Tuesday, April 7, 2009

Checkmate for Pensions?

The FT reports that investment losses hit public sector pensions:

The crisis facing pension plans for US state and municipal employees is deepening as investment losses deplete the resources of retirement funds for teachers, police officers, firefighters and other local government workers.

The largest state and municipal pension plans lost 9 per cent of their value in the first two months of this year, according to data from Northern Trust. That followed a loss of 26 per cent in 2008. Smaller funds, which underperform the larger ones, lost more, experts say.

The pension funds, which number 2,600 in total, hold more than $2,000bn after losses last year of close to $1,000bn.

The losses have left retirement plans about 50 per cent funded – that is, they have only half the money needed to cover commitments to 22m current and former workers, experts say. State governments typically put the funding figures closer to 60-70 per cent, although most experts use different calculations.

“There is a massive national underfunding problem,” said Orin Kramer, chairman of the New Jersey pension fund. ”

Unlike company pension plans, state and municipal retirement funds have no federal guarantee fund. This has led to predictions of benefit cuts and possible federal intervention.

“The federal government will get involved, without question,” said Phillip Silitschanu, analyst at Aite Group, a consultancy. “They could provide federal loans, or demand cutbacks as a condition of stimulus money, or there could be a federalisation of some of these pensions.”

Without investment income, funds are liquidating assets at huge losses to pay pensions.

Police pensions are in especially poor shape, in part because states have promised earlier retirement on full pensions, but seldom increased contributions.

In late January, Terry Savage wrote that the pension tsunami is about to hit:

One day soon you may have to decide whose retirement comes first: yours or the fireman’s? Or the policeman’s? Or your child’s schoolteacher’s?

Your city and state have made generous pension promises to all those public servants—funded with your tax dollars. Only suddenly it turns out that those pensions aren’t very well-funded, after all!

While you’ve been worried about your shrinking 40l(k), our public servants have been smiling. They know their defined-benefits pensions are guaranteed by your local taxing body.

And while barely 20% of private-sector employees are eligible for defined-benefit pension plans, fully 90% of state and local workers get that coverage, according to the Federal Reserve Bank of Minneapolis.

But now, because of a combination of too-high estimates on investment returns, too-low annual contributions, and the current stock market losses, those pension funds are woefully underfunded!

Many funds’ 2008 market losses won’t be revealed for months. But the Center for Retirement Research at Boston College estimates that state pension plans have losses greater than $865 billion, a decline of nearly 40% in just the past year.

The National Bureau of Economic Research says the value of pension promises already made by US state governments will grow to approximately $7.9 trillion in just 15 years.

But the same report points out that states are unlikely to be able to keep those promises: “We conservatively predict a 50% chance of aggregate underfunding greater than $750 billion and a 25% chance of at least $1.75 trillion in underfunding.”

Put in current dollars, to bring those pension funds up to appropriate levels would cost almost $2 trillion. And while the Federal government can just “print” the money, the cities and states have no such option. That means we, the taxpayers, are facing hefty local tax hikes to pay for required pension plan contributions. Or we’ll face other cuts in state and municipal spending, for safety or education or Medicaid.

The Web site http://www.pensiontsunami.com/ has been tracking these issues as they arise around the country. California is the epicenter of the crisis for now—but this is certainly a national issue.

Could the cities and states simply default on their obligations when the time comes? At a recent Federal Reserve conference, attorney James Spiotto of Chapman and Cutler in Chicago noted: “There are varying levels of protection, ranging from strict constitutional rights to general statutory provisions, that might allow for some renegotiation of benefit levels in light of adverse conditions.” In other words, if the cities and states try to cut back on promised benefits, they will face a huge court battle.

Spiotto notes that since 1937, more than 564 cities have filed for Chapter 9 bankruptcy reorganization, which allows a city to renegotiate its union contracts and potentially abrogate previous pension deals. And while the federal Pension Benefit Guarantee Corporation protects at least some amount of private pension (up to $51,750 in 2008), there is no similar agency to protect public pensions.

As pension-fund losses are disclosed and the extent of the underfunding is revealed, unrest will mount. Do you think those firemen, and policemen, and teachers are going to keep working—knowing that there is a question about their pension at the end of the line? And as a taxpayer, are you willing to make up the difference?

Unfortunately, these are the issues I have been writing about for months. We have reached a dangerous level of underfunding in pension plans across the world and politicians have not addressed this issue. In fact, the pension crisis was totally ignored at the G20 last week.

And let there be no doubt, the scale of this problem is global. In Japan, the $1.5 trillion state pension fund is likely to cut back its purchases of domestic stocks and foreign bonds this year, removing a key source of support for the Nikkei but providing some relief for the sliding yen:

With a major portfolio rebalancing out of the way, the Government Pension Investment Fund — the world’s largest pension fund—is expected to buy fewer assets within Japan and abroad, and may even need to sell assets as pension payments rise.

