Pensions and Bankruptcy Claimants

The tug of war continues between pension plan participants and outside creditors. As a result, doing business with troubled municipalities may end up costing creditors time, money and headaches. Just a few days ago, Judge Christopher Klein with the United States Bankruptcy Court for the Eastern District of California ruled against Franklin Templeton Investments. By doing so, this asset manager will not be able to recoup the $32 million it sought from the City of Stockton as the municipality seeks to exit bankruptcy. Instead, as Reuters journalist Robin Respaut writes in "Holdout creditor in Stockton bankruptcy denied higher claim" (December 10, 2014) the city's plan would give Franklin "just over $4 million of the $36 million it said it is owed." This follows an October thumbs-up from the Court to reduce the payout to bond investors in order to maintain retirement and health care benefits and thereby (hopefully) prevent an exodus of badly needed city workers. 

A topic not actively discussed but critically important to ignore is that once-burnt lenders are unlikely to come knocking again. If they do, they will charge a higher cost of capital and demand tighter collateral safeguards to reflect the bigger risk associated with exposure to struggling borrowers. After all, lenders are accountable to their customers. As Bond Buyer's Keeley Webster describes, investors in Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund will suffer as the result of a low recovery rate in the neighborhood of twelve percent for loans made to Stockton. 

As Attorney B. Summer Chandler discusses in "Is It 'Fair' to Discriminate in Favor of Pensioners in a chapter 9 Plan?" (American Bankruptcy Institute Journal, December 2014) putting pensioners ahead of other unsecured creditors may not seem right to some but could be supported by "limited case law assessing chapter 9 plans..." taking into account "the unique nature of a municipality, its relationship to its citizens (including pensioners and current employees) and the purposes of chapter 9..."

To reiterate, customer risk is real for organizations such as Franklin Templeton. Unless its higher costs can be passed along to customers, expect some lenders and suppliers to say "never mind" and look elsewhere for business. This would logically reduce the supply of capital and services and could mean higher costs for all municipalities, not just those seeking bankruptcy protection. As my co-authors and I discuss in "Muni Bonds, Pension Liabilities and Investment Due Diligence" by Dr. Susan Mangiero, Dr. Israel Shaked and Mr. Brad Orelowitz (American Bankruptcy Institute Journal, July 2014), the evolution of decision-making can reduce uncertainty. We add that "...legal, economic and political skirmishes associated with municipal bond distress now being played out are helping to set the stage for future clarity." We assert that future bond buyers may still lend to a municipality if they "are comfortable in their belief that large unfunded post-employment obligations can be compromised as part of a distressed-debt workout..." and that "fresh capital can be a lifeline for a municipality that has fallen on hard times, even if it comes with a higher service cost.'

The best outcome is that pension-plagued municipalities seeking to exit from bankruptcy get their financial house in order as quickly as possible. While retirement plan participants have received a reprieve in some situations such as what happened with Stockton, the overall funding crisis is likely to reverberate in ways that could lead to future skirmishes. Witness what is happening right now, courtesy of the U.S. Congress. According to "Pension Bill Seen as Model for Further Cuts" (December 14, 2014), Wall Street Journal reporter John D. McKinnon portends future diminutions in employee benefit payouts if such action is deemed to prevent the "failure of just a few" plans being able to destroy "the federal pension safety net" (i.e. the Pension Benefit Guaranty Corporation). While the focus of lawmakers right now is on corporate union plans, it is not much of a stretch to imagine certain reductions being allowed throughout the United States and in other countries, postured as protection for the "greater good."

Taxpayer Bailout of Underfunded Pension Plans

Over dinner last night with friends, my husband told a joke about Kim Kardashian and Paris Hilton (or whomever you want to designate as fact-challenged individuals). The hotel heiress asks "Which is closer to us - Florida or the moon?" The reality star replies - "Hello, can you see Florida from here?" Unfortunately, this type of silliness has reared its head often over the years with regard to the topic of promising too much and funding too little. The math just does not work. To the logical observer, this flight of fantasy was always destined to self-destruct. It was more a question as to how long the downward spiral would take for impacted U.S. and non-U.S. government plans.

On July 27, 2006, I wrote "Tea Party Redux: State Pensions in Turmoil." It was blatantly clear that trouble was heading our way. Since then, headlines about retirement plan gaps continue to dominate the news.

In what could be a bellwether situation, the State of Illinois wants to address a shortfall that is referred to as "the biggest in the U.S" and is fighting the court system to be empowered to do so. See "Illinois Fights Court Block of $111 Billion Deficit Fix" by Andrew Harris (Bloomberg, November 27, 2014). In "Why Illinois pension reform may be constitutional" (Crain's Chicago Business, December 6, 2014), Joe Cahill explains that "important state interests" may justify the limiting of pension contracts that are deemed constitutional and therefore inviolable. He references Felt v. Board of Trustees. Those who disagree that reform is legally possible suggest that taxpayer hikes and/or reduced overall municipal spending are inevitable.

Now it appears that U.S. lawmakers may have their sights set on private pension plans too. In "Congress could soon allow pension plans to cut benefits for current retirees" (December 4, 2014), Washington Post journalist Michael A. Fletcher describes a move that, if enacted, would see lower payouts for plan participants of multi-employer plans in distress. The alternative is to have the Pension Benefit Guaranty Corporation ("PBGC") take over any failed plans. As stated in "Solutions not Bailouts" (February 2013), Randy G. Defrehn and Joshua Shapiro write that benefits would be lowered anyhow in the event of a PBGC assumption of plans deemed as insolvent. In "The lame-duck Congress plots to undermine retiree pensions," Los Angeles Times reporter Michael Hiltzik urges readers to stay tuned as the December 11, 2014 vote on an omnibus spending bill may contain language that, if passed into law, would snip dollars from union retirement arrangements. He quotes advocates of defined benefit plans as pushing for careful deliberation instead of rushing ahead.

Expect lots of changes in 2015 and thereafter. The pension crisis (at least for some sponsors and their employees) is not going away anytime soon. In the meantime, smart cookies are invited to the negotiations table. The worst thing that could happen is to ignore reality. Leave that to Kim and Paris. 

Public Plans For Private Sector Employees - Say Whaaat?

The news about public retirement plans for private workers may not be as snappy as a dog with red sunglasses taking a selfie but it sure caught my attention.

On June 17, 2014, Pensions & Investments reported that efforts are underway to "provide retirement security for all New Yorkers - not just participants in the $150 billion New York City Retirement Systems." In "NYC comptroller to launch advisory panel for retirement security," writer Robert Steyer tells readers that Chief Investment Officer Scott Evans will lead the group, with members yet to be appointed. The Nutmeg State is on the same glide path with its creation of the Connecticut Retirement Security Board. Michelle Chen of The Nation applauds this initiative while Bill Cummings of the Connecticut Post decries the costs that small business owners will bear if a mandatory offering occurs.

In "State-based retirement plans for the private sector" (August 6, 2014), the Pension Rights Center lays out legislative happenings elsewhere as part of a "movement afoot to use the efficiencies of public retirement systems to administer new types of pension plans for private-sector workers." The list includes Arizona, California, Colorado, Illinois, Indiana, Maine, Maryland, Massachusetts, Minnesota, Nebraska, Ohio, Oregon, Vermont, Washington, West Virginia and Wisconsin.

Certainly there is merit for any effort that helps to promote savings and financial independence. That said, there is a plethora of critical questions to be answered before any products are developed, let alone forced on taxpayers and employers. For one thing, who will serve as a fiduciary for each plan and what regulatory regime will prevail? ERISA does not extend to government plans. Will state trust law apply? Second, some of the aforementioned states are struggling with underfunded plans for municipal workers. If said deficits are revealed as the result of questionable investment and benefit mix decisions and/or limited oversight, does it make sense to put these same persons in charge of a new plan? Third, to the extent that state funding is used to install these new plans, how will fiscal policy change as a result? Fourth, are there true efficiencies to exploit and in what areas - investment, operational, technology, etc?

Maybe state delivery of private retirement benefits makes sense but I hope that a lot of important issues get vetted before too much big spending takes place.

A Pension Rock and a Hard Place

Not surprisingly, the conversations about pension reform are getting louder and taking place more often. Calls for further transparency, political posturing and headlines regarding the link between municipal debt service and questions about the contractual nature of pension IOUs are three of the many factors that are being hotly debated, with no end in sight. Interested parties are invited to read "Muni Bonds, Pension Liabilities and Investment Due Diligence" by Dr. Susan Mangiero, Dr. Israel Shaked and Mr. Brad Orelowitz, CPA. Published by the American Bankruptcy Institute, the authors bring attention to the fact that courts are making decisions about critical issues such as whether creditors, in distress, can move ahead of public pension plan participants. Click here to read more about the article and the connection between retirement plan promises and municipal bond credit risk.

Others are approaching the topic of public and corporate pension plan obligations from the perspective of younger workers being asked to subsidize seniors. In "Why We Need to Change the Conversation about Pension Reform" (Financial Analysts Journal, 2014), Keith Ambachtsheer writes that "Pension plan sustainability requires intergenerational fairness." He adds that suggestions such as lengthening the time over which an unfunded liability can be amortized or assuming more investment risk "effectively pass the problem on to the next generation once again."

Legislators are slowing starting to act, in large part because they cannot afford not to do so. According to Wall Street Journal reporter Josh Dawsey, New Jersey Governor Chris Christie has spent his summer with constituents, holding town hall meetings to explain his decisions about pension plan funding. See "Christie Plays Pension Issue Beyond N.J." (August 9-10, 2014). On August 1, 2014, he signed Executive Order 161 to facilitate the creation of a special group that is tasked with making recommendations to his office about tackling "these ever growing entitlement costs."

