started even before the 2008 financial crisis and has continued to grow.

Brown explains several reasons for this pursuit of riskier investments and higher yields. For one, current demographics mean pension payments are increasing. In Brown’s home state of Kentucky, the percent of assets being paid to retirees nearly doubled between 2001 and 2007.

He says politicians are also at fault:

“Part of the cause is that politicians, during the reasonably good economic times before the financial crisis, were loath to make the full contributions recommended by actuaries — the people who tell lawmakers how much to contribute to keep pensions funds functioning into perpetuity.”

On top of that, pension plans often use less than realistic methods to evaluate their health. Brown notes the tendency of pension plans to set a high discount rate (e.g., 7 or 8 percent) when judging their ability to pay future pension liabilities. By setting a high discount rate, they are counting on getting a high rate of return on their investments, when they should really wager on a lower rate of return closer to that of Treasury bonds. This is because the higher returns come from riskier investments and are not guaranteed. Therefore, the high rate of return should not be depended on in the case of pensions that have a legal obligation to be paid. High discount rates are really only appropriate for debts that do not have to be paid for certain.

Brown adds,

“By discounting at high rates, pension fund managers are essentially acting as if these payments do not demand risk management. To make matters worse, high discount rates let politicians off the hook by lowering today’s payments on behalf of tomorrow’s retirees.”

In other words, it makes pensions look like they are better funded than they really are. So politicians don’t have to be the bad guy and tighten the belt to get funding in order. Unfortunately, such habits have ended up encouraging pension managers to seek riskier forms of investment, like “alternatives,” which may look better on the books, but in reality are less reliable.

Says Brown,

“The financial crisis was a contributing factor to a problem that would have existed anyway. That problem is lawmakers effectively telling pension fund managers that they need to aspire to get higher returns so fewer present state resources have to be devoted to fund generous pension promises. Unfortunately, as is often the case in politics, the potential for malfeasance arises anytime someone is allowed to avoid responsibility tomorrow for promises they make today.

That’s the real lesson from the real crisis in public pensions.”

>>Source: Brown, Caleb O. “The Real Reasons We Have a Public Pension Crisis.” The American. American Enterprise Institute. 23 Oct. 2013.