(April 9, 2013) — Last week, Japan’s largest pension fund, the Government Pension Investment Fund (GPIF), revealed that it is reviewing its asset allocation. As part of Japan’s movement toward “Abenomics,” the pension will be cutting back on its highly concentrated (67%) allocation to Japanese sovereign debt.
The GPIF is realizing that, besides the interest rate risk they take with such a large fixed income holding, they are also incredibly concentrated in one asset class, in one nation. Diversifying Japan’s national pension fund investments is wise—and US Social Security should do the same.
Social Security faces the same issues other pension funds face: longevity risk, reliability of funding sources, asset management. Yet, the Social Security trust fund is completely undiversified in its portfolio. That portfolio is entirely composed of obligations of the United States Treasury. This makes it riskier than it should be. Unlike practically all pensions in the world, Social Security is invested entirely in one asset class, in one country—an approach that would be illegal under US law for corporate pensions. More diversification would provide greater long-term security for the fund and would provide the opportunity for the national retirement system to be healthier and better funded over time.
In the United States, we tend to think of Social Security as something distinct from pension plans. But essentially, it is the same thing. Contributions go into a pool that covers all of us until we die. In a corporate pension plan, the plan sponsor makes the contributions (employees do not see this contribution to the pension plan as part of their compensation, though employers surely see it as a cost of employment); in most public plans employees and the government both see themselves as “contributors” to plans (indeed many public negotiations are about how much the employee will contribute); and in Social Security our “contributions” are taken in payroll taxes that are targeted for Social Security.
Most pension plans pursue prudent and diverse investing to allow growth and reasonable security of their assets over decades. The world’s best pension plans have highly diversified investments that are not concentrated in one asset class or one country. The Teacher Retirement System of Texas is one of the world’s leading investors and has only 22% invested in bonds, and that is not all in treasuries. The Canadian equivalent of Social Security is called the Canada Pension Plan. Its funds are invested by the Canada Pension Plan Investment Board (CPPIB), a completely independent investment organization with hundreds of employees and senior offices as far away as Hong Kong. It has 34% in fixed income. Texas Teachers has returned 7.2% over the past 10 years. CPPIB has returned 6.7% over the same periods.
The Employee Retirement Income Security Act (ERISA), a federal law that regulates private sector defined benefit plans, actually creates a fiduciary requirement that pension plans prudently diversify their investments. The current “investment policy” of Social Security (investment entirely in treasuries) would violate that federal law if Social Security were governed by it.
Over the last 10 years, the annualized return on 30-year government bonds has been 5.8%. That is only a point or so below Canada’s returns, but remember: according to the official website of the Social Security Administration, ten years ago, at the end of 2002, the Social Security Trust Fund held $1.4 trillion. That one percent difference, compounding annually on $1.4 trillion over ten years would have been about $150 billion! The return on US treasuries is often spoken of as the “risk-free rate.” Yet we know that no investment is risk free, and the 2011 downgrade of the US credit rating suggests that some investments today are sounder than American sovereign debt. More important than the risk of loss (negligible) is the risk that returns will be lower and riskier than a more diversified investment portfolio would provide. This is particularly true today as many market participants anticipate that rates could rise substantially and quickly; if that were to happen, the value of Social Security’s portfolio could drop significantly.
Plans like Texas Teachers and CPPIB invest heavily in private equity and hedge funds. They’re sophisticated, long-term investors able to analyze the risks and rewards of those investments. Social Security should not go that far. But a sensible start would be to diversify a bit out of its current “one asset from one country” policy. Those more diverse investments should not just go into one asset class, but into a globally diversified portfolio that will provide for a safer and stronger future for our economy and for Americans’ retirement.
In Japan, it is traditional for investors to hold large amounts of the nation’s own debt. Yet even with that tradition, the GPIF has concluded that a two-thirds allocation to the nation’s own debt is too high. If two-thirds is too high in Japan, then 100% is surely too high in the US.
Charles E.F. Millard is the head of pension relations at Citigroup. He ran the United States Pension Benefit Guaranty Corporation from 2007 to 2009. The views expressed are his own.