Penchant for Pensions

By Riley McDermid, Deputy Editor

Some of the nation's highest-profile institutional investors take a close look at a federal proposal to give them stakes in America's ailing banking sector.

By Riley McDermid, Deputy Editor

It's been a rough couple of years for public pension funds smacked by withering balance sheets and increased scrutiny by regulators and plan participants.

Whether it was millions of dollars of losses tied to sweeping financial swindles from fund managers or Ponzi schemes, or massive capital markets dips that caused the average pension fund to lose around a third of its value, many of the nation's public employees have watched with gritted teeth while their retirement savings dwindled.

Now, however, there may be some light at the end of what has seemed for many public pension funds to be a very long and very dark tunnel.

A recent legislative proposal to allow public pension funds to buy preferred stock in beleaguered U.S. banks in exchange for a guaranteed rate of return is sparking interest in the pension industry, with many plans saying privately they would love to participate and experts parsing the details of the plan.

Rep. Gary Ackerman (D-NY) has proposed legislation in the U.S. House of Representatives that would allow public employee pension plans throughout the nation “that choose to invest in banks and financial institutions to earn a guaranteed rate of interest fully backed by the United States Treasury."

The bill, which does not yet have a formal reference number, would allow money from public pension funds to only be invested with banks and financial institutions that are currently on the federal government's Troubled Asset Relief Program (TARP) list and that intend to use the funds in order to expedite making credit available to consumers.

Some public pension funds immediately expressed interest in the proposal, saying although they would wait to hear the eventual details of the proposal, it seemed like an “intriguing” strategy.

“On its surface it seems to be one of the more creative ideas to date on how to get our markets moving in the right direction again while affording those most negatively impacted a possible road to recovery,” John J. Gallagher Jr., executive director of the Policemen's Annuity and Benefit Fund of Chicago, told Markets Media. “Fund staff will continue to monitor this legislation as it develops.”

Ackerman has calculated that annual rate of return at about 8.5 percent, a tempting guaranteed revenue stream for any investor battered by this year's mercurial capital markets, especially funds required by law to achieve an average annual investment return of 8 percent. Reaching that goal has become an increasingly Sisyphean-task as the value of most assets has tanked over the last 18 months of tempestuous economic performance.

Allowing public pension funds to get a piece of the TARP pie, and keep plan participants and overseers happy, is one way for besieged funds to please many often clamorous interests. The bill would tackle the actual allocation by allowing public pension funds to pool their money into a sole-purpose entity that would buy $50 billion to $250 billion worth of preferred stock, letting them in on the ground floor of a potentially rebounding sector that could eventually pay off at par.

It also lets taxpayers already burdened by decades of bailout-related debt have a brief respite, the proposal's sponsor says.

“This legislation is a smart and simple way to stop the federal government from having to spend billions of dollars in taxpayer money to stimulate the economy,” says Ackerman.

With an eye to the sort of publicity closely watched by plan participants looking for any sign of health, or trouble, at their pension plan, many of the largest public funds declined to comment for this article on the basis that they would not issue opinions on pending legislation.

These included Evelyn Tatkovski, press secretary for Pennsylvania's Public School Employees' Retirement System, Eva Goltermann, director of public information for Illinois Teachers' Retirement System, and Clark McKinley, information officer for California Public Employees' Retirement System.

Terry Stanton, a spokesman for the Michigan Treasury Department, which handles pension funds' investments, says the fund “generally does not discuss investment rationale, strategies, and the like.”

Sector trackers, too, are eyeing the bill as a possible bright light in a year of continual bad news for many market participants, especially ones watched as closely by the public and regulators.

Steve Foresti is managing director and head of the investment research group of Wilshire Consulting, which provides asset/liability analysis and asset/spending policy analysis, investment structure analysis, manager selection and evaluation, performance measurement and investment research services to more than 125 clients with total assets of approximately $800 billion.

He says the guaranteed rate of return is likely to be the main selling point for the Ackerman legislation, as the American government makes for a “very compelling” investment option for public pension plans.