New Jersey is not alone. Prairie State politicos are attempting to forge reform. In "4 reasons you should care about pension reform in Illinois" (July 25, 2014, Chicago Sun Times reporter Sydney Lawson explains that the $175.7 billion owed to participants and bond investors will cost every taxpayer about $43,000 if paid today. According to its website, the Better Government Association estimates that replenishing numerous police and fire retirement plans in Cook County will "require tax hikes, service cuts or both."

The Big Apple retirement crisis  is no less massive. New York Times journalists David W. Chen and Mary Williams Walsh write that "the city's pension hole just keeps getting bigger, forcing progressively more significant cutbacks in municipal programs and services every year." A smaller asset base and decision-making that occurs across five separately managed funds are described as trouble spots for Mayer Bill de Blasio. Noteworthy is the mention of an investigation by Benjamin M. Lawsky, head of the Department of Financial Services, that seeks to understand how service providers were selected to work with New York City pension plans and the level of compensation they receive. See "New York City Pension System Is Strained by Costs and Politics" (August 3, 2014).

Curious about the extent of this New York City and New York State focused investigation, I asked one of my researchers to file a Freedom of Information Act request in order to obtain details. We are awaiting the receipt of meaningful results. So far, we are being told that information is not available to send. What is known so far, based on an October 8, 2013 letter from Superintendent Lawsky to Comptroller of the State of New York, Thomas P. DiNapoli, is that questions will or are being asked about retirement plan enterprise risk management and "[c]ontrols to prevent conflicts of interest, as well as the use of consultants, advisory councils and other similar structures."

Pandering for votes by promising lots of goodies may not be a successful recipe for reforming pensions that need help. Moreover, judges are in the driver's seat once a dispute about contractual status is litigated. In a recent opinion, a federal court of appeals ruling about lowering cost of living adjustments overturned an earlier decision that such an action was unconstitutional. See "Baltimore wins round in battle over police, firefighters pension reform" (The Daily Record, August 6, 2014). Click to download the August 6, 2014 opinion in Cherry v. Mayor and City Council of Baltimore, No. 13-1007, 4th U.S. Circuit Court of Appeals.

Like Homer's Odysseus who was caught between Scylla and Charybdis, policy-makers, union leaders and heads of tax groups are navigating some very rough waters indeed. We have not seen the end of these heated debates about what to do with underfunded municipal pension plans. Trying to align interests of seemingly disparate groups is only the beginning.

New GAO Study Addresses Performance Audit Reports

Courtesy of the U.S. Government Accountability Office, a new study looks at performance audits for different types of pension plans. The report is entitled "Oversight of the National Railroad Retirement Investment Trust" (May 2014) and responds to requests from members of the U.S. Congress for information about this $25 billion retirement plan. Based on countless interviews with regulators, private fiduciary experts (and yes, I did answer some questions about benchmarking) and pension fund executives, the authors put forth the idea that performance audits could be mandated to occur more often. Interestingly, GAO researchers point out that "the frequency with which the Trust has commissioned performance audits is comparable to or exceeds most state efforts," adding that "...nine state plans are audited at least once every 2 or 3 years" with interviewees from 19 states pointing out that retirement plans "were subject to audits at longer set intervals that varied from state to state or were not reviewed according to any established time frame."

Pension fund accounting and performance benchmarking is certainly getting its share of attention. U.S. Securities and Exchange Commissioner Daniel Gallagher recently decried what he believes is an under-reporting of "trillions of dollars in liabilities. In his May 29, 2014 speech before attendees of the Municipal Securities Rulemaking Board's 1st Annual Municipal Securities Regulator Summit, Commissioner Gallagher talks about pension and OPEB liabilities as a serious threat and warned that "...it is imperative that bondholders know with precision the size of the potential pension liabilities of the entities in which they are investing. And yet, they do not." He adds that the "threat has been hidden from investors." As Lisa Lambert and Lisa Shumaker describe, government officials say that these sharp remarks sting and will scare people into thinking that a systemic problem exists. Read "Pension groups strike back at SEC commissioner's criticism" (Reuters, June 16, 2014). In its Q1-2014 update, the National Association of State Retirement Administrators ("NASRA") show that public pension fund assets have grown to $3.66 trillion, up slightly from the year-end 2013 level of $3.65 trillion.

On the rule-making front, the Governmental Accounting Standards Board ("GASB") just published an update to its pension accounting standards and posted a pair of brand new proposals to "improve financial reporting by state and local governments of other post-employment benefits, such as retiree health insurance." See "GASB Publishes Proposed Accounting Standards for Government Post-Employment Benefits" by the editor of AccountingToday.com, Michael Cohn. You can download the three documents by visiting the GASB website. Click to access GASB's microsite about Other Postemployment Benefits ("OPEB").

The good news, as I have said all along, is that initiatives for heightened transparency are underway. For more difficult situations, don't be surprised if litigation about disclosures continues to occur. In case you missed the February 24, 2014 Practising Law Institute ("PLI") CLE webinar, you can purchase the slides and audio recording of "Muni Bonds, Pensions and Financial Disclosures: Compliance, Litigation and Regulatory Trends." I co-presented with Orrick, Herrington & Sutcliffe LLP partner, Elaine Greenberg. My focus was on risk management, valuation, performance and investment decision-making.

Pay to Play and Pension Funds

Having just co-authored an article about the Foreign Corrupt Practices Act ("FCPA") and its application to pension plans, the topic of economic inducements and fiduciary duties is fresh on my mind. As part of my research, I investigated what "pay to play" rules currently exist and what initiatives are underway to avoid inappropriate monies being paid by vendors to persons who control or have influence over the public purse. Certainly the topic is attracting attention. On October 8, 2013, the Superintendent of the New York State Department of Financial Services ("DFS"), Benjamin M. Lawsky, wrote to the Honorable Thomas P. DiNapoli, Comptroller of the State of New York, about the auditing of government pension plans and their service providers. "Controls to prevent conflicts of interest, as well as the use of consultants, advisory councils, and other similar structures" was listed as one of several areas of emphasis.

Jump ahead to this week's headlines and, not surprisingly, "pay to play" appears once again. With his June 9, 2014 press release, New York City Comptroller, Mr. Scott Stringer, announced the approval by all five New York City pension plans (with roughly $150 billion in assets) to ban the use of placement agents. This extends the prohibition of placement agents for all asset classes and not just the restriction imposed earlier for private equity investments. Click to read "New York City Pension Funds Enact Placement Agent Ban" for a list of the current trustees for the New York City Employees' Retirement System, Teachers' Retirement System, New York City Police Pension Fund, New York City Fire Department Pension Fund and the Board of Education Retirement System.

The "thumbs up" from New York City pension plan trustees follows Comptroller Stringer's six point plan that he announced on January 30, 2014. Besides putting the kibosh on the use of placement agents, his office intends to "...dramatically reform policies and procedures governing [Bureau of Asset Management] by appointing senior risk and compliance officers to strengthen, monitor and continually improved operations..." Investment disclosures about personal trading of in-house fiduciaries is part of the game plan for New York City pension plans.

On a separate note, disclosure mandates about personal trading for members of the U.S. Congress and their aides and federal employees making more than $119,554 appears to have taken a step backwards with respect to government sunshine. According to "Insider Trading in DC Just Got Easier" by John Carney (CNBC.com, April 16, 2013), a modification of the Stop Trading on Congressional Knowledge ("STOCK") Act was passed by lawmakers on April 12, 2012 and then signed into law on April 15, 2013. As a result, any disclosures about personal trades that are part of the public record "aren't readily available...and have to be requested from individual agencies using the names of the individuals about whom information is sought." When asked about the change in disclosure requirements for all but the President, the Vice President, Members of and candidates for Congress and certain appointed officers, White House Press Secretary Jay Carney referred to recommendations made by the National Association of Public Administration ("NAPA") as the basis for "indefinite suspension" due to "substantial national security, personal security, and law enforcement issues on this matter." You can decide for yourself. Click to download "The STOCK Act: An Independent Review of the Impact of Providing Personally Identifiable Financial Information Online - A Report by a Panel of the National Academy of Public Administration Submitted to the Congress and the President of the United States" (March 2013).

2nd Annual Tri-State Institutional Investors Forum

I have the pleasure of moderating a timely and topical panel on June 11 for US Markets Center for Institutional Investor Education. Entitled "Fiduciary Responsibility for Management & Trustees," this session will focus on the importance of the Board in creating good governance practices. Topics to be discussed include the role of audits as a way to monitor activities, creating proper standards that allow for stakeholder transparency and lines of authority and reporting. The role of staff, the investment consultant and investment manager will likewise be covered. Panel participants are shown below:

Moderator:

  • Dr. Susan Mangiero, Managing Director, Fiduciary Leadership

Panelists:

  • Charles Tschampion, Director of Special Projects, CFA Institute
  • Edward M. Cupoli, Board Member, New York State Deferred Compensation Plan
  • Patricia Demaras, Senior Counsel, Xerox Corporation.

Click to download the entire program for the 2nd Annual Tri-State Institutional Investors Forum. Click to register. I hope to see you there!

