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Pensions Look to Leverage Up?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
Craig Karmin of the WSJ reports Pensions Look to Leverage Up:
Public
pension funds needing to boost their returns but
The
strategy calls for leveraging pension funds' safest asset—government or
otherhigh-grade bonds—while reducing exposure to stocks.
The
State of Wisconsin Investment Board, which manages $78 billion, became
among the first to adopt the strategy when it approved the plan
Tuesday. The fund will borrow an amount equivalent to 4% of assets this
year, and as much as 20% of its assets over the next three years.
Fund
officials say that use of leverage could eventually go higher—in
theory, at least, up to 100% of assets, according to the staff
analysis. But Chief Investment Officer David Villa says that level
wouldn't be palatable for the Wisconsin fund. He said the pension fund
was advised by four money managers, including Connecticut hedge-fund
firms AQR Capital and Bridgewater Associates.
Wilshire
Consulting, which advises pension funds on investments, says leverage
helps the funds meet their long-term return targets without relying too
heavily on volatile stocks, or tying up their money for long stretches
in private investments. Low interest rates make it impossible to meet
those targets with simple bond investments. Wilshire managing director
Steven Foresti says he has been in discussions with about a half-dozen
funds that are interested in the leverage strategy.
While
public pensions for years have had indirect exposure to borrowed money
through property or buyout funds, most have steered clear of borrowing
money in their own portfolios.
That public pension funds would
contemplate the use of borrowed money so soon after a credit crisis
stoked by financial leverage already is setting off alarms for some in
the industry.
These analysts wonder if this is little more
than the latest gimmick peddled by investment consultants. In previous
years, consultants pitched a strategy called portable alpha, an
aggressive bet involving leverage and hedge funds that magnified
returns when the stock market was surging but aggravated losses when
the market turned down.
"When people reach for return with
nontraditional approaches they can take on risks they don't fully
appreciate," says Daniel Jick, head of HighVista Strategies, a
Boston-based firm that manages money for small schools and other
investors. As many investors found out in 2008, he added, "using
leverage can force you to sell assets you'd rather not sell."
Moreover,
he questions the timing of leveraging bonds when many economists are
forecasting a pickup in inflation and an increase in interest rates as
the economy recovers. That would cause bond prices to fall, and
leverage could magnify those declines.
Some
advocates of the leveraged approach acknowledge these drawbacks, but
say the strategy makes sense anyway. Most big public pensions have
expected annual rates of return between 7.5% and 8%. Wisconsin, for
example, assumes 7.8%.
Many analysts consider those return
rates unrealistic. Yet pension funds are loath to change them because
that would require local governments to get more money from taxpayers
to compensate for lower projected returns. Even at an 8% return, the
average public fund will have about 55% more in liabilities than in
assets 15 years from now, due to recent losses and challenges in
raising contribution rates, according to PricewaterhouseCoopers.
Most
pensions piled into stocks in the late 1990s, counting on a booming
market to increase assets, which in turn allowed these funds to
increase retirement benefits or reduce state contributions. Since the
tech-stock bust, however, many pensions became queasy with the
volatility attached to stocks and have been trying to find a substitute
to help meet their return targets.
During
much of the previous decade, many pensions thought they found the
answer in private equity, which put up big numbers. But these funds
collapsed in value in 2008 alongside the stock market while locking up
pension fund capital for 10 or more years.
"We started talking
to the board about this two years ago," says Mr. Villa, Wisconsin's
investment chief. "It would have been nice to have this in a place
prior to the crisis." That is because the strategy calls for leveraging
assets that held value in 2008, Treasurys and other highly rated bonds.
"Fixed income is a good hedge in a crisis scenario," says Rick
Dahl, chief investment officer for the Missouri State Employees'
Retirement System, who said he is considering using this strategy. "If
I can ramp up my fixed income to the point where it gets equity-like
returns that makes a lot of sense."
But he isn't yet convinced. "I'll need to think through all the ramifications, too," Mr. Dahl said.
Rick
Dahl is one of the smartest pension fund managers I've ever spoken
with. While adding leverage to fixed income may sound crazy at this
point of the cycle, it might be a worth pursuing, especially if pension
funds believe we are heading into a protracted deflationary episode.
