Illinois' TRS Going For Broke?

Crain's Chicago Business reports, Pension peril: Illinois' TRS goes higher-risk with investments (h/t, Jack Dean at Pension Tsunami):

The Illinois Teachers' Retirement System — the worst-funded major pension plan in the U.S. — is pumping more of its assets into higher-risk investments while using accounting methods that some pension experts say understate its funding shortfall.

Springfield-based TRS, the state's largest pension provider, plans to allocate about a third of its $37.8-billion portfolio to alternative investments such as private-equity and hedge funds, a four-month Crain's investigation of TRS holdings and practices finds. These unconventional assets typically dangle the potential for higher returns, but only because they also carry greater risks and fees. TRS is shifting its portfolio while it's still developing an in-house risk-management system.

Gunning for bigger returns exposes the plan to the possibility of bigger losses, further jeopardizing the pensions of 362,121 former and current teachers. The system, which has just 46.5% of the assets it needs to cover promised payments to retirees, is counting on an 8.5% annual return, which many portfolio managers and investors, including Berkshire Hathaway Inc.'s Warren Buffett, say is unrealistically high. If TRS banked on a 7.75% return — the rate that two other Illinois public pensions lowered their forecasts to this year — its assets would equal only 43% of obligations. That would swell its shortfall to $50.1 billion from $43.5 billion.

"They're pushing the envelope, to be sure," says Robert DiMeo, a consultant at Chicago-based DiMeo Schneider & Associates LLC who mainly works with corporate and non-profit retirement plans and some public pensions. "They're probably in the top quartile in terms of risk. And they're probably in the bottom quartile in terms of funding status, and those two probably go together."

The plan also is dabbling in volatile derivatives, including wagers on Brazilian interest rates, and credit default swaps on sovereign debt from Italy and Spain.

Illinois taxpayers are already on the hook for most of the $81.3 billion in TRS' long-term obligations because the state is required to fund the lion's share of TRS benefits. That liability will keep expanding, likely at a faster rate than assets, unless fund administrators and lawmakers can make up the $43.5-billion shortfall. If the plan defaults, the state will be lobbied hard to come to the rescue.

"Taxpayers are, one way or another, going to end up bearing a large portion of this burden," says Joshua Rauh, an associate professor at Northwestern University's Kellogg School of Management who has co-authored several studies on pensions.

Even before TRS raised its alternative asset investment goal, the plan ranked fourth-riskiest among public pensions in the U.S. because of its ratio of alternative and stock investments relative to cash and fixed-income holdings, according to Crain's sister publication Pensions & Investments. That 2010 survey showed that TRS had 83.2% of its portfolio in equities, alternatives and other classes, with just 16.8% in fixed-income and cash.

TRS Executive Director Richard Ingram calls the system's investment strategy and financial assumptions reasonable "with a very manageable parameter of risk." Mr. Ingram, who took the helm early this year, points out that the TRS fund averaged 9.9% annual returns over the past 30 years, justifying retention of an 8.5% assumption. He says he isn't chasing higher returns to plug the asset gap.

"It would not be prudent in any fashion for us to try and reach to make up the shortfall through investments," Mr. Ingram says. "There is no way that you can invest your way out of a 50% underfunded situation."

The pension plan was 70% funded in 1987. It has fallen increasingly short mainly because the state has shirked its $15 billion in recommended contributions since 1970, denying the fund the assets needed to earn sufficient investment income. Bruising investment losses in the recent financial collapse also depressed assets.

Despite TRS net returns of 23.6% for the fiscal year ended June 30 — which beat the median annualized result of 21.6% for U.S. public pensions, according to San Francisco-based Callan Associates Inc. — TRS is still trying to recover from losses of 22.7% in 2009 and 5% in 2008. Over the past 10 years, the return for TRS has slipped to 6.0%, slightly better than the 5.7% median.

Assets are still down from a high of $41.9 billion reached in 2007. Meanwhile, liabilities swelled in each of those four years.

Stacey Gottlieb, 40, a social worker at Cyd Lash Academy in Gages Lake, and her husband, Neil Mott, 37, a Rolling Meadows High School chemistry teacher and chess and tennis coach, have contributed 9% of their salaries to TRS for a combined 23 years. (Local school districts contribute an additional 2.5% of the fund's annual income.)

While they have some other savings, including 403(b) plans for teachers, they are heavily dependent on their pensions because TRS enrollees can't receive Social Security benefits.

