Before presenting an economic perspective to guide 2009 investments, it's first useful to recap the impact of the financial markets' meltdown on public sector retirement plans and the retirement sector in general:
o First, the Social Security and Medicare systems are largely unaffected by the capital markets meltdown. They have never invested in the stock market, so their swelling actuarial deficits are the result of economic weakness and failure to properly fund the systems, not the markets' failures. If anything, there could be an argument made to start investing the Social Security trust funds in the stock markets now, as prices are dirt cheap, but that seems unlikely in light of the current feelings about the market and its performance. o The IRA and 401(k) industries have suffered mightily. Millions of private-sector workers whose life savings are held in these market-sensitive accounts are facing the prospect of deferring their ultimate retirement dates. Companies that make a business serving these accounts will lay off tens of thousands of workers in coming months. Industry consolidation in the defined contribution marketplace seems inevitable, as large firms face pressure to shed non-core businesses. I have no inside information on this, but one must wonder whether and why outfits like AIG and Merrill Lynch/Bank of America will retain their retirement businesses if they could raise capital by selling those units to other long-term players at a reasonable price. o In the 457 and 403(b) marketplace, the asset-based revenues of major plan administrators have shriveled, and they face pressures on profit margins. In addition to layoffs, some will be tempted to inject higher-fee investment products into the lineup. Plan sponsors should beware of gimmicks like "managed accounts" which purport to offer downside investment protection or peace of mind to nervous participants, but at dramatically higher costs. Insurance companies long trusted in this sector as annuity providers and "guaranteed account" sponsors need to be carefully re-examined for credit quality. Some of those guarantees may be shakier now than a year or two ago. o Pension plans have lost 20 to 30 percent of their asset values since the market's peak, and their average funding ratios have declined from 85 percent to less than 65 percent on a real-time basis. Their weaker funding ratios ultimately will compel them to charge employers a higher contribution rate to pay off their unfunded liabilities. These added costs will begin to surface late in 2009 and especially in 2010. o With weakening funding ratios, there are fewer dollars available to pay for cost-of-living allowances for retirees. o Retiree medical plans (known as OPEB for "other post-employment benefits") were almost entirely unfunded, so the market's demise had far less impact on them directly. However, the recession has robbed public employers of revenues they desperately needed to begin paying their actuarially required contributions, so the vast majority of governments are still paying-as-they-go and thus are failing to fund their systems actuarially. This will drive the unfunded liabilities of these OPEB plans even higher, probably from $1.5 trillion in 2007 to a number closer to $2 trillion by 2010.Many public employers will ultimately have to face the music and start reducing these benefits, in a triage effort to maintain their primary pension plans.
The recession is likely to continue until the housing market finds a bottom. President Obama's plans to stimulate the housing market must visibly take root before this recession can end. It's hard to see the economy becoming anything better than sluggish before mid-2010.
Obama's health care plan. Speaking of President Obama, there are some who hold out hope that the new administration's plans for national health care will somehow reduce their state and municipal liabilities for retiree health care. Don't hold your breath on that one: It's hard to imagine where the federal government would find the money to bail out a $1.5 trillion deficit for state and local OPEB liabilities. Realistic solutions for those deficits are discussed below: They require investment and financial actions by public employers, not wishful thinking for help from the feds.
State and local government revenues will not recover until long after the recession ends. Property tax revenues in particular will lag the economy and the markets on the upside, which means that local-government revenues likely will continue to shrink throughout 2009 and into early 2010. Additional revenues will simply not be available to properly fund pension plans or to begin making full actuarial contributions to OPEB plans that now provide unsustainably generous benefits.
Interest rates on Treasury bonds are likely to remain low in 2009, and inflation rates will remain benign. Looking beyond 2010, however, the risk of higher inflation and rising bond yields will be a concern to retirement plans and retirees, depending on how much high-powered money is created by the Federal Reserve and how well the global markets absorb the trillions of Treasury bonds issued to pay for the stimulus package. Bond portfolio managers will probably find it impossible to "earn their coupon" when this recession ends.
"The Inflation Enigma" will become a key topic at pension conferences as trustees debate whether today's deflation will become tomorrow's inflation if the dollar weakens in global markets because foreign investors lose confidence in American obligations. What worked last year and this year may not work after 2010 -- and trustees need to model the impact of various inflation scenarios to gauge their risks.
Commodity prices should eventually stabilize and even rebound from distress lows at the end of recession, and may offer an inflation hedge for retirement plan investors. Treasury inflation-protected securities may gain new interest for the same reasons, and real estate will regain favor once concerns about inflation resume.
Credit markets should recover slowly before year-end, as the stimulus plans and the global hosing-out of rotten mortgage paper finally begins to restore bond investor confidence in non-government paper. High-yield bonds, mortgage securities, corporate bonds, preferred stocks and other income-oriented assets will eventually regain favor among institutional investors as they abandon U.S. government paper.
Benefits bonds later this year. Likewise, the municipal bond market will unfreeze in coming months, and this will likely usher in a new wave of pension obligation bonds and the first-ever wave of OPEB-obligation bonds by opportunistic state and local governments looking to replace costly actuarial funding methods with cheaper taxable bond interest rates.
