New beginnings

I have a lot more to say about pensions, but that will have to wait until next week as the moving truck is coming tomorrow morning first thing. If I spend any more time at the computer while my partner packs, there will (rightly) be consequences.

It will be a disorienting move – both of us have lived in cities for our entire adult lives, and we’re moving to Princeton, which is about as non-urban as you can get. We also closed on a house yesterday (another first for both of us), and I’m preparing to start a doctoral program at the university this fall. That’s a lot of change at once, and it couldn’t be more welcome.

So here’s to new beginnings. Back next week.

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Detroit’s dodgy numbers

Cate Long wrote an important piece at her Reuters blog today on the possibility that Detroit’s emergency manager has over-inflated the city’s pension liabilities. As Long notes (and as I describe in the post below), Orr changed the way the city measures its pension liabilities without disclosing the methodology used. This change triggered a nearly five-fold jump in stated liabilities, producing a $3.5 billion figure that has now become taken for granted in news coverage of the bankruptcy. Without knowing the methodology, it’s impossible to know how accurate that figure is.

Long’s post is about some new information that has come to light in a Pensions & Investments article, which describes the methodology used based on a copy of the report from Milliman, the new actuary. According to the article, Milliman got to the $3.5 billion figure in part by adding the value of the city’s outstanding pension bonds to its existing remaining unfunded liabilities. To call this “unorthodox” as one actuary did in the P&I article would be a big understatement – the bond liabilities are not part of the pension itself, but are owed by the city.

If Orr is taking this approach, then there are some serious problems with the numbers he has cited about the city’s indebtedness Here is the rundown of the city’s on- and off-balance-sheet debts from Orr’s June presentation to creditors (all figures in billions):


The liabilities for the pensions and the bonds in that report were listed and summed separately as part of the $18 billion total. If Orr did in fact incorporate the bonds into the pension liabilities, then he is double-counting the bonds.

There is an argument to be made that regardless of where they fall on the balance sheet, both the bonds and the unfunded liabilities are obligations related to the pensions that the city can’t pay. But that’s not the argument Orr has been making in the press – he has been consistent in citing the $3.5 billion figure as belonging to the pensions themselves, along with the $18 billion figure as the city’s total debt.

As to why Orr would do this, the incentives are obvious. Inflating the liability numbers contributes to a Thatcher-esque TINA environment around the entire bankruptcy that helps make big concessions from creditors seem inevitable. This is doubly true of the pensions, which have been the focus of much of the reporting on Detroit.

Orr’s own statements have also made it increasingly difficult to give him the benefit of the doubt. In an NPR interview yesterday, Orr was asked about the fairness of reneging on obligations to city employees who had held up their end of the labor contract. His first response was to say that the employees, like everyone else in the city, had been let down by their leaders. The interviewer then asked him whether that wasn’t arguing for punishing the retirees for the behavior of the city government. Orr’s response:

ORR: Well, you know, the workers, in a sense, you’re right, you know, they’re sort of caught with that reality, but also they voted for the leadership of some of their pensions. I mean, Robert, you’ve done stories on Detroit before and you’ve heard about numerous members and sometimes the attorneys representing them ended up going to jail for graft.

So these were indicators that even the most casual observer, but certainly someone who is interested in the pension process, you know, probably should’ve looked at it a little bit harder and wondered how they were being managed and then, unfortunately, birds have come home to roost now.

First of all, it’s unusual for public sector union members to elect anywhere near a majority of the boards that oversee their pensions, so Orr is blaming the victims for something they had little control over. Second, I have no doubt some members were “wondering how they were being managed” – what exactly were they able to do? Orr didn’t say, but the implication that the members were somehow at fault was glaring enough that the interviewer pushed Orr on it, at which point he completely changed gears and fell back on his mantra:

It doesn’t matter what I say. It doesn’t matter what we look back on. There’s just no money.

That statement would be a lot easier to accept if he would release the actuarial report. Simply declaring mathematical inevitability when your numbers don’t add up is not the way to an equitable solution. Especially when your instinct is to blame the retirees for failures they had no control over.

