Money and Finance

Public Pension Funds Are Adding Risk to Raise Returns

Does anyone think this is likely to end well?

States and companies have started investing very differently when it comes to the billions of dollars they are safeguarding for workers' retirement.

Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

"In effect, they're going to Las Vegas," said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. "Double up to catch up."

Though they generally say that their strategies are aimed at diversification and are not riskier, public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.

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Towers Watson, a big benefits consulting firm, surveyed senior financial executives last year and found that two-thirds planned to decrease the stock portion of their companies' pension funds by the end of 2010. They typically said their stock allocations would shrink by 10 percentage points.

"That's 10 times the shift we might see in any given year," said Carl Hess, head of Towers Watson's investment consulting business. Economists have speculated that a truly seismic shift in pension investing away from stocks could be a drag on the market, but they say it would not be long-lasting.

Corporate America's change of heart is notable all on its own, after decades of resistance to anything other than returns like those of the stock markets. But it's even more startling when compared with governments' continued loyalty to stocks. When governments scale back on the domestic stocks in their pension portfolios these days, it is often just to make way for more foreign stocks or private equities, which are not publicly traded.

Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

(Corporate plans do their calculations differently, and for them, investment returns are a less important factor.)

The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be.

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today's market conditions.

But plan officials say they cannot.

"Nobody wants to adjust the rate, because liabilities would explode," said Trent May, chief investment officer of Wyoming's state pension fund.

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Wisconsin, meanwhile, has become one of the first states to adopt an investment strategy called "risk parity," which involves borrowing extra money for the pension portfolio and investing it in a type of Treasury bond that will pay higher interest if inflation rises.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.

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