State Pensions Funds: Bad Moon Rising?

Donald J. Boyd of the Rockefeller Institute of Government is quoted in today's New York Times on the huge losses in state pension funds, "It is truly astounding. They ($477 billion in losses) don't translate immediately into budgetary stress for states. But what does happen is through the wizardry of actuarial valuations, they will drive pension contributions by states and localities up considerably in the coming years, and that's true despite the good stock market of 2009, and the relatively good stock market of 2010."

His characterization omits something important. Localities have already felt this pain through problems with the retirement plans for police and firefighters. State laws call for the cities to make up shortfalls, and in my city, the cost of this shortfall has already been borne by the taxpayers. Our City's problem is now sitting invisible to all except career government insiders at the State level, where it will be papered over with propaganda about public employees being scapegoats. The New York Times story lays out the issue with state pension fund shortfalls well. My issue comes from reading the Conference Board's "2010 Institutional Investment Report," which covers 2009 data.

In the early stages of the financial crisis we read many stories about states and municipalities creating problems for themselves by buying auction-rate securities, which promised above money market returns with no additional risk. Of course, these were unsuitable investments for the clients pushed on to them by unscrupulous brokers. City managers and state officials later filed suit whining that they never understood the risks of what they were buying.

The Conference Board report notes, "....many of these (hedge fund) investments are not publicly traded and lack an efficient quotation system. As a result, the value of alternative asset classes, as represented at the end of 2009, might not yet fully reflect the losses incurred by the public market during the 2008 financial crisis."

Among the Top 10 defined benefit plans ranked by the level of hedge fund investments at year-end 2009, fully 8 are public plans! As a percent of defined benefit assets, they are:

• Pennsylvania Retirement (12.8%)
• California Public Employees Retirement (2.8%)
• Massachusetts PRIM (10.9%)
• Pennsylvania Public School Employees (7.6%)
• Virginia Retirement (7.2%)
• New Jersey (4.3%)
• New York State Common Fund (2.3%)
• University of California (6%)

Going way down the list of the Top 200, one finds the Missouri State Employees Fund with 25% of their assets in hedge funds. I wonder what their board of trustees talks about? Another small detail is that Pennsylvania Retirement and Massachusetts PRIM have the bulk of their hedge fund assets in the "fund of funds" category which are expensive and more fraught with valuation and liquidity issues.

Hedge funds certainly have their place, and most of the top Ivy League endowment funds have used them very effectively in meeting the budgetary needs of their institutions, for which the endowments often provide as much as a third of the annual operating budget. However, these plans have access to the best funds, the best managers, and the best pricing. Their business school faculties, as at Yale, Dartmouth and others provide tremendous analytical horsepower to the internal management teams. They also have influential and knowledgeable alumni oversight from the financial services industry. In this context, the asset class makes perfect sense. For state and public employee retirement plans, I would say they are another set of land mines that deserve more transparency and public scrutiny, and we shouldn't pass the problem on to the general taxpayers. On that point, as John Fogerty writes, "I see trouble on the way."