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

 

At the invitation of the ERISA Advisory Council, I presented testimony about "Hard to Value Assets" on September 11, 2008 in Washington, D.C. Some of the questions I was asked to answer are listed below:

• Should valuation issues play a role in the selection of plan investments, and in achieving proper asset allocation and diversification?
• What, if any, modifications to plan investment policies and guidelines should plans consider when utilizing "hard to value assets?"
• As fiduciaries, what do you deem to be or what do you expect to be "hard to value assets?"
• Who can the fiduciary rely upon when ascertaining the value of "hard to value assets" when the fiduciary is incapable of valuing, in order to fulfill their fiduciary responsibility to plan participants?
• What valuation policies and procedures should a fiduciary adopt when holding "hard to value" assets?
• What disclosures and education measures are required or suggested for participants and fiduciaries with respect to plans which invest in "hard to value" assets?

Given the recent tumult in the global financial markets, it seems as if an eternity has passed since the September 11 hearing date. Valuation continues to be a hugely important topic. I hope that my comments are informative and helpful to readers. Let me know what you think. Click here to read "Testimonial Remarks Presented by Dr. Susan Mangiero." Click here to send an email.

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According to its February 18, 2008 press release, the Pension Benefit Guaranty Corporation is changing its asset allocation mix to 45 percent invested in fixed income, 45 percent invested in equity and 10 percent left for alternative investments. A spokesman explains that ratcheting up on private equity funds and real estate is expected to generate higher returns but reduce risk because of greater diversification, giving "the Corporation a 57 percent likelihood of full funding within ten years compared to 19 percent under the previous policy." In the past, the PBGC mix favored bonds with 75 to 85 percent being invested in fixed income securities, including some monies earmarked for liability-driven investing ("LDI") strategies. Some PBGC critics recently cited high opportunity costs by concentrating on notes and bonds.

With an accumulated deficit of $14 billion at the end of fiscal year 2007 and the recognition of the long-term nature of its obligations, the decision was arrived at, after "an extensive review process that began in mid-2007." Interestingly, an "Investment Program Fact Sheet" seems to contradict the newfound logic, stating that "Because of the statutory restrictions on investment of the Revolving Funds and a change in PBGC's investment policy adopted in 2004, fixed-income securities dominate PBGC's asset mix." Additional text emphasizes a relatively low tolerance for uncertainty. "The current investment policy continues PBGC's investment focus of limiting financial risk exposure by investing the majority of PBGC's assets in long duration fixed-income securities in order to reduce balance sheet volatility."

It would be interesting to know more about exactly why the PBGC decided to move into real estate and private capital pools now. How did they net the expected lower risk (due to diversification) against incremental risks association with interests that seldom trade? Access to meeting minutes would make for good reading. Though it is not an official U.S. government agency ("financed by premiums paid by employers, assets from failed pension plans, recoveries from bankruptcies and returns on invested assets"), many people believe that American taxpayers are ultimately on the hook in the event of a PBGC bailout. With a recession on the way and relatively low interest rates that push liabilities upward, bad news for this insurance agency is not out of the realm of possibility. Additionally, though premiums have increased, few economists believe that risky plans are paying their "fair share" and that "good" plans are subsidizing poor financial management elsewhere. If true, PBGC's exposure to default is that much higher.

The PBGC says it reviews its investment policy every two years. How often does it assess its outside managers? Will due diligence for alternative fund managers differ from the check-up imposed on traditional managers? How will the PBGC address valuation issues related to private equity, venture capital and real estate? What performance metrics can we expect PBGC to share with interested parties if "hard to value" assets are held at cost versus "fair market value?" Is there or will there be a Chief Risk Officer for PBGC who addresses asset-liability management on an enterprise risk basis? How will banks be impacted if private plans decide to follow PBGC's example and shy away from LDI? Will corporate plans follow suit?

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The ill-effect of aggressive mortgage lending on pension funds is still unfolding but actively monitored, given the sheer size of many plans. A February 5, 2008 news release, issued by the Massachusetts Institute of Technology (MIT), suggests that the sub-prime fallout is real. Citing a second straight drop in the quarterly Transaction-Based Index ("TBI"), a measure of commercial real estate trades by pension funds, MIT Center for Real Estate Director David Geltner blames the credit crunch. A 5 percent decline for the fourth quarter of 2007 follows a prior 2.5 percent three-month drop. These hits are in stark contrast to reported growth in the TBI of 64 percent from 2004 through 2006. Click here to read the MIT story. Also check out the February 6, 2008 CNBC broadcast.

