Tuesday, February 5, 2013

Excessive Risk-Taking at Public Pension Funds?

Elena Farah of the Houston Chronicle reports, Socialized Losses Encourage Excessive Risk-Taking by Pension Funds:
Big bets with private equity[1] by public pension funds represent a perfect example of how misaligned incentives endanger public money. This can only hurt public employees and taxpayers in the long run.

In an attempt to achieve an aggressive target return of 8 to 8.5 percent in a low-yield investment climate, public funds are increasingly assuming risk from investing in illiquid, volatile assets, such as private equity and real estate. These investments often lack transparency.

Fund managers are hoping to benefit from the “illiquidity premium” to boost weak funded ratios battered by the Great Recession. Otherwise, failure to reap attractive returns on investment of pension assets would force sponsor governments to cough up additional annual pension contributions at the time of budget crunch, raise employee contributions, modify benefits or terminate public defined benefit plans altogether –- none may be politically attractive or feasible.

In 2011 private equity accounted for about 7 percent of total defined benefit assets among the top 200 U.S. retirement funds,[2] with higher allocations for some individual funds. Senior pension executives are steadily moving their money into “sub-asset” classes, such as emerging markets, high-yield bonds, and bank loans. Additionally, according to the U.S. Government Accountability Office, the percentage of large plans investing in hedge funds also grew from 47 percent in 2007 to 60 percent in 2010.[3]

According to a 2012 Pyramis Global Institutional Investor survey, this trend is likely to continue, with 67 percent of largest public pension systems indicating plans to boost their share of illiquid alternatives, and 37 percent increasing exposure to “sub-asset” classes. This is a dramatic investment paradigm shift from relying on a traditional blended portfolio of stocks and bonds, which historically generated real rolling returns of about 5 percent over a typical time horizon of 30 years.[4]

Equally worrisome is that investment decisions are increasingly “streamlined” to allow investment managers to take advantage of arbitrage opportunities and “dynamic management” of public funds through flexible mandates. This is bound to lead to poor oversight and lack of representation in portfolio allocation decisions, spelling trouble when markets turn in unexpected directions.[5]

Rewind a mere twenty years ago to the bankruptcy of Orange County, CA, which to date remains the largest municipal failure in the U.S. history with a $1.7 billion loss wiping out nearly 23 percent of its investment pool assets.[6] While in 1994 faulty bets on derivatives were responsible for Orange County’s unprecedented pension collapse, can excessive bets on private equity and exotic “sub-asset” classes lead to the next downfall of pension systems — this time at the systemic level?

Implications of such pension debacle would be dreadful for pension beneficiaries whose pension savings would be wiped out and for sponsoring governments already facing structural budget pressures which most certainly would fail to close the funding gaps with contributions. Millions of retirees would find themselves without annuities and millions more would approach retirement without any savings, overwhelming social safety net programs and spiraling down the standard of living at a time most localities, states and the federal government are already wrestling with debt crises of their own, as well as aging infrastructure.

This is a scenario we as a society simply cannot afford.

Given such dramatic societal costs of potential failure of pension systems, what guarding mechanisms exist to prevent collapse of pensions due to poor investment choices?

Shockingly, current incentives regarding costs and benefits encourage excessive risk taking with public money, privately accruing gains and socializing all losses. Fund managers are compensated lavishly for short-term gains, while bearing no responsibility for sour bets, with taxpayers — and public employees — remaining on the hook if any of these bets fail to pay off. The only real winners are investment managers and their staffs.

Under a similar context of perverse incentives, traders lost billions on Wall Street shocking markets. We now are doing it all over again with public funds. Compensation structures at pension funds, as well as aggressive target return rates encouraging funds to take excessive risk, deserve continued public scrutiny and oversight, since “we the people” will have to foot the bill when — not if — these “alternative investments” go wrong.

[1] “Pensions Bet Big With Private Equity.” Wall Street Journal, January 24, 2013.

[2] “Funds Boost Private Equity Investing By 38%.” Pensions & Investing, February 7, 2011.

[3] “Defined Benefits Plans: Recent Developments Highlight Challenges of Hedge Fund and Private Equity Investing.” GAO, February 2012.

[4] “Investment Return Assumptions for Public Funds: The Historical Record.” Callan Investments Institute Research. June 2010.

[5] “U.S. Publics: Seeking Less Correlation and Better Execution.” Pyramis Global Advisors, 2012.

