State Pensions Need Reforms, Not Fewer Options

Across the country, state and local pension systems have not amassed enough assets (stocks, bonds, and other financial investments) to cover the retirement benefits promised to current and retired state and local employees. This gap is referred to as the pension funds’ “unfunded liabilities”.

According to the Pew Charitable Trusts, the unfunded liabilities of state-administered pension systems across the country were $1.1 trillion in 2015 – a 17 percent increase from 2014! According to the American Legislative Exchange Council, the unfunded liabilities is significantly higher, more than $6 trillion.

While there are disagreements about the size of these unfunded liabilities, one thing is clear: state and local public pensions are spiraling toward insolvency. Despite these problems, politicians across the country are placing restrictions on the assets that public pension funds can hold, which are only making this pending insolvency worse.

For example, New York City has announced that it will “divest fossil fuel investments from its $189 billion public pension funds over the next five years.” New York City justifies this investment restriction due to global warming concerns. But, imposing restrictions on public pension fund managers will not achieve the goal of punishing the targeted industries.

It is certainly true that New York City’s divestment of the fossil fuel industry will put downward pressure on the stock prices of these companies. Further, if all public pension funds followed New York City’s lead, then this would put even greater pressure on their stock price.

However, this downward price pressure will not punish the fossil fuel industry (or any targeted industry). Ultimately, the long-term earnings potential of fossil fuel companies will determine the value of their stocks. If their earnings are strong, then when public pension funds divest of their holdings this creates buying opportunities for other investors. As these new investors benefit from the price discount created by the unwarranted divestment mandates, the industry’s stock price will once again reflect the companies’ earnings potential.

While the companies will be held harmless in the long-term, the same cannot be said of the public pension funds. When public pension funds divest from profitable companies, they reduce their investment returns (possibly even taking a loss depending upon how the divestment is conducted). Public employees, retirees, and taxpayers are harmed because lower investment returns worsen the large unfunded liabilities problem.

An oft-cited justification for divestiture argues just the opposite – that social investing (such as divesting from fossil fuel companies) enhances financial returns. And, perhaps the financial returns from investing in socially favored stocks (such as Tesla or Vestas, the largest global wind turbine manufacturer) will be significantly higher than the average market return. But, if this is the case, then the managers of the public pension funds are not divesting for social reasons; nor do they require a mandate from the politicians to make these investment decisions. Instead, such investment decisions illustrate that the fund managers are faithfully fulfilling their fiduciary responsibilities.

Beyond the impact on potential returns, when politicians impose social mandates on public pension funds, they are using assets that belong to someone else (public employees and taxpayers) to implement their political preferences. It is simply inappropriate for politicians to treat the public pension funds as their own personal slush funds to implement policies that they could not achieve through the legislative process.

Making matters worse, public employees and taxpayers are a diverse group of people. It is inconceivable that there will be universal support – or even the support of a majority of the population – for the socially divisive issues that drive calls for divestment. Therefore, the financial risks created by social divestment will not reflect the values of many people who will be potentially harmed by the policy.

The social responsibility of the managers of public pension funds is to responsibly invest the money entrusted to them. This goal is difficult enough on its own, and far too many public pension funds are failing to meet this standard.

Restricting investment options to reflect the social goals of certain politicians or interest groups makes reaching this goal even more difficult. The most socially responsible path is to empower public pension funds to fulfill their fiduciary duty and resolve the large social questions in the political arena – where they belong.

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Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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