Who's Accountable for Destroying Pensions?

by: Amit Chokshi, CFA

The Wall Street Journal recently ran an article discussing a new leveraged approach taken by the State of Wisconsin Investment Board that highlights a number of shortcomings of pension investing practices. Wisconsin, like many state pensions, has been brainwashed by various investment consulting firms that continuously trot out skewed data from sources such as Ibbotson that have led these pensions to use grossly unrealistic annual rates of return for asset allocation purposes. As a result, these pensions have bolstered allocations into increasingly riskier asset classes, led in part by the "advice" of investment consultants, to stretch for their returns. Unfortunately, the strategies pursued by pensions such as Wisconsin are leading to the growing likelihood of a pension implosion, with the taxpayers and current and future pensioners all ultimately losing out. And as with the Too Big to Fail problem, those that are most responsible for this pending problem - the managers of the pensions and the investment consulting industry - will be held blameless.

Wisconsin has recently decided to leverage up its high grade credit portfolio. So funds holding Treasuries and high grade corporate bonds would be levered up to juice overall returns. Conceptually it would work this way: Wisconsin may have $100MM in T-bonds and high grade corporate bonds currently yielding 5.5%. Wisconsin expects to ramp up leverage to 20% so the pension would borrow $20MM to invest $120MM in high grade bonds and Treasuries. If financing for this $20MM costs about 3% and the $120MM portfolio returns 5.5% in one year, if Wisconsin were to close out the portfolio, its return would be $120MM x 1.055 less $20MM x 0.03 less the $20MM in funding. This would result in $106MM left over from Wisconsin's initial equity investment of $100MM - a 6% return. Basically leveraging the portfolio by 20% gets you 50 basis points. That's not that attractive when one considers we're at a very low interest rate environment, which the WSJ points out.

What if we have another credit crisis? I don't personally think we'll see what was experienced in 2008 but there's a lot of room between the calm credit waters we are now experiencing and the end of the world in 2008. As the Fed reins in its quantitative easing programs, credit instability may emerge. Not to mention other outliers that may have outsized market impacts in the short-term (Dubai, Greece, etc.). What if Wisconsin's $120MM portfolio loses 10%? Many corporate bonds are trading above par but yielding paltry rates. In a credit crisis, Wisconsin's investments in high grade corporate bonds could suffer a haircut as yields rise. More importantly, lenders may require more collateral if the portfolio drops in value and funding costs may rise. Let's ignore those factors and just run the same math. In this case, with a 10% hit, Wisconsin's portfolio would take a 13% loss. A 13% drawdown is not the end of the world provided it's in the appropriate securities basket but the fact that Wisconsin has been steered into a structure that can yield large losses in what are seemingly the lowest risk securities is ridiculous. This is approaching equity-like downside with very little upside unless more leverage is assumed, increasing the overall risk profile.

And the way this story will ultimately end is higher taxes and reduced payments to beneficiaries and fat contracts to folks like Wilshire Associates, who helped steer pensions into these investment fads, to "help" with the problem. The most glaring problem is that pensions have laughable expected rates of return for their investments, ranging from 7-8%. This is perpetuated by investment consulting firms that push Ibbotson data which projects market returns off of arithmetic averages when the historical geometric average returns are significantly below those figures. For forecasting, the arithmetic mean is used but volatility raises the arithmetic mean and penalizes the geometric mean. The geometric mean is what you as an investor realize, however, and it's why this concept should be understood by all investors. For example, the arithmetic average of two years of +18% and -16% is +1%, while the geometric return, or what an investor would be left with after a two year investment, would be -0.4%. Yet the arithmetic average would be used to determine future asset allocations. As a result, high volatility asset classes like equities have arithmetic means that are vastly overstated for projection purposes relative to their likely returns.

The WSJ article mentions that pensions such as Wisconsin's $78B pension fund have been "frustrated" with hedge fund and private equity in recent years which has led the pension to consider this strategy. However, the problem is that the pensions fail to conduct some introspection into why that's the case. The data has always been available and clearly shows that alternative asset funds, particularly LBO funds, raised during boom periods perform terribly while those assets that are raised in recessionary time periods perform the best. Why? It's because of valuation. During boom periods, leverage is loose so LBO firms and hedge funds can pay more for already inflated assets. When credit tightens, valuations compress and the sliver of equity supporting those assets implodes and hence pensions are left holding the bag. However, in economic and market pullbacks, credit and capital are both tight, limiting the number of truly attractive opportunities available. As a result, valuations are not frothy and this is what sets the stage for better future returns. This is borne out by the data. LBO funds raised in 1999-2000 have performed poorly while those from 2001-2002 performed very well. It's likely that pensions like Wisconsin waited for more and more confirmation and finally had investment consultants steer them into greater alternative asset allocations heading into 2005-2007. These will likely be the worst performing LBO and alternative investment performance funds in history.

