WASHINGTON - A new report from the Center for Retirement Research at Boston College finds that that public sector pension plans have riskier portfolios than private plans and have optimistic projections about their assumed rate of return.
“This situation is worth monitoring closely because optimistic return expectations could yield required contributions that are ultimately inadequate to meet benefit obligations and, thus, threaten the financial stability of public plans,” said the report released Tuesday.
Kroll Bond Rating Agency said in a new commentary that the findings highlight how sub-par plans exacerbate the problem of low returns with dramatic and aggressive shifts in allocations.
State and local pension plans use their assumed investment return – 7.4%, on average, in 2017 – to value liabilities and calculate required contributions,” said the Boston College report co-authored by Jean-Pierre Aubry, associate director of state and local research, and Caroline Crawford, assistant director of state and local research.
The health of state and local pension plans has become more interesting to muni market participants in recent years, as municipal bankruptcy proceedings have demonstrated that bondholder and pensioner interests often collide.
Another study also issued by the Center for Retirement Research released last July found that the average annualized return for public pension funds was only about 5.5% during 2001-2016.
The July study found that investment returns by plans in the top and bottom quartiles varied from 6.35% to 4.6%, which the study said “could account for roughly a 20-percentage-point disparity in their funded ratios.”
In addition, investment allocations have changed in recent years.
From 2001-2008, the average allocation to fixed income, stocks, and other non-traditional asset classes – alternatives such as private equity, hedge funds, and real estate – was roughly the same for public and private plans.
More recently from 2009-2015, public plans invested in “a significantly larger share in risky assets than private plans,” the new report said.
Public plans invested 72% of their money into what the authors categorized as risky assets such as hedge funds and real estate while private plans were only 62% invested in that category.
The public plans were 50% invested in equities and 22% in alternatives.
Funds in the bottom quartile of performance increased their allocation to alternative investments from 7% to 33% between 2001 and 2016, KBRA noted.
In addition, a 2016 study by Pew Charitable Trusts on State Public Pension Funds’ Investment Practices and Performance found that the shift to alternative investments led to higher management fees. Pew found a 30% increase in fees over 10 years.
“One of the hardest tasks for a fund manager is to reverse poor performance,” KBRA said. “Indeed, due to the size of many pension plans, particularly those burdened by a few consecutive years of low returns, pivoting away from subpar performance can be likened to turning the Titanic. The larger the plan, the less likely that subtle changes in allocations can make an appreciable difference in overall performance. Therein lies a quandary; attempting to compensate for low returns with dramatic and aggressive shifts in allocations toward sectors such as alternatives, especially the wrong ones, can exacerbate the problem.”
KBRA’s bottom line: “Investment performance remains a crucial component of the health of pension funds and explains a significant portion of the funding disparity.”
