Monday, August 6, 2012

US Public Plans Gain a Paltry 1.15% in FY 2012

Martin Z. Braun of Bloomberg reports, U.S. Public Pensions Earn 1.15% for Worst Showing Since 2009:

U.S. state and local-government pensions ended the 2012 fiscal year with a median gain of 1.15 percent as the European debt crisis and a slowing global economy damped stock returns, Wilshire Associates said.

It was a reversal after two years of gains for the retirement funds, which have $2.8 trillion in assets, according to the U.S. Census Bureau. The performance, included in a report Wilshire is set to release today, may add to political pressure on public workers to accept benefit cuts and increase contributions to the plans.

In the last three weeks, the California Public Employees’ Retirement System, the biggest U.S. pension, reported returns of 1 percent for the fiscal year ended June 30. New York City’s $122 billion pension funds reported preliminary returns of 1.7 percent, and Maryland’s $37.1 billion plan earned 0.36 percent.

“The grave concern with Maryland is it assumes a very rosy and very optimistic return rate of 7.75 percent,” said Christopher Summers, president of the Maryland Public Policy Institute, which promotes policies based on free enterprise and limited government. “You have the 11th or 12th year in a row where the actual liabilities of the pension system are larger than its assets.”

State and local government pensions count on returns of 7 percent to 8.5 percent to pay retirement benefits for teachers, police officers and other civil employees. To make up for losses suffered during the 2008 financial crisis and the recession, municipal officials had to contribute more to the funds, straining budgets and leaving less money available for services.

Funding Gaps

Estimates of public-pension funding deficits vary from $757 billion to $4.6 trillion, depending on assumptions. To help close the gap, 29 states made changes to their pensions in the calendar year 2011, such as increasing employee contributions, raising the retirement age and revising automatic cost-of-living adjustments, according to the National Conference of State Legislatures.

Rhode Island enacted the most sweeping change, closing the defined-benefit pension that covers state employees, teachers and many municipal employees. Current members will be transferred to a hybrid plan that consists of a reduced defined- benefit plan and a 401(k)-type account.

The median annualized return for public pensions in the past 10 years was 6.32 percent, Wilshire said. Public funds returned 21.4 percent in fiscal 2011 and 12.6 percent in 2010, according to Santa Monica, California-based Wilshire. The median public pension lost 17.4 percent in 2009.

Stock Drag

Bigger allocations to U.S. and international stocks dragged down performance compared with corporate pension funds, which invest more in bonds, said Robert Waid, a managing director at Wilshire.

Corporate pension plans had a median return for the year ending June 30 of 3.68 percent, the best among institutional funds, according to Wilshire. Foundations and endowments had the worst returns, at 0.37 percent.

“In general, allocation to bonds helped all plans,” Waid said. “It was a classic story of equity versus bond exposure.”

The MSCI EAFE Index (MXEA), which measures stock performance in developed markets outside the U.S. and Canada, lost 13.8 percent for the year ending June 30. The Standard & Poor’s 500 Index (SPX) gained 5.4 percent for the period.

The report, compiled by the company’s Wilshire Trust Universe Comparison Service, covers about 900 institutional investment trusts, including foundations and endowments, union retirement funds, corporate plans and public pensions.

The median public pension had 54.9 percent of its holdings in stocks, 26.3 percent in bonds, 3.98 percent in real estate and 3.12 percent in alternative investments such as leveraged- buyout or distressed-bond funds. About 2.73 percent was held in cash.

The weak performance of US public plans shouldn't surprise anyone, especially after CalPERS and CalSTRS reported paltry returns.

The major culprit explaining these results is that unlike corporate plans that are de-risking and investing more in bonds, US public plans are heavily exposed to public equities. The larger the exposure to stocks (like foundations and endowments), the weaker the performance.

However, if I'm right and stocks soar to new highs, this underperformance will reverse, favoring funds that are more exposed to risk assets. We shall see what lies ahead but one thing is for sure, whether or not stocks and other risk assets surge, Tom Stabile is right, US pension funds need to rethink their targets:

New York mayor Michael Bloomberg’s recent crusade to ban the sale of “supersize” sugary drinks in cups larger than 16 ounces may seem a threat to civil libertarians, soda addicts, and dentists’ profits alike, but it is not his only swipe this year at glut. He also has barked at the city’s pensions to scale back what he deems a portly 8 per cent target rate of return.

Mr Bloomberg – who described the number as “absolutely hysterical” and “laughable”, according to the New York Times – has company among those who question the 7 to 8 per cent target rates most US public pensions hold despite today’s weak investment returns.

The limp results posted by many US pension schemes as their fiscal years closed on June 30 only adds to a sense these targets are off kilter. For instance, the California Public Employees’ Retirement System’s 7.5 per cent assumed target rate was a far cry from both the prior year’s 20.7 per cent returns and this past year’s paltry 1 per cent.

Of course, these target rates are not built to serve as a pension’s goal for any single year, but instead as annualised average returns across stretches of three decades or more. Various inputs – including interest rates and inflation, projected payouts, contributions, and benefit policies – help set the targets.

Indeed, while pressure from politicians and labour unions – as well as Sunday’s scant returns and Monday’s bleak outlooks – also factor in, decisions to change rates are seldom knee-jerk reactions. Most pensions do not amend rates more than once in a decade.

That is why a recent wave of target rate resets rolling through US public pension trustee boardrooms stands out. A National Association of State Retirement Administrators report last month found 45 of 126 large US pensions have reduced investment return assumptions since 2008, and industry consultants say many others have discussed changes or tweaked other assumptions, such as projected inflation, which lowers effective return rates.

A common theme in the retuned rates is how the post-financial crash world has crossed a line, exposing structural flaws in public finances and the global economy, thereby damping investment return prospects.

