Pension Pandemic: Part I
I was chatting with a buddy of mine this afternoon about yesterday's comment on Turkey's pension funds returning 32% in 2008 because of their large allocations to high quality government bonds.
We chatted about where most pension funds are now going to find the yields to make up for those huge losses they suffered in 2008. Hedge funds? No. Private equity? No way. Real estate? Hell no! Even long bonds are yielding next to nothing and they will not produce the stellar returns achieved in 2009.
So where are pension funds going to go to make money? I have some ideas, which I will discuss tomorrow, but it's worth mentioning what another successful trader told me tonight: "Pension fund managers have an asymmetric payoff. If they lose billions, they get fired, get a huge package, polish up their c.v. and get hired by some other pension fund. If they make billions, they get a huge bonus and they are treated like gods. Their incentives are skewed to take huge risks and not to protect against downside risks."
This trader is smart and he eats what he kills. He knows what it means to have "skin in the game" because if he is not making money, he's in big trouble. It's the risk of ruin that keeps him on his toes, always thinking about how he can protect the downside risk before he enters a position.
But pension funds got sloppy in the last six years and 2008 was a huge wake-up call that reminds them to always worry about systemic risk and to stop blindly throwing billions into the latest "product" that investment banking sharks or brain dead pension consultants are peddling and packaging to them.
When investment bankers came to see me with their latest product, I was always skeptical and grilled them on all the possible risks. The more arrogant they were, the harder I grilled them and I never trusted anyone who did not thoroughly explain the risks of any product.
When I was investing in hedge funds or private equity funds, I would grill them too and I made sure the managers had significant skin in the game. If the fund was managing billions and sending me over sales people to "schmooze", I started getting concerned because it typically means they are becoming big fat asset gatherers who are more focused on collecting the 2% management fee than the 20% performance fee (Hint: always look at the ratio between sales to investment staff!)
But unlike hedge fund managers or private equity fund managers, pension funds do not have high water marks before performance bonuses kick in or skin in the game to make sure they are feeling the pain when the pension fund is down.
Sure, they are not getting compensated as generously as hedge fund or private equity managers, but they are not starving either and their incentives should be more closely aligned with the best interests of their stakeholders. Moreover, the benchmarks used to evaluate their compensation should reflect the risks and beta of each underlying investment activity.
Most pension fund managers do get compensated based on long-term (for example, rolling four year returns) and short-term performance and some pension funds are compensating their senior managers based on total fund performance.
But none of this prevented the losses we saw in 2008. Why? Having worked at two of the largest public pension funds in Canada, I will tell you exactly why: senior pension fund managers work in silos and nobody is connecting the "BIG PICTURE" to see how the risks in one asset class will contaminate other asset classes and how along with other pension funds, they were fueling the bubble in alternative investments. They all got sloppy - real sloppy - and they all got whacked in 2008.
Every day I read articles that remind me the pension pandemic is getting worse. Bloomberg reported that state governments from Rhode Island to California have run up estimated pension-fund losses of $865.1 billion, forcing some to cut benefits for new hires:
Assets for 109 state funds declined 37 percent to $1.46 trillion over the 14 months ended Dec. 16, according to the Center for Retirement Research at Boston College. The Standard & Poor’s 500 Index of stocks fell 41 percent in the period.
“Not a whole lot of people get too excited about pension funds,” Philadelphia Mayor Michael Nutter said in an interview. “But if you have to pay those costs, they do grab your attention.”
After Philadelphia’s fund lost $650 million in the first nine months of last year, Nutter joined the mayors of Atlanta and Phoenix in writing a letter to Treasury Secretary Henry Paulson seeking financial help for U.S. cities. Their November letter cited investment deficits and rising pension costs.
The $865 billion in losses, which exceed the $700 billion Troubled Asset Relief Program that Congress approved in October, comes as states face budget deficits totaling $42 billion.
The Boston College center analyzed holdings reported on financial statements from 2006, when the 109 funds had about 20.4 million members. It didn’t specify which of the 218 U.S. state funds it studied.
To return to 2007 actuarial funding levels by 2010, the 109 funds would need annual returns of 52 percent on assets, the analysis found. Annual returns of 18 percent would achieve the goal by 2013, the center said. The projections are based on a 5.7 percent annual increase in liabilities and a $50 billion increase in assets from contributions above annual payouts.
State funds have enough money on hand to pay benefits for the foreseeable future, said Alicia Munnell, the center’s director. “Even if markets recover, this will be a one-time loss that will have to be made up in the future by taxpayers,” she said.
