​​But cryptocurrencies are also exceptionally volatile over much shorter periods of time. ​Day-to-day price fluctuations of cryptocurrencies eclipse those of traditional currencies, stocks, and precious metals, and do so consistently across assets and time periods. This phenomenon is not entirely driven by the longer-term ups and downs reported in headlines. Bitcoin, Ethereum, and other cryptocurrencies frequently exhibit daily price drops during bull markets and increases during bear markets far in excess of traditional assets. The interactive chart below provides one way to visualize this day-to-day volatility—the daily percentage increase or decrease in price in U.S. dollars from the previous day. 

This interactive tool allows the reader to investigate the phenomenon of day-to-day volatility for different cryptocurrencies, traditional assets, and time periods. During the period 2018–2022, Bitcoin’s average daily change (​​measured as the absolute value of the percentage change from the previous day) was 2.87%, versus the Euro (0.34%), pound (0.43%), and yen (0.35%). Other major cryptocurrencies, such as Ethereum (3.76%), Ripple (4.04%), and Dogecoin (4.55%), exceed Bitcoin’s already-high fluctuations. 

The table below presents this statistic for each asset or index tracked by the data tool. 

Why is the day-to-day volatility of cryptocurrencies important? 

Despite much public discussion about cryptocurrencies as speculative investments or world-changing technology, their success ultimately hinges on widespread adoption as currencies—including as a medium of exchange. Day-to-day volatility creates exchange rate risk over short periods of time. This creates problems for a currency’s usefulness as a medium of exchange if one or both parties to the transaction need to quickly move their money into a different currency. Either the buyer or seller, or both, must take this exchange rate risk, increasing the transaction cost and, ultimately, the price. 

To date, the use of cryptocurrencies as a medium of exchange has taken off in only a small number of market niches, most notably dark net markets where mostly illicit goods are for sale. A 2018 article reported that Bitcoin’s high short-term volatility was adding to the cost and lowering the number of transactions on such platforms. 

There are likely multiple causes for the unusually high volatility of cryptocurrencies. While more widespread adoption may be part of the solution, other likely causes are structural and follow directly from the way cryptocurrencies are designed. Large banks and other financial firms hold huge reserves of traditional currencies, and stocks have market makers, both serving to smooth out short-term volatility and make exchange markets more liquid. Bitcoin, on the other hand, eschews large central intermediaries by design.   

Solutions lie in further entrepreneurial innovation, and that process is already well underway. Bitcoin’s ​​Lightning Network is designed to facilitate faster transactions at a larger scale. Stablecoins, pegged in value to fiat currencies like the dollar or other assets, eliminate high day-to-day volatility by design. They can be used to keep money in the crypto ecosystem—protected from short-term fluctuations and, in theory, easier and faster than traditional fiat currencies--to exchange with Bitcoin or Ethereum. However, their relative novelty opens the door for long-tail risk as well as fraud. 

These and other avenues carry some promise to address day-to-day volatility and make cryptocurrencies more viable for everyday use. But innovation must continue. The Lightning Network and Stablecoins both introduce the scope for large financial intermediaries and dependence on the fiat system that crypto pioneers sought precisely to avoid. Furthermore, the much larger number of people not yet sold on crypto may see these as further complications to already convoluted and risky alternatives to fiat. 

The crypto community must turn away from ​​voices such as Bitcoin maximalists that say the perfect solution is already in hand, and keep innovating and experimenting.  ​Regulators ​could do great harm by making rules that ossify this still-developing technology or cut off as-yet unrealized solutions that only a market process of discovery can deliver. 

We hope that the interactive tool provided here, which offers an intuitive way to visualize the phenomenon of day-to-day volatility in cryptocurrencies, will play a part in opening the conversation and potential for fresh ideas. 

Methodology 

We selected the top 10 cryptocurrencies by market capitalization from CoinMarketCap in addition to FTX’s FTT token. The top 10 cryptocurrencies include seven traditional cryptocurrencies and three stablecoins. We did not include the latter, which track the day-to-day volatility of fiat currencies by design, in the interactive chart, but do report their average daily changes in the summary table. Daily price and exchange rate data are sourced from Yahoo Finance via the R library quantmod. The only modification to the original source data occurred for the Ruble to Dollar data (RUBUSD=X). On Jan. 1, 2016, the original value appears to be off by a factor of 100, this value is divided by 100. Additionally, on June 13, 2022, and July 18, 2022, the adjusted close is outside of the bounds of the high and low—and inconsistent with historical data on the close price from The Wall Street Journal. These two values were replaced with the open price from the following day.

Daily percent change values are calculated from the percent change from the previous trading day’s adjusted close price. Our comparison of daily changes across different types of currencies and assets presents a challenge because different assets trade according to different schedules. Stocks trade on exchanges with daily opening and closing times and close on weekends and certain holidays. Traditional foreign exchange markets stay open around the clock, Monday through Friday, but close on weekends, and this is further complicated by time zones and different holidays globally. Cryptocurrencies trade continually.  

There is subjectivity inherent in addressing this issue. We chose to limit our analysis to the trading days of our traditional stock indices (S&P 500 & Russell 2000), which align with New York Stock Exchange trading days, and use reported adjusted close as the price. While this eliminates a small amount of data from the sample for cryptocurrencies, we conducted robustness checks and confirmed this does not drive our results about persistent differences in day-to-day percent changes. 

The post Examining day-to-day crypto volatility and why it’s important appeared first on Reason Foundation.

The ban has served as a test for what other states and municipalities might expect if they enact similar prohibitions on flavored tobacco products. Although officials often promote tobacco control policies as ways to protect public health, the unintended consequences of menthol cigarette bans on total cigarette sales have puzzled many public health officials and raised important questions about the effectiveness of the prohibitions.

In my analysis of the comprehensive flavored tobacco ban implemented in Massachusetts, the data show that the prohibition of menthol cigarettes was followed by millions of additional cigarette sales in the six-state region of Massachusetts and its bordering states. The year following the ban on menthol cigarette purchases saw 15 million fewer packs of menthol cigarettes sold than the year before the ban. However, approximately 22 million additional packs of nonmenthol cigarettes were sold in those states in the year after the flavor ban, leading to a net increase in cigarette sales.

In the 12-month period following the implementation of the comprehensive flavor ban in Massachusetts, the state sold 29.96 million fewer (22.24% less) cigarette packs compared to the prior year. However, a total of 33.3 million additional cigarette packs were sold during the same post-ban period in the counties that bordered Massachusetts in the states of Connecticut (3.05 million additional packs), New Hampshire (25.84 million), New York (1.04 million), Rhode Island (6.01 million), and Vermont (1.21 million). Thus, considering the change in cigarette sales in the entire six-state region, there was a net increase of 7.21 million additional cigarette packs sold in the 12 months after the menthol cigarette ban in Massachusetts, a 1.28% increase in cigarette sales compared to the prior 12-month period before the ban.

A paper by Samuel Asare et al. (2022) published in JAMA Internal Medicine publicized a reduction in cigarette sales in Massachusetts following the menthol cigarette ban but failed to include all but one of the bordering states in its analysis. Additionally, the paper analyzed Nielsen Retail Scanner data, which only represented approximately 30% of all US mass merchandiser sales volume that year. In contrast, the Management Science Associates Inc (MSAi) data in my analysis represents all cigarette distribution throughout the entire US.

In conclusion, policymakers must be careful about enacting prohibitions for a variety of reasons, including when the banned product is still available for sale in nearby municipalities. This is especially true when tax rates in neighboring states are relatively low. In 2020, the sales tax for cigarettes in New Hampshire ($1.78 per pack) was approximately half that of Massachusetts ($3.51 per pack), which further incentivized bulk purchases of cigarettes and allowed for a sizeable smuggling market for black market sellers after the flavored tobacco ban was implemented. 

With similar flavored tobacco prohibitions being proposed in states like Maryland, which currently has a cigarette sales tax of $3.75 a pack, policymakers should keep in mind that neighboring Virginia has a much-lower sales tax of $0.60 per pack and that the cross-border smuggling of cigarettes would inevitably follow a menthol cigarette prohibition in Maryland.

The data from Massachusetts and neighboring states show the menthol ban did not stop people from buying cigarettes, with sales increasing by seven million packs in the year after Massachusetts’ flavored tobacco ban. Massachusetts’ flavored tobacco ban primarily sent buyers to others states and illicit markets, so other cities and states should consider the real-world impacts of implementing similar prohibitions.

The post The effect of menthol bans on cigarette sales: Evidence from Massachusetts  appeared first on Reason Foundation.

Government pension plans depend on annual investment results to help generate the funding needed to pay for the retirement benefits that have been promised to teachers, public safety, and other public workers. Since investment returns contribute to long-term public pension solvency trends, interested parties keep a close eye on the annual return results of these pension funds to see how they are performing compared to their own assumed rates of return. 

Reason Foundation’s list of public pension investment return results includes all major state pension plans that have reported their 2022 fiscal year results as of this writing.

The distribution of 2022 investment returns shows a significant range of results across all of the state pension plans reporting results at this time.

The Oklahoma Public Employees Retirement System reported a -14.5% return for its 2022 fiscal year, which is the lowest return rate among the public pension plans reporting results.

The New York State and Local Retirement System (NYSLRS) and the New York Police and Fire Retirement System (PFRS) reported 9.5% returns—the highest return rate in the nation for fiscal 2022, although their results are mostly attributed to plans’ 2022 fiscal year ending in March 2022, before the largest market losses in the 2022 calendar year.

Overall, the median investment return result for state pension systems in 2022 is -5.2%, which is far below the median long-term assumed rate of return for 2022 of 7% for the plans included in this list. With return results for the 2022 fiscal year so far below pension plans’ return assumptions, most state pension plans will see growth in their unfunded liabilities and a worsening of their reported funding levels.

With each public pension plan achieving different investment returns, the funding impact will also be different for each pension system.

Methodology

'Estimated Investment Gain/(Loss)' is calculated by taking the plan's FY 2020-21 Market Value of Assets and multiplying it by the difference between '2022 Return' and 'Assumed Rate of Return.' Estimated values are meant to approximate total amounts of investment loss that plans would fully & directly recognize this year due to FY 2021-22 return deviating from the assumption (i.e., not accounting for the smoothing mechanism). Investment returns shown are Net of Fees, if not stated otherwise. ‘Deviation from Assumed Rate of Return’ shows the difference between ‘2022 Return’ and ‘Assumed Rate of Return.' Positive returns are highlighted in light blue, and negative in orange. The distribution of the 2022 investment returns chart is based on the `normalized` probability density function, with all probabilities (i.e., all points on a line graph) summing up to 100%. 

The post The 2022 fiscal year investment results for state pension plans  appeared first on Reason Foundation.

States are increasingly enacting open enrollment policies that give students options across school district boundaries. But this is only half the equation. Policymakers must also ensure that education dollars follow the child to the school of their choice, a concept referred to as funding portability. Without sufficient portability, school districts have weak financial incentives to enroll transfer students and may limit opportunities for families. Non-portable dollars also reinforce district boundaries, which lock families into public schools based on where they can afford to live, not what is necessarily best for their children.

The primary culprits inhibiting funding portability are districts that are entirely locally funded due to high property wealth, and both local education funding and state funding streams that aren’t sensitive to changes in enrollment.

New Hampshire provides a valuable case study that illustrates these problems. In total, 39 of the state’s 237 districts are off-formula and don’t generate additional state aid when new students enroll. Moreover, nearly two-thirds of New Hampshire’s non-federal education dollars are generated locally and aren’t portable across school district boundaries. As a result, most districts only receive a fraction of their average per-pupil spending amounts when enrolling additional students, which weakens financial incentives for an open enrollment program.

