Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Pension Funds Are Playing the Markets Wrong
Transcript
- Lucas: So here's a number that stopped me this morning: The California Public Employees' Retirement System — CalPERS — has returned about 6.8 percent annualized over the past twenty years. That's not terrible, until you realize the S&P 500 did over 10 percent in the same period. Luna: That's a gap of more than three percentage points per year. On a fund that manages over 500 billion dollars — that's real money. Lucas: Exactly. Over two decades, that compounding difference adds up to something like 150 billion dollars in missed gains. Money that could have gone toward reducing unfunded liabilities or easing the burden on taxpayers. Luna: So why is CalPERS stuck with such a low return? Is it just bad luck, or is there something structural going on? Lucas: Structural, for sure. Public pension funds face a set of constraints that private investors don't. First, they have to be extremely diversified — it's written into their mandates. So they're forced to hold large allocations to bonds, real estate, private equity, even cash, when equities are outperforming everything else. Lucas: Second, they're political animals. The board members are often appointed by governors or elected officials, and they're sensitive to public opinion. That means they shy away from stocks that might be controversial, or they pile into local infrastructure projects that have lower returns. Luna: Right, like the famous case of CalPERS investing in California real estate during the housing boom — that didn't end well. Lucas: Exactly. They lost billions in the 2008 crash because they were overweight in California real estate. But the political pressure was to 'invest in our own state.' Luna: So the incentives are misaligned. Fund managers want to avoid controversy, not maximize returns. Lucas: That's the heart of it. A study from the National Bureau of Economic Research looked at public pension funds across the US and found that political factors — like having board members appointed by elected officials — are correlated with lower returns. Specifically, funds with more political appointees underperform by about 50 to 100 basis points per year. Luna: Fifty to a hundred basis points doesn't sound huge, but on billions of dollars, that's massive. Lucas: Right. And the underperformance compounds. The same study estimated that if all state pension funds had achieved the same returns as the average corporate pension fund over the last 30 years, they would have accumulated an extra 1.2 trillion dollars. Luna: That's enough to close most of the funding gap. Let's talk about the bond allocation specifically. Why are these funds so heavy in bonds? Lucas: Tradition, mostly. Public pension funds use something called an actuarial discount rate — the assumed rate of return they use to calculate how much money they need today. That rate is typically around 7 percent. To hit that, they need a mix of assets. But bonds yield maybe 4 or 5 percent these days, so they have to compensate with equities and alternatives. Lucas: The problem is that many funds have a floor on their bond allocation — they have to hold at least 20 or 30 percent in fixed income, even when yields are low. That drags down the overall return. Luna: And it's not just bonds. They also hold a lot of cash and hedge funds — both of which have underperformed equities over the last decade. Lucas: Exactly. A 2019 report from the Center for Retirement Research at Boston College showed that public pension funds with higher allocations to alternative assets — like private equity — actually had lower returns than those that stuck mostly to public equities. The fees eat up the outperformance. Luna: So they're paying high fees for private market exposure and still lagging the S&P 500. That seems like a policy failure. Lucas: It is. And reform is hard because of the political dynamics. When pension funds try to shift more into equities, they get criticized for being too risky. When they lose money on a big real estate deal, there are hearings. But the slow bleed from underperformance doesn't get the same attention. Luna: What would an ideal allocation look like? If you were designing a public pension fund from scratch. Lucas: Well, I'd look at what the best corporate pension funds do. Companies like IBM or Verizon have funded their pensions almost entirely with bonds — because they're matching liabilities. But public funds have longer horizons and can take more risk. So a 70-30 equity-bond split makes sense, with the equity portion in low-cost index funds. Lucas: A study from the Hoover Institution argued that if all state pension funds simply invested in a 60-40 global stock-bond portfolio with low fees, their median return would be about a percentage point higher per year. Luna: That one percentage point, compounded over 30 years, is enormous. So why don't they do it? Lucas: The short answer is politics. Fund managers are afraid of being blamed for a bad year. If they're 100 percent in equities and the market drops 30 percent, that's a scandal. But if they lose the same amount slowly over a decade through underperformance, nobody notices. Luna: So the system is designed to avoid blame, not to maximize returns. That's a classic public choice problem. Lucas: Exactly. And the result is that taxpayers end up footing the bill. When pension funds underperform, the gap has to be filled by higher contributions from the state — which means higher taxes or cuts to other services. Luna: Let's look at a specific example. CalSTRS — the California teachers' pension fund — had a similar problem. What changed? Lucas: CalSTRS has actually been more aggressive in shifting to equities. They're now at about 50 percent equities, 25 percent fixed income, and the rest in alternatives. But they've also reduced fees by bringing more investment management in-house. Lucas: That's one reform that works. The California State Teachers' Retirement System saved about 200 million dollars a year by cutting external managers and doing their own indexing. That's pure alpha. Luna: Two hundred million a year — that's real money for teachers' retirement security. So there are ways to improve, even within the political constraints. Lucas: Yes, but it's slow. Most funds are still stuck in the old model. And the longer they wait, the bigger the shortfall gets. The total unfunded liability for state pension funds is now over 1.5 trillion dollars, according to the Pew Charitable Trusts. Luna: That number keeps growing, partly because of these investment choices. It's not just a funding problem — it's a management problem. Lucas: Right. And that's the angle we don't talk about enough. Everyone focuses on how much states need to contribute, but nobody asks whether the money is being deployed efficiently. Luna: Before we wrap up, I want to circle back to something you mentioned earlier — the idea that small changes in allocation can have huge effects. If a listener wanted to dig into this more, what should they look at? Lucas: I'd start with the annual reports of your state's pension fund. Look at the asset allocation and compare it to the S&P 500's return over the last 10 years. Then look at the fees they're paying. It's an eye-opening exercise. Lucas: And if you find that they're underperforming, write to your state legislator. These are public funds — you're a stakeholder. Speaking of which, a quick note: if walking through the economy with us has made something click, a couple of dollars a month is genuinely what keeps these shows going. You can find us at buy me a coffee dot com slash fexingo. Luna: Yeah, it really does make a difference. Even small contributions help us keep the podcast ad-free and focused on the numbers that matter. Lucas: Exactly. So back to the pensions — one thing I find fascinating is that the Canadian pension funds, like CPPIB, have a very different model. They manage assets internally, with a focus on long-term value, and they've consistently outperformed US public funds. Luna: What's their secret? Lucas: Independence from political interference. CPPIB has a professional board, a clear mandate to maximize returns without political goals, and they pay competitive salaries to attract top talent. The result is returns that are about 1.5 percentage points higher per year than the median US public fund. Luna: That's a huge difference. So the model exists — it's just a matter of political will. Lucas: Exactly. And that's the real challenge: convincing politicians that letting go of control will actually save them money in the long run. But the numbers are clear. The cost of playing it safe is higher than the cost of taking smart risks.