“We can’t make enough on investments to drive out of this hole if all you do is depend on investments,” said Mike Burnside, executive director of the Kentucky Retirement Systems in Frankfort.
As of June 30, Kentucky’s largest fund for state workers held about 52 percent of the assets needed to pay current and future benefits to its 117,000 members. The plan had an unfunded liability of $4.8 billion at that time, while the entire system’s liabilities totaled about $16 billion.
‘Negative Cash Flow’
“When we are experiencing a negative cash flow and we are having to eat capital to make payroll, we are accelerating the complications,” Burnside said.
Increasing taxes to fill the pension gap has little support, said Frank Karpinski, executive director of the Employees’ Retirement System of Rhode Island in Providence.
“I don’t think anybody wants to do that, likes to do that or would say it would be an easy sell anywhere, especially given the current economic situation,” he said.
State and local governments contributed $64.5 billion to pension plans in fiscal 2005-06, according to data from the U.S. Census Bureau. That’s about 57 percent of the $113.2 billion spent on police and fire services.
Attempts to reduce benefits also face opposition.
“I believe that our members will oppose such initiatives in collective bargaining or in state legislatures,” said John Adler, a director with the Capital Stewardship Program in New York for the Service Employees International Union, which represents public workers. The union’s 850,000 members were in retirement plans with more than $1.5 trillion in assets as of Jan. 1, 2008, Adler said.
To cut pension costs, some states are creating two-tiered systems offering less to new hires.
Kentucky lawmakers this year set the state’s first minimum retirement age, 57, for employees hired after Sept. 1, and required 30 years of service, up from 27, to receive full benefits. They capped cost-of-living adjustments, which had been tied to the Consumer Price Index, at 1.5 percent. The system had an unfunded liability of about $16 billion as of June 30, executive director Burnside said.
New York Governor David Paterson, trying to close a $15.4 billion budget gap over 15 months, wants to reduce new workers’ benefits and raise the retirement age to 62 from 55. New York’s pension system was over funded, with assets of $153.9 billion, as of March 30.
Of the 109 state funds, 43 were funded at 79 percent or less of estimated current and future costs. Those below 80 percent “constitute the weakest cases,” said Ted Hampton, an analyst with Moody’s Investors Service Inc. in New York. The average level is 85 percent, according to an analysis prepared for a Moody’s report published in July 2008, Hampton said.
A survey of state funds found they owed $2.35 trillion to pension payments over 30 years, a December 2007 report by the Pew Center on the States found.
Company pension funds have also lost assets in the stock- market decline. The value of so-called defined benefit plans fell to $1.2 trillion at Dec. 31 from $1.6 trillion a year earlier, according to Mercer LLC, a New York-based pension consulting unit of Marsh & McLennan Cos.
Last month, after Pfizer Inc., International Business Machines Corp., United Parcel Service Inc. and dozens of other companies said losses could force them to make unexpectedly large contributions, Congress voted to delay provisions of the Pension Protection Act of 2006. The law would have penalized employers that didn’t cover at least 94 percent of their liabilities this year.
For state plans, which weren’t covered by that mandate, the funding issue is complicated by 12 percent growth in membership since 2002, with 23.1 million now participating, according to census data.
Excluding Social Security, public employers’ pension costs are three times the retirement costs of their private counterparts, according to a June 2008 report by the Washington- based Employee Benefit Research Institute.
Some state retirement systems have seen losses in derivatives as well as stocks. Public pension funds bought more than $500 million in so-called equity tranches of collateralized debt obligations, according to public records compiled by Bloomberg in 2007. CDOs are packages of securities that are backed by bonds, mortgages and other loans. Their equity tranches are considered their riskiest portions.
The Missouri State Employees’ Retirement System invested $25 million in half the equity portion of the BlackRock Senior Income Series 2006 collateralized loan obligation, managed by New York-based BlackRock Inc. Moody’s last month cut ratings on parts of the debt, saying a drop in value of the underlying collateral may cause “an event of default.”
Chris Rackers, the manager of investment policy and communication for the Missouri fund, didn’t return calls seeking comment.
In Rhode Island, state and local governments were scheduled to make contributions equaling 25 percent of their payroll expenses to retirement plans in 2010, said Karpinski, the executive director. Barring a recovery, the contributions may increase to as much as 30 percent in 2011, he said.
“That is kind of the elephant in the room,” he said. “Where are the funds going to come from to make these kinds of required contributions?”
