Pension Funds are Money Pots for the Biggest Risk-takers on Wall Street
The Real Risk of Pension Plans: They Give Retirees False Security
Business Week - Retirement security is ending the year at an all-time low. The $1.1 trillion last-minute spending bill will allow trustees to cut benefits in multiemployer defined benefit pension plans. And while it affects a relatively small population, 10 million people at most, it
opens the door for other employers to make similar cuts. Maybe that’s a
long way off; maybe not. But the provision is a rude awakening: We may romanticize guaranteed retirement benefits and lament our 401(k) world, but pensions aren’t safe these days either.
Until recently, a pension benefit seemed as good as money in the bank. Companies or governments set aside money for employees’ retirements; the sponsors were on the hook for funding the promised benefits appropriately. In recent years, it has become clear that most pension plans are falling short, but accrued benefits normally aren’t cut unless the plan, or employer, is on the verge of bankruptcy—high-profile examples include airline and steel companies. Public pension benefits appear even safer, because they are guaranteed by state constitutions.
By comparison, 401(k) and other defined contribution plans seem much less reliable. They require employees to decide, individually, to set aside money for retirement and to invest it appropriately over the course of 30 or so years. Research suggests that people are remarkably bad at both: About 20 percent of eligible employees don’t participate in their 401(k) plan. Those who do save too little, and many choose investments that underperform the market, charge high investment fees, or both.
It turns out that pension plan sponsors, and the politicians who oversee them, are just as fallible as workaday employees. We all prefer to spend more today and deal with the future when it comes. Pension plans have done this for years by promising generous benefits without a clear plan to pay for them. When pressed, they may simply raise their performance expectations or choose more risky investments in search of higher returns. Neither is a legitimate solution. In theory, regulators should keep pension plan sponsors in check. In practice, the rules regulators must enforce tend to indulge, or even encourage, risky behavior.
Because pension plans seem so dependable, workers do in fact depend on them and save less outside their plans. According to the 2013 Survey of Consumer Finances, people between ages 55 and 65 with pensions have, on average, $60,000 in financial assets. Households with other kinds of retirement savings accounts have $160,000. It’s true that defined benefit pensions are worth more than the difference, but not if the benefit is cut.
As the new legislation makes clear, pension plans can kick the can down the road for only so long. Defined contribution plans have their problems, but a tremendous effort has been made to educate workers about the importance of participating. (Even if the education campaign has been the product of asset managers who make money when more people participate, it’s still valuable.) Almost half of 401(k) plans now automatically enroll employees, which has increased participation and encouraged investment in low-cost index funds. And now it looks like a generous 401(k) plan with sensible, low-cost investment options may turn out to be less risky than a poorly managed pension plan, not least of all because workers know exactly what the risks are.
Prudential Piles on the Corporate Pensions
Business Week - Big
U.S. companies have found a way to escape the burden of ballooning
pension obligations: pay an insurance company to take them over. Since
2012 corporations have transferred $41.4 billion of U.S. pensions to
insurers, according to Limra, an insurance industry trade association. Prudential (PRU) has dominated the dealmaking, agreeing to acquire more than $35 billion in pension obligations from companies including Bristol-Myers Squibb (BMY), General Motors (GM), Motorola Solutions (MSI), and Verizon (VZ)—meaning
the nation’s second-biggest life insurer now has the responsibility of
making pension payments to almost 200,000 of those companies’ retirees.
For corporate executives, the transfers offer peace of mind. They no longer need worry about how stock market crashes or low bond yields will affect the company’s pension burdens. And they don’t need to estimate how long each of their retirees will live. For insurers, pensions are familiar territory: They already sell annuities and are in the business of managing pools of money to meet long-term obligations. Corporations have “no strategic rationale for wanting to hold on to these liabilities,” says Jonathan Novak, who oversees American International Group’s (AIG) institutional life business. “It’s a far more natural fit for the skill set of the life insurers.”
Prudential’s pension acquisitions: $25b in assets for 110,000 GM retireesFor workers, the benefits of the deals are less clear. Pensions lose federal government protection when they’re transferred to insurers, according to Karen Friedman, policy director at the Pension Rights Center, a nonprofit consumer organization. “The verdict is not in on how safe these transactions are,” she says. “They happen very quickly. We still think the government regulators need to act.”