"My husband and I need the pension system to continue to work or we will have very limited retirement funds," says Ms. Gottlieb, who earns about $85,000 a year.

Ms. Gottlieb worries about TRS' investments in hedge funds because she thinks they're lightly regulated. Mr. Mott says the state should be more prudent. Both wish they could choose investments themselves.

"It's just very frustrating that things have gotten so out of whack and there isn't a ready solution," says Mr. Mott, who earns $90,000 a year. "Their solution seems to be going to Vegas with our money."

Since Mr. Ingram arrived at TRS last January, he's held a dozen town hall meetings around the state with teachers and retirees who routinely ask him whether they'll get the benefits they've been promised. So far, TRS hasn't missed any.

"I tell them we're treading water — we're right in the middle of the river right now," he says. "If someone walked through the door right now and wrote us a check for $45 billion, we're all set. If the state stops paying us their annual contribution today, over the next eight to 10 years we'll run out of money. So those are the two extremes."

The state's pension system in general is teetering. Moody's Investors Service in September 2010 revised Illinois A1-rated debt to add a negative outlook, its worst credit rating among states, partly because of the state's inability to address pension liabilities. Illinois had the largest unfunded pension liabilities of any state, with $85 billion owed for its five state-funded plans, as of June 30, 2010, Moody's says. Those plans' assets come to less than half that amount, according to the state's annual report.

"We have taken action on the state with respect to its rating or outlook because of pension-funding challenges a number of times in recent years," says Moody's senior analyst Ted Hampton in New York. Pension investment strategies "that diverge from the norm significantly, such as increased exposure to certain asset classes," can be "red flags" in the firm's analysis of any state, he says.

New York's Fitch Ratings and Standard & Poor's Financial Services also give Illinois the lowest debt rating of any state except California. States with the lowest ratings pay the highest interest rates when borrowing.

While states on average were 78% funded, Illinois was just 51% funded, according to a Pew Center on the States report issued earlier this year based on 2009 data. Wisconsin and New York both were at 100%.

Kellogg's Mr. Rauh estimates Illinois pension plans will run dry by 2018, even if they chalk up 8% returns and the state contributes enough to cover newly accrued liabilities.

"There's a school of thought that if you are very aggressive (in investing) and have huge success, you don't need to do pension reform," says Rep. Tom Cross, the Illinois House Republican leader, who has urged pension reform. "It's a very risky proposition."


In 2008, TRS Chief Investment Officer Stanley Rupnik, 40, waded into two new asset classes: "absolute return," industry lingo for hedge funds, and "real return," which can also include hedge funds. Mr. Rupnik, who was promoted to his post in 2004, became interim executive director in late 2009, when his boss, Jon Bauman, was ousted following a TRS board pay-to-play scandal.

The new investments did particularly poorly in the financial meltdown of 2009. Absolute return lost 13.9% vs. a gain of 5% for its benchmark, the 90-day Treasury bill plus four percentage points. Real return plunged 26.2% compared with a 3.5% gain for its benchmark, the consumer price index plus five percentage points.

TRS was in such straits when the 2008 financial crisis hit that Mr. Rupnik was forced to sell assets in a depressed market to generate cash flow for payments to retirees, who receive $46,452 a year on average.

Illinois' public pension plans owe their troubles to broken promises by the Legislature. To preserve labor peace, the state routinely offered generous pension benefits. But to avoid hiking taxes and upsetting even more people, it didn't pay its share to cover these payments. Lawmakers could get away with this because the pension bills didn't come due for years or even decades.

"There have been a lot of legislators kicking the can down the road and now trying to take it out of the hide of the employees," says Dan Montgomery, president of the Illinois Federation of Teachers.

TRS' situation is familiar to Mr. Ingram, 56: He came from the New Hampshire Retirement System, which was 58% funded. While Mr. Ingram runs TRS operations and Mr. Rupnik oversees investments, the 13 trustees — half appointed by the governor and half elected by TRS members, with state Superintendent of Education Christopher Koch serving as president — have final say on matters.

In April, trustees approved a plan to boost investments in the absolute return class, or hedge funds, to 8% from 5%, and Mr. Rupnik expects it ultimately will rise to 10%. The board also voted to boost private-equity investments to 12% from 10%, starting the following July. That raised the combined percentage of absolute return, real return and private equity — all considered alternative investments — to 30% of the portfolio, up from a quarter.