Detroit Swaps, Counterparty Risk and Valuation

When I worked on several swaps and over-the-counter options trading desks, there was always a lot to do in order in order to properly set up a program with an end-user. Sometimes this involved in-person training of a board or asset-liability management committee or otherwise authorized persons who had made an organizational decision to employ derivatives. Credit limits had to be vetted, decisions about collateral had to be made and master agreements were negotiated and signed. Throughout the process, everyone was mindful that big money was at stake and that getting the preliminaries finished on time, with diligence and care, was both crucial and important. The key was (and still is) to plan ahead for a worst case scenario wherein a contractual counterparty cannot or will not perform. Should that occur, the remaining party would likely seek to unwind or offset a given position rather than allow a bad situation to linger. A valuation of the over-the-counter derivative instrument in question, such as an interest rate swap, would be determined and mutually agreed upon. Contractual terms such as the rate of swap exchange, time remaining and the quality and quantity of collateral posted by either or both counterparties would typically be used to determine the amount of money owed by the non-performing entity. An agreement as to when "non-performance" commenced would be yet another factor. In a dispute situation such as a lawsuit, damages might be part of the calculation.

Sounds straightforward, right? Well, things are seldom simple, especially when one counterparty is in financial distress. When a counterparty owes money but cannot pay on a given date or has insufficient monies to settle a swap as part of a buyout, the remaining counterparty has to look to the underlying collateral, consider litigation and/or negotiate for some type of remuneration. Legal decisions can complicate things. Consider the situation with Detroit.

On January 16, 2014, Judge Steven W. Rhodes, U.S. Bankruptcy Court for the Eastern District of Michigan, opined that a $165 million payment to UBS and Bank of America to end certain interest rate swaps was too much money to outlay right now. Refer to "Detroit bankruptcy judge rejects $165M swaps deal with banks" (Crain's Detroit Business, January 16, 2014).

By way of background, these over-the-counter derivative contracts were related to the issuance of pension obligation bonds. The objective at that time was to protect the Detroit issuer (and taxpayers by extension) from higher funding costs if interest rates climbed. By having a swaps overlay, the bank counterparties were to pay Detroit if rates increased above a specified level. Conversely, lower rates would obligate Detroit to make periodic swap payments to the banks involved.

Reporters Nathan Borney and Alisa Priddle describe a 2009 effort to collateralize the swaps with casino-related revenue in "Detroit bankruptcy judge denies proposal to pay off disastrous debt deal" (Detroit Free Press, January 16, 2014). They add that this move was aimed at avoiding "an immediate payment of $300 million to $400 million on the swaps, potentially violating the Gaming Act" since interest rates had not risen. According to "Detroit continues talks with banks after canceling swaps truce" (Bloomberg, February 7, 2014), the swaps have a monthly price tag of about $4 million, "have cost taxpayers more than $200 million since 2009" and are being questioned by the city with respect to their "legitimacy."

Numerous questions come to mind and will no doubt be raised as the banks and city officials continue to talk or the attorneys take over, should litigation ensue. The list includes, but is not limited to, the following:

  • Who had the authority to commit Detroit to the swaps trades? Click to view an interesting visual put together by the Detroit Free Press and entitled "Were The $1.44-Billion Pension Deal And The Pledge Of Casino Tax Revenue Legal?" (September 14, 2013).
  • Were any of the recommending swaps agents subject to a conflict of interest, as has been suggested by The Detroit News?
  • What was the due diligence carried out by city officials before the swaps were put in place?
  • How were the collateral-related terms decided and by whom?
  • How were swap interest rate triggers determined?
  • Was there an independent party in place to regularly review the quality and quantity of posted collateral?
  • What role did the internal and external auditors play with respect to oversight of the reporting of the swaps and related bond financing?
  • Was there an appreciation that rising rates would mean a payment by the swap banks to the city and that this inflow could have been used to offset the higher cost of variable rate debt?
  • Who undertook the analysis of the effectiveness of the swaps as a hedge against rising rates and was the hedge deemed likely to be protective?

There are lessons to be learned aplenty about swaps, contractual protection, collateral valuation, oversight, authority and much more. No doubt there will be much more to say in future posts.

Probing Pension Advisers For Possible Conflicts of Interest

 

In "New York Is Investigating Advisers to Pension Funds" (New York Times, November 5, 2013), Mary Williams Walsh writes that "state financial regulators have subpoenaed about 20 companies that help New York's pension trustees decide how to invest the billions of dollars under their control to determine whether any outside advice is clouded by undisclosed financial incentives or other conflicts of interest." 

Conflicts of interest are not new nor are they are likely to disappear overnight. In 2010, the U.S. Securities and Exchange Commission ("SEC") adopted measures to discourage bad acts. Three elements were cited in "SEC Adopts New Measures to Curtail Pay to Play Practices by Investment Advisers" (June 30, 2010) to include the following items:

  • Prohibition of "an investment adviser from providing advisory services for compensation — either directly or through a pooled investment vehicle — for two years, if the adviser or certain of its executives or employees make a political contribution to an elected official who is in a position to influence the selection of the adviser";
  • Prohibition of "an advisory firm and certain executives and employees from soliciting or coordinating campaign contributions from others — a practice referred to as "bundling" — for an elected official who is in a position to influence the selection of the adviser"; and
  • Prohibition of "an adviser from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser, unless that third party is an SEC-registered investment adviser or broker-dealer subject to similar pay to play restrictions."

In the case of the New York State Common Retirement Fund, with nearly $161 billion in assets in Q1-2013, the single person trustee and New York State Comptroller, Thomas P. DiNapoli, describes numerous attempts to enhance transparency and avoid conflicts. From the official website, one can download files that include:

  • New York State Common Retirement Fund Placement Agent Disclosure Policies and Procedures of the Office of the State Comptroller," last updated on September 11, 2013;
  • "Transactions Compliance Review: New York Common Retirement Fund," dated February 22, 2010; and
  • An amended list, published on May 6, 2009 and disclosing "placement agents used during the administration of Alan Hevesi. The list was amended June 18, 2009 to reflect new information provided by the State Attorney General’s office."

While the published files are a good start, it would be nice to have even more information, especially with respect to the detailed due diligence process that was or is being employed by various advisers for recommended asset managers. My understanding is that the New York Financial Services Superintendent, Benjamin M. Lawsky, has requested pitch books as well as information about compensation levels, the nature of existing relationships between investment advisers and consultants and asset managers and how performance numbers are to be reported, including a description about the assessment of investments that do not trade in a public market. This makes sense given the growth in allocations to hard-to-value positions.

Letting the sunshine in is a good thing for plan participants and taxpayers alike. It would be hard these days for anyone to legitimately criticize attempts to avoid costly conflicts of interest, especially if misaligned objectives lead to grossly imprudent investment decisions.

In recognition of the importance of good pension governance, the National Association of State Retirement Administrators ("NASRA") adopted a resolution to expressly address ethics and disclosure requirements. Excerpting from Resolution 2011-02, it is stated that "Public fund fiduciaries should carefully review the trust and conflict of interest laws applicable to the system to ensure that the fiduciaries’ relationships with other parties are not incompatible with the duties to the system, and service providers to the system should divulge pertinent business activities, relationships and alliances including, among other things i) all services the firm, its principals, or any affiliates provide that generate revenue, ii) if the firm is owned in whole or in part by other firms or organizations, or if the firm owns other firms or organizations, that sell services to public pension systems, and iii) if the firm, its principals, or any affiliate has any strategic alliances with firms that sell services to public pension systems."

As headlines about underfunding and bankrupt cities continue and fiscal policy becomes even more entwined with the investment activity of $3 trillion in public pension coffers, I predict that state and federal investigations will likely go up in number, magnitude and frequency.

Labor Force Shrinks - Hurts Economy

Labor Day always marks an assessment of where things stand with the state of employment (or unemployment as the case may be). This year is no different except that the news continues to get worse with respect to how many people are contributing to the country's bottom line.

According to MarketWatch contributor Irwin Kellner, the unemployment rate is a poor substitute for knowing whether people are ready, able and willing to work. In "Labor pains - don't count on jobless rate" (September 3, 2013), the point is made that the participation rate is at an all-time low. Excluding military personnel, retired persons and people in jail, fewer adults than ever before in the history of the United States are pursuing work. One reason may be that schools are not preparing young people to assume jobs that require a certain level of skills. Another reason is that being on the dole is a superior economic proposition for some individuals. Yet another factor is that long-term unemployed persons are too discouraged to keep going.

Indeed, I wonder if there is a productivity tipping point, beyond which a person says "never mind" to gainful employment. Certainly people with whom I have spoken talk about the need to work many more years beyond a traditional retirement age. However, they are quick to add that they enjoy what they do and sympathize with those persons who have jobs they loathe or are hard to do after a certain age. Some people simply believe that going fishing on other people's dime, as a ward of the state, is a rational response to current incentives.

The numbers are gigantic and that should put fear in the hearts of those who are pulling the economic wagon. According to labor expert Heidi Shierholz, "More than half of all missing workers - 53.7 percent - are 'prime age' workers, age 25-54. Refer to "The missing workers: how many are there and who are they?" (Economic Policy Institute website, April 30, 2013). The Bureau of Labor Statistics, part of the U.S. Department of Labor, estimated in July 2013 that there are 11.5 million unemployed persons, of which 4.2 million individuals fall into the long-term unemployed bucket since they have been out of work for 27 weeks or longer. Click to review statistics that comprise "The Employment Situation - July 2013."

The combination of no job and an anemic retirement plan, if one exists at all, are harbingers of doom for taxpayers and for plan sponsors that are under increasing pressure to help their employees. Mark Gongloff, the author of "401(k) Plans Are Making Wealth Inequality Even Worse: Study" (Huffington Post, September 3, 2013) describes a recent study that has the wealthiest Americans with "100 times the retirement savings of the poorest Americans, who have, basically no savings."

