Guest Post: What About Stress Testing Pensions?

Submitted by Leo Kolivakis, publisher of Pension Pulse.


The New York Times reports that more states start pension inquiries:

The sprawling investigation into New York’s pension investments hints at a much bigger problem than the handful of indictments so far would suggest.

What started as an investigation by the New York attorney general, Andrew M. Cuomo, into the state comptroller’s office — where Mr. Cuomo says favors were being exchanged for contracts to invest pension money — has mushroomed into a broad look at more than 100 firms by attorneys general in at least 30 other states.

A survey of practices across the country portrays a far-reaching web of friends and favored associates: political contributors, campaign strategists, lobbyists, relatives, brokers and others, capitalizing on relationships and paying favors. These influential figures can determine how pension funds are invested, as well as state university endowments, municipal bond proceeds, tobacco settlement funds, hurricane insurance pools, prepaid tuition programs and other giant blocks of public money.

“What has developed is a corrupt system, where Wall Street, various fiduciaries, politicians and corporate managers are draining America’s savings,” said Frederick S. Rowe, a hedge fund manager who serves on the Texas Pension Review Board, an oversight body.

In Texas, lawmakers have been working on a bill to strengthen the state pension board and outlaw outside payments to public pension officials. But the bill has been drastically weakened by local pension officials who argued the law would strip them of their independence.

That may leave it up to the Securities and Exchange Commission to strengthen controls at the federal level. The commission has jurisdiction over investment firms, but not local politicians.

Investing public money on the basis of political considerations, rather than merit, heightens the risk of waste and loss, an urgent issue given the market losses of the last year. In 2007 the Government Accountability Office studied a group of pension funds known to be advised by consultants with conflicts of interest, and found their average yearly investment returns were 1.3 percent lower than those of other pension funds.

That may sound small, but it can severely erode a fund over time because the losses multiply.

“If compound interest is the eighth wonder of the world, then it’s the plague of all time when it’s working against you,” Mr. Rowe said.

Mr. Cuomo has said it is too early to estimate the size of any losses caused by the improprieties in New York. Even if the losses cannot be measured, though, he considers it essential to stop the uncontrolled peddling of access.

“You can’t put a price tag on public integrity,” Mr. Cuomo said in a recent news conference. “We have to be sure the system works and people have trust in the system.”

In recent weeks, the New York comptroller and officials in other states have issued rules barring the use of intermediaries — often called placement agents — who are paid by money managers to open doors and help them win allocations from state and local governments. But even those restraints, long resisted, may not work well. Across the country, an examination of practices suggests that time and again pension officials are making poor investment choices and incurring losses because personal connections skew their decision-making.

Consider DV Urban Realty Partners, which won $68 million from five public pension funds in Chicago. The firm was founded by a nephew of Mayor Richard M. Daley and proposed using the money to improve neglected neighborhoods that were central to the city’s 2016 Olympics bid.

So far, the investments have lost money. Now the city inspector general is investigating whether the mayor’s nephew exerted improper influence, but is having trouble because some of the pension funds have declined to respond to subpoenas. Robert G. Vanecko, the mayor’s nephew, has said he did not trade on his family connections.

In Texas, the city of Fort Worth’s pension fund decided to diversify into hedge funds. To help choose which ones, it hired Consulting Services Group of Memphis, which recommended that the city create a custom basket of hedge funds that paid management fees to Consulting Services Group.

Fort Worth embraced its recommendations and invested in the Bayou Fund, a fraud scheme that was exposed in 2005, and then in the Ponzi scheme operated by Bernard L. Madoff. Ruth Ryerson, who has since joined the Fort Worth pension fund as chief investment officer, says that Consulting Services was conflicted because it was collecting fees from both parties in the deal.

In New Mexico, the former chief investment officer of the state teachers’ pension fund has filed a lawsuit saying he was forced out after he opposed a $40 million investment in mortgage-related securities. The investment was made anyway, and the securities are now worthless. The lawsuit describes an informal network of state officials, political insiders and campaign contributors stretching to Illinois.

The disgruntled officer, Frank Foy, says these people worked in concert to talk him into making the investment, then worked together to remove him from office when he did not cooperate. His lawyer, Victor R. Marshall, said the campaign was orchestrated by David Contarino, a chief strategist to Gov. Bill Richardson. Mr. Contarino denies the accusations.

