Tuesday, August 24, 2010

Are Pensions the Next AIG?

Tyler Durden of Zero Hedge posted an excellent comment, Illinois Teachers' Retirement System Enters The Death Spiral: AIG Wannabe's Go-For-Broke Strategy Fails As Pension Fund Begins Liquidations.

I quote the concluding remarks, but it's worth reading the entire comment:
Alas, at this point it is too late: for TRS, and likely for many, many other comparable pension funds, which had hoped that the Fed would by now inflate the economy, and fix their massively incorrect investment exposure, the jig may be up. As liquidations have already commenced, the fund is beyond the point where it can "extend and pretend", and absent the market staging a dramatic rally, government bonds plunging, and risk spreads on CDS collapsing, the fund is likely doomed to a slow at first, then ever faster death.

Then one day, Goldman's risk officers will call the TRS back office, and advise them that due to its "suddenly riskier profile" established in no small part courtesy of Goldman's investment allocation advice, the collateral requirements have gone up by 50%. The next step is either Maiden Lane 4... or not. For the sake of the 355,000 full-time, part-time and substitute public school teachers and administrators working outside the city of Chicago, we hope that the TRS has now been inducted into the hall of the Too Big To Fail, as otherwise roughly $34 billion in (underfunded) pensions are about to disappear.
You can read the Bloomberg article, Illinois Pension May Sell $3 Billion of Assets to Pay Benefits as well as the Chicago Tribune article. According to Barry Burr of Pensions & Investments, the system is the fifth Illinois statewide defined benefit plan to sell off investments this fiscal year to pay benefits:

Illinois State Universities Retirement System, Champaign, expects to sell $1.2 billion in investments from its $12.2 billion defined benefit fund this fiscal year to raise liquidity to pay benefits to participants.

The Illinois State Board of Investment, Chicago, could sell $840 million investments from its $9.9 billion fund to pay benefits of the Illinois State Employees' Retirement System, Illinois Judges' Retirement System and Illinois General Assembly Retirement System. ISBI oversees the investments of the three systems.

The liquidity stress from the investment sales at the five plans could force each of them to restructure their strategic asset allocations, terminate investment managers and search for new managers.

Illinois Teachers sold $290 million in investments so far this month and $200 million last month because of a lack of state contributions.

“Without the monthly state contribution, TRS estimates sales of roughly $3 billion for the entire fiscal year, or approximately $250 million every month,” Mr. Urbanek said in a statement in response to an inquiry.

So far, TRS has accomplished the investment liquidation through “appropriate rebalancing,” Mr. Urbanek said in the statement. “As the year progresses, this approach will no longer be sufficient to cover the total amount of benefit payments and more targeted asset sales will need to be considered.

“TRS staff continues to study the impacts of the current liquidity situation on the total portfolio and recommendations will be made as necessary to adjust targets. These changes could include revisions to the system's target asset allocation and termination of investment manager relationships as 10% or more of the portfolio is liquidated to pay benefits this fiscal year,” he said.

Mr. Urbanek said the investment sales could force changes in the system's current asset allocation impacting whether it could meet its current 8.5% target rate of return.

“In the current market environment, there are significant market opportunities to institutional investors with available capital. In the absence of the required contribution from the state, TRS and the other Illinois pension systems will no longer be able to participate in these opportunities,” he said.

R.V. Kuhns, the system's investment consultant, is evaluating possible allocation changes for liquidity needs as they arise, Mr. Urbanek added. He said it was “impossible” to know details of possible searches or terminations at this time.

Since the start of the fiscal year on July 1 through Aug. 20, the system has received only $90 million in contributions from the state. For the current fiscal year, ending June 30, 2011, the system requested $2.35 billion in contributions from the state, Mr. Urbanek said.

In the last fiscal year, the system sold $1.3 billion in assets to pay pension benefits; it received $170.4 million in employer contributions and $899 million in member contributions, while requesting $2.08 billion in employer contributions alone.

TRS' current asset allocation is U.S. equities, 30.5%; international equities, 20.3%; fixed income, 17.5%; real estate, 9.6%; real return, 9.3%; private equity, 8.3%; absolute return, 3.6%; and short-term investments, 0.9%.

When the financial crisis erupted, it first hit banks, insurance companies, hedge funds, real estate/ private equity funds, asset managers, and then hit pension funds. But pensions remain very vulnerable because as interest rates fall and assets dwindle, their pension deficits explode, and if they need money to cover benefits, well guess what, they're forced to sell liquid stocks to meet those obligations.

And they typically sell stocks at the worst possible time. This is what happened to the Caisse in 2008 when they lost $40 billion and got whacked hard with non-bank asset-backed commercial paper (ABCP), forcing them to shore up liquidity at the worst possible time.

Other funds like PSPIB also got hit with ABCP (to a lesser extent), but they benefited from net inflows, so they weren't forced to sell stocks to meet pension obligations. The same goes for CPPIB, which suffered a 19% loss in FY2009, but kept buying stocks throughout the crisis.

But unlike the Caisse, PSPIB, and CPPIB, the Illinois TRS is not managed anywhere near as well, and they took stupid risks to meet unrealistic investment targets. Moreover, instead of learning from their mistakes, they continued taking excessive risks to try to address their widening pension deficit.

When you're a mature pension plan, you got to manage your liquidity risk very carefully. Go back to read my conversation with Jean Turmel who sits on the board of Ontario Teachers' Pension Plan (OTPP). They manage liquidity risk looking ahead 18 months. The folks over at Illinois TRS should fly over to Toronto and have a serious discussion with OTPP's senior managers.

Finally, today I read that Nortel retirees stand to lose one third of their pension and that Ontario will toughen pension funding requirements for companies and bolster its guarantee fund as it works to fix a pension system hit hard by the financial crisis (better late than never).

While pensions are finally getting the attention they deserve, I'm worried that they're the next AIG (but much, much bigger). The Fed is going to do what it can to bail out pensions, but I have serious doubts that even they are fully aware of the magnitude of the pension Ponzi and how it could easily topple the global financial system (ever tried quantifying total aggregate pension leverage and counterparty risk? Good luck!).

When pensions are forced to liquidate to meet pension obligations, we should all be concerned. Luckily, there are some huge sovereign wealth funds that stand ready to pick up shares from struggling US pension funds, but if this becomes a pattern among US (and global) pension funds, watch out, the pension tsunami will have far reaching effects which will make the whole AIG fiasco look like a walk in the park.

***TRS responds***

Please see TRS's response to "death spiral" comments.

No comments:

Post a Comment