Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

Bloomberg reporters Michael McDonald and Adam L. Cataldo cite New Jersey Governor Jon Corzine as a vocal critic of pension obligation bonds. "It's the dumbest idea I ever heard," describing $35 billion in public IOUs (a record issuance level since 2003) as "speculative." From Alaska to Connecticut, state pension plans are issuing debt to replenish retirement plans and thereby avoid funding gaps later on.

As long as the cost of money falls below the realized rate of return, life is good. Unfortunately, reality sometimes intervenes. In a recent survey, Greenwich Associates reports that public pension managers project outperformance of nearly 150 basis points over market benchmarks, something they deem "unrealistic." Another critic, Warren Buffett, writes about "fanciful figures" in his 2007 Letter to Shareholders, adding that few pension plans will be able to achieve their assumed investment rate of return. Read "Warren Buffet on Pensions - Crazy Assumptions?"

Click to read "'Dumbest Idea Ever' Used as Pensions Plug Deficits," May 1, 2008. Also check out the Pew Study entitled "Promises with a Price: Public Sector Retirement Benefits" and dated 12/18/07.

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When I was a young MBA pup (New York University), an investment professor asked students to purchase "Security Analysis" by Benjamin Graham and David Dodd. Not an unusual choice until one noticed the 1940 copyright. My reaction at the time was to think that this scholar needs to retire soon if he can't find a more modern text. Alas, the marvels of youthful ignorance, heh?

This flashback came to mind in reading the flurry of newspaper articles about the intended $23 billion purchase of Wm. Wrigley Jr. & Co. by private candy giant Mars Inc. Helping to finance things is no other than Warren Buffett who negotiated an approximate 10 percent of the deal for Berkshire Hathaway. With a stake in Sees Candy and the Coca-Cola Company, this uber value investor is familiar with beverages, salty snacks and sweets. (Note that Thomson Financial News, via Forbes.com, reports that Moody's Investors Service has put some of the Chicago gum giant's debt ratings under review as a result of the proposed structure.)

According to "Mars to Buy Wrigley’s for $23 Billion" by New York Times reporter Andrew Ross Sorkin (April 28, 2008), Wrigley's sales revenue just topped $5 billion. The National Confectioners Association reports that "gum sales continue to surge growing 9.3% over the latest fifty-two weeks" with the "key growth engine" being "seasonal confectionary products."

This news item is interesting but even more so after reading "Inside Citi, a Hedge-Fund Push Blows Up" wherein Wall Street Journal reporter David Enrich describes sales enthusiasm gone amuck. Having sold interests in "safe" fixed income hedge funds Falcon and ASTA/MAT to retail clients, global wealth management staffers are wrestling with a lawsuit, unhappy brokers and disgruntled investors. The article continues that Citi sold "only to clients with large, diversified portfolios." As litigation ensues (assuming it does), more will be known about sales practices and representations made to clients, existing and prospective.

Will an ordinary stick of gum pave the way for riches and leave certain "exotic" alternatives in the dust? One wonders - shades of the tortoise versus the hare? What are the lessons for retirement plans as billions of dollars are making their way into non-traditional securities?

Editor's Note: Here are a few fun facts about the confectionary industry.

• Halloween is a top 10 "candy buying day" according to The Nielson Company.
• U.S. and UK consumers think that food companies should be doing more to make healthier goodies.
• Sixty-five percent of Americans who consume chocolate prefer the milk variety. See www.candyusa.org.
• January 3 is National Chocolate-Covered Cherry Day, April 12 is National Licorice Day, May 23 is National Taffy Day and August 30 is National Toasted Marshmallow Day. See www.candyblog.org.
• "The first patent for chewing gum was issued in 1869 to William F. Semple, a dentist from Mount Vernon, OH" as reported by the International Chewing Gum Association.
• Bubble gum is pink because the inventor had no other colors left. See http://www.betteroralhealth.info/orbit_us/about-wrigley/fun-facts/index.htm.  

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According to Financial Times reporter Deborah Brewster ("Investors pull out of mutual funds," April 27, 2008), nearly all U.S. mutual fund managers saw a drop in assets in Q1-2008. Sagging returns are a main driver on the retail side. Citing Strategic Insight, Brewster writes that individuals and institutions have pulled $100 billion from American, European and Japanese equity funds.