My predictions are these. Even if you are a rugged individualist who keeps a tidy financial house, you will be paying for the economic misfortunes of others. Taxes are destined to rise, benefits may fall and you will likely have to work for a long time to pay for this country's dependents. Retirement plan trustees, whether corporate or municipal, will be under increased pressure to make sure that dollars are available to pay participants, regardless of plan design. In lockstep with expected changes in fiduciary conduct, ERISA and public investment stewards could face more enforcement, scrutiny and litigation that asks what they are doing and how.

Economic Indicators to Include Focus on Pensions

In what most people would call a significant announcement, the U.S. Bureau of Economic Analysis ("BEA") will begin measuring economic growth this summer by taking pension finance into account. According to its March 2013 announcement, BEA will record defined benefit plan transactions on an accrual accounting basis. This entity, part of the U.S. Department of Commerce, will now include a pension plan subsector in the national income and product accounts ("NIPAs"). As much as possible, the BEA will "provide estimates of the current receipts, current expenditures, and cash flow for the subsector." The intended changes contrast with the current method of including information about disbursements and earnings of pension plans as participants' personal items and using a cash basis for reporting.

The goal of enhancing transparency about employer-provided defined benefit retirement plans is laudable. However, in reading the fine print, one wonders if the opposite will occur and users of post-implementation data will be more confused. For one thing, the BEA states that it will adopt an accumulated benefit obligation ("ABO") for "both privately sponsored and state and local government sponsored plans" and use a projected benefit obligation ("PBO") for federal government plans. This means that you will never be able to compare all defined benefit plans with a single set of rules. Second, the BEA describes a discount rate assumption that "will be based on the AAA corporate bond rate published by the Federal Reserve Board." Since debt issued by the U.S. is no longer rated AAA and recent regulations allow for temporary funding relief for corporate pension plans, how will BEA numbers compare and contrast with financial accounting numbers over time? Third, since certain data is not available prior to 2000, the BEA will extrapolate to generate "normal costs" for past years. Will their method of extrapolation allow for an accurate "apples to apples" assessment of historical pension earnings and costs? In the plus column, applying the same discount rate for private pension plans versus state and local offerings will help to better assess the economic viability for each sector.

Should the Public Employee Pension Transparency Act move forward, disclosures will be based on the BEA approach. Understanding what BEA numbers do or do not show will therefore be a critical exercise for policy-makers, investors and participants.

For a detailed discussion of these intended changes on the part of the BEA, read "Preview of the 2013 Comprehensive Revision of the National Income and Product Accounts: Changes in Definitions and Presentations," BEA, March 2013. Click to read about advantages of passing the Public Employee Pension Transparency Act. Click here to read criticisms of this proposed rule. On April 23, 2013, the U.S. Senate received a version of the Public Employee Pension Transparency Act in the form of S. 779. This proffered legislation cites a staggering $5.170 trillion in pension liabilities of the 50 states combined. It is no wonder that numerous individuals want a true tally of what is owed.

Public Pension Plans and Private Equity

 Reporter Michael Corkery paints a grim picture of what lies ahead for government workers. In “Pension Crisis Looms Despite Cuts by Nearly Every State” (Wall Street Journal, September 22-23, 2012), steps taken to reduce costs “have fallen well short of bridging a nearly $1 trillion funding gap.” Besides reduced benefits for new hires, increased contributions required of both new and existing workers, suspended cost-of-living adjustments and lower benefits for current workers, governments are starting to implement defined contribution plans such as 401(k) arrangements. No doubt the debate about constitutionality will rage on but the fact remains that the status quo is nearly impossible to maintain.

For some plans, a solution is to alter assets and invest more in alternatives such as private equity and hedge funds. According to the Private Equity Growth Capital Counsel, private equity and some pension funds have done well by each other. Its map of state-by-state performance shows positive returns for public pension funds such as the California State Teachers’ Retirement System. Whether the relationship between the two groups will continue is uncertain. As Kate D. Mitchell, Managing Director with Scale Venture Partners and a speaker at the 2012 Dow Jones Private Equity Analyst Conference observed, a shift from defined benefit plans to defined contribution plans for countless state and local employers will likely mean fewer dollars for the private equity industry. What happens then will depend on whether new monies will be available from other sources or instead cause a contraction in long-term deployment of assets by general partners ("GP").

In addition, political pressures are a reality, especially with respect to how capital gains are currently taxed. Should rates increase at the same time that fewer dollars are available from public pension plan coffers, the private equity industry could find itself under pressure in terms of growth potential and profitability. Other speakers at the Dow Jones Private Equity Analyst Conference were extremely upbeat about the outlook for uber growth in certain geographic sectors and industries. If they are right, investors in private equity will want to look carefully at the make-up of a GP's portfolio.

California Pension Reform

With one of the largest pension systems in the United States, California reform has been a topic of conversation for awhile. Last week, the state senate voted 36-1 to position massive changes for a final okay from Governor Jerry Brown. A combination of salary caps (used to determine pension benefits), increased retirement age and higher contributions from employees is expected to save taxpayers billions of dollars every year. Some critics say that this is a drop in the bucket and that much more is needed.

According to "Calif. Lawmakers Pass Pension Reform Measures" by Erin Coe (Law360.com, August 31, 2012), Governor Brown had hoped for broader changes to "rein in rising retiree health care costs," create a 401(k) type retirement plan for new employees and allow the state's pension board more latitude in decision-making. 

Click to download the 60-page document that lays out the details of AB  340, the California Public Employees' Pension Reform Act of 2013.

Lots of people throughout the United States are watching and hoping that change occurs quickly. Plan participants want assurances about promises made. Taxpayers are groaning about possible hikes to cover what they describe as employee benefit plan largesse. Municipal bond investors are nervous about defaults.

Reason Magazine's Steven Greenhut writes that Vallejo's attempts to restructure were followed by "Stockton, then Mammoth Lakes, and now San Bernardino and soon possibly Compton," with pension and health care plan participants often showing up as creditors.According to "Battle over pension debt looms in San Bernardino bankruptcy" by Tim Reid (Reuters, August 30, 2012), the California Public Employees' Retirement System ("CalPERS") is listed as San Bernardino's largest creditor. A sign of possible trouble ahead, what is at stake depends on who you ask. CalPERS estimates that is owed $319.5 million in contrast to the city's number of $143.3 million.

Earlier this year, Senator Orrin Hatch's office published a report that showed that state and local pension plans with funding ratios below eighty percent had risen from about five percent in 2000 to forty percent in 2006. The study adds that eleven states will likely exhaust their defined benefit plan assets by 2020. The report suggests that heightened disclosures on the part of state and local plan sponsors and a change from a defined benefit plan arrangement to something else merit emphasis before taxpayers are asked to pay more. Click to read "State and Local Government Defined Benefit Pension Plans: The Pension Debt Crisis that Threatens America," United States Senate Committee on Finance, January 2012.

Notably, this blogger addressed the issue of public pension plan funding on July 27, 2006 in "Tea Party Redux: State Pensions in Turmoil." The reference to "tea party" was to a historical event and not the political party.

Pension Limited Partners and Private Equity Fees

News about private equity scions has dominated the headlines during this almost home stretch of the 2012 U.S. presidential campaign but other reasons abound as to why we should pay attention to this $2.5 trillion market, not the least of which is a continued allocation to this asset class by plan sponsors.

According to "Top 200 pension funds still carrying torch for alternatives," Pensions & Investments writer Arleen Jacobius (February 6, 2012) describes a 16% increase to $313 billion for the year ending September 30 or about three times the commitment to hedge funds for the same time period. Seeking diversification and higher returns are common explanations for the attraction.

The flip side is that private equity funds want pension money. In "Private equity courts pension funds for M&A finance," Reuters' Simon Meads writes that "private equity firms in Europe are sounding out yield-hungry" institutional investors as an alternative to "hard-pressed banks."

Pensions, endowments and foundations are getting the message that they may be in the cat bird seat in terms of power and the ability to negotiate on their terms (assuming that they are not creating an in-house private equity bench or partnering with industry giants as co-investors to source deals). In "Private equity LPs draw favorable deals from GPs" (The Deal, July 12, 2012), Vyvyan Tenorio writes that the current supply-demand relationship is allowing institutional investors to enjoy a bigger slice of transaction fees charged to portfolio companies when they exit. Pensions may receive a break on management fees too, depending on the willingness of market leaders to budge for large check-writers, many of which are asking that a separately managed account be established.

Besides the tug of war between general partners and limited partners over fees, the institutional presence is being felt in discussions about compliance and best practices.

Foley & Lardner LLP attorneys Roger A. Lane and Courtney Worcester cite valuation methodologies and the use of debt to finance deals as two areas that keep "Private Equity In The Crosshairs" (Law360.com, July 11, 2012). Referencing several current lawsuits to illustrate each issue, they write that private equity funds are likely to face "certain specific legal hurdles and challenges" in the near future.

Law professor Steven Davidoff and New York Times contributor adds that limited and costly credit, slower fund-raising, a decline in returns and more expensive transactions are some of the reasons that small and medium players are heading for the hills. Even investing outside the United States could be a problem if local economies slow down and/or finding a partner is difficult and expensive. According to "For Private Equity, Fewer Deals in Leaner Times" (Deal Book, New York Times, May 29, 2012), Davidoff adds that industry consolidation will continue, activist deals may become more popular (when they offer more bang for the buck) and pursuing targets will require aggressive attention.

All in all, the prognosis for the private equity industry reflects structural changes in the global markets and the relationship between investors like pension plans and their general partners.

