The Teachers' Retirement System of the State of Illinois (TRS) provides retirement benefits for public educators in Illinois outside of the city of Chicago. It has over 400,000 members. It is currently meeting its required payments, but like many other state and local government pension plans, it is woefully underfunded when its assets are viewed in light of future obligations.
As dire as the situation may appear in the public pension world, it can be a little too easy to overlook that as underfunded as many of these plans are, they still manage very large investment portfolios. At year-end 2015, TRS reported over $46 billion in investments.
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Investments in public pension plans in Illinois are managed under the Illinois Pension Code, which includes a directive that they be managed under a “prudent person rule.” This rule compels investment decisions and management to be undertaken “solely in the interest of fund participants and beneficiaries.”
This may sound like a wise and prudent public policy. But when viewed in light of other state law, as well as financial market history, the “prudent person rule” poses some disturbing implications.
Let’s say you are invited to wager on a coin flip, on behalf of someone else, and the law tells you that you must solely do so in their best interest. You have a choice of three wagers, and can also choose to do nothing.
1. A $100 payment received if it is a heads, and a $50 obligation if it is tails.
2. A $100 payment received if it is a heads, and no obligation if it is tails, because taxpayers in general will be required to pay the $50.
3. A $1,000 payment received for heads, and no obligation if it is tails, because taxpayers in general will be required to pay the $500.
Under these conditions, and given your duties in the “prudent person rule,” wager 2 is clearly preferred to wager 1. And wager 3, a bigger bet, is clearly preferred to wager 2. The expected return on wager 2 is $50, given that taxpayers pay the freight for a tails, and the expected return on wager three is $500.
Last year, the Illinois Supreme Court ruled that pension benefits are protected under the Illinois constitution. Given that the benefits are guaranteed, this can lead to incentives like those arising in the wager choices above.
This isn’t just simple storytelling / examples. We’ve learned that our financial markets are subject to some of the same forces, in light of the guarantees standing behind “too-big-to-fail” banks and other large financial institutions.
Back in the savings and loan crisis in the 1980s, for example, as regulators allowed many insolvent firms to continue operating, often with the aid of false accounting principles, many of those institutions chose to take higher risks, given that the upside was controlled by insiders, but the downside was spread among the public generally, given the taxpayer-funded safety net. These incentives amplified the costs of the savings and loan debacle, and the resulting moral hazard effectively laid the groundwork for the disaster leading into the financial crisis of 2007-2009.
Are we reliving this sad and sorry history today, in public pension plans? Taking a simple look at the risk in the TRS investment portfolio from 2005 to 2015, it is possible the answer is yes.
Here are two developments that suggest risk in the TRS investment portfolio increased from 2005 to 2015.
- The share of U.S. Government and government-backed debt and short-term investments in total investments -- from 2005 to 2015, the share of these “safer” assets in total investments fell significantly.
- The weighted-average credit rating for fixed-income investments, excluding U.S. government debt --from 2005 to 2015, this weighted average also fell significantly.
Granted, the TRS has also engaged in a growing (and dizzying) array of “hedging” transactions with derivatives, and has also embarked upon new “real return” and “absolute return” strategies. TRS investments have grown increasingly diversified, globally. But these developments bring new uncertainties, as well as risk management issues.
Perhaps the “prudent person rule” isn’t so prudent.