Overcoming Public Pension Fund Risks?

Pensions & Investments reports, How to overcome public fund risks:

Public employee pension plans are exposed to several risks, not all of which are fully considered by fund officials, and especially state and local legislators.

Robert Stein, chairman of the Society of Actuaries Blue Ribbon Panel on Public Pensions, listed the most important of these risks at a seminar on risk reporting for public plans at the Mossavar-Rahmani Center at the Harvard Kennedy School last month.

The first is the obvious one: Actual investment results not equaling the investment return assumption. Mr. Stein showed one large pension fund's 20-year annual return through 2017 was 7%, and its 10-year return was 4.1%, but its investment return assumption during that period was never lower than 7.25%, its current return assumption.

Other key risks identified by the Blue Ribbon Panel included asset/liability mismatch; interest rate risk — the risk that interest rates will change; the risk that beneficiaries will live longer than expected; and plan maturity — fewer active employees supporting more and more retirees.

Perhaps the biggest risk for public employee pension plans is contribution risk — the risk that the required contributions are not paid, as has happened at several large plans that are now drastically underfunded.

Public employee fund officials should identify and measure each of these risks for their plans, decide how much risk should be taken, and set asset allocations that best reconcile the plan funding programs with the plans' tolerance for adverse outcomes.

Attendees at the seminar, who included academics, actuaries and fund officials, agreed new tools are needed to provide better measurement of the risks confronting public funds.

In my opinion, the biggest risk any pension plan has is a chronic pension deficit. I emphasize chronic because having a pension deficit isn't the end of the world but if it lingers and gets really bad, like less than 50% funded (assets only cover 50% of liabilities) over a long period, then the situation is far more worrisome and may require drastic measures.

There are several ways to confront a pension deficit but my advice is you need to confront it both on the asset and liability front:

• On the asset front, many US public pensions need to get real on the investment returns. Forget achieving 8%, over the next ten years achieving 7% will be very hard without taking huge risks. Most of Canada's large public pensions use much lower discount rates, 5% to 6% to discount their future liabilities.
• As far as liabilities, Canada's top public pension plans have adopted a shared risk model, typically in the form of adopting conditional inflation protection. This is done to share the risk between active and retired members. So, when they run a deficit, these pensions can increase the contribution rate and/or cut benefits by fully or partially removing inflation protection. This is a marginal cut in pension benefits but it has a huge effect, especially for mature plans. It's done for a brief time until the plan's funded status is fully restored. 

The basic message for many underfunded US public pensions is to get real on your investment projections and get real on your liabilities and how you can realistically address them.

When people ask me why Canada's pensions are in great shape, I tell them it's because they've addressed their asset-liability mismatch a long time ago with realistic investment returns and by adopting a shared risk model.

They've also got the governance right and pay their pension fund managers properly to manage as many assets internally as possible, and this across public and private markets.

Compensation risk is a key risk for many US public pension funds which do not compensate their public pension fund managers properly because there is way too much government interference.

In Canada, the governance is such that there is no government interference in the day to day management of public pension funds.

As far as contribution risk, make it constitutionally illegal to take contribution holidays. Period.

Lastly, Ian McGuGan recently wrote an article for the Globe and Mail, A Test For Market Complacency, where he discusses how pensions are taking ever more equities risk to make their7.5% return target and this could lead to trouble when markets buckle (h/t, Denis Parisien).

Go back to read my last comment where I discuss why hedge fund titan Ken Griffin is focusing on tail risks now and why I think every investor needs to focus on managing downside risk here.

My biggest fear is US public pensions are cranking up the risk at the worst possible time. So far, it's working as both interest rates are rising (higher discount rate means lower future liabilities) and the US stock market continues to do a lot better than the rest of the world, which is good because assets are increasing along with rates, the best of both worlds for pensions.

But if something goes wrong, a lot of chronically underfunded US public pensions are going to be caught in the storm and it could be a long and violent one.

Still, there is no denyng there is huge momentum in US markets right now, something that CPPIB's president and CEO Mark Machin recently discussed with Amanda Lang of Bloomberg BNN.

Mark also appeared on CNBC  saying the CPP Fund is diversified geographically and across asset classes, focusing on China, India and Brazil. Listen carefully to his wise insights below.