Pensions Wrestle With Return Rates?

Before delving into my latest comment, make sure you carefully read my previous comment on reflections from Greek Gods so that you understand the dynamics of the USD carry trade and how it's influencing currencies and global stocks. Spoke with my mom in Brussels earlier this morning and she prefers it when I keep my comments professional and gets very upset when I focus on negative personal stuff on my blog. So being a good Greek son who loves his parents a lot, will make an extremely valiant attempt to forget the weasels from the past and focus on delivering excellent investment and pension comments.

Michael Corkery of the WSJ reports that Pensions Wrestle With Return Rates:

Turmoil in Europe, the sluggish economy and low interest rates are intensifying pressure on public pension-fund systems to reduce the annual-performance assumptions they use to determine contributions from taxpayers and employees.

Some lawmakers and pension officials are pushing to abandon the roughly 8% annual-return assumption set by many public-employee funds, saying the rate is unrealistically high given upheaval in markets around the world and the preceding financial crisis.

"After 10 years of listening to the experts be wrong on the downside more than half the time, I would like to be more cautious," said James Dalton, chairman of the Oregon Public Employees Retirement System.

The pension system, which covers about 325,000 members, affirmed its 8% assumption this summer despite a dissenting vote from Mr. Dalton. Oregon exceeded its 8% assumed rate over the most recent 20-year period but fell short over five years and 10 years.

In Minnesota, lawmakers are considering whether to lower the large state pension funds' 8.5% return assumptions, among the highest in the nation. Pension officials at the Teachers' Retirement System of the State of Illinois are mulling a change to the system's 8.5% return target.

The nation's largest public pension, the California Public Employees' Retirement System, could face pressure to trim its assumptions if the $220 billion fund's monthly returns are disappointing. Calpers is set to release those results this week.

The assumed rate of return is critical because it determines how much a city or state and its workers must contribute to a pension system. As with many other investors, optimism prevails among many pension-fund managers. "We are in a low-return environment with a lot of downside risk," said Joseph Dear, Calpers chief investment officer. Nevertheless, Mr. Dear sees little reason to change the fund's 7.75% assumption, because that target is achievable over the long term, he said.

Since the financial crisis, at least 19 state and local pension plans have cut their return targets, while more than 100 others have held rates steady, according to a survey of large funds by the National Association of State Retirement Administrators.

But to keep meeting these assumptions, pension funds might be tempted to take on more risk, some officials and analysts warn.

"To target 8% means some aggressive trading," said Jeffrey Friedman, a senior market strategist at MF Global. "Ten-year Treasurys are yielding around 2%, economists say we are headed for a double-dip, and house prices aren't getting back to 2007 levels for the next decade, maybe."

"Good luck to them," Mr. Friedman said of pension managers still striving to hit longstanding targets.

The Teacher Retirement System of Texas reaffirmed its 8% annual return target after its consultant said the pension system, with about $100 billion in assets, should expect a median rate of return slightly greater than 8% over the next decade.

The consultant, Hewitt Ennis–Knupp, also noted that, during the past 20 years, the Texas pension fund earned a rate of return of 8.9% on invested assets. Brian Guthrie, executive director of the Teacher Retirement System of Texas, said he hasn't "looked under the hood" of the analysis, though pension officials checked with their actuary to make sure the target is in line with most other pension funds'. A spokeswoman for EnnisKnupp declined to comment.

"It doesn't matter what your assumptions are," said Laurie Hacking, executive director of the Teachers Retirement Association of Minnesota, which supports sticking with its 8.5% target return assumption. "It is what that market delivers that matters and how you react to that."

Ms. Hacking said Minnesota reacted to big investment losses after the financial crisis by cutting back on pension benefits and increasing contributions to the fund from employees and school districts. Those moves had a greater impact on the funding level of the teachers' system, now a relatively healthy 78%, than lowering return assumptions, she said.

But tweaking the number could have immediate, real-life consequences. Many public pension funds use their assumed rates of return to calculate the present value of benefits they owe retired workers in the future. So the lower the rate, the greater the obligations appear.

This spring, the New Hampshire legislature put off implementing a decision by the retirement board to lower the rate to 7.75% from 8.5% this year. The move by lawmakers was meant to spare New Hampshire cities and towns from having to make additional contributions to the fund without much warning, even if it means keeping return assumptions few people expect the fund to meet.

"It's a tough decision," said Jeb Bradley, Republican majority leader in the New Hampshire State Senate. "We knew we had to lower it, but we were trying to give ample warning" to cities and towns, he said. Many unions representing New Hampshire public workers objected to the delay in reducing the assumed rate.

In Minnesota, legislators last year reduced cost-of-living adjustments for retired public workers until the funding level of the pension system improves. Lowering the rate of return could lower the pension system's funding level and potentially delay when the cost-of-living adjustments are restored. Some state lawmakers say lowering the rate will benefit the system over the long haul. "A new day has dawned," said Morrie Lanning, chairman of the Legislative Commission on Pensions and Retirement in Minnesota, who wants to lower the return target. "It may have made sense in the past, but it's not realistic anymore."

