America's Looming Pension Disaster?

John W. Schoen of CNBC reports, Are public pensions headed for another disaster?:
Despite healthy gains from the ongoing stock market rally, public pension funds are still badly underfunded and the shortfall continues to widen.

To try to close the gap, many states have shifted pension fund assets into stocks and alternative investments like hedge funds. But in doing so, they face a greater risk of  (not) being able to meet their long-term promises to pay retiree benefits, according to a new report from the Pew Charitable Trusts.

In the short run, the heavy investment in riskier assets has been paying off. After big losses during the financial collapse in 2008, large funds posted annual returns of more than 12 percent for the fiscal year ended last June, according to the report.

But the gains haven't come close to making up for years of underfunding by states that simply failed to set aside what their pension accountants told them they'd need to keep their retirement promises to state workers. As of 2012, the latest data available, states had set aside only $3 trillion to meet the more than $4 trillion in benefits earned by public workers.

"It is function of bad policies and bad budget practices," said Gregory Mennis, head of the Public Sector Retirement Systems Project at Pew. "There are states where the funding policies are reasonably sound—New Jersey is a perfect example—but the state simple simply chooses not to make the payments that their own policy recommends making."

In New Jersey, Republican Gov. Chris Christie, a potential 2016 GOP presidential candidate, recently announced a plan to divert $2.4 billion in pension payments to close a $2.7 billion budget gap. In 2012, the state came up with just 39 percent of the annual contribution required to meet its estimated $47 billion pension liability.

New Jersey isn't alone. About half the states kicked in at least 90 percent of their annual required contributions in 2012, the latest data available.

As a result, most states have set aside far less than they'll need to keep their promises to current and future public retirees. Only Wisconsin has fully funded its pension plans.

Some 14 states have saved at least 80 cents for every dollar they'll need to cover their pension liability. Illinois has set aside only 40 percent of what it owes; Kentucky (47 percent), Connecticut (49 percent), Alaska (55 percent), Kansas (56 percent), Louisiana (56 percent), and New Hampshire (56 percent) have the worst-funded public employee pension plans (click on image above).

That widespread underfunding helps explain why—despite recent pension reforms and benefit cuts in dozens of states—the gap between public funding and long-term liability continues to widen in many states.

"The problems that occur as a result of underfunding don't necessarily show their impact immediately - so result people can kick the can down the road and not feel the pain until the future," said Mennis. "That's what allows for bad budget decisions to be made today."

To help close the funding gap, states have shifted their pension assets away from relatively safe investments like bonds into higher-risk holdings like stocks and hedge funds, according to the Pew report. In 1982, nearly 80 percent of public pension assets were held in bonds and cash; by 2012, the share had fallen to 25 percent.

More recently, funds have shifted to riskier, so-called "alternative" funds that include private equity, hedge funds and real estate. Between 2006 and 2012, those assets, as a share of overall investments, more than doubled to 23 percent.

The shift to those higher-risk assets has helped states boost their projections on investment returns—but has also put those funds at greater risk of losses when the markets pull back. Those losses would further strain state budgets—leaving taxpayers on the hook to make up future pension fund investment losses.

The shift to heavier reliance on stocks and other riskier investment has also added a new layer of cost in the form of higher fees paid to hedge funds other investment managers. Those fees jumped by 30 percent between 2006 and 2012, according to the Pew report.

But it's not always clear that taxpayers are getting their money's worth for the added investment cost, said Mennis, because information about pension fund fees and investment performance is incomplete.

"This all points to the need for addition information on a more consistent basis so that stakeholders understand how well their funds are performing after all the expenses are taken in to account," he said.
You can read the entire Pew report by clicking here. There is nothing that shocks me in this report. I've been covering the pathetic state of state pension funds for years. I've also witnessed firsthand the much touted "shift into alternatives," which is a bunch of nonsense brokers and useless investment consultants peddle to dumb public pension funds desperate for yield in a low yielding environment.

State pension funds praying for an alternatives miracle are in for a rude awakening. If you don't believe me, listen to the Oracle of Omaha and Bridgewater. Moreover, the alternatives gig is up. Some of the larger funds, like CalPERS, are set to chop their hedge fund allocation, and I believe more will follow as people realize the prime beneficiaries of the big alternatives gamble are overpaid hedge fund and private equity gurus.

