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Part One
REAL MONEY AND THE CRASH OF â08
Those who cannot remember the past are condemned to repeat it.
âGeorge Santayana
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Chapter 1
Rethinking Real Money
I. Why Real Money?
Real money is a commonly used term in the financial markets to denote a fully funded, long-only traditional asset manager. Real money managers are often referred to as institutional investors. The term real money means the money is managed on an unlevered basis. This contrasts with hedge funds, which often manage money using borrowed funds or leverage. Real money funds can and often do employ leverage, but they normally attain leverage on a nonrecourse basis (e.g., investing as a limited partner in a fund that is levered). Examples of real money managers are public and private pension funds, university endowments, insurance company portfolios, foundations, family offices, sovereign wealth funds, and mutual funds.
This book focuses on the mistakes made and lessons learned in 2008 and attempts to incite a dialogue about how to construct better portfolios in the real money world. For this reason, mutual funds will be excluded from the discussion, since they are usually managed under strict mandates and asset class restrictions, rather than as broad portfolios where asset allocation decisions dominate the investment process.
Real money funds are important and worth analyzing because: (1) they are some of the largest pools of capital in the world; (2) they have a direct impact on the functioning of society; (3) they lost staggering amounts of money in 2008; and (4) in many cases, these funds are ultimately backstopped by the taxpayer if they fail to deliver their promises. Real money funds are in crisis and are âtoo big to fail.â
Size
Real money funds comprise a majority of world's managed assets, which totaled $62 trillion at the end of 2008. Within this grouping, pensions are by far the largest category, at $24 trillion, with U.S. pensions at $15 trillion, or almost one-quarter of total managed assets (see Figure 1.1).
Impact on Society
Much of real money exists to deliver the promise of future retirement benefits, to support education, to guarantee the payouts from insurance agreements, to support charitable activities, and even to back national interests. In short, real money is the foundation for many important aspects of modern society. Pensions form an important part of the fundamental social contract between workers and employers, both in the public and private sectors. Public pensions in particular help ensure that basic societal functions are populated by competent people. Some of these functions include: police officers, firemen, judges, sanitation workers, teachers, health workers, politicians, and soldiers, amongst many others. To give an example of how real money affects society, after the crash of 2008, Philadelphia city officials threatened to lay off workers and cut sanitation and public safety services unless they could delay pension contributions. Stories such as these will likely become much more prevalent over the next few years.
2008 Losses
During the financial crisis, real money accounts suffered immense drawdowns. Pension funds globally saw their assets fall by almost 20 percent, while university endowments in the United States lost 26 percent on average. More surprisingly, because of the severity of investment losses, many institutions were forced to modify their operations to reflect a new reality: universities laid off staff, froze or cut salaries, issued debt, reduced financial aid, and suspended building projects; pensions increased employee and employer contributions, raised retirement ages, and cut benefits; charitable foundations canceled grants and delayed new programs; families curtailed spending and in many cases have been forced to sell assets.
The severe losses in 2008 also exposed some fundamental flaws in how real money portfolios are managed. Portfolio construction methodologies failed to account for both worst-case scenarios and potential illiquidity. A primary lesson of this experience is that the pain of investment losses is not linear; there is a kink, after which point losses begin to force changes in behavior. As a result, short-term investment performance has consequences even for âlong-termâ investors.
Taxpayer
Although all real money accounts are important to society in one way or another, pensions are the largest and arguably the most important. Well before the crisis of 2008, demographic challenges had been steadily putting pressure on pension systems in the developed world. Nevertheless, at the end of 2007, after an extended bull run for assets, many plans were fully funded, whereas at the end of 2008 most had become significantly underfunded.
Although a university going bust or a charitable foundation closing down is tragic for those directly involved, the effect would be relatively isolated. On the other hand, a pension fund going bust has implications for taxpayers. In the United States, the taxpayer is the explicit backstop for public pension funds and the implicit backstop for corporate pension funds, the latter of which are guaranteed by the Pension Benefit Guaranty Corp. (PBGC), a federal agency. The PBGC is currently facing its own crisis, with a reported deficit of $33.5 billion at midyear 2009, a more than tripling of the $11 billion deficit reported at midyear 2008. The deficit is the largest in the agency's 35-year history. More importantly, without confidence by workers that their benefits are intact, society breaks down.
In Ohio, for instance, the teachers pension system reported that it could take 41 years for its investments to meet its liabilities to retirees based on actuarial assessmentsâand this was before 2008. During the 2008â2009 fiscal year, the pension fund lost 31 percent, prompting officials to claim that they would never be able to meet liabilities. Because of the inherent complexity and subjectivity associated with calculating the funding levels for pension funds, the true costs are often disguised in the near-term (see box on page 7).