The
problem with this strategy is what happens when all the pension parrots
start doing it? Who is overseeing systemic risk of public pension funds
investing in hedge funds, private equity, and now leveraging their
fixed income portfolios? I hope someone at the Fed is also "thinking
through all ramifications" of this strategy because before you know it,
leverage in bonds is about to grow exponentially, posing a new set of
macro risks for the global financial system.
Postscript
The idea of using leverage intelligently can be traced back to Bridgewater Associates:
Engineering Targeted Returns and Risk
The
“All Weather" beta strategy suggests that you can maximize your
portfolio’s Sharpe ratio (lower risk or higher returns) by leveraging
asset classes including bonds. Any asset class that is expected to earn
more then the risk free rate, and less then the equity premium. The
idea being that by fixing your portfolio for a specific expected return
(10% in their article) with leverage you are getting more
diversification by having lower asset class correlation, which reduces
your portfolio’s risk. In theory it makes sense, but in practice,
complications can arise as correlations are notoriously unstable.
»
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The entire world is a convexity trade unwind disaster waiting to happen. These guys piling on levered carry trades will only enhance the damage.
The problem with pensions is they target nominal returns with risk being a residual plug. Their collective return assumptions are simply too high and their funding calcs are flawed (by design). As the smartest allocators I know (hint, they don't work for public plans) are sitting on a pile of cash with unlevered balance sheets the brilliant folks in Wisconsin (and they're asshat advisors) are going to pile on levered risk in the most unattractive financial market. None of these guys wanted to own USTs when nominal rates exceeded their return assumptions. Now, they want to pile in levered. Simply brilliant.
Lastly, I especially like the assertion that these guys have some ability to correctly time such uses of leverage. Their fee collecting asset managers will surely NEVER tell them it's an awful time to pay fees (b/c they will pay on notional invested capital hence more fees for asset managers). This leaves the pension manager and the consultant. Best of luck with either of those groups EVER making the right decision on a timely basis. As evidence....how'd that whole portable alpha thingy work out? Oh, right, that was TOTALLY different.
http://www.youtube.com/watch?v=0o8XMlL8rqY&feature=player_embedded
The idea of using leverage intelligently can be traced back to Bridgewater Associates:
http://invivoanalytics.com/wp-content/downloads/DALIO_PMPT2007update.pdf
The “All Weather" beta strategy suggests that you can maximize your portfolio’s Sharpe ratio (lower risk or higher returns) by leveraging asset classes including bonds. Any asset class that is expected to earn more then the risk free rate, and less then the equity premium. The idea being that by fixing your portfolio for a specific expected return (10% in their article) with leverage you are getting more diversification by having lower asset class correlation, which reduces your portfolio’s risk. In theory it makes sense, but in practice, complications can arise as correlations are notoriously unstable.
That article was pretty long on theory and short on examples. What I am suggesting is that there is some level of yield which represents the Maximum Sustainable Return that can be achieved by any portfolio, and that going beyond that level is simply a glorified method of rolling the dice.
The figures presented were a couple of years old, and don't tell us how the “All-Weather” portfolio perfomed during the most recent debacle. But my general observation is that a lot of sophisticated investors using very complex strategies were, as we have seen recently, actually just rolling the dice.
The elephant in the room, which no one wants to acknowledge, is that there is a fundamental reason why pensions are in crisis across all levels of government and private entities: the declining rate of wealth production. This is the result of many decades of poor fiscal and monetary policy, whose net effect has been to channel savings away from productive investments and instead toward consumption and speculation. In other words, society has been living off its accumulated wealth, rather than adding to that wealth.
There is no portfolio strategy that can remedy this situation, and only two solutions exist. One is to default on promises which cannot be kept, or write them down to their current value, and simultaneously return to sound fiscal and monetary policies. The other is to continue down the same path until the financial system implodes, or explodes, at which time those thought to be responsibe for the fiasco will be lynched by angry mobs.
Dumb question. Who is lending the Pension Plans the money to leverage? I assume the rate the Plans pay for the loaned money is lower than the return from the income investment. Yet, they say the income investments are "low risk". So, why would anyone lend them money at a lower rate than they could get themselves by putting the money into the low risk income investment?