Stock markets typically rally before recessions end, as investors begin to sense the opportunity to make money in the ensuing recovery. A recovery-inspired rally in equities seems likely in 2009. A nagging fear of some market strategists, however, is that the economy fails to achieve a sustainable recovery and double-dips -- as it did in the early 1980s and, more frighteningly, in 1932, when a 70 percent market rally gave way to a deeper depression. Only with hindsight in 2010 will we know if that scenario has been avoided.
STRATEGIES
In this economic environment, here are some strategies for various types of public sector retirement investors. To help you jump to those that interest you most, I have bulleted them sequentially as they appear below:
· Revisit asset allocations, investment strategy and expected market returns · 457 plans · OPEB sustainability audits · Pension obligation bonds · OPEB plan investment strategy · TIPs and inflation · Real estate: When? · Annuitizing employee savings (air time conversions) · Think globally · Position for agility!
As a corollary to this thought, trustees should look very carefully at the performance of their active portfolio managers and ask themselves the hard question: Are you getting your money's worth from active management? From your investment consultant? Have your active managers actually earned their fees over the past year? Over the past 10 years? Has your investment consultant systematically identified and recommended active managers who achieved their purpose? Is the consultant defending incumbents whose records are failures? Many have not earned their keep, and there is good reason to suspect that many will fail in the coming years, as discussed in the "bonus section" of my companion column this month. Alternatively, is the consultant "churning managers" to earn more fees from new manager searches?
Likewise, 457 plan administrators should professionally review their risk exposure and even some key plan design features. With interest rates on money market funds approaching zero -- and the yields on guaranteed accounts, GICs and stable value funds dropping monthly as portfolio maturities roll off -- the default options used in many plans should be re-evaluated. Many of the investment funds used in 457 plan menus now look like a Civil War battlefield after a retreat -- littered by dead bodies and walking wounded. A knowledgeable professional consultant may well earn his or her fee this year by showing the plan sponsor and the oversight committee where some inefficiencies and risks are hidden in the investment menu.
OPEB sustainability audits. As noted in my prior column on OPEB sustainability, the financial officials working in larger jurisdictions that cannot afford to make their actuarially required contributions should invest a trifle -- usually less than one-tenth of 1 percent of their actuarial liabilities -- for an audit or assessment of their long-term capacity to actually pay for the retiree medical benefits that have been promised to workers and retirees. There is no other single investment a public agency can make in 2009 that will produce a higher return than an OPEB sustainability audit. The resultant cost savings and reduction of liabilities will not be painless or easy, but without a clear map and strategy, the hole will only get deeper.
Pension obligation bonds. An inevitably hot topic in public pension finance 2009 will be POBs -- pension obligation bonds -- and their new cousins, OPEB-OBs (OPEB obligation bonds). Market conditions in 2009 may be ideal if stocks remain depressed while the municipal bond market re-opens to permit plan sponsors to issue taxable securities that can raise capital to invest in the stock market. History shows that POBs issued in recessions have the highest probability of future success, and that stocks returns have outpaced bond interest costs over 20- and 30-year periods, as reported in my prior columns.
Five key strategic considerations for public officials pursuing the POB strategy:
(1) Issue bonds only during an appropriate "Benefits Bonds" market window, typically in a recession.
(2) Why would you sell bonds to buy bonds?
(3) Don't fund the pension plan beyond 85 percent if you do borrow.
(4) Don't bet the ranch on one deal.
(5) Set up a POB trust to protect taxpayers and bond creditors from union raids on the cookie jar in future bull markets.
On the second point, my research shows the folly of the traditional model of issuing POBs at taxable municipal bond rates in order to invest in a pension portfolio that invests 35-40 percent of its money in taxable corporate bonds and other fixed-income securities. That is a waste of borrowing capacity that simply enriches bond attorneys, financial advisors and money managers. The only genuine long-term capital markets arbitrage strategy for POBs is to invest proceeds in stocks and real estate, which produce stronger long-term returns than bond yields. POB bond issues should therefore be smaller and fund only the equity component of a pension portfolio.
On the third point, it also makes no sense to fund a pension plan at 100 percent of its liabilities at the bottom of a recessionary bear market. Capital gains in the next market up-cycle will then result in "over-funding," which inevitably brings political demands for benefits enrichments. Thus, the average POB issue should take the plan from 60 percent funded to 80 percent or 85 percent, and invest the new money entirely or primarily in stocks. A special trust fund should also be created to prevent investment profits from funding future benefits increases before the bonds are paid off.
In light of the risk of a double-dip recession or the possibility that this credit implosion is a cousin of the Great Depression, most POB issues should be done in two parts to keep some powder dry in case there is another downturn in the markets once the federal stimulus program wears out.
In a companion column on Bonding for Benefits, I explain these concepts more fully and provide a useful graphic to illustrate clearly the unavoidable importance of market cycles in executing this strategy prudently.
