Wednesday, September 3, 2008

Are Pension Funds Drifting Towards Disaster?


Do you remember the last great pension debacle? Following the tech meltdown, many defined benefit pension plans began to accumulate large deficits because of stock market losses in 2000 through 2002. Despite a rebound in equity prices from 2003 to 2005, pension deficits continued to soar as lower interest rates dramatically increased the value of pension liabilities.

Well, if you thought that was a tough period for pension funds, get ready for the looming disaster that will rock global pension funds in the next three years and probably even longer.

This week we learned that total
assets of the world’s largest 300 pension funds grew by over 14% in 2007 to around US$12 trillion:

Watson Wyatt global head of investment consulting Carl Hess said: “The world’s largest pension funds continue to benefit from a high profile as global demographic challenges remain front of mind. “As a result many large pension funds have prioritised their funding arrangements, helping them to grow despite adverse market conditions in the latter part of last year.”

Hess explained the persistent extreme investment conditions had also increased scrutiny on risk management as funds contemplated a new framing of risk in light of the continuing financial crisis.


The survey also showed the size of assets in North American and European funds had grown steadily over the past five years at compound growth rates of 13% and 21% respectively.
And in Australia, assets grew at the fastest rate – 27% in US dollar terms, while Canadian, Swedish and Dutch funds grew at 22%, 19% and 18% respectively.

Hess said: “Large pension funds, notably the top sovereign funds, will continue to grow and be successful if they remain adaptable and prioritise excellent governance and risk management.


Another article that looked at all institutional investors - not just defined funds - found that institutions hold a record amount of US equities:

Using the latest available data, the business membership and research organization found institutional holdings of US equities stood at $13 tn in 2006, up from $11 tn in 2005 and $571 bn in 1980, according to the 2008 Institutional Investment Report.

The 2006 figure represents 66 percent of all US equities, a record high for institutional ownership, said the report. Meanwhile, the level of retail ownership in 2006 slumped to an all-time low of 44 percent.

Total assets controlled by institutional investors – defined as pension funds, investment companies, insurance companies, banks and foundations – rose from $24 tn in 2005 to $27 tn in 2006. In 1980, assets stood at just under $3 tn.

Pension funds hold the largest share of institutional assets, about 38 percent or $10 tn, the report stated. Within this category, state and local pension funds – which are often activist in nature – have grown more rapidly than other types of pension funds.

State and local pension funds increased their share of US equities from 3 percent in 1980 to 10 percent in 2006, noted the report. By contrast, private trustee pension funds have seen their share decline to 13.6 percent in 2006 from 15.1 percent in 1980.

...

The report also revealed that investments by pension funds in hedge funds have increased quickly over recent years, but remain a small amount of overall assets. The value of assets allocated to hedge funds rose to $76.3 bn by September 2007, an increase from $29.9 bn by the same month in 2005, said the report. That still only accounted for 1.4 percent of total pension fund assets, however.

Another report from the Conference Board states that pension funds worldwide have pumped more than $1.8 trillion into some 10,000 hedge funds as of September 2007, a 23.6 percent jump from the year-ago period (see my last entry on hedge funds):

The Conference Board's Institutional Investment Report said pension funds comprise the largest block of institutional investor assets, with $10.4 trillion, or 38.3 percent, of total assets as of year-end 2006.State and local pension funds grew more rapidly than corporate pension funds because they more actively exert corporate governance pressures on companies.

Pension fund investment increases mirror global total institutional investments, which controlled $27.1 trillion in assets at the end of 2006, up from $24.4 trillion a year earlier. The equity market value of total institutional equity holdings increased to $12.9 trillion, or 66.3 percent of total U.S. equity markets, from $571.2 billion in 1980, which represented 37.2 percent of total U.S. equity markets.

Carolyn Kay Brancato and Stephan Rabimov, authors of the report, said the increase in equity market investment “represents a historic all-time high” for institutions.

The report said U.S. pension funds historically invested “very little” of their assets in international equities. In 2007, U.S. pension funds boosted international equity investments to 15.3 percent from 13.5 percent in 2005, but continued to invest significantly less than in 1999 when pension funds invested 18 percent of their assets in international equities.

The big problem is that global pension funds are too exposed to equities at a time when equities are likely to experience a prolonged period of subpar returns.

(In some countries, like South Korea, the financial regulator is calling for state pension funds to spend more on equities to help stabilize local stock markets. Yikes!)

What about hedge funds, private equity and real estate? What about them? The big gains in alternative investments were made in the last six years. The bubble in alternative investments has now popped and they will also experience a prolonged period of subpar returns.

Why am I so bearish? Because I see the BIG PICTURE and it isn't pretty. I have been calling for debt deflation since July 2003. I was too early and I underestimated global liquidity trends and the sustainability of the US housing bubble. I also underestimated the securitization bubble that accompanied that housing bubble, allowing millions of people to buy homes with little or no credit as interest rates were kept artificially low.

Well that party is over too. The only sectors that I am mildly bullish on in equity markets are alternative energy (especially solar shares which I think might be the next big thing) and medical device companies and biotech (due to the aging population).

But I am not expecting some miraculous rebound in equities - far from it. Debt deflation will wreak havoc on global banks and global pension funds. The latter are so exposed to equities that they will suffer significant losses in the coming years. Worse still, in their search for 'higher yields', global pension funds have contributed to a bubble in alternative assets, including bubbles in commercial real estate, private equity, hedge funds and commodities.

Moreover, according to the Wall Street Journal, even "relatively safe" liability-driven investments, or LDIs, are now being knocked sideways by the credit crunch, hitting pension funds hard:

Many pension funds have employed LDI strategies that depend on cash funds hitting their benchmarks, usually tied to interbank interest rates. Those targets have become harder to achieve since the credit crisis forced banks to raise the interest rates at which they lend to each other.

And where so-called enhanced cash funds have been invested in assets such as asset-backed securities that have been marked down amid the credit crunch, the problem has become even worse.

It will get a lot worse. The mantra from 1982 to 2000 was "stocks for the long-run". I believe that the mantra for the next decade will be "government bonds for the long-run".

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