And pension losses are now threatening 2009 corporate profits:
Last year, pension plans of America's 1,500 largest companies lost more than $400 billion, mainly because of the collapse of the equities market in which the bulk of those plans are invested, according to a new report from Mercer, a financial-consulting firm.Pension plans are also being hit on the other side of the balance sheet, as shrinking yields on Treasury bonds expand the scope of their pension fund liabilities.
Taken together, the double dose of bad news means companies will have to pony up as much as $70 billion in pension contributions in 2009 — up from $10 billion in 2008 — a development that will surely crimp many companies' earnings.
Companies, historically, have made a deliberate decision to hold equities in pursuit of superior investment performance, and in some years that has worked. But this year, "it's gone wrong, and spectacularly so," says Adrian Hartshorn, a principal in Mercer's financial-strategy group. In 2008 the Standard & Poor's 500 index declined 37%.
The developments will further complicate matters for many companies struggling to survive in what is arguably the bleakest economic and financial crisis since the Depression. The true scope of the market's toll on pension plans will become apparent in the coming weeks, when companies release fourth-quarter and year-end earnings statements.
In conference calls to investors and analysts, top corporate executives are likely to explain how they plan to handle the loss. Many will probably reduce sharply or even eliminate new benefits packages, cut wages and resort to more job cuts to recover the loss. It will also likely mean reducing investments in new products and even borrowing from other parts of the business. "It's very difficult to do all of that," Hartshorn says.
The Worker, Retiree and Employer Recovery Act signed by President Bush last month will help a bit by giving pension-plan sponsors more time to get a grip on asset losses. Even so, 2009 will present a costly pension-plan repair bill.
Despite all the pension-plan woes, employees who have a defined-benefit plan aren't as exposed to the market's volatility as people invested primarily in 401(k) plans, experts say. Even in the event of a corporate bankruptcy, employees with defined-benefit plans are to some degree protected by the Federal Government's Pension Benefits Guaranty Corporation.
Another study by Watson Wyatt reports that U.S. companies may be forced to contribute almost $109 billion to their corporate pension plans this year to fill funding gaps caused by turmoil in the financial markets:
Companies are failing to meet the minimum funding thresholds on their pension plans, which will force them to devote more capital to shore up their obligations, according to consulting firm Watson Wyatt, which conducted the study.
The U.S. Senate unanimously approved legislation last month to help pension plans, but according to the Watson Wyatt study, that legislation will only lower the funding requirement by about $16 billion.
Watson Wyatt expects companies also would have to contribute more than $102 billion in 2010. Both of these figures are up sharply from the $38 billion that companies were required to contribute to the plans last year.
"While the (legislation) will provide some relief, given the magnitude of declines in pension assets and funded status, companies will still struggle to meet the large and unexpected contributions required in the next two years," Watson Wyatt said in a statement.
Watson Wyatt said proposals now before Congress for further legislative relief could sharply reduce the funding requirements, by giving companies more choices about ways they can "smooth" the value of pension plan assets over several years rather than marking the value of pension plans to the current market level.
The Pension Protection Act of 2006 requires companies with underfunded plans to pay additional premiums and closed some loopholes that allowed companies to skip payments. But companies have told Congress they may not have the cash to meet all of those funding requirements this year.
Corporate defined-benefit pension plans cover about 44 million Americans, according to the Pension Benefit Guaranty Corp."As contributions jump, employers may be forced to make tough choices to cut costs," said Mark Warshawsky, director of retirement research at Watson Wyatt, in a statement. "We hope that with more temporary funding assistance, employers will still be able to provide defined benefits plans and their employees will continue to enjoy retirement security."
In light of this crisis, it is hardly surprising to see expectations for pension plans are forced to shift:
That 8 percent annual return on investment you and your pension fund manager were banking on is looking almost as optimistic as Bernard Madoff's magic 12 percent, as deleveraging and deflation bite.
With extremely low or negative real interest rates and everyone from consumers to banks trying to shed debt and assets at the same time, what seemed like reasonable projections for a mixed portfolio of stocks, bonds and other assets are now substantially too high.
The implications are a potentially huge hit to corporate earnings and the economy. Companies will be forced to put up more to keep their pension funds adequately funded, while even consumers not encumbered by lots of debt are likely to raise their savings rate to compensate for lower returns, thus acting as a drag on consumption.
