Don’t Believe Everything Wall Street or Your Professor Tells You

In a previous blog entry, we noted how the Wall Street Journal – the newspaper that is written for stock and bond financiers and investors in New York – recently ran an alarmist but factually empty story that positioned the Teacher Retirement System of Texas as taking inordinate risks with its private equity portfolio. 

We noted how the story’s sky-is-falling “Pensions Bet Big with Private Equity” headline, and some wording in the third paragraph, might lead a reader to believe that “private equity and other non-traditional investments” are aggressive, risky investments when compared to those on Wall Street. In reading the story, it was not hard to infer that there is less risk from traditional stocks and bonds offered by the downtown New York financial companies, you know, the ones that advertise in the Wall Street Journal.

Our worry about the story was its implication that off-Wall Street investments, sometimes referred to as Main Street investments, are inherently more risky and don’t belong in public pension portfolios.

But when we added just a tad of critical thinking, we noticed that the story offered no comparisons of risk factors, or any proof of long-term return superiority of one style of investing. The story only notes how private equity investments play a big part of the TRS portfolio, saying “It now boasts some of the splashiest bets in the industry, having committed about $30 billion to private equity, real estate and other so-called alternatives since early 2008.” (Note the value-laden term “splashiest bets.”)

Even the following paragraph in that WSJ articled noted how the strategy is “averaging returns of 4.8% and 15.6% over the past five-year and three-year periods, respectively.” Not bad, in our view. The story did not include supporting evidence as to how those investments are risky or detrimental to TRS performance. Nor was contrasting evidence presented as to how other pensions’ private equity ‘splashy bets’ played out. Nor was evidence presented as to how “bets” using “traditional” Wall Street investments might have fared over the same time period, or which risk metrics were at play.

Our concerns that this article might negatively influence some people were well-founded, as it turns out.

Professor Elena Farah, senior fellow for public financial sustainability at the University of Houston, began her  recent blog by referencing that WSJ article and posited that the risks taken using private equity are “a perfect example of how misaligned incentives endanger public money. This can only hurt public employees and taxpayers in the long run.” She positioned public pensions as using “risky” private equity to achieve their overly aggressive investment targets.

Professor Farah’s blog article went on to offer one sky-is-falling scenario after the other, all of which supported her premise that private equity offerings are more risky than other types of investments and shouldn’t be used by public pensions.

This just simply isn’t true and her viewpoint is dangerous to taxpayers in many ways.

If anything, private equity components of pension portfolios offer one more element of diversification that help reduce the overall risks of an investment strategy. We’ve previously mentioned how, at one time, the City of Houston’s Treasurer’s strategy for pension investments was limited to U.S. Treasury instruments, which might seem risk-free, except for all the opportunity losses the city’s taxpayers were forced to pay for with higher contributions.

To offer an alternative view of alternative investments, we asked Marcelia Freeman, a director at Invesco Private Capital, to offer their justifications for the use of private equity in pension portfolios. Here’s what she said:

Throughout the Great Recession, we saw that these outsized returns could not be broadly found in public markets, and thus investors were forced to look toward alternative investments like private equity, hedge funds, bank loans, etc. These type of investments not only provide alpha beyond S&P 500 and T-Bill returns, they also provide other benefits like diversification, lower correlation among portfolio investments, etc.

Another major benefit for private equity includes investments in small business around the country, who otherwise were capital starved during the recession. The increase in pension fund investing in the asset class benefits not only pension fund members and beneficiaries, but also communities and economies in which we all must thrive, both in the short and long term. The cost of not investing in ourselves as a nation far outweighs the well-aligned manager fees paid to private capital firms.

“Lack of transparency” in alternative investments and even public securities often indicate inefficiency of markets. Profits are often gathered by skillful managers within inefficient markets, making manager selection paramount in order to produce significant alpha. With the use of consultants, investment committees, and other oversight mechanisms within public pension fund investing, high performing, top quartile managers can be hired, and can thus produce outsized returns for pension fund members and their beneficiaries.

We have more to say about other elements of Ms. Farah’s blog, but that will have to wait for future blog entries.

For now, we hope our readers understand that Texas pension systems seek to balance the risks they take. Wall Street investments are no less risky than Main Street investments, despite what the Wall Street Journal might implicate. And in many cases Main Street investments might be far more less risky, especially if they are more directly under the watch and control of a pension Board. Indeed, the failure to consider ‘alternative investments’ – in Wall Street speak – could actually be a violation of Trustees’ duty as fiduciary.

This subtle shift in orientation that seeks to deem Wall Street investments as “traditional” and alternative investments as “non-traditional” is dangerous to public perceptions about the steady work that pension Boards perform to find the best overall mix of investments for their members and taxpayers.  And this skewing of perception simply isn’t warranted based on performance.

