The Peril Of Public Pension Funds

More

One of the mildly surprising things about the Stuyvesant Town debacle is the kinds of investors the deal attracted.  What were entities like CalPers and the Church of England doing plowing their money in along with real estate moguls like Tishman Speyer?


The answer is "looking for alpha".  Underfunded pension funds have been looking for extra return in order to make up the holes . . . and the problem is worst among public pension funds, because until recently, their accounting wasn't very good, so politicians were fond of making unfunded promises in lieu of wages.

Needless to say, public pension funds cannot necessarily afford to attract top investment talent, particularly since appointments tend to have a political as well as financial component.  They're thus vulnerable to making investments that aren't in their best interest--not just in real estate, but in things like derivatives, as Felix Salmon notes:

In reality, it's not the pension funds which are engaging in "derivatives abuse", but rather the investment bankers who sell the pension funds complex over-the-counter derivatives which make the broker lots of money and which rarely do any good for the end client. As Clavell says,

Let's assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense...

Admitting you don't know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don't know. Really, you don't. Hang on, I hear you shouting that you're actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don't. Know.

The fees are hardly the worst part; more worrying is that many public pension funds and other public trusts are assuming risks they don't necessarily understand.  They think they're gaining alpha--higher expected value on their investments.  But often they're confusing alpha with beta, which is to say they're getting higher returns not because they're making good investments, but because they're taking on more risks.

I don't think I need to convince many people that high-risk, high-return investments are a bad way for public pensions to try to deal with their massive unfunded liabilities.

Felix is right that the investment bankers who push these sorts of things on public pension funds are, at the very least, doing something unsavory.  But they don't deserve all the blame.  Public pension funds shouldn't be trying to make up their deficiencies by chasing unrealistically high returns.  Of course, if politicians and their appointees had the courage to pay for the gifts they gave public employees, rather than looking for loopholes, we wouldn't be in this mess in the first place.

Jump to comments
Presented by

Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

Get Today's Top Stories in Your Inbox (preview)

What Crazy Tech Idea Could Become Real?

"There could be great intelligence enhancements, like infinite memory."


Join the Discussion

After you comment, click Post. If you’re not already logged in you will be asked to log in or register. blog comments powered by Disqus

Video

A Time-Lapse of Alaska's Northern Lights

The beauty of aurora borealis, as seen from America's last frontier

Video

What Do You Wish You Learned in College?

Ivy League academics reveal their undergrad regrets

Video

Famous Movies, Reimagined

From Apocalypse Now to The Lord of the Rings, this clever video puts a new spin on Hollywood's greatest hits.

Video

What Is a City?

Cities are like nothing else on Earth.

Video

CrossFit Versus Yoga: Choose a Side

How a workout becomes a social identity

Video

In Online Dating, Everyone's a Little Bit Racist

The co-founder of OKCupid shares findings from his analysis of millions of users' data.

Writers

Up
Down

More in Business

Just In