“Though the 8.5 percent income level is only guaranteed in the first year of the investment, at current yield levels, the subsequent year's income guarantees lock in an attractive spread over future Treasury yields,” says Foresti. “That kind of return is becoming increasingly hard to find in this market climate.”

Foresti estimates that combination of a “high income stream, low return volatility and guaranteed principal” should prove successful in attracting capital from “public pension plans with the liquidity wherewithal to commit capital for a minimum of three years.”

Thus far, the proposal has not been updated since its original introduction this February, but the mere idea of a guaranteed rate of return that would allow pensions a shot at TARP-assisted bank stakes has raised eyebrows in the sector. But that is precisely the point, Ackerman says.

“By guaranteeing public employee pension fund investments in financial institutions, the federal government will use its balance sheet as a way to inject much needed funds into the nation's banking system rather than using more public money,” he says in a statement. “This bill provides an opportunity to leverage the government's resources to stimulate contribution by the private sector.”

How would it work?

Several experts say that if the Ackerman plan was enacted and the investments were of interest to clients, the process of gaining access to the bonds would most likely be through current fixed income managers. The fund would then give their fixed income manager discretion to include those types of bonds within their portfolio.

“It is not typical for funds to actually select individual securities, this is a function that is usually performed by investment managers to ensure proper security due diligence is performed by a specialist within the asset class,” says Kristin R. Finney-Cooke, a principal and national public fund segment leader for investment consulting at Mercer Investment, which operates the Mercer Pension Health Index to keep an eye on how well the industry is coping. “That sort of discretion will be necessary to assure the public pension funds have done adequate due diligence when selecting these stakes.”

Risk has become a watchword for most investors after crushing losses have mounted and plan administrators scramble to eliminate their most dangerous liabilities. Steven Schwarzman, co-founder of private equity giant Blackstone Group, estimated in March that those losses have wiped out 45 percent of the world's wealth.

Most public pension plans have rules that strictly limit the amount of market risk they are allowed to acquire, a tricky dance for plans looking to increase their assets but not tempted by the sort of minimal yields risk-free investments like Treasury bills are currently offering.

“Public sector plans have much more flexibility in funding, accounting, and other reporting requirements,” but they do face a greater amount of scrutiny because of the tangible real-life effects of their investment strategies, says Olivia S. Mitchell, a professor with the International Foundation of Employee Benefit Plans and a professor of insurance and risk management at the Boettner Center for Pensions and Retirement Research.

Plan Pushback Appears

Despite its infancy, the plan could run into some resistance from other regulators, several pension funding experts tell Markets Media.

Mitchell, who is also the executive director of the Pension Research Council at the Wharton School at the University of Pennsylvania, says that states have long defined contribution limits and would be unlikely to give up that right any time soon.

“Many public employers might be attracted by federal government guarantees in exchange for holding toxic assets,” says Mitchell. “But funding and contribution pattern decisions in the past have been fiercely guarded by states as a federal-state matter with a long-standing Constitutional history."

Mitchell says public sector employers are likely to be “quite skittish” about submitting to new federal regulation, even with a guaranteed rate of return to soften the blow.

“At the end of the day the decision would be a difficult one, and it would have to depend on perceived costs and benefits to the public employer and the covered employee,” as well as some of the economy's most vulnerable investors, retirees, says Mitchell.

The political costs of engaging in a tandem agreement with the government also loom as a significant concern for both regulators and funds interested in participating.

Privately, several Chicago-area public pension funds says that the proposal would likely encounter stiff resistance from governing boards fed up with risky strategies.

“Our collective public fund members might react with anger at boards that decide to pursue this opportunity should it arise,” one tells Markets Media on background. “Some may feel quite strongly that their assets not be used to fund the very same banking institutions that have greatly contributed to this fund alone losing over a billion dollars in assets last year.”

Public policy think-tanks went even further. Jacob Funk Kirkegaard, a research fellow at the Peter G. Peterson Institute for International Economics, says the Ackerman framework is a “horrible idea” that could pose “very substantial” longer-term risks to state/local pension funds “for the simple reason that no one, except the federal government, should want to invest in a non-recapitalized U.S. banking system right now.”

