Felix Salmon

How volatility hits pension plans

Felix Salmon
Nov 11, 2011 17:05 UTC

Nanea Kalani of Honolulu Civil Beat has obtained non-public performance numbers for the Hawaii Employees’ Retirement System, and they’re not pretty at all: in the three months to September 30, the fund managed to lose $1.4 billion, or 11.2% of its value.

What we’re seeing here is the brutal effect of volatility on portfolio performance. Let’s say you start with $1,000. If your portfolio falls by 5% and then rises by 5% — or, for that matter, if it rises by 5% and then falls by 5% — you end up with $997.50 — just a quarter of a percentage point away from where you started. But if it falls and rises (or rises and falls) by 20%, then you end up with just $960, down 4% on your initial investment.

There’s two different lessons to be drawn from the way that Hawaii is investing its money. Firstly, going for active rather than passive investment doesn’t work very well. The policy benchmark — what the fund would have returned if it was passively invested rather than actively managed — has consistently outperformed actual performance. And


Secondly, Hawaii hasn’t chosen its managers very well: it’s also consistently underperforming the median public pension fund. If you’re relatively small (about $10 billion, in this case), it’s hard to outperform. As the Pension Consulting Alliance note puts it, “Relative underperformance can largely be attributed to the Plan’s equity (domestic and international) managers’ combined performance trailing their respective benchmarks”.

But there’s a deeper problem here, I think — and that’s related to the fact that the fund is being asked to return an “assumed actuarial rate” of return of 8% per year — in an environment of high volatility and extremely low interest rates. The right thing to do is to say “sorry, I can’t do that” — but that’s a great way to get fired. So instead, fund managers move further and further out the risk curve, in an attempt to hit their target returns. With predictable consequences.

Sometimes, the strategy works. In fact, the strategy is always going to work some of the time. The note proudly says that “the Plan outperformed the policy benchmark and the Median Plan in three of the last five 12-month periods”. But this is the problem with volatility: if you overshoot on the way up and you overshoot on the way down, you end up underperforming overall.

I’m not particularly picking on Hawaii, here, I’m just using it as an example. Most public pension plans have very similar problems. They take on more risk than they should, just because they’re being asked to hit unrealistic return targets. And the losers, of course, are all of us.


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The Gordian nightmare of public pensions

Felix Salmon
Dec 27, 2010 14:52 UTC

Maybe it’s because I’m European, but I simply cannot get my head around a developed nation where people with lifelong service in the police or the fire brigade can find themselves with no pension at all. Zero. But if you’re unlucky enough to have served in Prichard, Alabama, that’s the situation you’ve found yourself in for the past 14 months

The NYT had a heart-rending story on the city’s finances last week: it seems that if a city has unfavorable demographics and an incompetent government, then there’s no one—not the state, not the federal government, not any kind of pensions guarantee agency—willing to step in and make things right.

Nettie Banks, 68, a retired Prichard police and fire dispatcher, has filed for bankruptcy. Alfred Arnold, a 66-year-old retired fire captain, has gone back to work as a shopping mall security guard to try to keep his house. Eddie Ragland, 59, a retired police captain, accepted help from colleagues, bake sales and collection jars after he was shot by a robber, leaving him badly wounded and unable to get to his new job as a police officer at the regional airport.

Far worse was the retired fire marshal who died in June. Like many of the others, he was too young to collect Social Security. “When they found him, he had no electricity and no running water in his house,” said David Anders, 58, a retired district fire chief. “He was a proud enough man that he wouldn’t accept help.”

Back in March, Prichard was given two months to work out how it was going to pay its pensioners—and that was after they’d already gone without pay for half a year. Today, we’re told, “a mediation effort is expected to begin soon.” And according to Michael Corkery, the city has proposed capping benefits to current retirees at about $200 a month.