States are grappling with reality of a low return environment. The pension crisis rocking state plans will not go away and it got worse following a horrendous third quarter where bond yields plummeted and asset values plunged, exacerbating pension deficits. I always thought an 8% return target is way too optimistic in this environment, forcing underfunded pension plans to take riskier bets. These bets will come back to haunt many pension funds that are ill-prepared for deflation.

The model that is killing pension funds will continue killing them over the next decade. As we enter an era of fiscal austerity, tough political choices on pensions lie ahead. Pension plan members simply can't have their pension cake and eat it too.

I leave you with two must watch interviews. One with Jim Bianco of Bianco Research who reminds us everything we learned about investing is wrong and another with Ed Dempsey, CIO of Pension Partners, who after predicting a "summer swoon," now sees a "Fall melt-up." In the short-run, I agree, investors are too bearish, stocks can rally sharply, but this will not make a dent in the overall profile of pension plans. They simply will have to accept that low returns and volatile markets are going to be the new norm for a long time and plan accordingly, focusing on risk, not returns.

Feedback: A senior pension fund manager was kind enough to share his insights with me:

I must admit I agree with your mother on that one, while fully recognizing that 1) it is YOUR blog (and this is still a free country); 2) I am not your mother…

Pensions, and savers in general, are faced with a choice that is very straightforward (and not new) in this challenging investment environment:

  • Lower your expectations – i.e. accept lower benefits and/or saved assets at a given future date. For DB plans, this means cutting benefits one way or another (deferring eligibility, de-indexing, reducing eligibility, reducing outright benefits, means-testing of benefits, etc.);
  • Increase your contributions – i.e. save more now;
  • Choose a strategic/benchmark portfolio that has more risk/more return (and pray);
  • Allow for (more) active management around that strategic/benchmark portfolio (easier said than done, but not impossible).

Not doing anything will not get anyone in trouble in the next five years, but will ensure long-term failure. So we have to be realistic and choose one of the above, or a combination thereof.

The main constraint on making these choices for (defined benefit) plan sponsors is socio-political-legal, especially for the first two options (reducing benefits or increasing contributions) and every plan will have more or less flexibility there. As an asset manager, I do not find these appealing anyway, except in extreme cases of under-capitalization, because they strike me as a cop-out. It sounds too much like: “we can't manage your money well enough so we are going to make you pay more to make up for this skills shortfall.” Maybe I’m being too hard on myself, but that option has been used too often versus striving to be a better investor.

There has been a ton of research on building better benchmarks over the past 15 years. I have done some of it in currencies. I must admit that I am very disappointed with the degree of buy-in across the industry with many plans still sticking with what have been proven to be sub-optimal benchmarks, and this is true across most asset classes. Yes, it’s hard, or impossible, to prove beyond a reasonable doubt, that one benchmark will be superior (in the investment sense) to another over the next 3, 5, 10 or 20 years, but plan sponsors must show greater openness to change and have shown themselves to be far too conservative at a time when the investment landscape and capital markets have changed dramatically.

At the other extreme, some plans focused exclusively on theoretical or “paper” risk and return metrics have made asset shifts into asset classes that proved inferior because they carried high transactions costs that were not properly understood, that proved highly illiquid at times of stress, etc. and this has reinforced plan sponsor caution about making some changes to their benchmarks. In this case I would say give the actual investment managers a voice, instead of the product salespeople and the investment consultants, who may not have the actual investment experience to understand how these products will work in real life.

More/better active management is very easy to say, hard to actually do. My theory there is that “traditional” active management, the kind that aims to add a little bit of value all the time and generate a product that sells with all the right “metrics”, is very tough. Most markets are fairly efficient, good managers are few, hard to find, and not necessarily consistent, alpha is often disguised beta, etc. we all know the drill and numbers speak for themselves: the median active manager in most products/asset classes is barely worth the fees.

However, I invite you to think of “non-traditional” asset management, which I best define as NOT managing with a view to generate an alpha stream that will be commercially appealing over a short span of time, coherent with an individual’s career horizon, but that is rather focused on ensuring the long-term superior returns of an investment portfolio. How do you do that? Well, you make sure you avoid the big drawdowns. Traditional portfolio optimization looks at average relationships that quickly become meaningless. Active managers must focus rare periods of stress that will “make or break” a portfolio. Can you imagine how well a plan that managed to cut its 2008 losses in half would look like today? See, the problem is who wants to tie his/her career to that? Something like that may not happen for many years. How does one build the credibility needed to make a big bet and save the portfolio if one isn’t continuously investing and building a track record?

It’s very tough, because the compelling portfolio logic will be very seriously defied by individuals with career spans, motivations and objectives that are NOT aligned at all with the long-term health of a plan. For example, I remember arguing with very experienced, very smart, and very successful portfolio managers and strategists in 1999-2000 that stocks were ridiculously expensive, whereas they came up with all kinds of reasons why an average P/E of 30 could make sense forever. Who does not remember that period, eh? But I ask you: how many plans cut their equity exposure in half in 1999/early 2000? In fact, most increased it for fear of “underperforming their peers”.

Anyway, I guess my point is that plan sponsors have to get creative if they want to survive and thrive, and right now I don’t see a lot of that happening. Long story short, 8% average annual rate of return is probably unrealistic in this day and age, but I don’t think it’s an excuse to give up on investment solutions to improve long-term performance and just soak the pensioners.