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How did Detroit’s pensions fail so badly?

Pension liabilities are at the center of the fiscal collapse that led to Detroit’s bankruptcy filing today. The scale of the disaster, and the precedent its resolution will likely set, call for a closer look at what went so badly wrong for the funds.

Rapid decline                                   

The scale of pension underfunding we see in Detroit doesn’t usually happen overnight – it’s usually the result of years of terrible short-term political decisions. One of the many shocking aspects of Detroit’s pensions mess is that it became an enormous problem very quickly.

According to a 2005 press release from Fitch, in 2002 the city’s two big pensions  – one for municipal employees and the other for police and fire employees – were funded at 91.6% and 103.2% of liabilities, respectively. The pensions’ portfolios suffered significant losses in the market crash around that time, and the city did nothing to make up the difference (they were not alone in this). By fiscal 2005, the funding ratios had collapsed to 77.6% and 79.7% of liabilities, for a total unfunded liability of $1.7 billion.

That’s when the infamous then-Mayor Kwame Kilpatrick decided to turn to Wall Street for help.

Dealing with Wall Street: Heads I win…

In 2005, the city joined many other municipalities by issuing municipal bonds to “fund” its pension obligations. While these bonds do no such thing – they simply kick today’s liabilities into the future –they have proven to be catnip to borrowers as well as to Wall Street, which earned significant underwriting fees.

Even the initial borrowing appears to have been botched by the city council. A 2005 memo to the council from the city’s fiscal analyst seems to give evidence of confusion over the scope of the bond proceeds, which at $1.44 billion left nearly 20% of the funding gap unaddressed (some council members appeared to think otherwise). Not content with this arrangement, which cost the city over $40 million in underwriting fees, the city inexplicably decided only one year later to refinance $948 million of the total, paying underwriters an additional $61.8 million for the privilege.

Worse still, the council made the fatal decision that has come back to haunt so many municipalities (and even a potential Fed Chairman). No doubt following Wall Street counsel, the city entered into a complex arrangement involving floating-rate debt and interest rate swaps for $800 million of the new debt. In an opaque Rube Goldberg arrangement that only a banker could love, the deal ostensibly reduced the city’s interest rate expenses.

In reality, the deal turned into one of the largest line items in the city’s liabilities. The swap contracts included standard language to the effect that enormous fees could be triggered by major credit events such as a credit downgrade. It’s hard to imagine the city’s dysfunctional council reading the offering document, though perhaps they did. Either way, when the city was downgraded, hundreds of millions in fees were levied by the investment banks. Those fees now total $343.6 million, according to the emergency manager’s report, which is the lion’s share of the nearly $500 million in bond fees the city has paid Wall Street in recent years.

Criminally poor governance

In addition to making the terrible financial decisions above, Detroit’s financial managers have indulged in a who’s who of the worst in pension governance practices in recent years, treating the city’s pension funds as a piggy bank for personal and political gain. Worse, the rot among senior administrators seems to be condoned by their peers (for more, see here). The center of a recent series of indictments (including those that brought down the former mayor Kilpatrick) appears to have been the senior counsel for both pension funds. This attorney kept his job at one of the funds even after the investigations broke. His replacement at the other fund – chosen by the board – was chosen in spite of the fact that he was likely one of the parties caught on tape paying bribes in the investigations.

Corruption and bribery weren’t the only governance failures. In 2012, the city simply forgot to make its legally mandated annual payment to fund its pension. When the missing payment was discovered by an external auditor, the city’s interim leaders appeared to engage in a round of finger pointing that led nowhere. “For whatever reason, it was an oversight,” said the city’s fiscal analyst. It’s not clear whether the payment was ever made.

Manufacturing outrage

The one party who hasn’t come in for blame from the media but – in my view – really should is emergency manager Kevyn Orr. Orr is clearly not to blame for the historical problems that got the pensions into their current mess. But he has been extremely aggressive in boxing the pensions and their members into a weakened negotiating position by attacking them from two angles.

