WASHINGTON — Government officials and pension board members need to be more vigilant about monitoring and evaluating the risks and costs of pension plan investments, given that plans have increased their reliance on riskier investments over the past few decades, according to a new report from two groups.
"It is understandable that public pension plans have implemented ... changes in asset allocation in order to maximize long-term returns and diversify their investment portfolios," said the report released by The Pew Charitable Trusts and the Laura and John Arnold Foundation. "But these changes in investment practice have coincided with an increase in fees as well as uncertainty about future realized returns, both of which may have significant implications for public pension funds' costs and long-term sustainability."
Historically, public pension funds invested most of their assets in fixed-income investments. These types of investments, such as government and corporate bonds, are seen as relatively low-risk because their realized rates of return are unlikely to differ substantially from expectations, the report said.
Prior to the early 1980s, many plans had limited investment options because of regulations. For example, states were limited by "legal lists" that were also used to regulate insurance and savings banks. In the 1980s and 1990s, however, investment restrictions were gradually relaxed in states, so plans had more freedom to invest in a variety of types of assets, the report said.
Beginning in the early 1980s, pension plans began shifting large portions of their portfolios from fixed-income securities to equities. Also, during the past decade, funds have increasingly invested in alternative investments like private equity, hedge funds and real estate, which often have the highest risk but the possibility of the highest rate of return.
According to Federal Reserve data cited in the report, roughly 96% of public pension assets were invested in fixed-income securities and cash in 1952, but only 47% were invested in those "safe assets" in 1992, and only 27% were invested in those assets in 2012.
From 1992 to 2012, the median pension fund's assumed rate of return decreased by 0.25 percentage points, to 7.75% from 8%. But the yield on risk-free, 30-year Treasuries declined by 4.75 percentage points during that period, to 2.92% from 7.67%, the groups said.
The move toward investing more heavily in equities and alternative investments was beneficial to plans from 1982 to 2000, when plan assets per worker more than doubled. And in the fiscal year ending June 30, 2013, the median return for public pension funds was well above the median assumed rate. But public pension funds then experienced large losses during the market downturns in the early 2000s and 2008, the report said.
"There is both an upside and a downside to investing in stocks and other asset classes," the report said.
Plans are relying more heavily on riskier assets to deliver higher long-term returns so that they can keep their funding costs low. When plans maintain high rates of return, governments' annual payments are smaller but the risk of missing the target return rates are higher. When investment returns are below targets, governments have to increase their annual budgetary payments to make up the shortfall, the report said.
"Unfortunately, these increases typically coincide with broader economic problems, meaning that governments are called to put more into the system when they can least afford to do so," the groups said.
Additionally, the shift toward plans investing more in complex alternative investments has coincided with a significant increase in investment fees, though there is wide variation in how state plans' fees have changed from 2006 to 2012, the report said.
The trends of more reliance on risky investments and higher investment fees "point to the need for additional public information on plan performance, insight on best practices in fund governance, and attention to the effect of investment fees on plan health," the report said.
State and local elected officials can work with plan administrators to make sure that the risks and costs of investment decisions are thoroughly understood and are taken into account when decisions are made, the researchers said. Also, government officials can demand better reporting about the costs and risks of investments so they can use this information to figure out how to deal with poor outcomes if they occur.