[6] Jorion, Philippe. Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County. Academic Press: 1995
The article above raises some key issues, like how the aggressive target return of 8 to 8.5 percent in a low-yielding world promotes excessive risk-taking. Frances Denmark of Institutional Investor wrote an excellent long article, Debate Heats Up Over Public Pension Fund Discount Rates, exposing  key differences between US and European pension plans in the way they value future liabilities.

But my big beef  with the article is it paints illiquid assets with an extremely negative brush. Keep in mind, excessive risk-taking can occur anywhere, including in public market investments like in currencies, high-yield bonds and hedge fund investments focusing on structured credit. I've seen plenty of public pension fund managers take inordinately stupid risks across public and private markets, and internal and external absolute return strategies (hedge funds).

I've already commented on pensions betting big with private equity and followed up with an in-depth discussion on why the Caisse is focusing on less liquid assets and whether pensions are taking on too much illiquidity risk.

One of the best comments on the risks of illiquid asset classes I received came from Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP). Jim notes the following:
I find this whole discussion quite interesting. Private assets are just as volatile as public assets. When private assets are sold the main valuation methodology for determining the appropriate price is public market comparables, so you would be kidding yourself if you thought that private market valuations are materially different than their public market comparables. Just because you don’t mark private assets to market every day doesn’t make them less volatile, it just gives you the illusion of lack of volatility.

Another important element which seems to get missed in these discussions is the value of liquidity. At different points in time having liquidity in your portfolio can be extremely valuable. One only needs to look back to 2008 to see the benefits of having liquidity. If you had the liquidity to position yourself on the buy side of some of the distressed selling which happened in 2008 and early 2009, you were able to pick up some unbelievable bargains.
Moving into illiquid assets increases the risk of the portfolio and causes you to forgo opportunities that arise from time to time when distressed selling occurs - in fact it may cause you to be the distressed seller! Liquidity is a very valuable part of your portfolio both from a risk management point of view and from a return seeking point of view. You should not give up liquidity unless you are being well compensated to do so. Current private market valuations do not compensate you for accepting illiquidity, so in my view there is not a very compelling case to move out of public markets and into private markets at this time.
Of course, even though Jim thinks current private market valuations do not compensate you for accepting illiquidity, HOOPP still invests in private equity and real estate. They might do it differently than others, picking their spots carefully and using a different approach (like buying land to build a building in downtown Toronto), but they aren't against illiquid investments.

In my discussions with Neil Petroff, CIO at Ontario Teachers' Pension Plan, he explained to me how they changed compensation after the 2008 crisis so senior managers get compensated primarily based on overall Fund results, forcing them to take part in reviewing all major investments across public, private and hedge funds. According to Neil, this ensures collaboration among various investment teams as they take a more holistic approach to risk. "It also minimizes blow-up risk from any one department."

Neil also told me something novel they implemented which I'm not sure any other public pension fund is doing at this time. Long-term compensation -- the bulk of comp -- is vested over a four-year period in a separate fund and if they have a disastrous year, it can be clawed back entirely, much like a private equity fund.

In theory, clawbacks should mitigate (but not eliminate) excessive risk-taking behavior. Some think pensions should also use hurdle rates and high water marks but then you have to compensate their senior managers like hedge funds and private equity managers. Nonetheless, a pension fund is not a hedge fund or private equity fund, and their compensation should reflect this. Importantly, pension fund managers have no skin in the game, and are therefore not taking as much personal risk as hedge fund and PE managers (this is a controversial topic with diverse views).

Another issue that I want to bring to your attention is when pension fund managers do not take enough risk. This too is a problem, especially after the 2008 crisis where every pension fund is focused on reputation risk and a cover-your-ass mentality permeates these organizations. Risk is part of the game of investing over the long-term but you still need to take intelligent risk and be properly compensated for taking this risk.

Finally, have a look at my comment on pay and performance at US public pension funds. Interestingly, it's not always true that top performers are the best compensated pension fund managers or those plowing into alternative investments. You want to make sure you're properly compensating these guys and gals based on long-term risk-adjusted returns, net of all costs (internal/ external, including foreign exchange costs).

Below, Manhattan Institute Senior Fellow Steve Malanga talks about US state pension debts. He spoke on Jan. 9 on Bloomberg Television's "Street Smart." Malanga points out Illinois is at a "critical juncture" but his solution -- 401K(s) and DC plans -- will only make the problem worse.