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

• Dr. Susan Mangiero, AIFA, AVA, CFA, FRM - Moderator and President, Pension Governance, Incorporated
• Attorney James Baker - Speaker and Partner, Jones Day
• Attorney Daniel Berger - Speaker and Partner, The Pomerantz Law Firm
• Attorney Jay McElligott - Speaker and Partner, McGuire Woods LLP.

Since the passage of the Private Securities Litigation Reform Act of 1995, pension plans in the U.S. and abroad continue to play the role of lead plaintiff. Empirical evidence suggests that their presence can often impact litigation terms such as settlement amunt and timing. Hear experts talk about (a) when, and on what basis, pensions are likely to serve as lead plaintiff (b) what happens when a pension plan opts out of settlement (c) trend in sequential lawsuits (ERISA first, followed by securities litigation complaints (d) relationship between fiduciary liability insurance costs and litigation damages and (e) globalization of class action litigation that involves pension plaintiffs. 

Email PG-Webinars@pensiongovernance.com or click here for more information 

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According to "Calpers Weighs Expanding Own Hedge-Fund Investments" by Jenny Strasburg and Craig Karmin (Wall Street Journal, April 16, 2009), the giant California pension fund may be the first stop for fledgling hedge fund managers who seek start-up resources. Described as a way to have "more control over its money," incubating hedgies would "mirror an approach the $175 billion pension fund has taken with private-equity managers."

 Interestingly, news accounts have Calpers losing a senior investment officer in late January 2008. Credited for helping "CalPERS pioneer many new investments," including hedge funds, Christianna Wood has joined Capital Z Asset Management as CEO. Their website describes Capital Z Asset Management and its affiliates as providing "sponsorship capital to hedge funds and structured products while assuming a meaningful minority interest in their management companies and general partners." Refer to "CalPERS Manager Leaves for Hedge Fund" by Murray Coleman, IndexUniverse.com, January 29, 2008.)

The role of CalPERS and other potential "angels" raises a host of interesting questions, some of which follow:

• Will large retirement plan incubators displace high net worth investors?
•  Will large retirement plan incubators displace fund of funds and/or pension consultants?
•  How will pension fiduciaries properly discharge their oversight duties if they are taking management positions in hedge funds that in turn receive plan assets? (Recall that CalPERS acquired a 9.9% ownership stake in Silver Lake Partners, a private equity firm that invests in technology and technology-enabled companies. CalPERS has a seat on Silver Lake's Advisory Board as a result. If CalPERS is allocating monies to Silver Lake Partners, has their due diligence process changed? See "Silver Lake Announces Long-Term Strategic Partnership with CalPERS," January 9, 2008, Reuters.com).
• Might venture capital firms be adversely impacted if pensions decide on a "do it yourself approach instead of plunking down money with Silicon Alley or Valley or international equivalents? (Dan Primack, editor of PEHub.com, aggregates national and regional venture capital data. See "Q1 VC Numbers: Oh, The Horror," April 18, 2009).

 As the capital markets reconfigure, there are opportunities aplenty for everyone. Will the economic crisis beget a brave new world wherein retirement plan assets are used to grow small companies? Who will win? Who will lose? Interesting food for thought.

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According to the Stanford Law School Securities Class Action Clearinghouse, several cases against Washington Mutual, Inc. were consolidated in May 2008. Ontario Teachers' Pension Plan Board was designated lead plaintiff. The "complaint alleges that, during the Class Period, defendants issued materially false and misleading statements regarding the Company's business and financial results....On September 30, 2008, defendant Washington Mutual Inc. filed a notice of bankruptcy."

According to "Suing a Broken Bank" (CNN Money, March 30, 2009) and other sources, a motion to dismiss has since been filed.

Elsewhere in this video, I am asked by CNN Money anchor Poppy Harlow to comment on financial reporting as an element of risk management. (I agreed to discuss transparency in general but told producers upfront that I possessed no information about this particular case, other than what I had read as a member of the general public.) About allegations that material information was withheld from shareholders (whether this case or others), I stated that "It's essentially the same thing that we saw a couple years ago with Enron and WorldCom - Who knew what, when and on what basis and what was the obligation of senior management to disclose information to the shareholders?" Click to view "Suing a Broken Bank." In terms of full disclosure, I own 212 shares of Enron common (worth about a penny per share).

I wrote about Washington Mutual on September 26, 2008 when I posited whether better disclosure would have helped WaMu shareholders. At the time, the U.S. Securities Exchange Commission had just released a statement urging more "transparent disclosure for investors." I countered that "sufficient" news is always welcome but wondered (and still do) if numbers alone are meaningful. I think not. Let me repeat what I said then.

<< What exact type of disclosure can really make a difference? I vote for information about process and accountability. Otherwise, financial statement users end up with snapshot assessments of mandated metrics. While these numbers could be potentially helpful, they are made less so without an understanding as to how they are derived, why they change and the extent to which an organization is exposed to economic danger. A few of the countless questions on the minds of inquiring individuals are shown below. (This is by no means an exhaustive list.)

• Who has the authority to effect change for all things financial management?
• Who oversees authorized persons and the latitude they enjoy to make decisions?
• How are risk drivers identified, measured and managed on an ongoing basis?
• What creates "stop loss" threshholds?
• How are functional risk managers compensated? >>

In addition to their already long "to do" list regarding asset allocation, plan design and so forth, countless pension fiduciaries are charged with corporate governance related duties such as monitoring. After all, they are frequently large shareholders in public companies stateside and abroad. It is interesting to note that most securities litigation leads are either public pension funds (U.S. and non-U.S.) or Taft-Hartley plans but not ERISA funds. Why this is true is one of the questions that will be discussed during our April 27, 2009 webinar entitled "Pension Plans as Plaintiffs - 800 Pound Gorilla of Litigation." Click here to register.

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According to "Investors warn private equity over cash calls" (March 26, 2009), Reuters reporter Simon Meads writes that private equity firms are facing "intense pressure" from limited partners (pensions, endowments and foundations). Cash strapped themselves, institutional investors are telling asset managers not to come knocking on cash infusion doors any time soon.

Does this phenomenon present a fiduciary conundrum? For one thing, might a limited partner be sued for a contractual breach if they refuse to pony up additional monies? Second, could a dearth of new cash making its way to private equity fund managers end up creating more financial pain for the limited partners? After all, if a private equity and/or venture capital fund finds itself short of the almighty dollar (or other currency), it may be unable to invest in new companies deemed to be high growth and/or be hamstrung from keeping current portfolio companies afloat. On the other hand, limited partners may be reeling from their own pain (whether Madoff induced, stemming from equity losses or something else) and figure that the cost of incremental disbursements outweighs the expense of abstaining.

One thing seems clear.

Institutional investors are demanding more for less. In "Calpers Tells Hedge Funds to Fix Terms -- or Else" (March 28, 2009), Wall Street Journal reporters Jenny Strasburg and Craig Karmin write that this large California giant is "demanding better terms from hedge funds, including lower prices and 'clawbacks' of fees if performance weakens." Said to have been sent to 26 hedge and 9 funds of funds, a March 11, 2009 memo outlines terms, with a proviso that counter terms will be considered.

In a March 6, 2009 article by the same two writers, the deputy chief investment officer for the Utah Retirement System echoes similar sentiments. In his "Summary of Preferred Hedge Fund Terms," Larry Powell calls for lower fees, adding that "management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners." The 4-page letter urges a share structure that transfers "liquidity risk evenly among commingled investors" that could result in how gates, lock-ups and redemption terms apply to short and long-term investors, respectively. Regarding disclosures, Powell describes a minimum laundry list to include items such as:

• Annual audited financial statements
• Quarterly information about fees, operational costs, concentration of clients and soft dollar activity
• Monthly Net Asset Values, return attribution by strategy, geography and/or sector, largest long/short positions, leverage at the fund and strategy level
• Weekly return attributions and month-to-date estimates of return.

We've heard numerous institutional investors put a stake in the ground for what they perceive to be a more level playing field (their words). Just a few months ago, I led a workshop on risk management and "hard to value" investing red flags to a group of large public plan auditors. Many of the audience members described a "disclose" or "we'll walk" policy now in force with respect to alternative funds. (Hopefully it goes without saying that not every alternative fund is a "hard to value" fund.)

Several things come to mind. Could demands from institutional investors be potent enough, if met, to stave off new regulatory mandates, some of which are outlined in "Does More Financial Regulation Make Us Safer?" (March 29, 2009)? Second, might we see a flurry of alternative fund manager fee-related lawsuits, similar to 401(k) "excessive" allegations that are making their way through the court system?

The match is on - investor versus manager. Who will get the biggest slice of the pie going forward with respect to economic rights?

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My quotes in "Pension Bills to Surge Nationwide: Many States and Cities Face Hard Choices Because of Market Declines" by Craig Karmin (Wall Street Journal, March 16, 2009) seemed to have resonated with a lot of www.pensionriskmatters.com readers. If you didn't read the article, I said that current funding woes will result in a "huge showdown between taxpayers and public employees" and "The anger is more acute today when people are feeling economic hardship."

In response to queries about New Jersey's plan to use what some might describe as gimmickry to defer pension liabilities, I said that "An IOU is an IOU whether you recognize it now or push the bad news into the future. Taxpayers have the right to know the extent of a town’s pension plan underfunding. A more fundamental question to ask is why there is a need for a deferral in the first place. Why haven’t these plans been better funded to date? Who is accountable and what are their plans to address the retirement plan crisis?

Here is a sampling of the feedback from readers of this blog.