And while higher savings rates are ultimately what the economy needs, most U.S. company pension plans that promise a payoff based on workers' final salaries assume an overall return on assets of about 8 percent a year. Individuals and their investment counselors are often even more optimistic, penciling in 9 percent or 10 percent a year and often maximizing exposure to riskier assets to try to get there.
"The available return from markets has been for some time a lot lower than people have understood," said Gary Dugan, chief investment officer at Merrill Lynch's wealth management arm in London.
Returns have been shaped by debt, both that employed in investment strategies to magnify returns and that taken out by consumers and partly recycled into corporate profits. And remember, too, if you are an investor who doesn't leverage, you are still affected, as those who did inflated valuations and will remain sellers.
"The challenge is to increase savings to pension plans or long-term savings - a very substantial increase - because long-term returns are negligible," Dugan said. He estimates equity market returns of 4 percent to 7 percent during the next few years.
It may not seem like a lot to assume a 6 percent or 7 percent annual return rather than 8 or 9, but a rule of thumb is that every 1 percent less in performance requires an extra 10 percent in annual funding to counteract.
David Zion at Credit Suisse in New York estimates that the pension funds of the S&P 500 companies could be underfunded by $362 billion, a drop of $420 billion in the year. This is far worse than back in 2002, after the last stock market slump, and leaves 70 of the 500 with underfunding equivalent to more than 10 percent of their market cap.
This can easily affect earnings if companies decide to raise their contributions, which, if done en masse, will further depress stock markets and the value of the pension funds. Rinse and repeat.
For final salary pension plans, last year was doubly awful: Losses were extremely deep and the interest rates they use to value their future liabilities to pensioners moved in the wrong direction, down.
Funds use a discount rate, in the United States usually one tied to the yield on corporate debt, as a tool to determine their future obligations to pensioners; the lower the rate, the bigger the obligation now.
That makes very low inflation or even deflation a real bear for pensions. The Mercer U.S. pension index rate, a benchmark for these valuations, fell by almost 1.5 percentage points to 6.11 percent in December as government rates fell.
Expect this all to be an emerging trend in the next year, and not just in the United States. Of course it is possible that companies and their regulators will move to a fudge, not lowering return expectations and even giving companies a break on how they value their obligations, arguing no doubt that the current low interest rates are exceptional. Investors who buy shares in these companies, and whose future stream of earnings may be hit by pension costs, may not be so forgiving.
People who are saving for their retirements also have to make assumptions about what their investments will command and how much they need to save to reach their goals. It's very likely that those rates of savings need to rise and the assumptions fall. It will also be interesting to see if equities as an asset class remain as popular.
The pension pandemic is spreading everywhere. Pension funds in Australia, Canada, Chile, Ireland, the Netherlands, the United Kingdom, Japan, and elsewhere are recording huge losses and little is being done to address this issue.
This is why Jon Entine calls the politicizing and implosion of pension funds the next catastrophe:
Funds worth trillions of dollars start to plummet in value. Political pressure to be “socially responsible” distorts the market decisions of government-related enterprises, leading to risky investments. Investors who once considered their retirements safely protectedwake up to a sinking feeling of uncertainty and gloom.
Sound like the great mortgage-fueled financial crisis of 2008? Sure. But it also describes a calamity likely to hit as soon as 2009. State, local, and private pension plans covering millions of government employees and union workers with “defined benefit” accounts are teetering on the brink of implosion, victims of both a sinking stock market and investment strategies influenced by political considerations.
From January to October 2008, defined benefit funds—those promising a predetermined amount of retirement money to the payee—averaged losses of 26 percent, according to Northern Trust Investment Risk and Analytical Services, making it the worst year on record for corporate and public pension funds. The largest public pension fund in the United States, the California Public Employees Retirement Security System (CalPERS), lost a staggering 20 percent of its value in just three months last year. In May 2008, Vallejo, California, became the largest city in the state ever to file for Chapter 9 bankruptcy, thanks largely to unmanageable pension obligations. The situation in San Diego looks worryingly similar. And corporations with defined benefit plans are seeking relief in Washington as part of a bailout season that shows no sign of slowing down.
If the stock market remains in a funk for even a few more months, corporations that oversee union pension funds and state and municipal leaders responsible for public retirement pools may be faced with difficult choices. First on the docket might be postponing cost-of-living increases and reducing health care coverage for retirees. Over the longer term, benefits for new employees will have to be shaved and everyone is likely to see an increase in personal payroll contributions. Corporations will have to resort to more cost cutting and layoffs of their own just to guarantee the solvency of their pension funds. And things could go from bad to terrible if the managers of those funds do not quickly revise their investment practices.
