Reducing Risk and Restoring Our Pension Benefits
By
Rudy Fichtenbaum
Currently STRS is taking a lot of risk and that risk has been increasing over time. STRS along with other pensions have shifted their asset allocation away from fixed income towards equities. A big part of the shift toward equities has been through alternative investments most of which is in the form of private equity or investing in hedge funds. At the end of the day, equity is equity, and we can see this when we look at the correlation between public equities, those traded on stock markets, and private equities, deals in the alternative space that have very high expenses. They are highly correlated - - they move up and down together. Historically stocks and bonds were seen as being uncorrelated so having a balanced portfolio was seen as a way of reducing risk. One problem facing STRS and almost all other pensions is that returns on fixed income have been declining and so pensions have been looking for alternatives to fixed income, hence the development of “alternative investments.” But alternative investments, created by Wall Street, are just expensive forms of equity or involve making loans, which are equivalent to buying bonds (fixed income).
Investing is buying assets that generate cash flows. The assets that generate cash flows are stocks
(equities – both public and private) generate dividends, bonds (government and corporate bonds and private loans) generate interest and real estate (commercial and residential). What gives an investment value is that it generates cash flows in the future and the prices of stocks, bonds and real estate are fundamentally related to the value of those cash flows. Some investors may also buy commodities, like oil futures, gold, art, cryptocurrencies etc. These are considered speculation (as opposed to investing) because they do not generate cash flows. The only way to make money on speculating is for prices of assets to go up. This means it is a zero-sum game i.e., whatever one person gains the other loses. There is no way to put a value on speculative assets because they do not generate cash flows in the future. The only other way to “make money” involves gambling. Gambling is making a bet that some assets will go up or down. The problem with gambling is the odds are stacked in favor of the house.
With investing, because there is a stream of cash flows, the expected value of the assets should rise over time if the economy grows. How much they rise depends on the rate of growth in cash flows and the value that people put on those cash flows that they can receive in the future. The further out in the future that one receives cash flows the lower the value because it is better to have a dollar today than it is to have a dollar tomorrow.
Speculating has an expected value of zero. Think about flipping a coin. If the coin is fair, and you flip it a thousand times it will come up heads 50% of the time and tails the other 50% of the time. So, trying to make a living by guessing whether a coin will come up heads or tails is a fool’s errand. With gambling, the expected value is negative. Think about a dealer in a casino flipping the coin and each time the coin is flipped the casino charges a fee. If two people play the coin flipping game in a casino, statistically they will both lose because the expected value is zero minus the fee both pay to play.
Buying stocks, bonds, and real estate, can involve elements of investing, speculating, and gambling. Buying an index is nearly the purest form of investing because the fees are low, and you are buying the right to receive a future stream of cash flows. When you engage in active investing there is an element of speculating because you are guessing that one company or property will produce larger cash flows in the future and that people will put the same or possibly a greater value on those cash flows in the C future. Think about the economy as being a series of bets on the future performance of various businesses. Betting that the economy will grow over a 20-year period in the future is like buying an index. But betting that you are smart enough to pick which companies and properties will be winners and losers in the future is a lot more like speculating. Unless you have information or some other edge that no one else has, the odds of consistently beating the market are vanishingly small. Moreover, when you consider that there are fees involved in active management and purchasing alternative investments, your purchases of these assets are a lot more like gambling in a casino run by Wall Street.
The other major risk for STRS is a draw down that could ultimately cause the pension to be insolvent resulting from a significant decline in markets. Historically, markets have always had periods in which they go up followed by periods of decline. Right now, we are in the longest expansion in U.S. history and the longer it goes on the more likely we experience a significant downturn. (The downturn caused by COVID-19 was so short lived that it did not have a significant impact on the value of STRS’s assets.)
Now you may be thinking that STRS has weathered many downturns so what’s the big deal. After all, STRS even survived the Great Recession. The difference is that in 2008 the net cash outflow (the difference between contributions and payments) was about $2 billion a year. Today the net cash outflow is about $4 billion per year.
Here is the way to understand the possibility of a drawdown. Suppose there is a 25% decline in STRS’s assets which are close to $100 billion. That would reduce assets to $75 billion. For STRS to get back to $100 billion it would need to increase its assets by 33% which would mean several consecutive years of earning double-digit returns. It would need to earn at least 5.3% just to stay at $75 billion. If the rate of return were 3.5% for the year assuming that payments are made at the beginning of the month and returns are received at the end of each month the pension would have $73.7 billion at the end of the year and so to get back to $100 billion would require a 36% increase. What is happening here is that even when the pension earns positive returns, they are not enough to cover the cash outflow so at the end of each month there is less to invest. The following year it will take at least 5.4% just to stay at $73.7 billion. So, it is easy to see how a pension like STRS could face a drawdown from which it cannot recover.
The best way to mitigate the risk that STRS faces is to index its investments and find an alternative source of cash, one that does not come from investing, but comes from using its balance sheet and the advantages (the edge) it has over banks and hedge funds to earn fees. So instead of paying Wall Street, Wall Street will be paying us for providing liquidity which they need to survive. Our fees will be either negatively correlated or uncorrelated with equities and will allow STRS to significantly increase its earnings while reducing risk. By having a significant additional source of cash STRS will over time be able to lower its exposure to equities and have the cash needed to restore our COLA and reduce contributions and restore other benefit cuts for active members.
STRS is our pension, we paid for it, and it is time for the Board and the senior staff to recognize that at the end of the day the only reason the pension exists is to pay benefits to members.
Dr. Rudy Fichtenbaum is Professor Emeritus of Economics at Wright State University. In May, 2021, he was elected to a retired seat on the STRS Board, effective September 1, 2021