• In response to "New Jersey Governor Calls for a Deferral of Pension Contributions" (November 29, 2008), one reader wrote: "This is apparently a done deal since towns and counties are making up their budgets assuming as much. Very sad that actuaries have been marginalized (bribed) to keep quiet."
• In "Forbes Describes Public Pension Benefits as Rich" (February 23, 2009), a reader wrote: "It's helpful, we think, to occasionally put California's state worker issues in a larger context. Take a look at The Arizona Republic's story, "Union's request to halt state layoffs denied."
• In another response to the Forbes post, dated February 23, 2009, a reader asserts the following: "I think this analysis is a bit overly simplistic. The general characteristics of a governmental workforce can vary greatly compared to the national private sector labor market. Many federal, state and other governments are loaded with a high share of college grads and highly technical workers. You should probably try to adjust for such differences, if you want to make such comparisions. I used to work for the labor statistics branch of the U.S. Department of Labor. It was a building of economists, actuaries and statisticians. Meanwhile, in the rest of the economy, every new job being created was as a Wal-Mart greeter. Should the government number jockey take pay cuts because outside jobs are falling in quality or should they be compared to people holding similar jobs in the private sector? Also, many government workers are not in the Social Security system so a pension with a sixty percent replacement ratio is not as crazy as it sounds (and a sixty percent combined replacement ratio shouldn't sound crazy - that's a big part of the problem). Look at the fed programs (FERS and CSRS) to illustrate..."
• Another reader said, after reading my words about taxpayer- public worker friction: "We have, in the words of EJ McMahon, a "public pension time bomb" on our hands that the ordinary taxpayer does not understand. See http://www.empirecenter.org:80/Special-Reports/2006/06/defusing_new_yo.cfm. In my local Long Island school district of 1,600 students, the average teacher is paid in excess of $93,000. That is a base salary only, no overtime, extras, benefits - It is outrageous."

If you want to comment, please email us. We want to hear what you have to say, especially in the spirit of nurturing an informed debate.

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According to "Taxpayers may pay for pension shortfall" by Neil Vigdor (Greenwich Time - March 1, 2009), prosperity for this lovely Connecticut may soon be a distant memory. A recent meeting of town officials revealed that "the town's pension fund has lost nearly 24 percent, more than $100 million, since last year. Continued deterioration in the equity markets could lead to a $16+ million contribution in short order. Layoffs of public workers have already begun with more likely to come. Though some employees are being directed to 401(k) plans in lieu of the traditional defined benefit plan, municipal woes are a huge headache.

Making matters worse, Greenwich - the home of more than a few major hedge funds - may soon be slapped with onerous compliance costs if Nutmeg state legislators have their way. Hartford Business Journal reporter Greg Bordonaro writes that three bills could potentially roil an already challenged industry. One bill would prohibit investments in hedge funds for individuals (institutions) with less than $2.5 ($5.0) million in assets. Another proposed rule would force additional transparency for any hedge fund that take pension assets. Only time will tell if lawmakers get their way. Earlier attempts at state mandates were rebuffed, fearing that the state would lose tax revenue from wealthy hedge fund managers. However, choppy markets make alternatives a ripe target for attack. Should compliance costs soar, Greenwich town leaders will have more to worry about than pension deficits. As hedge fund attorney John Brunjes says, "It's a highly competitive business, so it would take very little in terms of regulation for hedge fund managers to consider doing business elsewhere." Click to read "Lawmakers Propose Stiff Hedge Fund Oversight.

What's interesting is that equity-related losses are tempting plan sponsors to accelerate their allocation to strategies that lure with the potential of higher returns. Whether doubling up makes sense is a topic for another day. However, alpha-seeking institutions may have nowhere to go if new rules depress expected returns by increasing costs. The counter argument is that regulations are long overdue. No doubt it will be an interesting year for hedgies.

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In "Library retirees' serious ca-sssh" (February 23, 2009), New York Post reporter Chuck Bennett writes that several now retired employees of the New York Public Library System are pulling in pensions in excess of $180,000 per year. That kind of money buys a lot of books indeed. Bennett adds that New York City's contribution of $320 million last year includes "$17 million to support the pension funds of New York's three library systems."

In a related piece, the same reporter informs that "more than 10,000 retired cops - all under the age of 50" account for one fourth of New York City's tab for police pensions. Taking into account a projected liability of $7.8 billion for police pensions by 2013, or "11 percent of the entire projected $70 billion budget," you begin to wonder how the Big Apple can keep up. Firefighers' retirement benefits add to the fiscal pain. Referring to both Mayor Bloomberg and Governor Paterson, Bennett suggests that reform is inevitable. Either people work longer before being able to retire (not always feasible for individuals with physically taxing jobs) and/or they contribute more (if they are doing so at all) to help plan for their Golden Years. See "Time Bomb of Young Cops: Under-50 Retirees Pose Di$aster Threat" (February 23, 2009).

Clearly, there are tough choices ahead to be made.

• How will younger workers in these fields react if their benefits are cut in order to fund promises made to older peers? 
• Will taxpayers be forced to choose among public services?
• Will it be harder to attract and retain qualified state, county and city workers?
• Will competing unions negotiate against each other in order to win scarce resources?

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According to Forbes Magazine journalist Stephane Fitch, public pension participants are living the life of Riley. "Gilt-Edged Pensions" (February 16, 2009) showcases individuals who have been able to retire at a relatively young age and with a comfortable nest egg, courtesy of taxpayers, at least in part. Examples include the following:

• Retired police offer who received a pension at age 42 worth about $2 million
• New Jersey social studies teacher who earns $80,000 per year, pays 5.3% towards a pension, can retire at age 60 with full benefits and the ability to teach part-time thereafter
• Florida security guards who can moonlight for private companies, with time clocked on such assignments being credited toward public pension payouts

Adding insult to injury, Fitch relies on Bureau of Labor Statistics data to suggest that a pay gap exists, in favor of public workers. He writes that "State and local government workers get paid an average of $25.30 an hour, which is 33% higher than the private sector's $19."

I'm not picking on public workers but I do think it is important to understand how much taxpayers owe now and in the future for others' benefit claims. (By the way, I think that includes Social Security and Medicare unfunded liabilities too.) Many people I know are amenable to the notion of a municipal employee receiving higher benefits if they receive lower cash wages, as compared to the private sector. However, few taxpayers want to subsidize both current and future compensation, especially if they themselves are cash strapped (self-employed, lost their job, work for a company without a retirement plan, etc).

The stage is set for continued frustration on the part of public employees (many of whom no doubt work quite hard to do a great job) versus Joe and Sally Taxpayer who have less and less disposable income to finance giant IOUs.

Editor's Note: Fitch quotes me in the article by writing that "Taxpayers are on the hook," says Susan Mangiero, who maintains Pensionriskmatters.com, a blog highlighting pension plan issues.

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According to PE Week Wire (January 15, 2009), the Los Angeles City Employees' Retirement System ("LACERS") has rescinded its authorization to invest in Cityfront Capital Partners, L.P. ("Cityfront") since said fund has yet to raise a "minimum of $50 million in committed capital, which was to include LACERS' commitment." Part of this California pension fund's allocation to "Specialized, Non-Traditional Alternative Investment Programs," an agreement was reached on August 14, 2007 to invest $5 million in this "small and middle market buyout fund of funds investment vehicle." According to a January 13, 2009 "Report to Board of Administration," LACERS' Chief Investment Officer explains that the buyout fund has "only been able to raise $7 million in 'hard commitments' with no near-term expectations of achieving the $50 million minimum level."

Cityfront is not alone in feeling the pinch. According to "VCs Feeling the Pain of Newly Poor LPs" (January 16, 2009), PEHUB writer Connie Loizos writes that some institutional investor limited partners are strapped for cash, having lost money in the market of late. For those for which the problems are dire, they are simply failing to meet a capital call(s) when the venture capital or private equity  fund comes calling for more money.

On January 17, 2009, Wall Street Journal reporter Pui-Wing Tam wrote that, not surprisingly, venture capital investment has "dropped 30% in the fourth quarter to its lowest level since 2005." Traditional exit strategies such as issuing equity via an IPO (initial public offering) or being merged or acquired are currently seen as unlikely options for many VC-backed companies. See "Venture Funding Falls 30%." (A subscription may be required to read this article.) A few weeks earlier, fellow Wall Street Journal reporter Craig Karmin wrote that pension funds are rethinking how much money should remain in private equity, hedge funds "and other nontraditional investments." Karmin describes a capital call "crunch" with private equity funds demanding cash but pension funds expecting to "offset the payments with returns from other private-equity investments." Elusive gains create a double whammy for both limited and general partners alike. See "Once Burned, Twice Shy: Pension Funds" (January 3, 2009).

Business Week Executive Editor John Byrne and writer Steve Hamm tackle the topic of increasing risk aversion on the part of venture capitalists in a December 30, 2008 video entitled "Is Silicon Valley Losing Its Magic?" Citing Andy Grove, author of Only the Paranoid Survive, Hamm avers that the ability for young companies to innovate is being curtailed as venture capitalists and private equity bankers scale back. Institutional investors that do not make capital calls and/or step up to the plate to allocate fresh monies may prevent venture capital and private equity funds from generating robust returns. On the other hand, institutions which are not enjoying attractive, risk-adjusted returns from venture capital and private equity funds could be reluctant to make capital calls.

It is a veritable catch-22.

Editor's Note: 

• Click to read the August 14, 2007 LACERS' authorization memo.
• Click to read the January 13, 2009 LACERS' recission recommendation memo.

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According to the Wall Street Journal video "Connecticut Town Loses Millions With Madoff" (January 14, 2009), Fairfield is the first municipality to "go after" Madoff. In an attempt to recover $42 million or 15% of the this Connecticut town's pension plan, an arrest warrant has been issued for Mr. Madoff. The town is pursuing civil action as well. Click to watch the video.

What would be interesting is if Fairfield law officials succeed in jailing Madoff after several failed attempts by the U.S. government to do the same.

Editor's Note: In 2006, Money Magazine ranked Fairfield, CT as #9 on its list of "Best Places to Live."

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According to Hugh Wheelan ("Prince Charles to propose 'pension plan for the planet'," Responsible Investor, November 17, 2008), England's Prince Charles is working hard to save the rain forests. Since late 2007, His Royal Highness is described as actively encouraging long-term investors such as insurance companies and retirement plan sponsors to buy 15-year bonds "with competitive returns." Issued by companies that are creating "sustainable energy solutions," proceeds of the bonds would likewise be used to make developing companies less dependent on income earned by chopping down trees. The P8, a consortium of 10 (not 8) interested pension funds, is said to include the (1) Universities Superannuation Scheme (2) Dutch giant ABP (3) CalPERS and (4) CalSTRS. (See "Prince Charles lead 'P8' pensions powerhouse finalises climate change report ," Responsible Investor, July 31, 2008.)

