While the U.S. stock market has produced one of the longest and strongest bull runs in its history over the past nine years, the financial condition of many of the country’s 6,000 or so state and municipal pension funds has deteriorated. Some are in bad shape.
Yet, even as these pension funds grapple with a huge deficit, $1.4 trillion as of 2016, the drumbeat for exiting investments in certain industries—oil, coal, arms, even car companies—goes on. Should pensions, particularly underfunded ones, make investment decisions based on political litmus tests rather than follow the standard fiduciary duty to make the best returns possible with the least risk?
There’s a strong argument to ignore the calls for divestment, which limit a fund’s diversification. Sectors go up and down in the business cycle, and a portfolio permanently eschewing a key sector—like energy, for example—will likely suffer underperformance through the added risk of loss of diversification across the market’s sectors.
Despite big fluctuations in oil prices over the years, the energy sector of the Standard & Poor’s 500 index is up 159% to date since the end of 1999, third-best out of 11 sectors and similar to the 158% rise in crude prices. Technology? Up 43% over that period, second to last. In late 2016, the California Public Employees’ Retirement System (Calpers) said its exit from some tobacco stocks in 2000 reduced portfolio returns by $3 billion from 2001 to 2014. Diversification pays.
How bad are things at state pensions? An April 12 report from Pew Charitable Trusts on the funding gap in 2016, the latest year for which comprehensive 50-state data is available, put the deficit at $1.4 trillion, up nearly $300 billion from 2015.
Blame the politicians. They have a habit of increasing state employee benefits just before elections. When benefits rise faster than the region’s economy can support, there’s trouble. Illinois is the poster child for underfunding among the states, with a funded ratio of 36% in 2016. What’s happened there is instructive: Benefits have grown over 1,000% over the past three decades, six times faster than the state revenue growth and eight times faster than the median household-income growth. The second reason for pension underperformance around the country is that returns have been depressed by the big drop in interest rates over the past 30 years, which makes it harder for pensions to match assets to liabilities.
Chicago-based Ted Dabrowski, president of Wirepoints, a public policy research, news, and data organization, has had a ringside seat in the Land of Lincoln. Calls for divestment for social goals is “a dangerous policy change,” he says. “The minute you stop investing for maximum returns it isn’t clear what you are investing for. When you start subordinating returns to social goals it gets vague.”
Moreover, in a defined-benefit state pension plan, beneficiaries are often captive investors who can’t opt out, as someone in a private pension can. Some folks might not want to divest from oil companies, as many politicians and activists push for. While some investors are willing to take the potentially lower returns from a less diverse portfolio, many don’t want to.
Steve Crouch is one of them. The director of public employees, Stationary Engineers, Local 39 in California, says, “the pension system’s role isn’t to be socially responsible on certain issues….The sole purpose is to make money for the beneficiaries. If the plan isn’t fully funded, then employers and employees have to make up the difference.” Taxpayers, too, we’ll add.
Pension costs keep going up, and the unfunded liability gets passed along to the employer and employees through contract talks, affecting pay and benefits, Crouch says. He notes that last week 11 California members of Congress petitioned Calpers to divest from car manufacturers failing to meet state emission standards: “Where does it stop?”
And it’s possible, adds Dabrowski, that a state that previously directed its pension system to exit gun makers, for example, might later find itself with new elected officials who remove that limitation.
These state pension deficits could even be worse than they look, says Christopher Burnham, the president of the newly formed Institute for Pension Fund Integrity (IPFI). Burnham was elected Connecticut Treasurer as a Republican, serving 1995-1997.
Estimating the underfunding liability isn’t easy, because much depends on the fund’s assumed rate of return. The higher the rate, the lower the liabilities. The Pew Charitable Trusts report noted the state pensions’ median assumed return rate was 7.5% for 2016, but the median plan’s actual rate of return turned out to be 1%. If the median assumed rate were 6.5%, the underfunding would rise to $1.7 trillion from $1.4 trillion.
Given how low interest rates have been, private pension funds have used a more conservative return assumption, about 4.5% according to IPFI. Burnham says that if public pension funds used the most conservative return rate, total state and locally administrated pension liabilities could be more than $6 trillion. “Politics has no role to play in the fiduciary responsibility and the management of other people’s money, especially when pension funds are egregiously underfunded,” he says. Asset-class inclusion in a pension should be chosen on return and risk profiles. The fiduciary responsibility is “first and foremost. And risk is best dealt with through diversification,” Burnham adds.