The first has been by massively inflating the pensions’ reported liabilities. Pension liabilities are enormously important but imaginary numbers based on projections about a combination of factors. Perhaps the most important of these is the discount rate, which in turn is usually based on the bond market. Using a higher discount rate makes liabilities seem smaller, and vice versa. The power to define that rate confers the right to define a pension’s viability.

Orr has played a savvy game around Detroit’s discount rate. In his creditors’ report, he noted that the old discount rate yielded a funding gap of just under $700 million, while using “more realistic assumptions” would boost the liability nearly five-fold to $3.5 billion. By repeating that number in talking to the press, without ever revealing the methodology behind it, Orr has mainstreamed the notion that the pensions face a funding crisis that demands emergency tactics.*

Orr’s second tactic has been more subtle. Less than a week after releasing his report, Orr also launched  a very public investigation into corruption at the pension funds. It’s hard to see what this investigation will achieve that the regular legal process has not, but it’s also hard to miss the political implications for the already weakened pensions beyond making the very retirees who have been hurt by the city’s buffoonery even more vulnerable.

Conclusion: TBD

It’s far too early to have anything conclusive to say, other than the obvious – this is the leading edge of a series of decisions that will need to be made about prioritizing bond investors versus retirees. It is going to be a painful process.

* Orr may also have needed to boost the perceived liabilities to give himself more leverage over the funds. The rules that give him emergency control over the funds stipulate that their funding ratios have to be below 80%. The police & fire fund didn’t meet that criterion under the old discount rate; presumably it does under the new one (though again, we don’t have any numbers to know for sure).

7/19/13 – slight copy edit

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“They get your money. You get a piece of paper.”

My first job in investment management was as a mutual fund analyst at Morningstar, and to this day I still remember my first Morningstar Conference. This was back in the days just before emerging markets were commonly accepted as an asset class, which in investment industry terms is tantamount to saying “when dinosaurs roamed the earth.”

That’s likely why the emerging markets fund manager panel is the one that sticks in my memory. The first speaker was superstar Templeton manager Mark Mobius, who entered the conference by wading through the audience of khaki-clad financial planners in a cream-colored suit, with a completely shaved head, and surrounded by giant bodyguards in black suits with earpieces. Mobius gave his characteristically bullish take on the emerging markets and recounted several stories about his recent travels across Asia and Africa, and zeroed in on the massive changes taking place in China as the drivers of a once-in-a-lifetime investment opportunity. I vaguely remember anecdotes about the proliferation of cranes in Shanghai and the wonders of the enormous new consumer market just around the corner.

I don’t remember the name of the next speaker, which is appropriate since he worked in the hive mind of the Capital Group that runs the American Funds. What I do remember is the manager’s deep skepticism of China’s separate equity market for foreign investors in Chinese shares. Given the near total lack of transparency and protection for minority shareholders, the manager said, it wasn’t hard to see who got the better end of foreign investment in Chinese shares. “They get your money. You get a piece of paper” without any rights, he said (more or less – I didn’t write it down).

To be fair, both Templeton and the American Funds went on to invest heavily in Asia, as did most other fund managers. Nonetheless, I was reminded of that manager’s skepticism when I saw this in Bloomberg over the weekend:

China’s 20-year economic boom has boosted the wealth of its 1.3 billion citizens at the fastest pace worldwide and spawned some of the biggest companies in history. Foreigners earned less than 1 percent a year investing in Chinese stocks, a sixth of what they would have made owning U.S. Treasury bills….

While China’s shift toward a market economy has lifted per-capita incomes by 1,074 percent and helped its companies raise at least $195 billion through stock sales in Hong Kong, investors with $695 billion say that corporate governance concerns, competition and state intervention have eroded returns for minority shareholders. Now, as China allows unprecedented access to its local capital markets amid the weakest projected gross domestic product growth since 1990, Aberdeen Asset Management Plc says valuations must fall further before it buys.

“China is a case in point that great GDP doesn’t mean a great stock market,” Nicholas Yeo, a money manager at Aberdeen Asset, which oversees about $322 billion worldwide, said by phone from Hong Kong on July 10. “The lack of quality in terms of corporate governance is one of the main reasons we find why companies don’t perform well over the long term.”