Richard Palmer, Daily Express blogger has a different take. In "Prince Charles Wants to Raise Your Taxes to Save Rainforests" (November 4, 2008), eco-friendly investing would get a boost, courtesy of the UK taxpayers as well. Not only would wealthier countries guarantee rain forest bonds, their citizens could pay a utility tax for the alleged benefits provided by tropical jungles - "global air conditioning system, storing its largest body of freshwater and providing a livelihood for more than a billion people."

With the current market situation, one wonders if initiatives such as these will fall by the wayside, for some time, at least. Leaders of developed countries have their hands full as they try to stimulate their beleaguered economies. At the same time, funding status for more than a few pension plans worsens, leaving them with fewer monies to allocate.

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In a November 27, 2008 video, New Jersey Governor Jon Corzine decries property tax increases at a time of recession. For some municipalities, hiking taxes is the solution to making good on retirement benefit IOUs. It seems that the Garden State executive is not alone. Recall that 300 corporations and organizations recently wrote to Congress, asking for contribution relief as required by the Pension Protection Act of 2006. (See "Pension Plan Metrics - What's Wrong With This Picture?" November 15, 2008.)

A short-term fix, while comforting to some, is seen by others as the equivalent of placing a bandaid on a festering sore. Unless you clean the wound, it is unlikely to ever heal.

Politics and pensions = strange bedfellows? The pillow fight is about to begin.

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According to "States try to stem losses in public pension funds" (November 6, 2008), USA Today reporter Kathy Chu describes the precarious situation now faced by more than a few public pension systems. In order to stem the tide of mounting losses, due in part to market turbulence of late, states are "raising the amount that employers and employees contribute to traditional pensions" while others are freezing benefits or shrinking cost-of-living adjustments.

In addition, there is a certain "catch 22" reality that may render it difficult to solve structural financial problems any time soon. Plan participants suffer when a state or municipality's financial health takes a turn for the worse. On the other hand, funding problems with state/city/county pension plans can cause trouble for the public sponsor, resulting in a ratings downgrade and/or higher cost of capital and/or difficulty in raising external money. This is turn could compound problems with a public entity's ability to write checks to retirees. Chu lists economic changes being made by Wisconsin, Arizona, California, Baltimore and Iowa, respectively.

Having just gone through a U.S. presidential election with numerous discussions about red and blue states, maybe we should instead describe states, cities and counties as "in the red" or "more in the red." It is a sobering thought, isn't it?

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According to "California officials hope for easing of credit crunch" (October 4, 2008), Los Angeles Times reporters Marc Lifsher and Evan Halper paint a gloomy financial picture for this giant state. They explain that Governor Arnold Schwarzenegger may have no choice but to ask for help from Washington if short-term credit markets do not soon improve. An inability to issue Revenue Anticipation Notes with a face value of $7 billion will make it difficult to "get cash to pay for day-to-day operations, including paying workers, funding schools and feeding prisoners, between the end of October and the spring." Click to read the October 2, 2008 letter from the former action hero to The Honorable Henry M. Paulson, Jr.

Vox populi Jon Ortiz (aka Sacramento Bee reporter) and creator of The State Worker blog writes that State Treasurer Bill Lockyer may set his sights on the public workers' pension money pot, CalPERS. Author of an October 3, 2008 letter to The Honorable Bill Lockyer, State Senator Dean Florez writes that "the state should look to one of the world's largest investors, the California Public Employee Retirement System as a reasonable purchaser of short-term California state government debt."

In "Could CalPERS help with California's cash crunch? Maybe" (October 3, 2008), Ortiz posts a response from CalPERS spokeswoman Pat Macht who comments on process. "If we are approached, our investment staff would do their normal due diligence and make an objective evaluation of its merits, including returns as well as how it would fit within our asset allocation ranges and targets which guide our investment selections."

Editor's Questions: Will other cash-strapped states ask public and municipal pension plans to buy state debt? If so, how might this impact the funding status of those employee benefit schemes?

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Star-Ledger reporter, Dunstan McNichol, reports of a now-settled legal tussle between municipal worker unions and the State of New Jersey ("Court OK's Jersey plan to invest pension money in hedge funds," August 23, 2008). At the heart of the matter is The Garden State's desire to allocate 10+ percent of its $78 billion retirement system assets to hedge funds and other non-traditional investments as a way to avoid getting slammed when stock markets sour. (Unions have described alternatives as risky.) At the same time, "Court lets NJ invest pension money in hedge funds" (The Associated Press, August 23, 2008), reports a recent actuarial analysis that puts the shortfall as bigger than originally believed, due to a surge in police and firefighters who "are retiring with disabilities."

According to statistics published by the State of New Jersey, Department of the Treasury, Division of Investment, the alternatives portfolio (commodities, real estate, private equity and hedge funds is 11.7 percent (versus a target allocation of 10.3 percent) as of June 30, 2008. In its press release, dated July 15, 2008, the recent loss of 3.1 percent (at mid-year 2008) still leaves a five-year average return of 9.1 percent, higher than "the assumed actuarial investment return of 8.25 percent." Division Director William Clark credits alternatives for avoiding a loss of approximately $3 billion, had the pension's asset mix "not been diversified away from its historic concentration purely on equities and bonds."

New Jersey is not alone in seeking alternatives as a diversifier. Yet there remains a critical question as to when and why equities are deemed "riskier" than alternatives. Of course, one must be particularly careful with his or her answer. Market capitalization, strategy, relevant time period, restrictions on transferability and industry and economic fundamentals are a few of the many determinants of risk (financial and otherwise) that distinguish traditional equity holdings from alternatives.

Editor's Note: To learn more about official symbols, including the State Seal, visit the State of New Jersey website.

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According to blogger extraordinaire and Sacramento Bee reporter Jon Ortiz , the California giant will now invest in "PPP" (public private partnership) deals but with strings attached. According to their policy entitled "Infrastructure Program," posted on "The State Worker" and elsewhere, projects to build bridges, roads and other types of infrastructure should avoid displacement of California municipal workers "provided that CalPERS' fiduciary responsibilities are met." Subsequent text adds that "the investment vehicle shall make every good faith effort to ensure that such transactions have no more than a de minimus adverse impact on existing jobs."

Far be it from me to impugn any group of workers, municipal or private. However, one does wonder if CalPERS and infrastructure fund managers will soon find themselves at loggerheads. If I read the policy correctly, it seems to put an awful lot of responsibility on external portfolio managers to address wage differentials (if any exist) for the express purpose of assessing the cost-effectiveness of labor resources. Employment economics is a speciality in its own right. Should infrastructure moneymen (and women) hire outside experts to undertake a comprehensive study to determine whether private versus public workers are best suited for a particular project? How might such fees, paid to labor economists by money managers but passed along to institutional investors such as CalPERS, erode reported returns? Could returns be eroded by so much that the benefits of investing in infrastructure in the first place are more than offset by CalPERS' mandate to avoid loss of state jobs?

According to Brian K. Miller ("CalPERS Changing PPP Language," GlobeSt.com, August 15, 2008), the California Public Employees Retirement System ("CalPERS") altered its policy so as not to be sued by the Professional Engineers in California Government ("PECG"). The American Council of Engineering Companies of California (the private equivalent of the PECG) countered that threat of litigation does no one any good.

Does this type of allegedly veiled political "intervention" sound familiar?

Just a few days ago, Massachusetts State Treasurer Tim Cahill said "no thanks" to Governor Deval Patrick, when asked to allocate pension assets to bonds issued by the state's student loan organization. In "Cahill rejects student-loan proposal" by Casey Ross (The Boston Globe, August 8, 2008), fiduciary concerns are front and center. In "Massachusetts Pension Plan Urged to Invest in School Loans" (August 8, 2008 blog post), I wrote as follows:

Here's the rub. The state pension trustees have a fiduciary duty to make sure that the plan is in good financial shape. Will statutory investing put those fiduciaries at risk for allegations of breach in the event that MEFA bonds sour or perhaps offer a sub-optimal return?

I think the same principle applies to the CalPERS decision, sending mixed signals about competing constituencies - state engineers versus plan participants. Complicating things, could state workers win now by keeping their jobs (for certain infrastructure projects) but lose later on if infrastructure investments fare poorly due to labor-related cost issues and so on?

What a dilemma!

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In "States Double Down on Hedge Funds as Returns Slide," Bloomberg reporters Adam Cataldo and Michael McDonald (August 14, 2008) suggest that public pensions may get a double whammy if alternative investments go south. New York, New Jersey, South Carolina and Massachusetts are just a few of the large public plans now allocating monies to non-traditional investments such as hedge funds, real estate and private equity. This is not necessarily good or bad though one wonders about the timing. Will current market volatility help or hinder plans in search of higher returns? This blogger is quoted as follows:

"It doesn't come risk-free," said Susan Mangiero, president of Pension Governance, LLC, a research firm based in Trumbull, Connecticut. "You could end up having a worse performance and the chain of events is lower funding status and increased taxes."

Managing director Eileen Neill, with Wilshire Associates, states the need to "diversify some of the equity risk" and to attempt strategies that will help match the growth in liabilities. As I told the Bloomberg reporters (though not included in this article), how one measures diversification potential is key to understand. Correlation analysis only goes so far when markets are turbulent and bad news tends to adversely impact otherwise uncorrelated markets. Additionally, correlation assumes a linear relationship when comparing returns for a particular investment pair (hedge fund versus a large cap equity index for example). When the relationship is non-linear, correlation is less useful as a gauge of potential risk reduction.

Just as important, past is not prologue. Assessing historical returns can be misleading at best. Stan Rupnik, Chief Investment Officer at the Teachers' Retirement System of the State of Illinois, is quoted as saying that "Chasing performance, especially in a public fund, can be a dangerous thing." It is important for trustees to make sure that "what if" analysis is being done on a regular basis, taking into account relevant risk drivers. Consider private equity and venture capital. An accelerating credit crisis has made it extremely difficult for companies to go public or for potential suitors to finance their bid. As a result, returns suffer. No surprise that pension investors (and their plan participants) take a hit too.

