The abuse of expected returns assumptions at public pension funds in America is something I have regularly raised a red flag about. Take a look here at The Economist’s comparison of American public pension fund rules with those for private funds and foreign public funds. The opportunity to use inflated future return expectations leads public pensions in America to make less than realistic assumptions about future liabilities, thereby threatening the system itself by making risk more attractive than it should be.
Private-sector pension funds in America and elsewhere (and Canadian public funds) regard a pension promise as a kind of debt. So they use corporate-bond yields to discount future liabilities. As bond yields have fallen, so the cost of paying pensions has risen sharply. At the end of 2007, American corporate pension funds had a small surplus; by the end of last year, they had a $404 billion deficit.
American public pension funds are allowed (under rules from the Government Accounting Standards Board) to discount their liabilities by the expected return on their assets. The higher the expected return, the higher the discount rate. That means, in turn, that liabilities are lower and the amount of money which the employer has to put aside today is smaller.
Investing in riskier assets is thus an attractive option for a public-sector employer, which can tap only two sources of funding. It can ask its workers to contribute more, but since they are well-unionised that can lead to friction (after all, higher pension contributions amount to a pay cut). Or the employer can take the money from the public purse—either by cutting other services or by raising taxes. Neither option is politically popular.
Unsurprisingly, therefore, the academics found that American public pension funds choose a riskier approach. Theory suggests that as pension funds mature (ie, more of their members are retired), they should allocate their portfolios more conservatively, because the promised benefits need to be met sooner and funds cannot risk a sudden decline in the value of their assets. That is the case with private-sector pension funds, but public funds take more risk as they mature—putting more money into equities, alternative assets (like private equity) and junk bonds.
Public pension plans have also increased their allocation to risky asset classes as interest rates and bond yields have declined. Again, this does not make sense in theory. The expected return on both risk-free and risky assets should decline in tandem. But a fall in ten-year Treasury-bond yields of five percentage points has been associated with a 15-point increase in public funds’ allocation to risky assets.