During melting markets, all pension funds come under siege. If you’re covered by a “defined contribution” plan, contributions are invested, usually by your employer and usually in the stock market, and the returns are credited to the employee’s account. Your retirement savings grow if the market rises or, as is the case now, bleed when it crashes. You carry the risk on your shoulders.
The risk shifts to the employer under “defined benefit” plans, in which future outlays are guaranteed. That seemed like a great idea for business as recently as 2007, when the market was rising and the pension funds of America’s 500 largest companies held a surplus of $60 billion. Now they’re at a deficit of $200 billion, with fund assets dropping like a lodestone.
The Pension Protection Act of 2006 requires that companies keep the accounts fully funded over time, meaning that they have to have enough money to pay all of their retirees should they decide to withdraw their funds. Yet more than 200 of the 500 big-company plans are nowhere close to meeting that standard, and those dire numbers are increasing.
Companies with defined-benefit pensions may soon find themselves choosing between making payroll or pumping money into their pension plans. If companies are forced to make up the shortfall out of their assets, which seems likely, that would send profits tumbling even more, further destabilizing the stock market. And even with a cash infusion, many businesses might still have to freeze or even cut benefits.
Both the corporations and the pensioners are victims of a market meltdown whose depth and duration almost no one predicted. Yet the investment performances of their corporate pension funds, while dismal, are holding up better than the returns of many public and union defined benefit plans. Those funds are facing their own reckoning, but in this case a lot of the pain is self-created and exacerbated by politics.
Social Investing Shenanigans
There is about $3.5 trillion sloshing through the U.S. retirement system, scattered across more than 2,600 public pension funds and federal retirement accounts. Another $1 trillion or so covers union workers at corporate jobs in which the union has key management control of the fund. These public and union-based defined benefit plans cover 27 million people and represent more than 30 percent of the $15 trillion dollars held in U.S. retirement accounts.
Traditionally, public investments and union-based corporate pension funds were managed according to strict fiduciary principles designed to protect workers and taxpayers. For the most part they invested in safe government securities, such as bonds or U.S. Treasury bills. Professional managers oversaw the funds with little political interference.
But during the last 30 years, state pension funds began playing the market, putting their money into riskier and riskier securities—first stocks, corporate bonds, and foreign investments, then real estate, private equity firms, and hedge funds.
Concurrently, baby boomers whose politics were forged in the 1960s and ’70s began using those pension funds to advance their social visions. Investments designed for the long-term welfare of retirees began to evolve into a political hammer. Some good occasionally came from the effort, as when companies were pushed to become more accountable in their practices. But advocacy groups often used their clout to direct money into pet social projects with dubious fiduciary prospects. Sometimes the money went to the very companies and financial instruments that, in the wake of the market meltdown, are now widely derided.
Many union funds and larger state pension plans screen stocks and investment opportunities based on what are known as “socially responsible investing,” or SRI, principles. Instead of focusing solely on maximizing value, fund managers have used the economic clout of concentrated stock holdings to make a statement by divesting from companies that don’t make it through certain “sin screens.”
These included companies involved with weapons, nuclear energy, tobacco, alcohol, natural resources, and genetic modifications on agriculture, many of which did well over the past decade. Stocks of public companies deemed to have poor records on labor, environmental issues, women’s rights, and gay rights are also frequently screened out, as are corporations that do business with regimes that activists consider unsavory. In some cases, investments have been withheld altogether from some of the markets expected to best weather the current financial storm, including China and India, because of perceived transgressions.
Socially responsible investing now claims a market of more than $2 trillion, according to the Social Investment Forum, the trade group for social investors. There are dozens of mutual funds and investment advisory companies that incorporate ideological screens. Most of them are liberal, although there are now a few conservative funds and some based on religious principles, such as Islamic law. Activist treasurers and pension fund managers in numerous states and municipalities, most notably in California, New York, and Connecticut, have incorporated social screens into their investment strategies.
Many of these funds prospered in the 1990s, when the basic material stocks that they frowned upon swooned, while the favored sectors—mostly technology and financial stocks, which were considered “clean investments”—did great. But the technology and communications bust of 2000–02 knocked out one of SRI’s pillars, and now the crash in financial stocks has destroyed the other. Despite much hype to the contrary, socially responsible stocks, as measured by major broad-based SRI stock funds, have significantly underperformed the market this decade, and some of the most aggressive pension funds that use “responsible” screens—such as the California Public Employees’ Retirement System—have taken some of the largest hits.