In our view, one of the true shortcomings of the “move all public employees to 401(k) plans” arguments is that they would be limited to stock and bond mutual funds. As an asset class, those have not performed as well as commodities in recent periods, and thus their underperformance risk an entire generation’s opportunity to participate in wealth accumulation for retirement.

We continue to urge readers to view media many news reports and blogs with measured skepticism. Public pension investing is far more complicated, and its practitioners far more sophisticated, than some would have you believe. – Max Patterson

Conflicting Portrayals of Risk for Pension Portfolios

We like most are steady consumers of media, but it’s important to keep perspective whenever you read anything. And we mean ANYTHING!!

Consider the alarmist headline on the front page of the Wall Street Journal, “Pensions Bet Big with Private Equity” followed by the tone-setting sentences in the third paragraph:

It’s a sign of the times. Numerous pension funds are still struggling to make up investment losses from the financial crisis. Rather than reduce risks in the wake of those declines, many are getting aggressive. They are loading up on private equity and other non-traditional investments that promise high, steady returns in the face of low interest rates and a volatile stock market.   

Hmm… There’s a lot to argue with in that paragraph:

• Only people in New York, and on Wall Street might consider Wall Street investments to be “traditional” investments, whereas most people out in greater America still understand the value of investing directly, with up and coming companies, or their local farmer, or prime real estate, or popular restaurateurs, that fulfill the needs of people in regions, sectors, etc.
• Risk is an acquired taste. Not everyone enjoys the stockmarket roller coaster rides that Wall Street has provided the last 12 years. There are far more conservative investment opportunities that provide steady income out beyond the Hudson river. Only those with a New York, Wall Street perspective might consider Wall Street to be a reducer of risk!
• And given the track record of Wall Street investments over the last 10 years, which many call the “lost decade,” going off the Street could hardly be labeled “getting aggressive.” Others might term it “getting real” or “adjusting to lackluster results available through Wall Street.”

The story goes on to tell how Teacher Retirement System of Texas has dedicated about $30 billion of its $114 billion under management to “private equity, real estate and other so-called alternatives.”  By the time you get through the article – and you find that the TRS system is doing fine with its funding ratio and that it’s private equity holdings are doing a good job of providing income for retired teachers – you kind of want to say, “So what? If it’s working, why is this on the front page of the Wall Street Journal?”

We’ve been seeing more of these sorts of stories that micromanage and Monday morning quarterback Texas pensions’ investments. The Dallas Morning News had a long story about the Dallas Police and Fire pension’s use of luxury real-estate in its portfolio. We’ve heard of investigations into other pension’s investments. Dallas Police and Fire is one of the strongest performing pensions in the state, so again, at the end of the day, we say “So what?”

To confuse the average media consumer yet again, contrast all that with a Reuters story titled “Local pension plans punished by safe investments: study.”

The report notes how local pensions had, before 2007, invested too conservatively and fallen behind large state-run pensions in their funding ratios. The Boston College study then found that, after 2007, locally administered plans outpaced state-run plans using international stocks and alternative investments. Smaller pensions that didn’t have diverse asset classes fared the worse.

To all the confusion, we say this: Let local pensions do their job. They will find a way to make the money they need to pay their public servants. Texas has a very robust system that allows local pensions to pick investments that make sense and gain good returns. We’ll be releasing a survey soon that shows just how well they do. Don’t get confused by reports in the media that seem to conflict and confuse. Texas’ local pensions are doing well. – Max Patterson

Texas Pensions Respond to Cities’ Circumstances, Face Lawsuits

We admit that the actions of the Laura and John Arnold Foundation sometimes leave us scratching our heads as to what they are trying to achieve.

Take the foundation’s recent release of its “LJAF Policy Perspective: Pension Litigation Summary.”

The report rightfully notes how pensions large and small across the nation frequently initiate reforms to their system, to enable their plan to match contributions and investment returns with expectations for future benefits. The objective, of course, is usually to minimize the contributions needed from taxpayers. A noble pursuit we believe.

The reforms aren’t liked by every one – especially those whose benefits may be impacted in the future. They then typically challenge the reforms in court. The LJAF report says, “Within the past three years, at least 24 jurisdictions have faced lawsuits alleging that pension reform measures are unconstitutional.”

Our response? So what.

Isn’t it still a prerogative of free men and women to understand whether their rights to what they see as their money is in fact theirs? We hope so. As to how the courts decide these cases is still in the process, but what we do know is that there are always efforts to “reform” pensions to the facts at hand. The LJAF says its report fills the information gap, compiling the active cases in one place so that everyone might keep a close eye on them.

