Congressional Budget Office - Public Pension Plans - Risk

From Mario Iacone, May 20, 2009

I have repeatedly expressed for some time that STRS has too high of a percentage of risk based investments. I have also communicated such to STRS and Board to no avail.

STRS is NOT a WALL STREET INVESTMENT FIRM! STRS members are not stock investors knowingly and willingly taking risk to accumulate wealth.

STRS IS a TEACHER PENSION FUND! STRS members make mandatory contributions saving money for their pensions believing that they are not taking risks and will receive guaranteed benefits.

For sometime now, I have been trying to point out a serious problem affecting STRS members as a result of the fund being so heavily weighted in risk equities. Risk equities such as stocks may produce higher returns in the long term, but serious short term decline in the markets or a serious downturn in the economy, such as the current one, causes problems for the fund and its members.

The serious short term downturn in STRS investments appears to necessitate current changes and cuts in the pension plan which will result in reduced benefits for the entire membership, active and retired.

That situation led me to observe and conclude,

Increased Risk may provide Better Long Term Gains, but has also caused Short Term Cuts for the members, many of whom will not benefit from future long term success. That statement is based upon my personal opinion and observation.

However, recently I was referred to a letter written by the CBO to the PBGC advising PBGC against increasing risk in their investment portfolio and stating why such should not be done.. Their advice and guidelines regarding too much risk in public pension plans is very similar to my personal observations of the STRS situation.

This Congressional Budget Office (CBO) risk level guideline for public pension funds was issued in April, 2008, before the 2008 crash.

The advice was not given in hindsight. Much more detailed information is available on CBO website. Type PBGC in the search box. Also check out their guidelines for public pension funds. Government Accounting Office (GAO) basically ruled the same.

CBO issued a letter today reviewing a new investment policy recently adopted by the Pension Benefit Guaranty Corporation (PBGC). As part of its analysis, CBO reviewed the assumptions underlying PBGC’s decision and assessed the revised policy’s potential for affecting the corporation’s ability to meet its obligation to retirees and for increasing costs to taxpayers.

Prior to February of this year, PBGC’s investment strategy was to hold about 75 percent of its portfolio in bonds, with the duration of those assets matched to the corporation’s obligations. The remainder of the portfolio was invested in equities. PBGC’s new strategy reduces to 45 percent its allocation to fixed-income assets, in order to increase the proportion devoted to equities (45 percent) and to further diversify into alternative asset classes (10 percent).

The change in investment strategy represents an effort on the part of PBGC to increase the expected returns on its assets and to diminish the likelihood that taxpayers will be called on to cover some of its liabilities. The new strategy is likely to produce higher returns, on average, over the long run. But the new strategy also increases the risk that PBGC will not have sufficient assets to cover retirees’ benefit payments when the economy and financial markets are weak. By investing a greater share of its assets in risky securities, PBGC is more likely to experience a decline in the value of its portfolio during an economic downturn — the point at which it is most likely to have to assume responsibility for a larger number of underfunded pension plans. If interest rates fall at the same time that the overall economy and financial markets decline, the present value of benefit obligations will increase, and the pension plans likely to be assumed by PBGC will be even more underfunded as a result.

The effect on taxpayers of the change in PBGC’s investment strategy depends on assumptions about future premiums and benefits and expectations about the government’s ultimate responsibility to covered retirees. Although the Employee Retirement Income Security Act of 1974 (ERISA) explicitly states that the federal government does not stand behind PBGC’s obligations, an implicit expectation exists among many market participants and policymakers that taxpayers will ultimately pay for benefits should PBGC be unable to meet those obligations. If policies governing future premiums and benefits remain unaffected by the new investment policy, taxpayer’s increased risk of substantial losses will be balanced by the higher expected returns that the new policy allows. However, if the higher expected returns mean that premiums are reduced or benefits increased relative to what would otherwise occur, plan sponsors or beneficiaries will reap some of the benefits of the change in investment policy, but taxpayers will bear the added risks.