“Investing in socially responsible stocks just because they are socially responsible is not—underline not—a valid investment thesis,” says Steven Pines, a senior investment consultant for Northern Trust. Many of the largest socially responsible mutual funds, including a leading benchmark, the Domini Social Index, have been laggards for years. The Sierra Club’s high-profile social fund, which had regularly trailed the benchmark S&P 500 index by about 6 percent a year, liquidated in December, a victim of its poor performance record. As recently as last November, 76 out of the 91 socially responsible stock funds were underperforming the Dow, according to the investment research company Morningstar.
“This crisis highlights the limitations of social research methods,” says Dirk Matten, who holds the Hewlett-Packard chair in corporate social responsibility at York University’s Schulich School of Business. Although some socially responsible research models are more sophisticated than others, particularly ones that eschew simplistic screens, social investors have downplayed the actual business of a business, including whether it can create jobs and spread wealth, while overweighting what Matten believes are more symbolic concerns, such as announced programs to combat climate change.
Sometimes corporate social responsibility can mask or come at the expense of responsibility to shareholders. Fannie Mae, for instance, was named the No. 1 corporate citizen in America from 2000–04, based on datacompiled by the top U.S. social research firm, KLD Research and Analytics in Boston. Well, it does have a great diversity program.
As recently as mid-2008, three of the top eight holdings by the leading social investing organizations in the country were financial stocks: AIG, Bank of America, and Citigroup. AIG was praised for its retirement benefits and sexual diversity policies; Bank of America strove to reduce greenhouse gas emissions and promote diversity; and Citigroup donated money to schools and tied some of its loans to environmental guidelines. The stock prices of all three companies tanked in 2008.
From South Africa to the Shop Room Floor
The catalyzing event that changed pension funds from boring retirement pools to political operators was the international boycott of apartheid South Africa in the 1980s and the campaign to limit investments in companies that did business with Johannesburg. The success of the campaign energized baby boomers, now entering their prime earning years, who were committed to “making a difference” with their dollars. Taking a cue from these social investors, pension funds began dabbling in what came to be known as economically targeted investments—injecting money into communities or projects that addressed social ills, with healthy returns becoming a secondary concern.
The earliest pension fund social investing initiatives were often cobbled together during crises, with little appreciation for unintended consequences. In the 1980s, for example, the Alaska public employee and teacher retirement funds loaned $165 million—35 percent of their total assets—for the purpose of making mortgages in Alaska. When oil prices fell in 1987, so did home prices in the nation’s most oil-dependent state. Forty percent of the pension loans became delinquent or resulted in foreclosures.
While unions and social investors often work together, their investment strategies are not always in sync. In 1989, under union pressure, the State of Connecticut Trust Funds invested $25 million in Colt’s Manufacturing Co. after the beleaguered gun maker—hardly a favorite of the SRI crowd—lobbied the state legislature to save jobs. Colt’s filed for bankruptcy just three years later, endangering the trust funds’ 47 percent stake.
In the late 1980s, the Kansas Public Employees Retirement System, then considered a model of activist social investing, placed $65 million in the Home Savings Association, after its lobbyists told top officials that this would help struggling segments of the state economy. That investment evaporated when federal regulators seized the thrift. All told, the Kansans wrote off upward of $200 million in economically targeted investments.
Olivia Mitchell, executive director of the Pension Research Council at the Wharton School, has reviewed the performance of 200 state and local pension plans from 1968 to 1986 . She found that “public pension plans earn[ed] rates of return substantially below those of other pooled funds and often below leading market indexes.” In a study of 50 state pension plans during the period 1985–89, the Yale legal scholar and economist Roberta Romano concluded that “public pension funds are subject to political pressures to tailor their investments to local needs, such as increasing state employment, and to engage in other socially desirable investing.” She noted that investment dollars were directed not just toward “social investing” but also toward companies with lobbying clout.
Because of poor returns, these early experiments in economically targeted investments lost their allure. Most states and municipalities steered clear of social investing for a time. That hesitancy eroded during the 1990s, partly as a result of a new strategy employed by organized labor.
With their membership falling, union leaders found it harder to influence companies or politics from the factory floor. The new approach was to ally with social investors and adopt one of their key tactics: lobbying through shareholder resolutions intended to pressure corporations. “The strengthening of shareholder democracy promises to further empower investors to address governance issues such as out-of-control executive pay as well as environmental and social issues such as climate change,” Jay Falk—president of SRI World Group, which advises pension funds on social investing—said in 2007, as the tactic was gaining traction.