Public Pension Investing in Europe

Market uncertainty typically paves the way for new investment strategies and what is happening abroad is no exception. In a recent article entitled "State pension eyes European chaos for opportunity," journalist Rob Varnon (Connecticut Post, May 23, 2012) writes that the State of Connecticut has soft circled $50 million to allocate to a so-called "opportunity fund" that has its eyes on "European distressed and defaulted debt."

I am quoted as saying that "Investing in Eurozone sovereign debt by institutional investors with a long-term focus may make sense" as long as a pension fund carefully weighs "the risks against the expected returns." I added that many of these opportunity funds are new which means that there is no track record available to review.

Besides liquidity risk, I cited the political will to adopt austerity measures as being variable across borders yet critically important to assess.

Finally, I emphasized the "we are one" aspect of global capital markets, namely that what happens in Europe is unlikely to stay in Europe. U.S. pension plans are almost sure to be impacted. For one thing, trading sentiment is seldom self-contained these days, a trend that is reflected in record high correlation coefficients for various equity and fixed income venues. Second, a pension plan could be already invested in U.S. multinational companies that heavily rely on European economic growth (or lack thereof) to generate sales and profitability. By investing further in European opportunity funds, a U.S. pension fund adds to that exposure and thereby lessens the extent to which it is diversifying geographically.

Continental Europe is not the only region beckoning to Yankee pension funds. According to "China may give foreign pension funds new investment opportunities" by Amy Li (Wall Street Journal, May 15, 2012), authorities are thinking about a mechanism to expand outside capital infusions. Other cited possibilities include the allowance of hedge funds to invest and for certain parties to be able to "open new yuan-denominated onshore bank accounts."

An important factor to consider, among many, is that "boots on the ground" can make an invaluable difference in helping pension fiduciaries to adequately vet non-U.S. partners. International investing has its own set of challenges and getting local help can make sense.

Is Risk Management For Pension Funds Important?

As part of a panel this morning on pension risk management in San Francisco for The Pension Bridge 2012, I was happy to get feedback from lots of people who found the session helpful. While an hour is scant time to address such a critical topic, some of the observations from the session are noteworthy.

  • Everyone on the panel linked pension risk management to governance, adding that those in charge have to acknowledge the importance of identifying uncertainties and allocating resources accordingly before a robust process can begin.
  • An early morning speaker cited risk management as the most important topic being discussed by pension boards today. Yet few in the audience raised their hands when asked how many pension funds had risk management policies and procedures in place.
  • Trying to explain the disconnect between perception and reality is tough. Some panelists suggested that the difficulty in trying to define risk is part of the reason why discussions have not yet led to actions.
  • I commented that operational risks are not going to be picked up by standard financial metrics yet cannot be ignored.
  • My suggestion to the pension fund trustees in the audience was to meet with plan counsel in order to understand their duties and obligations. Inviting a fiduciary liability insurance professional to that same meeting might be helpful in identifying risk governance gaps that could cost a plan more money in premiums. Even better yet would be the hiring of an independent third party to conduct a fiduciary audit of the pension plan's investment processes to discern where internal controls should be improved.
  • I disagree with comments made by one of my fellow panelists about the role of the Chief Investment Officer in leading the risk management function. An industry best practice touted by many experts is to have a separate Chief Risk Officer who reports to the Board and who is given sufficient latitude to say "no" to the investment team when they start to take on too much uncompensated risk.

The take away for me from the risk management session today is that many organizations still do not embrace the urgent need to properly identify, measure and manage a large number of financial, operational and fiduciary risks. This is not a good thing. Talking about risk management and the related governance process is a step in the right direction but not enough by far.

ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds

 

Join me on May 1, 2012 for a timely and interesting program about alternative investment fund due diligence and other considerations for ERISA plan sponsors, their counsel and consultants. Click here for more information.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices by institutional investors. Best practices will be offered to mitigate government scrutiny and suits by plan participants.

Description

With the DOL's and SEC's new disclosure rules and heightened concerns about compliance and valuation, corporate pension plans that invest in alternatives must focus on properly vetting asset managers more than ever before or risk being sued for poor governance and excessive risk-taking.

The urgencies are real. The use of private funds by asset managers is crucial for 401(k) and defined benefit plan decision makers. Understanding the obligations of private funds is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers make it incumbent on counsel to hedge fund and private equity fund managers to fully grasp and advise on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will outline best practices for implementing effective due diligence procedures.

Outline

  • ERISA fiduciary duties for institutional investors
    1. Hedge funds and private equity funds compared to traditional investments
  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans

 

Benefits

The panel will review these and other key questions:

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans
  • What are the regulatory concerns for ERISA pension plans that allocate assets to hedge funds and private equity funds?
  • What are the potential consequences for service providers that fail to comply with new fee, valuation and service provider due diligence regulations?
  • What can counsel to pension plans and asset managers learn from recent private fund suits relating to collateral, risk-taking, pricing, insider trading and much more?
  • How should ERISA plans and asset managers prepare to comply with expanded fiduciary standards?

 

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

Faculty

Susan Mangiero, Managing Director
FTI Consulting, New York

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Alexandra Poe, Partner
Reed Smith, New York

She has over 25 years of experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs. She counsels hedge and private equity fund advisers in all stages of their business and due diligence matters.

 

 

Public Pension Reform is Seen as Urgent

According to "State Pension Reform, 2009-2011" by Ron Snell (National Conference of State Legislatures, March 2012), all but seven states have made "major changes" in order to lower pension fund obligations. Increasing employee contributions, reducing employer contributions and/or tightening up age and service requirements that dictate when someone can retire are a few of the reforms underway. Modifying how benefits are calculated, offering limited benefits to new employees and replacing defined benefit plans with defined contribution plans are a few of the action steps taken by legislators who worry that there is not enough money to maintain the status quo.

For a state by state listing of the types of retirement plans in place, check out the "Checklist of State DB, DC, and Other Retirement Plans" by Ronald K. Snell (National Conference of State Legislatures, January 2012).

While the pace of change has been noticeably faster in the last few years than ever before, budget reformers still angst about whether various courts will prevent reform by insisting that benefits are guaranteed pursuant to the terms of a given state's constitution and therefore cannot be altered.

Palm Beach Post reporter John Kennedy reports that workers in the Florida Retirement System may not have to add 3 percent to their pensions if the highest court in the state rules that doing so would violate its governing dictates. See "Challenge of Florida's forced pension contribution goes to Supreme Court" (March 16, 2012). In "Pension-deal danger: Vote twist leaves door open to lawsuit," New York Post reporters Fredric U. Dicker and Erik Kriss explain that a new pension tier system, signed into law by Governor Andrew Cuomo on March 16, 2012 may face a legal block by "Senate Democrats or one of the public-employee unions that are trying to fight this." As described in "Untouchable Pensions May Be Tested in California" by Mary Williams Walsh (New York Times, March 16, 2012), cities in the Golden State may be barred from enacting reform because of binding provisions in the state constitution. Whether a financially troubled municipality that files for bankruptcy protection will be subject to federal laws - with state mandates taking a legal back seat - is another "hold your breath" issue.

In "Tea Party Redux: State Pensions in Turmoil" by Susan Mangiero (www.pensionriskmatters.com, July 27, 2006), the question was asked whether taxpayers will "enough." With numerous headlines squarely focused on budget crises related to benefit plan funding, "enough" may not come soon enough for some.

Louisiana Pension Funds and Hedge Fund Redemption Concerns

As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

  • "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
  • "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

A New History For U.S. Pension Funds

As many Americans celebrate the Fourth of July with sparklers and picnics, it is notable that public pension plans in the United States are undergoing radical changes. From their original inception as rewards for civil servants and military personnel, retirement plans are often now seen as costly drains on municipal and state coffers.

A few days ago, the Atlanta City Council voted unanimously to reform its pension plan and thereby "generate $22 million to $30 million in savings over the next 10 years and $500 million over the next 30 years."

Jurists in Colorado and Minnesota recently said "no" to public retirees who sued to reinstate reduced benefits on the basis of alleged contractual guarantees.

While Monday is an official day off for many individuals, it's back to work on Tuesday July 5 with continued debates in town halls throughout the nation (and abroad) about employee benefit plans.

Related Links For Readers:

Co-Leading Pension Risk Management Workshop in Orlando

I am off to Orlando to address the Florida Public Pension Trustees Association about pension risk management. I will be joined by an esteemed colleague, Dr. Michael Kraten, in a presentation about the fundamentals of enterprise risk management (including the famous COSO cube) and the role of the service provider in creating hedging programs and vetting asset managers who use derivatives. The workshop will include two case studies about foreign currency overlay programs and investing in hedge funds and private equity funds, respectively.

Having addressed the Florida Public Pension Trustees Association ("FPPTA") several times before about pension risk management, I am impressed with its commitment to fiduciary education about investment best practices.

Click here to review the FPPTA agenda for the 2011 summer conference.

U.S. Postal Service Pension Suspends $800 MM Contribution

Let me start out by saying that the persons at my local post office are courteous, helpful and generally terrific people. That said, like most, I was surprised at the news about a suspension of nearly a billion dollars owed to this federal pension plan.

I guest blogged about this issue for CNBC on June 23, 2011. My commentary is reproduced below.

No Pension Checks for the Postman to Deliver?

The mail gets delivered in rain or snow but it might not include pension checks for postal workers. According to a June 22, 2011 press release from the United States Postal Service, it intends to suspend what it owes to its pension plan as a way to “conserve cash and preserve liquidity.” By doing so, it frees up $800 million in cash for the current fiscal year.

This federal plan sponsor is not alone.

