And Exempted Themselves from Accounting For That Risk





Low interest rates - especially the ultra-low rates we’ve seen in the wake of the Great Recession - can slow growth, create zombie companies, and have contributed to a worrying rise in corporate debt. However, how falling interest rates have changed the allocation of pension funds over the decades has received less attention.





Low interest rates have forced pension funds to take on riskier assets to maintain yields. Even well-funded funds have increased their risk by shifting into equities, and many pension funds are now both underfunded and invested in risky assets.





Back in 1962, pension funds projected an average annual return of 8% and the yield on long-term bonds was much higher than it is today. A pension fund could put all of their money in extremely safe assets and meet their projections. And that’s exactly what they did - In 1962 roughly 95% of pension fund assets were in fixed-income and cash. Today, the average pension fund projects an annual return of 7.6%, while the 30-year treasury rate has fallen to just 3%.









In order to meet the required returns, public pension funds have thus been pushed into equities and other riskier assets. In 1992 just over half of allocation was still in fixed income. As of 2012, only 25% of public pension fund assets were allocated in fixed-income assets or cash - with the remaining 75% in equities and other higher yield alternatives. According a recent report from the PEW charitable trust:





In a bid to boost investment returns, public pension plans in the past several decades have shifted funds away from fixed-income investments such as government and high-quality corporate bonds. During the 1980s and 1990s, plans significantly increased their reliance on stocks, also known as equities. And during the past decade, funds have increasingly turned to alternative investments such as private equity, hedge funds, real estate, and commodities to achieve their target investment returns.





The report goes on to say that because of this shift towards riskier assets “Public pension systems may be more vulnerable to an economic downturn than they have ever been.”





Accounting for Risk in Public Pension Funds

There is one other key reason public pension funds have transitioned to riskier assets.

States have passed laws exempting state government pension plans from the standards that private pension plans are held to. These public pension plans are permitted to use generous assumptions about risk that are not permitted in the private sector. So while public pensions have moved into objectively riskier assets, they haven’t been forced to account for that risk.





According to a 2018 report, if public sector pension plans were held to the same standards as the private sector, even with their other extremely optimistic estimates, only Wisconsin’s would be considered stable. To quote the report:





However, the Pension Protection Act does not apply to public sector DB pension plans. Using the states’ own estimates of their liabilities and assets, 32 states are at risk of default by private sector standards. If the Pension Protection Act were applied to the public sector and states had to use a similar discount rate as the private sector, about 4.5 percent, only Wisconsin’s pension system has enough assets to be considered stable.





And this is not a controversial point – an overwhelming majoring of leading economists agree that the government accounting standards used by US state and local governments understate their pension liabilities and the true cost of future pensions.





Impact of Risk

You might be wondering how much of a difference this really makes, well, those calculations have been done. A more recent estimation from 2018 calculates that “Unfunded liabilities of state-administered pension plans, using a proper, risk-free discount rate, now total over $5.96 trillion. The average state pension plan is funded at a mere 35 percent.”





However, in a lot of ways this has become a political issue and these estimates should be taken with a grain of salt. But what is less debatable is that pensions are now facing greater risks than they have been for decades.





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