OPEB plans. Most governments will be unable to fund an OPEB trust account, but those that do should seriously consider investing all or most of their annual contributions in stocks. With 30 years of future funding required to pay off their huge unfunded liabilities, startup OPEB plans can take greater risks than most pension plans. They are like college graduates making their first contributions to an IRA or a deferred compensation plan -- taking higher market risks than mature investors -- because they will have much more time until the funds reach their investment horizon, and there are many more years of future contributions ahead to dollar-cost-average. I would rather see a startup OPEB plan take the risk of a higher equity ratio than the risk of hiring active portfolio managers who may underperform the market index, especially for smaller plans with assets under $10 million.
OPEB plans are also strong candidates for partial-bonding solutions in 2009, issuing OPEB obligation bonds (OPEB-OBs). Because they are typically zero-percent funded now, they should not issue more than 65 percent of their total liabilities to fund their investment portfolios, and those bond proceeds should generally be invested in stocks except for the cash-flow needed to pay benefits in the first three to four years if the employer's annual benefits payout exceeds the remaining actuarial contributions after the bonds are sold. For OPEB plans in particular, it seems wise to fund only one-half of the potential bond issue in 2009 and leave the remainder to be done at the bottom of the next recession. Nobody needs to finish the entire OPEB funding plan immediately, and there is significant market risk for those who bet the ranch on one market cycle. In many states, it is imperative that the professional associations and municipal groups obtain the legislation needed to permit these financings to get underway, as clear legal authority is lacking in many states.
A tip on TIPS. Presently, the spreads on Treasury Inflation Protected Securities are favorable, partly because of the flight to quality on conventional T-bonds. Retirement investors and trustees concerned about the potential risk of resumed inflation may be prudent to invest a portion of their portfolios in inflation-protected bonds. Pension funds are probably better candidates than individuals, because of management fees. Internal staff guided by an investment consultant can buy these and put them away, as there is little value added by professional portfolio managers -- other than "total return" bond managers who move in and out of these securities on a tactical basis
Real estate. Everybody hates real estate now. The residential market will likely sink another 10 percent before we reach equilibrium, and it could get worse. Commercial real estate held up well in the first half of 2008, but has now begun to weaken as the economy soured in September. The first half of 2009 will likely see even weaker commercial and industrial real estate returns. Somewhere near the end of this recession, however, there will arise an opportunity for pension funds and retirement investors to secure high-income-producing properties that also offer a strong hedge against future inflation.
Public pension funds as "annuitizers." A worthwhile but admittedly unconventional concept for public pension funds to explore is their capacity to provide shell-shocked employees and retirees a stable income stream for their supplemental savings in the future. With insurance companies offering low rates on life annuities at the same time their credit-worthiness has weakened, 2009 could be a great time for public pension funds to allow retiring employees to trade in their 457 and 403(b) accounts to receive a conservatively underwritten lifetime pension. Such pension exchanges could be based on a conservative earnings assumption of 6.5 percent going forward, which represents a fair mid-point between investment grade bond yields and expected pension portfolio returns. Fair-value pricing should be somewhat above the private-sector annuity rates now available to retirees. The so-called "Air Time" provisions of the 2004 Pension Protection Act permit such arrangements.
What makes no sense whatsoever is for a pension fund to take on this actuarial risk using assumed pension fund investment returns as the discount rate. That's almost as stupid as DROPs (deferred retirement option plans) that credit employees and retirees with the pension plan's assumed rate of return -- which is a complete financial giveaway. Pension funds have lost millions on this DROP-rate scam in the past decade.
Think globally. Investment markets have been trashed all around the world. Overseas markets have suffered even more than domestic bourses. Opportunities abound for making sound, long-term investments in the aftermath of the wicked bear market of 2008. Many great ideas will be presented to public pension boards and their CIOs. The one that probably deserves the most serious attention is the asset allocation policy regarding international investments. With the dollar strong now in the midst of this financial crisis, there could be an opportunity later this year for pension funds to shift a greater portion of their portfolios into offshore assets as a hedge against a possible future weakening of the dollar. With the rout in commodity-producing countries' stock markets, the collapse of emerging markets, and the slowdown in China and India, the second half of 2009 could be an opportune time to make a long-term secular investment play on the theme that American dominance of the capital markets is likely to weaken in the next decade or decades thereafter. There is no need to rush to this conclusion until the risk of deflation has subsided, as the dollar may strengthen if the Europeans grudgingly cut their central bank rates as expected and the U.S. leads other economies out of recession later this year.
Position for agility! If there is one over-arching theme in this column, it is this: 2009 is a watershed year for pension plans. The losses of 2008 will be with us for years, I suspect, so those who are frozen in their past decisions will suffer from a failure to re-align their strategies, their asset allocations, their portfolios and their plan designs to match the new realities they face. With every crisis comes opportunity, and this crisis is no exception. Plan administrators should work with their trustees and stakeholders to reposition their plans to move quickly and skillfully as new opportunities arise and the next economic recovery finally begins to take shape. This does not mean you should abandon your discipline, but rather that you must recognize which losses are irretrievable and move forward. Don't sit on dead money, even if it hurts to admit mistakes. I'm not smart enough to know when the sunshine will return to financial markets (or I wouldn't be writing columns), but I am confident that the timeless advice of wise men will bear true: This too will pass.