Union-led pension funds are also trying to rattle political cages, but they’re running closer to empty every day. Even before the sell-off, in the summer of 2008, while nearly 90 percent of nonunion funds met minimum safe funding thresholds—meaning they had adequate cash on hand to pay their benefits—40 percent of union funds were at risk. “These are high risk numbers even in a steady economy,” writes Diana Furchtgott-Roth, a pension fund specialist with the conservative Hudson Institute, in a recent study. Furchtgott-Roth notes that union fund management practices are opaque, costs are higher than at nonunion funds, and the plans have promised more than they can ever hope to deliver. “When workers entrust their retirement assets to an outside party, it is important that this party’s only interest be achieving the best returns possible,” she argues. “Unions clearly do not do this.”
The biggest comeback of socially responsible investing also took place in the 1990s, when elected officials in New York, Connecticut, Minnesota, and—most notably—California began to dabble in asset allocation decisions based on a growing list of social concerns. CalPERS is the 800-pound gorilla among public pension funds. At its peak value in October 2007, CalPERS and its sister fund, CalSTRS (the state teachers’ pension system), held over $400 billion in assets. Their portfolios have more global influence than the entire economies of most sovereign nations. And during just three months last fall, more than 20 percent of the funds’ combined value evaporated—a horrendous performance for public investments designed to minimize risk and protect retirees. “We have ups and we have downs,” said Pat Macht, CalPERS assistant executive officer, as the fall 2008 massacre unfolded.
CalPERS and CalSTRS began flexing their financial muscles by demanding corporate governance reform, publicly excoriating companies they deemed to be poorly managed. It was an aggressive, almost unprecedented demonstration of the growing corporate transparency and accountability movement. The state’s pension fund meddling went into high gear in 1998 with the election of Phil Angelides as California treasurer. If there is a face to pension fund activism, it’s Angelides’. As political issues go, treasury and pension fund investments are not the sort of hot-button topics that ambitious California politicians usually ride to glory. But Angelides had a vision: to use retirement dollars as a way to change the world, and the state treasurer position became his tool.
Under Angelides’ direction, CalPERS emerged as a leading voice on behalf of shareholder rights, at least as he defined them. To this day, the California funds instigate a dizzying number of proxy fights at the companies in which they invest, focusing not just on governance-related issues like executive pay but on everything from carbon taxes to divestment from companies that do business with Sudan. This social activism has acted as a model for public pension funds in other states. Laws directing funds to scrap investments in companies that invest in disfavored countries have passed or are being considered in 20 states, including Texas, Maine, Tennessee, New Jersey, Florida, and Idaho.
In 1999 Angelides’ funds committed $7 billion to a program called Smart Investments to support “environmentally responsible” growth patterns and invest in struggling communities. As in Alaska and Kansas in the 1980s, however, there were no accountability provisions to measure the impact of the venture, let alone to determine its financial consequences.
Supported by labor unions and minority groups, Angelides argued that the state had too many billions stashed away in so-called emerging markets—Third World nations where democracy is weak and wages are low—and not enough invested at home creating jobs and housing. So in March 2000, he rolled out an ambitious social investing program, dubbed the Double Bottom Line, which included dumping $800 million in tobacco stocks and persuading fund managers to shed investments in countries that Angelides thought had questionable environmental or governance practices. He claimed the initiatives would not sacrifice investment returns, saying at the time: “I feel strongly that we wouldn’t be living up to our fiduciary responsibility if we didn’t look at these broader social issues. I think shareholders need to start stepping up and asserting their rights as owners of corporations. And this includes states and their pension funds.”
How has this social engineering worked out? Angelides left his job as state treasurer in 2006 for an unsuccessful run for governor, but his legacy of politicizing pension fund investing remains. In 2003 CalPERS rejected a recommendation from its financial adviser, Wilshire Associates, to invest in the equity markets of four Asian nations—Thailand, Malaysia, India, and Sri Lanka—based on their alleged misdeeds. That was a costly decision, as their stock markets roared in the ensuing years. Another decision to shun investment in China, India, and Russia cost the fund some $400 million in forsaken gains, according to the fund’s own 2007 internal report.
Under sharp criticism and amid devastating declines, CalPERS last August finally repealed the screening policy, claiming victory in its reform efforts. “Year by year, scores [of countries and corporations that invest in them] are improving, and many countries have responded to our standards for investing,” CalPERS President Rob Feckner said in a press release.
