The Case against Stock in Public Pension Funds

Abstract

The case against equity investment by U.S. corporate pension funds has been well documented for a quarter century. The public sector has ignored or dismissed that case because of differences between taxation and accounting between the private and public sectors, the differing interests of shareholders and taxpayers, and the presumption that public plans last forever. Despite these differences, shifting public pension fund investments from equities to bonds adds value for local taxpayers. It also minimizes the risks of intergenerational taxpayer conflicts, undercharges to employees’ compensation packages for the value of the pensions, employee claims on pension surplus, and higher governmental borrowing costs.

The case against equity investment by corporate pension funds has been well documented for a quarter century. The public plan sector has ignored or dismissed that case because of differences in taxation and accounting between public and corporate pension plans, the differing interests of shareholders and taxpayers, and the presumption that public plans last forever.

Despite these differences, we show that in a transparent environment, shifting public pension fund investments from equities to bonds adds value for local taxpayers. Equity investment does not reduce the economic (risk-adjusted) cost of a pension plan. It does, however, enable violations of intergenerational fairness. The current generation of taxpayers may benefit by anticipating risk premiums without bearing risk while imposing uncompensated risk on future generations. Any apparent savings from the higher expected returns of equities vis-à-vis bonds result from simply ignoring the risks or passing them on to future generations.

In some instances, the beneficiaries of equity investment may be the employees rather than current taxpayers—that is, employees receive credit for the risk premiums while taxpayers bear the risks. Such problems arise when sponsors anticipate risk premiums in determining the charges to employees’ compensation packages for the value of their pensions or when employees are successful in pressing claims on any pension surplus.

As in corporate pension plans, equity investment wastes the tax shelter available to the taxpayers who bear the pension costs. Because individual federal tax rates are lower on equity returns than on bond returns, individual taxpayers should prefer to use the pension fund tax shelter for their bond exposure while holding equities in their own unsheltered personal portfolios.

The transparency in public pension accounting needed to support our arguments does not yet exist. The current opacity of governmental pension finance, together with the lack of advocacy for future taxpayer generations, creates strong incentives for the status quo. The financial world is changing, however, and governmental plan sponsors and their investment managers should prepare. The private sector is moving irreversibly toward greater transparency, and the arguments for all-bond investment in corporate pension plans are gaining traction. It is only a matter of time before the same trends develop in governmental plans. Sponsors who anticipate those trends will be able to adjust with smooth transitions rather than disruptive course corrections.

We thank Bruce Cadenhead, Tom Lowman, Bob North, Mike Peskin, Bill Sohn, and Peggy Warner for their comments and suggestions.

Notes

¹ Bader (2003) elaborated this point.

² More likely, surplus would not be removed from the plan but would be used to reduce future contributions to the plan.

³ The strategy applies to any fund for which returns on stocks or bonds are taxed identically (or not at all, as in tax-exempt funds such as pensions) and whose costs are ultimately borne by people whose equity investments are taxed more favorably than their bond investments.

⁴ We recognize the danger that, based on the optimistic projections of the mutual fund industry, public employee groups may reject properly priced defined benefits in favor of inadequately understood defined-contribution plans. But mispricing defined benefits to compete with misrepresented defined contributions is not an appropriate response.