As Mr. Foy describes it, Mr. Contarino also exerted his influence to persuade another state funding pool to put $50 million in similar mortgage securities. That was the State Investment Council, headed by Governor Richardson.

Gary B. Bland, the state investment officer, denied the accusations in a court response in February, calling Mr. Foy’s lawsuit “a political witch hunt.” Since then, the New Mexico state council has begun reviewing whether investment firms paid fees to anyone in connection with obtaining the state’s business. That review was prompted by the New York investigation of placement fees.

The New Mexico council recently disclosed that a top fund-raiser and political ally of the governor, Marc Correra, was paid a placement fee by the investment firm that sold the toxic mortgage securities criticized by Mr. Foy. The records also show that Mr. Correra has been paid roughly $11 million as the placement agent for more than 20 other investments — all private equities, hedge funds and complex structured debt — that have come through the investment council’s door since Governor Richardson took office in 2003.

Investments like those promoted by Mr. Correra, called alternative investments, are controversial for public investment funds to invest in because there is not a ready market for them should the government suddenly need money. They are hard to value, too, and they carry higher risks in the pursuit of higher returns. The investment firms that offer them tend to earn much higher fees, which means a bigger cut for the placement agents.

Mr. Correra’s lawyer, Ronald L. Rubin, said his client earned his fees through hard work and believed he had complied with all the rules. “He wants to follow the law,” said Mr. Rubin, with the firm of Tannenbaum, Helpern, Syracuse & Hirschtritt in New York.

Governor Richardson has suspended new investments in private equity firms, hedge funds and other alternatives.

The current investigations into influence peddling across the country are virtually all connected with investments that expose taxpayers to the greatest risks, and that pay money managers the highest fees, cutting into future returns.

“Money that’s gone can’t compound,” said Mr. Rowe, the hedge fund manager on the Texas Pension Review Board. “The savings pool can’t grow to the extent that it should.”

Mr. Rowe, who has been outspoken about the need for tighter controls on public pension money, was chairman of the Texas Pension Review Board until last year, when he was removed by the governor of Texas, Rick Perry.

Mr. Rowe is absolutely right, money that is gone can’t compound. The more I read about this pension probe, the more I get the sense that the authorities are only scratching the surface of the systemic fraud at public pension funds.

And while authorities in the U.S. look into systemic fraud at public pensions, authorities in Canada might want to do the same here and also look into demystifying pension fund benchmarks so we can stop grossly overpaying our public pension fund managers as they trounce bogus benchmarks.

Regulators all over the world should look into ways at preventing fraud at public pension funds. Relationships between senior pension fund managers allocating to private equity funds, hedge funds, real estate funds, infrastructure funds and all other funds should be carefully scrutinized by the board of directors.

Importantly, there should be clauses barring anyone allocating to an external investment manager from working there for a minimum five year period after leaving the pension fund.

This is simple common sense, but you’d be surprised how cozy senior pension fund managers get with external investment managers. Expensive dinners, entertainment, not to mention trips on private jets, can easily lead to kickbacks.

The Sacramento Bee reports that CalPERS and CalSTRS have invested at least $525 million with money managers who paid finder’s fees to two “placement agents” under scrutiny in connection with a New York state pension fund scandal:

Even as the scandal appears to be gaining steam, CalPERS and CalSTRS said Wednesday they’re comfortable that the investment decisions were made on the merits and not the influence of placement agents. The investments represent a sliver of the $289 billion managed by the two funds.

“The placement agent has no input into the due diligence,” said Sherry Reser, spokeswoman for the California State Teachers’ Retirement System.

Nonetheless, CalPERS, the California Public Employees’ Retirement System, is drawing up a policy requiring disclosure of fees paid to placement agents. CalSTRS instituted a disclosure policy in 2006.

Money managers often use placement agents as “door openers” to help them secure business with big public pension funds. The practice is legal but often isn’t disclosed to the pension funds. In the New York case, prosecutors said two men close to the state’s public pension fund obtained massive kickbacks from money managers, brazenly selling access to the fund.

Even though placement agents have no input on the due diligence, they can easily bribe some senior pension fund officer to invest with a manager. In the past, serious conflicts of interest occurred when consultants were recommending funds to their pension clients which they were investing with. Consulting contracts should also be scrutinized because kickbacks can occur there too.