In a related piece ("Risk of property defaults growing - February 6, 2008), Financial Times reporters Daniel Pimlott and Gillian Tett describe a disturbing (though not surprising) trend in commercial property loan defaults. They quote Sam Chandan, chief economist at research company Reis, as saying that "It will be very difficult to acquire refinancing." The article also references Wachovia Capital Markets by pointing out that $20+ billion of floating rate commercial mortgage-backed securities ("CMBS") come due this year, $2 billion of which "face the greatest risk of default" because they are final maturity loans "with no option to extend."

What remains to be seen is whether pensions' foray into real estate, direct or indirect, via an emerging real estate derivatives market, diminishes as values turn south. Shying away from this alternative investment class could have a dramatic impact on the strategic asset allocation of defined benefit plans, especially as relates to portfolio diversification. Certainly such a response will impact companies and individuals who want to sell property. A February 2007 Pension Real Estate Association (PREA) report estimates institutional real estate holdings for 2005 at $146.8 billion, an allocation of 6.92%.

Editor's Note: Click to read "Constructing the Real Estate Derivatives Market" (March 25, 2007 post) and "Are Pensions Ready for Property Derivatives?" (March 9, 2007 post).

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Our March 9, 2007 post about real estate derivatives created a buzz, at a time when the financial industry grapples with the usual fits and starts of developing a new product. This post looks at where things stand. Expect more news in the aftermath of the upcoming March 28-29 conference of the Pension Real Estate Association (PREA) in Boston.

Creating a new market for any financial instrument requires sufficient interest. People have to be willing to buy and sell in large enough numbers to keep the bid-ask spread somewhat "low". Otherwise, participants will likely struggle to unwind a position. Additionally, too few actors result in excessively "high" costs that could destroy the economic rationale for trading in the first place. The burgeoning market for commercial property derivatives is no exception. According to Jim Clayton, PREA's Director of Research, there are two types of swaps being developed. The total return swap takes a LIBOR versus real estate index structure. The second version is a swap of total returns on two respective NCREIF (National Council of Real Estate Investment Fiduciaries) property sectors. Carter adds that "index return swaps allow investors to adjust exposure to real estate without buying or selling properties, thereby creating flexibility for portfolio management while eliminating the required physical delivery of the asset."

While true that more than a few pension funds now invest in commercial properties outright, obstacles remain. Valuation challenges, relatively high transaction costs, long lead times, difficulties in selling short and oft-encountered illiquidity are a few factors that influence the asset allocation decision. For a review of market development activities in the UK and US, click here to read "Commercial Real Estate Derivatives: They're Here ... Well, Almost" by Jim Clayton (PREA Quarterly, Winter 2007, pages 28-31).


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David Oakley reports the imminent launch of a U.S. commercial property derivatives market trading platform as early as this week. (See "Property derivatives poised for US launch", Financial Times, March 5, 2007.) Estimated at $26 trillion in value, Oakley writes that "property is one of the few major asset classes without a developed derivatives market in the U.S."

Four banks have signed with the National Council of Real Estate Investment Fiduciaries to license their index data for three years - Bank of America, Credit Suisse, Goldman Sachs, and Merrill Lynch. Click here to read the NCREIF press release.

This type of financial instrument has already taken hold in the UK with a property derivatives market that has grown to nearly $10 billion in the two years since inception. No surprise then that US banks will plan to follow suit, especially with respect to the use of good data (cited as a driving factor behind the UK experience).

Note that the NCREIF Property Index (NPI) is self-described as "a unique property valuation and performance metric. It is the largest, oldest, and most recognized measure of institutional quality, privately owned commercial real estate in the U.S. The benchmark represents (as of Fourth Quarter 2006) marked-to-market valuations on 5333 U.S. properties reported quarterly by a large number of institutional owners and fiduciaries. It has a total market value of $247 billion. The NPI includes sub-indices by property type, and location."

Structured as a type of interest rate swap, one counterparty receives a cash flow tied to real estate market performance. A second counterparty receives a variable rate-driven cash flow every few months, tied to LIBOR (London Interbank Offered Rate).

For a pension fund unable to buy property and/or allocate monies to a real estate investment trust or real estate private equity fund, this new derivative may be a good workaround. Suitability will depend of course on many factors such as terms specific to the derivative instrument contract, what the plan is seeking to achieve and whether exposure to real estate makes sense.

The Baltimore Sun reports continued good performance as recently as two months ago. (See "Commercial real estate funds continue to thrive" by Andrew Leckey, originally published January 7, 2007.) On the other hand, valuation and liquidity must be taken into account. Future expected risk-adjusted returns and correlation patterns with other assets are similarly important.

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