In what seems like an unending stream of bad news on the government pension front, countless cities and states are making adjustments to their existing pension and health care plans for retirees.

Two legislative bills in Minnesota would freeze public pensions as of July 1. Following an arbitration, City of Detroit policemen will see smaller payouts. Florida teachers are suing over a new retirement income tax. Congress is seeking more transparency about public pension plan IOUs and has talked about how large scale municipal bankruptcies related to retirement plan liabilities could adversely impact the financial landscape.

While some sources say that the underfunding crisis is improving for states and cities, others angst that the problem is getting worse and that major reforms are needed now. As we head into an election year, politicos are atwitter about the funding gaps associated with entitlements like Social Security and Medicare. Add underfunded public and corporate plans to the mix and things get scary fast.

Some retirement plans are trying to make up for losses by investing in riskier assets. Absent a robust risk management infrastructure, taking on more risk could worsen funding problems later on.

There are solutions but someone has to lead the way. Raising taxes and/or rescinding benefits is unhappy news to voters. More likely to occur is a legislative mandate to pass the retirement plan hot potato onto Corporate America.

Unfortunately, individuals are unlikely to escape unscathed. The tax man cometh almost surely. Joe Q Citizen may end up footing the bill for someone else’s pension plan even if his doesn’t offer one. The gap in funding for entitlements, public plans and personal savings makes for a trifecta with few winners unless material changes are made soon.

Note to Readers:

Public Pension Risk Management and Fiduciary Liability

A few weeks ago, Attorney Terren B. Magid and Dr. Susan Mangiero jointly presented on the topic of pension risk management and fiduciary liability with a particular emphasis on public plans. Attorney Magid's insights reflect a particularly unique perspective inasmuch as he served as executive director of the $17 billion Indiana Public Employees' Retirement Fund ("PERF"). Dr. Mangiero shares her views as an independent risk management and valuation consultant, author, trainer and expert witness.

Click to download the 25-page webinar transcript for public pension fiduciaries entitled "Are You Properly Mitigating Risk? Assess Your Fiduciary IQ" with Attorney Terren B. Magid (Bingham McHale LLP) and Dr. Susan Mangiero (Fiduciary Leadership, LLC). Comments about ERISA plans are provided when applicable.

Topics discussed include, but are not limited, to the following:

  • Public Pension Transparency Act
  • Discount Rate Choice
  • Dodd-Frank Wall Street Reform and Municipal Advisor Registration
  • Expanded Definition of ERISA Fiduciary
  • Fee Disclosure Under ERISA 408(b)(2)
  • Failure to Pay and Actuarially Required Contribution ("ARC")
  • Benefit Reductions
  • RFP Process
  • Fiduciary Audits
  • D&O Policy Review
  • Vendor Contract Examination
  • Qualitative and Quantitative "Investment Risk Alphabet Soup"
  • Interrelated Risk Factors
  • Key Person Risk
  • Hard to Value Investing
  • Model Risk
  • Stress Testing
  • Pension Litigation
  • Fiduciary Breach Vulnerability
  • Characteristics of a Good Model
  • Side Pockets and Investment Performance.

Comments are welcome.

Pension Rate of Return Reality

According to its March 15, 2011 press release, the Board of Administration for the California Public Employees' Retirement System ("CalPERS") votes to maintain its current per annum discount rate assumption of 7.75 percent. Citing its actuary's take that maintaining the "discount rate at its current level is prudent and reasonable" and its long-term investment posture, this giant pension system justifies the status quo.

A few months ago, CalPERS "slightly decreased the allocation for traditional bonds and shifted the funds to inflation-protected bonds and commodities to reduce volatility risk." Its historical and projected analysis suggests an average gross (net) annual return of 7.95 (7.80) percent for the next several decades. Prior to 2004, CalPERS states that it had assumed an annual discount rate of 8.25 percent.

Not everyone agrees that defined benefit plan rates of returns should hover around the magic eight percent that has been long used for determining funding status. St. Petersburg Times reporter Sydney P. Freedberg describes the dilemma in "Experts say Florida overstates future pension returns" (March 21, 2011). If states assume a rate that is overly optimistic, reported IOUs will be smaller as a result on paper but not in reality. At some point, real money will be required to write checks to beneficiaries. On the flip side, the use of a more likely rate of return will balloon unfunded liabilities, forcing economic and political change right away.

The larger the funding gap (and assuming no changes in contributions), the more likely it is that traditional pension plan decision-makers will steer money towards higher risk investments, in anticipation of higher returns. This may be a valid strategy AS LONG AS new risks are properly identified, measured and managed. Otherwise, the situation could become even worse as out of control risk-taking leads to more and larger portfolio losses down the road.

As described in "Will the Real Pension Deficit Please Stand Up?" by Dr. Susan Mangiero, CFA, FRM (June 22, 2006), the American Academy of Actuaries writes in its July 2004 primer on pension fund accounting and funding that "Amounts calculated under pension funding rules are completely different than those calculated for pension accounting, and one must be careful not to mix the two topics."

The important issue continues to be how long it will take before plan participants, sponsors, shareholders and taxpayers get the real scoop on what is owed, when and by whom.

Bill Gates Talks About Public Pensions

Business Insider journalist John Ellis summarizes Bill Gates' remarks at the TED conference on March 3, 2011 about public pension plans. Apparently, the founder of Microsoft is concerned that ailing state budgets will impair their ability to fund public education. His take on mounting IOUs is that much more needs to be done to structurally address the issues instead of "building budgets on tricks - selling off assets, creative accounting and fictions, like assuming that pension fund investments will produce much higher gains than anyone should reasonably expect."

Note to Readers:

Congress Wants Public Plan Transparency

According to a press release dated February 9, 2011, U.S. Congressman Devin Nunes and U.S. Senator Richard Burr are about to force their peers to focus on public pension fund finances. While the House gets the Public Employees Pension Transparency Act this week, a version for the United States Senate is expected in a few days. The goals of this proposed legislation are several:

  • Provide one set of financial statements (and underlying assumptions) for state and municipal plans to the U.S. Secretary of the Treasury that are based on prevailing accounting methods, even if flawed.
  • Report a second set of financial statements that reflect the level of liabilities for each reporting entity as determined according to a uniform set of rules. "These guidelines will include more realistic discount rates, as well as controls to assure assets are counted using a reasonable estimate of fair market value."
  • Penalize non-compliant government units by withholding federal subsidies of state and local debt and nixing federal tax-exempt status for their bonds.

According to "US House Republicans Rule Out Federal Bailouts For States" by Andrew Ackerman (Wall Street Journal, February 9, 2011), today's Congressional discussion about the state of public employee benefit plans made it clear that states and/or municipalities seeking refuge from their funding problems will not get a federal bailout.

Unless struggling government plan sponsors rescind benefits and/or increase local tax revenue and/or take on a lot more investment risk, they are going to feel immense pain in the coming years. The bad news is not spread out equally. A table that describes the "Public Pension Crisis" and is based on "Public Pension Promises: How Big Are They and What Are They Worth" by Professors Robert Novy-Marx and Joshua D. Rauh projects that Oklahoma, Louisiana, Illinois, New Jersey, Connecticut, Arkansas, West Virginia, Kentucky, Hawaii and Indiana will exhaust their funding first.

The vicious cycle begins. If municipal bond investors view these issuers as higher risk, their respective cost of money will go up. More expensive debt service will exacerbate the overall problems, irregardless of which accounting rules are used for reporting. Taxpayers will get more upset and possibly vote with their feet, moving to what they perceive as fiscally sound cities, towns and states. Yet another falling domino, a shrinking tax base will mean fewer available dollars to pay bills, widening the money gap.

According to "Bond Rating Drop Ignites Pension Fight" by Lisa Fleisher and Jeannette Neumann (Wall Street Journal, February 9, 2011), the Garden State is now on the receiving end of a ratings downgrade and "is one of the seven lowest-rated states in the country." They report that New Jersey missed a $3.1 billion pension payment and could well have been a factor in the drop from AA to AA-.

I hate to say "I told you so" AGAIN but I wrote about the political impact of pension funding in the mid 2000's since it was obvious even then that there were large problems afoot. If you missed it, read "Tea Party Redux" State Pensions in Turmoil" by Susan Mangiero (July 27, 2006) and note that the term "tea party" has nothing to do with the party or movement of late.

Watch carefully as to how these plans change their asset allocations. Already there is a significant move towards investing in funds and instruments with an expectation of higher returns. That's not a problem as long as a robust risk management process in put in place or improved upon if it exists already. My forthcoming book on this topic will elaborate on the potential dangers of taking on too much risk.

Public Pensions, Politics and Risk Management

According to "Florida governor wants cheaper state pensions" by Michael Connor (Reuters, February 1, 2011), Governor Rick Scott wants to put public employees into 401(k) plans and migrate away from traditional defined benefit plans. Though the state's system is "relatively strong financially," the article goes on to say that local town halls "pay between 9 and 20 percent of each worker's salary for pensions" and that "Florida's 572,000 state and local-government workers now see no paycheck deductions for a fixed-benefit pension program, which supports 319,000 retirees."

Expect more to come after Governor Scott puts his budget to the Florida taxpayers on Monday, February 7, 2011.

Notably, risk management is not any less important for defined contribution plans. To the contrary, a quick survey of some of the litigation underway is focused on 401(k) issues relating to fees, portfolio selection choices, investor education and much more. Moreover, greater pressures for reform are going to force enhanced transparency and allow little time and latitude for decision-makers to focus on prudently realizing risk-adjusted returns. The last thing a board member, lawmaker, regulator or politician wants to address is a worsening retirement IOU situation when taxpayers, shareholders, employees and other stakeholders are grumpy and impatient.

