Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

According to "The Lowdown on LIBOR" (May 29, 2008) Businessweek reporters Ben Levisohn and Lauren Young write that $150 trillion is the "value of financial products with interest rates tied to" the London Interbank Offer Rate. In pensionland, this important benchmark rate shows up in a variety of ways.

A plan sponsor that employs swaps to manage interest rate risk often plays the role of Floating Rate Payor. As LIBOR rises, so too does its cash flow obligation as part of the periodic derivative trade settlement. Hedge funds may report a return that shows a shrinking basis point spread as LIBOR takes an upturn, challenging pension funds to explain "sub-par" performance to relevant constituencies. Equity values may be depressed if issuers in which a pension fund invests depend on short-term loans tied to LIBOR. Higher rates may force delinquincies for adjustable rate mortgage borrowers, impacting the price, liquidity and riskiness of some mortgage-backed securities, These are just a few of the LIBOR-related pain points for pension investors.

The saga doesn't end with volatility and escalating levels but rather continues with the process of rate-setting itself. Fearing reprisal from capital markets as credit conditions worsen, banks are thought to be quoting rates that are lower than where they are actually able to borrow from peers. In response, the British Bankers' Association undertook a thorough review of the group of banks that determine daily LIBOR levels, used in turn to price loans, settle derivative trades and/or value securities for an assortment of currencies. The following banks are used to determine U.S. dollar LIBOR:

• Bank of America
• Barclays Bank plc
• Citibank NA
• Credit Suisse
• Deutsche Bank AG
• HBOS
• HSBC
• JP Morgan Chase
• Lloyds TSB Bank plc
• Rabobank
• Royal Bank of Canada
• The Bank of Tokyo-Mitsubishi Ltd
• The Norinchukin Bank
• The Royal Bank of Scotland Group
• USB AG
• West LB AG.

According to a May 30, 2008 news release, a British Bankers' Association sponsored "FX and Money Markets Advisory Panel" has responsibilities to strengthen the oversight of BBA LIBOR. More details are expected shortly. Click to read "BBA Libor Panels."

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According to Boston Globe reporter Matt Viser ("Bigger pensions drawing protests," May 28, 2008), an increase in retirement benefits for teachers and state workers will cost more than $6 billion. Meant to help individuals cope with a higher cost of living, some local officials say it will cost jobs instead. With no funding and limited budgets, the money has to come from somewhere and layoffs are inevitable. Making matters worse, taxpayers argue that closed-door hearings make it impossible to understand the likely fallout for cities and towns. Critics counter that "this has been a very open, transparent discussion." Besides the obvious impact on cash flow, State Treasurer Timothy P. Cahill calls attention to the bigger picture, adding that the "Legislature's approach will put the state's credit rating in jeopardy."

According to "Promises With a Price: Public Sector Retirement Benefits," Pew Center on the States, December 2007, Massachusetts has an unfunded liability in excess of $14 billion. (In contrast, the reported unfunded liability for states such as California and Illinois topples $40 billion.) According to their color coded map, Massachusetts is a blue state, meaning that its defined benefit plan funding falls between 70 and 79 percent.

Though written nearly two years ago, our blog post entitled "Tea Party Redux: State Pensions in Turmoil" (July 27, 2006) is worth a quick read. There is absolutely no doubt that retirement issues will occupy more and more of lawmakers' time. To repeat what I said then:

<< Nothing is ever free. Someone, somewhere, somehow, pays the bill. How will politicians respond? After all, grumpy taxpayers tend to vote. >>

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According to 60 Minutes, some 80 million "millenials" are descending on Corporate America with aplomb. Tech savvy and self-obsessed, these 20 somethings are creating all sorts of challenges for button down HR departments. Key questions arise.

• What kinds of retirement plans make sense, especially if your workforce is an age barbell (with more younger and older workers and fewer in between)? 
• How does a manager motivate the "me" moguls in waiting? ("No, you won't be promoted by the end of the week.)
• What kind of financial education must a plan sponsor provide when the younger set overspends and believes in now power? According to acclaimed author of "My Reality Check Bounced: The Gen-Y Guide to Cashing In On Your Real-World Dreams," Jason Ryan Dorsey repeats what many surveys show. Few individuals under 30 think Social Security is a reality for them.
• For parents and their employers, how do you properly plan for looming retirement when grown-up children have returned home to nest for awhile?

Despite a job slump in some industries, the future is going to be grim for those employers who fail to recognize the coming demographic time bomb. Watch "The Age of the Millenials" (May 25, 2008, CBSNews.com) and learn about youth power in the workforce.

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According to New York Times reporter Mary Walsh, some defined benefit plan liability measurements are being called into question. Pressure to pretty up numbers or the use of older methods that don't reflect economic reality are two potential pitfalls. According to "Actuaries Scrutinized on Pensions" (May 21, 2007), New York actuary Jeremy Gold is credited for encouraging a reality check. If true that defined benefit liabilities are routinely undervalued (as some believe), the inevitable result is an added burden on taxpayers and/or recipients of municipal largesse when bills come due.

Making matters worse, lowball estimates of retirement plan IOUs can lead to expensive new benefits and/or an inappropriate investment policy. Walsh cites Alaska, New York and Texas as a few of the states with actuarial "issues." Unlike private plans, critics suggest that lax rules for public plans open the door to potential abuse.