Ideally, school finance systems should “attach” dollars directly to students so that all state and local education funds flow seamlessly across district boundaries. States vary considerably with how close they are to this vision, and the first step for policymakers is to take stock of funding portability in their state. From there, states can take three different pathways to improve portability: comprehensive school finance reform, targeted solutions, and creating a distinct funding mechanism that supports open enrollment. While all solutions are worth considering, the most direct approach is to follow Wisconsin’s lead by establishing a stand-alone funding allotment for public school open enrollment. Three best practices can help policymakers craft this funding policy.

Uniform: Start with a Single Statewide Base Per-Pupil Amount

Open enrollment funding policy should center around a single per-pupil amount that follows students across school district boundaries, an approach Wisconsin has successfully employed for more than two decades. This provides robust transparency while also guaranteeing that all school districts are operating under the same set of financial incentives. There are numerous ways to set this amount, but policymakers should strive to maximize the share of overall state and local per-pupil funding attached to students.

Responsive: Account for Students’ Needs

Policymakers can attach weights or additional per-pupil amounts to students with disabilities and other categories of need. For example, Wisconsin provides a greater per-pupil amount for students with disabilities, plus reimbursement for costs that exceed this amount up to a specified limit, which is paid for by students’ home districts.

Incentivize: Tap into Local Education Dollars

Ideally, states should ensure that local dollars follow the child across school district boundaries. One way to do this is to deduct a per-pupil amount from home school districts’ state aid for each student who transfers out and allow it to follow the child across district lines. Tapping into local dollars ensures that districts’ incentives are maximized, and this approach negates the need for district-to-district billing of local dollars, which is undesirable because it reinforces the idea that dollars belong to districts, not the students.

Fundamentally, establishing portable education funding moves states closer to a boundaryless public education system—an idea first pioneered by Milton Friedman. In its purest form, this means eliminating residential assignment and funding students directly so that they can choose whatever option best fits their needs.

Download the full policy brief: Public Education Funding Without Boundaries

The post Public education funding without boundaries: How to get K-12 dollars to follow open enrollment students appeared first on Reason Foundation.

While these ESG policies are often subjective and political, proponents tend to claim that they are an objective lens to value firms and allocate investments. The evidence for this claim is weak, however.

For many activist investors and politically-motivated institutional investors, investment performance may not be the main priority. ESG can be used to provide activist investors a framework to reshape how finance and investing relate to business into something that better conforms with their visions of the world. There are generally two approaches for these groups: divestment and/or engagement. 

Divestment 

The theory behind divestment is that by selling or avoiding the purchase of so-called ‘bad’ companies and industries, these firms and industries will be punished with a higher cost of capital. The cost of capital is the required rate of return or profit a firm must earn on capital investments to satisfy its owners and creditors. Companies can raise capital from equity by selling ownership or debt by taking a loan from a creditor. A higher cost of capital reduces the number of new investment opportunities available to a business.  

The latest Global Sustainable Investment Alliance report put ESG investments at 36% of all managed assets. According to the Global Fossil Fuel Divestment Commitments Database, 1,556 institutions have now divested from fossil fuels. These institutions include Harvard and Oxford Universities, several New York City pension funds, and the Norwegian Sovereign Wealth Fund. 

The actual impact of these divestment strategies is not clear. The cost of capital in the oil and gas industry has declined over the past decade, which is in line with the general decline in the total market. Conversely, the cost of capital did jump considerably in the green and renewable energy industry in 2021, but there is a fair amount of volatility across all sectors year-to-year. 

Examining the impact of divestment, Jonathan Berk and Jules H. van Binsbergen, professors from Stanford's Graduate School of Business and the University of Pennsylvania's Wharton School, respectively, were not able to find a meaningful impact of ESG investing on capital costs within the energy markets. "When calibrated to current data, we demonstrate that the impact on the cost of capital is too small to meaningfully affect real investment decisions," Berk and Binsbergen write. Instead, the authors suggest socially conscious investors should focus on changing corporate policy. 

Engagement 

Changing corporate policy through shareholder influence and proposals is the engagement side of environmental, social, and governance strategies. Publicly traded companies hold annual shareholder meetings in which shareholders can vote on various proposals in proxy voting. ESG proposals in proxy votes are increasingly common and supported by large asset managers. 

One of the better-known examples of engagement occurred in 2021 in association with the oil company Exxon Mobil. A green activist hedge fund, Engine No. 1, which says it seeks "to create value by helping companies transform their businesses to be sustainable," gained support from asset managers, including BlackRock, Vanguard, and State Street, and elected three supported directors to Exxon's board. Four directors were nominated by Engine No. 1.  

However, this election was not an isolated occurrence. According to Morningstar, an investment research and management services firm, there were 273 ESG shareholder proposals in 2022. Notably, the number of proposals that pass has steadily increased over the last three years. Twenty resolutions passed in 2020, 36 passed in 2021, and 40 passed in 2022.  

The support for these resolutions is highest with institutional investors, particularly public pension funds. While general shareholders supported 63% of ESG resolutions, according to Morningstar, public pension funds supported 90%—which was even higher than the rate of ESG-focused funds. The Teachers Insurance and Annuity Association of America (TIAA) supported 92%, BlackRock supported 74%, and State Street supported 66%. Vanguard was the only asset manager of the "big three" to support ESG shareholder resolutions less than the general shareholder, voting in favor of 51% of proposals, Morningstar found.  

Unfortunately, there are no standardized disclosures or reporting for public pension proxy votes. Morningstar looked at 65 public pensions but could only locate records for 34 (29 were included in its analysis). Only one-third of these public pension plans had their records available online. Six percent charged a fee to provide their proxy-voting records, and five percent declined to give them. The lack of reporting on proxy votes among public pension systems should be viewed as a red flag suggesting these funds may be avoiding transparency and accountability.  

While the actual impact of divestment strategies appears tenuous, there are an increasing number of ESG shareholder resolutions with considerable support from institutional investors, particularly public pension funds.  

It is inappropriate for public entities to engage in political, non-pecuniary investment activities, regardless of whether it occurs through divestment or shareholder proposals. Public pension plans have a duty to base their investment decisions on pecuniary factors, such as investment performance and financial risk. Reason Foundation's Pension Integrity Project recommends that policymakers help prevent politically-driven investing and proxy voting by public pension systems by allowing the public to view all of the system's proxy votes well in advance of them being cast, as well as by requiring an annual report showing all of a public pension plan's proxy votes.

To serve the public workers relying on public pensions and to protect taxpayers, who are ultimately liable for paying for them, there must be complete transparency and appropriate rationales for proxy votes and divestment decisions made by public pension systems.  

The post The mechanics of ESG-driven divestment, engagement and proxy voting  appeared first on Reason Foundation.

Greenwashing and Marketing

Both Goldman Sachs and Deutsche Bank’s DWS are currently facing U.S. Securities and Exchange Commission (SEC) probes over the alleged “greenwashing” of their investment funds, according to The New York Times. Greenwashing is a term used to describe firms or investment funds that make unsubstantiated or misleading claims to appear more environmentally and ESG-friendly. The Times reports:

ESG reporting has emerged as a top priority for the SEC under the agency’s chair, Gary Gensler. Earlier this year, the commission proposed changes that would require more disclosure from companies to investors about the risk that climate change and new government policies on it might pose to their operations. And last year, the regulator set up a special ESG task force to focus on whether Wall Street firms and companies were misleading investors about their investment and business criteria in the environmental, social and governance area.

The investigation into Goldman’s mutual funds appears to be related to the new enforcement initiative. Last month, the investment advisory arm of Bank of New York Mellon paid $1.5 million to settle an investigation by the SEC. into allegations it had omitted or misled investors about its ESG criteria for assessing investments. The SEC is also looking into Deutsche Bank.

The Deutsche Bank/DWS investigation may be related to whistleblower Desiree Fixler’s claims that ESG assets under management were inflated. Fixler told the Financial Times, “I still believe in sustainable investing, but the bureaucrats and marketers took over ESG and now it’s been diluted to a state of meaninglessness.”

Last year, Tariq Fancy, the former head of sustainable investing at BlackRock, questioned the legitimacy of ESG investments in an op-ed for USA Today:

I led the charge to incorporate environmental, social and governance (ESG) into our global investments. In fact, our messaging helped mainstream the concept that pursuing social good was also good for the bottom line. Sadly, that’s all it is, a hopeful idea. In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.

Consistent with Fancy’s claim that ESG is little more than “PR spin,” many other critics contend the ESG signaling and actions from some of the largest asset managers are partly attempt to attract younger investors—who may be attracted by the idea of “socially conscious” investing. A Southern California Law Review paper by Michal Barzuza, Quinn Curtis, and David Webber in 2019 argues that:

…index funds must seek out differentiation in the market where they can find it. Using their voting power to promote their investor’s social values, and doing so publicly and loudly, is a way for these funds, which otherwise risk becoming commodities, to give millennial investors a reason to choose them.

Higher Fees For ESG-Related Funds

The asset management industry has experienced declining management fees since the 1990s, in what is commonly referred to as “fee compression.” A July 2022 analysis from Morningstar showed that for asset-weighted passive funds, fees have “declined 66% since 1990.”

But in many cases, ESG investments are proving to be an opportunity for funds to charge higher fees. The Economist looked at three very similar exchange-traded funds (ETFs) managed by BlackRock: Core S&P 500 (IVV), ESG Screened S&P (XVV), and ESG Aware MSCI USA (ESGU). Despite very similar composition and synchronized performance in 2022, the ESG ETFs had 2.7 to 5-times higher expense ratios, the percentage of a fund’s assets used to cover operating expenses.

Whether this difference is due to the relative size of these funds and the back-end work involved in constructing the index, it is a persistent pattern. In 2021, Morningstar found a significant so-called “greenium” upcharge for ESG funds. While Morningstar found fees were at record lows in 2021, the asset-weighted average expense ratio was 0.55% for sustainable funds—significantly higher than 0.39% for traditional funds.

Politicizing Public Pensions and Taxpayers’ Dollars

Higher fees and marketing strategies are not parts of the environmental, social, and governance-related sales pitches made to investors. Instead, ESG advocates and asset managers make the case that environmental, social, and corporate governance considerations are in the best interest of investors. BlackRock CEO Larry Fink, for example, wrote in his 2022 letter to “CEOs and chairs of the companies our clients are invested in”:

Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not ‘woke.’ It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper.

Despite Fink’s framing, ESG policies often take sides on some of the most contentious contemporary political issues, including energy, environmental policy and climate change, foreign policy, abortion, guns, workplace issues, and more. ESG often moves these issues from legislative, judicial, and political spheres into financial markets and corporate boards, increasingly politicizing what might previously have been non-political organizations and institutions focused on their core missions and products.

To claim otherwise presupposes that ESG considerations are an objectively better way to operate and evaluate firms. Thorough analyses, like research by the University of California-Los Angeles Professor Bardford Cornell and Aswath Damodaran, a professor at New York University, concluded: “evidence that investors can generate positive excess returns with ESG-focused investing is weak.”

Still, to be clear, private individuals and institutions are free to allocate their assets in whatever ways they see fit. Public sector financial assets are a different story. Public pension funds have a fiduciary duty to manage assets in ways that ensure the funds can meet the retirement needs of their members. For public pension systems, political activism of any stripe, as my Reason Foundation colleague Richard Hiller notes, is “inconsistent with these fiduciary responsibilities and retirement plan objectives.”

The over $5 trillion in state and local public pension investment assets should not be treated as money that is up for grabs or that can be leveraged for political causes by politicians, system administrators, and subgroups of plan participants. Unfortunately, however, government entities across the board are increasingly becoming activists on political issues.