The problem here isn’t gold-plated pensions—Prichard was paying out only $1,000 a month on its average pension when it defaulted back in October 2009. Neither is it, as Mish would have it, the Alabama legislature, which passed various bills amending city pension plans over the years. And it’s not greedy bondholders, either, asserting their seniority over pensioners: Prichard doesn’t have any outstanding bonds, and even bank loans don’t seem to be an issue.

Ultimately, the problem here is a confluence of two factors. On the one hand you have the nationwide—and indeed global—issue of unfunded public pension liabilities. On the other hand you have the statistical inevitability that in a country with thousands of municipal pension plans, some of them are going to run out of money.

One thing I’m pretty sure about: if and when a city with bonded debt arrives at the same place as Prichard, all the covenants in the world won’t be enough to protect bondholders from default. It’s politically impossible to pay creditors on Wall Street while short-changing people who worked for the city for decades and who have no other income to fall back on.

And more generally, the problem of municipal pensions is shaping up to be a Gordian nightmare. Cities which have diligently funded their own pension plans won’t ever want to bail out those who haven’t, or see federal funds used for such purposes. But on the other hand, situations like Prichard’s are clearly unacceptable, which means that there has to be some kind of bailout. Public pensions, I fear, could turn out to be the biggest moral-hazard play ever.


“It’s politically impossible to pay creditors on Wall Street while short-changing people who worked for the city for decades and who have no other income to fall back on.”

Many of those “creditors on Wall Street” are pension funds or other retirees on fixed income. Who makes the decision as to which retirees are more deserving to keep their retirement income? Robbing Peter to pay Paul?

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Corporate optimism datapoint of the day

Felix Salmon
Aug 25, 2010 14:39 UTC

Randall Forsyth reports on the magical math of corporate defined-benefit pension plans:

Fitch’s analysts find the mean assumed return for corporate pension plans in 2008 and 2009 was 8%. That’s with an allocation to fixed-income assets of 34% of the total.

Obviously, there’s no way that fixed-income assets can return 8% going forwards from here. There’s also little sign that pension plans are reducing their fixed-income exposure. And I can’t imagine that fund managers genuinely believe that long-term stock returns are going to be somewhere in the teens.

As a result, any intellectually honest plan is going to have to start cutting the interest rate it’s using to calculate the net present value of its future defined liabilities. And every percentage point by which they cut that discount rate means that the present value of their liabilities soars by between 10% and 20%. Cut by two or three percentage points, and suddenly all those cash-heavy corporate balance sheets start looking a lot lighter:

That’s the thing about deflation; it’s like a neutron bomb for corporate, public-sector and consumer balance sheets. Asset values and returns get decimated while liabilities remain standing.

There’s no news here, of course. Inflation is painful for the poor, but much easier for the rich, whose wealth is tied up in things like stocks and houses which tend to retain their real value. Deflation makes goods more affordable for the poor, but is horrible for anybody counting the days until their future liabilities come due.

Still, for the time being, I’m going to place my faith in the continued ability of corporations and pension-plan trustees to delude themselves about future returns and prudent current discount rates. The 8% return assumption didn’t make much sense in 2008 or 2009 either, and so the fact that it makes even less sense in 2010 is hardly a reason to think it’ll be reduced. It’s much easier for the current tranche of executives to leave this problem to their hapless successors.


I don’t understand your first comment. The mathematical “mismatch” doesn’t have anything to do with the funded status of a pension. The funded status is based on the plan assets (at fair values) relative to the firm’s benefit obligation. There’s no mechanism that virtually guarantees pension plans will be underfunded all the time.

While the benefit obligation is based on an estimated discount rate, the plan assets are not – they’re just the current market value of the firm’s pension fund. If the firm estimates a discount rate of 5% for liabilities, it doesn’t matter whether they estimate return on plan assets as 3%, 5%, or 7%. The estimated return on plan assets does not affect the the asset value, nor does it affect the plan’s funded status.

Corporations hate DB plans because they bear the financial market risk on the funding side as well as the actuarial risk on the payout side. Individuals hate DC plans because those risks are transferred from the employer to the employee. Someone has to bear the risk, though.

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