Friday, December 5, 2014

Why do US public pension funds carry so much risk?

Under-funded pension funds can "catch up" by either (1) saving more or cutting benefits; or (2) going into more risky investments that have higher expected return, which makes the current liabilities look smaller (because future liabilities are discounted at the higher rate).  They often choose the latter because it is less painful, at least in the short run, than the former.

In November the Society of Actuaries noted that “public sector plans in the U.S. are unique in that they have taken additional risk as the plans have become more mature, compared to private sector plans in the U.S. and private and public sector plans in Canada, UK and the Netherlands, which have taken less risk as plans have matured.” The reason: GASB accounting rules let U.S. public plans credit themselves with the higher returns on risky assets before those returns are earned, creating an artificial incentive to take risk. U.S. corporate pensions and public plans overseas may credit themselves only after investment risks pay off, and thus better balance risk and return.

To see how much they are over-investing, they compare the actual asset allocation (75% in risky investments for California) vs. a conservative "rule of thumb" for individuals:

Many individuals follow a rough “100 minus your age” rule to determine how much risk to take with their retirement savings. A 25-year-old might put 75% of his savings in stocks or other risky assets, the remaining 25% in bonds and other safer investments. A 45-year-old would hold 55% in stocks, and a 65-year-old 35%. Individuals take this risk knowing that the end balance of their IRA or 401(k) account will vary with market returns.


  1. Yet another terrible side-effect of our fed action post 2008. Asset/Liability matching has been largely off the table because YTM on bonds across the spread and term structures are terrible. It's less than clear that adding risk will be the right decision. I think it will end poorly.

  2. In the summer of 2014 Calpers announced their withdrawal from hedge funds. Calpers, with a total asset pool of $301 billion, withdrew approximately 40% of their hedge fund allocation down to 1.5% of total funds by the end of June. As one of the largest public pension funds, the decision by Calpers to readjust their hedge fund allocation helped influence the decision by other states, such as Ohio and New Jersey, to evaluate theirs too. Ohio has chosen to lower their investment to 10% from 15% and New Jersey went down to 12% from 12.25%.

    The decision to move away from hedge funds was primarily motivated by the lower returns experienced in recent years as well as fee structures. By the end of March the average public pension plan saw a 3.6% return over a three year period as opposed to the 10.9% return seen in private equity funds. Hedge funds also have more expensive fee structures. The average hedge fund charges fees on 2% of total assets held and 20% of profit.

    Fitzpatrick, D. (2014). Calpers Pulls Back From Hedge Funds. The Wall Street Journal. Retrieved from

  3. It’s obviously not used properly and often invested at wrong place with too much expectation. I believe the best investment for anyone is Forex trading, it’s a legitimate business. Also, I am at the moment trading with OctaFX broker, it gives us even better opportunities with 50% bonus on deposit that too one which is use able, so that’s why I am able to work smoothly and this is why I consider this as the best way of investment for all.

  4. All investment decisions involve a trade-off between current sacrifice and future gain (froeb, 2016).
    Because of their high fees, hedge funds have definitely seen an exodus of sorts as investment managers are taking a closer look at the sacrifice versus the gains.
    Given the fluctuation in the stock market, and the fact that we have an aging population – advancements in medicine and technology are keeping people alive longer than their previously figured actuarial assumption – the pension fund industry is changing.
    The PBGC guarantees a significantly lower benefit level for participants in a multiemployer plan than it offers for single employer plans, and retirees could see a drastic reduction. If a multiemployer plan goes insolvent, a retiree is only guaranteed a maximum of 12870 per year (Hicken).
    Many unions need to play “catch-up”. Unions generally pay an actuarial consultant and an investment consultant to assist the Board with any decisions regarding funding. Going into risky investments, while having a higher expected return, can also see large losses if there are continuing problems with the stock market.
    Ten years ago, “public pensions stayed away from hedge funds”. However, in recent years, more pension funds have invested in them. The problem is that the fees are higher than most investment options. “Hedge funds general charge a 2 and 20, every year they take 2% of all the money you have invested and 20% of any profits”. Most public pension invest billions of dollars. The TRST is investing 10% of its money in hedge funds, state of NJ is investing 12% and Ohio school Employees is 15%. (Arnold, 2014).

    Arnold, Chris. (2014). Some Public Pension Funds Making Big Bets on Hedge Funds. Retrieved

    Hicken, M. Retired Union Workers Facing ‘unprecedented’ pension Cuts. CNN Money. Retrieved from

    Froeb. (2016). Managerial Economics.