Thursday, October 23, 2008

KABOOM! Pension Bombs Exploding Everywhere!


The California Public Employees’ Retirement System (CalPERS), the largest US public pension fund, saw the value of its assets fall by about $50billion (20%!!!) from the end of February to October 10 because of stock markets falls and other heavy investment losses:

The pension fund now looks set to tap Californian state employers for higher contributions, at a time when the state's budget is stretched to the limit as a result of its own investment problems.

CalPERS, which was one of the first public pension funds to begin investing in private equity and hedge funds, has seen its net worth fall from approximately $240bn in February to $190bn today.

A decision on whether employers will need to increase their contributions will not be taken until returns for the 2008 fiscal year are known.

"Cushioning the impact of investment setbacks is the fact that Calpers experienced double-digit gains in the four years leading up to the 2007/08 fiscal year," said Ron Seeling, the fund's chief actuary. "We had saved 14pc of the fund for cushioning the blow of a future market downturn, and our smoothing policy is working as it should."

If returns do not improve, Calpers said it may require employers to increase payments. The current average employer contribution rate is 13pc of payroll – but increases in contributions could exceed 4pc if losses continue.

Even if increases are needed, they will only come into effect in the fiscal year beginning July 2010, due to the benefit of substantial gains in previous years.

Whether Californian state and local authorities could meet those payments remains to be seen, however. The state has been one of the hardest hit by the foreclosure crisis, reducing tax-take and leading to additional spending on social welfare.

The situation in California had become so bad at one stage earlier this month that Governor Arnold Schwarzenegger said he may need a $7bn loan from the US government in order to meet short-term cash needs as a result of money locked up in the frozen credit markets.

That immediate need was resolved after institutional investors purchased revenue anticipation notes from the State treasury, but the overall financial picture remains gloomy.

Calpers is not alone in its problems, with the California State Teachers' Retirement System, America's second-largest fund with 795,000 members, seeing a 9.4pc drop in value to $147bn in the three months to the end of September.

The situation adds further woes to Americans already struggling with price inflation and reduced incomes as a result of the continued economic downturn across the nation.

CalPERS' results should cause politicians around the world to quiver. As world leaders meet next month to discuss how they are going to deal with the financial crisis, there is another more insidious crisis going on - THE PENSION CRISIS!

And CalPERS is not alone. If the stock market does not rebound soon and the recession stretches into next year, as many analysts predict, state leaders may be faced with difficult choices to shore up pension funds that have lost billions of dollars in value since January:

Among immediate options: postponing retirees' cost-of-living increases [Ontario Teachers will cut inflation protection by 50% in 2010]. Other, long-term choices include cutting benefits, increasing employee payroll contributions or relying on more taxpayer dollars to make up for the losses.

"Those are all definitely things to be considered," said Terry Slattery, president of the National Association of State Retirement Administrators and executive director of the Public Employees Retirement Association of New Mexico.

Any policy choices would be agonizing not only for retirees but all state taxpayers. Employees contribute to state pension funds as do government agencies through tax dollars. About 20 million current state and local government employees and 7 million retirees, ranging from teachers to police officers to office workers, are promised pensions, according to a recent GAO report. Benefit checks total about $150 billion a year.

Paying retired public employees already is one of states' growing costs, so the market falloff could not come at a worse time. Thousands of aging baby boomers are claiming retirement benefits, and many states are issuing pension checks for longer periods because people are living longer.

On top of this, many states are struggling to finance Medicaid, education, transportation and other programs while their tax revenue is shrinking.


Hardly a day goes by without a state announcing a double-digit loss in the value of its pension fund. The latest was Virginia, which reported Oct. 16 that its state worker pension fund declined 20 percent in value since July, or about $11 billion.

North Carolina's $66 billion public pension fund dropped 12 percent in value over the last year. Tennessee's $30 billion fund declined 10.7 percent since July 1, or more than $5 billion. Just since Sept. 29, New Mexico's $9.7 billion public employee pension fund fell 10.2 percent and its $7 billion teacher retirement fund by 12.5 percent. Pension officials also reported losses in Connecticut (11 percent) and Massachusetts (15 percent). Even Maine's $9.6 billion pension fund, which analysts regard as having one of most conservative investment mixes in the country, has lost 14.5 percent in value since January.

State pension officials had been nervously watching their portfolios decline all year. Then the credit crunch hit in September, causing battered stocks to plunge further despite the federal rescue plan. "It's painful. It's hard to watch," said Slattery of New Mexico.