Editor's Note:

• Check out "29 States Faced Total Budget Shortfall Of At Least $48 Billion in 2009" by Elizabeth C. McNichol and Iris J. Lav, Center on Budget and Policy Priorities, August 5, 2008
• Read "The Tech I.P.O. 2008, R.I.P." by Tom Steinert-Threlkeld, "Between the Lines," August 8, 2008
• An online statistics textbook, courtesy of Stat Soft, provides some insight about correlation and linearity.

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According to journalist Casey Ross, Massachusetts Governor Deval Patrick is asking the state retirement system to allocate $50 million to the student loan business by buying about to be issued MEFA bonds. According to their website, the Massachusetts Educational Financing Authority ("MEFA") regrets that it is "unable to secure funding due to increasingly difficult capital market conditions." Harvard University and local colleges are likewise encouraged to do their fair share. (Read "A late try to salvage student loans" by Casey Ross, Boston Globe, August 7, 2008.)

Even if one accepts the premise that granting school loans is a good thing, the issue remains. Should state executives mandate investment policy? The student loan organization cites a low default rate of less than one percent, asserting that the $51+ billion pension plan can thereby avail itself of a relatively safe investment.

Here's the rub. The state pension trustees have a fiduciary duty to make sure that the plan is in good financial shape. Will statutory investing put those fiduciaries at risk for allegations of breach in the event that MEFA bonds sour or perhaps offer a sub-optimal return?

A pension plan is a “trust” that is created to benefit the plan participants (in this case state workers). Legal counsel is likely to confirm that those in charge of the plan should be acting solely in the best interest of the plan participants (duty of loyalty). Additionally, are trustees deemed truly independent if they make a decision that is tied to political exigencies? Unless school loans can be assessed as a suitable investment for the pension plan (and maybe they can), one wonders if trustees "do good" for Massachusetts youth at the expense of retirees.

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Hat tip to Robert Elder, journalist for American Statesman, who writes that a prominent Dallas financier has been jettisoned as chairman of the Texas Pension Review Board, "which oversees nearly 400 public pension systems that hold $200 billion in assets." In "Perry ousts head of pension board" (American Statesman, June 24, 2008), Elder describes Frederick Rowe as a vocal critic of alternative investment commitments by retirement plans that do not always fully consider risks.

According to its website, the Texas Pension Review Board has a variety of duties, including the oversight of "the actuarial analysis process" and making recommendations of "policies, practices, and legislation to public retirement systems and their sponsoring governments." If one clicks on "Tools," you can download the audio files of board meetings. The most recent one (dated April 10, 2008) is worth a listen as it centers on asset allocation and risk assessment with then Board Chairman Rowe criticizing a "backward-looking" approach to assessing investment performance and a reliance on investment consultants who advocate alternatives and "reduce what they call risk in patching together this crazy quilt of uncorrelated assets." (It's a large file and may take a few minutes to download.) 

In its "Written Investment Policies for Public Pension Systems," the section on risk is brief and focuses on the erosive impact of inflation and the possible gap between actuarial interest assumptions and realized performance. The statement that "to increase one's understanding, one can also look at the actual rates of return and volatility for the past 25 years" caught my eye. As most financial experts know, the risk-return tradeoff, along with correlation patterns (and much more), can change dramatically over time. To rely only on historical numbers without conducting a "what if" analysis (which may be a regular activity by various Texas plans) is ill-advised. Additionally, a decomposition of a period as long as 25 years into economic "regimes" goes a long way to avoid the artificial smoothing of risk measurements. Decisions based on metrics that lower risk may not always be the best ones, putting it mildly. However, to be fair, readers are urged to describe investment objectives in terms of return (absolute and relative) as well as the risk-adjusted rate of return. It would be nice to see this document beefed up to include extensive guidance on how various risks (economic, operational, default, etc) will be measured, monitored and managed.

In a separate article ("TRS switches key outside law firm," American Statesman, July 24, 2008), Elder writes about a recent change of fiduciary counsel that has apparently upset some trustees of the Teacher Retirement System of Texas. Elder describes the decision as "unusual" because of a close split vote and imminent plans to discuss "governance policies and ethics rules in September" (suggesting that some trustees favor continuity). One pension attorney with whom I recently spoke offers that a change of fiduciary counsel is not in and of itself a red flag.

In a lengthy comment, posted to Elder's blog, Public Capital, Mr. Jim Lee, Board Chairman of TRS writes that "8 trustees voted for or expressed support" for the hiring of a new outside legal expert and that trustees unanimously voted in favor of "diversification changes in April 2007." He adds that a variety of alternative investments "will make up potentially another 30 percent of the portfolio, up from approximately 4.5 percent" as part of a "very deliberate progression." Printed page 68 of the Comprehensive Annual Financial Report (for fiscal year ending on August 31, 2007) shows a private equity target allocation of 10% with a minimum range of 5% and a maximum range of 15%. The given target for hedge funds is 4% with a minimum range of 0% and a maximum range of 5%. The target for real estate is 10% with a minimum range of 5% and a maximum range of 15%.

As stated many times herein, alternative investments are not inherently "good" or "bad." However, as more U.S. and non-U.S. plans (public and corporate) invest in alternatives, it is extremely important to understand how decisions are made with respect to risk assessment, including valuation of "hard to value" assets. In the case of TRS, with a total fund value as of August 31, 2007 of $111.1 billion, the aforementioned annual filing cites the creation of a risk committee of the board to oversee "the overall risk of the portfolio" and establish "policies and practices to measure, manage and mitigate" exposures. A second initiative is the determination of "key risk parameters", derivative instrument limits and related counterparty credit ceilings, along with addressing liquidity, operational, settlement and legal uncertainties.

Editor's Note: The Teacher Retirement System of Texas was cited as "Public Pension Fund Investor of the Year" by Alternative Investment News, an Institutional Investor publication. Click to read the June 26, 2008 press release.

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Looking forward to "enhancing and diversifying" the $29 billion investment portfolio of the South Carolina Retirement System ("SCRS"), the South Carolina Retirement System Investment Commission awards a strategic mandate to the D.E. Shaw Group. According to the July 28, 2008 press release, capital will be allocated to an "array of absolute return, direct capital, private equity, real estate, long-only and 130/30 opportunities." (The SCRS website describes the Investment Commission as consisting of six "financial experts," having been created in 2005. A designated fiduciary for the SCRS, The Commission "is now responsible exclusively for investing and managing all assets of the SCRS.)

According to the "South Carolina Retirement System Investment Commission - Annual Investment Plan, Fiscal year 2007-2008" (last updated on July 19, 2007), an asset allocation has been approved that "is significantly different from the previous asset allocation." While equity cannot exceed 70 percent of the total investment portfolio at any time, alternatives are targeted to make up fifteen percent of assets, with five percent each in private equity, real estate and "Global Asset Allocation/Absolute Return" (GAA/AR). As shown in the table below, deviations might occur, in part perhaps because "it may take five years or longer before the total allocation to private equity is fully invested." (Private equity was just approved in November 2006, via a constitutional amendment, followed by a state referendum and ratification by the state legislature.)

Excerpt from the Annual Investment Plan: (%)

Sub-Asset Class	Target	Minimum	Maximum
GAA/AR	5	2	8
Private Equitiy	5	0	10
Real Estate	5	0	10

In reading further, investment managers are clearly held responsible for "compliance with all guidelines," using "then current market values" as a benchmark. Given that FAS 157 presents all sorts of mark-to-market (or mark- to-model) challenges for alternative fund managers, it will be informative to track how D.E. Shaw and others (a) satisfy SCRS guidelines while (b) helping this public plan giant embark on what might be construed by some as an "aggressive" foray into non-traditional strategies ("aggressive" in the sense that the minimum versus maximum totals could vary considerably, from 2  percent to 28 percent of total assets). Many questions arise, some of which are listed below.

• Will the Investment Commission create and make public a separate risk management and valuation policy(ies) for alternative investments?
• How will the use of derivative instruments for 130/30 strategies be tracked across managers in the context of asset allocation sub-sectors?
• Why does the "Derivatives Review" exclude a statement about the monitoring of collateral by those fund managers who employ derivatives, direct and embedded? (The "March 31, 2008 Quarterly Report" does describe "continued development and refinement of risk control reports to monitor liquidity, leverage and counter-party risk.")
• Will the cost of requiring "all managers" to "present book value and current market value for all securities held" on a quarterly basis turn out to be prohibitive and counterproductive? This assumes that "all securities" include those that, by their very nature, represent a bundle of "hard to value" economic rights. For example, will private equity managers be asked to get an independent, third-party appraisal of holdings every quarter? 
• The aforementioned "March 31, 2008 Quarterly Report" states that "two private equity funds were approved totaling" 85 million Euros. Will these non-U.S. dollar investments be hedged? If so, how will fund managers be graded in terms of performance? Will fund managers be graded differently, depending on choice of hedging instrument and/or strategy?
• How will an allocation to alternatives be determined in the context of variable funding ratios? (According to the "2007 Popular Annual Financial Report," actuarial assets as a percentage of actuarial accrued liabilities fell from 86 percent in July 2002 to 69.6 percent in July 2006. Noted is a 229.84 percent increase in cash and cash equivalents between 2006 and 2007 "until final allocations to the new asset classes could be implemented.")

Ideally, the Investment Commission will fully inform plan participants and other interested parties (state taxpayers for example) about their deep dive into alternative waters and related, but critical, issues such as valuation and risk management.

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Welcome to new blogger, Jon Ortiz. A seasoned reporter for the Sacramento Bee, Ortiz is the creator of The State Worker and plans to update and debate issues relating to "state pay, benefits, pensions, contracts and jobs."

