The United States’ public pension funds are in a terrible predicament. As of August 2017, Bloomberg reported that 43 out of 50 States have had a disturbing increase in their funding ratio gaps, with only District of Columbia being overfunded out of all 50 states. The PEW Charitable Trusts reports that overall, the public pension fund system is underfunded by more than US trillion, with a record number of Baby Boomers going into retirement. These events spur not only financial, but social crises. If retirees have learnt no wealth creation and preservation techniques other than a dependence on pensions, the U.S. may face a widening of socioeconomic strata en masse.
Initially we blame local and state governments for failing to meet tax dollar fund contributions, and rightly so. Wayne Winegarden, Sr. Fellow at the Pacific Research Institute, states that from 2001 to 2015 total state contributions only met 88% of total nationwide contribution requirements. Full contribution is not expected in the short term, due to increased pension liabilities. States such as Oregon, Minnesota and Colorado have funding ratios gaps of more than 10%; Minnesota’s funding ratio worsened by a whopping 26.6% for FY 2016. That is terrifying from an economic standpoint, filled with nationwide implications reminiscent of Detroit’s 2013 bankruptcy filing. As Winegarden clearly points out, there are three fiscal policies that can mitigate worsening funding gaps:
- Cut promised pensions;
- Levy future tax increases;
- Reduce future government spending.
In addition to these fiscal mitigating policies, public pension funds need to adjust fund return expectations. From the late 1990s to 2000 both private and public pension funds had similar return projections approximating 8%. However, while private pension funds have adjusted fund expectations to consider the tech crash and Great Recession repercussions, public pension funds by and large have not. Indeed, private pension funds now have an adjusted return of approximately 5%, while public pension funds still have expected returns of 8%. Yet, the funding ratio gap widens for 86% the United States’ public pension system.
Second to consider is the change in asset allocation within public pension funds over the past decade. Public pension funds have made a marked shift to alternative investments for portfolio diversification, which have heightened risk and reward implications. The Pew Charitable Trusts (PEW) April 2017 report, State Public Pension Funds Increase Use of Complex Investments, give a thorough overview of issues and challenges regarding the state pension fund system. According to the PEW report, public pension funds have undertaken a stronger portion of alternative investments within fund portfolios that require customized expertise, different from stock and bond management. From a governance perspective, the PEW report states that overall most public pension fund boards may have been lacking in expertise to be part of investment decisions of such complex caliber.
The PEW Charitable Trusts report does not purport that alternative asset allocation is the reason behind our failing public pension system. The PEW report relates that there was no solid correlation between the use of alternative investments and fund performance. However, the PEW report found that pension funds with “long-standing alternative investment programs” outperformed similar funds that made trigger decisions to add alternative investments to the portfolio, where the original strategy consisted of mainly conservative investment vehicles. For instance, the Washington Department of Retirement Systems (WDRS) has one of the strongest track records in fund performance, and has had an alternative investment strategy since 1981, with 36% alternative asset allocation. Conversely, the South Carolina Retirement System (SCRS) quickly changed its fund portfolio to 31% of high yield alternative investments based on a 2007 state stipulation, with 10 year returns decreasing from 8% to 5%, even with a higher risk/reward objective. In addition, public pension fund valuation reporting for both fixed-income, public equity, and alternative investment portfolios has led to confusion in fund performance evaluations.
Third and the most insidious issue is the gargantuan rise in investment fees which public pension funds have faced. The PEW Charitable Trusts clearly delineates that public pension fund allocation to alternative investment vehicles has increased fund investment fees to aggregate US$10 billion as of 2014. Reported fees as a percentage of total assets have increased by 30% to date. And, these figures pertain to reported fees. Unreported performance fees carve a hefty portion of gross fund returns and can remain undisclosed depending on state fee disclosure requirements. According to the PEW report, unreported fees may amount to US$4 billion per annum. Public pension funds need to invest in higher yielding assets, since on the fiscal side contributions are sorely lacking. However, if total investment fees outweigh net returns, we have a further exacerbated public pension liability position.
The PEW Charitable Trusts give specific recommendations to begin the process of effective internal governance within the public pension fund system. Highlights of these recommendations are as follows:
- Public pension investments now have higher risk in portfolios comprising bond, stocks and alternative investments. Investment policy statements must be made fully accessible online for all stakeholders. All statements must fully disclose investment strategies.
- Include performance results by asset class, to highlight the performance and cost of all utilized investment strategies.
- Performance reporting is extremely inconsistent within state public pension funds. Some states report gross of fees, while others report net of fees. All public pension funds should report both net and gross of fees regardless of positive or negative returns.
- Public pension funds do not report comprehensive undisclosed fees such as carried interest. Include line itemization of fees paid to individual investment managers in comprehensive fee reporting.
- Most public pension funds report returns in a 5 to 10 year window. It is recommended to increase fund performance reporting to a 20 year horizon to get a fuller understanding of long-term strategies.
A combination of strong fiscal and governance policies at the state and local level are immediately needed to restructure the public pension fund system, and curb the worsening funding ratios over 43 of all 50 states. Public pension funds need to fully admit the glaring issue of underfunding, and possibly look to successful funds such the Oklahoma Teachers Retirement System or the Washington Department of Retirement Systems for replication of certain investment strategies. State and local overspending on aesthetics and mismanagement needs to be curbed and channeled into the basics, such as pension fund contributions. We cannot depend solely on the U.S. federal government to prevent such a financial catastrophe as possible public pensions default. It is up to the state and local governments to take a long, hard look at current mismanagement and ineffective governance, and bring pension contributions back to positive. We cannot have a replay of Detroit’s 2013 pension fiasco pan out over 43 states.
- Meisler, Laurie. “Pension Fund Problems Worsen in 43 States.” Bloomberg Online. 2017.
- The PEW Charitable Trusts. “State Public Pension Funds Increase Use of Complex Investments.” 2017.
- Winegarden, Wayne. “Step One: Recognize The Public Pension Crisis.” Forbes Online. 2017.