America’s public pensions are in trouble. On current trends, these funds will not be able to meet all of their obligations to their beneficiaries—teachers, police officers, nurses, and other public servants. Between 2006 and today, the average funded ratio of major public pensions has dropped from 83 percent to just 72 percent—meaning nearly 30 percent of pensions will not be paid, unless taxpayers cover the difference. In dollar terms, we estimate that gap at $1.6 trillion.
The situation has been deteriorating for some time and has recently been made worse by three structural changes. First, life expectancy is rising; today’s retirees will be drawing their pensions for about two years longer than in 2000. That accounts for about $300 billion of the funding deficit, by our calculation. Second, in a related phenomenon, the population is aging; fewer working-age people are supporting more retirees. The ratio of pension contributors to beneficiaries has shrunk, from 2.8 in 1991 to 1.6 in 2013.
Third, the markets in which pensions invest have changed. In the 1980s, when many current portfolio managers came of age, high interest rates on Treasury bonds made returns of 7 percent or more relatively easy to achieve. Pensions invested heavily in fixed income. Between 1992 and today, however, the average annual yield on 30-year Treasuries has fallen from about 7.5 percent to about 3 percent. Meanwhile, the return assumptions used in pensions’ calculations long remained at 1980s levels.
The gap between expectations and reality has become wide and noticeable, and under public scrutiny, pensions have begun to gradually reduce their discount rate—from 8.2 percent in 1999 to 7.4 percent today. That has pushed up estimates of future liabilities by about $150 billion.
Pensions have also shifted their investments away from low-risk fixed income and toward higher-volatility equities and alternative assets. Pensions’ fixed-income allocations have shrunk from more than 75 percent in 1982 to just 27 percent today. Allocations to equities increased dramatically, and allocations to alternative investments more than doubled between 2006 and 2012, from 11 percent to 23 percent. So when the global financial crisis hit, pensions were far more exposed to risk than ever before. Pensions have slowly recovered from their investment losses, but they are still well behind their pre-2008 trajectory.
The hard way
Two solutions—increasing contributions to pension funds and cutting benefits—are immediately obvious. But neither is easy to do. Funds could ask for greater contributions from workers, but achieving this is politically difficult. Only a few states have been able to get the required legislation passed. Even when these bills are enacted, the changes tend to be too small and compromised to make a difference. Between 2008 and 2014, almost all legislated increases were from 1 to 3 percent—and they were offset by decreases in employer contribution rates. In addition, most increases affect only future members rather than current contributors.
Cutting benefits is also a significant political challenge. Thirty-five states cut benefits in some manner between 2008 and 2011, but most of these shifts apply only to future retirees. Twelve states made changes that affect active members, and eight enacted reforms affecting retired beneficiaries.
To be sure, there are some bright spots in benefit reform. Rhode Island raised the retirement age and began a transition to a hybrid defined-benefit/defined-contribution plan. It also suspended its cost-of-living adjustments until the pension’s funding reaches 80 percent of liabilities. Together, these reforms cut $3 billion of the state’s unfunded liability of $7 billion. However, most states have done much less, or nothing at all, opting instead to kick the can down the road.
A third option
Improving investment performance is not simple, but for many institutions it may be easier to accomplish than cutting benefits or increasing contributions. Strengthening the pension organization and deepening its skills and knowledge can produce superior investment returns. Both the Washington State Investment Board (WSIB) and Teacher Retirement System of Texas (TRS), for example, have embarked on serious programs to boost their returns. WSIB has been among the highest performing state funds over the past ten years, while TRS ranks as the top-performing pension investor in private equity after pursuing a program focused on that area. These pensions and other top performers are taking three core steps to improve their investment performance.
Most critically, top performers recognize the need for a full staff of professional portfolio managers. The typical US public pension is run on a shoestring. Top US public pensions average more than $1 billion in assets under management for each employee, including noninvestment and administrative staff. One state fund manages about $175 billion with a staff of 50; that’s $3.5 billion for each portfolio manager, IT manager, and executive assistant. Compare that with other investment organizations, where similarly huge funds are managed by much larger staffs. BlackRock, the largest asset-management firm, oversees $4.77 trillion with more than 12,000 employees (more than $358 million per employee). The Canada Pension Plan Investment Board manages $265 billion with a staff of 1,157 ($229 million per employee), while the Ontario Teachers’ Pension Plan manages $155 billion with a staff of 1,100 ($141 million per employee). These pensions, despite (or perhaps due to) their fuller staffs, tend to be among the better-performing funds.
Not only must pensions add staff, but that staff must also be paid well; boosting compensation is a second essential step. Plenty of talented investment professionals are keen to serve the public but find the drop in pay that they would experience in leaving the private sector too steep to bear. The success of Canada’s pensions in drawing talent away from the private sector has been due in no small part to their adherence to pay-for-performance concepts, including bonuses, and a deeply seated performance culture. The result is considerably higher compensation—in our estimate, up to ten times higher than in the United States—and performance that justifies these paychecks. Yet getting agreement from state legislatures for big pay raises will not be simple; nor will it be easy to gain understanding from taxpayers. But make no mistake: improving investment performance will require an overhaul of the way pensions attract and compensate their investment professionals.
Third, US pensions must upgrade their governance approach. In Canada, home to several of the world’s top-performing public pensions, pension boards tend to be drawn from the ranks of business professionals. In the United States, by contrast, boards tend to comprise public officials, union representatives, and employee representatives. Twenty-eight percent of Canada’s board members have an investing background, more than double the 12 percent at top US public pensions.
This lack of experience is costly. American boards are often less familiar with the operating models and investment needs of institutional investors. In a study of 35 of the largest North American pension funds, we have found a positive and statistically significant relationship between a pension board’s investment experience and its funded ratio. It appears that boards with greater investment experience are taking the steps necessary to preserve pension funding, while others are lagging behind.
Funds that have professionalized their investment organizations and boards get better results. The big Canadian pensions all have funded ratios above 90 percent (with most of the top ten above 98 percent), compared with the US average of 72 percent.
And this difference is likely understated, as most Canadian pensions use more conservative discount rates to calculate liabilities than their US peers.
How do they do it? Our research has found that across all institutional investors, top performers display consistent strengths in five areas: the mandate, the governance model, the investment philosophy, the investment strategy and processes, and talent management. The mandate and governance model provide strategic direction and effective leadership toward the organization’s goals, while the investment philosophy, investment strategy, and talent management ensure that the investor capably executes its core function: putting money to work.
Better investment performance from highly capable organizations will not be enough on its own to eliminate the funding gap that America’s public pensions face. But it is a vital—and too-seldom discussed—component of the total solution. If pensions put their investment house in order, they can more credibly ask for major contribution and benefit reforms. In that way, they can bend the “third rail” of politics—the programs that support Americans in their old age. America’s state pensions should act now to stem the crisis, and improving investment performance is the right place to start.