On ESG, two major groups in climate activism are the Ceres Investor Network and Climate Action 100+. Eleven public pension plans, eight state treasurer offices, and three state investment boards have signed on as members of Ceres, which describes itself as “a nonprofit organization transforming the economy to build a just and sustainable future for people and the planet.”

Similarly, 16 public pension plans, three state treasurer offices, and four state investment boards are members of Climate Action 100+, which says it “is an investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change.

A report from Morningstar found that public pension funds supported ESG shareholder resolutions at a greater rate than ESG-focused funds in 2021. Among key ESG shareholder resolutions in 2021, the report found:

Perhaps not surprisingly, public pensions based in Democratic-leaning states tended to vote in favor of ESG resolutions more often than those based in Republican-leaning states—the former had an average 98% support rate across public pension funds compared with the latter's 80%. Public pensions located in split states landed in between, at 85%. The less predictable outcome may be that all three groups came out well ahead of general shareholders' average 63% rate of support across key shareholder resolutions and didn't look too different from the 85% rate of support seen from ESG-focused funds.

The report also found that policymakers and taxpayers should: “Insist that public pension funds provide better transparency on their voting policy, votes, and voting rationale.”

As the financial industry receives increased scrutiny related to its ESG practices and likely inflated claims, the involvement of public pension systems becomes better known, and some politicians push to make ESG-related investments and issues mainstream public issues, there could be a reckoning ahead. Given the size of the ESG asset management industry, ESG investments and practices are likely to continue to be a significant part of financial markets and the business world for the foreseeable future. However, all parties involved should embrace a serious review of existing approaches and increased transparency, especially when it comes to public pension systems and taxpayers' dollars.

The post Scrutinizing high ESG fees, greenwashing and the politicization of public pension funds appeared first on Reason Foundation.

At the end of the second quarter of 2022, the $30.6 trillion debt of the United States federal government was 1.2 times larger than the annual economic output of the country. The U.S. is now reaching federal debt levels, as a share of gross domestic product (GDP), that we have not seen since the end of World War II.

Federal spending is increasingly untethered from fiscal realities. From 1965 to 2022, the federal government ran an annual budget deficit in 52 of the 57 years.

The annual federal budget deficits during and following the Great Recession of 2007-2009 were dwarfed by the recent federal deficits of 2020 and 2021, however, when annual budget deficits were $3.1 and $2.8 trillion respectively. The COVID-19 pandemic and accompanying lockdowns and policies sparked the largest spending bills in American history, including the $2.2 trillion CARES Act signed by then-President Donald Trump in March 2020. A year later, in March 2021, President Joe Biden signed the $1.9 trillion American Rescue Plan Act.

After accounting for inflation, the national debt jumped by almost $5 trillion in less than two years—rising from $25.9 trillion in the first quarter of 2020 to $30.6 trillion at the end of the second quarter of 2022. To get a sense of the magnitude of the growth of the debt, the current debt of more than $30 trillion translates to each American individual owing $91,814 based on the U.S. Bureau of Economic Analysis (BEA) estimate of 333 million Americans. This is an increase in the national debt of nearly $14,000 per person just since the first quarter of 2020.

While the increase in the national debt during the pandemic has been particularly shocking, it is consistent with a decades-long, bipartisan trend of deficit spending where government expenditures consistently exceed government receipt of money. When tax revenue is insufficient to cover government spending, the government must issue U.S. Treasury bonds, shorter-term obligations like bills and notes, or other debt instruments. 

Federal Debt Holders

The federal debt is often classified into two buckets: intragovernmental holdings and debt held by the public.

Intragovernmental Debt

Intragovernmental holdings are government debt held by government agencies. As of September 8, 2022, intragovernmental holdings totaled $6.6 trillion, which is 21.4% of the total outstanding public debt. The largest share of this intragovernmental debt is held by the Social Security Trust Fund (46%).

Debt Held by the Public

Debt held by the public can be broken down into debt held by the U.S. public, foreign entities, or the U.S. Federal Reserve. The U.S. public is a broad category that encompasses domestic non-federal investors. It includes state and local governments, private pension funds and insurance companies, banks, and other investors. Foreign entities include the governments and central banks of other countries and private international investors. 

In recent years, even relative to the first two groups of debt holders, the U.S. Federal Reserve has greatly increased its holding of government debt. The Federal Reserve buys the debt with newly created reserves, but these purchases raise the risk of inflation by monetizing the debt. Since new reserves can increase the nation’s supply of money, they can lead to higher prices as more dollars chase the same volume of goods and services. The Federal Reserve asserts, “Federal Reserve purchases of Treasury securities from the public are not a means of financing the federal deficit.” But Federal Reserve asset purchases are traditionally a means of circulating newly printed bills. While new tools like interest on monetary reserves can mitigate the impact of such expansion, the dramatic increase of Federal Reserve debt purchases (which include mortgage debt and corporate bonds as well as Treasurys) is a serious concern.

Given the persistence of federal deficit spending, if demand for U.S. debt does not keep pace with debt accumulation, the risk of debt monetization via Federal Reserve purchases rises further.

Foreign Holders of U.S. Debt

Demand for U.S. debt has increased because the dollar is the de facto reserve currency of the world. The Bretton Woods system, which pegged other currencies to the U.S. dollar which was redeemable for gold, effectively ended after President Richard Nixon suspended dollar-to-gold convertibility. Since that point, the nations belonging to the Organization of the Petroleum Exporting Countries (OPEC) have principally denominated oil sales in U.S. dollars, therefore boosting demand for America’s debt.

The United States heavily relies on foreign buyers for debt financing, which can potentially be a liability if or when international conflicts arise. Russia held $139 billion in U.S. debt in 2013. After the Russian annexation of Crimea in 2014, the U.S. responded with aggressive sanctions and threats to remove Russia from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system. In response, Russia’s central bank began divesting from U.S. Treasurys. Today the West is once again sanctioning Russia after its invasion of Ukraine.

Historically, many countries have relied on the safety and stability of U.S. Treasurys. Western sanctions on Russia are a reminder that this “risk-free” asset is not risk-free for those failing to align with American foreign policy. The mid-March reporting that Saudi Arabia may begin pricing Chinese oil sales in yuan is an indication that U.S. financial dominance is not completely unchallengeable. Yuan-denominated oil sales could further erode Chinese demand for our debt, which has declined in recent years.

Today, China and Japan account for nearly one-third of all foreign holdings of U.S. debt. Given America’s friction with China and the population decline experienced in Japan, it is not a certainty that these two countries will indefinitely continue to sweep up large volumes of additional U.S. debt.  

Ultimately, the United States government must understand that we do not have an unlimited capacity for financing our deficit spending. This will become even more difficult as we pay out the rapidly growing liabilities for programs like Social Security and Medicare.

Other Long-Term Federal Financial Obligations

Organizations incur long-term financial obligations in forms other than bonds and the U.S. federal government is no exception. Some common types of financial obligations include pension and retiree health care costs for veterans, civilian federal employees, and the general public (through Social Security and Medicare benefit commitments). Looking at the federal government's balance sheet as of 2021, public holdings of U.S. Treasury securities make up less than one-quarter of total federal liabilities. Unfunded entitlements, like Medicare and Social Security, account for the most at 59% of obligations.

Overall federal obligations have now surpassed $300,000 per American. While substantial in their own right, the debt obligations of state and local governments across the country are dwarfed by the various categories of federal debt.

Conclusion

Unfortunately, the United States does not seem positioned for economic expansion like it was the last time the debt-to-gross domestic product (GDP) ratio was this high during the post-World War II era. Following WWII, debt was reined in by brief periods of inflation and several decades of exceptional economic growth.

In the first two quarters of 2022, the U.S. economy experienced negative growth. With weak or negative economic growth expected, and no significant restriction on federal spending in sight, the debt-to-GDP ratio will continue to rise.

Jeffrey Rogers Hummel, Professor Emeritus in the Economics Department at San Jose State University, was consulted on the “Federal Reserve Assets as Percentage of Publicly Held Debt” chart.

Data & Methodology

• Federal Spending Versus Receipts: 
  • Overall data is from the U.S. Department of Commerce’s Bureau of Economic Analysis (BEA) National Income and Product Accounts data, specifically Table 3.2 (Government Current Receipts and Expenditures, which is reported quarterly). 
    • Spending data is from “Current Expenditures” on lines 24 and 44. 
    • Revenue data is from “Current Receipts” on lines 1 and 41. 
    • The inflation-adjusted data series are adjusted according to Q2 2022 dollars using the U.S. GDP implicit price deflator (FRED: GDPDEF) sourced from BEA.
    • The percent of GDP data series are calculated using quarterly Gross Domestic Product data (FRED: GDP) sourced from BEA.

• National Debt: Data are sourced from the U.S. Department of the Treasury—titled “Federal Debt: Total Public Debt” (FRED: GFDEBTN).
  • The debt data are inflation-adjusted to Q2 2022 dollars with the U.S. GDP implicit price deflator (FRED: GDPDEF) sourced from the U.S. Department of Commerce’s Bureau of Economic Analysis (BEA).
  • Per capita figures are derived from the above data and divided by U.S. population (FRED: B230RC0Q173SBEA) data sourced from BEA.
  • The percent of GDP data series are calculated using quarterly Gross Domestic Product data (FRED: GDP) sourced from BEA.

• Who Holds the Federal Debt: Data is sourced from the U.S. Department of Treasury.
  • Federal Reserve Banks: Public debt securities held by Federal Reserve banks. Data are sourced from Treasury (FRED: FDHBFRBN). The data are reported and presented at the quarterly level.
  • Foreign Entities: Federal debt held by foreign investors. Data are sourced from Treasury (FRED: FDHBFIN).
  • U.S. Public: Calculated by subtracting debt held by “Federal Reserve Banks” (FRED: FDHBFRBN) and “Foreign Entities” (FRED: FDHBFIN) from a FRED data stream, from Treasury, called “Federal Debt Held by the Public” source from Treasury (FRED: FYGFDPUN).
  • Agencies & Trusts: Federal debt held by agencies and trusts. Data are sourced from Treasury (FRED: FDHBATN).
  • All data series above are inflation-adjusted to Q2 2022 dollars with the U.S. GDP implicit price deflator (FRED: GDPDEF).
  • The percent of GDP data series are calculated using quarterly Gross Domestic Product data (FRED: GDP) sourced from BEA.

• Federal Reserve Assets
  • Total Federal Reserve Assets: The Federal Reserve has a balance sheet that contains both assets and liabilities. Notes in circulation, bank reserves, and other liabilities. On the asset side of the ledger, the Federal Reserve has securities that include things like: U.S. Treasurys, mortgage-backed securities, loans to banks or other institutions, and liquidity swaps with central banks from other countries. Total Federal Reserve assets as a percentage of publicly held debt are calculated by dividing reserve bank credit (FRED: RSBKCRNS) by total public debt outstanding (Treasury: tot_pub_debt_out_amt).
  • Total Treasury Deposits at the Federal Reserve: When the U.S. Treasury issues public debt and deposits the proceeds at the Federal Reserve this is considered a treasury deposit. This figure as a percentage of publicly held debt is calculated by taking reserve bank credit (FRED: RSBKCRNS) and backing out three other data streams (FRED: WTREGEN; FRED: WLRRAL; and FRED: WORAL) and dividing by total public debt outstanding When the Fed borrows from the private sector, it does through what is referred to as reverse repurchase agreements. That amount is calculated by backing out of reserve bank credit in two data streams (FRED: WREPODEL and FRED: WREPOFOR). The overall total of these two forms of Fed borrowing as a percentage of publicly held debt is the sum of the five data streams divided by total public debt outstanding.
    
