Public Sector Plans and the Consequences of Investment Risk

This article was originally published in Public Sector Inc.

The New York Times Julie Creswell reports on the strategy undertaken by some public sector plans to embrace more investment risk in the wake of the market crash of 2008. The results are not what plan managers were hoping for.

Pennsylvania's State Employee Retirement Fund sank a total of 46 percent of its investments in alternatives - believing much higher yields would help compensate for losses. The plan realized an annualized return of 3.6 percent, far below its 8 percent target. In contrast, Georgia's municipal retirement system, which as The NYTreports, is prohibited from investing in alternatives realized 5.3 percent over the period.

The strategy of betting on more risk to make up for losses hasn't done underfunded public plans any favors. That is because higher returns also come with greater risk. Unfortunately, plans have shifted to more risk exposure sine 2008. One reason is plan managers don't like the record-low returns on bonds which are returning in the two to three percent range.

So what is the solution? First disentangle asset investment strategy from liability valuation which is responsible for muddying the waters. Second, consider what the aim of the investment strategy is. One way to think about the problem is in terms of options pricing described by Andrew Biggs of AEI. Alternatively, M. Barton Waring suggestssurplus optimization in his recent book, Pension Finance. The takeaway is that plans do not have to invest solely in Treasury bonds. But they do have to accurately account for risk, something that the current approach to liability valuation has short-circuited in the defined benefit model.