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According to "Government Rule Makers Looking at Pensions," New York Times reporter Mary Walsh (July 11, 2008) describes a new initiative, sure to create headaches for troubled state and city pension plan auditors. Announced at its July 10, 2008 public meeting, the Government Accounting Standards Board plans to "force state and local governments to issue better numbers and reveal the true cost of their pension promises." Walsh describes a GASB report that is frightening at best. (I am trying to get a copy of the report to upload to this blog.) Questionable practices include:

• Award of retroactive employee benefits without recognizing the incremental costs
• Use of "skim funds" which diverts some investment income dollars away from the pension plan for other uses
• Amortization of expenses over 50 or 100 years (versus the customary 30 years)
• Use of a 30-year amortization period with an annual reset back to Year 1.

Additionally, on June 30, 2008, GASB issued Statement No. 53, Accounting and Financial Reporting for Derivative Instruments in order to promote transparency about the use of derivatives by public entities. In its news release, GASB describes the need to determine "whether a derivative instrument results in an effective hedge." Unclear is whether GASB 53 applies to public pensions that employ derivative instruments for hedging, return enhancement or a variety of other applications. Also unclear is whether embedded derivatives must be accounted for. (I am researching these questions.)

Having been on the front lines of FAS 133 implementation (the corporate equivalent of GASB 53), challenges await auditors and pension finance managers alike. Click to read "FAS 133 Effectiveness Assessment Issues" by Dr. Susan Mangiero (GT News, June 15, 2001) or "Is correlation coefficient the standard for FAS 133 hedge effectiveness?" by Dr. Susan Mangiero and Dr. George Mangiero  (GARP Risk Review, May 2001).

Notably, a survey soon to be released by Pension Governance, LLC and the Society of Actuaries suggests that public and corporate pension plans worry about accounting representation. A large pool of U.S. and Canadian respondents rank compliance with new accounting rules as their number one concern. The survey, entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" is tentatively scheduled for release during the week of July 21, 2008.

Editor's Notes:

• You may have to register in order to read articles online by New York Times reporters.
• Check out "The $3 Trillion Challenge" by Katherine Barrett and Richard Greene (Governing, October 2007) and the related "Q&As With the Experts" - Gary Findlay, Susan Mangiero and Richard Koppes.

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In response to our June 29, 2008 post entitled "California Pension Fund Investments in Tobacco," a consultant questioned CalSTRS' claim that the fund had suffered an opportunity loss of $1 billion by divesting itself of $238 million in tobacco stocks.

Sacramento Bee reporter Jon Ortiz sent the following text, excerpted from a CalSTRS report (page INV82, "Performance Review of the Modified Benchmarks"):

<< The performance of the modified benchmarks from inception to December 31, 2007, was
reviewed at the April 4, 2008 Investment Committee meeting. Over the seven and a half years,
since inception, it is estimated that CalSTRS has suffered slightly over a $1 billion opportunity
loss by not investing a market weighting in the tobacco industry. This calculation too is open for
debate, but it remains in Staff’s view that this is a reasonable approximation of the opportunity
loss. >>

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In "UK Pension Fund Goes Green" (June 28, 2008 post), this blogger cites diversification as one element of the decision to allocate monies to "socially responsible" investments. Anticipated performance is another consideration and not just for "virtuous" stocks.

In "CalSTRS wavers on its ban on tobacco investments" (June 5, 2008) Sacramento Bee journalist Jon Ortiz writes that the board of the California State Teachers' Retirement System is mulling over whether to reverse its earlier divestment of $238 million in tobacco company equities. Thinking that the industry is no longer vulnerable to massive lawsuits and/or government mandates, the $169 billion public pension fund estimates it would have earned $1 billion more had it stayed the original course.

An excerpt from its "Statement of Investment Responsibility" puts "preservation of principal and maximization of income" as "the primary and underlying crieria for the selection and retention of securities." The "CALSTRS 20 RISK FACTORS" do not expressly preclude investing in any particular industry. According to "CalSTRS rethinks tobacco taboo" by Jon Ortiz (June 4,2008), gambling and alcohol company stocks remain part of the pension fund's equity portfolio.

While CalSTRS ponders an add-back of tobacco, the University of Toronto announced on April 9, 2008 that it will be dropping its investments for ethical reasons. According to "University of Toronto to Sell-Off Tobacco Industry Holdings," the school will be the "first institution of higher education in Canada to divest from the tobacco industry."

Editor's Note: For articles about tobacco-related investing, visit Tobacco.org. On a related note, and if you appreciate a good satire, check out a movie entitled "Thank You for Smoking." This gal has laughed through the film version of the popular Christopher Buckley novel at least four times.

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According to Institutional Investor ("Buying into Green Investing" by Henry Teitelbaum, June 2008), green is good for at least one large UK pension fund, the Universities Superannuation Scheme Limited ("USS"). Joined by three other organizations (Alliance Trust PLC, SNS REAAL N.V. and Mitsui & Co Ltd), this trustee company with 30+ billion GBP in assets is part of a 56 million GBP financing round for the Climate Change Capital Group, a London investment bank "dedicated to the low carbon economy." Teitelbaum adds that the USS is already sold on the commercial viability of environmentalism, demonstrated by its membership in the Enhanced Analytics Initiative. According to research done by this blogger, the USS is credited with taking "ethical, social and environmental considerations" into account when "assessing the merits of investment in a given company" as early as 2001. (See "Pension funds can get more from 'green investing' - SRI expert" by Nat Mankelow, bfinance, May 12, 2001.)

While few dispute the merits of considering a Socially Responsible Investing ("SRI") component for portfolio diversification purposes, it would be helpful to know how USS determines its strategic commitment to SRI economic interests as a separate asset class. Moreover, how does this pension giant consider "green" or "vice" factors before taking direct equity stakes in oil or tobacco companies? Top 100 USS equity holdings, as of March 31, 2008, include Royal Dutch Shell (position 1 with an estimated market value of 705.8 million GBP), BP (position 3 with an estimated market value of 625.2 million GBP) and British American Tobacco (position 14 with an estimated market value of 194 million GBP). This blogger is not maing a value judgment about investing in the stocks of these or other companies but rather simply thinking out loud about diversification analysis as it relates to SRI exposures.

Valuation is yet another consideration. As pension plans invest in environmental companies, how do (should) they properly determine the probability (and amounts) of revenue realization for start-ups and/or firms that depend on relatively new technologies to generate income? In the absence of accounting rules (across countries) or new regulations that mandate periodic assessments of value, the challenge is significant. Add the time pressures of compliance and these already important questions demand good answers.

Editor's Note: According to the EAI website, membership is "open to institutional investors and asset managers who commit to allocate individually at least 5% of their brokerage commissions to extra-financial research" or said, another way, the assessment of externalities on long-term investment performance. Most members are non-US organizations. The New York City Employees' Retirement System ("NYCERS") is a member.)

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Sacramento Bee investigative journalist Jon Ortiz reports that the giant California Public Employees' Retirement System ("CalPERS") has just announced an 8 percent rise in "its Kaiser basic premiums." According to "Rate outlook dismal for individual health plan subscribers" (June 24, 2008), roughly 2.5 million individuals will feel the pinch. Citing Dr. Michael Kraten, Connecticut-based industry expert, relatively healthier baby boomers and cheaper generic drugs have helped to stave off premium increases, but not for long. Even if large organizations like CalPERS are able to drive a hard bargain, "Whatever price breaks the big players get are passed down the line as providers haggle with doctors and hospitals over payment for services and raise or lower rates on other policy purchasers."

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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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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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According to State Editor Jay Jochnowitz for timesunion.com, Attorney General Andrew Cuomo is investigating "alleged abuses of the state pension fund" at school district, town and village levels. External contractors may be costing Empire State taxpayers a bundle in the form of "undeserved" retirement benefits. (See "Cuomo expanding pension probe," April 14, 2008.)

Not surprisingly (and assuming facts bear out the presence of fraud), folks are in a major huff. To read a few takes on the fast-changing situation, check out these items.

• "Cuomo: 90 attorneys' pensions potentially fraudulent" by Robert E. Kessler (Newsday.com - April 10, 2008)
• "New York's Pension Scams Must End Now" by James Ostrowski (Free New York - April 14, 2008)

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Governor Arnold Schwarnegger has put the kabosh on a state legislative attempt to prohibit the state's two largest public pension funds from allocating to certain money managers. Arguing that AB 1967 puts undue strain on the California Public Employees' Retirement System and the Calfornia State Teachers' Retirement System by prohibiting money managers who invest in countries with human-rights issues. If adopted, The Carlyle Group (owned in part by the United Arab Emirates) would be off limits and thereby shut off private equity deal flow. In his April 9, 2008 op-ed piece, published by the Los Angeles Times, Governor Schwarnegger writes that measure AB 1967 would "cause a deep wound to our retirement funds and government programs when we can least afford it." Though he earlier signed measures to divest from Sudan and ban investing in Iran, the state's head politico avers that this bill would (a) cost CALPERS and CalSTRS billions of dollars in lost opportunities over the next 5 to 10 years (b) do little to discourage sovereign wealth fund investing overall and (c) be a fig leaf with respect to boosting human rights. Click to read "California can't afford a symbolic divestment that won't affect human rights."

On April 10, 2007, Sacremento Bee reporter Dale Kasler writes that Assemblyman Alberto Torrico (D-Newark) is withdrawing Assembly Bill 1967 "for the time being. (See "Lawmaker pulls bill to set human-rights limits on public pension fund investments.")

Of course, this does not eliminate an obvious question. Should the state (in an editorial sense, not a particular geographic locale) direct public plan investing?

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Related to our April 6, 2008 post about risk management oversight (asking who is in charge is a logical query), Wall Street Journal reporter Jed Horowitz writes about unhappy pension campers.  Three plans are now on record as opposing the re-election of various Morgan Stanley directors, including Chairman and CEO John Mack. They include: (a) California State Teachers' Retirement System (b) State Universities Retirement System of Illinois and the State of Connecticut Retirement Plans & Trust Funds. Citing "failure to generate returns consistent with the broad stock market," inter alia, they decry an adverse impact of the company's risk-taking on the value of their Morgan Stanley shares. See "Morgan Stanley Board Feels Heat Over Loss" (April 7, 2008).