Pension funds that had investments tied to Lehman Brothers Holdings Inc., which filed for bankruptcy, and insurance giant AIG International Group Inc., which received a federal bailout, lost tens of millions of dollars in value, although only a fraction of their overall holdings.

Florida's pension system, for example, lost nearly $350 million in September in securities of Lehman, AIG and two troubled financial institutions, Washington Mutual and Wachovia Corp. That sounds like a lot of money, but state officials said it was less than two-tenths of 1 percent of the fund's total holdings.

Pension fund managers have been assuring retirees and employees over the last month that the funds are safe and their assets ample to pay benefits for several years. They say the funds are more diversified than most Americans' tax-deferred retirement plans, and are designed to withstand the variations of the stock market. History bears this out; pension funds survived the 1987 market crash and most recently the 2001 terrorist attacks.

"Markets go up and down," said Carroll South, executive director of the Montana Board of Investments, whose teacher and public employee pension funds lost about 5 percent in value since July 1, compared to two years ago when they posted double-digit gains. "You have to take the good along with the bad."

South's counterpart in neighboring Wyoming, state treasurer Joe Meyer, was more succinct. Asked by state lawmakers Oct. 9 whether they should be worried about the state's pension fund loss of about $275 million this year, or about 3 percent, Meyer's confident advice was, "Go fishing."

Still, state pension fund managers and other analysts say they are worried that a recession, which many economists say could last as long as two years, could dig a deeper hole for many pension plans that already are underfunded. A study released in December by the Pew Center on the States (of which Stateline.org is a part) said the 50 states have promised to pay $2.7 trillion in pension and health benefits over the next 30 years. But states have only set aside about $2 trillion, the report said.

Pension specialists say that the funding ratio, or the assets of the fund divided by its benefit liabilities, should be at least 80 percent.

New research by Sujit CanagaRetna, a senior fiscal analyst at the Council of State Governments, shows that 30 state pension plans met the 80 percent benchmark at the end of 2007, the most recent year data were available. Five states - Oregon, North Carolina, Florida, Delaware and New York - were 100 percent or more. The bottom five states were Illinois, Oklahoma, Connecticut, Rhode Island and West Virginia [go to the link to see table].


The fear now is that with the recent plunge in the value of state pension funds, many states will fall below the 80 percent benchmark. The lower the funding ratio, the more it is likely a state would have to make up the difference by reducing benefits, increasing contributions or raising taxes.

"The losses in their pension and other asset funds along with the freezing up of the credit markets has only made the financial position of states even more dire," said CanagaRetna.

Girard Miller, a benefits and investment analyst , said in a recent column for Governing magazine and in an interview with Stateline.org that he believes the average public pension plan's funding ratio could fall as low as 65 percent next year, boosting states' unfunded pension liabilities. That assumes an average decline in a fund's investment value of as much as 25 percent, he said.

Most pension fund actuaries-outside analysts who calculate risk-had assumed that the investment value of most state funds would rise by 8 percent. If a state's return is below projections, the actuaries could ask them to budget more money.

Miller said pension fund managers soon could be telling state policymakers, "Unless something dramatic happens in the markets, we're not going to be able to afford what we thought we would."

The market downswing has drawn attention to the change in investment strategy that has evolved in states. Twenty years ago, most state pension funds invested in safe, government securities such as bonds or U.S. Treasury bills.

To produce higher yields in their underfunded plans, states gradually have been putting their money into somewhat riskier nongovernmental securities such as stocks, corporate bonds and foreign investments. Some states also have invested in hedge funds, and venture capital funds, or seed money to start a business.


Federal Reserve Board data show that about 70 percent of state and local pension investments are in equities, compared to 62 percent in 2000 and 38 percent in 1990.

By diversifying their investments, analysts said, states can survive hits such as the bankruptcy of Lehman and collapse of AIG. Pension analysts say that over time, stocks are still the best-performing investment. Fund managers contacted by Stateline.org said they have no immediate plans to make radical changes in their investment mix despite the financial crisis.

South of Montana said he has been put on the defensive recently to explain why the state invests in stocks. "It would be riskier not to invest in stocks," he says he answers.

Riskier not to invest in stocks? Take the good along with the bad? Go fishing? Really? Ask Japanese pension fund managers what was the number one asset class during the lost decade of deflation (hint: its starts with a "B" not an "S").

Sometimes I feel like I am the only guy fighting a lonely battle trying to tell people to wake up and smell the coffee. Millions of workers are totally oblivious to the shenanigans that are going to end up costing them and taxpayers billions of dollars.

