Doom News

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Mary Williams Marsh of the NYT reports that Public Pension Funds Are Adding Risk to Raise Returns:

States
and companies have started investing very differently when it comes to
the billions of dollars they are safeguarding for workers’ retirement.

 

Companies
are quietly and gradually moving their pension funds out of stocks.
They want to reduce their investment risk and are buying more long-term
bonds.

 

But states and
other bodies of government are seeking higher returns for their pension
funds, to make up for ground lost in the last couple of years and to
pay all the benefits promised to present and future retirees. Higher
returns come with more risk.

 

“In effect, they’re going
to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former
chairman of the Texas Pension Review Board, which oversees public plans
in that state. “Double up to catch up.”

 

Though they generally
say that their strategies are aimed at diversification and are not
riskier, public pension funds are trying a wide range of investments:
commodity futures, junk bonds, foreign stocks, deeply discounted
mortgage-backed securities and margin investing. And some states that
previously shunned hedge funds are trying them now.

 

The Texas
teachers’ pension fund recently paid Chicago to receive a stream of
payments from the money going into the city’s parking meters in the
coming years. The deal gave Chicago an upfront payment that it could
use to help balance its budget. Alas, Chicago did not have enough money
to contribute to its own pension fund, which has been stung by real
estate deals that fizzled when the city lost out in the bidding for the
2016 Olympics.

 

A spokeswoman
for the Texas teachers’ fund said plan administrators believed that
such alternative investments were the likeliest way to earn 8 percent
average annual returns over time.

 

Pension funds rarely
trumpet their intentions, partly to keep other big investors from
trading against them. But some big corporations are unloading the
stocks that have dominated pension portfolios for decades. General
Motors, Hewlett-Packard, J. C. Penney, Boeing, Federal Express and
Ashland are among those that have been shifting significant amounts of
pension money out of stocks.

 

Other companies say they plan to
follow suit, though more slowly. A poll of pension funds conducted by
Pyramis Global Advisors last November found that more than half of
corporate funds were reducing the portion they invested in United
States equities.

 

Laggards
tend to be companies with big shortfalls in their pension funds. Those
moving the fastest are often mature companies with large pension funds,
and who

fear a big bear market could decimate the funds and the
companies’ own finances.

 

“The larger the pension plan,
the lower-risk strategy you would like to employ,” said Andrew T. Ward,
the chief investment officer of Boeing, which shifted a big block of
pension money out of stocks in 2007. That helped cushion Boeing’s
pension fund against the big losses of 2008.

 

Shedding stocks
gave Boeing “material protection right when we needed it most,” Mr.
Ward said. By the time the markets had bottomed out last March,
Boeing’s pension fund had lost 14 percent of its value, while those of
its equity-laden peers had lost 25 to 30 percent, he said.

 

“We estimated that the strategy saved our company in the short term right around $4 or $5 billion of funded status,” he said.

 

Boeing and other companies seeking to reduce their investment risk are
moving into fixed-income instruments, like bonds — but not just any
bonds. They are buying and holding bonds scheduled to pay many years in
the future, when their retirees expect their money.

 

The
value of the bonds may fall in the meantime, just like the value of
stocks. But declining bond prices are not such a worry, because the
companies plan to hold the bonds for the accompanying interest payments
that will in turn go to retirees, not sell them in the interim.

 

Towers Watson, a big benefits consulting firm, surveyed senior
financial executives last year and found that two-thirds planned to
decrease the stock portion of their companies’ pension funds by the end
of 2010. They typically said their stock allocations would shrink by 10
percentage points.

 

“That’s 10 times the shift we might see in
any given year,” said Carl Hess, head of Towers Watson’s investment
consulting business. Economists have speculated that a truly seismic
shift in pension investing away from stocks could be a drag on the
market, but they say it would not be long-lasting.

 

Corporate
America’s change of heart is notable all on its own, after decades of
resistance to anything other than returns like those of the stock
markets. But it’s even more startling when compared with governments’
continued loyalty to stocks. When governments scale back on the
domestic stocks in their pension portfolios these days, it is often
just to make way for more foreign stocks or private equities, which are
not publicly traded.

 

Government pension plans cannot beef up
their bonds that mature many, many years from now without dashing their
business models. They use long-range estimates that presume high
investment returns will cover most of the cost of the benefits they
must pay. And that, they say, allows them to make smaller contributions
along the way.

 

Most have
been assuming their investments will pay 8 percent a year on average,
over the long term. This is based on an assumption that stocks will pay
9.5 percent on average, and bonds will pay about 5.75 percent, in
roughly a 60-40 mix.

 

(Corporate plans do their calculations differently, and for them, investment returns are a less important factor.)

 

The problem now is that bond rates have been low for years, and stocks
have been prone to such wild swings that a 60-40 mixture of stocks and
bonds is not paying 8 percent. Many public pension funds have been
averaging a little more than 3 percent a year for the last decade, so
they have fallen behind where their planning models say they should be.

 

A growing number of experts
say that governments need to lower the assumptions they make about
rates of return, to reflect today’s market conditions.

 

But plan officials say they cannot.

 

“Nobody wants to adjust the rate, because liabilities would explode,”
said Trent May, chief investment officer of Wyoming’s state pension
fund.

 

The $30 billion Colorado state pension fund is one of a
tiny number of government plans to disclose how much difference even a
slight change in its projected rate of return could make. Colorado has
been assuming its investments will earn 8.5 percent annually, on
average, and on that basis it reported a $17.9 billion shortfall in its
most recent annual report.