“The fact of the matter is that what generally applies to private investors' looking at investing in the U.S. banking system is true for state/local pension fund investments, too,” says Kirkegaard, who specializes in pension policy for the private, nonprofit, nonpartisan research institution. “Right now, investments are only sensible to the degree that they are guaranteed by the federal government, something of course implicitly accepted by the provisions in Rep. Ackerman's proposal.”

He compared Ackerman's plan to the “generally disastrous” pension bonds issued by state and local governments over the years, in which authorities tried to raise “cheap tax-preferred money and then invest it superiorly in pension funds to recoup prior years' underfunding.”

“It didn't work then, and it isn't going to help state or local pension funds now,” says Kirkegaard, who agrees that despite recent market rallies, the U.S. banking system remains a tricky investment horizon. He says that many market watchers were likely to see the participation of public pension funds in the Ackerman plan as yet another example of the federal government's flailing plan to rescue struggling banks.

“I cannot but see that as a cynical attempt by Rep. Ackerman to use state and local pension funds, subsidized by the general U.S. taxpayer, to try to avoid the increasingly inevitable scenario of full-scale nationalizations of major U.S. banks,” says Kirkegaard. “It seems like a rather desperate attempt at staving off the nationalization scenario by raising nominally ‘private funds,' or at least funds not directly from the U.S. Treasury, to invest in the banking sector.”

That sort of approach is not likely to help anybody in the market, Kirkegaard says, because it does not deal with the underlying investment policies that led to the credit crisis last year.

Several experts interviewed for this story echoed that assessment.

Josh Galper, a managing principal at Finadium, a financial consulting firm which closely tracks the annual performance of 85 major U.S. public pension plans, called the proposal “misguided,” precisely because of the riskiness associated with American banks.

He says many market players would remain wary about how well-received the idea of public pension funds engaging in potentially risky investment strategies would be to a populace growing increasingly sensitive to the appearance of government bailouts.

“Ackerman has effectively offered pension plans guaranteed principal, and what we could imagine would be a Fed funds type of return with a free call option on the stock price of large banks using TARP funds,” says Galper. “If the value of bank equities decline or if they are nationalized temporarily or permanently, this can leave the federal government on the hook for a substantial bailout of pension plans, not to mention banks.”

As a result, he says the market most likely feels that “insofar as TARP banks remain publicly traded investments, it is up to the market to set the price of a stock with attendant winners and losers.”

“While I appreciate [the] interest in stopping the federal government from needing to put more money into troubled banks, I don't think that guaranteeing principal for other investors is the right way to go,” says Galper.

Thus far, the market's continued struggle with valuation and episodic policy decisions has caused much of the recent volatility, a fact Galper says regulators should keep in mind when pitching new programs. There has also been little proof that a push to nationalize private business will be well received by most of the market.

“Much as I hope that pension plans are able to meet all of their obligations without trouble, I do not think that more government guarantees of private sector institutions are a good way to solve this problem,” says Galper.

How did we get here?

The average public pension plan has lost around a third of its value over the last 12 months of tanking markets. Many of those pension funds are taking fresh looks at their asset allocation in an effort to weed out risk.

"Many pension plans pursue investment strategies that can really only be characterized as 'boom and bust' and overlook the value that diversifying into alternative assets can have for a portfolio," says Joseph Hamilton, global head of pension strategy at Deutsche Bank. Hamilton says that until that type of feast or famine investing becomes a thing of the past, pension funds will continue to be pinched when markets take a downturn.

The heady days of fat returns and mythically low risk are likely gone for most of the market, including pension funds both public and private, and funds are now engaged in trying to figure out what went wrong so quickly.

As part of the post-mortem surrounding why a plan like the Ackerman legislation would be a welcome reprieve for many funds, it is important to understand the dynamics of why pension funds, both public and private, invested the way they did during the last decade's massive bull market.

Part of the central argument about the current losses surround a controversy that the returns traditionally touted during the last decade were never historically sustainable to begin with.