Mark my words: all pension funds will get slammed this year and for many years to come. Some a lot worse than others, but pension bombs are exploding everywhere and there is no end in sight.

If you think the $700 billion bailout was the end of it, you're dreaming. Just today, Rep. George Miller, D-Calif., said that the government agency that guarantees pension plans for millions of Americans lost at least $3 billion in the past year after investing in mortgage-backed securities:

The government-run Pension Benefit Guaranty Corp. lost at least $3.1 billion in the first 11 months of fiscal year 2008, according to preliminary unaudited figures obtained by the House Education and Labor Committee, of which Miller is chairman.

"This dramatic loss represents a swing of more than $6 billion from the previous year," Miller said during a hearing in San Francisco. "It's likely that the agency's losses will be substantially worse once numbers from September are reported."

This pension scandal has been years in the making. The herd mentality took over as pension trustees bought the crap pension consultants were feeding them, "diversifying" away from low yielding government bonds into equities, including private equity, commodities, hedge funds, real estate and even CDOs and CDS.

Having met many of the pension officials from U.S. and Canadian public pension funds, I can tell you that most of them have no clue of the inherent risks of hedge funds and even private equity funds. I saw how many of these "senior" pension managers heavily relied on pension consultants who were peddling bad advice to serve their own funds.

It is the biggest scandal of our era. Most of these "top"pension consultants were investing with the funds they were recommending. They were all full of conflicts of interest (they were full of something else too).

Other pension funds just followed the herd and did what Ontario Teachers did or what Harvard and Yale did, fearing "peer group" risk. But they too are going to pay a heavy price for their mindless stupidities. There is a reason why the hedge fund guys call it "dumb money".

If I were a stakeholder or a union representing workers, I would be grilling pension fund managers, the same way I used to grill arrogant hedge fund managers who thought they could pull fast ones on me.

First, I would demand to know if the benchmarks governing each and every investment activity of internal and external managers accurately reflect the risks of the underlying investments.

Stakeholders should force their pension funds to write a public document on how the benchmarks governing each and every investment activity accurately reflect the risks and beta of underlying investments.

As I have stated many times, financial audits are simply not enough. You need to perform rigorous semi-annual performance audits of each and every investment activity right down to the internal guys managing the cash (remember ABCP here in Canada? That saga is far from over!!!).

Importantly, when it comes to hedge funds, private equity, private real estate funds, commodity funds, infrastructure or whatever, make sure you get the benchmarks right or else you risk paying your pension fund managers for taking undue risks and/or delivering beta (market) returns.

Second, ask your pension managers how their results stack up to a portfolio made up of 50% bonds, 50% stocks. I am willing to bet you that all the big "sophisticated" pension funds are under-performing this benchmark.

When it comes to pension governance, remember the three Ts: transparency, transparency, TRANSPARENCY!!!!!

Finally, Dutch pension fund ABP, one of the largest pension funds worldwide, released a press release stating it's been hit by the credit crisis and it reported a shortage in reserves:

Its smaller peer Pensioen Fonds Zorg en Welzijn (PFZW) told Dow Jones Newswires it has also reached a reserve shortage, due to further losses on its investments in the past weeks.

ABP's cover ratio, the ratio between its funds and its financial obligations, has dropped below the requirement of around 125% set by the Dutch central bank, or DNB, due to a negative return on investments in the first nine months of 2008. During this period APB lost euro 22 billion on its investments.

ABP's cover ratio has dropped to 118% at the end of the third quarter, from 132% at the end of the second quarter. ABP is now legally required to write a recovery plan to show it will bring its ratio back to the required level.

ABP provides pensions for Dutch workers in the government and educational sectors. It is one of the top three global pension funds, together with the Government Pension Fund of Norway and the Government Pension Investment Fund of Japan.

ABP said the cover ratio has further deteriorated following the end of the third quarter, but didn't provide the current ratio.

However, ABP did say its cover ratio is still above the minimum cover ratio of 105%, below which a pension fund can no longer meet its obligations to pensioners.

Although PFZW's cover ratio of 126% at the end of the third quarter was still above the required level set by the central bank, the ratio dropped in October due to losses on its investments.

The PFZW spokesperson declined to comment on the current ratio but said it was above the critical 105%-level.

Both pension funds have been strongly hit by the crisis on the stock markets. During the first nine months of the year ABP lost 24.1% on its equity portfolio, PFZW lost 18.2%.

