Public Pension Funds Are Adding Risk to Raise Returns

Published: March 8, 2010, New York Times

States and companies have started investing very differently when it comes to the billions of dollars they are safeguarding for workers’ retirement.

Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

“In effect, they’re going to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. “Double up to catch up.”

Though they generally say that their strategies are aimed at diversification and are not riskier, public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.

The Texas teachers’ pension fund recently paid Chicago to receive a stream of payments from the money going into the city’s parking meters in the coming years. The deal gave Chicago an upfront payment that it could use to help balance its budget. Alas, Chicago did not have enough money to contribute to its own pension fund, which has been stung by real estate deals that fizzled when the city lost out in the bidding for the 2016 Olympics.

A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.

Pension funds rarely trumpet their intentions, partly to keep other big investors from trading against them. But some big corporations are unloading the stocks that have dominated pension portfolios for decades. General Motors, Hewlett-Packard, J. C. Penney, Boeing, Federal Express and Ashland are among those that have been shifting significant amounts of pension money out of stocks.

Other companies say they plan to follow suit, though more slowly. A poll of pension funds conducted by Pyramis Global Advisors last November found that more than half of corporate funds were reducing the portion they invested in United States equities.

Laggards tend to be companies with big shortfalls in their pension funds. Those moving the fastest are often mature companies with large pension funds, and who fear a big bear market could decimate the funds and the companies’ own finances.

“The larger the pension plan, the lower-risk strategy you would like to employ,” said Andrew T. Ward, the chief investment officer of Boeing, which shifted a big block of pension money out of stocks in 2007. That helped cushion Boeing’s pension fund against the big losses of 2008.

Shedding stocks gave Boeing “material protection right when we needed it most,” Mr. Ward said. By the time the markets had bottomed out last March, Boeing’s pension fund had lost 14 percent of its value, while those of its equity-laden peers had lost 25 to 30 percent, he said.

“We estimated that the strategy saved our company in the short term right around $4 or $5 billion of funded status,” he said.

Boeing and other companies seeking to reduce their investment risk are moving into fixed-income instruments, like bonds — but not just any bonds. They are buying and holding bonds scheduled to pay many years in the future, when their retirees expect their money.

The value of the bonds may fall in the meantime, just like the value of stocks. But declining bond prices are not such a worry, because the companies plan to hold the bonds for the accompanying interest payments that will in turn go to retirees, not sell them in the interim.

Towers Watson, a big benefits consulting firm, surveyed senior financial executives last year and found that two-thirds planned to decrease the stock portion of their companies’ pension funds by the end of 2010. They typically said their stock allocations would shrink by 10 percentage points.

“That’s 10 times the shift we might see in any given year,” said Carl Hess, head of Towers Watson’s investment consulting business. Economists have speculated that a truly seismic shift in pension investing away from stocks could be a drag on the market, but they say it would not be long-lasting.

Corporate America’s change of heart is notable all on its own, after decades of resistance to anything other than returns like those of the stock markets. But it’s even more startling when compared with governments’ continued loyalty to stocks. When governments scale back on the domestic stocks in their pension portfolios these days, it is often just to make way for more foreign stocks or private equities, which are not publicly traded.

Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

(Corporate plans do their calculations differently, and for them, investment returns are a less important factor.)

The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be.

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions.

But plan officials say they cannot.

“Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.

The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report.

But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace.

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

If Colorado could somehow get 9 percent annual returns from its investments, though, its pension shortfall would shrink to a less daunting $15 billion, according to its annual report.

That explains why plan officials are looking everywhere for high-yielding investments.

Mr. May, in Wyoming, said many governments were “moving away from the perceived safety and liquidity of the investment-grade market” and investing money offshore, but he said he was aware of the risks. “There’s a history of emerging markets kind of hitting the wall,” he said.

Last year, the North Carolina Legislature enacted a measure to let the state pension fund invest 5 percent of its assets in “credit opportunities,” like junk bonds and asset-backed securities from the Federal Reserve’s Term Asset-Backed Securities Loan Facility, an emergency program created to thaw the frozen markets for such securities.

The law also lets North Carolina put 5 percent of its pension portfolio into commodities, real estate and other assets that the state sees as hedges against inflation. A summary of the bill issued by the state’s treasurer and sole pension trustee, Janet Cowell, said it would provide “flexibility and the tools to increase portfolio return and better manage risk.”

But some think they see new risks.

“It doesn’t pass the smell test,” said Edward Macheski, a retired money manager living in North Carolina. “North Carolina’s assumption is 7.25 percent, and they haven’t matched it in 10 years.” He went to a recent meeting of the state treasurer’s advisory board, armed with a list of questions about the investment policy. But the board voted not to permit any public discussion.

Wisconsin, meanwhile, has become one of the first states to adopt an investment strategy called “risk parity,” which involves borrowing extra money for the pension portfolio and investing it in a type of Treasury bond that will pay higher interest if inflation rises.

Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proof Treasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.

Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.

It decided to start with a small amount of leverage and gradually increase it over time, but word of even a baby step into derivatives elicited howls of protest from around the state.

The big California pension fund, known as Calpers, was already under fire for losing billions of dollars on private equities and real estate in the last few years. So far it has stayed with those asset classes, while negotiating lower fees and writing off some of the most troubled real estate investments.

It announced in February that it had started looking into whether it should lower its expected rate of investment return, now 7.75 percent a year. It has embarked on a study, but a spokesman said that process would not be done until December, safely after the coming election.