• Biggest Foreign Holders: Data is retrieved from the US Treasury Department’s Major Foreign Holders of U.S. Treasury Securities historic tables, which due to aggregations below certain thresholds may result in missing data for certain years for some countries. Data are adjusted to 2021 dollars with the US GDP implicit price deflator (FRED: A191RD3A086NBEA).

• Beyond Publicly Held Debt
  • Federal: Data for these series are taken from the Financial Reports of the United States Government for the years 2000 through present published by the U.S. Treasury Department. 
    • The data is inflation-adjusted to 2021 dollars with the US GDP implicit price deflator (FRED: A191RD3A086NBEA). 
    • Per capita figures are derived from the above data and divided by U.S. population (FRED: B230RC0A052NBEA) data sourced from BEA. 
    • The percent of GDP data series are calculated using annual Gross Domestic Product data (FRED: GDPA) sourced from BEA.
  • State & Local: The bonded debt data come from the U.S. Census Bureau’s Survey of state and Local Government Finance (2020 and 2021 levels are extrapolated). 
    • Pension Debt: Data are sourced from the Board of Governors of the Federal Reserve System (FRED: BOGZ1FL223073045Q). Excluded here are state and local retiree healthcare liabilities for which time series data are not available. Reason Foundation has estimated that these liabilities totaled $1.2 billion in 2019. 
    • The data is inflation-adjusted to 2021 dollars with the US GDP implicit price deflator (FRED: A191RD3A086NBEA). 
    • Per capita figures are derived from the above data and divided by U.S. population (FRED: B230RC0A052NBEA) data sourced from BEA.
    • The percent of GDP data series are calculated using annual Gross Domestic Product data (FRED: GDPA) sourced from BEA.

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While private investors are free to utilize whatever assessments they deem most valuable, ESG assessments are rightly seen by many as out-of-scope for public pension systems and other investments of taxpayer-sourced funds. Public pension trustees, for example, are required by state laws to exercise their fiduciary responsibilities to maximize public pension systems’ investment returns at acceptable levels of risk for retirees and future beneficiaries.  

In what appears to be a contradiction of these fiduciary standards, many public pension plans, along with some state treasurers, comptrollers, and state investment boards, have become signatories to global climate accords and members of climate activist groups.  

One commonly used set of ESG investment standards originates from the Paris Aligned Investment Initiative (PAII) created in 2019 by the Institutional Investors Group on Climate Change to provide “a member-led forum to explore how investors can align portfolios to the goals of the Paris Agreement.”   

The North American group involved in PAII, the Ceres Investor Network on Climate Risk and Sustainability, says it works “with our members to advance sustainable investment practices, engage with corporate leaders, and advocate for key policy and regulatory solutions to accelerate the transition to a just, sustainable, net zero emissions economy.” 

And another group related to Ceres is Climate Action 100+, which says it “is an investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change.” 

Regardless of how one feels about environmental policy, it involves overtly political questions that must be adjudicated via a legislative process. It is inappropriate for public pension funds to leverage their assets for political purposes rather than serving their duty to fully fund the pension benefits that have been promised to public workers.   

The map below identifies the US state and local public entities signed on to Ceres and/or Climate Action 100+. You can click (or select on mobile) on individual states to see the public entities that have joined these groups.

The post The public pension systems signing on to politicized ESG investment efforts appeared first on Reason Foundation.

Reason Foundation’s 2022 K-12 Education Spending Spotlight includes both real and nominal U.S. Census Bureau data for all 50 states dating back to 2002, which is the starting point for continuous state-level summary figures.

Reporting from the 2020 fiscal year is the most recent school finance data available at this time. Reason Foundation’s K-12 Education Spending Spotlight data analysis and dashboard with 2019 data can be found here.

2020 Data Highlights

• Inflation-adjusted per-pupil education revenue increased in 49 of 50 states between 2002 and 2020. 
• While spending went up, 22 states plus the District of Columbia saw declines in student enrollment during this time.
• Between 2002 and 2020 total education spending on employee benefits (such as pensions and healthcare) in the U.S. nearly doubled from $90 billion to $164 billion a year. 
• Overall inflation-adjusted spending on salaries grew much less – from $342 billion to $372 billion – in this time period.
• Per-pupil education spending on total benefits increased by an average of $1,499 while per-pupil spending on total salaries increased by $492 between 2002 and 2020.
• All 50 states saw real per-pupil spending increases on total benefits between 2002 and 2020. During that time, 14 states saw benefit spending grow by over 100% and two states saw growth of 200% or more. 
• In 2020, total education system long-term debt surpassed $500 billion, reaching a total of $505 billion in the U.S. Between 2002 and 2020 long-term debt grew by $188 billion or $3,798 per student.

K-12 Education Revenue Growth

Nationwide, inflation-adjusted per-pupil K-12 revenues grew by 25%—or by $3,211 per student—between 2002 and 2020. During this time, per-pupil revenues increased in all but one state (North Carolina). Sixteen states, plus D.C., increased their education funding by 30% or more during this time period. In the most recent year, education spending grew by $8 billion across the United States, for an average increase of $169 per-pupil from the 2018-2019 school year to the 2019-2020 school year. 

The below map displays the rates at which states have increased their education spending since 2002. Users can explore various data and national education spending trends using the drop-down and slider in the interactive map.

Well before the pandemic decimated student enrollment numbers, many states were already losing students. The District of Columbia and Michigan both saw over a 24% decline in students between 2002 and 2020. Overall, 22 states and D.C. experienced enrollment declines between 2002 and 2020. All these states, with the exception of Michigan, increased their total inflation-adjusted education spending during that time.

In per-pupil terms, every state except North Carolina saw an increase in education revenue from 2002 to 2020. Table 1 below shows the rates at which states have increased education spending since 2002 and the changes in student enrollment figures during that time period. 

Table 1: Changes in Per-Pupil Revenue from 2002 to 2020 by State

State dollars accounted for the largest slice of the K-12 funding pie at 47% in 2020. Figure 2 displays how education funding sources, as well as total funding by state, have changed over time. Select a state from the drop-down menu to find state-specific metrics over time.

Instruction and Support Service Spending

Instruction and support services are the largest spending categories for schools each year. These categories cover everything from teacher salaries to school counseling services. Between 2002 and 2020, instruction expenditures increased from $6,818 per-pupil to $8,176 per-pupil. Interestingly, salaries only accounted for about $226 of this per-pupil growth while spending on benefits, such as retirement and health care, soared by $995 per-pupil during that time

Inflation-adjusted support service expenditures grew from $3,841 per pupil in 2002 to $4,815 per pupil in 2020. Salaries accounted for $268 of this growth while spending on benefits increased by $473 per pupil. 

Between 2002 and 2020, the total amount spent on instructional and support benefits in the U.S. nearly doubled from $87 billion to $159 billion a year (or from $1,840 per pupil to $3,307 per pupil).  Overall spending on instructional and support services salaries grew from $331 billion to $360 billion in the U.S. in this time period (from $7,014 per pupil to $7,509 per pupil). 

Between the 2018-19 and 2019-20 school years, increased spending on instructional benefits far outpaced spending increases on salaries in some states. In Hawaii, spending on instructional benefits increased by more than double the increased spending on instructional salaries—benefits went up by $246 per pupil while salaries increased by $120 per pupil from year to year. In Kentucky, spending on instructional benefits went up by $9 per pupil between the 2018-19 and 2019-20 school years, while spending on salaries actually decreased by $96 per pupil.

A Closer Look at Support Services

Importantly, the support services category covers a wide range of expenditures. To get a better understanding of how these categories further break down, readers can examine the financial accounting manual published by the National Center for Education Statistics. 

Note that spending increases between 2002 and 2020 weren’t disproportionately absorbed by schools or general administration, which grew from $629 to $758 per pupil and $224 to $265 per pupil, respectively. The biggest increase in support services came from growth in pupil support services, which increased from $566 per pupil to $864 per pupil. This category includes non-instructional items such as psychological, guidance, and health care-related expenditures. It also includes paraprofessional services offered to students with disabilities such as speech pathology and occupational therapy. You can view a breakdown of support service spending for every state using the drop-down in the right-hand corner of the below visualization. 

Also note that the biggest single cost under this group is operation and maintenance, which accounted for 25% of all support services in 2020. This includes items like building repairs, security, and groundskeeping. Spending on this category actually fell between the 2019 and 2020 school years, reversing the nine-year trend of continued growth.

More on Total Benefit Growth

A substantial cost-driver for K-12 education is spending on benefits. Total benefits are a Census Bureau expenditure category that includes retirement contributions, pension costs, health care insurance, retiree health care insurance, workers compensation, and other expenses for school employees. Disaggregated figures aren’t available, but research suggests that teacher pension costs are responsible for a substantial share of the observed growth in benefit expenditures. Inflation-adjusted total benefit costs rose dramatically between 2002 and 2020. Every state saw real per-pupil spending increases on total benefit expenditures. 14 states saw benefit spending grow by over 100% and two states, Illinois (200%) and Hawaii (260%) saw growth of 200% or more. 

Nationally, the average expenditure on benefits was $3,406 per-pupil in 2020, up 79% since 2002.

Table 2: Total Benefit Spending by State

Education Debt Obligations by State

The Census Bureau also reports how much short and long-term debt school districts across the county have on their balance sheets each year. In 2020, K-12 long-term debt surpassed $500 billion, reaching a total of $505 billion.  Between 2002 and 2020 long-term debt grew by $188 billion or $3,798 per student in real terms. It is important to note that these totals do not include any pension or other post-employment debt states and schools owe. 

Conclusion

Reason Foundation’s K-12 Education Spending Spotlight can help state policymakers and other stakeholders make informed policy decisions that best serve students. The full 2019 Spending Spotlight with data for all 50 states is available here. 

Additional analysis of 2020 education spending can be found below:

• How K-12 support services spending can divert education funding from instruction
• Increases in education spending have little correlation with actual student counts, data show

Methodology

The educational finance data used for this report come from Census Bureau’s Annual Survey of School Style Finances (F-33 survey). The full F-33 survey reports figures at the district level – the data used in this report come from the aggregated state summary tables which are aggregated by Census. Due to differences in state financial accounting methods, Census makes adjustments to make the state data more comparable.

These charts and underlying data utilize Census reported fall enrollment to calculate per pupil figures. This is consistent with Census reported per pupil figures, except for “Total Instruction” and “Current Spending”. For these categories, at the per pupil level, Census pulls out certain categories (e.g., payments to charters and private schools for “Total Instruction”).

A consequence of this is that in the “K-12 Instructional Spending” chart there are instances (Rhode Island and D.C.) where the Total Instructional figure is less than the sum of instruction salary and benefits. While the total figure is consistent with Census reporting, this results in a negative “Other” value which is calculated from the other three variables (Other = Total – (Salary + Benefits)).

The inflation-adjusted figures are scaled with the Consumer Price Index for All Urban Consumers (CPI) using monthly figures that are averaged over the fiscal year (July to June). Inflation-adjusted figures are in FY 2020 dollars.

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“In the face of new challenges and uncertainties, we’re providing over $17 billion in relief to help families make ends meet and doubling down on our investments to keep building the California Dream on a strong fiscal foundation,” said Gov. Gavin Newsom of the state spending plan he signed in June.

Stimulus checks marketed as ‘inflation relief’ are the largest item in that $17 billion portion of the budget. The payments will go to single adults making up to $250,000 a year and couples making up to $500,000, costing taxpayers $9.5 billion. Another spending item getting far less attention, but with nearly an identical price tag, is a $9 billion increase in the base student funding for California’s public school funding formula, which determines how much money school districts receive each year.