One of the biggest risks is for the Japanese government bond market, which is about to see a big increase in bond issues to pay for fiscal spending, just as the pension fund’s buying is expected to fade.

The pension fund was seen as one of the main drivers behind recent capital outflows from Japan that surprised the currency market with their size and persistence, analysts and traders said.

The rebalancing of the fund’s portfolio between October and March was cited as an important market factor, helping the Nikkei 225-share index hold above a 26-year low hit in October and playing a role in the yen’s broad slide to six-month lows against the dollar.

‘‘It was huge that there was buying by public funds,’’ said Toru Tanaka, senior manager for Mitsubishi’s treasury and foreign exchange office in Tokyo.

‘‘That did a lot to set the stage for the yen’s fall to 99 to the dollar,’’ he said. ‘‘If you can no longer hope for that to appear, it will be a positive factor for the yen.’’ Such buying was aimed at rebalancing the portfolio to keep the pension fund’s asset holdings in line with its preset target ranges, analysts said. After global stock markets slumped, it needed to buy domestic and overseas equities as its relative exposure to those asset classes shrank.

The pension fund may have to dish out more money than it receives this year as more of Japan’s baby boomers retire and begin receiving pensions, potentially leading the fund sell assets to raise cash.

The fund had earmarked ¥9.5 trillion, or about $95 billion, for financial market investment in the business year that ended in March. But starting this month, it will no longer have as much funding as loan payments from public entities dry up.

The fund ‘‘is not expected to sell or buy actively in stocks and foreign securities during the new business year,’’ said Takahiro Tsuchiya, a strategist at Daiwa Institute of Research.

The giant pension fund is estimated to have bought ¥2.2 trillion to ¥3.3 trillion in overseas equities between October and March.

In Switzerland, the global financial crisis has left almost six out of ten pension funds in Switzerland undercapitalised, the Federal Social Insurance Office said on Monday:

Close to 57 per cent of funds were unable to meet their obligations at the end of March, authorities said. Of those, two-thirds were capitalised between 90 and 100 per cent. The rest were capitalised below 90 per cent.

Some 43 per cent of a total of 1,900 funds nationwide were in sound financial shape. By the end of last year, the figure stood at 50 per cent.

Funds that are running a deficit have until the end of June to submit corrective action to the industry's supervisory authority. Under Swiss law, any gap must be absorbed within a maximum of ten years.

Funds may pay out lower interest rates or could ask for contributions from policyholders and employers to rectify their shortfalls. Under federal regulations, they are not permitted to wait for the economy to stabilise to shore up their portfolios.

In the U.K., the aggregate deficit of the FTSE 100 pension schemes has almost doubled from 124 billion pounds ($185 billion) to 245 billion pounds in the year to the end of March on an "economic" basis, consultant Redington Partners said on Monday:

The economic basis calculates the deficit by measuring pension liabilities against the interest rate swaps curve as opposed to against AA-rated corporate bonds, the measure widely used by corporate sponsors to calculate pension deficits.

"Pension liabilities have risen very sharply, entire asset classes are in free fall and all at exactly the point of the most extreme weakening of the collective corporate covenant in history," Dawid Konotey-Ahulu, partner at Redington, said.

"There have been many references in the past to a 'perfect storm' but this time it's the real thing."

On an IAS19 valuation basis whereby liabilities are calculated using yields on AA rated corporate bonds, FTSE 100 aggregated funds have dropped to a deficit of 51 billion pounds from a surplus of 21 billion pounds during the year to end of March.

Redington said the environment for pension funds is looking increasingly risky due to the onset of weakening corporate sponsor covenants.

The FTSE 100 market capitalisation has fallen to 989 billion pounds from 1.38 trillion in the past year meaning the aggregate deficit of the FTSE 100 pension schemes has increased to 25 percent of market capitalisation from 9 percent.
In response to the pension crisis, the FT reports that the Pension Protection Fund is seeking changes to pension payments:

Employers will have to pay more into the Pension Protection Fund during good economic times to offset lower payments in a recession, under changes to the scheme set to be looked at by the body that provides the official safety net for pension schemes.

Alan Rubenstein, new chief executive of the PPF, said "counter-cyclical" insurance premiums could provide a break for businesses, adding that the fund was sympathetic to complaints from employers about the rising costs of pensions.

"There is a thought that we should be much more countercyclical than we are now," he said in his first interview since becoming chief executive last week. "If so, we would hold the levy - even in nominal terms - but raise it by more than the rate of inflation in future years."