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According to "Pension burden grows for states" (Seattle Times, March 15, 2008), available pension assets are quickly shrinking, especially as equity returns continue to plummet. The article states that global stock market value dropped by more than $5 trillion in January 2008, prompting Standard & Poor's analysts to warn of danger ahead in the form of poor funding ratios.

The accompanying visual says it all, with the biggest pension deficits reported for Illinois ($32.4 billion) and Connecticut ($14.8 billion). 

Don't forget OPEB (Other Post-Employment Benefits). GASB 45 (Government Accounting Standards Board) is creating real pain for a significant number of public entities. Check out this exchange of unhappy taxpayers in West Hartford, Connecticut regarding the extent of unfunded healthcare promises to municipal workers.

Click to read a "GASB Q&A." If you missed the October 2007 cover story of Governing, click to read "The $3 Trillion Challenge" by Katherine Barrett and Richard Greene. Also read the "Q&A With Experts," including one about risk management prescriptive steps by this blog's author, Susan Mangiero.

Editor's Note: GASB 45 is entitled "Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions."

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As a result of its investigation of the Retirement System of Alabama ("RSA"), the U.S. Securities & Exchange Commission, Division of Enforcement, issued a March 6, 2008 report "to emphasize the responsibilities of all investment professionals, including large public retirement systems and other public entities, under the federal securities laws and to highlight the risks they undertake when they operate without a compliance program."

At the heart of the matter was an allegation of improper trading of shares in The Liberty Corporation, prior to the public announcement of its acquisition by Raycom Media, Inc. ("Raycom"). While this state agency, with over $30 billion in assets under management, is described as having cooperated with the SEC, pre-event, it had no "program, policy, practice or training to ensure that its investment staff understood and complied with the federal securities laws in general or insider trading laws in particular. RSA also did not have a compliance officer, and the responsibilities of its general counsel did not include oversight of RSA's investment activities."

According to this official report, RSA founded Raycom in 1996 and was its "primary financing source." (Enforcement investigation aside, this begs an interesting question. Why was the Retirement System of Alabama in the business of creating a private business?) A disturbing excerpt from the SEC report is shown below.

<<RSA's purchases of Liberty stock were unusual in at least two respects. First, RSA's CEO directed the trades even though he normally was not involved in equity trading decisions. Second, Liberty's market capitalization at the time was less than $1 billion and did not satisfy the $5 billion market capitalization guidelines RSA generally used for the two funds that purchased the shares.>>

While state pension plans are not subject to the Investment Company Act of 1940 and the Investment Advisers Act, public plans and their employees are subject to anti-fraud provisions of the "federal securities laws and Commission rules thereunder."

The Commission concluded that bad acts could have been avoided if the state pension plan "had adequate policies and procedures to assure compliance with the federal securities laws." The SEC took into account the following - (a) RSA's cooperation (b) remedial action and (c) the fact that no individual gained from said trades.

Click here to read "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Retirement Systems of Alabama.".

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According to Global Pensions (January 10, 2008), Canadian, US and UK public pension fund investors are satisfied private equity investors. Surveying 108 institutions, Private Equity Intelligence Ltd (Preqin) found that "private equity out-performed for these pension plans in 82% of cases." In another survey, Preqin found that "95% of these investors predicted their private equity investments would out perform public market returns from a 2% advantge to over 4% in coming years."

Acknowledging the huge amount of money making its way into private equity, this blog's author wrote about the 4P's on December 31, 2007 - Pensions, Private Equity, Performance and Placement. We urged readers to study the risks, alongside the expected benefits, adding that valuation of private company economic interests can be challenging.

In response, Mr. Doug Miles, CEO of Globalprivatequity.com, Inc. wrote that life has surely changed when it comes to estimating value. We hope you find his commentary interesting. We welcome guest bloggers on any topic related to pension investing and risk management (which importantly includes the topic of valuation). Drop us a line if you want to share your thoughts with our fast-growing audience.

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Early editions of today's business papers describe an imminent sale of roughly 10 percent of technology private equity fund Silver Lake to pension giant, the California Public Employees’ Retirement System ("Calpers"). With a price tag of $275 million, Calpers will have a say in managing Silver Lake and also receive a pro-rata share of their earned investment fees. Private equity investors typically pay 2 percent of assets under management per annum plus 20 percent of gains in excess of an agreed upon benchmark. (See "California Pension Fund Expected to Take Big Stake in Silver Lake, at $275 Million" by Andrew Ross Sorkin, New York Times, January 9, 2007).  

A direct investment stake in Silver Lake creates new challenges, not the least of which is the subsequent negotiating power of Calpers with other private equity funds.

• Will this $260+ billion institutional investor now have greater sway with alternative fund managers, bargaining hard for fewer restrictions on transferability?
• If so, how will that impact the riskiness of its investment portfolio?
• Will Calpers ask Silver Lake to be more institution-friendly with respect to greater disclosure, lower fees, asset selection that reflects suitability, better risk controls and so on (assuming that Silver Lake is not already doing everything it can in these areas)?
• Will Calpers be exposed to fiduciary liability in the event of a Silver Lake buy-out gone bad?
• How will Calpers change its internal risk management policies and procedures as a result of this investment in Silver Lake? This includes the process by which "hard to value" holdings are marked to model or market.
• How will Calpers recognize the Silver Lake investment in terms of strategic asset allocation?

Notwithstanding these unanswered questions, this announcement is fascinating news to some, especially on the heels of a January 7, 2007 Financial Times article that quotes representatives of pension funds such as the Oregon Public Employees Retirement System and the California State Teachers' Retirement System as saying "never mind" to eroded returns. Acting defiantly, these institutional investors are in no mood to make private equity executives whole for higher taxes that may soon be mandated by Washington. (The current tax rate of 15 percent could rise to 35 percent.) (See "Pension funds in threat over private equity fees" by Francesco Guerrera and James Politi.)

Editor's Note: We talked about private equity on December 31,2007. Read "Pensions, Private Equity, Performance and Placement."

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According to a just released study by the Pew Center on the States, state pension plans in aggregate owe nearly $3 trillion in pension benefits, of which about $400 billion is unfunded. Unfortunately, for some state residents, the financial pain is not evenly spread throughout the nation. Consider some of the findings.

• "Only a third of the states have consistently set aside the amount their own actuaries said was necessary to cover the cost of promised benefits over the long term.
• Twenty states had funding levels of less than 80 percent at the end of FY 2006—below what most experts consider healthy.
• Several states have seen particularly troubling drops in their pension funding levels. Some of the biggest drops have occurred in Hawaii, Kentucky, New Jersey, Pennsylvania and Washington."

Hold onto your hats.

The study further reports that post-employment healthcare benefits have a price tag of about $381 billion with only 3 percent of this total liability having been funded to date. "None of the five largest states—California, Texas, New York, Florida and Illinois—had put aside money for non-pension benefits as of FY 2006." and 11 states, including California, New York, New Jersery and Connecticut owe more than $10 billion to plan participants.

Ouch!

As this blog has pointed out repeatedly, there is no free lunch. Putting off the inevitable is going to be painful for employees, retirees and taxpayers.

Now imagine you are a resident of a state with post-employment funding woes. Your taxes go up to pay for someone else to retire at the same time that you are struggling with your own situation. That's exactly what is happening for millions of people, causing great angst for all.

Read "Promises with a Price" in full text. If you missed it, the October 2007 issue of Governing (by the same authors of this new Pew report) addresses anemic pension governance standards at the state level in "The $3 Trillion Challenge." Part of that article includes a sidebar with yours truly on suggested questions to ask as part of a governance check-up for a particular plan. Read the Q&A with Susan Mangiero.

Also check out our earlier blog post entitled "Tea Party Redux: State Pensions in Turmoil." Written a year ago, the message is still the same. Ask your state legislators for their proposed solution to the retirement funding crisis.

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Attorney Francis Pileggi, creator of the Delaware Corporate and Commercial Litigation blog, has an interesting post about a recent pension lawsuit. In Louisiana Municipal Police Employees' Retirement System v. Countrywide Financial Corporation, 2007 WL 2896540 (Del. Ch., Oct. 2, 2007), statistics played a central role in an option backdating case brought by the Louisiana Municipal Police Employees' Retirement System ("LAMPERS"). 

The court, citing the "close call" nature of the statistical evidence, nonetheless concluded in favor of the plaintiff. Pursuant to Section 220 of the Delaware General Corporation Law, LAMPERS will have some access to the financial records of Countrywide.

Click here to read this interesting October 10, 2007 post.

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Talk around the pension water cooler often turns to questions about which system will implode first. In a newly published article about pension governance, Governing correspondents, Katherine Barrett and Richard Greene, suggest that some public plans may soon make the "most wanted" list. Citing LongHorn state blues, Texas Attorney General Greg Abbott is quoted as saying that ”Inadequate governance will cause a pension fund to nose-dive and crash.” Other states are feeling the heat too, especially now that accounting rules have forced additional disclosures of post-employment health care benefit costs.

Conflicts of interest, fraud in some cases, political cronyism and little, if any, board training for persons making multi-million dollar decisions are some of the reasons to think the glass is half-empty.  Uncertainty for retirees is bad enough but don't forget that taxpayers are ultimately on the hook for funding these benefits. (Click here to read our 2006 post entitled "Tea Party Redux: State Pensions in Turmoil.")

This blog's author is quoted in an accompanying featured Q&A. Offering suggestions to improve board performance, I likewise provided thoughts about the rise in pension fiduciary breach litigation and described a few of the many risk management standards for prudent investing.

Click here to read the Q&A interview and here to read the full text article entitled "The $3 Trillion Challenge" (Governing, October 2007 cover story).

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According to the Michael Page International Salary Survey 2007, "demand for risk professionals continues to grow with increasing focus on strong technical skills" at the same time that "packages have been upgraded as clients struggle to retain/attract the best people." According to their research, total compensation for directors in the market risk area ranges from $350,000 to $800,000 while directors in the quantitative areas enjoy $400,000 to $950,000 in salary and bonus.