Of course, the problem isn't alternatives per se. The problem is the approach to alternatives which keeps feeding the Wall Street beast and keeps the details of these exorbitant fees hidden from public record. But if my hunch is right -- and it always is -- the era of fee compression is just beginning but it's too little too late for most state pension funds that are getting raped on fees and face massive pension shortfalls. When the next crisis hits, they're cooked!

I'll tell you who else is cooked, individuals relying on their 401(k) and firms that provide them to retail investors. Steve Johnston of the Financial Times reports, US pensions ‘cash negative’ by 2016:
America’s sprawling 401(k) pension system will turn cash flow negative in 2016, threatening disruption for asset managers and selling of equities, according to analysis by Cerulli Associates, a research house.

The $3.5tn system attracted fresh contributions of $300bn in 2012, with $276bn either withdrawn as cash by retirees or rolled over into individual retirement accounts (IRAs), Cerulli estimated.

However, by 2016 it forecasts that inflows will be $364bn and outflows $366bn, with the deficit only widening year on year after that as the core of the baby-boomer generation retires.
“This has significant implications for asset managers and other financial services providers,” said Bing Waldert, a director at Cerulli. “It is going to be a disappointment for a lot of fund managers that have put a lot of effort into the DC [defined contribution pension fund] market.

“For asset managers, the consistent contributions are particularly appealing and provide a source of positive flows even in poor markets when a firm may experience outflows from other segments of the industry.”

The largest managers in the 401(k) market are Fidelity Investments; Canada’s Power Financial, which owns Great-West Financial and Putnam Investments; TIAA-CREF; Vanguard; ING of the Netherlands and Prudential Financial of the US.
Funds run by such managers are typically among 10-20 options available to 401(k) savers, but when money is rolled over into an IRA, they face far stronger competition.

“In IRAs you are not just competing against asset managers, you are competing against the world. There are insurance-based products, ETFs [exchange traded funds] and individual securities. There is more freedom and flexibility,” said Mr Waldert.

Fidelity and Charles Schwab, which run direct-to-consumer platforms, are significant providers in the IRA market, alongside wealth managers such as Merrill Lynch and UBS. Vanguard also has a strong foothold.

Amin Rajan, chief executive of Create Research, a consultancy, said IRAs tend to have a 20-35 per cent exposure to equities, compared with 45-60 per cent in 401(k) plans. This suggests equity-focused houses could lose market share to bond-based rivals such as Pimco and Principal Global Investors as the demographic changes mean the 401(k) system shrinks relative to the IRA market, which is already larger at about $5.4tn.

Sue Walton, director at consultant Towers Watson Investment Services, agreed, saying: “People go to the extremes. They get to retirement heavily weighted to equities and they make this shift to go too conservative”, buying low-risk fixed income and money market funds.

Mr Rajan believed the wider US DC market, encompassing both 401(k)s and IRAs, would turn cash flow negative by 2020, following in the footsteps of the defined benefit pension market.

Mr Waldert said that regulators could intervene to slow the transition from 401(k)s to IRAs, given concerns that the costs of managing assets in an IRA tend to be far higher than the institutional pricing levels secured by 401(k)s.
In a recent comment on Canada's looming pension wars, I argued that we need to delay the rollover of 401(k)s or RRSPs into IRAs or RRIFs. I also argued for risk sharing in traditional defined-benefit plans and beefing up the governance of these plans.

The discussion on pensions in the United States is mute. It's as if there is no crisis going on. I'm telling you right now, when the next crisis hits, you will see many U.S. public and private pensions get decimated. It's not a matter of if but a matter of when and the longer they put off real reforms, including reforming their terrible governance, the worse it will get.

Below, CapRidge Partners' Steve Leblanc explains why pension funds have been forced to move into riskier assets. Leblanc was the former CIO at Texas Teachers where he made big bets in private equity so it doesn't surprise me he started his own real estate fund (who funded him?!?) and is defending the shift into alternatives.

The clip also features Carlyle's co-CEO, David Rubenstein, defending the huge fees alternatives funds are charging, stating: "you get what you pay for." Well, that's not always true Mr. Rubenstein and you know it! A lot of the alternatives powerhouses have become big, fat, lazy asset gatherers perfectly content collecting the 2% management fee, focusing more on marketing than performing.

Finally, while 60 Minutes bungled their report on whether the U.S. stock market is rigged, they hit another home run yesterday discussing how untreated mental illness is an imminent disaster. The parallels between a failed mental health system and a failed retirement system are eerily similar but one thing is for sure, the longer U.S. politicians neglect the problem, the more people will fall through the cracks, the worse the imminent disaster will be.