Companies typically transfer plans covering employees who are retired or near retirement and are no longer accruing additional benefits. At some companies, retirees outnumber employees. Motorola Solutions, which employs 15,000 people, had 95,000 participants in its pension plans before striking a deal with Prudential in September to take over payments for 30,000 of them. The agreements have increased in popularity in recent years as a recovering stock market helped bring pension assets back in line with liabilities, making the transfers less costly for companies. In a typical transaction, the insurer gets about $1.09 in assets for every dollar of pension promises it takes on, according to consulting firm Mercer (MMC).
$3.2b in liabilities for 30,000 Motorola Solutions beneficiaries
The market is growing fast. About $100 billion to $150 billion in transactions could take place in the next five years, says Mercer. MetLife (MET) took on about $279 million of obligations in the first nine months of the year, while AIG has acquired $65.6 million, according to Limra. Prudential was No. 1 with $604.8 million (the figures include only completed deals). The latest: On Dec. 16, MetLife said it agreed to take over pension benefits for about 7,000 people from TRW Automotive (TRW) in a $440 million deal.
Ultimately, AIG estimates, at least $1 trillion in U.S. pensions could go to insurers. To ensure a deal is profitable, insurers have to make complicated calculations about mortality, interest rates, and investment returns over periods of 20 years or more. Small variations from a forecast could have a large impact on results. “The competitive landscape for large closeouts leaves little margin for error,” MetLife Chief Executive Officer Steven Kandarian warned in October. “A negative surprise relative to assumptions could impact returns for decades.”
Prudential’s success in winning the biggest deals could mean its pricing is too low. Moody’s Investors Service (MCO) tried to figure out what would happen if death rates fell at about 2 percent a year faster than Prudential’s expectations. That’s the equivalent of the average 70-year-old living 1.7 years longer than expected. That sort of shock, while highly unlikely, could lead to big losses for the insurer, especially if it takes on many more pensions, Moody’s analysts warned. “Once you write a block of business, you’ve assumed that risk for decades,” says Scott Robinson, a senior vice president at Moody’s. “If you write a big deal, you don’t get a second chance.”
Aegon (AEG), the Dutch owner of Transamerica, says insurers need to take a lot of credit risk to earn enough to meet the obligations they’re taking on and generate a profit. “We’ve looked at that market, and we cannot make that pricing work,” says Chief Financial Officer Darryl Button. “I don’t think that product in that market is rationally priced in the U.S.”
Story: What Does Your Retirement Plan Really Cost?
The Hidden Risk in the World’s Best Pension System
Compared with defined-benefit plans in the U.S.—rare, underfunded, and governed by accounting standards derided by almost every economist—the Dutch pension system looks even better. It does have a weakness, though, one that’s often overlooked, even though it may be the only aspect of the Dutch system that’s likely to be adopted here: In the Netherlands, annual cost-of-living increases depend (PDF) on the health of the pension’s balance sheet. If returns fall, benefits don’t increase. If the fund performs badly enough, pensioners may even suffer benefit cuts.
This kind of risk-sharing has been catching on in America. Public pension benefits are often secured by state constitutions, but it’s not clear whether those guarantees extend to inflation-linked adjustments. Eager to contain costs, some states have eliminated cost-of-living increases entirely. The state of Wisconsin adopted a variant of the Dutch model in which retirees in the Wisconsin Retirement System get a cost-of-living adjustment only when pension assets return at least 5 percent. Previous inflation adjustments can be clawed back; monthly checks were 10 percent smaller in 2013 as a result of the financial crisis. Although, unlike in the Dutch plans, retirement income can never fall below its nominal level at retirement.
Such risk-sharing seems to solve one of the U.S. pension system’s biggest problems: Most pensions are horribly underfunded, because guaranteeing income for thousands of people no matter what is more expensive than most state governments can even admit to themselves. Letting benefits fluctuate with the pension funds’ assets puts some boundaries around the guarantee that make it more affordable. Stanford economist Josh Rauh and University of Rochester’s Robert Novy-Marx estimate that if other states followed Wisconsin’s lead, unfunded pension liabilities would fall 25 percent. If they went with the full Dutch-style model, and could cut benefits, unfunded liabilities would fall 50 percent.