My advice to plan sponsors is trust nobody. Assume that kickbacks can easily happen when people are in charge of allocating billions to external funds and take the necessary measures to mitigate fraud risks.

Another article I read on Pension Tsunami was by Tom Byrne in New Jersey reporting that pension restructuring is inevitable:

Your pension plan is broke and will stay broke under the present plan. But don’t take my word for it. I had a conversation with one of your union leaders, and was told that union leaders are really politicians too, and if they tell you the truth about your pension, they will be voted out. So their best course is to promise you benefits, and hope that the “game over” sign doesn’t flash on their watch.

Actuarial math is not simple, but the basic premise is. Your pensions and post-retirement health care benefits are terribly underfunded due to a combination of poor investment results and employer contributions that were far lower than needed. The low contributions started in the mid-1990s and ironically, many union leaders acquiesced in these early schemes. I remember, because I was Democratic state chairman at the time, and tried to sound a warning way back then.

But now the hole is much deeper, and in theory there are only three ways out. One is vastly improved investment returns. But they would have to be way outside any historical norms, and this is highly unlikely. Two is sharply higher employer contributions. However, the state has finite taxing capacity. Taxes would have to be raised by $5 billion just to cover the annual gap between what the state paid last year for pensions and post-retirement health care and what actuaries say should have been paid. Not so long ago, New Jersey had a near-rebellion when taxes were raised about $2.8 billion, so $5 billion is highly unlikely. Moreover, even if a huge tax increase were enacted, the 50,000 or so households who shoulder about half of the income tax burden would have additional incentive to simply change domicile and not pay. So the reality is that higher contributions are not likely.

Option three is a restructured plan. It is not a good option. But it is the only option. And it is going to happen no matter what. The only questions are when and whether it is going to happen on terms that you can live with, or on terms that are dictated by market forces. In other words, if there are no changes, the plan simply runs out of money and the state’s younger workers are left with absolutely nothing. Alternatively, a restructuring occurs by apportioning outcomes in a fairer manner by adjusting the retirement age, capping benefits so the highest earners don’t take a disproportionate share, and optimizing a secure retirement for all.

There is one huge potential advantage of a restructuring. Right now, you are praying that the state and towns make the necessary contribution once a year. You would be more secure if your employer made a contribution in each pay cycle, as happens in a defined contribution plan. I don’t have the exact answer, but I’d rather have some certainty about my retirement than a big but empty promise. Maybe some hybrid of a defined benefit plan and a defined contribution plan is the optimal solution. I don’t know. But I do know that the sooner that you open honest discussions about all this, the better off you will be. In planning for retirement, a higher degree of certainly is itself a benefit.

This brings me to my concluding remarks. Federal Reserve Chairman Ben Bernanke on Thursday called for a holistic approach to strengthening oversight of the banking system and said information gleaned from big bank “stress tests” should pave the way for improvements on that front:

Regulators must not only sharpen their assessments of individuals banks, but also examine the financial system as a whole to detect risks that could endanger the normal flow of credit, market operations and commerce – critical elements to the smooth functioning of the U.S. economy, Bernanke said.

“A principal lesson of the crisis is that an approach to supervision that focuses narrowly on individual institutions can miss broader problems that are building up in the system,” the Fed chief said in remarks delivered via satellite to a Fed conference in Chicago.

The current financial crisis – the worst since the 1930s – has revealed “serious deficiencies” on the part of some financial institutions, which regulators are working to fix, Bernanke said.

Those deficiencies on the part of banks include not having adequate capital, or buffers, on hand against potential losses. Some banks also did not plan effectively to make sure they have easy-to-sell “liquid” assets if economic conditions worsen, and they did not have strong risk management policies in place to detect problems, he said.

“Increasing the effectiveness of supervision must be a top priority,” Bernanke said.

In fielding questions after his remarks, Bernanke said he hoped stress test results would give Wall Street “greater confidence” that the nation’s 19 largest banks will be “strong and able to lend even if the economy is worse than expected.”

Going forward, Bernanke stressed the need for banks to build up a capital buffer in good times so that it can be drawn down if things turn sour. If banks had done this in the current crisis it might have provided “some assistance,” although he didn’t know if it would have prevented the financial debacle.

