Underfunded Pensions Making Riskier Bets?

John Mellow of CNBC reports, Underfunded Pensions Pressured to Make Riskier Bets:

After a tumultuous August, pension funds for companies, governments and unions are falling further under water, raising pressure on boards to take on more risk at a time when the economic and policy outlook has never been more uncertain.

Entering 2011, pension plans for companies in the S&P 500 were just 75 percent funded, down from 85 percent in 2010 and roughly 78 percent following the Lehman collapse, according to Goldman Sachs. Funding levels—likely even uglier on a municipal and union level—just got worse.

“The recent fall in equity prices and in interest rates has led to sharp declines in the funding position of many institutional investors,” wrote Jim O’Neill, head of Goldman Sachs Asset Management, in a note to clients Thursday. “Recent market movements have left many institutional investors wary of taking risk, but at the same time mindful of the necessity of doing so in a thoughtful way.”

After a volatile August that ultimately brought the S&P 500 into negative territory for the year, September kicked off with its worst 3-day start post WWII. Meanwhile, the 10-year Treasury yield is trading at a lowly 2 percent.

Stocks added to losses Thursday as Federal Reserve Chairman Ben Bernanke failed in a speech to hint at the specific stimulus he will use to fight the next stage of this struggling recovery. Pessimism that any proposals from President Obama will be voted down by Republicans added to the drop and cloudy outlook.

But regardless, Goldman Sachs Asset Management Thursday advised its pension clients today to increase exposure in emerging markets, crude oil and high yield corporate bonds. Goldman also advised using options to hedge equity downside risk.

“While market volatility is, in our view, likely to stay elevated in the near term, we remain reasonably constructive on the global economy, particularly on the outlook for growth and emerging markets,” said the note, citing favorable demographics and rising productivity.

Pension fund managers face the difficult choice between taking this advice at a time when conditions seem the most dangerous and staying conservative as these strategies begin to pay off over the long term.

At some point, especially with percentage of the population over 65 years old expected to double in the next 20 years, the funds will be forced to drop their annual return assumptions – typically above 8 percent – upon which their future obligations are calculated. Companies and states are reluctant to do that though because that means an immediate hit to their bottom line. The other choice is cut the benefits side.

Many funds are turning to hedge funds to generate the returns for them in this tumultuous environment.

“Most pension funds should already be in commodities and emerging markets and deploying options strategies,” said Damon Krytzer, a trustee for the San Jose Police and Fire retirement plan and a managing director at Waverly Advisors. “The problem is many are behind the times.”

Krytzer, Goldman and others are not necessarily advising funds “trade their way out” of the funding hole. Instead, they are just advising the funds to get positioned for a long period for this nation of slow growth and low rates where alternative and global strategies work best.

But it’s just a tough sell to traditionally conservative pension boards. Especially when emerging markets, based on the iShares MSCI Emerging Markets ETF, plunged more than 11 percent in August alone.

So what's going on? Are pensions de-risking or making riskier bets? In recent comments I've highlighted how pensions like GM are de-risking moving into bonds, but likely taking on more risk than they're aware of.

But with long-term bond yields at historic lows, most underfunded pension plans are cranking up the risk to meet their actuarial return targets which are based on rosy investment assumptions using an insanely high discount rate of 8%. The mismatch between reality and rosy investment assumptions is what's prompting underfunded pensions to take on more risk in all asset classes, including alternative investments like hedge funds.

However, one truism in markets is that more risk means more potential upside and more potential downside. And the downside skew is enormous in this wolf market dominated by high frequency trading computers. So I warn pensions to be careful allocating to hedge funds, especially the ones focused on asset gathering not performance, stay nimble, be opportunistic and use options to mitigate downside risk. The added cost of protection will pay off if another crisis erupts.

Finally, we'll see if President Obama's $450 billion stimulus bill passes Congress but it's Europe that worries me these days. European leaders are foolishly escalating tough talk on Greece. I agree with Chris Ciovacco, shorts may prey on serious problems in Europe, which is why policymakers and central bankers must exercise caution, be extra vigilant and deliver policies that are in the best interest of the global economy. As President Obama highlighted in his speech below: "The next election is 14 months away. And the people who sent us here -- the people who hired us to work for them -- they don’t have the luxury of waiting 14 months. Some of them are living week to week, paycheck to paycheck, even day to day. They need help, and they need it now. "