Money market funds, charging lower fees, seem to be picking up the slack. This suggests an inevitable decline in profitability for the asset management business. In "Has the Financial Industry's Heyday Come and Gone?" (April 28, 2008) Wall Street Journal reporter Justin Lahart writes that "the businesses of borrowing, lending, investing and all of the middlemen in between" are slowing and thereby creating ripples throughout the U.S. economy. With documented job cuts in the financial sector, new regulations and questions about "excess" risk, a discernible shift is underway. A shrinking financial sector and reduced availability of credit hits consumers and corporations hard.

In addition, defined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

The issue is important for many reasons, not the least of which is the impact on statutory funding requirements, cash flow and related share price. In March 2008, money manager Charles Gilbert spoke to a Society of Actuaries audience about the double whammy of falling interest rates (increases the defined benefit liabilty) and unhealthy stock returns (reduces portfolio value).

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 New York Times reporter Alina Tugend ("Pick a Planner Who Can Spell ‘Fiduciary’," April 26, 2008) writes about the importance of doing proper homework when it comes to selecting an investment advisor, stockbroker or financial planner (consultant). Her rule? Ask someone you are thinking of hiring - Are you willing to wear the hat of fiduciary? Since not everyone is required by law to embrace the fiduciary mantle, and some do so only in exchange for additional compensation, the question is far from trivial. She quotes Sheryl Garrett, author of Personal Finance Workbook for Dummies (John Wiley & Sons, 2007) as urging individuals to document agreed-upon terms, including those that relate to the discharging of fiduciary duties such as care and loyalty. Fees and conflicts of interest are other considerations. For example, a compensation structure that includes commissions may encourage the sale of unsuitable securities to small investors.

As more employees migrate (by choice or force) to defined contribution plans, investment literacy is critical. Interested readers may want to check out the following resources:

•  "Final Report on Financial Planner Standards of Conduct" by the FPA Fiduciary task Force, June 1, 2007
• Investor Protection Trust library
• "SEC to continue assault on fiduciary protection in 2008" by Diahann W. Lassus (Investment News, January 7, 2008)
• "Can you trust your financial advisor?" by Liz Pulliam Weston (MSN Money, date not given) - Cites 2005 complaint count against advisors with almost 4,000 taking the form of "breach of fiduciary duty" 

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In a recent speech, Federal Bureau of Investigation ("FBI") Director Robert S. Mueller, III, warns white collar criminals that agents are busy at work. Citing an alarming increase in fraud (up by "more than 80 percent since 2003"), Mueller provided some interesting facts to attendees of the American Bar Association, Litigation Section Annual Conference.

• The FBI has nearly 2,000 agents working on almost 17,000 white collar cases, "from public corruption and financial fraud to health care and mortgage fraud."
• The FBI has successfully prosecuted more than "490 corporate and securities fraud convictions in 2007" with more than 30 insider trading indictments affecting employees of at least four major banks.
• The FBI is investigating in excess of 1,300 mortgage fraud incidents and has identified "19 corporate fraud matters related to the subprime lending crisis."
• The FBI has its sights on "accounting fraud, insider trading, and deceptive sales practices."

Urging reform to protect shareholders and other relevant parties, this lead G man cites the need for independent (and arguably competent and objective) auditors, outside counsel and independent directors. Conflicts of interest remain a concern.

Click to read the full text of Director Mueller's speech.

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According to "Fighting Climate Change, State by State" by Anne Moore Odell (February 27, 2008), local governments are investing in environmentally-friendly companies for the long-term. Various treasurers from California to Connecticut have collectively committed billions of dollars to clean technologies. Evidence that they mean business, nearly 500 institutions came together in New York on February 14, 2008 to address the "scale and urgency of climate change risks, as well as the economic opportunities of a global transition to a clean energy future."

Progress since the 2005 inception of the Investor Network on Climate Risk ("INCR") includes an agreement to verify if, and to what extent, fund managers and financial advisors have bettered their "capacity to assess climate risk." For mutual funds, this includes an annual scorecard that reflects how portfolio managers vote on various shareholder proposals relating to climate.

To learn more, click to read "Investor Progress on Climate Risks & Opportunities: Results Achieved Since the 2005 Investor Summit on Climate Risk at the United Nations," dated February 2008.