So why do pensions consistently stumble and bumble into disaster? Part of it is that despite the portrayal of "sophistication" at the institutional investor level, many are simply trend followers and chase the hot trend. I discussed this when interviewed for an article in Mergers Unleashed in October 2008, entitled Fundraze. Another problem is that while pensions want those that can do the typical MBA-speak "outside of the box" type of thinking, many pensions are unable to do the same.

For example, even with the advent of separately managed accounts ("SMAs"), pensions prefer the status quo. Pension and other large investors generally prefer larger funds due to operational infrastructure and longer term track records larger funds have. Many pensions cut initial checks of $5-$50MM and have targeted allocation levels that allow those initial investments to be added to over time to $100MM+ allocations. This has led to greater institutionalization of the financial industry where a hedge fund with $50MM could be on the radar of pensions 15 years ago but now needs $500MM for many pensions to consider. The reason is because these pensions need to conduct the same level of due diligence for a $50MM fund as a $500MM fund and would rather write the bigger check which a $500MM fund could handle (the pension cannot be more than 25% of assets in a fund in the US).

However, SMAs circumvent this problem, allowing small managers to run large books for pensions. Unlike hedge fund investments, SMAs are more liquid for the pensions and offer full transparency. Unlike many funds that threw up gates in 2008 that prevented investors from withdrawing, SMAs can be pulled at anytime. Due to the assets of a pension or any investor being separated from broader investment pools, there really is no asset size impediment for a fund manager to run SMAs for pensions. However, many still prefer to stick with the typical investment format and refuse to work with lesser known managers.

I recently had a conversation with some pension managers and while my hedge fund is too small for them consider, I offered to run a SMA and charge 1.5% (waive performance allocation fee). This coming from a fund manager that has outperformed the market with all investors in the black from 2007-2009, eats his own cooking, uses no leverage, and is offering a fee that is below even actively managed mutual funds - yet there was still no interest. Now of course this story is commonplace to many, many smaller fund managers; rejection rates are expectedly high in a competitive field, but what is particularly strange is that when you have a product that has the numbers and metrics, why are pensions consistently ignoring these products and paying the 2/20 to larger firms and not broadly using the leverage that they have, to at the very least negotiate better pay terms?

I think it's sometimes the "institutional imperative" which Peter Lynch coined best when he said nobody gets fired for holding IBM stock. The same applies to fund investing. Lose a fortune in a fund raised by Carlyle or Blackstone? Big deal, everyone else was in it too. But lose money in a smaller fund, SMA, or unknown security, the question is why the hell did you invest with them or in that stock. However, the most important aspect is that pensions seem to shy away from using the institutional strength and leverage that they have with fund managers. After a disastrous period from 2007-2008, why are pension managers willing to pay 2/20 to fund managers that have devastated their portfolios? Why not impose stronger terms and pressure the fees? These pensions have a fiduciary duty not only to the direct beneficiaries - the pensioners - but the taxpayers.

In very few cases is the performance of a fund so proprietary and specialized that 2/20 is justified. Obtaining fee cuts is a direct positive benefit to the overall pension performance and hence the stakeholders of the pensions, yet pension managers have little backbone in front of the larger, established funds. For example, a $100MM that generates a 15% return and charges just 1.5% would yield a net return of $114MM in one year (assume the fee is based on the average of $100MM and the year-end figure of $115MM). A 2/20 fund that generated the same return would yield a net return of $110MM. And while there has been some fee negotiations, it's generally been tailored towards reduced management fees in exchange for longer lock ups. In either case, 2/20 structures dictate fund managers "justify" the structure by taking on larger risks.

Pensions also exhibit ridiculous apprehension towards volatility. Pensions have extremely long time horizons so should be much more willing to accept healthy levels of volatility. The standard deviation of a broad equity portfolio would be about 18%, meaning there would still be a 33% chance of results being even wider than that! Hedging can help but at the same time an over-emphasis on volatility will penalize longer term performance of pensions.

Pensions also have relied far too greatly on the investment consulting industry. Rather than accept a greater degree of personal career risk, pension managers invest by committee and are assisted by consultants in determining which funds to invest in. Many of these pension managers, consultants, and investment firms have been exposed to have questionable kick-back agreements in recent press reports.

Unfortunately, it's nearly impossible to break the overall cycle of pensions chasing returns and trends. Pensions cannot control the liability side of their balance sheets unless a long and politically impossible conversation is held with pensioners who are due benefits that in today's environment may simply be far beyond what can be reasonably paid. As the liability side of pension balance sheet grows, the focus is on boosting the asset side as quickly as possible. Raising taxes in a severe economic downturn makes no sense nor would taxpayers be willing to subsidize pensioners due to the incompetence of pension managers who assumed idiotic rates of return when negotiating benefits for pensioners, again making a middle ground difficult to achieve. Consequently, it appears that pensions will continue to kick the can down the road, assuming greater risk and hoping they can thread the needle but ultimately placing the entire pension system at risk.