The High-Wire Act
Public fund investors now work in a world where risk means safety.
The public retirement fund's investment committee is holding its monthly meeting. Times have changed over the past decade. Ashtrays have been replaced by plastic water bottles. Flip charts have given way to PowerPoints.
But that's not all that's changed. A decade ago, when restrictions on the fund's investments began to be liberalized, investment officials switched out of bonds into stocks--mostly the "blue chips" of large, widely held corporations. Asset values soared. Funding ratios improved. The fund's actuary--all smiles in the committee room--had been able to increase the earnings-rate assumption, which meant lowering the state's contribution levels.
Today, the fund's investment committee is sweating its latest actuarial report, which shows that the number of retirees in the system is growing rapidly, along with benefit payments. What with the stock market collapse of 2000-02, the fund suffered withering losses in value, followed by paltry returns on those blue chips. Sure, there are new opportunities, but they involve leaving the public markets and diving into hedge funds, private placements or investments offshore. Risky stuff. As to that smiling actuary, she now looks dour and is lowering the earning assumptions, which means higher contribution levels. That, of course, is going to make the top politicians angry.
And then there's the new accounting requirement to calculate and report the present value of health benefits for retirees, which makes the unfunded liability look even worse. And will make the politicians even angrier. Unless returns on the fund's investments do a replay of 10 years ago, contributions will need to go up by a lot and in a hurry. With these headaches, it is no wonder the committee members are beginning to think about retiring themselves.
The committee is, of course, imaginary, but the headaches are not. Big-time, long-term investors, of which public pension funds are the premier example, are finding themselves in an investment world not only made flat by international competition but one that in the process has been turned upside down. The traditional investments-- high-quality bonds and large-company common stocks--have been hung out to dry. Interest rates are fairly low, which translates into paltry bond yields; the stocks of big-time corporate America have taken a pasting from the small- and mid-cap stocks (favored by hedge funds), commodities and the resurgence of emerging country funds. So one has to ask: Just what is risky when the risky stuff has been so profitable and the solid investments are poor performers?
THE DEEP HOLE
Once upon a time, public pension benefits were paid out of annual revenues. Over the last half century, as government workforces grew, retirement funds began accumulating large benefit obligations. Now, traditional retirement programs are supported through the process of funding, which means that budgeters set aside money annually for future benefit payments, which then builds up through investment earnings. Actuaries come in every so often and check the amount set aside versus the accumulation of future-benefit liabilities. Using a battery of assumptions, the actuary determines the needed level of funding.
Full funding has meant that, given the assumptions and current levels of contributions the fund would have enough on hand to pay future benefits. Unfunded liability means it does not, by the amount of added assets that are needed. Overall, today's unfunded liability probably weighs in at $300 billion for state governments and another $100 billion for local governments. Of course, the $400 billion is not needed immediately--but only five years ago, funds had virtually no unfunded liability in the aggregate.
That's only one rub. The other is that time marches on, and on the cost side of the ledger, the state and local government workforce is graying. The projections in Virginia, for example, show that the number of current workers per retiree has dropped from 5 workers per retiree in 1984 to about 2.7 workers per retiree at present. That ratio will sink to about 2.2 workers per retiree by 2015. Furthermore, fewer workers are taking early retirement and that can translate into higher disability claims.
And those are not the only growing liabilities. Suddenly, the required acknowledgment of the Other Post Retirement Benefits--OPEB-- has created a new financial crater to fill. It's not a new obligation, just a new accounting rule promulgated by the Governmental Accounting Standards Board. In essence, GASB Rule 45 says that state and local governments, in order to conform with Generally Accepted Accounting Principles for governments, must calculate the value of present and future post-retirement benefits (under prevailing programs) and the annual amounts that are needed to fully fund those costs as annually earned going forward. They also must account for unfunded amounts due to past commitments. Setting aside the complexities, the new rule will require a reporting (but not an actual contribution) of the amounts needed to bring the jurisdiction into fully funded status in 30 years on past liabilities, as well as making contributions that assure that the former amount does not grow.