The “Oracle of Omaha,” Warren Buffet, even weighed in on the issue. In his annual letter to Berkshire Hathaway shareholders in February 2008 Buffet took direct aim at the storied “Great 8,” percent earnings forecast commonly predicted for pension funds.

“How realistic is this expectation?” Buffet asks. “Let's revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3 percent when compounded annually.”

Other market gurus have been inclined to agree with that diagnosis. Experts and financial players across the sector, including the founder of Vanguard mutual funds, John Bogle, addressed a Congressional hearing on retirement in February. Bogle says the push to 8.5 percent annual earnings was part of a drive created in 1981 to boost the benchmark from a traditional 6 percent return.

That put unrealistic pressure on the sector to meet projected returns that were unlikely to continue in the longer term.

“And the pension plans of our state and local governments seem to be in the worst condition of all,” Bogle says. “Because of poor transparency, inadequate disclosure, and non-standardized reporting, we really don't know the dimension of the shortfall.”

Numbers that illustrated those shortfalls were born out by even the nation's largest public pension funds, with CalPERS returning only an average of 3 percent a year since 1999, a far cry from its general estimation of around 7.8 percent annually.

Funds that fell far short of heavily-touted estimates have often made both regulators and fund participants nervous and ultimately made it impossible for many funds to reach impossible benchmarks, says Bogle.

Market Strategies

Still, some pension funds are trying to see the downturn as an opportunity, telling Markets Media that the current market environment is paradoxically the time to regain an appetite for risk. The Policemen's Annuity and Benefit Fund of Chicago, one of the Illinois public pension funds reeling from significant losses, plans to take on even more risk in the down market, says Sam Kunz, chief investment officer.

“It's always when things look the worst that you get good opportunities. You see some good prices and that's what we're buying,” he tells Markets Media.

The fund will also maintain its investment policy instead of switching strategies.

"Starting in March, we have a search infrastructure scheduled in commodities and a search in currencies. All this was already planned and unfortunately, there are two ways to see it: We made the decisions too late or bad luck in the markets,” Kunz says. "We try to be opportunistic here as a new way to invest for us.”

Fund of Chicago controlled $3 billion in assets as of Dec. 31, compared with net asset base of $4.3 billion a year earlier, says Kunz. Funding status as of Dec. 31, 2007, totaled 51.6 percent. The 2008 funding levels were due to be released in May.

Kunz says the pension fund considers 2008 abnormal.

"If you base your long-term plans on what happened in 2008, you're up for a surprise. 2008 is an isolated case,” he says.

Despite industry reports that liability-driven investment strategies outperformed traditional asset allocation funds, Kunz says LDI is “completely out of the question for now.”

"It's a very interesting approach. If your funded status is around 100 percent, you can match your liabilities better. The one thing missing in LDI strategies is the benefit of humanity moving forward. All the wealth created by corporations reflected in the stock market disappears. If you think that the economy 50 years from now is going to be a bigger, better place, you completely miss that if you do an LDI. It's a case for equities I'm making,” he added.

Recent studies have shown that most pension funds tend to be deeply divided on how the global downturn will play out, with most saying they will attempt to diversify as much as possible while weighting more heavily in products like corporate bonds in an attempt to de-risk assets.

Mercer's Finney-Cooke tells Markets Media that even with a plan like the Ackerman proposal, public pension funds are still feeling pressured to retrench in safer, more transparent assets.

Finney-Cooke says that given the overall current market conditions, plans have been “proactively” moving toward approving or implementing already-approved “opportunistic sub asset classes.” She says that usually between five to 10 percent of total assets are dedicated to that type of investing, which can include leveraged bank loans, distressed debt, commodities or absolute strategies.

Keeping a healthy presence in those types of products can pay off during tough times, she says, a lesson most investors would do well to learn now.

“The rationale for carving out an opportunistic bucket is that during times of high volatility and/or dislocations in the capital markets, of which we are now seeing both, these strategies are designed to take advantage of the current market turmoil and deliver positive risk-adjusted returns back to investors,” says Finney-Cooke.

