Public Pensions Pile on Risk to Beat Underfunding

(January 30, 2012) — Strict government accounting standards and fears of a larger shortfall push underfunded public sector pension plans in the United States to take on more investment risk than their private sector peers, new research has found.

Public sector pension fund investors and their fund managers react differently to an underfunded status than their private sector peers, Nancy Mohan and Ting Zhang at the University of Drayton found in research published this week.

The pair said that during their research they had found evidence that government accounting standards ‘strongly affect risk-taking behavior’, as most pension plans used higher return assumptions to discount their pension liabilities.

The paper said: “We find that government accounting standards strongly affect public fund investment risk, as higher return assumptions (used to discount pension liabilities) are associated with higher equity allocation and beta.”

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In addition, as most of these public sector plans remain open for new members whereas many private plans are now closed, state retirement systems, for example, can push liabilities further into the horizon.

The paper said: “Unlike private pension plans, public funds undertake more risk if they are underfunded and have lower investment returns in the previous years, consistent with the risk transfer hypothesis.”

This hypothesis supposes that future tax payers will pick up the bill for pension payments being made at the current time. The paper said this occurred often when a public sector plan was underfunded.

Another factor that raised the risk profile of public sector pension plans was the ‘union effect’, according to the paper. This meant that instead of increased contributions by employers and staff being made to meet better benefit payments won by union bargaining, fund managers were encouraged to take on more risk in the hope of bringing in higher returns to fulfill the obligation.

Finally, the community of public sector pension funds was guilty of following the footsteps of those that had seen impressive investment returns.

“There also appears to be a herding effect in that a change in California Public Employees Retirement System (CalPERS ) portfolio beta or equity allocation is mimicked by other pension funds.”

(January 30, 2012) — China’s importance as a primary driver of growth for the global economy will continue to attract the attention of institutional investors from around the world, consulting firm Towers Watson has predicted.

China continues to attract attention as a primary growth engine for the global economy in the coming years despite problems with Europe’s sovereigns and concerns with the US economy tending to dominate attention of most investors, Naomi Denning, Head of Investment, Asia Pacific, at Towers Watson, wrote in a whitepaper. “Of course, China is not immune to the challenges facing the rest of the global economy and has challenges of its own, but I suspect very few investors are not at least thinking about how they can benefit from China’s growth and how their investment portfolio can be positioned to take advantage of the opportunities in China,” she concluded.

According to the consulting firm, China never lost its glow for serious international institutional investors “but it has had its lights dimmed briefly by an interim crisis of confidence among short-term market riders.” After three decades

of double-digit growth, China grew around 9% when the crisis was in full swing and the country is expected to maintain a growth rate through a protracted period of global economic slowdown, Towers Watson said, acknowledging that growth may be slowing.

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The whitepaper by Towers Watson continues: “Growth may be slowing, but the outlook for China is considered healthy compared with the situation of many other countries. In contrast to the weaknesses and current account imbalances of major developed economies, China’s low national debt and large reserves provide a solid base for moving forward.”

New England-based investment consulting firm NEPC has echoed the perceived continuing opportunity in China and other emerging economies. “Despite recent poor performance, emerging markets remain a key recommendation of NEPC…Part of our long-term case for developing markets is that we expect emerging market currencies to continue to appreciate relative to the dollar, boosting returns for unhedged local currency investments.”

Meanwhile, late last year, research by the Emerging Markets Private Equity Association (EMPEA) highlighted an improvement in the emerging market sector, concluding that private equity investment in emerging markets is returning to pre-crisis levels.

The firm found that in total, India and China — the two Asian giants — attracted 68% of private equity capital invested in emerging markets in the first six months of 2011, with $5.8 billion going into China and $3.8 billion into India.

“Western institutions are continuing to seek greater exposure to the world’s fastest-growing markets, and institutions in the emerging markets themselves are significantly ramping up their investment in the asset class,” said Sarah Alexander, President and CEO of EMPEA, in a statement.

Related article: Are Emerging Markets the Next Bubble?