Governments have typically paid retiree health costs on a pay-as-you- go basis, with annual appropriations, sometimes using "excess earnings" in the pension system. The new GASB rules do not require that practice to change, but they require that existing programs be accounted for on an actuarial basis and that future benefits as they are accrued be reflected as "obligations" on the jurisdiction's balance sheet. Those numbers are quite formidable. The state of California, for instance, estimates a liability of $40 billion to $70 billion with a required annual contribution of $6 billion (six times the current $1 billion contribution rate). Maryland estimates a $20 billion deficit; Michigan, $30 billion. Overall, a very rough calculation suggests that OPEB liabilities will sum to $300 billion or so nationally, of which only a tiny portion will have been funded.
DOUBLING UP ON EQUITIES
The load on investment earnings is huge. The Virginia Retirement System, for instance, found that the average age for employee retirement at full benefits was 61, with a remaining life expectancy of 24 years while in retirement. That means investment earnings will fund 76 percent of the pension benefits, while 24 percent is funded by employer and employee contributions.
Fund assets continue to grow, of course, and fund investors continue to pump money into equities. As of the end of 2005, 73 percent of pension assets were in equities and mutual funds. Equities can be investments in the stock market or in various "private capital outlets," including the ever-more-popular hedge funds.
The good news is that as a class, equities have been a good place to be the past three years. The bad news is that the big blue chips and the widely held stocks favored by funds have not done so well. In short, the horrendous value losses during the 2000-02 debacle have yet to be replaced in the broad market averages.
Meanwhile, the niches of the financial markets have been growing into the main event. Small-cap firms, commodities and offshore investments are consistently beating the returns on traditional investments. Investor appetite for them has surged accordingly. And so has the proliferation of lightly regulated hedge funds, which are better able to swing with the times.
The past few years have been pretty successful for the hedge funds. There are now about 8,500 firms with more than $1 trillion in assets, and they are still growing. As privately held firms, they are subject to next-to-no securities regulation in the United States, and even less in the foreign countries in which they operate (such as the Cayman Islands and Bermuda).
With a lack of regulation, it is hard to get much of a feel for hedge fund operations. They operate as a private fund and in secret, and they typically deal in leverage (using a lot of borrowed funds) and employ derivatives (where the value of the transaction is derived from values in other markets). They tend to move into areas of finance that institutional investors frequently cannot--and with a lot of speed.
Hedge funds can have a wide variety of objectives or approaches--from a low-risk goal such as maintaining market values to high-risk speculation. To the extent that the numbers are believable, it appears that funds over the past few years on average have been earning at 7 percent a year (according to the Standard and Poor's Hedge Fund Index), although many have done much better. Some have also gone bust. For those who do well, hedge funds are very profitable. The manager of a high-performance fund frequently takes 10 to 20 percent of the profit, as well as 1 to 2 percent of asset value for managing the funds.
For investors, a hedge fund that works is the most profitable place to be on Wall Street. While hedges play everywhere, there is also reason to believe that they are dominant trading forces in the organized markets.
Critics point to their secretive ways. And there is some evidence that funds can manipulate their earnings data in ways that are proscribed by such recent market reforms as the Sarbanes-Oxley Act disclosure laws. One of the inadvertent outcomes of Sarbanes-Oxley may have been to limit the appeal of regularly listed companies to major investors, who are now shifting more to the hedge funds and various private capital financing devices. Thus, greater disclosure in one area may have driven more investment into the private, largely unregulated investment markets.
In a nutshell, the world of investment--and like it or not, public pension funds have become major players there--has become incredibly intricate, with options and alternatives spinning into an incredible number of niches. For public pension investment committees, charged with being prudent in investment practices and pressured to earn extraordinary returns, it is a revolution that inspires many but really worries others.