They also reported negative returns on their investments in real estate. ABP reported a negative return of 7.2% on this investment category, PFZW lost 3.4%. [read my last comment on commercial real estate]

Overall ABP and PFZW lost 9.8% and 8.1% respectively on their total investments.

The total value of ABP's assets dropped to euro 195 billion at the end of the third quarter. At the end of 2007 ABP still held euro 217 billion.

In the third quarter alone it lost euro 10 billion. PFZW saw its assets drop to euro 81.9 billion.

ABP Chairman Elco Brinkman said the ABP pension fund was hit by the credit crisis, but the payment of pensions wouldn't be affected.

"Financial markets worldwide have been hit by a strong storm. Of course ABP feels this," Brinkman said, adding, "We will continue to pay out pensions in a normal way."

ABP said it will present a recovery plan to DNB before the end of 2008.

I am not as worried about ABP as I am of U.S. state pension plans. A minimum coverage ratio of 105% is pretty solid, if they can maintain it in these treacherous markets. Moreover, unlike their North American counterparts, they are now legally required to write a recovery plan to show how they will bring the coverage ratio back to the required level.

In a few months, we will find out the performance of the large Canadian pension funds. I can guarantee you they will not fare any better as most are hemorrhaging after this year. The financial crisis wreaked havoc on all asset classes, including alternative investments like hedge funds, private equity funds and private real estate funds. It's going to be an extremely ugly year.

Let me end by stating that I sincerely hope politicians and government regulators worldwide are paying attention to the global pension crisis.

Forget the "credit tsunami", watch this "pension tsunami" wreak havoc around the world over the next decade and possibly decades.

***Update on MOSERS

Missouri’s state employees’ pension assets have taken a big hit this year as the stock market has tanked:

But Gary Findlay, executive director of the Missouri State Employees’ Retirement System (MOSERS), remains largely unperturbed. He credits a diversified asset base, a smart allocation strategy and a strong long-term record for allowing the fund to avoid some of the damage while positioning the system for good long-term returns.

“We have exposure to asset classes that are not all that common,” Findlay said. “And we’re very nimble because we’re not that large.”

As of June 30, the fund had 6.5 percent of its investments in timber, another 6.2 percent in real estate, 3.1 percent in commodities and 8.8 percent in debt and equity investments not traded on public markets.

But the fund, whose assets totaled about $8 billion at the end of June, couldn’t dodge the tumult in this year’s financial markets. From Jan. 1 through Oct. 17, the value of the fund’s assets dropped between $1.6 billion and $1.7 billion, or 19.6 percent, Findlay said.

However, passive investing in the same asset classes as the fund holds would have produced a loss of 26 percent, he said. And the All-Country World Index, which the fund uses as a benchmark, dropped 40.7 percent in the same period.

“We strive to be, on a relative bases, in the mainstream during up markets, ” Findlay said. “For the year ended June 2007, for example, we were up 18.7 percent, which was slightly better than the median. But our goal is to be defensive enough so that we do substantially better in down markets. Being down 19 percent is not pretty, but it’s better than down 26 or down 40 percent.”

The fund, which covers 54,500 state workers and 30,132 retirees, also follows a strategy that allows it to take advantage of tough times in the market.

The fund divides its assets among three board categories: roughly 45 percent in stocks, 30 percent in bonds and 25 percent in alternative investments. As the different asset classes move up or down in value, managers occasionally buy and sell assets to keep the total fund close to the target allocation.

That forces managers to buy asset classes that have dropped in value and sell assets that have risen or at least have held up better. Findlay said.

“By buying assets that have depreciated and selling those that have not, we are buying low and selling high,” Findlay said.

The result is a solid long-term performance record. As of June 30, the fund had an annual return of 12.1 percent over the last five years, about 40 percent higher than needed to meet the fund’s objective of earning 5 percentage points above the inflation rate.

While the most recent year’s return was a modest 1.6 percent, Missouri was one of only two states’ employee pension funds that produced a positive return that year, Findlay said. The other was Pennsylvania.

MOSERS is one of the best pension funds in North America and their CIO, Rick Dahl, is one of the best CIOs in the pension industry. I have tremendous respect for Rick and his team.

What impresses me from MOSERS is that they are transparent, they educate their board members and their stakeholders, they got the benchmarks right, including on alternative investments, and they are small enough to be nimble and pick their spots when opportunities arise.

But even they can't escape the carnage in equity markets and the deflation that has spread across all asset classes.

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