The shortfall associated with underfunded pensions can be made up by either investment performance or pension reform (i.e., changing the structure of the pension in some way). Yet pension reform amounts to fiscal tightening at a time when the global economy is weak and personal budgets are stretched. At the same time, these decisions are made by politicians, whose tenure in office does not compel them to make difficult, long-term decisions. Because voters do not opt for more tax or less benefits, the problems are often ignored, growing bigger by the day. Pensions loom as the next big financial crisis.
But crises often bring about change. We now have new information, which raises many important questions about what to do going forward. In order to understand more clearly what happened in 2008 and be able to formulate a plan for where we go from here, it is worthwhile to examine a brief history of real money, focusing on the U.S. pension world because it is the largest pool of funds and the biggest risk to the taxpayers of the world's largest economy.
Pension Funding Levels
Pension plans have two primary elements: (1) the future benefit obligations earned through employee service; and (2) the plan assets available to meet the liabilities owed to the beneficiaries. The challenge in assessing the health of pension plans is that both future liabilities and returns are estimates.
Since the payments to beneficiaries will be made far into the future, actuarial assumptions are required to estimate mortality rates, medical costs, and future salary increases. The future stream of assumed payments is discounted into a single present value estimate, whereby the discount rate is determined by reference to a benchmark yield. The higher the discount rate, the lower the benefit obligations. Very small changes in the discount rate have enormous real dollar implications for estimated funding levels.
Likewise, the value of plan assets available in the future to meet the pension obligations is also an estimate. The future value calculation is a function of expected returns on plan assets. Expected long-term returns are often developed using historical or âassumedâ rates of return. In sum, it's a big guessing game.
II. The Evolution of Real Money
In the Beginning, There Were Bonds
Although pensions have existed for hundreds of years, the current structure took shape after 1948. In that year, the U.S. National Labor Relations Board (NLRB) ruled that corporate pensions must be included in contract negotiations between employers and employees. Before the ruling, the amount of capital allocated to an employee pension scheme, if such a plan even existed, was at the employersâ discretion. This ruling defined how much a corporation must contribute to the employee pension plan annually, regardless of company performance and profits. As a result, money began to consistently move into pension funds, creating significant growth in assets and eventually leading to the large, powerful, professionally managed institutions that exist today (see Figure 1.2).
At the time, pension assets were managed very conservatively; fixed interest on bonds was matched to meet fixed commitments to pensionersâsimple asset/liability matching. Bonds were selected from preapproved âlegal listsâ of securities, and it was common to have a limit for equities. In 1949, public and private pension assets in the United States were $15.7 billion. The asset mix was roughly half in government bonds, and half in other fixed income and insurance company fixed annuity investment products. There was minimal exposure to equities.
Along Came Inflation
By 1970, public and corporate pension fund assets in the United States reached $211.7 billion, the majority of which was concentrated in fixed income. Beginning with the 1973â1974 oil embargo, wave after wave of commodity price-induced inflation roiled fixed interest portfolios through the remainder of the decade. Nevertheless, assets continued to pour into pension funds because of strict commitments mandated on employers.
At the end of the decade, U.S. pension funds had $649 billion in total assets, and the outperformance of equities versus bonds during the previous ten years did not go unnoticed by pension fund managers. While bond portfolios got destroyed, equities at least managed to preserve capital in real terms (see Figure 1.3). Panicked and weary pension fund managers began rethinking their portfolios, and the shift out of bonds into stocks began in earnest. By 1980, corporate pensions had 45 percent of their assets in equities, while public pensions had 16 percent. In many cases, public plans were still capped as to how much equities they could own. The largest U.S. pension fund, the California Public Employeesâ Retirement System (CalPERS), for example, had a maximum allocation to equities of 25 percent, which was eventually lifted in 1984.
The 60â40 Model and the Great Moderation
Through the 1980s and 1990s, pensions continued to shift their assets out of bonds and into stocks, ultimately moving toward the now ubiquitous 60â40 policy portfolio (60 percent in stocks and 40 percent in bonds, often domestic only). The 60â40 model which became the standard benchmark by which to judge portfolio performance. The shift into stocks, and corresponding increase in risk, occurred in lock step with Federal Reserve Chairman Paul Volcker's famous battle with inflation, which saw the fed funds rate peak at 20 percent in 1981. In 1980, the so-called âmisery indexââunemployment plus inflationâpeaked at 20 percent.
As the excess pessimism of the 1970s gave way to excess optimism during the Reagan 1980s and euphoria during the technology revolution of the late 1990s, 60â40 pension portfolios performed well. The big decisions that investors faced at this time were whether to tweak the 60â40 allocation to, say, 65â35 or 55â45. In actuality, the market environment throughout the 1980s and 1990s rendered these decisions inconsequential as both stocks and bonds benefited greatly from falling inflation and declining interest rates. The environment later became known as the Great Moderation, and was summed up well in a 2004 speech by thenâFederal Reserve Governor Ben Bernanke (see box).
