If someone offered you a chance to flip a coin, and get $1.10 for a heads and $0.90 for a tails, how much would you pay to take this bet? Something close to a dollar, given that is the expected return, and perhaps a little less, given that people tend to be risk-averse.
Suppose instead that someone offered you a chance to flip a coin, and get $1.50 for a heads and $0.50 for a tails. A riskier bet, but one that still has an expected value of a buck. Once again, you would be willing to bet something close to a dollar. It might be a little less than the amount you were willing to put down on the first bet, given the risk.
Now, let’s change the situation. We have the same two bets, with one new twist. This time, a tails returns a dollar, in both cases, while in the first case the heads returns $1.10, and in the second a heads returns $1.50. Bet number two becomes clearly preferred, under these assumptions.
In the real world, consider a government that insures claims on financial entities (like banks, or public pension funds) against loss. In Illinois, for example, a state supreme court ruling last year guaranteed the retirement benefits promised to government employees.
These benefits are provided through pension and other plans that invest employee and employer contributions. In Illinois, the investment decisions made by plan managers are framed by a ‘prudent person rule,’ which calls for plans to be managed solely in the interest of plan participants (the ‘beneficiaries’).
Now that the benefits promised to the beneficiaries have been guaranteed by the state, however, this can lead to some curious and alarming incentives. The beneficiaries aren't so sensitive, because the downside has been shifted to taxpayers in general.
This dynamic was working in spades in the latter phases of the 1980s savings and loan crisis, as many underwater institutions were allowed to stay open, in important part with the aid of flawed government regulatory accounting principles. Money kept flowing in, given that government effectively insured the deposits. These “zombie banks” then “gambled for resurrection,” in Edward Kane’s terms. Many of those gambles turned sour, effectively trebling an already-costly financial crisis.
Heads I win, tails they lose – lots of people will take that bet. Unfortunately, many sorely underfunded state and local government retirement plans may be operating under similar incentives. They’ve been concentrated in riskier bets (with higher fees, for the investment managers).
Taxpayers deserve much more frequent and transparent disclosure of the investment performance in government retirement plans today. Taxpayers may also deserve an equity stake in these plans, and reconsideration of the legal fiduciary duties framing decisions of investment managers.
Ed Kane (mentioned above) has made this case for taxpayers standing behind “too-big-to-fail” financial circumstances. See this article, for example.