Monday, November 28, 2005

Another Pension Headline to Make You Cringe

Courtesy of the New York Times, we have, "Pension Officers Putting Billions into Hedge Funds." This is just a bad situation getting worse. Defined benefit pension plan sponsors are in a hole and continue to dig--someone should take away the shovel. Let's be clear from the onset:

1) I do not have any major issues with defined benefit pensions per se. If corporations want to sponsor them and workers will accept them in lieu of cash wages, then so be it. My own research contradicts the widespread perception that DB pensions offer the typical worker a better retirement outcome than DC pensions, given the way people contribute to them and invest them. They also make the firm's financial statements a bit more complicated.

2) I do not object to corporations making investments in hedge funds, if that's what the shareholders want to do. It is not my preference, because the impact of the investments on the firm's financial statements might make performance evaluation more difficult. But that's a small complaint.

3) I do not object in principle to PBGC insurance, but I do object to the way it is implemented. The insurance premium is too low on average, is inadequately related to the amount of underfunding, and is completely unrelated to the investment mix of the fund's assets. That premium structure, combined with lax funding standards, is what has put the PBGC in its current predicament, even without hedge fund investments.

The cocktail comprised of equal parts (1) - (3) is a vile brew. And the interaction with the political process will be a disaster. From the article:

While most pension plans have modest stakes in hedge funds, others have invested more than 20 percent of their assets. Weyerhaeuser, the paper company, has 39 percent of its pension fund's assets in hedge funds. In Congress, there has been a push for amendments that would make it easier for hedge funds to manage even more pension money, without having to comply with the federal law that governs company pensions.

Such a bad idea. So now the PBGC won't be able to figure out whether it is offering portfolio insurance to Long Term Capital Management? Continuing with the article:
Weyerhaeuser's big position has significant benefits for the company. Accounting rules let companies factor expected pension returns into their operating income; Weyerhaeuser's hedge-fund-laden portfolio allows it to claim expected annual returns of 9.5 percent. By comparison, the 100 largest companies that sponsor pension funds predicted last year that their average long-term returns would be 8.5 percent, according to Milliman Inc., an actuarial firm.

For Weyerhaeuser, each 0.5 percent increase in the expected rate of return is worth an additional $21 million to the company's pretax income this year, according to S.E.C. filings. Weyerhaeuser did not respond to phone inquiries about its hedge fund investments, but said in S.E.C. filings that its actual pension investment returns more than justify its assumption of 9.5 percent.

The article is missing the point here--the higher the rate of return the company can assume on its pension assets, the lower the contributions it needs to make today. Note that funding rules do not require any reserve to be accumulated to protect against the extra risk associated with the higher returns, nor do PBGC insurance premiums go up due to the added risk. So to the corporation, this looks like free money.

And finally, more bad news from Congress:

In Washington, despite concerns over the health of the nation's pension system, there has been little discussion of pension plans' growing use of nontraditional investments. Even as Congress has been working to shore up the pension system and strengthen the Pension Benefit Guaranty Corporation, a provision to relax the pension law for hedge funds has been proposed.

The provision would raise the limit on how much pension money a hedge fund can handle before it is deemed a fiduciary under the pension law, which would require it to be more prudent and careful than is required under securities law and would bar some trades entirely. The provision was added to a broad pension bill in the House shortly before the Committee on Education and the Workforce approved the legislation.

Currently a financial institution becomes a pension fiduciary when more than 25 percent of its assets consist of pension money; the bill would raise that to 50 percent.

That's just sad. We should be heading in the other direction: pushing corporate DB sponsors to use a term-structure of riskless Treasuries to value and fund their liabilities. At some point, somewhere, someone is going to have to pay the true economic cost of their activities.

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Nathan Kaufman said...

People interested in hedge funds and this blog posting might find this book to be of interest:

When Genius Failed: The Rise and Fall of Long Term Capital Management (Roger Lowenstein)

I always had a difficult time with the diction "long-term" in regards to LTCM. I would like to open the discussion for nominations of more appropriate diction (eg, haphazard not long-term).

dearieme said...

Like Titanic Capital Management.

Anonymous said...

LTCM is also an example of "sharking" -- when positions started to go bad on LTCM, no one in for-profit trading world cared and even enjoyed watching such "proud" people grimace and lose money. A lot of people do not bend over backward to save a righteous or proud person. Regulators and the public are forced to do so.

Anonymous said...

Romans 5:7 in the NT captures a theme demonstrated in the LTCM debacle

Anonymous said...

The term hedge fund is quite broad and captures so many investment strategies that I find such blanket criticism to be a bit hard to accept.

Moreover, it is my impression hedge funds can employ various financial instruments that can actually reduce risk and can therefore invest more efficiently than mutual funds. That is to say, can generate better risk-adjusted returns.

Anonymous said...

do you think hedge funds in the NYT article include "private equity" or "venture capital", or do hedge funds exclude private equity and venture capital? what about commodities? maybe i should reread it more closely and answer my own question.

Arun Khanna said...

You might want to take a look at Mitchell Petersen's JFE (1994) paper titled, Cash flow variability and firm's pension choice.

Robert Schwartz said...

"We should be heading in the other direction: pushing corporate DB sponsors to use a term-structure of riskless Treasuries to value and fund their liabilities. At some point, somewhere, someone is going to have to pay the true economic cost of their activities."

Just about every change in pension plan regulation over the last 30 years has increase the cost of maintaining db plans. as a result, they have become more and more rare, which in turn has caused liberals to wring their hands about the disappearance of "traditional pensions."

You can't have it both ways guys. It can't be increasingly expensive and not be increasingly rare.