If you did not get to read it when originally published, click to download "Pension Risk Management: Necessary and Desirable" by Susan Mangiero, PhD, CFA, FRM, Journal of Compensation and Benefits, March/April 2006.

Editor's Note: Fiduciary Leadership, LLC is the new name for BVA, LLC.

Taxpayers and Public Pensions - Comments

Regarding today's post entitled "Taxpayers and Public Pensions," several people asked for air time. I've included their comments below. If you are interested in rebutting or adding a similar opinion, email contact@fiduciaryleadership.com.

"All public sector retirement plans should be the same. We need to cure the actuarial issues caused by retirees thinking they can contribute relatively minuscule amounts for 20 or 25 or 30 years and retire for 30 or 40 or even 50 years thereafter. It can't be done and we are seeing that now. Retirement before age 65 years should be discouraged. It is important to increase the number of years of participants' contributions and reduce the number of years associated with paying out benefits. I further recommend a maximum payout of $5,000 per month, regardless of sick days, overtime, unused vacation or any other nonsense included in the benefit calculation. Remember that the maximum payout for Social Security recipients  is about $3,000 per month."

"Civil Servant pensions are extraordinarily generous (with rich formulas, early retirement ages, and post-retirement COLA increases) and therefor extraordinarily EXPENSIVE. The total cost (as a level annual percentage of cash pay) of civil servant pensions is typically 25+% for non-safety workers and 35+% for Safety workers (due to an even richer benefits). This compares to a private sector pension that generally costs the employer about 7.5% of an employee's pay. With cash pay in the public sector now equal to or greater than cash pay in comparable Private Sector jobs, there is ZERO justification for ANY (yes, ANY) larger public sector pension benefits. Therefore, the cost of public sector pension in excess of the 7.5% offered in the private sector should be paid-for by the EMPLOYEES .... NOT the taxpayers. Hence, non-safety workers should contribute 25% less 7.5% or 17.5% of each person's pay. Safety workers should contribute 35% less 7.5% or 27.5% of each person's pay. Now, do I really believe this will even happen? No, of course not. My point is to demonstrate how ridiculously EXCESSIVE the pensions are for public workers and to state that the best (and very NECESSARY) solution is an immediate reduction in the BENEFIT LEVEL of at least 50+% for FUTURE years of service for CURRENT (yes CURRENT) workers. The taxpayers have been hoodwinked long enough."

Taxpayers and Public Pensions

As I've long maintained, THE pension dilemma of an aging population, low savings and greater liabilities is not simply a matter of economics. No politician wants to rescind benefits and/or raise taxes yet the reality in the United States and around the world is obvious. Taxpayers will increasingly force change by voting for candidates who promise reform.

A few days ago, I was sent a press release by the California Foundation For Fiscal Responsibility and was given permission to reprint it here. If you want to provide a countervailing opinion, send an email to contact@fiduciaryleadership.com with a few paragraphs stating your position. Let this important debate continue!

Release: January 28, 2011

Contact: Marcia Fritz
916-966-9366
MarciaFritz@CaliforniaPensionReform.com

Should Public Employees Pay Half

the Cost of their Retirement Benefits?

 

SACRAMENTO – Continuing its online conversation about pension reform, CaliforniaPensionReform.com today asked the public to share their views on a second issue central to the debate over public pension reform:

Should public employees pay half the cost of their retirement benefits?

“Earlier this month, we announced that CaliforniaPensionReform.com will host an online conversation about pension reform,” said Marcia Fritz, president of California Foundation for Fiscal Responsibility (CFFR). “Our first Question of the Week asked if public and private employees should have similar retirement plans. A related question is whether government employees should contribute half the cost of their retirement plans. I’ll be thrilled if the responses are as thoughtful and instructive.”

 

CaliforniaPensionReform.com will circulate the Question of the Week and periodic updates to those who sign up on its Web site. Future questions include:

  • Should public safety employees have different retirement plans than other government employees?
  • Should taxpayers pay healthcare costs for the lifetime of an employee who retires from government service?
  • Should an employee’s unused vacation and sick pay be considered when his/her annual pension is calculated?  

On January 6, CFFR posted two alternative pension reform approaches on its Web site and invited the public to comment. Proposals from others will be posted for public comment as they become available. CFFR is reaching out to economists, legal scholars, financial analysts and pension managers to analyze pension reform proposals and contribute to the CaliforniaPensionReform.com online library. “California can’t solve its fiscal problems until it solves its public pension crisis. Whether lawmakers or voters do the job, we need a plan that has been thoroughly analyzed and debated by voters, stakeholders and experts,” Fritz said.

###

Bad Disclosures - Recipe For Disaster?

According to "State workers face privatization" by Jason Stein (Milwaukee Journal Sentinel, January 6, 2011), over 300 Wisconsin State Department of Commerce employees may soon be classified differently. The stated goal is to better deploy its $183 million budget to try to create jobs. (Whether you believe that governments are the engine of jobs creation is a post for another day.)

Questions remain about the benefits for identified employees and whether they will be covered by the state's retirement system. A related question is whether the general public will have a true assessment of Wisconsin's retirement plan IOUs if these privatized workers are counted as "public" for some purposes but not for others. In reading the many comments posted for the aforementioned article, emotions are running high about the real costs associated with this decision. Clearly, more information would go a long way to quelling any concerns.

The topic of financial disclosures may soon create real problems for public plans and, by extension, ERISA plans that are sponsored by companies that issue stocks and/or bonds. In today's New York Times, Mary Williams Walsh reports that the U.S. Securities and Exchange Commission ("SEC") may be investigating the large California pension plan known as CalPERS. It's premature and inappropriate to speculate but the inference is that bond buyers may have been in the dark about the "true" risks associated with this $200+ billion defined benefit plan. If true, California could pick up an even bigger than expected tab and municipal security investors could be in a position of having paid too much to own state debt. See "U.S. Inquiry Said to Focus on California Pension Fund."

As recently as 2009, then Special Advisor to California Governor Arnold Schwarzenegger, David Crane, referred to public pension plan reporting as "Alice-in-Wonderland" accounting. He added that "state and local governments are understating pension liabilities by $2.5 trillion, according to the Center for Retirement Research at Boston College." Since these are legal contracts that bind the state, city or municipal sponsor, they are on the hook for bad results, with large cash infusions likely.

It's not rocket science to conclude that other states and municipalities could face the same type of securities regulation inquiry. Indeed, even ERISA plans are vulnerable to allegations of fraud or sloppy reporting if their risk disclosures are incomplete, inaccurate, misleading or all of the above. See "Testimony for Securities and Exchange Commission Field Hearing re: Disclosure of Pension Liability" (September 21, 2010). Investors want to know whether they have a striped horse or a zebra in their stable. They need and deserve a solid understanding of investment risks to which they are exposing themselves. That can only occur if accurate and complete information is provided. To its credit, CalPERS seems to be emphasizing risk-adjusted performance as paramount. A December 13, 2010 press release describes the adoption of a "landmark" asset allocation that emphasizes "key drivers of risk and return."

Email Dr. Susan Mangiero, CFA and certified Financial Risk Manager if you would like information about what a risk disclosure assessment entails for your organization or on behalf of a client(s). You may likewise be interested in one of our workshops for directors, trustees and/or members of the investment committee about performance reporting within a fiduciary and financial risk management framework.

Not 21 But Lots of Great Opportunities Ahead

A man is not old until his regrets take the place of dreams.
- - - - John Barrymore, "Good Night, Sweet Prince" 1943

If Betty White can rock Saturday Night Live to its highest ratings at the age of 88 and Sunset Daze is media gold for the senior reality television set, there is hope for anyone who wants to stay in the game rather than "retire" from the mainstream. In "Famous folks launched careers after 50" by CNN's Ethan Trex (May 16, 2010), more than a few individuals have realized great commercial success as seniors, including Colonel Sanders (of Kentucky Chicken fame), President Ronald Reagan and Takichiro Mori (twice reported by Forbe's as the world's richest man "with a net worth of $13 billion").

Good news is everywhere for the gray haired set if you accept current research about preservation and growth. In "Creativity and successful brain aging: Going with the flow" by Susan Krauss Whitbourne, PhD (March 23, 2010), having friends, enjoying leisure activities such as bridge or dancing and developing a "flexible mental attitude" are three hallmarks of a productive and enjoyable "later life."

At a time when the world is getting older, employers are challenged with managing the costs of providing post-employment retirement benefits as well as having skilled and experienced workers in place.

In a summary slide show, Business Insider excerpts from the 2009 EU Ageing Report to paint a sober picture of how age impacts gross domestic product ("GDP"), assuming that retired persons truly exit the economy and are given no opportunity to continue working in some fashion. (Keep in mind that official statistics do not fully capture actual employment.)

Country Pension Cost compared to GPD in 2007 Estimated Pension Cost compared to GPD in 2035 Estimated Change in Working Age Population by 2020
Netherlands 6.6% 10% -4.3%
Luxembourg 8.7% 17% -1.1%
Denmark 9.1% 11% -4.3%
Bulgaria 8.3% 9% -5.6%
Czech Republic 7.8% 7.6% -8.3%
Belgium 10% 14% -3.5%
Poland 12% 9.3% -5.7%
Hungary 11% 12% -5.0%
Italy 14% 15% -3.0%
Sweden 9.5% 9.4% -6.0%
Malta 7.2% 9.7% -7.1%
Greece 12% 19% -3.9%
France 13% 14% -5.5%
Finland 10% 14% -8.5%
Slovenia 9.9% 15% -6.6%

 

Things are not too much better in the United States with respect to financial solvency and unfunded retirement benefits. According to "The Market Value of Public-Sector Pension Deficits" by Andrew G. Biggs (Retirement Policy Outlook, American Enterprise Institute for Public Policy Research, April 2010), "public-sector pension plans have only a 16 percent probability of being able to cover accrued benefit liabilities with current assets."

