You simply cannot make this stuff up.
The Pension Benefit Guaranty Board, which backstops defined benefit plans (yes, Virginia, they still exist) faced a rather sizable gap between its expected returns on its $64 billion in holdings and its expected liabilities.
So in a stroke of sheer genius, it increased its allocation to risky assets considerably at precisely the time those assets started tanking. It even managed to cut its allocation to Treasuries way back, reducing its participation in the big Treasury rally of last year.
Now anyone who was finance literate would look at the PGB’s new asset allocation and recognize it as conventional wisdom as dispensed by pension fund consultants. And if you had read Benoit Mandelbrot or Nassim Nicolas Taleb, you’d also know that those pension fund consultants base their prescriptions on theories that simply do not pan out empirically, and worse, greatly understate risk.
This was patently a silly move. First, it seemed to reflect a classic trader’s bad reflexes, of taking bigger bets to dig his way out of a loss, although the former head honcho vociferously denies that (hat tip readers John, Michael and Chris) :
Charles E.F. Millard, the former agency director who implemented the strategy until the Bush administration departed on Jan. 20, dismissed such concerns. Millard, a former managing director of Lehman Brothers, said flatly that “the new investment policy is not riskier than the old one.”
He said the previous strategy of relying mostly on bonds would never garner enough money to eliminate the agency’s deficit. “The prior policy virtually guaranteed that some day a multibillion-dollar bailout would be required from Congress,” Millard said.
He said he believed the new policy – which includes such potentially higher-growth investments as foreign stocks and private real estate – would lessen, but not eliminate, the possibility that a bailout is needed.
Yves here. This is double-speak, and pretty inept at that. We are supposed to believe that foreign stocks and private equity are less risky than Treasuries? Even if you have a dim view of government securities, trust me, if that market hits a down draft, equity related instruments will do worse.
So Millard wants us to believe that there are financial free lunches, that he can invest in “higher growth investments” without taking on more risk. I have a bridge I’d like to sell him.
Now some will say I am being unfair to jump on the fund’s utterly wretched timing. Wrong. It was obvious a train wreck was starting (and this isn’t 20/20 hindsight, any reader of the Financial Times would have seen the warning signs). Risky assets were clearly overvalued, as Martin Wolf pointed out in March 2007:
It is always a mistake to confuse a cycle with a trend. In the case of corporate earnings, it is worse than a mistake, it is a huge blunder. The intense cyclicality of corporate earnings is the most important reason why the unadjusted p/e ratio is a worthless indicator of value. The question one has to ask is whether they will be sustained or fall back again, as they have done in the past.
Over the past 125 years, real earnings of companies in the [S&P composite] index have grown at only 1.5 per cent a year – lower than in the economy as a whole, because the index is always underweight in new and dynamic companies. Over the past quarter century real earnings have grown at an annual rate of 3 per cent. The annual growth of 25 per cent seen since the most recent trough will not last. On past experience, it is far more likely to turn negative….
The dangers ahead look big. One is that markets will overreach themselves, so generating a destabilising correction. Another is a reduction in excess savings outside the US and a tightening of world interest rates. Another is a slowdown in US productivity growth. Yet another is a shift in global monetary conditions that threatens the soaring profitability of the US financial sector. But the biggest risk is that the end of the US property boom will persuade US households to tighten their belts at last, thereby ending the US role as the world’s big spender before the big savers are prepared to spend in turn.
We can be confident that profit growth will not continue at recent rates. But a sharp reversal, though possible, may not be imminent either. The economic risks are evident and the market does look expensive. But I would not dare to forecast a turning point. Forecasting is for far cleverer and braver people than I am.
So making a big shift to assets that look overpriced is not a winning investment formula. And the Boston Globe article gives other reasons why this investment approach wasn’t so wise:
Last year, as director of the Congressional Budget Office, [Peter] Orszag expressed alarm that the agency was “investing a greater share of its assets in risky securities,” which he said would make it “more likely to experience a decline in the value of its portfolio during an economic downturn the point at which it is most likely to have to assume responsibility for a larger number of underfunded pension plans.”
This investment blunder is going to create a new set of woes sooner rather than later, particularly if Team Obama does push GM or Chrysler into bankruptcy.
Currently, the agency owes more in pension obligations than it has in funds, with an $11 billion shortfall as of last Sept. 30. Moreover, the agency might soon be responsible for many more pension plans.
Most of the nation’s private pension plans suffered major losses in 2008 and, all together, are underfunded by as much as $500 billion, according to [Zvii] Bodie [former advisor to the fund] and other analysts. A wave of bankruptcies could mean that the agency would be left to cover more pensions than it could afford.
Note the underfunding is not the amount due in any one year, but the net present value of the total shortfall in future years.
The Pension Guaranty Board is not formally backed by the US government, but pressure to correct the agency’s blunders will be considerable. How can you bail out bankers and not hapless retirees?