So how do pension professionals fare? In the Lonestar State, things aren't so bad. According to American-Statesman reporter Robert Elder, the Texas Retirement System board just approved a bonus plan that could mean $9 million in goodies for its investment staff. He adds, "The pension fund faces a shortfall of $12 billion between its assets and payout obligations, and retirees haven't had an increase in benefits in six years. It serves 1.2 million active and retired public school workers." (Click here to read "Bigger bonuses approved for Texas Retirement System investment staff" - September 14, 2007.)

From the outside looking in, it's impossible to know if Texas is on the right track or not. After all, Harvard Management Company lost "dozens of staffers" over compensation. While not a pension fund, the Boston experience is one of many where seemingly high pay packages are insufficient to keep talented risk professionals in place.

Expect plan sponsors to feel the pinch even more. According to its newly released "Strategic Plan FY 2008-2013," the Pension Benefit Guaranty Corporation announced plans to "improve risk monitoring and early warning activities and align resources to assure proper plan terminations." Of course, plan sponsors are likely to want their own team to tackle pension risk for a variety of reasons that go beyond regulatory inspection. This blog author's contention is that the investment management process is incomplete in the absence of a comprehensive risk management policy.

The bottom line is that risk managers don't come cheap. Plan sponsors (regardless of plan design - DB or DC) should factor in the costs of hiring skilled leaders in this area now, before demand skews in favor of the sellers even further.

Click here to read "Pension Risk Management: A New Paradigm" (Risk! - January 2007). Click here to request an email copy of "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange - July/August 2003). You may also want to click here to read our September 4, 2007 post on the topic of investment banking compensation.

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Voices of San Diego reporter Evan McLaughlin writes that the Fourth District Court of Appeal "upheld the district attorney's prosecution of six former pension board members." After several years of wending its way through the court system, allegations that trustees violated California's "conflict-of-interest law" will be heard. Charges emphasize "an agreement in 2002 that boosted the future pension pay of the defendants and thousands of other city employees in exchange for allowing the city to underfund the pension trust that year." Click here to read "DA's Pension Case Moves Forward" (September 7, 2007). Click here to read the ruling.

Regardless of the outcome, and acknowleging a presumption of innocence until proven guilty, a key take-away is that pension fiduciaries are absolutely on the hook. Not to be taken lightly, the job of retirement steward is a serious one. Civil and criminal penalties in the event of proven wrong-doing are possibilities. It's no surprise then that liability underwriters are fielding frequent calls for greater and more comprehensive coverage.

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One of the original thirteen colonies of an infant America, Massachusetts has a special place in history books. In an about face with respect to economic freedom, lawmakers are making it difficult for state pension officials to do their job. According to The Boston Globe, attempts by both the state House and Sentate (and efforts by the governor) would force liquidation of investments in companies that do business with countries such as Sudan, Iran and North Korea. 

Journalist April Simpson quotes Michael Travaglini, as saying that $1.1 billion would be impacted, roughly two percent of total assets. Executive director of the Pension Reserves Investment Management Board, Travaglini adds that "The rule of thumb for investments is you sell the stocks that aren't performing well and run with the funds that are. This type of legislation runs counter to that. There's a very real potential to negatively impact the investment returns of the pension funds." Click here to read "Pension divestment effort gets complicated" (August 31, 2007).

As this blog's author pointed out just a few months ago on CNBC, there are potential fiduciary consequences. While no one in their right mind supports terrorism, fallout is inevitable.

"First, selling stocks because of statehouse mandates could cost taxpayers and plan participants in the form of "unexpected" transaction costs. This would in turn exacerbate funding problems for any states already in the red. Second, trustees would have to decide how to invest the proceeds of disposed equities, possibly earning less than before. Third, there could be a conflict for fiduciaries in terms of duty. Do they follow new rules that require divestiture, even if it forces them to violate state trust laws that demand careful analysis before deciding on an "appropriate" strategic asset allocation? Fourth, plan fiduciaries will likely need to spend considerable time and money in order to identify which companies offend, now and regularly thereafter." Click here to read the rest of "Is There Fiduciary Liability Attached to Divestment?" (June 15, 2007). 

 

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Wall Street Journal reporter Craig Karmin reports that, post credit crunch, some public pension funds are having second thoughts about hedge fund and private equity investments. Cited as a "significant reversal in thinking," the article points out that pension funds have oft-cited alternatives as a way to diversify against shifts in market conditions. (See "Pension Managers Rethink Their Love of Hedge Funds," August 27, 2007.)

In an August 26 article entitled "Just How Contagious is That Hedge Fund," New York Times contributor and financial pundit, Mark Hulbert, debunks the notion that all hedge funds generate market-independent returns. He attributes asset class interconnections and similar strategies made by large hedge funds as culprits. A loss in one sector or fund is likely to appear elsewhere. Investing in "hard to value" positions is another challenge. (This blog's author, an accredited appraiser, is working with the National Association of Certified Valuation Analysts to develop a hedge fund valuation course for October 2007.)

The Pension Governance team has been playing the role of Cassandra for many months. Click here for our January 4, 2007 post about contagion, the notion that what occurs in one market or fund cascades throughout the system. Regarding valuation, we've described the issue ad nauseum. Click on the Hedge Funds and Valuation folders on the left side of this blog's home page for lots of posts about these two topics.

For those who missed our six webinar series entitled Hedge Fund Toolbox^SM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

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According to americanrevolution.org, colonial soldiers (and their widows) received pensions until about 1832 when benefits were stripped. For history buffs, the site's author encourages a reading of the archived details.

"All of the Revolutionary War Pensions have been abstracted and are at most Archives. These are large books and include a number of volumes.  Also, the Federal Archives have the original pensions on microfilm....reading these (as opposed to the abstracts) is quite interesting, because of details of exciting battles, and personal information."

For more information about the history of this important U.S. holiday (no Virginia, it's not just a sale day at the mall), check out the following sites.

History of the Fourth - PBS.org

Fourth of July - Wikipedia.com

Today in History - Library of Congress

Fourth of July - HistoryChannel.com

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According to Wall Street Journal reporter Craig Karmin, some legislators want public pension funds to shun companies that invest in terrorist countries such as Iran. Citing efforts by Missouri State Treasurer, Sarah Steelman, Karmin lays out the pros and cons of forced liquidation. (See "Missouri Treasurer's Demand: 'Terror-Free' Pension Funds," June 14, 2007.)

As part of a June 14 interview with CNBC's Maria Bartiromo, I offer four considerations (as much as I could say in a short on-air appearance). First, selling stocks because of statehouse mandates could cost taxpayers and plan participants in the form of "unexpected" transaction costs. This would in turn exacerbate funding problems for any states already in the red. Second, trustees would have to decide how to invest the proceeds of disposed equities, possibly earning less than before. Third, there could be a conflict for fiduciaries in terms of duty. Do they follow new rules that require divestiture, even if it forces them to violate state trust laws that demand careful analysis before deciding on an "appropriate" strategic asset allocation? Fourth, plan fiduciaries will likely need to spend considerable time and money in order to identify which companies offend, now and regularly thereafter.

No one supports terrorism but this "solution" might invite more problems. There is never a free lunch. Someone, somewhere pays.

Click here to watch the interview.

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A few months ago, California Governor Schwarzenegger created the Public Employee Post-Employment Benefits Commission. Tasked with identifying the nature of their $49 billion unfunded liability for state retirement programs, this group must submit a report to the Governor and state legislators by January 1, 2008 that (a) quantifies unfunded post-employment health care and dental benefits for which the state is obliged to pay (b) assesses and compares possible solutions to address unfunded liabilities and (c) recommends which course of action makes sense. Click here to read the official press release about the Commission. Click here to access the names, titles and affiliations of the original appointees.

A few weeks ago, San Francisco Chronicle reporter Greg Lucas wrote that two of the dozen members, including the head of the commission, have business ties with California pension funds. Not surprisingly, eyebrows raised. In response, "Schwarzenegger administration officials and CalPERS -- the nation's largest institutional investor -- say there is no conflict between the two commission members' private business ties and their role on the commission, but some independent observers say the connection could harm the credibility of the panel's recommendations." Click here to read "Pension reform panelists' ties to firms questioned" (San Francisco Chronicle - March 8, 2007).

Call me crazy but doesn't it make sense to remove any doubt about the ability for commission members to render an impartial analysis? The persons in question may be the most honest of men. I don't know them personally. What I do know is that this type of news is likely to be yet another nail in the coffin of uncomplicated pension reform. I've spoken to countless taxpayers across this great country who are starting to wake up and smell the cappuccino. They are not happy about the prospect of soaring taxes to fund these benefits and even less satisfied with the way change is proceeding.

Kudos to Governor Schwarzenegger for creating the Commission in the first place. However, for a task so important -- huge dollars at stake and millions of plan participants  -- why keep dreaming that no one will mind a few conflicts of interest, perceived or actual? Continue Reading...

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According to its website, the SEC sanctioned the City of San Diego "for committing securities fraud by failing to disclose to the investing public important information about its pension and retiree health care obligations in the sale of its municipal bonds in 2002 and 2003."

The SEC-issued Order "finds that the city failed to disclose that the city's unfunded liability to its pension plan was projected to dramatically increase, growing from $284 million at the beginning of fiscal year 2002 to an estimated $2 billion by 2009, and that the city's liability for retiree health care was another estimated $1.1 billion.

According to the Order, the city also failed to disclose that it had been intentionally under-funding its pension obligations so that it could increase pension benefits but defer the costs, and that it would face severe difficulty funding its future pension and retiree health care obligations unless new revenues were obtained, pension and health care benefits were reduced, or city services were cut. The Order further finds that the city knew or was reckless in not knowing that its disclosures were materially misleading."

The Order makes for fascinating reading. For one thing, an eight percent assumed rate of return on investments was used "without regard to its actual historical rate of return." Some increased benefits were treated as contingent liabilities that were not reflected in certain liability calculations.

Some general observations ensue.

1. Assuming no fraud, a plan's actuarial report should be read in conjunction with any other disclosures about a plan. To the extent that there are differences, responsible fiduciaries must ask hard questions in order to reconcile the "tale of two pensions."

2. This is unlikely to be the last event of its kind. Does this put additional pressure on rating agencies and other watchdog groups to identify potential red flags before the fact, to the extent possible?

