Wannabe Hedge Fund Managers?

What do you call institutions that expect to beat the market by mixing leverage with an aggressive investing strategy?

If you said "hedge funds," you'd be right. However, if you answered "the pension funds of U.S. states that have done a terrible job managing their finances up until now," you would also be correct.

To see what I mean, read the following report by Bloomberg reporters Michael McDonald and Adam L. Cataldo, "'Dumbest Idea Ever' Embraced by Pensions to Plug U.S. Deficits."

Pension bonds are making a comeback, as states and cities from Alaska to Philadelphia bet they can use the proceeds to help fill deficits in their retirement funds and still generate a higher return than what they pay in interest.

Officials may sell a record $35 billion of the securities this year after offerings declined since 2003, according to data compiled by Bloomberg. Connecticut issued $2.2 billion of pension debt last month, paying an average rate of 5.88 percent on money state officials project will earn 8.5 percent when invested.

With the economy slowing and states facing budget deficits that Standard & Poor's says will top $30 billion next year, officials are turning to the quick fix of borrowing even though the $50 billion of pension bonds sold produced mixed results for taxpayers. New Jersey sold $2.8 billion of the debt in 1997 and its pension gap has since ballooned to 10 times that amount.

"It's the dumbest idea I ever heard," said New Jersey Governor Jon Corzine, the Democrat and former chairman of investment bank Goldman, Sachs & Co. "It's speculating the way I would have speculated in my bond position at Goldman Sachs."

There are more than 100 public retirement systems in the U.S. managing a combined $2.3 trillion. The amount is $380 billion short of the funds needed to pay pensions over the next 30 years, according to the National Association of State Retirement Administrators in Baton Rouge, Louisiana.

'Politically Expedient'

While the systems earned on average 11.9 percent a year from 2003 to 2006, many of the pensions failed to make the contributions required to keep pace with benefits they promised, the Pew Center for the States, a nonprofit public policy research group, said in a December report. New Jersey's seven retirement funds have a combined deficit of $28.3 billion, up 14 percent from last year, according to state actuarial reports.

"It's politically expedient to go out and borrow money," said Robert Smith, president of Austin, Texas-based Sage Advisory Services, which oversees $5 billion in assets. "It's like taking a second mortgage on a house you haven't paid for yet."

Alaska lawmakers sent Republican Governor Sarah Palin legislation last month authorizing the sale of as much as $5 billion in pension bonds. Wisconsin Governor Jim Doyle, a Democrat, signed a law in March permitting Milwaukee County to borrow money to close a $406 million deficit.

Puerto Rico issued $1.58 billion of debt in January, including $668 million of 6.15 percent, 30-year securities, and said it plans to sell an additional $5.4 billion over the balance of the year.

High Yields

Issuers have little problem finding buyers for the bonds because they typically yield more than Treasuries and are backed by states and cities.

Connecticut received more than $4 billion of orders for its $2.2 billion Aaa rated general obligation pension bond offering, according to state figures. The portion that comes due in 10 years pays interest of 4.75 percent, more than the 3.81 percent yield on Treasuries of similar maturity.

Public officials first turned to the bonds to close pension deficits when Los Angeles County borrowed $461 million in 1986. Sales peaked at $17.8 billion in 2003 as Illinois sold $10 billion of the securities, data from Thomson Reuters show.

Former Republican New Jersey Governor Christine Todd Whitman sold $2.8 billion of the debt to help close a $4.2 billion deficit in the state's pension fund in 1997, the year she ran for re-election. The state later increased benefits by 9 percent for some public employees after market gains closed the gap.

Extreme Case

The strategy collapsed when stocks tumbled in 2001 and the economy slipped into a recession. Pension fund returns fell below the interest rate on New Jersey's bonds, and the state, faced with budget deficits, stopped making the annual contributions it needed to keep pace with rising costs.

"New Jersey is an extreme example, but it is highly illustrative of how critical consistent contributions can be to a state's pension system," Susan Urahn, managing director of the Philadelphia-based Pew Center for the States, wrote in December.

Philadelphia fell into a similar trap when former Mayor Edward Rendell, now Pennsylvania's Democratic governor, sold $1.29 billion in pension bonds in 1999. John Street, a Democrat who succeeded Rendell, failed to make full contributions to the fund as he tried to balance the budget.

The city has about 54 percent of the funds it needs to pay pension benefits over the next 30 years, about the same as in 1999 before it sold the bonds.

New Promises

Mayor Michael Nutter, a Democrat who took office in January, said he wants to borrow as much as $4.5 billion to close the deficit, promising this time the city will make the necessary annual contributions.

"We're going to be committed to making sure the fund stays well-funded," said Rob Dubow, Philadelphia's finance director.

Illinois Governor Rod Blagojevich is making similar promises four years after selling $10 billion in pension bonds. The state still faces a $42 billion deficit and the governor asked the Legislature to approve another $16 billion of the securities.

A study released last month by consulting firm Greenwich Associates in Greenwich, Connecticut, found that public pension managers expect to outperform market benchmarks by 1.46 percentage points over the next five years, an outcome it said was "probably not" realistic.

"It's lousy public policy," Corzine said.

Comments

[Jes]

It's pretty clear that government employees--municipal and state, at least, if not federal--are going to feel a lot like Enron folks did. What percentage of the working population do they account for?

[FB]

It's going to be interesting to see whether the high-level departures at Calpers are just a coincidence or whether the captains are abandoning a sinking ship.

[the_economist]

I am angry enough paying for bloated government pension once. I will be that much more when I have to pay for them twice.

[Rocky]

Some pension bond issuers are paying over 7% for their money. I have been collecting 7.33% since 1999 (non callable until 2015) from one California city. The annualized returned on the S&P 500 index has been 4% over the past 10 years, so one can assume that pension bonds have been a bust for this issuer. The interest on the pension bonds is exempt from California state income tax, a real plus for California investors. Unfortunately for California taxpayers, these bonds are not subject to voter approval and neither are the level of pension benefits paid to retirees.

[FB]

Well dumber than the Dumbest Idea Ever is the practice of retirement systems investing in funds-of-hedge-funds. So on top of the normal hedge fund fees of 2%/20%-of-profits, there is an additional layer of fee extraction: 1%/10%-of-profits.

[FB]

S&P expected recoveries of CDOs of U.S. home-loan bonds created since Sept. 30, 2005

Tranche/Rating Predicted Recovery
-------------- ------------------
super-senior AAA 60%
AAA 35%
AA 5%
A 0%