The difference between an exciting narrative and a great investment is often invisible even to the experts. That’s doubly true when competitive performance and marketing pressures lead investors to ignore the fundamentals of governance.

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Addendum – new chart

There was a fair comment on Twitter yesterday about the usefulness of the relative contribution chart in the post below given the absence of  the years with negative numbers. It’s true that the graphs were misleading without them, but it’s equally true that the relationships between losses, contributions and net funding were a mess to graph given both the varying signs as well as the magnitudes.

But it was a fair question, so here is a different view of the same data. To highlight the relative magnitudes of market returns vs. contributions without wrestling with percentages, I’ve combined employee and government contributions into the light blue bars, and added a dark green bar for total funding including both contributions and market gains/losses.

Aggregate fundingFor the curious, the market loss in fiscal 2009 was a whopping $613 billion.

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Correcting the record on public pension funding

This will have to be brief as I’m working on something related, but I wanted to share something I discovered today as it touches on the increasingly political subject of public pensions and underfunding.

In my research, I came across a statistic that 60 cents of every dollar in funding for public sector pension funds comes from investment returns. That sounded surprising, so I followed the trail of citations from the Pew Center to a lobbying organization called NASRA, which included the following graph in a 2011 report:

NASRAThis jumped out at me for two reasons. First, it undermines any notion that public sector pensions are bleeding the public dry – it appears as though public funds have been relying on the market rather than funding. This is consistent with Moody’s findings in its recent review of public sector pension funding, where the analysts noted that the most frequent cause of underfunding in the worst-funded pensions was inadequate contributions.

The second reason was that this figure covers a very long time period that includes both positive and negative market returns, which would make an average like this less meaningful. How would this look over time?

Thankfully, the Census makes the data very easy to access and use, and provides annual surveys going back to 1993 (all available here). There are a number of ways to look at the data, but I’ll focus on contributions, which the Census provides both in dollars and as a percentage of all sources of funding.

To evaluate the Pew/NASRA figure, I converted contributions from the three main sources of public pension funding – employee contributions, employer/government contributions and investment returns – into percentages of the total, and removed fiscal years with negative market returns to focus on the trend (and avoid messy percentages). The picture looks a lot worse than what the Pew/NASRA figure implies:

Pensions 2

What we can see from these figures is that the relative contributions of governments and employees have been dwarfed by those of Mr. Market. And pace the Pew Center and NASRA, investment returns today account for nearly 80% of public pension funding – the 60% figure they cite stopped being relevant during Clinton’s first term. This leaves state and local taxpayers – meaning, us – at the mercy of the financial markets when it comes to pension funding.

This is admittedly far from the whole picture. Pensions are effectively a kind of insurance, which means that both the assets (the funded portfolio) and their liabilities (the promised benefits) are important.  Even there, however, financial markets play an enormous role given that the discount rate used to calculate the truly big numbers in terms of liabilities are a function of market rates and returns.

I’ll leave that for another post, but for now it’s worth noting that we’re living with the fallout of policy decisions to turn social insurance into unfunded market risk.

For now, it’s also worth looking past the percentages to see the actual numbers, especially given the widespread belief that cash-strapped governments are plowing money into pensions. The data certainly support that view, though here again, the picture is more complicated than that political view would imply. Here are the dollar figures just for employee and government contributions:

A taxpayer’s take on this might be outrage – after all, the red bars have more than doubled, confirming that governments are sending more and more taxpayer dollars to fund public pensions. And the taxpayer would be right to be outraged, but so would employees. The blue bars representing employee contributions have also more than doubled over the period, so it’s not only governments that are paying more. Moreover, employees have been increasing their contributions steadily since 1993 – governments, by contrast, appear to have taken a funding holiday for most of the 1990s bull market, and only woke up to the need to fund pensions after the end of the tech bubble (if memory serves, there was also a GASB rule change right around then, though I could be wrong). Had governments kept pace with increases in employee funding, the current mess of widespread underfunding would likely be very different.