Nevertheless, the trimmed rates seem to use today’s trough to peg market behaviour for the next three decades – a fuzzy premise. It also confuses rates that presumably should serve as passive, long-range views with the twists of the Russell 2000 or Wilshire 5000 stock market indices.

The odd piece in the equation is squeezing current market conditions into longer planning horizons. It makes sense for a long-term rate to consider liabilities, contributions, and broad levers such as inflation, but mid-cap growth performance over the last quarter seems harder to fit.

Indeed, many US public pensions gauge market conditions when shaping near-term views, such as investment sector benchmarks for timeframes of a year or less, but these are usually part of a less formal planning process.

That could be a good point for pensions to adopt two core rates: one looking at big funding inputs and macroeconomic assumptions, establishing what they need to run soundly for decades; and another framed around possible returns, given the current market. Divorcing the two could tie politics and policy fights to long-range rates, without tainting a sober market call on the present.

Pensions might inch further by applying them to different asset buckets. Sums meant to meet far-off future liabilities could track a plan guided by extended-term rates. Meanwhile, cash for closer-in payouts could follow portfolios coloured by present views. A handful of pensions in Minnesota and Vermont already make use of current rules that let them set different short-term versus long-term actuarial rates.

Consultants rightly caution their pension clients to avoid ‘timing markets’, and some argue it is unwise for plan trustees to play investment guru – the job they give to asset managers. New, stricter accounting rules may soon force many pensions to cut long-span assumptions.

Still, pension trustees ought to stick their necks out just a bit – or demand aid from their consultants – to craft reasonable annual return targets. It beats only having long-term rates that may be unfair for outsiders to criticise, but also end up being too easy for trustees to hide behind.

Don't count on US pension trustees to "stick their necks out." As I've argued, most US plans need to nuke their governance model and adopt one that Canadian plans have in place. Consultants can feed pension trustees all sorts of garbage but at the end of the day, they need to be realistic about investment targets, especially in an environment of historically low bond yields and heightened political uncertainty.

Some global pensions are moving to capitalize on market dislocations. Raji Menon and Sinead Cruise of Reuters report that UK universities' pension fund eyes distressed debt spree:

Universities Superannuation Scheme, Britain's second-largest pension fund, may double its allocation to distressed debt at the expense of cash-strapped banks who can no longer afford to hold on to troubled assets.

The 32 billion pound ($50 billion) USS fund has around a quarter of its private equity assets, or 700 million pounds, in distressed debt.

This could rise to up to half of the fund's 3.5 billion pound private equity portfolio, Michael Powell, USS head of alternatives told Reuters.

After resisting fire sales at the crest of the financial crisis, banks weary of regulatory demands and shrinking profits are tiptoeing nearer to sales of capital-intensive loans, bringing cheer to British pension funds hungry for bargains.

"The long-term repo programme in Europe has enabled banks to repo these assets and raise finance on the back of them, instead of selling," Powell said.

"Given the macro environment in Europe and the fact that banks remain overleveraged, there will be distressed assets coming off those banks," he forecast.

Most of Britain's biggest banks have been able to resist substantial asset sales in the wake of the 2008 banking sector slump, in which banks like Lloyds and Royal Bank Scotland were forced to take state bailouts to survive.

But under pressure to repay taxpayers and rebuild capital reserves large enough to keep lending in a recession, banks are being encouraged to act now while there is ample demand to acquire such assets.

"The need for banks to realistically value some of their books has never been greater...there is a real appetite to purchase," said Philip Williamson, chairman of mortgage servicer Acenden and former chief executive of building society Nationwide.

Around 8 percent of the mortgage market is subprime, representing around 30 billion pounds of possible opportunities for investors, Williamson estimates.

"Rating agency downgrades, software glitches and resulting customer difficulties and executive pay have dominated the headlines but they pale into insignificance relative to the challenges banks face in dealing with deteriorating mortgage books," Williamson argues.

"Arrears and defaults continue to engineer increasing provisions...if around 15 billion pounds was offloaded this would go some way to easing their capital requirements."


The loans eyed by USS include a mixture of assets ranging from mortgage backed securities and corporate loans to leveraged buyouts.

"We are building the groundwork to increase the allocation as and when the opportunity arises. We have been looking at some of the non-performing loan portfolios coming out of European banks," he added.

Since the credit crisis, large numbers of corporate and particularly private equity owned companies have seen their debt trade well below face value, reflecting fear of hefty defaults.

Pension funds eager to increase the overall yield of their assets have turned to this segment of the market to buy this cheaply-priced debt, in hopes that companies will recover and repay their debts in full, earning them rich rewards.

Other pension funds weighing up allocations to the sector include the London Pension Fund Authority (LPFA), which runs around 4.2 billion pounds in assets.

Mike Taylor, chief executive of the LPFA, said the pension fund could invest up to 50 million pounds "opportunistically" in distressed debt, by allocating to a specialist fund manager.

USS's Powell said the current cycle was reminiscent of the last global distressed debt shakeout three years ago when the fund held almost half its private equity allocation in distressed debt.

The fund currently has 10 percent of its assets allocated to private equity. Total allocation to alternatives which includes private equity, infrastructure and hedge funds stands at around 17 percent of total assets.

"We could get up to that kind of (2009) allocation but it will probably be a different type of allocation. We do not see senior debt trading down to 50 cents as we did in 2008-2009, but we will probably see more idiosyncratic opportunities in the distressed sector," Powell said.

Powell knows what he's doing and I think doubling down on distressed debt is a very wise decision, one that will pay off handsomely in the future. US pensions funds looking for yield should take note.

Below, Marc Lasry, co-founder of Avenue Capital Group LLC, talks about his investment strategy for Europe's distressed debt, the outlook for U.S. markets and challenges for banks.

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