Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.
Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.
(Corporate plans do their calculations differently, and for them, investment returns are a less important factor.)
The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be.
A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions.
But plan officials say they cannot.
“Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.
The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report.
But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace.
Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.
If Colorado could somehow get 9 percent annual returns from its investments, though, its pension shortfall would shrink to a less daunting $15 billion, according to its annual report.
That explains why plan officials are looking everywhere for high-yielding investments.
Mr. May, in Wyoming, said many governments were “moving away from the perceived safety and liquidity of the investment-grade market” and investing money offshore, but he said he was aware of the risks. “There’s a history of emerging markets kind of hitting the wall,” he said.
Last year, the North Carolina Legislature enacted a measure to let the state pension fund invest 5 percent of its assets in “credit opportunities,” like junk bonds and asset-backed securities from the Federal Reserve’s Term Asset-Backed Securities Loan Facility, an emergency program created to thaw the frozen markets for such securities.
The law also lets North Carolina put 5 percent of its pension portfolio into commodities, real estate and other assets that the state sees as hedges against inflation. A summary of the bill issued by the state’s treasurer and sole pension trustee, Janet Cowell, said it would provide “flexibility and the tools to increase portfolio return and better manage risk.”
But some think they see new risks.
“It doesn’t pass the smell test,” said Edward Macheski, a retired money manager living in North Carolina. “North Carolina’s assumption is 7.25 percent, and they haven’t matched it in 10 years.” He went to a recent meeting of the state treasurer’s advisory board, armed with a list of questions about the investment policy. But the board voted not to permit any public discussion.
Wisconsin, meanwhile, has become one of the first states to adopt an investment strategy called “risk parity,” which involves borrowing extra money for the pension portfolio and investing it in a type of Treasury bond that will pay higher interest if inflation rises.
Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.
Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.
It decided to start with a small amount of leverage and gradually increase it over time, but word of even a baby step into derivatives elicited howls of protest from around the state.
The big California pension fund, known as Calpers, was already under fire for losing billions of dollars on private equities and real estate in the last few years. So far it has stayed with those asset classes, while negotiating lower fees and writing off some of the most troubled real estate investments.
It announced in February that it had started looking into whether it should lower its expected rate of investment return, now 7.75 percent a year. It has embarked on a study, but a spokesman said that process would not be done until December, safely after the coming election.