Where’s the Alpha?

May 4, 2011 (PLANSPONSOR.com) - In funding public sector defined benefit plans, the average assumed rate of return on assets held in trust to pay benefits is 8%. 

At least in the short term (the next five to ten years), consultants are predicting that the typical public fund allocation models should generate market returns (beta) of about 6.5%.  Considering that alpha (the return based on skill) is a zero sum game, how are public plans going to possibly achieve 8% – after all, for every winner, there has to be a loser as far as alpha is concerned. 

Here it is important to recognize that even with $3 trillion in reserve assets, public sector defined benefit plans only make up a fraction of funds invested.  A very significant part of the market consists of funds held in 401(k) plans.  Knowing that there will be winners and losers in the quest for alpha, it would appear that the investment professionals with very long-term time horizons (the public defined benefit plan managers) have a decided advantage over the investment amateurs who have finite time horizons (the holders of 401(k) accounts).  Whether or not there will be 150 basis points of alpha for the public funds to capture over the next few years remains to be determined but expecting professional investors with long-term time horizons to generate higher returns than the average 401(k) participant does not seem to be a stretch. 

Of course, the public fund managers could invest their portfolios in so called “risk-free” investments (see Public Employee Retirement Plans and the Myth of the Risk-Free Rate) and then watch the entire system fail because of the other risks taken on – an outcome that would probably not be all that disappointing to the risk-free rate proponents.  


The party line from the proponents of using a risk-free rate goes something like this.  “If the benefits you are promising are supposed to be 'risk-free,' then you shouldn't be taking risks on investments and assuming you're going to win. Because if you lose, you're simply passing the costs and the risks on to future taxpayers, and that's a dangerous way to run an enterprise.” 

That line of thinking is flawed in many respects.  One is that the fiduciaries who are responsible for administering the plans in the exclusive interest of the plan participants have decades of practical experience to support the risks being taken.  Another is that these fiduciaries are not in the risk elimination business but rather the risk management business and there is a fair amount of evidence to suggest that they have done it very well.  There are numerous examples of situations where risks can be reduced to zero but the costs of going that route make it totally impractical. For example, the risk of highway traffic fatalities and airline disasters can be reduced to zero – we just need to get congress to prohibit the use of vehicles and commercial aircraft – sort of like getting congress to mandate the use of unrealistic assumptions for valuing public retirement plan liabilities – eliminate one risk and create a raft of other problems that are much greater than the risk targeted by the initiative.

As a nation, we ultimately do the right thing but we sure seem to have a need to experiment with a number of wrong things in order to get there.  My prediction is that eventually it will be recognized that the current private sector approach to facilitating retirement income security is fatally flawed with eventual reversions to defined benefit plans as the primary source of retirement income for the masses in the private sector.  It may take a few more failures in the defined contribution arena but I have confidence that there are some very smart business people who will ultimately recognize that the public sector is currently getting it right.

- Gary Findlay, Executive Director, Missouri State Employees’ Retirement System (MOSERS).   

Mr. Findlay is executive director of the Missouri State Employees' Retirement System (MOSERS), a position he has held since 1994. Prior to that, he spent 16 years as an administration and benefit consultant with Gabriel, Roeder, Smith & Company, a national actuarial and benefits consulting firm that specializes in serving the needs of public employee benefit plans. He was CEO of that firm from 1986 until he joined MOSERS.  

Also in this series:  

Public Employee Retirement Plans and the Myth of the Risk-Free Rate

The 401(k) Myth