For a variety of reasons during the pandemic, statewide public school student enrollment dropped by 2.6% in the 2020-21 school year and 1.8% in the 2021-22 school year. The declines in major metro school districts were more acute, according to data from Burbio, a school data site. In Southern California, Los Angeles Unified School District wasn’t the only one losing large numbers of students. San Diego Unified School District and Long Beach Unified each lost more than 3% of their student populations last year. Orange Unified School District and Capistrano Unified fared better, losing less than 1% of their students. Overall, school districts located in cities and suburbs lost 2.5% and 1.6% of their students, respectively, last year.

Even though there are fewer kids in public schools, the state’s education spending continues to go up. But higher education spending isn’t leading to higher student test scores. Despite increasing education spending by 36% since 2002, California students produced only small increases in math and reading test scores as of 2019.

CalMatters reports: “Since California students began taking the new standardized exam — known as ‘Smarter Balanced’ — statewide reading and math scores have inched up an average of about 1 percentage point each year for the past five years.”

However, many education researchers fear school closures and other learning disruptions during the pandemic are likely to have erased any progress student outcomes made in the last decade. California’s current combination of a declining population and increased education spending is a recipe for fiscal challenges in the coming years. As a potential recession looms and inflation continues to rise, state leaders and school districts should be preparing their budgets accordingly, not continuing a spending spree.

The state budget is heavily reliant on personal income taxes, which, although more stable than many other revenue sources, can make state revenues volatile and contribute to large surpluses and deficits. During the 2008-09 recession, for example, a drop in revenue from income and corporate taxes coupled with years of runaway spending helped cause the state education budget to be cut by nearly 14%.

Right-sizing California’s education budget now, while the state has a surplus, certainly goes against the political pressures to perpetually increase spending. But California can’t keep increasing education spending while losing students and failing to produce significant achievement gains. To avoid sudden and drastic cuts when the next financial crisis inevitably hits the state and public schools, students and taxpayers would be better served by strategically rightsizing schools and the education system right now.

A version of this commentary originally ran in The Orange County Register.

The post California’s public schools are losing kids while getting more money appeared first on Reason Foundation.

The interactive map below shows the funded ratios for state-managed public pension systems from 2001 to 2022. A funded ratio is calculated by dividing the value of a pension plan’s assets by the projected amount needed to cover the retirement benefits already promised to workers. The funded ratio values for 2022 are projections based on a -6% investment return. 

Year-to-year changes in investment returns and funded ratios tend to grab attention, but longer-range trends give a better perspective of the overall health of public pension systems.

In 2001, only one state, West Virginia, had an aggregated funded ratio of less than 60%. By the end of 2021, four states—Illinois, Kentucky, New Jersey, and Connecticut—had aggregate funded ratios below 60%.

If investment returns are -6% or worse in the 2022 fiscal year, Reason Foundation’s analysis shows South Carolina would be the fifth state with a funded ratio below 60%. 

Over the same period, 2001 to 2021, the number of states with state-managed pensions with funded ratios above 90% fell from 33 to 20. If all plans return a -6% investment return assumption for 2022, Reason Foundation projects the number of states that have funded levels above 90% would shrink from 20 to six.  The six states with funded levels that would still be above 90% after -6% returns for 2022: Delaware, Nebraska, New York, South Dakota, Washington, and Wisconsin. 

Importantly, the -6% investment return assumption for the 2022 fiscal year used in this map may be too optimistic for some public pension plans. The S&P 500 lost 12% of its value over the 2022 fiscal year from July 1, 2021, to June 30, 2022. Vanguard’s VBIAX, which mimics a typical 60/40 stock-bond portfolio, was down 15% for the fiscal 2022 year ending in June 30, 2022. Thus, given the condition of financial markets this year, the public pension plans with fiscal years that ended in June 2022 are likely to report negative returns for the 2022 fiscal year.  

Another useful long-term trend to look at are the unfunded liabilities of state-run pension plans. Whereas a pension system’s funded ratio takes the ratio of assets to liabilities, unfunded liabilities are the actual difference between the pension plan’s assets and liabilities. Unfunded liabilities can be conceptualized as the pension benefits already promised to workers that are not currently funded by the plan. Again, the values for the 2022 unfunded liabilities map are a projection using an investment return of -6%. 

The five states with the largest unfunded liabilities are California, Illinois, New Jersey, Pennsylvania, and Texas. In fiscal year 2021, the unfunded liabilities of those states totaled $434 billion and would jump to $620 billion in 2022 with a -6% return.  

For more information on the unfunded liabilities and funded ratios of state-run pensions, please visit Reason’s 2022 Public Pension Forecaster.

Notes

ⁱ The state-funded ratios in this map were generated by aggregating (for state-managed plans) the market value of plan assets and actuarially accrued liabilities. Prior to 2002, Montana and North Carolina reported data every two years, therefore for 2001 figures from 2002 are used. Figures for Washington state do not include Plan 1, an older plan that is not as well funded.

ⁱⁱ The discount rate applied to plan liabilities will impact the funded ratio of a plan. Therefore, the map above can be best thought of as a snapshot of state-funded ratios based on plan assumptions by year. Overly optimistic assumptions about a pension plan’s investment returns will result in artificially high-funded states. Conversely, pulling assumptions downward, while prudent, will result in a worse-looking funded ratio over the short term.

ⁱⁱⁱ In addition to projections for fiscal 2022, some public pension plans in 29 states have yet to report their complete fiscal 2021 figures and therefore include a projection estimate for 2021 as well. Thus, 2021 projections were used for at least one plan in the following states: Alabama, Alaska, Arkansas, California, Colorado, Georgia, Hawaii, Illinois, Kansas, Louisiana, Massachusetts, Michigan, Missouri, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oregon, Pennsylvania, Texas, Tennessee, Utah, Virginia, Washington, West Virginia, Wisconsin, and Wyoming.

The post Projecting the funded ratios of state-managed pension plans appeared first on Reason Foundation.

Based on a -6% return for fiscal 2022, the aggregate unfunded liability of state-run public pension plans will be $1.3 trillion, up from $783 billion in 2021, the Pension Integrity Project finds. With a -6% return in 2022, the aggregate funded ratio for these state pension plans would fall from 85% funded in 2021 to 75% funded in 2022. 

The 2022 Public Pension Forecaster below allows you to preview changes in public pension system funding measurements for major state-run pension plans. It allows you to select any potential 2022 investment return rate to see how the returns would impact the unfunded liabilities and funded status of these state pension plans on a market value of assets basis.

The nation’s largest public pension system, the California Public Employees’ Retirement System (CalPERS), provides a good example of how much one bad year of investment returns can significantly impact unfunded liabilities, public employees, and taxpayers.

If CalPERS’ investment returns come in at -6% for 2022, the system’s unfunded liabilities will increase from $101 billion in 2021 to $159 billion in 2022, a debt that would equal $4,057 for every Californian. Its funded ratio will drop from 82.5% in 2021 to 73.6% in 2022, meaning state employers will have less than three-quarters of the assets needed to pay for pensions already promised to workers. 

Similarly, the Teacher Retirement System of Texas (TRS) reported $26 billion in unfunded liabilities in 2021. If TRS posts annual returns of -6% for the fiscal year 2022, its unfunded liabilities will jump to $40 billion, and its funded ratio will drop to 83.4%. The unfunded liability per capita is estimated to be $1,338. 

The table below displays the estimated unfunded liabilities and the funded ratios for each state if their public pension systems report -6% or -12% returns for 2022. 

Estimated Changes to State Pension Unfunded Liabilties, Funded Ratios

The first three quarters of the 2022 fiscal year clocked in at 0%, 3.2%, and -3.4% for public pensions, according to Milliman. The S&P 500 is down more than 20% since January, suggesting that the fourth quarter results will be more bad news for pension investments.

Considering the average pension plan bases its ability to fund promised benefits on averaging 7% annual investment returns over the long term, plan managers are preparing for significant growth in unfunded liabilities, and a major step back in funding from 2021. 

The significant levels of volatility and funding challenges pension plans are experiencing right now support the Pension Integrity Project’s position last year that most state and local government pensions are still in need of reform, despite the strong investment returns and funding improvements in 2021. Unfortunately, many observers mistook a single good year of returns—granted a historic one—as a sign of stabilization in what was a bumpy couple of decades for public pension funding. On the contrary, this year’s returns, as well as the growing signs of a possible recession, lend credence to the belief that public pension systems should lower their return expectations and view investment markets as less predictable and more volatile. 

State pension plans, in aggregate, have struggled to reduce unfunded liabilities to below $1 trillion ever since the Great Recession, seeing this number climb to nearly $1.4 trillion in 2020. Great results from 2021 seemed to finally break this barrier, with the year’s historically positive investment returns reducing state pension debt to about $783 billion. Now, state-run pension plans will again see unfunded liabilities jump back over $1 trillion, assuming final 2022 results end up at or below 0%. 

It is important not to read too much into one year of investment results when it comes to long-term investing. But during this time of economic volatility, policymakers and stakeholders should recognize that many of the problems that kept public pension systems significantly underfunded for multiple decades still exist. And many pension plans are nearly as vulnerable to financial shocks as they were in the past.

Going forward, state and local leaders should continue to seek out ways to address and minimize these risks, making their public retirement systems more resilient to an uncertain future. 

Webinar on using the 2022 Public Pension Forecaster:

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S&P acknowledges that “having a social mission and strong ESG characteristics does not necessarily correlate with strong creditworthiness and vice versa.” S&P’s ESG credit indicators politicize what should be a purely financial decision. This politicization has manifested itself in the capital markets where, for example, banks are pressured to cut off capital to the oil, gas, coal, and firearms industries. ESG is a political rating and should be characterized as such. This is clear when recognizing the two layers of indeterminacy that make ESG an exercise in servitude: 1) which “ESG factors” are chosen, and 2) the “correct” answer to any given factor. Whoever answers those questions has all the power in achieving a desired outcome.

These are not technocratic questions; they are normative questions. No financial firm should substitute its political judgments for objective financial analysis, especially on matters that are unrelated to the underlying businesses, assets, and cash flows it evaluates. This is especially true of a properly regulated independent entity like S&P that is charged with providing objective clarity and insight. The use of ESG-related quantitative metrics and analytical frameworks confounds the distinction between subjective normative judgments and objective financial assessments. It is therefore unconscionable for S&P to weigh in on indeterminate and normative questions. Moreover, the answers to the normative factors can and do change depending on circumstances. We believe this entire exercise in identifying, evaluating, and publishing ESG factors is highly intrusive and leads to manipulation, coercion, and misleading outcomes.

As the term environmental, social, and corporate governance suggests, ESG ratings attempt to assess the societal impact of a company across three broad dimensions: environmental impact, social impact, and corporate governance. These ratings and ESG-centered investing have gained significant traction among many major asset managers. BlackRock, Vanguard, and State Street (which, combined, are the largest shareholders in 88% of S&P listed companies, according to a 2017 study) all issued ESG commitments and guidance for their portfolio companies in 2022.

As evidenced by S&P’s ESG credit indicator for states, the reach of ESG is not limited to private companies and investors. State public pension systems in New York, California, Colorado, Maryland, and Maine have begun incorporating ESG principles in investment decisions. However, as the National Association of State Retirement Administrators (NASRA) notes, “ESG investing has been challenged by some who believe that this approach is contradictory to fiduciary duty.”

Pension trustees are required by state laws to exercise their fiduciary responsibilities to maximize public pension systems’ investment returns at acceptable levels of risk for retirees and future beneficiaries.

In response to fiduciary concerns, the environmental, social, and corporate governance model is commonly justified under the auspices that investors do well when companies do good. The evidence for this claim is not clear. A comprehensive analysis by Vanguard found:

This article sets out to empirically investigate the performance characteristics of investable ESG equity funds to assess whether support for a particular direction in performance impact can be found…After controlling for style factor exposures, the majority of funds in any of the tested ESG categories does not produce statistically significant positive or negative gross alpha. An industry-based performance contribution analysis reveals that systematic differences in allocations relative to the broad market exist. However, their median contribution to performance is close to zero over time. Overall, return and risk differences of ESG funds can be significant but appear to be mainly driven by fund-specific criteria rather than by a homogeneous ESG factor.