And while getting back to that “Great 8” may be a pipe dream, there are some strategies that public pension plans may attempt in the near-term.

Peter Grant, a consultant at financial advisory firm Towers Perrin who previously advised on corporate pension funds ranging from $80 million to more than $22 billion, says he expects pension funds now must tackle the difficult task of returning variability “without jeopardizing the upside opportunity.”

In order to do that, pension funds will probably adopt new exposure to fixed-income credit investments, as well as what Grant called “improved duration matching strategies, and prudent approaches to effectively invest contributions within the existing investment policy framework.”

“The nontraditional strategies, also known as alternatives, for pensions in 2009 more likely will be in the credit space with heightened awareness of the pension plan's liability duration,” says Grant.

But is important to maintain a balance, pension market watchers says.

Consulting firms say they have been careful to caution panicked funds that “risk mitigation and return expectation are not necessarily two sides of the same coin,” says Andrew Tunningley, head of investment consulting for Hewitt Associates, a global human resources consulting and outsourcing company, in the U.K.

Hewitt conducts a crucial barometer of global pension performance, the Hewitt Managed Fund survey and index, which has long been seen as a bellwether for broader trends in the sector.

“While liability driven investment is likely to continue to be a driving force in schemes' investment choices in the coming year, trustees should recognize that LDI strategies can produce very divergent returns, depending on risk definitions, while the timing of implementation is key,” he adds.

Thus far, Tunningley says, Hewitt has seen a range of plans from pension funds looking to cope through the next 12 months or so, and says while it may have fallen out of favor in some areas, diversification continues to be a key investment strategy for most public pension funds. A third of fund managers surveyed by Hewitt believe that global equities will be a good asset in 2009, about half the number that feel global equities would be the choice in 2008.

A separate study by the Global Pensions and Strategy Group at Deutsche Bank found that a diversified investment portfolio can outperform an equity and bond-only portfolio by 22 percent over an 8-year period, which is potentially welcome news during bleak market conditions.

“Slamming stable doors can be a significant value destroyer,” says Tunningley. “The overall trend for diversification” to a more “global” view is worthy of note, he adds. “If investing in equities, global equities represent the greatest opportunity set and can be another way to diversify some of the risks posed by being concentrated in one market."

Alternatives, too, remain a reliable standby for many managers looking to snap up bargains in more distressed markets and hoping diversification will minimize risk. Large institutional investors like endowments and pension funds have often looked to alternatives as a dynamic way to garner whopping returns in bull markets.

“The various sub asset classes within the alternative space still offer increased risk-adjusted return potential and continue to be additive for institutions looking to meet certain return goals that traditional asset classes alone will most likely not meet,” says Finney-Cooke. “That being said, I don't feel that alternatives will reach the percentage of overall assets that we have seen in the university endowment asset pools.”

Mitchell agrees with that assessment, adding that while global capital markets continue to gyrate, pension funds will be forced to choose between the lesser of two evils when planning for the longer term.

“While alternatives [like] venture capital, private equity and infrastructure seemed appealing a year or two ago, nothing looks very attractive at the moment,” she says.

After 18 months of unprecedented losses, value continues to be an elusive target, while scrutiny from fund participants and regulators continues to intensify.

Sponsors of private pension funds have a fiduciary obligation to work for the exclusive interest of plan participants so there has always been a balance between trying to maximize returns and protecting participant investments,” says Aliya Wong, director of pension policy, U.S. Chamber of Commerce.

“Given this focus, I don't think that there will be a huge shift from the current trend, particularly in the short-term,” she says.

The Silver Lining

Still, pension funds have found pockets of hope in various niche markets. There has been some lucrative territory in securities lending, with the Illinois State Board of Investment earning $21 million in 2008 from around $1.5 billion in loans, a major jump from around the typical annual gain of $10 million on the practice, William Atwood, executive director, says in a statement. The fund had around $9 billion in assets as of March.

“Yesterday's problems may prove to be today's opportunities,” says Foresti, adding that at this point, the deleveraging cycle that is well underway has made financing “extremely difficult,” thereby dramatically increasing the cost of borrowing.

