Wednesday, 03 November 2010 00:00

Pension Funds: Broken Model

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Pension funds should be dream clients for focused value investment managers. They have a long-term time horizon which should allow them a major competitive edge; the ability to take advantage of the market when its participants fall into despair. In my view, they have completely failed use their built in advantages because of significant structural problems, i.e. they hire money managers who commit a major investment faux pas, they perceive that volatility equals risk, which is a completely false truth foisted on us largely by academics. Volatility has no connection to risk when risk is defined, appropriately, as the chance of permanent capital loss.

Using consultants and placement agents can lead to additional problems. For instance CalPERS has experienced problems related to kickbacks. According to a recent story in The Deal ".. a former CalPERS president resigned from the board of the Los Angeles Fire and Police Pensions after the SEC sent a letter inquiring into his financial disclosures and dealings with Weatherby (where a former employee pleaded guilty to a securities fraud charge) and other consultants. Several other former board members have been served subpoenas or are ensnarled in civil litigation. All have denied these charges and in several cases in the end no charges were brought against them. CalPERS has since strengthened its policy on the use placement agents and the payment of fees.

They have been so focused on boosting returns as much as possible, mainly because they use excessively optimistic growth assumptions which has led to a historical underfunding of the plans. This causes them to chase hot sectors such as in the 1990s when they, according to a October 16, 2010 WSJ article, "...loaded up on stocks in the booming 1990s and had almost 70% of their money in them by the mid 2000s." The article continues but letting us know that, as of July, the pension funds have changed their views and have decreased their allocations to stocks to 45%.

Not only did pension funds wade into the stock bubble, they also went knee deep into the private equity bubble. For instance, as related the recent New Deal article:

"Between 2006 and 2008 CalPERS poured about $8.4 billion into 15 of the 20 largest buyout funds raised during that period."

Leaving aside what they should have done in those periods and how they should be positioning themselves going forward, for the moment , let's take a look at the same WSJ article mentioned above to learn what they are doing. In the article Towers Watson conducted a survey that revealed "..on average, they were planning this year to move 10% of their assets out of stocks and into bonds and alternative investments."

So as you can see they overloaded on stocks when stocks in general were highly priced and now they are moving into bonds during what is sure to develop to be a massive bubble in bonds during a period of historically low interest rates. The comedy team at Saturday Night Live would be hard pressed to write a better script.

Lest you think this tale of missteps is a one off occurrence let's examine what Mr. Buffett had to say in a New York Times article dated August 31, 1979 (which essentially quoted his Berkshire Hathaway letters to shareholders):

"In 1971, pension fund managers invested a record 122 percent of net funds available in equities [buying some with borrowed money at full prices]. In 1974, after the bottom had fallen out, they committed a then-record low of 21 percent to stocks."

"In 1978 pension managers, a group that logically should maintain the longest investment perspectives, put only 9 percent of net available funds into equities - breaking the record low figure set in 1974 and tied in 1977."

The situation is a tragic romantic comedy in which they constantly make the wrong choices in love. So how does all this relate to focus investors? This is yet another example of irrational behavior that we, who do have long term horizons, and don't equate volatility as risk, can take advantage of.


For more information I would recommend these two articles:

WSJ, October 16, 2010: Pension Funds Flee Stocks in Search of Less-Risky Bets

The Deal, Too Big to Sail?

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