Improving the Bay State’s Public Pension Fund Investment Policies

Improving investment management of the commonwealth’s 105 chronically underfunded pension funds would reduce burden on taxpayers

While current policies provide a solid basis for preserving assets in Massachusetts’ 105 public pension funds, improvements and updates would boost flexibility and investment returns, while also promoting accountability and limiting unnecessary risks, according to a new study published by Pioneer Institute.

“Massachusetts public-employee pension funds have been chronically underfunded,” said Pioneer Institute Executive Director Jim Stergios. “There are two ways to fix that: Increase annual payments, which would eat into funding for other priorities, or improve investment returns. While improving investment returns will not address the gap between moneys going in and payments going out to pensioners, it is a critical way to reduce taxpayers’ exposure.”

Improving the Investment Performance of Massachusetts Pension Funds is the second paper in a 10-part series on the commonwealth’s public-employee pension systems. Most of the reforms author Iliya Atanasov proposes in the report can be implemented directly by the Public Employee Retirement Administration Commission (PERAC) without legislative action. The proposals fall into three broad categories.

Improving the Investment Performance of Massachusetts Pension Funds

First, pension funds would benefit from adopting and continuously updating a system of clear benchmarks. The latter should be consistent with both assumed and target returns as well as with a dual mandate of capital preservation and reliable investment returns.

Choosing appropriate peer funds is essential to performance benchmarking. Funds should be selected based both on total assets under management and on cash-flow fundamentals such as scheduled contributions from governments and current employees, funding levels and projected pension outlays over the short and medium term.

Second, Atanasov recommends that pension funds move away from more volatile asset classes like commodities and private equity in favor of assets that generate free cash flows and improve fundamental diversification. Funds should maintain an appropriate cushion of liquidity in cash equivalents and gold as a hedge against market fluctuations. The boards’ annual reports should explain directly and in detail how the asset allocation and the implied risk level square with their cash-flow projections. They should also develop stress-test scenarios for weathering prolonged market underperformance or lack of adequate government funding.

Additional limits should be put in place to provide local retirement boards with safeguards that address risks that are based on their unique characteristics. For instance, small funds with older retiree populations should face stricter limits on the amount of illiquid assets they can have to ensure sufficient cash flow and avoid a “fire sale” of assets to meet immediate cash needs.

Third, the funds should boost the transparency of their decision-making by adopting the best practices of continuous review and improvement. Pension boards should provide to PERAC and publicize specific written justification for their choice of performance benchmarks and an annual evaluation of their own decision-making processes, as well as:

• Minutes within two weeks after every board meeting,

• Board or committee decisions, including specific reasons for hiring a particular consultant, custodian or asset manager, also within two weeks, and

• A breakdown of asset allocations as well as a 10-year cash flow projection for investments, government appropriations and payouts to current and future retirees

These recommendations are important because contrary to the commonwealth’s best practices manual, which assumes a positive correlation between risk and return, current research indicates that investments that provide better-than-average returns, particularly over the long term, do not necessarily carry more risk.

Atanasov is Pioneer’s Senior Fellow on Finance, and he is leading the Institute’s research initiatives on public pensions, infrastructure, and municipal performance. A former Presidential Fellow at Rice University in Houston, Texas, Atanasov is a PhD Candidate in Political Science and Government and an MA Candidate in Statistics.

###

Pioneer Institute is an independent, non-partisan, privately funded research organization that seeks to change the intellectual climate in the Commonwealth by supporting scholarship that tests marked solutions against the conventional wisdom of more governmental involvement in Massachusetts public policy issues.