This blog's author adds that a disconnect between actuarial numbers and economic assessments of promises to keep is no more disturbing than a gap between artificial accounting reports and the  "real" liability. This is not to say that actuarial or accounting numbers are inherently skewed. Such a statement would be a gross and unfair indictment of hard-working actuaries and CPAs who are careful to avoid relying on unrealistic assumptions or refuse to succumb to political pressures.

The main message is that investment fiduciaries have no chance of realizing a "good" outcome if they start with imprecise numbers. Greek hero Atlas may have the easier task.

Editor's Note:

1. Check out "Will the Real Pension Deficit Please Stand Up?" (June 22, 2006).

2. Click to read "Pension Actuary's Guide to Financial Economics" by Jeremy Gold et al, published by the Society of Actuaries and the Academy of Actuaries in 2006.

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Derobing is certainly a novel way to draw attention to "anemic" benefits. According to "Seniors strip in pension protest" by Stacey Zenin (theage.com.au, May 16, 2008), several hundred retirees took off a few pieces of clothes to campaign for a "fair go for pensioners." Believing that the current federal budget does too little to add to post-employment financial security, seniors clamor for "between $70 and $100 extra per week in their pensions." Not unique to Down Under, the problem of financing retirement benefits is fast reaching crisis proportion for numerous governments. Balancing a budget is tough going without considering changes in tax policies and benefit levels.

For an interesting take on the Australian pension system, check out "Risk-Based Supervision of Pension Funds in Australia" by Graeme Thompson, February 1, 2008, World Bank Policy Research Working Paper No. 4539.

Editor's Notes:

1. This blogger had the pleasure of working with Mr. Graeme Thompson on a Chilean pension project, done in conjunction with Dr. Roberto Rochas of the World Bank.

2. Check out the pension risk management section of the Social Science Research Network.

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According to business vox populist Gretchen Morgenson, a Los Angeles federal judge plans to hold mortgage company executives accountable by allowing a lawsuit to proceed. In "Judge Says Countrywide Officers Must Face Suit by Shareholders" (New York Times, May 15, 2008), Morgenson quotes Christa Clark, chief attorney for lead plaintiff, Arkansas Teacher Retirement System, as urging institutional investors to recognize a "duty to seek recourse when a company's directors engage in practices that are not in the best interests of shareholders."

It is impossible to know all facts at this stage, let alone guilt. Only ensuing testimony will shed light on whether Countrywide's CEO and about a dozen directors and officers are deemed culpable. According to the complaint (not yet included in the national judiciary's repository), those described as in the know were allegedly liquidating their personal holdings while making "misleading" public statements about the financial health of the company.

Two things are notable about this case. First, it is yet another indication of the power of institutional investors, in the aftermath of the passage of the Private Securities Litigation Reform Act of 1995. Second, questions remain about whether, and to what extent, other boards will find themselves defending suspicious practices. The outcome of this lawsuit portends greater focus on who should be held responsible for financial practices. So far, the outcome is mixed with respect to the sub-prime blame game.

The Fire & Police Pension Association of Colorado ("FPPAC"), Louisiana Municipal Police Employees Retirement System ("LAMPERS"), Central Laborers Pension Fund, and the Mississippi Public Employees Retirement System ("MPERS") are listed as additional plaintiffs.

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Back from speaking about hedge funds to a large investment fiduciary audience, I've had some time to reflect on the many topics discussed during this sold-out FI360 conference. I keep thinking about one session in particular. 

Focused on the role of the Investment Committee, a panel of veteran institutional investors and service providers waxed poetic about trustee selection, fees and the use of third parties. In response to a question about how to benchmark the performance of pension consultants, one panelist offered that seeking legal redress (in the event of a major problem) would make it difficult (perhaps impossible) to get sufficient responses to any future Request for Proposal ("RFP"). Other consultants, scared by a lawsuit against a peer, would shun the pension plan plaintiff. 

Did the speaker mean to say that a pension fund should avoid rocking the boat with a consultant if, by doing so, they limit the universe of potential service providers for the next bidding round? More broadly, what is the optimal role of the investment consultant? How should a pension plan explicitly grade whether a consultant is doing a "good" job in terms of providing services such as those listed below: 

• actuarial analysis
• strategic asset allocation
• selection and ongoing review of money managers
• fee due diligence
• financial risk management?

If a consultant signs on the dotted line as a fiduciary, are they frenemies or friends of the pension plan? How are their interests aligned as a result?

Ideally, service providers offer independent, objective information with the plan's participants interests in mind.

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A new study, published by Watson Wyatt, suggests that some pension funds are weary of expending higher investment costs. In "A fairer deal on fees," authors find that "pension funds around the world are paying on average 50% more in fees than they were five years ago" with costs now averaging north of 100 basis points. The study goes on to suggest that external asset managers and brokers get the lion's share, in exchange for promises of alpha but delivery of beta. As market conditions sour, pension decision-makers are going to feel even more pressure to justify the fees they pay to outsiders.

No surprise then that some pension funds are looking to indexing as a salvo. In "Pensions turn to passive management," Financial Times reporter Owen Walker (May 4, 2008) writes that assets being allocated to index-tracking funds are on the rise. John Davies of Standard & Poor's adds that financial service providers are fast developing products to appeal to thrifty fiduciaries.

Lest a pension fiduciary think that indexing (in whatever form) lets them off the hook, it's not that simple. If less money is apportioned to active managers, the ones who are selected (or kept) must do "extremely well" to offset any lower returns from the passive component of the overall portfolio. Assessing risk management policies of external managers remains a critical task.

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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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