This suggests it would be prudent for both private and public investors to assess ESG scores with skepticism. Even beyond very real concerns about the politicization of investment decisions, there needs to be an assessment of the validity of ESG rating metrics. Is there any precision in ESG ratings? In other words, do they measure what they’re trying to measure?

One of the leading ESG rating agencies, Morningstar’s Sustainalytics, provides publicly-accessible ESG Risk Ratings for many publicly traded companies. Sustainalytics’ ESG Risk Rating is a measure of “the degree to which a company’s economic value (enterprise value) is at risk [given the] company’s unmanaged ESG risk.” Sustainalytics assigns a rating by determining the total exposure risk of a company. Sustainalytics says the risk rating given to a company is a combination of entirely unmanageable risk and manageable risk that is not being addressed.

Size

Looking at the available ESG scores from Morningstar’s Sustainalytics ESG Risk Ratings, we see a trend where large companies rate better than small companies. On a scale in which a lower score indicates a better ESG rating, the median value of S&P 500 (large capitalization index) companies is 21.1 and Russell 2000 (small capitalization index) companies is 29.3. The difference in ratings is not just for the overall capitalization index but results in similar scoring across every single sector (communication services, consumer staples, energy, health care, etc.).

Large companies may have some structural advantages that make their businesses more ESG friendly, but it is also clear that they have structural advantages that enable them to boost ESG scores. A report for Legg Mason, which found a similar preference for company size across three rating agencies, notes:

“Many companies have started documenting their policies in publicly available sustainability disclosures; however, producing such disclosures is resource-intensive and financially burdensome. As a result, larger companies rate better as they generally have increased transparency and resources to dedicate to such initiatives.”

In some respects, the interplay between market capitalization and ESG scores is analogous to how businesses of different scales respond to government regulations. While reporting requirements may be burdensome for the large players, their bigger accounting, legal, and human resources departments are better able to take on these burdens than their smaller competitors.

Sector

In addition to size, there is also a clear stratification by sector in Morningstar's Sustainalytics. To some extent, this is logical. We would not expect a communication services company to have the same environmental rating as an oil company. Still, businesses are not isolated entities operating independently of other sectors.

For example, looking at the materials and technology sectors, the median materials sector ESG score is 30.9 while information technology has a median score of 22.4. If a technology company sources critical inputs like cobalt and lithium for its products from the mining sector, where do the ESG boundary lines fall, and are these ratings objectively reflective of a company’s true ESG impact?

Coherence

Beyond sector and size, there are specific results in Sustainalytics’ ESG risk ratings that call into question the logical coherence of the ratings. Notable is the comparison of leading defense contractors with a pasture-raised egg and butter company, Vital Farms. Even putting aside concerns about the underbelly of defense contracting, all four defense contractors are heavily taxpayer-subsidized. Northrop Grumman, Raytheon, Lockheed Martin, and Boeing, with ESG risk ratings ranging from 28.4 to 35, all rate better than Vital Farms’ 42.8. Ostensibly, the food company checks a lot of ESG boxes. It partners with small family farms and the company website states:

“Our purpose is rooted in a commitment to Conscious Capitalism, which prioritizes the long-term benefits to each of our stakeholders (farmers and suppliers, customers and consumers, communities and the environment, crew members and stockholders)...We are mission-minded people working together to bring ethically produced food from family farms to families’ tables.”

There may be a lot more to this picture, but seeing results like defense companies ranking better than Vital Farms raises several questions about ESG ratings. No single score applied to a complex world is flawless. Still, with ESG ratings increasingly being considered by corporations, governments, and institutional investors, the potential problems with these metrics shouldn’t be ignored.

Broadly, environmental, social, and corporate governance policies should be examined under a precision and accuracy framework. Do the metrics measure what they purport to measure—and are the priorities baked into ESG ratings the proper priorities in the first place?

The post The difficulties of assigning ESG ratings appeared first on Reason Foundation.

Using the latest capital market assumptions from established financial firms, Reason Foundation’s Pension Integrity Project built a portfolio simulation tool, which gives an idea of the range of returns that financial experts are expecting for pension funds for the next few decades. For a portfolio representative of the national average public pension system, median investment return projections in the tool fall in the range between roughly 4.5% and 7.5%. Four out of six market projections provide a median compound annual growth rate of less than 6%.

Setting a pension plan’s assumed rate of return at a lower, more achievable target lowers the likelihood of accruing unfunded liabilities—debt—in the future. Assumed rates of return are used to project out asset growth. When a plan’s expected return rate is too high and it fails to meet investment projections, the plan accumulates unfunded liabilities due to the lower-than-forecast returns. Several public pension plans have wisely lowered their assumed rates of return to reflect the long-term forecasts and reduce the potential for accruing debt.

In 2021, the New York State Common Retirement Fund lowered its assumed rate of return by nearly a percent, from 6.8% to 5.9%. The Maryland State Retirement and Pension System lowered its expected return rate 60 basis points to 6.8%, and dozens of other public pension plans have dropped their investment return assumptions by at least a quarter-point since last year.

The Ohio State Teachers Retirement System (STRS) lowered its investment return assumption by nearly half a percent, but STRS is now exploring an expansion of its cost-of-living adjustment (COLA) which would immediately burden the fund with more debt.

On Jan. 27, the pension board’s actuary presented the cost of a 2% COLA, which would add nearly $14 billion in liabilities (increasing the plan’s unfunded liabilities by 66%). Currently, STRS is not in the position to add to its liabilities. The Ohio State Teachers Retirement System has an 80.1% funded ratio, meaning it has just 80 cents for every dollar it already knows is needed to pay for the pension benefits that have already been promised to current and future retirees.

Since these funding measurements are based on return assumptions that are likely underestimating the system’s funding gap, Ohio’s pension system may be worse off than is currently being reported. In the same Jan. 27 board meeting, the plan’s investment consultant projected that the “10-year return for STRS Ohio’s current asset mix is 6%.” While the rate was recently lowered, the plan’s assumed rate of return remains at 7%, which is a full percentage point higher than its own consultant’s projection.

Last year’s strong returns should not be misread. Many pension plans, like Ohio STRS, are still in a fragile financial position. During the Great Recession of 2007-2009, the Ohio teachers plan’s funded ratio dropped from 79.1% funded to 60% in one year—and kept declining until 2013. When the COVID-19 pandemic hit, a Great Recession-like scenario loomed. While there was a steep sell-off in the second quarter of 2020, asset prices were buoyed by the federal government’s unprecedented fiscal and monetary intervention.

We are, unfortunately, sitting in an economically uncertain time. Consumer sentiment is lower today than it was in April 2020. Although unemployment is approaching pre-pandemic rates, labor force participation is 1.2% lower than it was in February 2020. Uncertainty regarding the pandemic, supply chains, and inflation remain.

In markets, the S&P 500’s 10-year price-to-earnings ratio is reaching a level not seen since the tech bubble. While policymakers certainly need to be careful extrapolating historic results to predict the future, an analysis of annual market growth going back to 1979 demonstrates that 2021’s phenomenal investment returns were quite clearly an exception, not the rule.

The great investment returns in 2021 can be seen as an example of the upside of markets, but public pension plan administrators also need to be fully prepared for the downsides. Public pension systems can largely avoid burdening taxpayers with unforeseen debt and putting workers’ retirement plans in jeopardy in the future by continuing to lower their assumptions on investment returns to better match the consensus 20-year forecasts of market experts.

Public pension plans also need to resist the temptation to use last year’s one-off, one-year investment return windfalls to fund new benefits like higher cost-of-living adjustments. Investment returns like those of 2021 are very unlikely to occur with very much consistency or regularity. While 2021 was a great help to improve the funded ratios of most public pension plans, those types of years should be viewed as times to help buoy public funds so they are better prepared for the market’s similarly unpredictable down years.

The post Despite historic 2021 returns, many public pension plans are wisely preparing for lower investment returns appeared first on Reason Foundation.

A Horizon Actuarial Services report released in Aug. 2021 surveyed firms like JPMorgan, BlackRock, and BNY Mellon to find that long-term investment returns are expected to decrease across the main asset classes that public pension plans invest in. The Horizon report states:

“Over the last five years, expected returns have declined for all but a few asset classes. The steepest declines have been for fixed income investments such as US corporate bonds and Treasuries, where return expectations have fallen more than 100 basis points since 2019. These declines were driven by recent monetary and fiscal policy interventions, and may have significant implications for multiemployer pension plans.”

Some public pension plans have made the prudent decision to reduce their investment return assumptions in light of this cautionary market outlook. Notably, the New York Common Retirement Fund lowered its assumed rate of return 90 basis points, which takes the assumed rate of return from 6.8% to 5.9%. This 5.9% expected return fits between Horizon’s 10- and 20-Year forecasts of 5.38% and 6.25%.

To get a better sense of the investment outlook for state pension plans, we created a tool that runs a simulation of the investment performance of a hypothetical public pension portfolio over 30 years. It displays the growth of $1 in assets; a distribution of the compound annual growth rate for those 30 years; and the simulation estimated probability of hitting several return assumptions.

The tool utilizes assumptions on asset returns, volatilities, and correlations pulled from BlackRock, BNY Mellon, Horizon Actuarial Services, JPMorgan, and Research Affiliates to simulate portfolio returns. Specifically, the model uses a Monte Carlo simulation with 10,000 simulations of the portfolio over 30 years. Users can select which capital market assumptions they want to run the model with. Additionally, users can select between the national average pension asset allocation, a 60/40 stock-bond portfolio, or a custom portfolio. Step-by-step directions on how to use the tool can be found below.

It is important to note that while this tool uses the latest assumptions from reputable financial advisors, they are still mere speculations on market performance. Additionally, while this approach for portfolio simulation is commonly used in the financial industry, it does not account for the time-variant nature of asset correlations. In times of financial stress, for example, assets can be more tightly correlated than they are in normal market conditions—aggravating portfolio losses. This was true during the Great Recession from December 2007 to June 2009 and could be true in a future crisis as well.

How to Use the Tool

1. To run the portfolio simulation with the preloaded settings, simply hit the “Run Simulation” button in the top right.
2. To modify the inputs, select the “Control Panel” button in the top left.
3. The user can modify both the asset returns, volatilities, and correlations by firm (both Horizon’s 10-year and 20-year assumptions are included) via the “Capital Market Assumptions” dropdown.
4. Asset allocation can be switched between the national average for state pension plans or a 60/40 stock-bond split. Additionally, asset allocation can be customized via the “Custom” button. Note that the portfolio must equal 100% to run the simulation.
5. Once selections are completed, click “Run Simulation” to see the results.

Outputs

1. Assets: Displays the 25^th percentile to 75^th percentile (middle 50 percent of the data) of asset growth for $1 for the 10,000 simulations over 30 years.
2. Distribution: Displays the distribution of compound annual growth rates for the 10,000 simulations over 30 years. Opposed to the arithmetic return, the compound annual growth rate (or geometric return) better represents the long-run growth of an asset. Also displayed are two lines: (1) the median simulation return and (2) where 7% return sits in the distribution which is often used as the assumed rate of return for public pension plans.
3. Return Probability: Displays the probability of the portfolio reaching various assumed rates of return given the results of the 10,000 simulations.

The post Modeling how public pension investments may perform over the next 30 years appeared first on Reason Foundation.

