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Shocked Shocked
There’s Gambling at the Springfield Cafe!

Illinois is facing a grim fiscal future, and while there’s plenty of blame to go around, its public pension funds are responsible for a good chunk of the damage. They invested 75 percent in equities, derivatives, and real estate without planning for what would happen if those risky investments underperformed (which they did). As Tia Goss Sawhney at the pension blog WirePoints notes, Illinois’s defense of its 2013 pension reform, now before the state supreme court, fails to acknowledge how foreseeable the funds’ losses were given the risks—recession or no recession. Instead, the state professes to be “shocked, shocked“:

The State’s defense of SB1 [the pension reform] is built around the central argument that everything was under control in 1997 and that the State has no choice but to use police powers to reduce the benefits of current and future retirees because of negative returns in fiscal years 2008 and 2009 – even though the 17 year 7.0% return inclusive of these years is well within the probable range of results for a portfolio with an estimated 8.5% long term return.

In defending SB1, neither the State, nor its expert actuary, acknowledge the massive investment risks assumed by large defined benefit pension plans. Instead the State describes the fiscal year 2008 and 2009 market losses and the impact of the losses on the plans that were (and still are) invested 75% in equities, derivatives, and real estate as “extraordinary adverse events”, “large, unforeseen”, “unanticipated and substantial”, “unexpected and unanticipated”, and “unforeseen and unintended”. Supporting the State’s assertions, the actuarial expert categorizes the 2008 and 2009 market losses and their impact as “unexpected and devastating external circumstances”, “significant unexpected developments”, “significant unexpected developments”, and “unexpected and unanticipated effects”.

There was gambling going on at Rick’s café and Illinois knew it:

These statements are at best misleading. The possibility of a significant market downturn resulting in market losses for a portfolio invested 75% in equities, derivatives, and real estate was and is foreseen, anticipated, and expected. And although the 2008 and 2009 fiscal year impact was substantial and somewhat extraordinary, the impact, when bundled with 15 other years of returns, it not extraordinarily adverse compared to other possible long-term results. The financial impact is devastating because the State knowingly took risks that it was not prepared to absorb. The State continues to take the same risks.

The casino is still open for business. Until states start accurately assessing the risks they take, and passing on the ones that are simply too high, reformers will only be rearranging the chairs at the blackjack table.

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  • FriendlyGoat

    In the era of extraordinarily-low interest rates, pension fiduciaries have a BIG problem concerning what risks are appropriate. We should at least acknowledge that everyone trying to assemble a retirement using a 401(k) plan or an IRA has the same problem.

    • Curious Mayhem

      Definitely. This was one of the problems that led to the misuse of derivatives in the credit bubble that crashed in 2008.

      All the formulas for these instruments require you to put in some value or values for the interest rate and for volatility. What to do when both have been artificially suppressed by monetary policy? Do you assume that the fantasy world created by central banks extends its fantasy to all financial decisions? Or do you acknowledge that the underlying reality is not reflected in these numbers and plan accordingly?

      All of us figuring out how to save and invest are dealing, as individuals, with the same dilemmas. The cost of making a mistake, or even of just inaction, is potentially high.

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