A further point. Isn't the collapse of firms and industries an inevitable progression of their natural histories. Firms are formed, they grow, as they grow they start with a few young workers, progress to a large number of mature workers, the firms become more efficient, reduce the number of workers needed to maintain their output, wind up with a large number of retirees, who add nothing to the firm, who the firm must dump or die.

Doesn't this life cycle contradict the entire idea of company based db plans.

Battlepanda said...

I'd be happy to let DB pensions go the way of the Dodo, and I'm speaking as a liberal. Americans need pensions they can take with them from job to job, just as Americans need affordable healthcare that is not predicated on their employer.

For me, the PBGC epitomizes the kind of unfair and inefficient backdoor socialism that is plaguing our country. Make no mistake, Vox, Uncle Sam is the PBGC. There's no way we can make the premiums high enough to make the PBGC self-supporting without crippling companie and further encouraging the kind of bad behavior outlined in this post. Now, I'm not saying that we should let pensioners who played by the rules all their lives eat cat food. But we should be bailing them out, not their companies. Public money should not start flowing until all the assets of the defaulting company has been liquidated to go towards their obligations. Will this cause a lot of short-term pain, of course. And innocents will lose their jobs. But ultimately, this bad behavior cannot continue.

We are not honest in this country about the kind of system we have. We worship the ideal of small government and laissez faire. But we don't want to face up to the fact that people get hurt as well as prosper. So we find back-door ways to subsidize employers into providing benefits, as if that's more market-kosher than providing the benefits to citizens directly. So, we end up with the worst of both world -- big-government level spendings without the secure safety net for our citizens that those spending levels usually bring.

Kent said...

big-government level spendings without the secure safety net for our citizens that those spending levels usually bring.

I agree that we have big-government spending that fails to provide the expected safety net. Where liberals and conservatives disagree is over whether such a safety net is even possible.

Great article, Andrew. As a non-economist, I find this kind of thing very informative, especially when you include lots of links to further information. I think I finally understand what "selling short" means.

Anonymous said...

My intuition tells me a lot of the hedge fund chasers these days are marginal people who are followers and not leaders. hedge funds were the place to be late 1999 through around 2002 or 2003. People investing in hedge funds today may be fighting yesterday's battle.

A big issue in pensions is clubby, buddy-buddy underperforming pension managers. Didn't a lot of pension assets perform miserably historically compared to indexes? how does this happen? my pot of activity managed money is up close to 20% this year and i am looking for a job.

As long as hedge fund wannabes are using history as a guide: prior to year 2000, the longest period in history between average S&P 500 highs was 8 years. This means the highs from 2000 could be realized by 2008, all with very low fees and transparency through ETFs. granted, history does not always predict the future...

When pensios say 40% or so to hedge funds, we need to know the definition of a hedge fund. We also need to know the time-to-maturity of the pension liabilities. If the 40% is a bunch of not liquid stuff, and the pension needs liquid stuff, this could be a big problem.

in general, i can see why pensiosn what to diversify away from traditional bonds and stocks into stuff like real estate, commodities, private equity, venture capital, hedge funds, etc. How we define all this (what is a hedge fund and hwat is not), and regulate it, is another matter.

Anonymous said...

one more: even though i said there were a lot of chasers and followers in hedge funds, there are still probably some sincere, authentic people whose time was right to enter hedge funds around 2004 and 2005. Congratulations to them.

You might read Absolute Returns, a book that gives a good overview of the universe and history of hedge funds.

I do not think markets are all that efficient to people who are born smart, work hard, and have education and experiences.

Anonymous said...

longest period between average S&P highs post WWII-

Bush and Greenspan seem to be a lot more active and interventionist in the eoncomy than Hoover. (Spending big $ and lowering itnerest rates a lot)

What do you think?

dearieme said...

"Americans need pensions they can take with them from job to job": goodness me, I didn't know you couldn't. Mrs Thatcher freed us on this: when you move jobs, you can transfer the value of your pension from your old employer's scheme to your new one. The valuation might or might not be generous, but at least you have the option.

Arun Khanna said...

Do labor market total compensation rates (wage rates plus benefits) reflect anticipated shortfalls in pension funds?
Perhaps firms should be required to have a percentage of their annual estimated pension fund liabilities invested in a sinking fund. PBGC insurance premiums clearly need to reflect risk profile of pension fund investments.

Anonymous said...


When you say "reflect risk profile", do you mean time-to-maturity of unfunded liabilities, or do you mean volatility of portfolio, or both?

Anonymous said...

How about following XOM in the next couple years as a bellwether...

Bernard Condon, July 7, 2005,

Pensions That Bear Mention

hope the link works - otherwise it is still free via google search.

Arun Khanna said...

By risk profile I was loosely thinking in terms of systematic risk of pension fund assets multiplied by funded liabilities/total liabilities of the pension plan.
However I don't know much about risk of pension funds so if there are better ways to determine risk of pension funds I will gladly defer and accept such measures.

Arun Khanna said...

By risk profile I was loosely thinking in terms of systematic risk of pension fund assets multiplied by unfunded liabilities/total liabilities of the pension plan plus unfunded liabilities/total liabilities.

doc said...

And who do you think is going to pay the full economic costs of the continuing tragedy of db pensions? It's be retirees and current workers, no?

John B. Chilton said...


Brad DeLong's Semi-Daily Journal: Ghosts That Haunt General Motors

Anonymous said...

You also might read Bogle's book The Battle for the Soul of Capitalism.

Bogle started Vanguard (mutual fund, investments).

Bogle is also a Republican and conservative.

A lot of the people that manage pensions are part of the same class of people that run large legacy corporations. The "professional" people that manage pension money do not always make demands on management needed for LT survival of company.

More shareholder activism during my lifetime, while possibly a pain for management, may be a good thing.