Tennessee is one of only nine states that still employ a resource-based formula for allocating education dollars to school districts. This approach puts the focus squarely on inputs rather than students’ needs and is mired in layers of complexity that reduce transparency. As a result, policymakers lack an effective lever for targeting dollars to students and are thus unable to formulate a coherent strategy for allocating the state’s $9.655 billion in state and local funding.

Our analysis of Tennessee’s school finance system reveals five key findings:

1. Only 3% of education dollars are allocated based on student characteristics.
2. Only 16% of education dollars are flexible for district and school leaders.
3. Funding for low-income students is neither regressive nor progressive.
4. In multi-system counties, county school districts tend to be at a funding disadvantage compared to municipal and special school districts.
5. Local wealth equalization is unnecessarily complex and opaque.

Tennessee should modernize its school finance system by adopting student-centered funding, a strategic approach to K-12 education funding that involves several policy reforms that are tailored to local needs and preferences. These policies can be adopted separately over time or as part of a comprehensive overhaul. Specifically, we have four recommendations for state policymakers:

1. Streamline dollars into a weighted student formula.

Most importantly, operating revenue should be streamlined into a weighted student formula that allocates dollars based on individual students’ needs. The concept is simple: a per-pupil foundational allotment is established for regular program students, then weights are added to this amount for selected categories of need. States such as Texas, South Carolina, California, and others all use some form of weighted student funding.

2. Reform Tennessee’s approach to equalizing local education dollars.

At the very least, Tennessee could eliminate the more complex Tennessee Advisory Commission on Intergovernmental Relations (TACIR) six-criteria model and fully adopt the Center for Business and Economic Research (CBER) model, which uses only the county property tax and sales tax bases. This would improve transparency by simplifying the current redundant system of using both models at once. But policymakers could go even further to ensure that students, not local wealth, are the primary determinant of funding levels. Ultimately, the goal is to streamline all or nearly all operating dollars into one coherent funding system where state and local dollars work together.

3. Resist the urge to add new complexities.

To the extent possible, policymakers should resist the urge to adopt policies that replace existing complexities with new ones.

4. Leverage public school open enrollment and transparency for accountability.

One way to help ensure accountability for spending and outcomes is to adopt universal inter-district open enrollment, a policy that allows families to enroll in public schools across school district boundaries. Tennessee currently lacks a robust open enrollment policy that would give families easy access to other public schools that they may, for a variety of reasons, believe to be a better fit for their child. Another pathway to stronger accountability that avoids rigid restrictions is to improve transparency in how education dollars are allocated and spent. Stakeholders and parents should have easy access to school finance data.

Full Policy Brief— K-12 Funding in Tennessee: A Student-Centered Approach

The post K-12 funding in Tennessee: A student-centered approach appeared first on Reason Foundation.

A pension obligation bond (POB) is a taxable bond usually issued by state or municipal governments to cover normal annual contributions or unfunded accrued actuarial liabilities (UAAL). While there are multiple reasons governments issue POBs, interest rate savings or arbitrage are central to the logic behind issuance. It is expected that the rate on the bond issued is lower than the expected rate of return on pension assets.

The S&P report authors contend “low interest rates and accelerating pension costs will continue to spur [issuance].” The GMS Group recently quoted a 20-plus year AA municipal bond yield of 2.93 percent—several percentage points lower than the assumed rate of return of state and municipal pension plans.  Data from the California Debt and Investment Advisory Commission shows that several California local governments issued POBs at a true interest cost of less than 2.8% in 2021 (true interest cost is the annual percentage rate a bond issuer pays on the overall series of bonds including origination fees and expenses). These include Santa Cruz County, the city of Manhattan Beach, and Orange Unified School District.

However, as the S&P report also notes, “an increased spread does not mean free money; it indicates increased exposure to market volatility risk when proceeds are deposited in the pension trust.”

This “spread” is classified by Roger Davis at Orrick as risk arbitrage: “…borrowing against the credit of the state or local government and participating through the pension fund in a portfolio of investments that is designed to produce a higher yield and manage the higher risk through diversification.”

As Davis also notes, there is no guarantee this arbitrage opportunity is profitable.

S&P outlines that the projected savings are frequently offset with poor investment performance or other changes that are not seen at the time of issuance. The Government Finance Officers Association (GFOA) considers POBs “very speculative” and “involve considerable investment risk.”

Still, S&P Global Ratings maintains pension obligation bonds can reduce the variability of contributions and may make sense within a larger funding reform solution. On a cautionary note, the report does identify areas of risk.

Most notable is market timing risk—analogous to the market timing retail investors face. Putting a large sum of money in at one time subjects that sum to short-term volatility. It is generally considered less risky to “dollar-cost average” by making incremental purchases over a longer interval of time. The S&P report tracked similar approaches, “establishing a set-aside reserve fund, often an IRC Section 115 trust dedicated to pension.”

However, depending on the time interval, such a strategy may not pay off in the current financial market. The S&P 500’s price-to-earnings ratio is reaching highs only surpassed during the tech bubble. Outlined by Reason Foundation colleague Marc Joffe in late 2018: “The worst time to issue a POB is near a market top, but, of course, it is impossible to know ahead of time that the market is peaking.”

Only time will tell whether the current rise in pension obligation bonds was well-timed or not but policymakers and public pension stakeholders should closely monitor whether these bonds and the assumptions driving them actually provide the long-term cost savings hoped for.

The post Governments increased their use of pension obligation bonds in 2021 appeared first on Reason Foundation.

This analysis reveals that most state pension plans saw significant drops in funding in the early and late 2000s, followed by a minor rally during the largest bull market run of our nation’s history. In the last five years, the average has remained in the lower 70 percent range.

Fortunately, a strong year of returns in FY 2021 will result in a significant bounce to the funding status of nearly all plans. Still, twenty years ago, state pension plans were nearly 100 percent funded in aggregate, and most plans are still working to overcome funding shortfalls that arose over a decade ago during the Great Recession. This year’s funded ratio increase does not change the trends plans have experienced for the last two decades and such history should inform plan assumptions going forward.

The graphic below shows each state’s public pension funded ratio (total reported actuarial assets compared to liabilities for all plans aggregated by state) from 2001 to 2020.

Methodology: Displayed funded ratios are the quotient of the actuarial value of assets (AVA) and actuarial accrued liabilities (AAL) of state-managed plans. The discount rate is a weighted average of state-managed plans’ discount rates with AAL as the weight.  Source: Data primarily come from Public Plans Data and is supplemented by Pension Integrity Project analysis of annual financial reports.

One of the largest reasons funded ratios have declined over time is investment returns coming in below plan expectations and insufficient annual contributions from states. For years, most pension plans have held too high assumed rates of investment returns that have led to underfunding. Despite excellent returns this year, a number of plans have taken prudent steps to lower their assumed rate of return in 2021.

A pension plan’s discount rate is also highly influential on a plan’s funded ratio and if the rate is too high it will hide the true extent of the state’s public pension liabilities. As some public pension plans have prudently adjusted their discount rates down to realistic levels, they have also revealed the true cost of fully funding their public pension systems. This affects funded ratios by revealing a higher pension liability. The second chart of this tool shows the change in each state’s discount rate between 2001 and 2020.

The post State pension plan funded ratios in 2020 appeared first on Reason Foundation.

Shortly after this news was disclosed, the FBI unveiled an investigation into the public pension fund. The Philadelphia Inquirer reported:

The federal investigation of Pennsylvania’s $64 billion pension fund for teachers has come into sharper focus with reports that officials are examining both the plan’s inflated estimates of its returns and its spending spree on Harrisburg real estate.

The probe by federal prosecutors and the FBI is exploring how top executives of the fund, known as PSERS, responded when word spread internally that its financial performance might fall short of its official goal, The Inquirer has learned.

Last month, the U.S. Securities and Exchange Commission widened the investigation, according to the Pittsburgh Tribune:

The U.S. Securities and Exchange Commission has widened the federal scrutiny of Pennsylvania’s mammoth public school pension plan, demanding records that could show whether the fund’s staff improperly traded gifts with any of hundreds of Wall Street consultants and investment managers.

The SEC’s new 30-page subpoena comes six months after the U.S. Attorney’s office in Philadelphia and the FBI opened a criminal investigation into possible bribery linked to exaggerated investment returns and Harrisburg land deals at the agency.

While the turmoil surrounding PSERS is newsworthy, many of the fundamental challenges facing the pension system are not unlike those facing other public pension plans’ asset management: high fees, underperformance, and a lack of investment transparency as plan managers attempt to chase increasingly unrealistic investment return targets.

The Outlook for PSERS

PSERS was 100 percent funded in 2002, but since then the pension plan has accumulated more than $44 billion in unfunded liabilities. 2020 reports show the plan is below 60 percent funded, meaning it doesn’t have the money to pay for retirement benefits already promised to workers. In August, Reason Foundation’s Pension Integrity Project and other groups were invited to present to a multi-day set of pension-related hearings convened by the House State Government Committee related to the financial solvency of PSERS and the separate state pension system covering state employees.

Public pension plan funding, generally, has suffered in the last two decades due to several severe market downturns and aggressive monetary policy that stripped fixed-income investments, a previous workhorse of pensions, of their yield. Instead of adequately adjusting plan assumptions about investment returns and contribution rates, many public pension plans in the U.S. sought to maintain high investment returns through riskier investments, like alternative assets. In 2020, PSERS allocated nearly two-thirds of its assets to alternative investments, such as real estate and private equity, in search of higher yields to make up for the system’s growing unfunded liabilities.

Despite realizing excellent investment returns in 2021, industry capital market forecasts continue to suggest persistently volatile near-term investment returns that stand to only add to over $1 trillion in current pension funding shortfalls. Most near-term investment outlooks we’ve seen from pension boards across the country predict anywhere from a 6.0 percent-6.3 percent return over the next 10 years. PSERS’ assumed rate of return was recently lowered and currently sits at 7 percent.*

PSERS’s investment outlook is similar to these broad projections. Figures 1 and 2 present the results of the Monte Carlo simulation analysis developed by the Pension Integrity Project. This iterative analysis uses 10,000 simulations of PSERS’s asset performance over 20 years, considering expected returns and volatilities of plan assets, to generate both probabilities of hitting certain returns and expected return distributions.

These findings suggest that PSERS is not likely to achieve even a 6 percent average return over the next 10-15 years—much less its current assumed return of 7 percent. This suggests there is a high probability that the public pension plan’s unfunded liabilities could get worse, not better, in the near-to-mid term. This underperformance—relative to the plan’s own return rate assumptions—will make the system’s long-term solvency challenges even larger.

Figure 1. Measuring the Probability of PSERS Achieving Various Rates of Return

Figure 2. Differing Investment Return Probability Distributions for PSERS

The results above show only the BlackRock market forecast is anywhere near the current assumed rate of return being used by PSERS, and BlackRock is based on a 20-plus year horizon for which there is little more underlying support rationale than “reversion to the mean,” or put more simply, “a guess that assumes past performance continues,” despite past performance being universally recognized as not being a reliable indicator of future results.

Assumed rates of return are generally set at the 50^th percentile, which means the best chance a plan has if they hit every single actuarial and demographic assumption set is a 50/50 chance of achieving long-term solvency. Thus, policymakers should be under no illusion that they can invest their way to solvency alone.

Examining Investment Fees at PSERS

While a few years of good investment performance cannot save a public pension plan, high investment fees combined with underperformance can certainly hurt a plan. Summing external ($2.21 billion) and internal management ($77.4 million) expenses, PSERS reported $2.29 billion in expenses over the past five years. For context, in 2020, the New York State Teachers’ Retirement System reported 36 percent less in total investment fees and expenses than PSERS despite having two times the actuarial value of assets.