At this point it’s important to note how “reform” is a relative word. The LJAF and others view “reform” as leading to the wholesale destruction of defined benefit plans.

By contrast, those who support their existing usefulness and practicality as a tool of city budget management would use the word “reform” as measures that continually adjust plans according to the real world financial situations that cities and their pensions face.

There is no one-size fits all policy panacea that would ‘fix’ all the problems said to exist, especially not a wholesale switch from defined benefit to defined contribution plans, of the sort that the LJAF has previously endorsed. That’s macro-reform, and could be said to be similar to throwing the baby out with the bathwater. The micro-reforms, occurring as they are in sloppy, choppy fashion, respond to particular problems.

Just to save you some time, there are two Texas cases in the LJAF report, both in Fort Worth. The city initiated reforms in response to the expected shortfalls their employees pension expected due to years of the city’s deferring the contributions it owed. The lawsuits were enacted in late 2012.

Again, when considering the larger issue of the health of local defined benefit pensions in Texas, we say “So what?” These aren’t reasons to get alarmed about anything, other than their clear spotlight on the tendency of delayed contributions causing problems down the line and likely to spur lawsuits. In our view, that’s the real lesson we see here.

As an aside, it must be nice to be on the dole of a billionaire’s payroll, to come up with these sorts of alarmist, but less than meaningful reports. – Max Patterson

Not Enough Private Sector Workers are Availing Themselves of Non-Government Retirement Plans

One of the complaints we hear about defined benefit plans is about how much money public sector employees are able to retire after 20-30+ years of service.

Of course, it is theirs, the money they have contributed from their salary to their pension account. As to why people begrudge people the use of their own money is beyond us.

But what most people don’t consider is that in most cases, public sector employees don’t have a choice of whether to contribute to their retirement. The money is automatically deducted from each paycheck.

Over 20 years, that money can accumulate and grow at very good rates of return, especially if administrative/investment costs are kept low over that time period. And remember that most public sector employees start their careers at fairly low salaries and raises are usually non-existent or rare in coming, unless the employee progresses through the ranks. Requiring these workers to contribute can be painful to them when considering their monthly take home pay. They do it nonetheless.

We mention all this because a new report from the Bureau of Labor Statistics makes note of a couple of dynamics that occur in the private sector with regard to retirement benefits. These dynamics can provide some insights into why public sector employees have been successful in accumulating, over time, considerable sums for their retirement. And it can also explain why many in the private sector are woefully under-prepared for their retirement.

The September 2012 report “Beyond the Numbers: Who has benefits in private industry in 2012?” says:

Nearly two-thirds of private industry workers had access to some form of retirement plan, typically either a defined-benefit plan (such as a pension) or defined-contribution plan (such as a 401(k)), and 48 percent chose to participate in a retirement benefit plan. (See table 1.) Access to retirement plans varied significantly by major occupational group, full- or part-time status, bargaining status, and wage category. Management, professional, and related occupations had nearly twice the access rate and more than 3 times the participation rate of service occupations. (Some examples of service occupations are healthcare support, protective service, food preparation, maintenance, and personal care workers.) Similarly, full-time workers had nearly twice the access rate and 3 times the participation rate of part-time workers. Union workers showed very high access (92 percent) and participation (85 percent) rates for retirement plans.

The “problem” that manifests here is that low paid service workers, who are also likely to part-time workers, aren’t contributing to their future. It’s difficult for them to do – and they don’t. This dynamic is proven by the next statement in the BLS report:

High-wage workers (those in the top 25 percent of all wage earners, with earnings at or above $24.81 per hour) had significantly higher rates of access and participation in retirement plans than those of low-wage workers (those in the lowest 25 percent of all wage earners, with earnings at or below $10.69 per hour). High-wage workers had access rates of 85 percent and participation rates of 75 percent. In other words, 89 percent of the high-wage workers who were eligible for retirement benefits participated in the plan (known as the take-up rate), a significantly higher share than the take-up rate of 45 percent for low-wage workers. Low-wage workers seem to be at a disadvantage because they may have more difficulty providing employee contributions, which are often required to participate in a retirement plan such as a 401(k).

Of course, the great advantage that public sector employees have is that many don’t have to contribute any portion of their salary to Social Security, whereas private sector employees pay 6.2% of their pay to SS, and their employer matches that amount for them. Many police and fire department employees, and some municipal employees, don’t pay into Social Security (and can’t expect any benefits from SS in retirement). So private sector employees, especially the lower paid, would have their take home pay reduced even further by contributions to non-Social Security retirement accounts. That’s awfully hard for them to do given the cost of living these days and their need to bring as much money home as possible

Can these disparities be addressed? Yes, they can, without impoverishing public sector employees in the same manner that current policies seemingly accomplish for lower paid, part-time private sector employees.