Mr Rubenstein said the subject was under discussion within the PPF and would have to be formally considered and approved by the full board.

If the board decided to adopt the proposal, he said, it would mean increasing premiums by more than inflation when times were flush but holding them in check when they were hard.

So far, the PPF has said it aims to hold the levy steady in real terms - rising only in line with wage inflation - until 2010-11. The fund raised £675m from employers last year and has said it would raise that to £700m this year, reflecting a 3.6 per cent rise in average wages. Holding that level into next year would mean a cut in employers' costs in real terms.

The PPF was created to protect pension promises made by employers that later become insolvent, leaving behind an underfunded scheme. Currently, it has agreed to protect pension benefits for 31,191 people and is paying out benefits of about £4m a month.

However, the severe recession has raised concerns from some quarters that the PPF's solvency itself is under threat. Last week, it assumed responsibility for its 100th scheme and there are another 290 schemes of insolvent employers being considered for admission.

Mr Rubenstein dismissed suggestions that the PPF was close to collapse as "nonsense".

Because it is not a commercial insurer that can raise premiums when claims rise, the PPF is equally not bound by the requirement to have assets on hand at all times that are in excess of the sums it must pay out.

Although the PPF is carrying a deficit of about £500m, Mr -Rubenstein scoffs at the idea that the spate of companies failing could sink the fund, saying: "I don't believe another big claim tips us from solvency to insolvency."

Moreover, the PPF's liquidity is bolstered every time it guarantees the benefits of a scheme because the investments of the entrant are immediately added to its own.

I am not going to debate the solvency of the Pension Protection Fund, but I believe when the full fury of the pension tsunami hits, its solvency will be severely tested. And as I have written in this blog, the solvency of the U.S. Pension Benefit Guarantee Corporation will also be severely tested as corporate insolvencies skyrocket.

The weakest pension funds are the smaller ones because they are heavily exposed to stocks and typically lack the resources to navigate through this financial crisis. But the larger pension funds are not faring that much better.

And are you ready for the kicker? Reuters reports that at least a dozen U.S. public pension funds, including the nation's biggest, are mulling whether to put money behind the federal government's plans to rid banks' balance sheets of toxic assets:

The U.S. government hopes that if banks dispose of troubled assets, they will be better positioned to increase lending.

For their part, investors may scoop up the assets on the cheap with government-backed low-interest loans.

"People are exploring options which could potentially allow them to move forward," the chairman of one public pension fund looking at investing in the assets said on Monday.

"There is enough interest in the concept that people are going to try to work on options on how to potentially pursue it," said the fund official, who requested anonymity.

The official was one from a dozen public pension funds, including representatives of funds from California, New York and New Jersey, who with some state treasurers, including Bill Lockyer of California, discussed the U.S. government's plans on Friday by telephone with Sheila Bair, chairman of the Federal Deposit Insurance Corp.

The FDIC, which insures bank deposits and manages banks in receivership, and the U.S. Treasury are launching the Public-Private Investment Program to help sell distressed bank assets and are urging investors to join in.

The program will use government funds and private capital to buy up to $1 trillion (683 billion pounds) in distressed loans and securities. Investors would receive low-cost financing from the U.S. government to buy the "legacy" assets at auctions.

The U.S. government also plans to match private investment with its funds and to share in expenses and gains of the pools of distressed assets.

The FDIC is handling auctions to sell banks' whole loans and the Treasury and Federal Reserve will oversee programs to handle banks' mortgage-related securities.

The Treasury on Monday eased terms for fund managers to apply to its toxic securities investment program and said it will consider widening the number of companies it allows to run public-private investment funds under the program.

FDIC spokesman David Barr said Friday's conference call was one of Bair's first steps to brief investors on the programs.

"The FDIC is seeking as much input as possible from various participants during our open comment period in order to fully inform our rulemaking process and ensure the greatest opportunity for success of the program," Barr said.

"We expect to hold an open call with the investor community next week and will announce the timing and details shortly," Barr added.

Among the pension funds' with representatives on Friday's call with Bair were the $174 billion California Public Employees' Retirement System, known as Calpers and the nation's biggest public pension fund, and its sister fund, the California State Teachers' Retirement System, or Calstrs.

Calpers spokesman Clark McKinley declined to comment on the call.

Calstrs spokeswoman Sherry Reser said the $114 billion fund already has a program in place to invest in assets of distressed companies with the potential for returns that are better than fixed income. "We're certainly assuming that there are going to be some diamonds amid the bits of coal," she said.

Calstrs, however, is waiting to learn more about the U.S. government's plan for distressed bank assets. "We're seeing how this program is going to gel," Reser said. "We're not making any commitments. It's just way too early in the discussions."