High investment fees would not be a concern if these funds sufficiently outperformed assets with lower investment fees. But since the 2008 global financial crisis, they rarely have. For the last five fiscal years, PSERS only outperformed Vanguard’s basic 60/40 stock-bond portfolio (VBIAX), net retail investor fees, once, although it should be noted that both performed well in FY 2021.

Figure 3 shows the two portfolio’s performance over the last five years. Comparing compound annual growth rates, over the past 10 fiscal years shows PSERS returned 8 percent and VBIAX returned 10.3 percent.

Figure 3. PSERS vs Basic Indexed Portfolio (VBIAX) Returns

Using PSERS’ market value of assets and the $2.29 billion in investment fees, we can calculate an average expense ratio of 0.83 percent for the last five fiscal years for which financial reports are available (2016-2020). The expense ratio is the amount paid to investment managers as a percentage of fund assets. If you have $100 in a fund that charged $1 in fees, that would be a one percent expense ratio. Investopedia notes, “a reasonable expense ratio for an actively managed portfolio is about 0.5 percent to 0.75 percent, while an expense ratio greater than 1.5 percent is typically considered high these days.”

Passively managed funds typically charge considerably less. Pension funds, like PSERS, with billions of dollars in assets, can incur even lower costs. Investment professional, Richard Ennis, points out: “Large funds can do [passive investment] for a single basis point [0.01 percent] of expense. The smallest fund in the country can do it at Vanguard for five basis points [0.05 percent].”

Assuming a passive index had approximately the same performance as PSERS and applying an expense ratio of 0.05 percent on the market value of assets, this hypothetical passive investment expense would have totaled $139 million, $2.15 billion less than reported external and internal investment fees over five years. This difference is displayed in Figure 4 below.

Figure 4. 5-Year Comparison—PSERS Investment Expenses vs Passive Investment Expenses

The experience of Pennsylvania’s teacher pension system is not all that unusual. An analysis of large U.S. public pensions by researchers Jean-Pierre Aubry and Kevin Wandrei of the Center for Retirement Research found that from 2006 to 2018 the average number of external managers used by plans nearly doubled from 28 to 55, which naturally correlates with higher costs. In the quartile that used the most managers in 2018, this figure jumps to 182 external managers (144 for alternative assets). PSERS lists 176 external investment advising firms in its 2020 annual report.

Whatever combination of active and passive investing trustees choose, they must call to mind that these advisors add costs. Looking at data from 2011 to 2016, Aubry and Crawford revealed three important findings:

• a correlation between higher fees and lower performance;
• alternative investments had higher fees; and
• plans that underperformed their benchmarks had higher expense ratios than plans that outperformed their benchmarks.

Although the plan wisely reduced its assumed rate of return from 7.25 to 7 percent earlier this year, the Monte Carlo analysis shows PSERS’ current rate is still too high. Putting the plan’s assumed rate of return at a lower, more realistic level would, despite a short-term increase in realized liabilities, lower the likelihood of unfunded liabilities accruing in the future. Additionally, lowering the assumed rate of return would reduce the pressure on the plan to engage in aggressive strategies and hire outside investment managers.

PSERS would not be alone in either lowering return assumptions or reducing investment fees. In August, New York State’s Common Retirement Fund announced it will lower its assumed rate of return by nearly a percent. Arkansas, Mississippi, Maine, and others are also making modest reductions to their investment expectations.

On the investment fee side, as Aubry and Wandrei document, several large public pension plans have “recently consolidated their external management team[s] as part of an overall commitment to reduce investment fees, which cut into their after-fee returns.” This year, the North Carolina Retirement System announced it cut $350 million in investment costs over four years after the State Treasurer pledged to cut, a more modest, $100 million.

By further lowering the system’s assumed rate of return and lowering the amount it pays in fees, PSERS can start to forge a pathway to meaningful pension reforms that help keep the promises made to teachers and public school employees and stop accruing pension debt that future taxpayers will be burdened with.

*Correction 10/13/21: The Pennsylvania School Employee Retirement System’s assumed rate of return was lowered from 7.25 percent to 7 percent on August 8th, 2021. This analysis previously stated the plan’s current rate was 7.25 percent. All references to the plan’s assumed rate of return, as well as figures 1 and 2, have been updated to reflect a 7 percent assumed rate of return. Figure 3 has also been updated to reflect PSERS’ latest investment returns, which were reported on 10/08/21. Additionally, fiscal year VBIAX returns no longer include a (~0.07%) downward expense ratio adjustment as further examination suggests this is included with other adjustments (e.g., dividends) in the “adjusted close” data used from Yahoo Finance.

The post Suggested reforms for Pennsylvania’s Public School Employees’ Retirement System appeared first on Reason Foundation.

To begin, it’s important to evaluate claims that public education funding across the states has decreased over time. To do this, we used the latest inflation-adjusted revenue figures from the U.S. Census Bureau for states included in EdChoice’s School Choice Spending Share ranking.[I]

Between 2002 and 2019, all school choice states except North Carolina saw inflation-adjusted increases in public school per-pupil revenue as Chart 1 illustrates below. New Hampshire had the highest growth in funding at 51%, going from $12,738 per student in 2002 to spending $19,283 per student in 2019. Between 2002 and 2019, the vast majority of states had education funding bumps exceeding 10%. Even school choice bellwethers like Florida and Wisconsin increased public education funding by more than 5%. North Carolina’s school revenue was essentially flat with a decrease of less than 1%.

Chart 1: Per Pupil Revenue Growth in School Choice States Between 2002 to 2019

Some may wonder, but what about comparisons to 2009 levels—the pre-Great Recession level for U.S. education spending? After all, this is the baseline year that some cite as evidence that public education is ‘starved’ for resources. 

Using 2009 as a reference point, half of the states with school choice still increased real spending by 2019, and these data don’t include more recent revenue trends from the latest school year—including a massive injection of about $200 billion in federal COVID-19 relief funding for K-12 public education.[ii] Future Census data will likely show a significant funding boom across school choice states through at least the current school year, regardless of what baseline year is used.   

School choice states have indeed increased funding for public education over time, and as our Reason Foundation colleague Christian Barnard says, it’s not even debatable. If anything, it’s school choice programs—which research indicates leads to increases in parent satisfaction, educational attainment, and test scores—that are underfunded. Most debates around school choice funding focus on comparisons between the average amounts provided to school choice participants and public school students. To be sure, these comparisons are important—and school choice participants almost always receive less—but they fail to convey the degree to which states are actually investing in choice programs. Fortunately, EdChoice has data on each state’s school choice funding as a share of its total K-12 education expenditures. They find that school choice programs—education savings accounts, vouchers, and tax credit scholarships— account for less than 0.4% of total U.S. education expenditures. Florida comes in on top of that list at a paltry 3.25%.

Taking a page from Director of the Edunomics Lab Marguerite Roza’s playbook we put these figures into per-student terms, which allows for more robust comparisons with other spending data. Using data obtained from EdChoice and U.S. Census Bureau public school enrollment figures, we estimated the per-student dollar amounts that states allocated to school choice in 2019 as displayed Chart 2.[iii] For example, Pennsylvania spent approximately $81 per student on choice programs while Louisiana spent $77. Interestingly, all but six of the 26 states spent less than $100 per student, including eight that fall below $10 per student.

For all of the battles that rage in state legislatures, courthouses, and opinion pages across the country, Chart 2 shows that school choice programs consume a tiny sliver of the public education funding pie. This becomes even more apparent when comparing these amounts to total spending on public schools. Rhode Island, Pennsylvania, and Illinois all spend in the neighborhood of $20,000 per student with the District of Columbia topping out at an astounding $31,109 per student.

Chart 2: School Choice vs. Public School Funding in 2019

The question then is where have the new K-12 dollars that have been spent in the last two decades gone if they have not funded school choice programs?

One substantial cost-driver is spending on instructional and support staff benefits, a Census expenditure category that includes teacher pensions, health care insurance, retiree health care insurance, and other expenses. Disaggregated figures aren’t available, but research suggests that teacher pension costs are responsible for a substantial share of the growth observed in the last two decades. As Chart 3 illustrates, inflation-adjusted instructional benefits—which doesn’t even include all district and school staff—have risen dramatically in school choice states. For example, Pennsylvania increased spending on instructional benefits by $2,414 per student from $1,358 in 2002 to $3,772 in 2019. This means that for every class of 20 students in Pennsylvania about $75,000 is now spent on instructional benefits alone—$48,000 more than was spent in 2002.  

Chart 3: Instructional Benefit Growth in States With School Choice Programs From 2002 to 2019

As a result, instructional benefits consumed substantial portions of public education’s revenue growth during this time period. For example, Virginia increased funding by $1,717 per student but benefits grew by $900 per student. Ohio’s benefits spending consumed $574 of its $1,749 revenue increase. For some states, spending on instructional benefits actually outpaced revenue growth. This was the case for Arizona where funding increased by $122 per student while benefits grew by $393 per student—a net loss of $270 per student. These comparisons are shown in Chart 4.  

Chart 4: Per Pupil Revenue vs. Instructional Benefit Exependiture Growth

Finally, it’s helpful to make direct comparisons between school choice spending and benefit cost growth. For almost every state, growth in per pupil instructional benefits between 2002 and 2019 exceeded spending on school choice, and in many cases, this gap is large. In Chart 5 you can see that in Georgia, benefits grew by $471 per student and school choice spending in 2019 was only $62 per student. Even in Indiana, a school choice heavyweight that experienced relatively moderate growth, the increase in benefit costs is still on par with school choice spending.

Chart 5: School Choice Funding vs. Additional Spending on Instructional Benefits Between 2002 and 2019

This raises an interesting question: how much would school choice states have saved if they maintained benefit spending at 2002 per pupil levels adjusted for inflation? In 2019, these 26 states combined would’ve spent about $17.8 billion less on instructional benefits, compared to the $2.6 billion they spent on school choice programs. In other words, growth in benefit spending is diverting over six times more from classrooms than what’s spent on school choice programs. Clearly, the notion that school choice drains funds from public education is not just unfounded, but it’s also a distraction from an actual fiscal crisis that’s consuming education budgets in virtually every state.

Chart 6: National School Choice Spending vs. Additional Spending on Benefits Compared to 2002 Levels

These education spending findings have a number of implications for state policymakers. For starters, it’s evident that school choice doesn’t drain funding from public education and lawmakers should dismiss claims to the contrary. It is also clear that more must be done to address ballooning pension debt that is crowding dollars out of public school classrooms. This problem is only worsening and poses a serious threat to future generations of K-12 students.

Reason Foundation’s K-12 Education Spending Spotlight provides school finance data for every state and breaks down important trends for education stakeholders. You can find the full interactive dashboard and data set here.

[i]We’re primarily interested in evaluating states with state-administered school choice programs and therefore excluded Vermont and Maine from our analysis. Additionally, Montana was also excluded since they didn’t spend anything on school choice in 2019 according to a dataset obtained from researchers at EdChoice. It’s also important to note that 2002 is used as a baseline year for public education revenue and expenditures since this is the starting point for continuous U.S. Census Bureau state-level summary figures.

[ii] For ease of explanation we include D.C. with the 25 states analyzed in our data for a total of 26.

[iii] EdChoice’s State Share rankings use the most recent school choice budget figures available, which vary among programs and states. To estimate per-pupil spending on school choice we obtained a more detailed dataset from Edchoice and combined 2019 school choice expenditures with 2019 enrollment figures from the U.S. Census Bureau.

Correction 10/7/2021 – This analysis previously stated that seven states spent less than $10 on school choice per student. That number has been updated to eight. Three calculations were updated to reflect underlying non-rounded figures: instructional benefit growth in Virginia is $900 (previously $901); instructional benefit growth in Ohio is $574 (previously $573), and the difference between per pupil revenue growth and instructional benefit growth in Arizona is $270 ($271).

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