CalPERS’ tobacco boycott was equally disastrous. With the float of most large cigarette companies so large, disgorging even a sizable fraction of one company’s shares has little impact on the stock price; it’s akin to taking a thimble full of water out of the deep end of a pool, only to have it dumped back in the shallow end when the buyer makes his purchase. Since California sold its tobacco shares, the AMEX Tobacco Index has outperformed the S&P 500 by more than 250 percent and the NASDAQ by more than 500 percent. That one decision alone cost California pensioners more than $1 billion, according to a 2008 report by CalSTRS.
Some of the most steadily performing sectors, through both good and bad times, have been the very “vice” stocks that are no-nos for most social investors. When times get tough, the sinners get sinning. “Demand for drinking, smoking, and gambling remains pretty steady and actually increases during volatile times,” says Tom Glavin, chief investment officer at Credit Suisse First Boston. Alcohol, tobacco, and gambling stocks rallied solidly during two of the last three major recessions, in 1990 and 1982. “Many of these industry groups tend to be beneficiaries of the flaws of human character,” Glavin says.
So what stocks did the California funds buy instead? High on the list were financial stocks, which have been given a green bill of health by social investors. CalSTRS recently acknowledged it had lost hundreds of millions of dollars on Lehman Brothers, AIG, and other fallen icons that were recent favorites of social investors.
But those losses may pale when the tab comes due for misplaced bets on the boom-to-bust California real estate market. According to a report released last April, CalPERS had 25 percent of its $20 billion real estate assets in the California market, which has declined faster than the real estate markets in most of the rest of the country.
In the summer of 2007, CalPERS was more than 100 percent funded. It’s now under 70 percent funded and falling, and that doesn’t fully factor in its plummeting real estate investments. Funding levels stand near a dismal 50 percent for Connecticut, where State Treasurer Denise Napier has been a vocal proponent of social investing. Both states are far below mandated minimum funding standards, and they pale in comparison to even the beleaguered ratios of corporate defined contribution plans, which have mostly avoided using social screens.
Large public pension funds have a selfish notion of risk: heads they win, tails you lose. If they gamble on risky investments that pay off, they are heroes, although the predetermined benefits don’t increase. But if those investments go south, tax dollars will have to bridge the gap. “This is adding insult to injury,” says Jon Coupal of the Howard Jarvis Taxpayers Association. “At the same time we’re seeing our own 401(k)s get hit, we’re on the hook to make up the shortfalls for public employees who are guaranteed their full pensions without any risk.”
When public funds slide in value, taxpayers get hit from all sides. The municipalities and school districts that hire firefighters, police, teachers, and other workers have to cut their staffs to recapitalize funds. Last October the Los Angeles County Board of Supervisors learned that the county would have to come up with an extra $500 million to keep its pension fund whole. That means the county may have to raise local taxes and cut services to deliver on overextravagant promises it failed to safeguard.
Public and union pension funds will be increasingly important factors in financial markets for the foreseeable future. As part of their fiduciary mandate to maximize investment returns, their trustees certainly have a right and duty to lobby for changes in corporate behavior that could result in better returns for their pension holders. But judging by the words and actions of some pension activists, “shareholder value” has become synonymous with “cause-related investing,” justifying a range of actions that may put at risk, directly or indirectly, pensioners’ retirement holdings.
If the goals of pension managers and retirees are not the same—as is often the case—then pension plans should not engage in social investing. In many instances, SRI amounts to union leaders or politicians gambling with other people’s money in support of ideological vanity.
A few politicians have begun speaking out against risking pension funds on political causes, for fear of limiting returns in a difficult investment climate. New York state and New York City public funds prohibit investing in new tobacco stocks, a policy that has drawn the ire of Mayor Michael Bloomberg, even though he is a zealous opponent of smoking. “I don’t think we should be using the city’s investment policies…to advance social goals, no matter how admirable those goals are and no matter how much I believe in it,” he has said.
Pensions are being dragged into treacherous waters by investors who consciously choose to direct their money in socially conscious ways. It’s a questionable risk for cautious times. The use of political criteria may be fine for affluent investors and activists who gamble their own money and assume the extra risk, but pension funds should be held to a higher standard.
But the problems in pension funds run much deeper than socially responsible investing, which can be done properly. There are huge governance gaps that need to be addressed, making pension funds more transparent and making their supervisors and managers more accountable for the decisions they undertake.
Tomorrow I will explore more facets of the pension pandemic and offer some thoughts on what needs to be done to address the global pension crisis.
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