The ramifications are huge in so many ways. Increased taxes, rescinded benefits or both are vote killers so you have to know that THE demographic time bomb is going to become political radiation in short order.

Until then, if you are healthy and able to continue working or are otherwise financially independent, enjoy the good life. Way to go!

Leverage - I Love You, I Need You - Don't Hurt Me

 

If institutional investors thought of leverage as a bouquet of daisies, they'd be playing "(S)he loves me, (S)he loves me not" and hoping to still be respected in the morning. Now that the worst economic recession of modern times might be abating somewhat, more than a few buy side executives are looking for a sweetheart to help them replenish diminished portfolio values. Let's just hope that the love affair is not fickle, causing more hurt than help.

In "Wall Street's New Flight to Risk" (February 15, 2010), Bloomberg BusinessWeek reporters Shanon D. Harrington, Pierre Paulden and Jody Shenn write that investors are on the prowl for yield. With over $150 billion allocated to U.S. bond funds, returns are low and the only way to add some excitement is with exotics such as "payment-in-kind" bonds that encourage the issuance of more debt than a borrower's operating cash flow would ordinarily support. Derivatives are another Valentine, with banks "again pushing" collateralized debt obligations ("CDO's) that can increase in value (depending on the trade) as defaults increase. 

On January 27, 2010, Wall Street Journal reporter Craig Karmin writes that public pension funds are borrowing money to enhance returns rather than allocating to alternatives such as hedge funds and private equity pools. According to "Public Pensions Look at Leverage Strategy," funds can turn in a good performance with the use of leverage without having to resort to "volatile stocks" or illiquid assets. Others quoted in this recent piece suggest that risks exist and must be acknowledged.

Heartbreak hotel - here we come.

Call me crazy but a move towards leverage (possibly excessive) seems scary UNLESS and UNTIL asset managers and institutional investors alike can demonstrate that they know how to properly measure and manage. For every person who is asked to define investment leverage, the answer is seldom the same. AIMA Canada makes a good effort to add clarity to this important topic. See "An Overview of Leverage" (Strategy Paper Series Companion Document, October 2006, Number 4).

L'amour with leverage - how sweet it is, until it isn't. Then what?

Hamsters and Investment Governance

The plight of the hamster is simple. He is cute, furry and going nowhere fast. Sure he gets exercise but, measured in inches and miles, he's stuck in the same place, treading the same pattern over and over again.

Lest this sound like a zany rant from a busy blogger, might I suggest that the current spate of "pay to play" scandals reflects what some in the industry have been saying for years? Be scared, be very scared about the dsyfunction that is roiling financial markets. 

With respect to writer George Santayana, "Those who cannot learn from history are doomed to repeat it." With Enron, Worldcom and Bear Stearns far from a distant memory, why on earth are we still reading about bad players who end up costing taxpayers, shareholders and innocent bystanders gazillions of dollars? Worse yet, those individuals who wear the fiduciary hat proudly are being unfairly tainted by those who should know better and/or simply do not care about the lives they ruin with their bad acts.

Recent articles about California and New York pension problems only add fuel to the fire and leave most folks scratching their heads, asking legitimate questions, some of which are listed below:

  • Given existing regulations, why are there so many scandals?
  • Where is the board oversight that is supposed to prevent conflicts of interest or at least nip things in the bud before losses mount?
  • How much are Sally and Joe "everyperson" supposed to tolerate in terms of broken trust on the part of those tasked with leadership?
  • Why aren't major lessons being learned sooner than later?

As an ardent advocate of capitalism (and no, we do not have a pure capitalistic system in place anywhere, contrary to Michael Moore's movie lament), I find the current state of affairs impossible to defend.

Bad practices have got to stop. We need to be moving forward, not running around and around, making no progress and chasing our tails. Let me also add that I am not objective here. Our company (newly named Investment Governance, Inc.) has been busy at work for nearly a year, building investment "best practice" tools (to debut in short order). What has kept our team going lo these many months of 15 hour days are the repeated and strident cheers from all the good guys and gals who take their institutional fiduciary work seriously and want things to improve in a big way.

Bravo to those for whom trust is a sacred word! We seek to help you gain the recognition and support you so richly deserve. 

Asset Allocation Alchemy

 

Asset allocation seems to be on the minds of many these days. This is not surprising since empirical studies repeatedly suggest that how monies are apportioned across sectors and instruments is a primary driver of returns.

Some states such as North Carolina are legislating more choices for state retirement funds. According to "Pension fund to get new options" by The News & Observer reporter David Ranii, the Tar Heel State Treasurer will soon have the ability to allocate to junk bonds and Treasury Inflation Protected Securities ("TIPS").

In "Asset allocation survey 2009," Mercer LLC queried European pension funds and uncovered a "continuing focus on risk management and recognition that good governance can improve the investment performance of institutional investors." Notable is the result that mature defined benefit plans tend to reduce their exposure to equity markets in favor of fixed income.

In contrast, Dr. David Gulley, Managing Director at Navigant Consulting, suggests that an exit from equity could be ill-advised for investors seeking returns over many years. In "A Surprising Bear Market Lesson About Bullish Projections" (Law360, July 2009), Dr. Gulley writes that "a substantial and objective body of evidence shows that equity returns are reliable in the long term" and that a positive equity risk premium is "actually a requirement enforced by the market's ability to deny money." If true, the impact is potentially sweeping. For one thing, a migration to Liability-Driven Investing ("LDI") which tends to favor fixed income might prove costly later on. Pension plan decision-makers seeking to reallocate away from long only strategies might incur transaction costs now, only to add opportunity cost to the mix if and/or when the sun rises again in stock land. The net result could be a doubling up of bad news bears (or worse).

Absent a universal acceptance about the role of stocks versus everything else, the debate about optimal strategic and tactical asset allocation mix will no doubt continue for many years to come.

 

Pension Plans as Plaintiffs - 800 Pound Gorilla of Litigation

Just a reminder that our webinar entitled "Pension Plans as Plaintiffs - 800 Pound Gorilla of Litigation" will be held on May 12, 2009 from 2:00 PM EST to 3:30 PM EST. Our esteemed speaker panel includes:
  • 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 

Are Pension Funds the New Venture Capitalists?

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.

Enron Redux? Pension Plans as Plaintiffs

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.

Hegemony in Alternatives Land - Are Pensions Getting the Upper Hand?

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?

Public Pensions: Can Deferrals Keep Coffers Full?

 

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.

Hedge Fund Haven Gets Double Whammy from Pension Plan and New Regulations

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.

New York Pension Plans Create a Stir

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?

Forbes Describes Public Pension Benefits as Rich

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.

Capital Calls Are Tough for Institutions and General Partners Alike

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: 

CT Town Swears Out Madoff Arrest Warrant for Alleged Pension Fraud

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."


Prince Charles Wants Pension Funds to Invest Green

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.

New Jersey Governor Calls for a Deferral of Pension Contributions

 

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.

Walking the Public Pension Plan Tightrope

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?

Golden State Asks Public Pension Plan to Help

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?

New Jersey Gets Okay to Invest $9 Billion in Alternatives

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.

CalPERS Invests in Infrastructure

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!

Public Pensions and Hedge Funds

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:

Massachusetts Pension Plan Urged to Invest in School Loans

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.

Pension Fund Governance in the Lonestar State

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.

South Carolina Retirement System Forays Into Alternatives

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.

New Blog About California Municipal Employees

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."

New Accounting Rules for Public Pension Funds

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.

CalSTRS and the Missing Billion Dollars

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. >>

California Pension Fund Investments in Tobacco

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.

UK Pension Fund Goes Green

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.)

California Healthcare Premiums Go Up

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."

Massachusetts Taxpayers Protest New Benefits

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. >>

Pension Obligation Bonds - Do They Pass the Test?

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.

New York Pension Probe

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.

The "Terminator" Ends Bill to Nix Private Equity Restrictions

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?

Three Public Pension Plans Say "No Thanks"

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).

Public Pension Pain - Ten Worst States in Terms of Funding

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."

SEC Warns Pension Plans on Matters of Fraud

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.".

Private Equity Returns Appeal to Pensions

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.

California Dreaming...Of Private Equity Returns

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."

Public Pension Plans Owe $2.73 Trillion

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.

Statistics Save the Day for Louisiana Retirement Plan

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.

Pension Governance Woes in Public Sector

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).

Salaries and Bonuses for Investment Risk Professionals

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.

Prosecution of Former Pension Trustees Moves Forward

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.

Should Lawmakers Determine Pension Investment Policy?

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). 

 

Some Pension Funds Say to Hedge Funds - Hold On There

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 ToolboxSM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

Revolutionary Pensions

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

Is There Fiduciary Liability Attached to Divestment?




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.

California Dreaming About Pension Conflicts of Interest


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...

Pension Disclosure and SEC Sanction



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.

Protesting Pension Contributions - Who Should Pay?



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.

Pension Weeds in the Garden State


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...

Pensions, Manhattan Style





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?")

State Pension Plan Storms Ahead



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?

California Dreaming: Pension Bill Fails



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.

Bye Bye Equities



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.

Dividends, Pensions and California Chaos



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 ...