Given statehouse initiatives relating to (a) divestment of certain international holdings and (b) limits on sovereign wealth fund exposure, is the commitment to being a friend of the earth a harbinger of future asset allocation directives or good portfolio diversification?

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Several recent experiences inspire this post. On the positive side, two weeks ago, I had the pleasure of spending time with my step niece, a darling little girl of 3. After just 15 minutes, I realized that her favorite way of getting attention is to scream "excuse me" as many times as it takes until nearby adults acknowledge her. Cute at first, it annoys after a few shouts but Lilly certainly gets her way.

On the other end of the experiential spectrum, my Sunday foray to Starbuck's introduced me to "Miss Manners Not." Though I was first at the counter and obviously not yet finished paying for a handful of gift certificates, a lady customer thrice reached over me and then pushed me aside to order a cup of joe. Not being shy, I murmured "sorry to be in the way." To my shock, she replied "it's okay." Yes, my first response was to tilt my cup in her direction ("oops") but give me credit for being an adult who quickly cooed sotto voce, "let it go." (You've met folks like this gal, right? Gotta love 'em for their arrogance and cluelessness.)

Here's the connection to all things pension.

Everyday brings new headlines about the retirement crisis. Just a few days ago, New York Times reporter Mary Walsh cites a new study that shows that 2007 investment gains for America's giant pension funds are fast being erased by early 2008 market tumult. Likely to add to the funding gap and compelling a need for cash infusions is a strategic move away from equity. More disturbing is that jumbo plans, in distress, could "swamp the federal insurance system," already reeling from certain airline and manufacturing company woes. Piling on is the Fed's lowering of interest rates which pushes up the size of defined benefit plan liabilities, exacerbating things. Given tighter funding rules, courtesy of the Pension Protection Act of 2006, plan sponsors have much less latitude in riding out the storm, if even possible. (See "Market Turmoil Has Taken a Toll on Big Pension Funds" by Mary Walsh, April 17, 2008. Also read "2007 Gains Reversed in First Quarter of 2008" by John W. Ehrhardt and Paul C. Morgan, "Milliman 2008 Pension Funding Study," April 2008.)

In January 2008, the U.S. Government and Accountability Office ("GAO") released an alarm bell in the form of its report entitled "State and Local Government Retiree Benefits." They concluded that "58 percent of 65 large pension plans" had funding ratios of about 80 percent in 2006, a decline since 2000. By extension, this means that 42 percent are in bad shape. (There is continuing controversy over whether 80 percent is deemed "safe" or instead suggests a need to worry.)

For individuals, new research cites the need for a long-term, relatively stable mix of stocks and bonds. In "Hitting or Missing the Retirement Target: Comparing Contribution and Asset Allocation Schemes of Simulated Portfolios," Professors Harold J. Schleef and Robert M. Eisinger argue that the likelihood of having enough money to retire comfortably is depressingly low. As New York Times contributor and money talking head, Mark Hulbert, points out, life-cycle or "target date" maturity funds may not perform "in line with their long-term averages." (Read "The Odds for a Retirement Nest Egg, Recalculated," New York Times, April 20, 2008.)

Of course, if Louis Lowenstein, author of The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It is right, fees and revenue-sharing arrangements will continue to erode retirement savings (meager for most), making it tougher to reach even a low savings goal. While employers shed their traditional benefit plans, they nevertheless have a vested stake in wanting their employees to be self-sufficient. Happy workers are typically productive workers who spin gold for shareholders and performance-compensated executives.

For the still clueless pension decision-makers, oblivious to the merits of effective asset-liability management (the equivalent of my coffee shop lady), hopefully the onslaught of economic and regulatory indicators will create a stir. If not, perhaps my young niece will take her "excuse me, excuse me, pay attention" show on the road.

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According to Wall Street Journal reporter Carrick Mollenkamp ("Libor Surges After Scrutiny Does, Too - April 18, 2008), the British Bankers' Association is moving ahead to investigate the veracity of self-reported cost-of-funds numbers. The fear is that banks are paying more to borrow in the short run than they want to admit. If peers discover the truth, bank borrowers may find themselves at a competitive disadvantage. Non-borrowers will feel the pinch too as will swap and over-the-counter fixed income option counterparties and those trading the Eurodollar futures contract. The London Interbank Offer Rate ("LIBOR") is a common base rate for most short-term loans and derivative instrument contracts.