But to call it risk-sharing makes it sound more benign than it really is, particularly because retirees can’t tolerate as much risk as working people can. Post-retirement, most people live on a fixed income. In general, it’s too late to save more or get another job. Many state employees don’t have other sources of inflation-linked income like Social Security. If “fairness” means everyone has to bear risk equally, then the Dutch system makes sense. But if it’s more “fair” to treat people differently according to their means, then it would be better to share the risk with current workers instead.
Inflation risk may not seem like a big deal now. But the future is uncertain, which is why the guarantees are so valuable. Until the financial crisis, Dutch pensioners took it for granted they’d get their cost-of-living adjustment each year. Gambling on future inflation may be preferable to an underfunded pension—or no pension at all—but it’s no free lunch.
Public Pensions Cannot Stop Chasing Performance
Business Week - At
the California Public Employees’ Retirement System, the biggest public
pension in the U.S., 1.6 percent of the assets were invested in hedge
funds
Two
basic principles of investing hold up remarkably well: Past results
really don’t predict future performance, and high fees eat away at your
returns. Smart investors don’t chase performance (as much as they can
help themselves) and keep costs to a minimum. Unfortunately for
taxpayers, the experts who run public pension funds aren’t following
these rules. What’s more, they have little incentive to start.
First, the good news: Public pensions in California, Ohio, and New Jersey have been reducing their investments in hedge funds, noting high fees and poor performance, the Wall Street Journal reported. The Los Angeles Fire and Police fund invested $500 million in a hedge fund that returned less than 2 percent over the last seven years; the fund had comprised just 4 percent of Fire & Police’s portfolio but 17 percent of investment fees paid.
The pension plans reconsidering these high-fee, low-performance investments include those with allocations to hedge funds ranging from 1.6 percent to 15 percent of assets, according to the Journal. What they share, though, is dismal returns: The average hedge fund return for public pensions was 3.6 percent for the three years ended March 31, a period when returns from stocks were up more than 10 percent.
But for all the griping about hedge funds’ high costs and lousy performance, it doesn’t appear pension funds have learned their lesson: They are maintaining their investment in private equity, in some cases, even expanding it. Private equity funds invest in non-publically traded assets; like hedge funds, they also promise higher returns—in exchange for high fees and often more risk. And historically, private equity has been a bust for pensions, too. Research by economists Josh Lerner, Antoinette Schoar, and Wan Wong found public pensions underperformed in private equity relative to other institutional investors such as endowments, private pensions, and insurance companies. In the period they looked at (funds raised from 1991 to 2001), the pension funds’ private equity investments didn’t do much better than an equity index fund.
So why the preference for private equity? It sure looks like performance chasing. According to the Journal, private equity investments returned more than 10 percent to large pension funds in the last three years. Accordingly, pension funds have dived in.
Just 0.6 percent of Ohio’s state pension assets were invested in private equity in 2002. By 2013 it took up more than 9 percent. The California Public Employees’ Retirement System (CalPERS) increased its investment from less than 1 percent to more than 12.4 percent of its assets between 2001 and 2013.
In 2013, Ohio celebrated its move: The five-year return on private equity was almost 12 percent—one of its best-performing asset classes. That means either pension fund managers have been luckier since 2001, more skilled, or private equity is having its day. Private equity is risky, and you’d expect high returns some of the time. The question is, can they keep it up?
Fund managers have every reason to be bullish. After all, they’re tacitly rewarded for chasing investments that promise higher returns. The funds use their expected return on their assets to figure out what they expect to owe pensioners in the future. The higher the expected return, the smaller their future liabilities appear. The only way to jack up the expected return is to pay for it, either by paying for access to more exclusive markets (like private equity) or by taking on more risk, or both. If pension funds invested only in low-cost index funds, it would be harder to justify the 7 percent to 8 percent return states currently forecast. This leaves pension fund managers with an incentive to constantly chase the latest, greatest, and most expensive assets.
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