“The high-yield bond market, which represents the debt of lower quality borrowers, has been particularly affected by the credit crisis,” says Wilshire's Foresti. “Spreads on high yield bonds have blown out to historically high levels reflecting an elevated liquidity and risk premium demanded by investors.”

He estimates that current yield spreads could provide long-term investors with a “substantial cushion” against a significant rise in future defaults among high-risk borrowers.

Foresti says Wilshire had been advising pension funds to look for opportunity in many private markets, including distressed and mezzanine debt segments

“Further opportunities may continue to arise in the private markets as limited partners with a need for liquidity seek to sell their positions into the secondary market,” says Foresti. “Such conversions of inherently illiquid underlying investments will likely require selling at a discount to clear in the current market environment.

He adds: “Public pension plans that have come through the recent environment with ample liquidity will undoubtedly explore some of these potential opportunities.”

Holding On, For Now

In the short term, public pension plans are left trying to find strategies that will staunch the bleeding in already-stressed portfolios and allow them to ride out the next six to 12 months in relative calm.

The appearance of new strategies from various city and state regulators to help squeezed public pension plans is also creating some buzz.

Several Illinois funds say privately that they would instead place their hope in a new commission created by the city of Chicago last year, in which a pension obligation bond alternative could raise proceeds that they would then invest in “preferred stock” that would have federal guarantees and a yield slightly above our actuarial assumption, “which could alleviate the arbitrage play for the city, if we can guarantee an 8.5 percent return.”

Despite its drawback, funds say that this particular program is becoming more attractive as market losses mount.

“I would not like to dispose of beaten down assets to raise capital for investment in this program, but if we did we would most likely look to our fixed income asset class first, since this would more closely resemble a fixed income investment,” says one of the larger Chicago area police pension funds. “One question would have to be addressed with regard to ‘lock ups' imposed by this federal initiative and we would be sensitive to any lock up periods due to our liquidity needs.”

How they manage to reposition successfully will ultimately depend largely on finding some kind of rhythm to the market and closely avoiding investment fads that may have hurt them in the past.

As such, pension funds should also be careful about considering diversification and alternatives to be a panacea to current portfolio ills, says Kirkegaard, of the Peter G. Peterson Institute for International Economics, primarily because many alternatives “badly burned” the funds over the last year.

“There is a reason why pension funds are rapidly demanding their money back from hedge funds right now,” he says. “Further, as quite a lot of these alternative strategies were based on the use of very high, excessive leverage.”

The sector is also likely to be squeezed by increasing regulation in the areas of hedge funds, over-the-counter derivatives and capital requirements, which could make many alternative strategies either illegal or unprofitable.

Some hedge fund managers have lauded recent moves by global and American regulators requiring some type of registration for the sector—a metric that could help many institutional investors, Mooring Capital Fund manager John Jacquemin told Markets Media.

The Vienna, Va.-based hedge fund manager called registration “a very good idea” and said that while he isn't advocating more regulation, greater transparency in such an influential sector will only benefit the market.

“At least then we know what hedge funds are out there and what size they are, with more reliable data, so that it's easier to assess the impact on market,” said Jacquemin on March 20. “The industry is such a large percentage of portfolios” that the entire market would gain from having more information.

“I'd rather see a uniform federal level so the process would be simplified and we'd have more transparency throughout the industry,” he said.

Even with the specter of a federally-administered program like Ackerman's on the horizon, many public pension funds will probably spend the next year trying to take balance sheets down to their leanest in years, while simultaneously toeing the lines drawn by regulators and individual governance boards.

Mitchell, of the Pension Research Council at the Wharton School, says many of these plans will probably try to create programs similar to one implemented in Philadelphia, where the funding period has been expanded from 20 to 40 years and discount rates have been stretched. Mitchell says public pension plans will also “whittle down” the required contribution amounts.

“These changes will not, of course, change the fundamental economics of the problem,” says Mitchell. “Funding holes due to having held risky investments will have to be filled in sooner or later.”

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Chicago Correspondent Karla L. Yeh contributed to this report

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Posted on April 7, 2009