Gambling To Fix Pensions Can Lead To A Bigger Bind
Map: U.S. State Pension Funding Levels
When the owners of Stuyvesant Town and Peter Cooper Village in Manhattan decided to abandon the properties to their creditors in January, residents were left in a kind of legal limbo, worrying about what would happen to the place they called home.
They weren't the only ones who felt the blow.
As it turned out, the $5.4 billion purchase of the two complexes had been funded in part by outside investors, including Florida's public pension fund and the California Public Employee Retirement System (or CalPERS), which is said to have invested about $500 million in the deal.
"Hindsight tells us clearly that that was gravely in error, and frankly the people who were responsible for that decision aren't at CalPERS anymore," says Joe Dear, CalPERS' chief investment officer. And Stuyvesant Town was only one of several bad investments for CalPERS, which saw its real estate portfolio lose half its value during the recent mortgage meltdown.
A Change Of Strategy
With $200 billion in assets, CalPERS can absorb the loss, but the collapse of the Stuyvesant Town deal says boatloads about how much public pension fund investing has changed over the past few decades. Once, public pension funds put their money into the safest of investments, like Treasury bills. But in the 1980s, many began shifting into stocks, which tended to have better returns over time.
When the dot-com bubble burst, many funds took a big hit, says Keith Brainard, research director of the National Association of State Retirement Administrators.
"A lot of these funds came out of the 2002 market decline believing they needed to further diversify their holdings," he says.
Today, pension funds like CalPERS put their money in a wide range of assets, like foreign and domestic stocks, corporate bonds, real estate, commodity futures, private equity funds and hedge funds. By putting their money into lots of different assets, pension funds lower the risk that they will be adversely affected by the ups and downs of the market, Dear says.
"The most certain, time-tested risk management tool in pension investing is diversification. That means diversification among types of assets, among geographies and among managers' styles," he says.
By investing more broadly, pension funds can reap big rewards in the long run, and many now project average annual returns of 8 percent or more over time. But they can fall well short of those goals in down times — like the recent recession.
When Desperation Leads To Growing Risk
Meanwhile, there's a danger that some funds will go too far.
Many state and city governments have failed to fund their pension systems adequately over the years, leaving them far short of the money they'll need to pay retirement benefits they've promised their employees. The problem has grown worse during the recent recession, which has left governments scrambling for ways to meet their obligations.
As a result, many pension funds are falling under greater pressure to take risks as a way of compensating for the pension shortfall, says Joshua Rauh, associate professor of finance at Northwestern University's Kellogg School of Management.
North Carolina's General Assembly recently approved a law allowing its pension fund, long known for conservative management, to invest 5 percent of its assets in riskier assets, like junk bonds. Pension funds in states like Florida have racked up losses from collateralized debt obligations tied to subprime mortgages.
"Many funds are investing in strategies that people might classify as risky," Rauh says. "They're investing money in private equity and other investment vehicles that may have a higher expected return on average, but also more risk."
He adds, "One of the reasons they are trying to do this is they are trying to gamble their way out of the problem."
Most pension funds still have plenty of money to keep writing checks for retirees for the foreseeable future. But as the collapse of the Stuyvesant Town deal makes clear, funds are also growing comfortable with a level of risk that might have been unthinkable a few decades ago.
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As the recession ricocheted throughout the country's financial markets, it didn't just affect personal retirement accounts like 401(k)s. The market volatility also hit big public pension funds, funds that were supposedly safe.
Now, most state and local governments have huge nest eggs they've set aside to pay retirement benefits for their employees, and they invest that money in everything from government bonds to real estate.
In a moment, we'll speak with Los Angeles Mayor Antonio Villaraigosa about that city's soaring pension costs and its impact on a massive budget deficit.
First, though, to NPR's Jim Zarroli who takes a look at the high-stakes world of pensions and whether some funds might be taking on too much risk in search of higher returns. It's part of our series on pensions airing throughout the week.
JIM ZARROLI: Stuyvesant Town is an 89-building apartment complex that sprawls across Manhattan's east side. At the height of the housing boom, the commercial real estate firm Tishman Speyer paid a record $5.4 billion for it and a sister complex across the street. Soni Fink of the tenants' association sits on a park bench in Stuyvesant Town and explains how the deal fell apart.
Ms. SONI FINK (Tenants' Association, Stuyvesant Town): Well, it's still owned by Tishman Speyer, who bought it in 2006, but they defaulted on the loans and have more or less walked away from the place.
ZARROLI: So Tishman Speyer was the lead investor, and were there other investors, as well?
Ms. FINK: There were Fannie Mae and Freddie Mac and the Church of England - poor thing - and the government of Singapore and a number of retirement funds.
ZARROLI: Among the investors hurt in Stuyvesant Town were the Florida State Retirement Fund and the California Public Employees' Retirement System or CalPERS which lost some $500 million. Joe Dear, CalPERS chief investment officer, says CalPERS took a serious risk by investing in the deal.
Mr. JOE DEAR (Chief Investment Officer, California Public Employee Retirement System): Hindsight tells us clearly that that was gravely in error, and frankly the people that were responsible for that decision aren't at CalPERS anymore.
ZARROLI: All told, CalPERS' real estate portfolio lost half its value during the market crash. With $200 billion in assets, CalPERS can absorb the loss. Still, the transaction illustrates how pension fund investing has changed.
Once, pension funds tended to invest in safe assets like Treasury bills. In the 1980s, many shifted their money into stocks, which promised higher returns over time. But when the dot-com bubble burst, many funds took a big hit, says Keith Brainard of the National Association of State Retirement Administrators.
Mr. KEITH BRAINARD (Research Director, National Association of State Retirement Administrators): And so a lot of these funds came out of the 2002 market decline believing that they needed to further diversify their holdings.
ZARROLI: Today, some funds have less than a fifth of their money in safe investments like Treasury bills. The rest goes into international stocks, private equity, even hedge funds. In some ways, diversification is a smart strategy: Invest in a wide range of assets, and you're less vulnerable if one of them loses value. CalPERS' Joe Dear says diversification makes sense for another reason.
Mr. DEAR: One of the principal advantage of a pension fund, particularly a public pension fund, is a very long investment horizon. It's completely different from what individuals face on their own individual retirement planning.
ZARROLI: In other words, pension funds go on indefinitely, collecting money and paying out benefits only gradually, and that means they have some leeway to take chances. They can put money in assets like real estate and private equity. These assets are risky because they can't be sold off quickly, but they can be very profitable over time.
But as Stuyvesant Town shows, pension funds can still get burned, and Dear says funds have to assess how much risk they want to take on very carefully. The danger is that some funds will go too far.
Joshua Rauh, associate professor of finance at Northwestern University's Kellogg School, says many states and cities face budget deficits right now, and with less money available, many funds are under pressure to take on more risk than is good for them.
Mr. JOSHUA RAUH (Associate Professor of Finance, Kellogg School of Management, Northwestern University): Many funds are investing in strategies that people might classify as risky. You know, they're investing money in private equity and other investment vehicles that may have a higher expected return on average but also more risk.
And, you know, as I said, I mean, one of the reasons why they're trying to do this is that they're trying to gamble their way out of the problem.
ZARROLI: In general, pension funds have plenty of money to keep sending checks to retirees for the foreseeable future. But it's also true that many have become comfortable with a level of risk that once was unthinkable, and they're vulnerable to market forces in a way they didn't used to be.
Jim Zarroli, NPR News.
RAZ: You can follow our series on the pension crisis this week on ALL THINGS CONSIDERED, MORNING EDITION and online at npr.org. Transcript provided by NPR, Copyright National Public Radio.