My political leanings should be clear by now – I think the underfunding of both public and private-sector pensions was a deliberate choice that we are all going to pay for. Whether you believe that or not, it’s imperative that we use the correct data when we discuss what happens next.

7/9/13 – slight copy edit

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Risk parity and the power of branding

The “risk parity” concept has been among the most popular ideas in fund management and asset allocation over the past few years, and has been one of the keys to the extraordinary success of Bridgewater, one of the most highly regarded hedge fund firms. Although the idea has never really made sense to me, I figured that the rocket scientists at Bridgewater, AQR and the like must have a handle on the obvious pitfall. According to an article in today’s Wall Street Journal (ht Barry Ritholtz), that may have been too generous an assumption.

Risk parity sounds eminently rational. You begin with a portfolio that is diversified across markets like bonds, stocks, emerging markets, real estate, etc. But where a traditional asset allocation portfolio would simply take the returns and volatility of this portfolio as a given, risk parity goes one step beyond this to engineer a targeted risk profile. It does this by using leverage/hedging to adjust the volatility of each of the asset classes in the portfolio so that they are equal (hence the “parity”).  Theoretically, this should allow the fund manager to engineer a target level of risk while still getting the benefit of diversifying across different markets.

In practice, what this has meant is that bonds – which tend to have the lowest volatility of the major asset classes over time – are leveraged so that their volatility is magnified. That’s a great strategy when things are going well, and it’s also a great answer to the need for greater returns – it allows you to hold bonds in your portfolio, but it also lets you get more juice from them. In normal times, it should also protect your portfolio from falling equity markets, since bonds (and particularly Treasuries) tend to do well then.

Unfortunately for risk parity funds, however, leverage works in both directions. When bond markets are not doing well, this all but ensures that you have leveraged exposure exactly where you don’t want it. Worse still, these are not normal times – in the strange markets of 2013, both equities and bonds have been falling together. The results, according to the Journal article, have not been pretty:

The recent market turmoil has tested many followers of the strategy. That is mostly because stocks have tumbled along with bonds after the Federal Reserve hinted at a reduction in its stimulus program last month. Making things worse, commodities and inflation-protected securities, which are widely used by risk-parity managers as a hedge against inflation, also suffered heavy losses because of receding inflationary expectations.

“We don’t expect to make money every year,” said Bob Prince, co-chief investment officer of Bridgewater, which regards itself as a pioneer of risk parity. Bridgewater’s $75 billion “All Weather” risk-parity fund is down about 8% for the year, according to a person familiar with the returns.

Risk–parity mutual funds have lost an average of 6.75% this year, according to Morningstar. Meantime, a stock-and-bond index comprising 60% of the S&P 500 stock index and 40% of the Barclays U.S. Aggregate Bond Index, a widely used bond benchmark, is up 6.76% this year, according to Morningstar. Risk-parity proponents often argue that their strategy is designed to beat a so-called 60/40 portfolio of stocks to bonds.

I think risk parity is particularly interesting in terms of the power of branding. In spite of this gap in the strategy’s logic, the idea of these as “all-weather” portfolios (Bridgewater went so far as to name its funds that) has taken hold first with institutions, and more recently with retail investors. And the biggest gap of all comes in the perception by many that these are defensive strategies, regardless of the fact that using leverage on bonds is the opposite of defensive.

For a sense of the difference between perception and reality, consider the investor’s perspective:

Many of risk parity’s followers have been counting on the strategy to generate solid returns under almost any circumstance, particularly in rocky markets such as the current one.

“Investors have come to view these as really defensive types of vehicles, so expectations are being disappointed,” said Josh Charlson, a senior mutual-fund analyst at Morningstar.

And compare that to the fund manager’s view:

“There are going to be environments where it massively outperforms and there are going to be environments like the last couple of months where it underperforms,” said Michael Mendelson, a principal at AQR who is a portfolio manager for the hedge-fund firm’s risk-parity strategies. “It’s going to go both ways,” he said, adding that risk-parity should outperform a traditional portfolio over the long-term.

I have a feeling a lot of investors are wishing they had heard the latter story rather than the former. They would have been much better served if they had.

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