Are you worried? You should be because the IMF warned today that toxic debt at global banks could spiral to $4 trillion:

Toxic debts racked up by banks and insurers could spiral to $4 trillion, new forecasts from the International Monetary Fund are set to suggest, British daily The Times reported on its website without citing sources.

The IMF said in January that it expected the deterioration in U.S.-originated assets to reach $2.2 trillion by the end of next year.

But it is understood to be looking at raising that to $3.1 trillion in its next assessment of the global economy, due to be published on April 21, the newspaper reported.

In addition, it is likely to boost that total by $900 billion for toxic assets originated in Europe and Asia, the Times said.

That should give these giant pension funds some pause for concern. Once they start opening up this can of worms, they are going to be on the hook for a lot more than they bargained for.

Finally, please take the time to read Dean Baker's excellent comment, A Trillion Dollars for Banks: How About a Second Opinion?:

Treasury Secretary Timothy Geithner wants to have the government lend up to a trillion dollars to hedge funds, private equity, funds and the banks themselves to clear their books of toxic assets. The plan implies a substantial subsidy to the banks. It is likely to result in the disposal of these assets at far above market value, with the government picking up the losses.

As much as we all want to help out the Wall Street bankers in their hour of need, taxpayers may reasonably ask whether this is the best use of our money. After all, the $1 trillion that is being set aside for this latest TARP variation is equal to 300 million SCHIP kid years. Congress has had heated debates over sums that were a small fraction of this size. To give another useful measuring stick, the Geithner plan could fund 1 million of the Woodstock museums that were the main prop of Senator McCain's presidential campaign.

The core problem is that many of our big banks are bankrupt. If they had to acknowledge the losses that they have incurred on their housing related loans (and increasing their loans in commercial real estate) Citigroup, Bank of America, and many other large banks would be insolvent. Thus far, they have avoided reality by keeping these loans on their books at inflated prices.

The Geithner plan is an effort to rescue the banks by using government funding to prop up the price of these bad loans to levels that will allow the banks to stay solvent. It is not clear that the plan is big enough to accomplish this goal, but that is the basic intention. If it doesn't work, then presumably Geithner will come out with another TARP permutation that involves giving the banks even more money.

There is an alternative. Rather than using government money to keep them alive, we could force the banks to go through a type of managed bankruptcy process like the one that is currently being proposed for General Motors and Chrysler.

Geithner has supposedly ruled out the bankruptcy option because when he, along with Henry Paulson and Ben Bernanke, tried letting Lehman Brothers go under last fall, it didn't turn out very well. Of course, it is not necessary to go the route of an uncontrolled bankruptcy that Geithner and Co. pursued with Lehman.

The government could set up an arranged bankruptcy under which creditors have accepted conditions in advance. While this may not be easy to negotiate, the government does have enormous bargaining power in pursuing such a deal. The creditors (other than insured deposits, which will be paid in full) of these banks may end up with nothing if the government just let the banks sink.

The prospect of even an arranged bankruptcy of a major bank will undoubtedly shake up markets, but many safeguards have been put in place since the Lehman collapse. If the stock market goes down for a few weeks or months, who cares? Running the economy to serve the stock market is a sure recipe for disaster; if President Obama fixes the economy, the stock market will do just fine in the long run.

Anyhow, the Geithner crew insists that there are no alternatives to his plan; we have to just keep giving hundreds of billions of dollars to the banks. Perhaps Geithner is right. But before we throw such huge sums away, further enriching the bankers who wrecked the economy, maybe we should get a second opinion.

Suppose that Congress appropriated a modest chunk of money to have independent economists put together teams to construct alternative plans. Why not give M.I.T. professor Simon Johnson, a former chief economist of the IMF, $5 million to hire a crew to outline his preferred path? Congress could give Joe Stiglitz, a Nobel Prize winner and one-time chief economist to President Clinton, who is also a harsh critic of the Geithner plan, a similar sum to put together his own team.

These economists could develop their best plans and put them out for public consumption. Geithner's crew can then tell us why their plans are unworkable and we must instead hand over the money to banks.

Given how much money Geithner wants to spend - putting it in the hands of the folks that brought on this economic crisis - it would seem appropriate to first examine all the alternatives. After all, we could find out what our options are in this case for the price of just a few A.I.G. executive bonuses. That has to be a good deal in anyone's book.

Before pension funds throw billions of dollars behind the Geithner plan, we need a second opinion.

The pension tsunami has arrived and these dangerous policies will only exacerbate the pension crisis, enriching the financial oligarchs while the masses watch their retirement dreams turn into retirement nightmares.

If you ask me, it's checkmate for pensions.

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