I'm trying to wrap my little brain around this strategy. The goal of leverage is to finance an investment by borrowing at a lower rate than the return of whatever that investment might be. So presumably, state/local pension funds will borrow at (taxable?) muni rates, and then use the proceeds to purchase . . . what? Corporate bonds, I guess, since it's hard to imagine that pension funds could borrow at less than treasury rates.
I have a pretty good idea what corporates yield, but what rates will pension funds pay to borrow? Will they issue 20-30 bonds and then invest the proceeds in corporates of similar maturities? I suppose that could work out. Or will they borrow short and lend long? With interest rates at the bottom of a 30-year down trend, that looks like a recipe for disaster.
Maybe the Feds will allow the pension funds to issue tax-free munis, which they can then invest in highly rated corporates of comparable maturity? Now that sounds like a sound strategy that could make a real dent in pension deficits. Of course, that would really just be a back door bailout by the Feds, and I suspect that Treasury might have some objections; given the size of federal deficits and the resulting need to sell a lot of new debt, I doubt Treasury would welcome so much competition.
Pardon my ignorance, maybe I should have found the answers to all these questions by reading between the lines. But it seems to me that there are a lot of missing elements to this story.
Mr. Villa must have liked the envelope full of cash that fell into his pocket when the deal was signed. He should prepare for the wrath of his fellow Wisconsonites when this blows up, and they don't buy his story that he was verbally assured that the likelyhood of anything going wrong was as remote as the chance of the US Govt. declaring bankruptcy.
Steven Foresti should hire good lawyers now, he will be in court for years over this. Pre-paid legal might take him on.
Lee S.
The funding gaps are also being tackled from the participants side. Colorado amongst others are starting to both cap COLA and increase participant pay ins. While this doesn't get you half way it does begin to close the gap particularly on the liability side. Inflation will lower the PV of those LT liabilities and get these guys back to a reasonable funding status. Who knows maybe these levered investments will get them overfunded so that they can then immunize the plans and go on gardening leave.
I'm just a working class schmuck in the hinterland of Ontario, so what the hell do I know but...it seems to me that these pension plan managers seem to ignore the fact that taking on higher risk in search of higher returns has the associated higher risk of higher losses as well. That is the essence of risk taking isn't it? Without the very real potential for losses there is no risk.
Those 8 % annualized return assumptions will force Public Pension funds into riskier assets. And after their recent catasrtrophic losses, the pressure is greater now than ever before to push the envelope.
It is amazing to me that CalStrs ( CA State Teachers Retirement Fund )can be underfunded to the tune of $ 42.6 billion with barely any attention paid to it at all. This is just one of many pension related IEDs embedded all around the road to " recovery ".
You are right, Leo. Nobody seems to be overseeing the systemic risk of these pension funds. The fund managers keep throwing dice despite the fact many have "sevened-out" repeatedly.
Here in Canada, the compensation schemes at public pension funds reward excessive risk taking. Not to mention that the worst kept secret is how almost everyone is gaming their private market and hedge fund benchmarks to make it seem as if they're adding value (in reality, they are adding leveraged beta). They got no skin in the game, so it's easy for them to bet the farm with other people's money. And what about the board of directors at these major public pension plans? They are asleep and totally incompetent for allowing these shenanigans to go on. Pay people on real performance and real alpha, not leveraged beta!
The carry trade comes pensions LOL It's pure ponzi. Leverage the life blood of Keynesian Ponzi economics. "Tuesday is coming Wimpy"
"I'll gladly pay you.."
+50
AHHH... what could possibly go wrong? They really should take the toys (money) away from these little kids pretending to be billion dollar casino tycoons. There may still be an 8% return available but it belongs to the other side of the table that suckers these fund managers into big bets. It's always been sound economic policy that when you've lost big you need to bet bigger. What about capital preservation as a good starting point?
Pensions that have been gamed away (by the managers but, in many cases, guaranteed by the taxpayer) and health care costs are the disasters coming at us full speed that can't be kicked down the road.
Leo, keep on top of this file - pensions are the "killer app".
Thanks exportbank. Of course Canadian pension fund managers discovered the intoxicating power of leverage a while ago - and its disastrous effects when the storm hits (ABCP, 2008).