Friday, July 12, 2013

Fighting Problems With Non-Solutions

Fighting Problems With Non-Solutions

For the past week or so I’ve been writing about the long-term deficit facing public pension plans.  It’s due in large measure to the fact that our elected officials haven’t been honest with us.  They’ve told us repeatedly that we can fund pensions for our teachers, policemen, and civil servants without fully funding the plans or taking more investment risk.  Of course, the politicians are telling us exactly what we as taxpayers want to hear, that we can have public services, infrastructure, and pensions without having to pay.

Earlier this week I took a look at Pennsylvania’s proposal to institute a 401(K) for new public employees in Pennsylvania (“Swapping a 401(K) for a Public Pension Isn’t Reform:  Pennsylvania [July 10, 2013]”).  While Governor Corbett has done an admirable job of describing the public pension problem in the Keystone State, he hasn’t been able to forge a solution.

Bad Mix (1997)

Senator Orrin Hatch (R-Utah) has put forth a proposal to address the problem.  Over the last couple of years, Senator Hatch has outlined the sources and magnitude of the public pension deficit.  In early 2012 he issued a detailed report on the subject.  However, his proposed solution is no solution at all.[1]  The Senator suggests offering states the opportunity to convert their pension plans into annuity programs managed and backed by insurance companies.  There are all sorts of the problems in the details of this idea, but the major shortcoming is that the proposal doesn’t solve the problem.  Like Pennsylvania’s 401(K) proposal, the Senator’s annuity model doesn’t address the existing deficit.  Instead, it offers new public employees an alternative and inferior form of retirement savings.

Here in North Carolina, Treasurer Janet Cowell continues to seek expanded investment authority.  I’ve critiqued the bill (see, “Expanding North Carolina’s Investment Authority, Again: Parts I and II [May 2-3, 2013]”) because of its approach and my skepticism about alternative investments used in large pension plans.  In a recent interview on CNBC[2], the Treasurer advocated for her bill.  She warned that fixed income, which is a significant component of the pension plan, is unlikely to contribute positively in the next few years.   Clearly, the Treasurer is concerned that when and if interest rates increase significantly, bond prices will fall.  She’s absolutely correct when she suggests that fixed income investments can be risky and may not be a great place to invest in the next few years.

The Treasurer argues that she needs to be able to increase her alternative exposure to as much as 40% so that the pension plan can achieve its investment objective of generating a 7.25% return.   However, when the Treasurer talks about alternative investments, she stops talking about risk.  Instead, she describes alternative investments as diversifications.  I’m sure that legislators and taxpayers prefer investments that provide more diverse sources of return.  However, the Treasurer fails to address the cardinal principal of investments.  You cannot increase your expected return on investment without taking more risk.  In order to have a reasonable chance of generating a 7.25% return (and thereby not increasing the long-term pension deficit in North Carolina), the pension plan will have to incur more risk.  Who bears the ultimate risk?  Taxpayers.  However, by increasing the risk profile of the pension plan, the Treasurer and legislature can avoid having an honest conversation with our citizens.  Frankly, taxpayers aren’t very receptive to honesty, so we’ll continue to get purported solutions that don't solve problems.


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