By contrast, all U.S. public pensions have on average just 8.8% in private equity and 7.9% in other alternative investments such as hedge funds, according to a report this year from Wilshire Associates Inc. in Santa Monica, Calif.

"It's not a sound approach, and I think it's the type of thing that can get you in very, very big trouble financially if it goes the wrong way," Rep. Cross says.

Mr. Rupnik says TRS allocations are bigger partly because large plans can more easily invest in alternatives, but the California Teachers' Retirement System, which dwarfs TRS with $148 billion in assets in 2011, has only 14% in alternatives.


While TRS allocation increases may seem small, every additional percentage point means $370 million flowing into an asset class. So TRS will inject $1.11 billion more into hedge funds and $740 million more into private-equity funds.

Hedge funds are often seen as risky because their managers make big bets against long odds or borrow money for trades away from the prying eyes of regulators. Their leveraged wagers can produce phenomenal gains — and losses. Greenwich, Conn.-based Amaranth Advisors LLC collapsed in 2006, and many other funds failed in the 2008-09 financial meltdown. Even savvy managers can stumble. New York hedge-fund manager John Paulson, who had bet right in the recession, reportedly has posted declines of as much as 44% in his fund through October.

"It's highly dependent on managers' skills, so that's where it can get dicey," says Jack Marco, whose Chicago-based Marco Consulting Group advises pensions. "Someone can be right and someone can be wrong."

Typically, the funds also have higher fees and less liquidity.

In October, the TRS board approved quadrupling to $600 million its investments in three hedge funds in its stable. It also said it plans two or three new investments in the next two years.

These new investments will be overseen partly by key TRS hedge funds — Stamford, Conn.-based K2 Advisors LLC and Grosvenor Capital Management L.P., a Chicago-based fund that aggregates hedge funds. Grosvenor is led by Michael Sacks, who was appointed vice-chairman of corporate recruiter World Business Chicago by Chicago Mayor Rahm Emanuel. Grosvenor and K2 decline to comment.

Mr. Rupnik says TRS is designing the absolute return investments so that they do not rise as much as a bull market or drop as much as a bear market. The class is designed to reduce risk and "protect assets in a difficult environment," he says. In the three years through June 30 since TRS added the class, it has delivered a 3% rate of return, lagging the 4.4% gain of its benchmark.

In a Nov. 10 letter to Mr. Ingram, Rep. Cross expressed concern about the "solvency" of TRS and asked for information about the plan's investment strategy, including use of leverage, or borrowing to make investments.

While Mr. Rupnik says its asset managers do not use extensive leverage, TRS might be unable to detect problems because it's still in the early stages of developing an in-house risk-management system. He says oversight is sufficient because TRS gets monthly reports from an outside consultant and relies on Grosvenor and K2 to monitor hedge funds' trading positions.

Aside from the risk of outsize losses, hedge funds and private-equity funds generally charge higher fees than other investment advisers. Expenses average 2% of investments in addition to a 20% cut of profits, compared with 1% assessed by most other advisers. Private-equity managers also lock funds up for longer periods, with money paid back over 10 years or even longer in a sour economy.

For TRS, the private-equity class has delivered a 10-year return of 9.6%, better than its 6.6% benchmark, which is the Russell 3000 index plus 300 basis points.

TRS' fixed-income investments also are riskier than they seem. The portfolio includes the sale of hundreds of millions of dollars' worth of credit default swaps obligating TRS to guarantee payment on debt issued by governments including hot spots Italy and Spain. Such investments, which TRS says equal less than 1% of its portfolio, were reported last year by Northwestern University's Medill Reports.

"They could easily lose a large portion of that," says Dale Rosenthal, a finance professor at the University of Illinois at Chicago. Mr. Rosenthal is a former strategist for Greenwich-based Long Term Capital Management L.P., an absolute-return fund that produced 40% annual returns before it collapsed in 1998.

TRS also has made big bets on the movement of Brazilian interest rates vis-à-vis U.S. interest rates that Mr. Rosenthal calls "crazy" because the stream of 11% yield payments is like getting "hazard pay" for a risky bet.

Before he left the board in September, former TRS Trustee Sidney Marder urged the system to better inform members about exotic investments in the fixed- income portfolio to avoid uncomfortable revelations later.

The market value of swaps in the portfolio was down 30% from its base cost as of Nov. 28, according to data obtained by Crain's under a Freedom of Information Act request.

