In a recent article in Pensions & Investments, Robert Pozen took the industry to task for recent changes in the allocation of pension plans:
As corporate pension plans have shifted away from equities, they have substantially increased their allocations to high-quality bonds after the financial crisis. Most of this increase was concentrated in U.S. Treasuries with maturities of one to 10 years. In making this move to high-quality bonds, the trustees of corporate pensions were trying to “de-risk” their portfolios. In their view, more bonds would mean lower annual volatility for their portfolios, which would in turn minimize future corporate contributions to the plans.
Yet this reduction in annual portfolio volatility comes with a price — lower long-term returns. The expected returns of U.S. corporate pension plans now are around 8% per year. The average corporate pension plan was 82% funded in 2009, and that will reportedly fall to 75% by the end of 2010.
Risk is like matter in physics-it cannot be created or destroyed. Like matter, it just changes form. Pension funds have not actually “de-risked.” They have reduced volatility and simultaneously increased their risk of long-term underperformance, not to mention drastically increasing their interest rate risk. As Pozen points out, this is a big problem because of the terribly underfunded state of pensions today:
Like their corporate counterparts, public pension plans are facing large funding deficits. These plans were on average about 80% funded in mid-2009, and at least eight state plans were less than 65% funded. Even these estimates are overstated because of the unique accounting rules applicable to public pension plans. If public plans were subject to standard pension accounting, their funding deficits would be 20% to 30% larger.
Up to now, public pension plans have been allowed to compute their deficits based on the returns they expect from their portfolios, rather than relevant current interest rates. The Governmental Accounting Standards Board has proposed that public plans begin to use current interest rates of high-quality municipal bonds. However, this proposal would be confined to calculating cash flows needed to eliminate a plan’s current deficit. It would still allow expected returns to be used for valuing existing plan assets.
Given these accounting rules, it is not surprising to see that public pension plans have set expected returns of 8% per year for their investment portfolios.
Wow! I’d like to be able to report my performance based on my expected return too! (I added the italics, just because it is so mind-boggling.) Why stop at 8%? Public pension plans could eliminate their funding issues simply by assuming that would earn 20% per year! Besides the bogus accounting for funding deficits, Pozen points out the other flaw in “de-risking:”
To achieve these returns, public pension plans have decreased their equity allocations and instead allocated much more to alternative investments. In other words, public pension plans have not “de-risked” their portfolios by replacing stocks with bonds. Instead, public plans have “up-risked” their portfolios by replacing stocks with hedge funds and private equity funds.
Posted by Mike Moody 