 

But
the state also disclosed what would happen if it lowered its investment
assumption just half a percentage point, to 8 percent. Though it might
be more likely to achieve that return, Colorado would earn less over
time on its investments. So at 8 percent, the plan’s shortfall would
actually jump to $21.4 billion. Contributions would need to increase to
keep pace.

 

Colorado cannot afford the contributions it
owes, even at the current estimated rate of return. It has fallen
behind by several billion dollars on its yearly contributions, and
after a bruising battle the legislature recently passed a bill reducing
retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent.
Public employees’ unions are threatening to sue to have the law
repealed.

 

If Colorado could somehow get 9 percent annual
returns from its investments, though, its pension shortfall would
shrink to a less daunting $15 billion, according to its annual report.

 

That explains why plan officials are looking everywhere for high-yielding investments.

 

Mr. May, in Wyoming, said many governments were “moving away from the
perceived safety and liquidity of the investment-grade market” and
investing money offshore, but he said he was aware of the risks.
“There’s a history of emerging markets kind of hitting the wall,” he
said.

 

Last year, the North Carolina Legislature enacted a
measure to let the state pension fund invest 5 percent of its assets in
“credit opportunities,” like junk bonds and asset-backed securities
from the Federal Reserve’s Term Asset-Backed Securities Loan Facility,
an emergency program created to thaw the frozen markets for such
securities.

 

The law also lets North Carolina put 5 percent of
its pension portfolio into commodities, real estate and other assets
that the state sees as hedges against inflation. A summary of the bill
issued by the state’s treasurer and sole pension trustee, Janet Cowell,
said it would provide “flexibility and the tools to increase portfolio
return and better manage risk.”

 

But some think they see new risks.

 

“It doesn’t pass the smell test,” said Edward Macheski, a retired money
manager living in North Carolina. “North Carolina’s assumption is 7.25
percent, and they haven’t matched it in 10 years.” He went to a recent
meeting of the state treasurer’s advisory board, armed with a list of
questions about the investment policy. But the board voted not to
permit any public discussion.

 

Wisconsin,
meanwhile, has become one of the first states to adopt an investment
strategy called “risk parity,” which involves borrowing extra money for
the pension portfolio and investing it in a type of Treasury bond that
will pay higher interest if inflation rises.

 

Officials
of the State of Wisconsin Investment Board declined to be interviewed
but provided written descriptions of risk parity. The records show that
Wisconsin wanted to reduce its exposure to the stock market, and
shifting money into the inflation-proof Treasury bonds would do that.
But Wisconsin also wanted to keep its assumed rate of return at 7.8
percent, and the Treasury bonds would not pay that much.

 

Wisconsin decided it could lower its equities but preserve its
assumption if it also added a significant amount of leverage to its
pension fund, by using a variety of derivative instruments, like swaps,
futures or repurchase agreements.

 

It decided to start with a
small amount of leverage and gradually increase it over time, but word
of even a baby step into derivatives elicited howls of protest from
around the state.

 

The big California pension fund, known as
Calpers, was already under fire for losing billions of dollars on
private equities and real estate in the last few years. So far it has
stayed with those asset classes, while negotiating lower fees and
writing off some of the most troubled real estate investments.

 

It announced in February that it had started looking into whether it
should lower its expected rate of investment return, now 7.75 percent a
year. It has embarked on a study, but a spokesman said that process
would not be done until December, safely after the coming election.

Politics
and public pensions - a deadly mix! When are these public pension plans
going to get it through their heads that 8% average annual return over
time is pure fantasy given where were are now? If inflation was
soaring, interest rates were above 20% and we had another Paul Volcker
as Fed Chairman, maybe this ludicrous "8% average annual return" would
be plausible.

But with the risks of deflation still high,
the Fed is desperately trying to reignite asset reflation hoping that
"contained inflation" will eventually materialize. If financial history
has taught us anything, it's that nothing is ever contained.

So
what are pensions to do? Private pensions are in no mood to crank up
the risk, but public pension funds are back to business as usual, and
even looking to leverage up to obtain their magic 8%. Many public plans, like OMERS, are still sticking to the motto that more private market assets will lead them out of their troubles.

They're in for a nasty surprise. Last January, I wrote that the alternatives nightmare continues, and I don't see it getting much better. In fact, as mighty endowment funds like the Harvard Management Company look to unload real estate and
other private equity holdings, private markets will likely suffer a long
drought, especially since public markets are not going to deliver
anything close to what they delivered in the last 30 years.

So what are public pension funds doing? Cranking up the risk, investing in failed banks, leveraging up, shoving more money in private equity and hedge funds, whatever it takes to achieve that insane 8% average annual return they're all still fixated on.

Any
idiot who has invested in markets knows that risk and return are
intimately related. Ideally, you want to achieve the highest possible
risk-adjusted returns, but this is not how most public pension funds
think. They just want to go about their merry way, trying to shoot the
lights out, taking increasingly stupider risks with pension monies -
money that is suppose to be invested prudently so workers can retire in
dignity and security.

On that last point, Reuters reports that Japan's public pension fund, the world's largest, has decided to not change its asset allocation model for the next five years after the Health Ministry urged the fund to keep investing in safe assets:

The
Government Pension Investment Fund holds assets of about $1.4 trillion,
larger than the gross domestic product of India, and is a major force
in financial markets, particularly the Japanese government bond market.

 

Its
current model calls for a 67 percent weighting in domestic bonds, 11
percent in domestic stocks, 9 percent in foreign stocks and 8 percent
in foreign bonds.

 

An
official of the Health Ministry, which supervises the fund, said last
month the ministry hopes the current asset allocation model, which is
under review, would be the base for a new model.

 

An official at the GPIF declined to comment on the report, adding that
its new allocation model will be announced before the start of the new
financial year in April after receiving approval from the ministry.