As you might be aware, America’s state and local governments are facing a series of fiscal crises that are inextricably bound to public sector pension funds.
This is something we’ve spent quite a bit of time documenting over the years, and especially since May, when the Illinois State Supreme Court struck down a pension reform bid, triggering a Moody’s downgrade [9] for the city of Chicago and thrusting the state’s budget crisis into the national spotlight.
In October, Comptroller Leslie Geissler Munger admitted that Springfield [10] would have to forego a $566 million pension payment in November.
And it’s not just Chicago. There’s also Houston, where a $3.2 billion pension-funding gap imperils the city’s credit rating [11] and threatens to hurt demand for the city’s debt. “Among other concerns, the city’s plans assume relatively high investment returns of 8% or above, meaning the funding gap may be understated,” Marc Watts, chairman of the Greater Houston Partnership’s Municipal Finance Task Force, told WSJ. “Yes, ‘relatively high investment returns,’ as in, ‘returns that in today’s world can’t possibly be generated by anything that even approximates a conservative mix of assets,’” we said.
This is a persistent problem with public pension funds. In order to keep the present value of the liability from ballooning, managers need to cling to a 7-8% return assumption. Of course in a NIRP world, that’s next to impossible to achieve unless you reach for yield by “diversifying” into riskier asset classes. Here’s a graphic from a 2014 report from a panel commissioned by the Society of Actuaries:
[12]
As you can see, the percentage of funds dedicated to “alternatives” has risen steadily. Consider another chart, this one from Bloomberg which shows that pension funds have essentially doubled their allocation to hedge funds over the past four years:
[13]
This is in part an effort to offset the inexorable declines in fixed income yields but regular readers will no doubt immediately identify the problem with this strategy. For those who need a reminder, here’s what we said in the wake [14] of the flash-crashing nightmare that hit markets in late August:
Incidentally, here’s what "hedge" funds should do: protect against massive, "fat tail" days like this Monday; instead they merely ride the beta train with the most leverage possible, hoping that the Fed will prevent any events that actually need hedging, and blow up in a fiery crash any time the market tumbles. Needless to say this makes most of them utterly useless, especially since one can just buy the SPY for almost nothing, and avoid paying the hefty 2 and 20 (or 3 and 45) fee.
Well, public sector pension fund managers have apparently been completely oblivious to that point for the better part of a half decade and as Bloomberg reports, it’s cost them dearly.
“The investment pools gained 0.4 percent through November, putting them on pace for the worst year since 2011,” Bloomberg says [15], before reminding the world that these things are blowing up faster than an ISIS oil convoy caught in the crosshairs of a Russian Su-34. “The industry’s struggle was underscored over the past two months as BlackRock Inc., Fortress Investment Group and Bain Capital closed hedge funds after running up losses.”
Here’s more:
The low returns are dealing a setback to governments that boosted exposure to hedge funds, seeking windfalls to help close a $1.4 trillion shortfall that’s facing public-employee retirement systems nationwide. The investment funds have underperformed stocks since 2008 as share prices rallied and volatility whipsawed global financial markets.
Public pensions count on investment returns of more than 7 percent a year, so anything less puts pressure on governments to set aside more to ensure they can cover all the benefits promised to employees.
With their investments faltering, funds with more than $16 billion of assets have announced plans to shut down this year, including those run by some of Wall Street’s most well-known firms, according to data compiled by Bloomberg. BlackRock decided to close its Global Ascent hedge fund following losses that triggered withdrawals by investors including the Arizona Public Safety Personnel Retirement System, Fort Worth Employees’ Retirement Fund and the Maryland State Retirement and Pension System.
The California Public Employees’ Retirement System, the U.S.’s largest public pension, said last year it would liquidate its $4 billion hedge-fund portfolio because of the cost and complexity.
Underscoring just how poorly these investments have performed especially considering the fee structure, Jeff Hooke, a managing director with Focus Investment Banking in Washington conducted a study with five state pension funds over five years which showed that the median return on hedge-fund investments a full 6 percentage points lower than a 60/40 equity-fixed income index fund managed by Vanguard. The expense ratio on the Vanguard fund: 0.23%. That’s a hell of a long way away from 2 and 20.
Hooke’s conclusion: “Hedge funds have cost the states tens of billions in opportunity costs the last five years.”
So amusingly, public pension funds probably could have closed their funding gap by just buying the S&P and watching the Bernanke/Yellen put work its magic, but instead, they went out and plowed retirees’ money into hedge funds that ended up massively underperforming and now, it’s too late to take advantage of the equity gravy train because the FOMC is about the yank the punchbowl.
We hope someone has learned a lesson here, but we seriously doubt it, because as Donald Boyd, senior fellow at the Nelson A. Rockefeller Institute of Government told Bloomberg, the longer pension fund managers cling to unrealistic return assumptions in a ZIRP and NIRP world, the more they’ll reach and the more they’ll likely lose which means “taxpayers and those who count on government services and investments will pay the price.”
