The investment objective of a public pension fund manager is a simple one: provide the promised pension benefits while exposing the fund (and the taxpayer who is the backstop) to as little risk as possible. But in a world of stakeholder capitalism this has all gotten a little more complicated.
An Australian man recently sued his pension fund for investing in non-green companies. Last week, Bruce Katz of Drexel and Colin Higgins of the Governance Project wrote that public pension funds should invest locally to boost local economies. They argue that there is a lack of transparency that leads funds to invest in private assets in America’s coastal cities even though there is arguably an ever-greater responsibility to invest in worthy local projects. New York mayor Bill de Blasio has made similar arguments, advocating for the investment of New York City’s pension funds in green assets; and when he was the New York City Public Advocate he argued that they should be invested in local infrastructure projects.
But investing with the goal of meeting your obligations and investing to boost local economies or achieve progressive policy goals are not in alignment. Investing in local projects not only tends to have lower returns and is subject to political capture, it is bad risk management. Pension funds depend on taxpayer revenue, the amount of which is closely correlated with the state of the local economy. Local economic setbacks cause the value of projects to fall just when the pension fund is most vulnerable to declining tax revenue. A basic principle of finance is that diversification offers a higher return (on average) with less risk. Investing in local projects, or even regional projects, concentrates that risk, meaning riskier investments for lower returns.
Accepting a lower return with less risk may seem acceptable if it helps a community or aligns with its values. But no community has a uniform set of values, meaning that these investments will be used as political favors for whoever is in office. What’s more, it is often the companies that are seen as being “unethical” — like the fossil fuel industry — that are the biggest investors in the asset classes that are seen as being socially responsible, e.g., renewables. “Socially responsible” is a vague concept and aiming at “socially responsible” investments can undermine principles of good investing. It may be fine for individuals who are clear about their values, but it works less well when governments are investing on behalf of a community.
Risks and returns notwithstanding, local pension funds investing in local projects won’t necessarily help the community. If certain projects receive cheaper financing from local pension funds, they will be subjected to even weaker market-based incentives to spend and operate efficiently than exist already. The recent expansion of the New York City subway is a case study in exorbitant costs and unaccountable management, and that project was not even the beneficiary of cheap pension money.
Further, pension funds are already severely underfunded. This means that in coming years communities will have to make hard choices about paying benefits or spending less on public services like education. This is already the case in municipalities currently facing financial distress. Investing in higher risk, lower return projects means that these tradeoffs will be more severe and arrive sooner, which is far more costly for communities than the benefits they receive from cheap capital for politically favored projects.
Pension finance, which involves investing so that future benefit obligations can be met, is already subject to great uncertainty and difficulty. Complicating the objective of this investment by constraining it to unclear geographical and social welfare goals only makes it more difficult, which will ultimately mean an even bigger bill for taxpayers and fewer services that they’ve come to rely on.
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