America’s public pension funds have gotten themselves into a bind. They’re responsible for paying trillions of dollars in future retirement benefits to teachers, firefighters, police, and other state and local employees, but their assets fall far short of what’s needed to fulfill those promises.
Increasingly, they’re turning to an age-old tactic to close the gap: using borrowed money, or leverage, to boost returns. It’s a troubling trend that regulators should watch carefully.
Leverage is a powerful and dangerous tool. Although it can expand investment, it also increases the risk of collapse and contagion, by allowing investors to lose more money than they have. It should be used by those who can handle the downside — not by those entrusted with retirement savings. As things stand, these funds are putting taxpayers and public servants at needless risk.
State and local governments’ obligations to future retirees amount to nearly $9 trillion. In principle, they could meet this obligation quite simply, by investing $9 trillion in safe bonds that mature when the debts come due. In practice, that’s not what they do. Instead, they figure that, given their long time horizon, they can start with less today and make up the difference by investing in riskier, higher-yielding assets. Pension funds have, for example, ramped up allocations to illiquid investments such as private equity, which locks up money for years in return for potentially big gains.
The strategy isn’t working out very well. Returns often haven’t matched ambitious targets, and private equity firms have lately struggled to sell investments, keeping money tied up for longer than expected. As a result, pension funds are facing cash strains and — despite the strong stock-market gains of recent years — remain more than $3 trillion (or 36%) short of what they owe.
Their response? Lever up. Public pension funds managing about $1.5 trillion — including juggernauts such as Calpers and Calstrs — have either started borrowing or included the option in their mandates. This can at times be useful, providing the cash needed to pursue attractive investments or rebalance portfolios. For the most part, though, leverage merely amplifies both gains and losses. It can also generate sudden demands for cash collateral in volatile times — a serious vulnerability for funds invested in hard-to-sell assets.
The disastrous recent experience of UK pension funds should be reason enough for caution. In 2022, a sharp rise in yields (and drop in prices) of British government bonds triggered large collateral calls at leveraged funds, forcing them into asset sales that drove prices down further, creating a vicious cycle. Only by intervening with a pledge of unlimited bond purchases was the Bank of England able to prevent a broader meltdown.
US pension funds don’t look quite so vulnerable. Most don’t use leverage, and among those that do, their exposure ranges from 5% to 15% of assets, compared with about 25% for UK funds in aggregate. That said, some of the US funds’ portfolio holdings, notably private equity, involve a lot of debt. Their sheer size would also make any forced selling more destabilizing — particularly given the strains already afflicting the US Treasury market.
This needn’t end badly. To ensure public pension funds don’t become a systemic threat, financial authorities should keep close track of their leverage (including via holdings with embedded leverage). More fundamentally, state and local governments should align their pension promises with their resources, rather than counting on risky investments to make up the difference. This requires tough decisions, such as whether to reduce benefits, increase taxes or demand more contributions from current employees.
Pensions are supposed to be guaranteed. They should be backed by the safest possible assets, not a combination of borrowed money and wishful thinking.
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