U.S. Public Pension Plans are Different (and Not in a Good Way!)

Posted by Jeffrey Brown on Jun 11, 2012

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy)

I have written numerous blogs about the frustration that the financial economics community has with the Government Accounting Standards Board (GASB) rules that govern the way we account for public pension liabilities in the U.S.  The basic problem is that GASB standards do not account for risk in an appropriate way (in fact, they do not really account for it at all!)  Instead, they allow public plans to under-state the size of their liabilities by acting as if they have a risk-free approach to investing money at approximately 8 percent per year forever.

On occasion, someone will ask me if this is really just an accounting issue, or whether it actually has real effects on real-world behavior.  Although I can give countless anecdotes for why it affects real behavior, it is always better when a highly respected and disinterested party can provide rigorous empirical evidence to support the claim.

Well, now we have such evidence.   Just last month, three financial economists (Andonov, Bauer and Cremers) publicly released a rigorous new research paper entitled “Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?”  In this paper, the authors use an international database to look at the asset allocation decisions and discount rate assumptions of both public pension funds and non-public pension funds in the U.S., Canada and Europe.  What is particularly nice about this paper is that it is able to show what outliers U.S. public plans really are.  Not only do they look quite different from corporate DB plans in the U.S., but they also look different from both public and non-public plans in other countries.

Specifically, the authors state that “U.S. public funds seem distinct in that they can decide their strategic asset allocations and liability discount rates largely without much regulatory interference, due to wide latitudes allowed in the currently applicable Government Accounting Board (GASB) guidelines. In particular, these guidelines link the liability discount rates of U.S. public funds to the (assumed) expected rate of returns of the assets, rather than to the riskiness of the liabilities as suggested by economic theory.”  As I have written before, this is an intellectually vacuous approach to discounting.  What I had not fully realized is how unique this mistake is to U.S. public plans.  The authors go on to state that in Canadian and European funds – both public and private – liability discount rates are “typically … a function of current interest rates,” an approach which (assuming the interest rate is chosen appropriately) is much more in line with basic economic theory.

The most striking finding is the impact that this difference in accounting has on real behavior.  The authors find that “in the past two decades, U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities.”  This really is a case of the tail wagging the dog – by allowing an intellectually flawed approach to discounting to be codified in GASB standards, we have provided incentives for public pension fund managers and their boards to over-invest in risky assets.

There are many losers from GASB-induced deception.  Public workers end up with less-well-funded pensions.  Taxpayers end up bearing financial risk without realizing it.  Investors in public debt are given inaccurate information about the size of the pension liabilities.  Isn’t it time that we fix this?

4 Responses to “U.S. Public Pension Plans are Different (and Not in a Good Way!)”

  • Ronald Dolgin says:

    Excellent, but more is involved. There is an even greater risk with our Illinois public pensions, that of political manipulation and criminal activity, as was shown in the case of the Illinois State Teachers Pension fund. The Trustees were packed by Blago et al with connivance of Rezko, they revoked prior limits and allowed 10% into Hedge Funds, paid a massive finders fee and massive commission to their political hack at Bear Sterns, made the investment and the Fund promptly went belly up. I may not have it exactly right, but pretty close. As soon as he took office, Blago set out to take over more control of the funds. There must be even more reforms to insulate funds from our corrupt political elected and appointed officials. R. Dolgin, LCSW, MBA

  • Jeffrey Brown says:

    Ronald … I absolutely agree that public pension fund governance is incredibly important and too often ignored. In many states, they are subject to political influence. When elected, the board members often have personal incentives that may differ from their interests as fiduciaries. And too mamy board members lack the financial expertise to be effective.

  • Ronald Dolgin says:

    I just read a blog which makes some related points, in regard to the economic costs of crony capitalism, Cochrane says economists can and should measure these: http://johnhcochrane.blogspot.com/2012/06/crony-capitalism.html#more.
    The research you cited affords a start to measure economic cost of “corrupt practice” in that the amount of added risk accrued by public funds over the private funds was measured.

  • Jeffrey Brown says:

    Thanks Ronald.
    John Cochrane is a heckuva good economist (as is Luigi Zingales, who he writes about). No question that cronyism is enormously costly – it is akin to a distortion of relative prices, which leads to an inefficient misallocation of resources. Measuring it in the context of public pensions is not easy, but I have an ongoing research project that looks at the over-investment by public pensions in firms headquartered in the state. Among other things, we are looking at how the over-investment decision is correlated with voting behavior. May post on this some day.