American regulators are worried too as market pundits predict that U.S. dollar LIBOR rates are likely to spiral. Just last week, three-month LIBOR loan rates rose to 2.8175% per annum, up from 2.7335%, "the biggest increase since the three-month rate rose 0.12 percentage point on August 9" when BNP Paribas prevented investors from withdrawing money from several of their funds. The current level is reported at "its highest" since March 13 when news came out about Bear Stearns.

A rising LIBOR makes swap-driven Liability-Driven Investing ("LDI") strategies more expensive for Fixed Rate Receivors - Floating Rate Payors. In addition, if quarterly checks indeed differ from estimated projections, pensions may eschew LDI strategies as too difficult to evaluate for accounting or risk management purposes.

Interestingly, quotation problems seem to be contained to U.S. dollar LIBOR situations and not other currencies such as the Euro.

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As an Accredited Valuation Analyst and long-time advocate of the notion that effective risk management and valuation go hand in hand, the release of two reports that emphasize good process in these areas is welcome news. See "Principles and Best Practices for Hedge Fund Investors" and "Best Practices for the Hedge Fund Industry." Click to read "PWG Private-Sector Committees Release Best Practicies for Hedge Fund Participants" (April 15, 2008) where "PWG" stands for the President's Working Group.

While I agree with Peter Schwartz that self-regulation and market discipline is ideal, I'd like to think that calls for reform are positive reactions to problems rather than "desperate" pre-emptive strikes against statutory mandates. Is that naive? Perhaps but hope springs eternal. (Read "Valuation is the Heart of the Matter," reprinted in "Money House of Cards or Disciplined Approach?" - April 17, 2008)

Where I part company with my colleague is that I believe one can (absent a once in a lifetime event) value complex securities if they are equipped with an analytical toolbox. If we peek inside, "hammers and nails" would include: (a) reasonable assumptions (b) appropriate and tested models (c) understandable and available data (d) identification of relevant risk factors that drive value (e) methodology that can be explained to others and reflects relevant economic considerations (f) disciplined, systematic process and (g) common sense.

Ultimately, value equals price when a willing (and hopefully informed) buyer and seller agree on terms. Until then, should we surrender to what some deem as villainous fair value accounting rules or roll up our shirt sleeves and get to work, acknowledging that a calculated "value" may differ from an eventual price?

I opt for the latter because I believe action beats passivity (though some may say nein to investing in the first place). Indeed there are numerous occasions that require an opinion of value for "official" reasons (tax reporting, account redemption, fund creation, determination of hedge size and so on.) What worries me is when alternative fund managers adopt an arbitrary stance or embrace a philosophy that discourages attempts to apply reason, discipline and care.

• Example One - Two or more appraisers may reasonably disagree on an exact identical DLOM ("discount for lack of marketability") for a particular economic interest. Yet a careful analysis of what contributes to a possible liquidity event is far superior to the X% times number of years formula in use by some alternative fund managers. 
• Example Two - Appraisers cost a fund (or its investors, depending on which party pays) because they charge a fee to render independent, objective third party assessments.  Are pensions, endowments and foundations better off by blithely relying on marks provided by traders, knowing that they are often compensated based on reported performance (inducing an inherent conflict of interest as a result)?
• Example Three - Should we accept that some instruments truly cannot be valued or instead identify economic and non-economic factors that impact the ability of an owner to eventually sell? Should we ignore emerging mechanisms that create markets in all sorts of "hard to value" business interests such as someone's client list or their employee stock options? 

Mr. Schwartz is certainly right to warn that some situations are challenging at best. As this blog has emphasized (perhaps ad nauseum), suitability assessment is a critical first step. It makes no sense to invest other people's money (plan participants) or encourage direct allocation (as with 401(k) plans) unless decision-makers truly understand risk drivers (qualitative, quantitative, economic, non-economic).

This blog will continue to address valuation issues. Your feedback is welcome. Drop us a line.

Editor's Note: Check out www.securitiesmosaic.com and the family of related websites. It's well worth your time. 

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