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Home Publications Blogs Beat the Press Barro on Pension Fund Investments

Barro on Pension Fund Investments

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Wednesday, 25 June 2014 09:28

Josh Barro has a thoughtful piece on public pensions and risk in the NYT's Upshot section. He makes many points with which I agree, most notably raising cautions about pension fund investments in "alternative investments." These are mostly private equity funds, but can also include venture capital and hedge funds. The problem with these alternative investments is that they come with unknown return distributions (essentially the pension funds have a promise that a smart investor will beat market indexes) and they come with high expenses. The public has good reason to be concerned when their pensions start to go more heavily into these alternatives to make up for funding shortfalls.

The issue where I differ is on how pensions need view the risk in the stock market. Josh notes my comment that pension funds don't need to be concerned about the short-term fluctuations in the market, only long-period averages. His counter is that many funds became underfunded when the stock market plummeted and therefore had to boost funding in the recession. He also notes that many pensions cut back funding and even raised benefits when the stock bubble in the 1990s led to considerable overfunding.

This points are correct, but they stem largely from bad projections about future returns, and I don't mean year to year, I mean long period averages. When price to earnings ratios in the market go above long-term averages, it is not possible to get historic rates of return. This means that the return projections used by pension funds in the 1990s should have been adjusted downward since there was no way on earth they would get the 7.0 percent real (10.0 percent nominal) returns that most funds were assuming.

The same story applied at the peak in the pre-recession period. They should have adjusted downward their assumption on long-term returns to a 5.0-5.5 percent real rate (8.0 percent to 8.5 percent nominal). After the market plunged they should have adjusted their return projections upward, which certainly would have been consistent with the sharp bounceback we have actually seen over the last five years. With these adjustments, pension funds would not have suddenly found themselves hugely underfunded even with the plunge in the market that we saw at the start of the recession.

None of this is 20-20 hindsight. I have been arguing this story about long period stock returns for almost twenty years, first in the context of Social Security and more recently in the context of pension funds.

Barro seems troubled by the idea that governments can benefit by investing in the stock market. It is not clear why this should be troubling, after all individuals benefit by investing in the stock market all the time. And the notion of risk arbitrage comes up in all sorts of different contexts.

For example, the claim that we made money on the TARP bailout is entirely a story of arbitrage. In a time where there was an enormous risk premium associated with lending, we made below market loans to favored banks, where the interest rate charged by the government was still above the risk free rate paid by the government. (The claim we make money on the Export-Import Bank is also a story of risk arbitrage.)

In short, we see instances of the government arbitraging risk all the time. It is not clear what policy we would be advancing if we prohibited it from doing so. We do know that such a prohibition would raise the cost of hiring public employees since they obviously value the guaranteed retirement income from a defined benefit pension.

 

 

Typos corrected -- thanks to Robert Salzberg.

Comments (4)Add Comment
Correction
written by Mark Brucker, June 25, 2014 10:54
The same story applied at the peak in the pre-recession period. They should have adjusted downward their assumption on long-term returns to a 5.0-5.5 percent real rate (8.0 percent to 8.5 percent nominal). After the market plunged they should have adjusted their return projections upward, which certainly would have been consistent with the sharp bounceback we have actually seen over the last five years. With these adjustments, pension funds would not have soundly SUDDENLY??? found themselves hugely underfunded even with the plunge in the market that we saw at the start of the recession.
high return assumptions were used to loot pensions
written by rob urie, June 25, 2014 12:27
Former New Jersey Governor Christine Todd Whitman set a national precedent when in the 1980s she raised return assumptions on the state pension plan to reduce the state's required contribution in order to give tax cuts to property owners. Since then the same tactic has been used by various states and corporations have used inflated assumptions for 'private' pensions to boost the value of stock options for executives. Pension regulations have been crafted to allow these abuses. Pension 'consultants' even advise corporations to underfund their pensions while making high risk investments because the plans can be 'put' to the PBGC if things go wrong.
Overt loans were a front; huge interest rate spreads the real story
written by Blissex, June 28, 2014 7:07
«For example, the claim that we made money on the TARP bailout is entirely a story of arbitrage. In a time where there was an enormous risk premium associated with lending, we made below market loans to favored banks, where the interest rate charged by the government was still above the risk free rate paid by the government.»


That's highly misleading, because the risk arbitrage was accompanied by enormous other subsidies based on enormously boosting bank's gross profits thanks to monetary and regulatory policies designed to vastly widen interest spreads and allow for higher leverage and lower reserves, and to lower standards for collateral to "anything goes".

To the point that insolvent banks could borrow money from the Fed at a lower interest rate than that paid by safe government bonds and thus make huge money risk free with a few presses on the keyboard.

Ensuring a huge widening of interest spreads is the "standard" technique used by central banks and government to recapitalize insolvent banks run by their sponsors and refill their executive bonus pools; for an earlier example:

http://www.interfluidity.com/posts/1160447599.shtml
«the spread between the Federal funds (and Treasury bill) rate and the prime rate widened from 1 1/2% to 3% in 1991. That was Greenspan's gift to the banking sector to insure that major banks would not fail.
You may recall at the time that rumors were rife — including some repeated on the floor of the House — that Citibank was about to go under. By doubling the margin between the prime and the funds rate — and essentially increasing the profitability fourfold after taking into consideration the costs of processing loans»

It is not current taxpayers that paid for the banker's new bonuses, it is borrowers, especially small borrowers for credit card and student debt.

The loans given overtly to insolvent banks were just a front; what mattered most was the enormously bigger welfare handouts via interest rate spreads and regulatory "forbearance". Being able to borrow at 0.25% from the Fed using toxic collateral while being insolvent and charge many times that to mostly solvent borrowers with good collateral (who could not borrow from the Fed) is a much huger subsidy than anything TARP offered.

The «made money on the TARP bailout» story is not even remotely «entirely a story of arbitrage».
Local gov pension fund return distribution are known for the past few decades
written by Blissex, June 28, 2014 7:27
«The problem with these alternative investments is that they come with unknown return distributions»
«Former New Jersey Governor Christine Todd Whitman set a national precedent when in the 1980s she raised return assumptions on the state pension plan to reduce the state's required contribution in order to give tax cuts to property owners.»

Oh it is much worse than that. In a blog by some economists who work for the Fed and who look to me tea party attack dogs:

http://macroblog.typepad.com/macroblog/2011/10/state-and-local-fiscal-fortunes-follow-the-money-collected.html

there is a a fascinating chart on "insurance trust revenue" (roughly the pension funds for local government employees) aggregate for USA local governments:

http://macroblog.typepad.com/.a/6a00d8341c834f53ef014e8c52cacf970d-popup

This chart shows the «unknown return distributions» from 1955 to 2010, and the returns on those funds since 1995 are systematically trending lower and far more volatile than a stock index, and the volatility is entirely on the downside. That is when the stock market goes up pension fund returns don't go up as much, and when the stock market market goes down the pension fund returns go down much more than that.

There lies I guess one of the great bribery stories of USA politics.

Because if the pension funds were invested in stock market indexes their returns would not be far more volatile than stock market indexes, either way, so probably they are invested in leveraged stock market derivatives; and that the volatility is entirely on the downside seems to suggest that the derivatives that they purchased from the banks were artfully construct to leave the upside and then some to those banks, and load the downside and then a lot more on the pension funds.

No uncorrupt pension fund would buy such derivatives having the option of buying stock index trackers or safe government bonds.

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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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