The Public Pensions Quadrilemma: The Intersection of Investment Risk and Contribution Risk

Pension plans for state and local government employees seek to accomplish four main financing goals: maintain sufficient funds to pay benefits as needed; keep contribution costs low for sponsoring governments and employees; stabilize contributions from year to year, to assist in budgeting; and stabilize costs from generation to generation, a precept known as intergenerational equity. Pension trustees, actuaries and other stakeholders generally believe that, with prudent management, a plan can satisfy these goals. However, plan stakeholders appear to take this conclusion as an article of faith rather than the result of quantitative analysis. I build a stochastic model of pension financing designed to explore the tradeoffs between plan goals. The model shows that, with regard to these financing goals, plan sponsors face a “quadrilemma”: a financing strategy can satisfy one goal only at the expense of others. In particular, the level of investment risk taken by public plans today, in search of returns sufficient to lower the cost of such plans to acceptable levels, implies large variations in contributions either from year-to-year or generation-to-generation in order to maintain the ability to pay benefits under all circumstances. A plan that takes a more conservative investment strategy can attain solvency, contribution stability and intergenerational equity, but at the cost of substantially higher contribution levels. This highlights the key trade-off facing public plans between affordability and other considerations, or more broadly between risk and return.