And he said regulators are putting more attention on assessing banks’ liquidity positions. Regulators are monitoring this “more intensely” and on a daily basis, Bernanke said.

Bernanke didn’t provide details about the results of “stress tests,” to be released later Thursday, that will reveal which banks have enough capital and the right mix of it to weather a deeper recession.

If they don’t, banks will 30 days to come up with plans to remedy the situation and then have six months to implement them. Bernanke earlier this week said he was hopeful banks could raise capital on their own, rather than having to rely on the government for aid.

Regardless, no bank will be allowed to fail, Fed officials have said.

Bernanke said all 19 banks are solvent.

Getting banks in a better position to lend more freely again is a prerequisite to turning around the economy.

The stress tests were “comprehensive, rigorous, forward looking and highly collaborative among the supervisory agencies,” Bernanke said, noting that more than 150 examiners, supervisors and economists took part. “Undoubtedly, we can use many aspects of the exercise to improve our supervisory processes in the future.”

Huge, globally interconnected financial firms whose failure could endanger the U.S. economy also should be subject to “a robust framework for consolidated supervision,” he said.

Sheila Bair, the head of the Federal Deposit Insurance Corp., on Wednesday told Congress new powers are needed to oversee such companies and suggested the FDIC could share those oversight duties with other regulators.

Regulators also must keep an eye on bonuses and other compensation practices to ensure they provide incentives to behave in ways that promote the long-run health of the bank. “Certainly an important lesson of the crisis is that the structure of compensation and its effect on incentives for risk-taking is a safety and soundness issue,” Bernanke said.

Earlier this year, public and congressional outrage was sparked by millions of dollars in bonuses paid to employees of American International Group Inc., which has been bailed out by the government four times.

On other issues, Bernanke said a government program to jump-start consumer and small-business lending called the Term Asset-Backed Securities Loan Facility, or TALF, should help ease stresses in the commercial real-estate market but won’t be a “panacea.”

The TALF, he said, after a “somewhat slow start is looking like it is beginning to pick up steam.”

The Fed’s TALF lifeline will definitely not be a “panacea” for commercial real estate, the other shoe to fall. At least two-thirds of the $410 billion of U.S. commercial mortgage-backed securities (CMBS) loans that mature from this year through 2018 are not likely to qualify for refinancing, according to a report by Deutsche Bank:

The predictions get worse for loans made in 2007 — the height of the commercial real estate bubble — where 80 percent are unlikely to qualify, according to the report released on Thursday by Deutsche Bank debt researchers.

As CMBS loans make up only about 20 to 25 percent of the entire commercial real estate market, other sources of financing, such as insurance companies and banks, are likely to see similar or worse potential defaults, the report said.

From about 2005 through the first part of 2007, the U.S. commercial real estate industry experienced an expanding bubble where loans were made using very aggressive assumptions about future rent, occupancy and prices.

Many of those deals were financed using debt equal or surpassing up to 90 percent of the price paid. The liberal use of debt financing in turn fueled prices.

But the credit crisis burst the bubble, and since then prices have tumbled about 25 to 30 percent from their peak, according to the report. Prices could further fall, resulting in values declining 40 to 50 percent.

When those loans come due, borrowers likely will find fewer sources of debt financing, Deutsche Bank said. Available lenders will finance a lower percentage of property value and that value is almost sure to be less, leaving a gap of about $100 billion, Deutsche Bank estimated. Many borrowers will end up defaulting as investors will not pay more than what the property is worth.

Deutsche Bank conservatively estimates that CMBS default-related losses for fixed-rate CMBS is $50 billion, 6.5 percent of the total aggregate outstanding balance. The analysts estimate that maturity default-related losses will be at least 4.6 percent of the CMBS loans securitized in 2005; 5.8 percent for those in 2006 and a whopping 12.5 percent of those securitized in 2007.

So while Wall Street cheers the results of those bank stress tests, I think the Fed and other regulators should start taking a holistic approach to regulating the financial system and look into better regulating hedge funds, private equity funds, private real estate funds, insurance companies and last but not least, private and public pension funds.

I think if they stress tested pensions, they’d be shocked find out how weak they really are (Hint: Don’t just look at funding status, look at total embedded leverage!).