"In the case of our derivatives, they are not standing alone as a bet, to use that term," Mr. Ingram says. "They exist and are paired with a long position, either a bond or something else. They're a hedge and not a bet."


The TRS assumption of 8.5% returns puts the pension under pressure to gravitate to the higher-risk, higher-reward investments, pension experts say. A return of 8% or higher is "very difficult to achieve in this market," says Julia Bonafede, president of Wilshire Associates. And that's doubly true for underfunded plans, she says: "They're going to be looking to the investment portfolio to do more of the work, which means that they're going to have to take on more risk."

Only 10 of 126 U.S. pension plans forecast 8.5% annual returns on investments, like TRS. Since 2008, 19 states have cut their assumptions, reducing the median to 8% today, according to the Essex, Conn.-based National Assn. of State Retirement Administrators.

TRS is due for its five-year review of assumptions next year. Mr. Ingram won't say whether it is likely to lower the assumption, deferring to a review process that includes opinions from consultants and a vote by the board. Its main consultant, R. V. Kuhns & Associates Inc. of Portland, Ore., recently said returns are more likely to be 7.75% over the next 10 years. Former trustee Mr. Marder says he favors reducing the assumption, though he adds that TRS' 25-member investment staff is doing a good job.

If the plan lowered the assumed rate of return, it would have to increase its stated liabilities to cover the smaller investment income. That would result in "political pressure," a TRS spokesman says, because the state would have to increase its contributions.

Another actuarial maneuver called "smoothing," which averages assets over five years, has made the plan appear healthier, too, because the impact of the losses in 2008 and 2009 is reduced. TRS adopted this metric in 2009. Using fair market value without smoothing, the funded ratio slips to 46.1%, from 46.5%, as of June 30. The difference was 7.9 percentage points a year earlier.

"If we had accounting that properly reflected the value of these promises, as a society we would be able to make more informed decisions about funding the benefits that we make and also about what level of benefits we offer," Mr. Rauh says.

He estimated last year that each Illinois household is already on the hook for $42,000 in liabilities linked to the state's three biggest pension funds and that the bill will rise if the plans aren't revamped in the next few years. His formula equals $17,562 in TRS liabilities per household.

While Rep. Cross' pension reform bill, which would have required employees to contribute more to their pensions and given them the option to switch to a 401(k) plan, was shot down this year after unions objected, more proposals are likely to follow, especially with Chicago corporate chieftains from the Civic Committee of the Commercial Club pressing the cause.

Mr. Ingram argues that teachers — and taxpayers — shouldn't worry over short-term returns.

"People are hypnotized by the ticker crawling across the bottom of the CNBC screen in their office," he says. "I don't even turn it on because I've been in this business too long." He notes that a 110-year-old woman who died earlier this year was the system's oldest beneficiary, having had an 85-year relationship with TRS. "For us, the long term is what matters."

The last time I publicly castigated Illinois TRS, I received feisty emails from them telling me I was wrong. But now that I see their incredibly brainless strategy of piling a third of their assets into alternatives, I know without a doubt they haven't got a clue of what they are doing.

What the hell are they doing giving money to fund of funds like K2 and Grosvenor Capital? It's bad enough that hedge funds are on the ropes, they are also getting raped on double-fees through fund of funds. And how were these fund of funds chosen? Wonder if those "ties to Rahm Emanuel" helped them secure that contract. Holy Mother of God! This smacks of Chicago "thug" politics at its worst.

And TRS can kiss those hundreds of millions of dollars in worthless CDS contracts goodbye. That's the clincher in this sordid affair. They should fire all these clowns, the state should top out its pension plans, and introduce some meaningful pension reforms, including governance reforms where you pay professional pension fund managers to deliver real results. If they need help, follow the model at HOOPP or Ontario Teachers' Pension Plan, two of the best defined-benefit plans in the world.

The only thing I can guarantee you is that blindly shoving more money into alternatives won't solve Illinois' pension woes, especially the way they're doing it. And their projected 8.5% annual return is ludicrous. With 10-year US bond yields hitting 1.81% on Monday, they are delusional if they think they can attain these results, even in the "long term" which Mr. Ingram so carelessly gloats about. Mark my words, their enthusiasm for alternatives will be short-lived and unless something drastic is done, Illinois TRS' "death spiral" will come to an ugly end (watch classic scene from Untouchables below).