Two very good recent books about pension finance, “State and Local Pensions” by Alicia Munnell and “Pension Finance” by Barton Waring, touch on the many daunting challenges faced by public pension systems.
These challenges include funding gaps, revenue shortfalls, required contributions, statutory changes and aggressive return assumptions. The authors also discuss optimal asset allocations within pension funds.
One conclusion reached by both authors is that the liability-matching principle is not frequently used in pension portfolio construction and is, therefore, a fundamental problem in pension fund investing. Significant allocations to equities are evidence of the violation of this matching principle. Public plan equity allocations averaged approximately 50% as of 2009 (the most recent year of full data in the Public Plans Database of 126 state and local pension plans produced by the Center for Retirement Research at Boston College).
Pension liabilities are bond-like obligations in that the promise of payment on a defined benefit pension plan is similar in profile to borrowing current compensation from employees to pay them back in the future in the form of pension benefits. Consequently, pension payouts are very similar in profile to deferred annuities. However, deferred annuity products offered by major insurance companies are primarily backed by fixed-income products. Our most recent data indicate that major life insurance companies, typically the biggest originators of annuities, have fixed-income allocations of approximately 75% while, according to a recent Pensions & Investments survey (Nov. 29, 2012), fixed-income allocations for U.S. public pension plans are approximately 27%. Given the similarity in profile of annuity products and pension benefits, it is surprising there is such a disparity in the composition of the portfolios.
Corporate pension plans already have progressed from the liability-matching principle to full risk transfer. The momentum in pension buyout transactions, including the recent General Motors Co. transaction, might be the start of the sea change in approach by corporate plan sponsors. As sponsors such as GM enter into pension buyout transactions, these pension plans transform into group annuities managed by large insurance companies. As mentioned above, insurance companies manage annuities with fixed-income assets to match their liability. Is it just a matter of time before more public pension sponsors embrace this matching principle?
The primary hurdle between public pension funds and liability matching is the statutory rate structure in public funds. Unlike corporate pension discount rates that are based on historical averages of corporate bond yields, public funds use a fixed statutory rate. With the median rate remaining at 8% and the market experiencing the lowest interest rates in modern history, the statutory rate seems unattainable without taking excessive risk in exchange for high returns.
The rate is also problematic, as Ms. Munnell points out, because it gives a false sense of security with respect to funding levels. Many plans negotiated more generous benefits when funding levels were at or above 100% based on the 8% discounting. These plans are now significantly underfunded after the market crisis and face a steeper hill to climb with increased benefit payments and a lower return market environment.
While an 8% statutory rate in this environment might invite excess risk into a portfolio, we are also concerned about the way pension funds look at expected returns on their assets vs. realized returns while trying to optimize their portfolios. Fundamentally, the expected return on a bond is simple — the yield to maturity. The realized return for a bond portfolio that is held to maturity is the yield to maturity of the bonds less any losses given default. The expected return on equities, however, is significantly more complicated and requires estimates of real earnings growth, inflation, dividend growth and price/earnings multiple projections. Not only is it more difficult to project equity returns, but also returns on equities are much more volatile than all of the major fixed-income asset classes (including high yield). In determining pension asset allocations to meet a statutory return, pension funds should consider the likelihood of realizing the expected return as opposed to simply modeling the expected return.