In order to meet the returns required for future pension costs, public pension funds have thus been pushed into equities and other riskier assets. In 1992 just over half their allocation was still in fixed income. As of 2012, only 25% of public pension fund assets were allocated in fixed-income assets or cash – with the remaining 75% in equities and other higher yield alternatives. According to a recent report from the PEW charitable trust:
In a bid to boost investment returns, public pension plans in the past several decades have shifted funds away from fixed-income investments such as government and high-quality corporate bonds. During the 1980s and 1990s, plans significantly increased their reliance on stocks, also known as equities. And during the past decade, funds have increasingly turned to alternative investments such as private equity, hedge funds, real estate, and commodities to achieve their target investment returns.
The report goes on to say that because of this shift towards riskier assets “Public pension systems may be more vulnerable to an economic downturn than they have ever been.” And this was from six years ago, when interest rates were much higher. Today the famously conservative central bank of Germany is talking about negative interest mortgages.
Accounting for Risk in Public Pension Funds
There is one other key reason that public pension funds have transitioned into riskier assets.
States have passed laws exempting state government pension plans from the standards that private pension plans are held to. These public pension plans are permitted to use generous assumptions about risk that are not permitted in the private sector. So, while public pensions have moved into objectively riskier assets, they haven’t been forced to account for that risk.
According to a 2018 report, if public sector pension plans were held to the same standards as the private sector, even with their own extremely optimistic estimates, only Wisconsin’s would be considered stable. To quote the report:
However, the Pension Protection Act does not apply to public sector DB pension plans. Using the states’ own estimates of their liabilities and assets, 32 states are at risk of default by private sector standards. If the Pension Protection Act were applied to the public sector and states had to use a similar discount rate as the private sector, about 4.5 percent, only Wisconsin’s pension system has enough assets to be considered stable.
And this is not a controversial point – an overwhelming majoring of leading economists agree that the government accounting standards used by U.S. state and local governments understate their pension liabilities and the true cost of future pensions. A recent estimation from 2018 calculates that “Unfunded liabilities of state-administered pension plans, using a proper, risk-free discount rate, now total over $5.96 trillion. The average state pension plan is funded at a mere 35 percent.”