3. What is the future of public plan pension and health care benefits? Courtesy of Sean McShea, president of Ryan Labs, a recent Economist article about Other Post-Employment Benefits ("OPEB") augurs poorly for taxpayers in states adversely affected by a new government accounting decree. "Going into effect on December 15, the rule requires municipal government employers to "treat their health-care promises to workers the same way they already handle their pension obligations: by reporting on the total size of their future commitment, instead of just this year's cost." (See "The known unknowns, Economist, November 16, 2006)

4. The size of the liability is important as is the rate of growth in the liability, netted against the expected change in asset performance.

5. Plans in crisis will be tempted to reach for higher expected returns. Identifying and evaluating incremental risk is essential. A bad choice could exacerbate an already grave situation.

With Thanksgiving in the U.S. only a few days away, we'll have to think long and hard about why we are grateful in benefits land.

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According to a recent article in the Press-Enterprise, University of California workers expressed their outrage at being asked to contribute to their pension plans. Likely to impact 18,000 workers, "UC officials maintain that employees must contribute to the pensions to preserve them." A university spokesman, Mr. Brad Hayward, said that this sharing of responsibility is nothing new. "UC employees did contribute to their pensions until the early 1990s." He added that employee contributions wil occur gradually with no expected impact on take-home pay during the first post-reform year.

Critics argue that clerical and other lower-wage workers are already in a financial pickle without adding additional burdens.

This story caught my eye for several reasons, not the least of which is what I believe is the beginning of a heated (perhaps incendiary) debate about the rights of taxpayers versus municipal workers. This would include public universities such as the University of California, self-described as among the best in the world.

(In case you missed it, click here to read about the modern day version of the Boston Tea Party.)

An oft-cited position is that municipal workers agree to accept relatively lower wages in exchange for generous benefits. Accepting this point as reality (and ignoring for a moment that some do not accept that view), does a public employer's proposed rule change suggest a violation of an implicit work arrangement with employees? (The situation is arguably different when a labor-negotiated contract exists.)

What are the rights of the taxpayers who fund these benefits? Do they ever get a chance to approve or veto benefit payments or are they simply expected to pony up when benefits are due?

Moreover, this event illustrates the undeniable trend towards shifting post-retirement financial responsibility to employees and away from employers. Low-wage workers are not the only ones affected. Even middle managers know that the array of post-employment benefits is dwindling. Many companies no longer offer a defined benefit plan or, in some cases, any type of defined contribution plan.

Then there is the issue of fiduciary responsibility with respect to oversight of a growing net unfunded liability. Returning to the article, Hayward is quoted as saying "We need to be in a position where employees who retire actually receive the benefit that has been promised to them."

On the outside looking in, this statement is disturbing. It seems to suggest that there are insufficient funds to make current retirees whole without getting monies from those who still draw a regular paycheck.

This sounds familiar, doesn't it?

Think Social Security and any other "pay as you go" scheme that cannot survive without cash from current payrolls.

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Gregory J. Volpe reports that New Jersey property taxpayers may be on the hook after all for state pension promises, despite efforts to cut costs by rescinding employee benefits.

In his August 24, 2006 article, Volpe writes that "The Office of Legislative Services, a nonpartisan agency comprising state workers, told the Joint Legislative Committee on Public Employee Benefits Reform on Wednesday that any law the Legislature passes to diminish retirement benefits for retired or active workers with more than five years in the system would be unconstitutional."

Despite disagreement about whether pension benefits can be cut to keep property taxes in check and otherwise enhance the state's financial position, legislators offered that health care benefits may be next on the chopping block.

As we'll discuss in future blog posts, if you think the pension issue makes you sick, health care benefits are going to take center stage in both the private and public arena in very short order.

More to come...

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New York Times reporter Mary Walsh and Michael Cooper offer a grim assessment of New York City's pension finances in their August 20, 2006 article entitled "New York Gets Sobering Look at Its Pensions". Their research suggests a funding gap as large as $49 billion or "nearly the size of the city's entire annual budget and the equivalent of the city's publicly disclosed outstanding debt."

A key point of contention is how to properly measure the true economic value of the city's pension obligations. According to the article, New York City employs a unique method that sets the pension shortfall to zero. By doing so, it is never clear whether the plan is in deficit and to what extent. Apparently the method started at a time of bounty, with the aim of preventing a raid by officials.

As this author has repeatedly said, you must be able to properly measure the pension liability. Otherwise, how can one identify what corrective action to take, if any, to set the plan right? (Written for private plans, the same commentary applies in concept to public plans. Good information is everything. Click here to read "Will the Real Pension Deficit Please Stand Up?")

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If her intent was to scare, New York Times journalist Mary Williams Walsh succeeds. Her August 8 front page story entitled "Public Pension Plans Face Billions in Shortages" cites a Barclays Global Investments calculation that "if America's state pension plans were required to use the same methods as corporations, the total value of the benefits they have promised would grow 22 percent, to $2.5 trillion" with only $1.7 trillion having been set aside to meet these obligations."

Importantly, municipal plans are not covered by the Pension Benefit Guaranty Corporation ("PBGC") nor does the Employee Retirement Income Security Act ("ERISA") apply. If a state, county or city government comes up short, taxpayers are on the hook.

At a time when many taxpayers are struggling to save for their own retirement, how happy will they be to get someone else's tab? We cautioned that taxpayer blues may soon be upon us. (Click here to read "Tea Party Redux: State Pensions in Turmoil", posted on July 27, 2006.)

Mary Walsh is right when she decries the absence of oversight and "comparable systems of checks and balances." This author finds it particularly appalling that Congressional lawmakers spent hours wrangling over the Pension Protection Act without word one about government plans.

What will it take for taxpayers to really "get it" and vote for fiscal prudence?

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A recent legislative attempt in California has apparently caused quite a stir. Assembly Bill (AB) 2122 sought to preclude companies from paying dividends to shareholders before satisfying pension obligations and to "make directors and officers of a corporation jointly and severally liable for improper distributions" under certain circumstances.

Refer to the July 13, 2006 post entitled "Dividends, Pensions and California Chaos".

Blogger Jerry Kalish provides a novel suggestion.

The proposed bill - and the politics behind it - conveniently ignores the massive unfunded pension liabilities in California, e.g, the California State Teachers' Retirement System faces a $24 billion unfunded pension liability.

But we got them beat in my home state of Illinois which at $35 billion has the largest unfunded pension obligation in the country. The Fitch Rating service released a "negative outlook" for Illinois finances - one of only three negative outlooks issued by the rating service in its review of the states. The other two? Louisiana dealing with the aftermath of Hurricanes Katrina and Rita and Michigan dealing with massive problems in the automobile industry.

Um! Should there should be a law that no more salary increases occur for state legislators until pension liabilities are met?

So where does this attempt stand now?

According to the website that tracks California legislation, the bill failed passage on June 22, 2006 with "reconsideration granted".

While laudable to encourage prudent pension funding, there are a host of problems associated with this type of reform.

Is Milton Friedman right when he said that "the government solution to a problem is usually as bad as the problem" and that "there's no such thing as a free lunch?" Notwithstanding the law of unintended consequences, empirically validated time and time again, there are a variety of better, and arguably more efficient and cost-effective ways to solve the pension "crisis" than putting state legislators in charge of a company's capital structure.

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The Star Ledger reports that New Jersey state officials "adopted a plan to shift billions of dollars in state pension money to private investment managers and set a course to reduce the funds' heavy reliance on the stock market." Journalist Dunstan McNichol describes a $16 billion reallocation from stock "in favor of larger holdings in toll roads, hedge funds and international stocks."

A harbinger of things to come?

Many experts agree that pending regulations and increased focus on pension obligations will move asset allocation to center stage, resulting in a variety of questions that demand good answers. (Asset allocation is oft-cited as the most important determinant of performance.)

1. How will an increased emphasis on alternative investments change the expected return-risk tradeoff of the pension portfolio (particularly as relates to estimating pairwise correlations of returns that vary over time)?

2. What are the liquidity implications of investing in public works projects, hedge funds, international stocks, commodities, private equities and so on?

3. How should pension plan decision-makers proceed in selecting alternative investment consultants (especially with respect to their ability to thoroughly analyze the impact of performance fees on net returns)?

4. How do alternative fund managers value their holdings, if at all?

5. How will overseers evaluate performance in the event of diminished transparency of returns and risk drivers that influence returns?

6. Will fiduciary liability change for funds that invest outside the traditional mix of equities and debt?

7. Do fiduciaries need additional training to feel comfortable asking the right questions about alternatives (and interpreting the answers with confidence)?

8. How should the Investment Policy Statement change to accommodate the use of alternatives?

Get ready pension fiduciaries! There is a lot of work to be done in moving the money around.

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According to CFO.com, the State of California may soon prohibit a company from paying out dividends or buying back shares until all required defined benefit plan payments have been made. AB 2122, introduced by Democrat Johan Klehs, could impact corporate leaders individually as well since it "would make directors and officers of a corporation jointly and severally liable for improper distributions", even if they had no knowledge of the impropriety.

Needless to say that if this bill becomes law, other states would likely follow, creating a cascade of new challenges for chief financial officers everywhere.

Think about it.

Capital structure, securities issuance and debt rating assignments would necessarily change as a function of a company's mix of employee benefits. Modeling a defined benefit plan liability (and related liquidity obligations) would take center stage. Shareholders seeking current dividend income may get an unpleasant surprise if dividend payouts become more volatile, even if a company enjoys steady growth in economic earnings.

Then there is the philosophical issue about the role of government with respect to corporate management. Does the state have the right to micromanage this way? Would shareholders shy away from investing in companies with defined benefit plans, knowing that the state has the right to prevent dividend distributions? Would companies rush to shed defined benefit plans, possibly exacerbating an already pronounced trend towards defined contribution plans? Would companies lobby more aggressively for exemptions from the dividend rule? Would that worsen campaign finance problems? Would D&O insurance costs skyrocket as a result of increased liability exposure for board members? Would federal lawmakers seek to follow suit?

The little bill that could ...

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