A new study published by Harvard’s John F. Kennedy School of Government joins a growing chorus of academic research that has raised alarm bells over the state of public pension funding in the U.S.

The authors found that:

…the existing status quo is enormously risky…The current system of pension accounting, whatever the discount rate used, doesn’t convey the risks inherent in the system and how policy choices affect those risk.

…

GASB standards do not account for these risks in any meaningful way. While outcomes are better at the median, performance in the left tail of the return distribution are dramatically worse.

While these comments were made in regards to U.S. public pension plans broadly, Nevada PERS is no exception to the rule.

From 1975 to 1995, it was reasonably safe to assume an 8 percent annual return simply by investing in Treasury bonds. But when bond yields started declining significantly in the early 2000s, PERS was confronted with a choice:

Reduce the system’s assumed investment return to reflect the changing market conditions, or move more of the portfolio into stocks — which offer the potential for higher returns to compensate for the higher levels of risk.

PERS chose the latter, going from a historical 50/50 split between stocks and bonds to a portfolio today that is now 72 percent stocks and private markets — the highest percentage in its history.

Compared to the hike in taxpayer and government workers’ retirement contributions that lowering the assumed rate of investment return would require, this move appeared painless.

But there was a cost to this shift, which as the Harvard study notes, has been totally ignored under the current accounting standards.

While the new portfolio may still be expected to return 8 percent on average, the damage done during periods of below-average returns is significantly higher. This is because, as PERS undertakes more risk, below-average returns move farther away from the expected mean (or midpoint) return of 8 percent.

In other words, the damage caused from periods of below-average investment periods grows exponentially, as the level of risk increases.

And as the size of the PERS fund grows — currently at $35 billion — so too does the potential destruction caused by such an event.

For example, there is currently a 10 percent chance that PERS will experience an additional shortfall of at least $6.56 billion in a single year!

This is equal to roughly 65 percent of all state and local tax revenue combined, or more than four times the amount government workers and taxpayers currently contribute to the system.

Yet, current accounting standards ignore risk entirely, which “is a clear hindrance to policymakers,” according to the authors:

The existing reporting by public funds in no way conveys the wide range of possible funding outcomes. Existing accounting practices often recognize the impact of decisions on one part of the distribution of outcomes (say the mean or median) without indicating that they also affect other moments.

While using a higher discount rate appears beneficial in the short-term — by decreasing the amount that taxpayers and government workers must contribute — the study finds that this is ultimately a losing strategy:

Changes in the discount rate have a perverse immediate impact on liabilities and funded ratios in that funds with higher rates and lower contributions appear better funded on impact. Over time, though, the reduced contributions associated with higher discounting leads to more not less underfunding. (Emphasis mine.)

The study, Risky Choices: Simulating Public Pension Funding Stress with Realistic Shocks, can be read on the Harvard website here.

For NPRI’s analyses of the Nevada PERS situation, visit: http://www.npri.org/issues/detail/pers