Monday, October 22, 2018

Strip-Mining US Public Pensions?

John W. Schoen of CNBC reports, Public pensions are paying higher fees for lower returns, Pew study finds:
Public pension plans are spending more than $2 billion a year in fees on high-cost, risky investments to boost returns. But those bets haven't been paying off, according a report Wednesday from the Pew Charitable Trusts.

The higher cost comes as public pension fund managers try to make up for a steep shortfall brought by years of underfunding and lackluster investment returns.

As of fiscal 2016, the latest data available, state pension funds tracked by Pew had a combined $1.4 trillion deficit – up $295 billion from 2015 and the 15th annual increase in pension debt since 2000. State public pension plans have assets of just $2.6 trillion to cover total pension liabilities of $4 trillion.

To try to make up that deficit, state pension fund managers have shifted investments away from the traditional mix of stocks and bonds to a greater reliance on alternative investments like hedge and private equity funds. Between 2006 and 2016, the average plan has raised its share of alternative investments from about 11 percent of assets to 26 percent (click on image).


That shift has also raised the cost of managing pension fund assets. In addition to the $2 billion, some funds are paying undisclosed performance fees, according to the Pew study, which makes the total cost impossible to measure. It's also difficult to compare the full cost of managing these investments, Pew noted, because some funds report their returns without factoring in management fees, while other report after subtracting those fees.

Despite paying higher costs, pension plan performance has fallen. Among the funds Pew studied, none met its investment target. The shortfall has left many retirement systems owing more in liabilities than they can afford to pay out, in some cases much more (click on image).


Pension fund systems in New York, South Dakota, Tennessee and Wisconsin had enough to cover at least 90 percent of their liabilities in 2016, while pension funds in Colorado, Connecticut, Illinois, Kentucky and New Jersey were less than 50 percent funded, according to Pew.

Another 17 states had less than two-thirds of the assets needed to pay future retirement benefits. Kentucky and New Jersey had the lowest funded ratios among states at 31 percent and Wisconsin had the highest at 99 percent.

Here's how the 73 funds tracked by the Pew study stack up. Hover over a state for details (click on image).

This article came out almost a month ago but someone in the US asked me to look into the state of state pensions and it has gone from bad to worse.

The only good news is bond rates are rising this year which means liabilities are declining but that can quickly change if a crisis occurs at which point bond yields will drop precipitously and asset values will get clobbered (the perfect storm for pensions).

As far as US pensions getting less bang for their alternatives buck, I've already discussed this at length in a previous comment of mine on the big squeeze.

For three decades, the hedge fund and private equity elites rode the 2 & 20 model to fame and vast fortunes but nowadays, only the very top fund managers can still command such fees and even they are finding it hard to justify.

Most big institutions are paying closer to 1 & 10 nowadays. Maybe not to Bridgewater, Citadel and Blackstone but even they are offering better fee structures to their big clients.

In a low rate, low return world, it's simply criminal to pay 2 & 20 even to the likes of a Jim Simons or Steve Cohen.

But fees aren't the main problem and I believe in paying fees for performance. The biggest problem with US public pensions is their approach to alternatives, particularly private equity.

Most of Canada's large public pensions pay big fees to their private equity partners but unlike their US counterparts, they leverage those relationships to gain more access to large private equity co-investments, a form a direct investing where they pay no fees.

So, when you hear Canadian funds are going direct in private equity, it's not that they stopped paying fees to private equity managers and are going purely direct. This is pure nonsense. They need Blackstone, KKR, TPG, and other top private equity funds and pay them big fees for their fund investments but they then leverage that fund relationship to gain access to great co-investment opportunities where they can scale into big deals and pay no fees, lowering their overall fees in the asset class.

So why aren't US pensions doing this? The short answer is they can't because they don't pay their pension staff adequately to quickly analyze co-investment opportunities so they need to look at other ways to do this like what CalPERS is trying to do bringing PE in-house.

My main message is that fees are fine as long as risk-adjusted returns are there over the long run but you need to approach private equity in a much more intelligent way than just doling out big fees for mediocre or even median returns.

As far as hedge funds, it's a very tough environment, so paying out big fees may be justified for top funds but most hedge funds are not doing well relative to the overall market and they're not delivering alpha (more like bad beta).

It can be argued the hedge fund industry has gotten too big for its own good and institutional investors have spoiled the party.

I'm more cynical. I happen to firmly believe the bulk of hedge funds suck, and I do mean suck! They're nothing more than glorified asset gatherers who are not able to consistently deliver stable and compelling risk-adjusted returns and when they do, beware of fraud or at the very least be very skeptical.

Admittedly, with all major central banks engaged in QE since 2008, it hasn't been the best environment for hedge funds but I'm tired of hearing excuses from grossly entitled hedge fund managers raking their clients on fees and delivering mediocre results.

I honestly wonder how many hedge funds have an "edge" in these markets. Very few.

Having said that, there will be dislocations and opportunities as central banks remove liquidity, so some hedge funds will shine but good luck finding them.

It's a very tough game and anyone who tells you otherwise is a fool.

And it doesn't help when articles come out on how Wall Street drove public pensions into a crisis or how a gang of hedge funds strip-mined Kentucky's public pensions.

You read these articles and realize how utterly corrupt the system is and how incompetent many US pension fund managers and their board of trustees are.

It's a scandal, the crime of the century and very few realize it because they're hopelessly unaware of the "pay to play" shenanigans that looted their public pensions for years.

I've said it before and I'll say it again, all the reforms in the world in US public pensions are worthless unless you first get the governance right and get politicians out of managing them in any way, shape or form.

You can read more on the Pew report here. You can also read different opinions like this one which says Pew got it wrong, pension funds need alternative investments.

They need alternatives but they need a new approach to lower overall fees via more co-investments and to do that, they need to get the governance right to attract talent to their public pensions. Period.

Below, the American dream has drawn millions to the “land of opportunity” and long encapsulated the idea that every citizen has the right to improve their lives. Yet, the current state of the US retirement system may threaten the ability of some to fully achieve the American dream by ensuring their health and quality of life in retirement. The traditional three-legged stool of retirement—social security, pension, and retirement savings—is transforming into a wobbly one-legged stool, with personal savings and investment providing the only retirement security.

On October 16, the Center on Regulation and Markets at Brookings hosted Kara Stein, commissioner at the US Securities and Exchange Commission, to give her perspective on how the SEC can best provide that assistance. Following Stein’s remarks, Brookings Senior Fellow Martin Baily joined her onstage for a discussion. After the discussion, Stein and Baily took questions from the audience.

And PBS FRONTLINE investigates the role of state governments and Wall Street in driving America’s public pensions into a multi-trillion-dollar hole. Marcela Gaviria, Martin Smith, and Nick Verbitsky go inside the volatile fight over pensions playing out in Kentucky, and examine the broader consequences for teachers, police, firefighters and other public employees everywhere.

The Pension Gamble will be airing Tuesday, Oct. 23 (check local listings). 


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