by John Bougearel – author of Riding the Storm Out
From Michael Kranish, staff writer from the Boston Globe, – “Just months before the start of last year’s stock market collapse, the federal agency that insures the retirement funds of 44 million Americans departed from its conservative investment strategy and decided to put much of its $64 billion insurance fund into stocks. Switching from a heavy reliance on bonds, the Pension Benefit Guaranty Corporation decided to pour billions of dollars into speculative investments such as stocks in emerging foreign markets, real estate, and private equity funds.” Millard recieved approval for the asset allocation shift in Feb 2008.
No stats on how large a portion of the funds the trust has lost, but we can safely assume it is going to be life-altering for the fund.
“Peter Orszag, head of the White House Office of Management and Budget, has “serious concerns” about the agency, according to an Obama administration spokesman. Last year, as director of the Congressional Budget Office, Orszag expressed alarm that the agency was ‘investing a greater share of its assets in risky securities.’”
The former agency director who implemented the asset allocation shift, Charles Millard pooh-poohed the Orzag’s accusation stating “the new investment policy is not riskier than the old one” and that the previous policy of relying largely on 30 year treasury bonds “virtually guaranteed that some day a multibillion bailout would be required from Congress.” Millard recognizing the obvious, sought to remedy that by diversifying into riskier asset classes.
Now that multibillion bailout required from Congress is just around the bend. Still Millard believes the fund the way it is now is suitably structured to weather the financial armageddon that we find ourselves in. When asked if the asset allocation shift was a mistake, he inferred the only way it would be a mistake is if the trustee managers lacked the will to embrace the asset allocation shift for the long haul. “Ask me in 20 years. The question is whether policymakers will have the fortitude to stick with it.”
Yikes! Millard thinks he plugged the fund into a black box system and all you have to do is ride it out for 20 years for it to bear fruit. Here is my shot back that I would like to remind Millard: It took 20 years for the Dow Jones to recover all its losses from 1029. Net net, if Millard had made this asset allocation shift in 1929, it would take 20 years for the fund to just breakeven, let alone address the the liabilities of generating an expected return of roughly 8%. some thought and regard for “risk-management” is an essential input if one hopes to be a moderately successful portfolio manager. Unfortunately, because of the flawed belief in the “miracle of diversification” risk management is largely dismissed as irrelevant.
“The worst case scenario is coming to pass,” said Mark Ruloff, a fellow at the Pension Finance Institute, an independent group that monitors pensions. He said the agency leaders “fail to realize that they are an insurer of pension plans and therefore should be investing differently than the risk their participants are taking.”
“Now, they warn about a “perfect storm” scenario in which the agency’s fund plummets in value just as more companies go into bankruptcy and pass their pension responsibilities onto the insurance fund. Many analysts say it is inevitable that the agency will face significantly increased liabilities in coming months. The Pension Benefit Guaranty Corporation may be little-known to most Americans, but it serves as a lifeline for the 1.3 million people who receive retirement checks from it, and the 44 million others whose plans are backed by the agency.”
The PBGB for Pensioners is the Equivalent of the FDIC for Depositors
“The agency was set up in 1974 out of concern that workers who had pensions at financially troubled or bankrupt companies would lose their retirement funds. The agency operates by assessing premiums on the private pension plans that they insure. It insures up to $54,000 annually for individuals who retire at 65.”
The FDIC has already had to tap the govt for a bailout this year, and the govt agreed to guarantee the FDIC with a $500 billion backstop of taxpayer money. The PBGB seems surely to be next. “That means taxpayers – including those who don’t get pensions – could be asked to pay for a bailout.”
According to Kranish, the PBGB was underfunded to the tune of $11 billion as of Sept 30 08, and other analysts believe the PBGB may be underfunded by as much as $500 billion now. As and when the wave of corporate bankruptcies hit US shores between 2009-2013, we will be enmeshed in yet another full blown crisis.
The Wave of Corporate Bankruptcies will Bankrupt the PBGB
Regardless of what path led Millard to make the painful mistakes he has made, the main takeaway here is the roughly $500 billion in underfunded private pension plans.
Not only are the private pension plans underfunded, but the record wave of M&A and Buyouts in 2004-2007 were largely financed by companies using collateralized loan obligations (CLOs)become due to be refinanced. My understanding is theses CLOs are term obligations with long fuses, roughly 5 years. When these term loans come due, I also understand that these companies will not be able to secure the funding they will need to refi the CLOs. Unable to secure adequate financing, a wave of corp bankruptcies should roll through corp America between 2009-2012.
And to your point, these bankrupt companies will leave the PBGB on the hook to insure those bankrupt firms private pension plans.
But, as you note, they are underfunded to the tune of $64 billion. If they are the backstop for private pension plans, who will be the PBGB’s backstop or guarantor?
Perhaps Geithner will be able to cook up another scheme whereby the FDIC not only guarantees the credit creation that will occur with PPIP but also the PBGB. Don’t know it will be any less legal constitutionally or otherwise than what Geithner is doing today with PPIP.
Foolish Abandonment of the Prudent Man Rule
As trustees and guarantors of private pensions and other people’s money, PBGB executives they have lost sight of its fiduciary responsibility to preserve capital. The evolution of portfolio management has inherently sought to take on more risk through diversification, which is exactly what Millard did.
We have come along way from the days of the prudent man theory which was “designed to save the farm and the seed corn, to preserve the principal at all costs.” Hmmm, investment theory lost sight of this rule about the time that they lost sight of the farm – as the family farm disappeared, so did the prudent man theory. With the loss of tangible and real value, so too we now lament the loss of the prudent man theory.
Onward through the decades, modern portfolio theory evolves and introduces the “prudent investment rule” which sought to balance acceptable risks and “expected” returns through diversification.
Implicit in the rule of diversification, it leads to the fallacious belief that not only can you reduce risk and smooth out portfolio volatility but also generate “higher returns” otherwise, there wouldn’t be much incentive to abandon the “farm” or prudent man theory.
It is worth pausing to note that under the prudent investment rule as embraced by pension funds all around the world “expected returns” have been forever and a day simply too high. This flaw in modern port theory as utilized in pension fund management is now being exposed by Leo and others.
What I don’t know is whether this is a flaw inherent in modern portfolio theory itself. What matters however, is that pension funds have gotten “expected returns” consistently wrong for several decades of the baby boomer generation. Now that the boomers are heading off towards retirement, the gap between “expected” and “actual” returns are becoming glaringly obvious.
From my limited understanding, most pension fund models “expected returns” are generally 8% or north of 8%. That is hardly a conservative number, especially net of fees! What has created this fatally flawed optimistic bias I wonder?
Shit, we’re gonna have hell to pay for this mistake made by our fiduciary trustees.