Here’s a quiz any undergrad business major should be able to ace: Assume you invest $10,000 in an asset with an expected return of 10 percent, and another $10,000 in an asset with an expected return of 4 percent. What’s the expected annual return on your portfolio over a 30-year period?
Answer: 8.1 percent (because $10,000 x 1.0430 + $10,000 x 1.1030 = $206,928, and $20,000 x 1.08130 = $206,928)
But in a new working paper, Rochester University finance professor Robert Novy-Marx asserts that a pension fund manager following accepted accounting rules for public pension funds would assume an expected portfolio return of 7 percent in this situation (which he gets by averaging 10 percent and 4 percent). From this false premise, Novy-Marx draws outlandish conclusions about pension fund accounting, such as the claim that a pension fund with just $10,000 invested in the higher-yielding asset would appear to be better funded, all else equal, than one with $20,000 split equally between the higher- and lower-yielding asset (because $10,000 x 1.1030 > $20,000 x 1.0730). Novy-Marx concludes that these rules give public pension fund managers a perverse incentive to “burn” the low-yielding bonds in order to inflate their plan’s funding status.
If this sounds absurd, it’s because it is. To begin with, you can’t just average the two rates of return as Novy-Marx does, because over time the portfolio becomes more weighted toward the higher-yielding asset. In practice, pension funds periodically re-balance in order to prevent a portfolio from becoming too heavily weighted toward risky assets, but they would have to re-balance continuously in order to reduce returns to 7 percent, which is unrealistic. In any case, Novy-Marx doesn’t even mention re-balancing, nor any other realistic pension fund practices in his paper. If he did, he’d also have to acknowledge that public pension funds assume stable, long-run returns that vary little across plans, clustering around 8 percent—less than the roughly 9 percent these funds have averaged over the past quarter century. Thus, they wouldn’t be affected by the kind of gaming Novy-Marx conjures up in this paper.
Novy-Marx’s claims are exasperating because the accounting method he prefers would actually create perverse incentives. Novy-Marx et al. believe that since pension liabilities are guaranteed (only partially, but that’s another matter), pension funds should be required to assume a nearly “risk-free” rate of return no matter the fund’s actual asset allocation. Thus, in Novy-Marx’s example, the assumed rate of return would be the 4 percent yield on nearly risk-free Treasury bonds even if the entire portfolio were invested in stocks with an expected 10 percent return (Novy-Marx doesn’t deny the existence of an equity premium).
It’s important to note that this wouldn’t encourage prudent investment practices any more than the doctrine of predestination eliminated sin. If anything, it might have the opposite effect—incite a desperate hunt for yield—as all pension funds would immediately appear drastically underfunded. It would not guarantee that the fund would earn a 4 percent return or better, since it wouldn’t require funds to invest in Treasuries or other low-risk assets. All it would do is make pension funds look bad and cause required contributions to spike, inciting a taxpayer revolt. It would also cause funded ratios and required contributions to vary for no logical reason, since Treasury yields fluctuate with monetary policy and market conditions that may have little or no bearing on pension fund adequacy.
Elsewhere, Novy-Marx has actually suggested that state and local governments with shaky finances should be allowed to contribute less to their pension funds because their higher borrowing costs—and the greater likelihood that they renege on pension promises—should translate to a higher discount rate on future pension liabilities. Though this illustrates where his logic takes you, Novy-Marx isn’t trying to promote fiscal irresponsibility.
(However, allies like Andrew Biggs of the American Enterprise Institute want to be able to assume high expected returns on assets in 401(k)-style plans while requiring public pension funds to assume low returns on the same assets.)
Novy-Marx’s latest sally is more an effort to provoke than to persuade. But he and his allies have already had a significant impact in the policy arena. The Government Accounting Standards Board has proposed valuing some pension liabilities using low municipal bond yields, a change that will likely result in significantly lower funded ratios and higher required contributions.
More generally, Novy-Marx and a small group of other economists have succeeded in attacking public funds for supposedly engaging in aggressive accounting and ignoring risk, deflecting attention from the real problem (in states where there is one) of elected officials neglecting to make required pension contributions. Astonishingly, they have done so without presenting any actual evidence that public pensions take on too much risk or inflate expected returns, but have rather harped on arcane accounting issues until enough people have concluded that where there’s smoke there must be fire.