In a zero interest rate environment, we can think about market participants in two groups:
- Those who are taking risk because they can.
- Those who are taking risk because they have to.
These are not the traditional buckets. Normally the dividing lines run retail versus institutional… investor versus trader… value versus growth or what have you.
Market participants can also be sorted by investment mandate.
Traditional money managers have “career risk” — they live and die on beating their benchmarks, or at least not lagging them too much.
Hedge fund managers, meanwhile, have their performance objectives and high water marks. They want to do well so they can get paid.
But neither of those groups have do-or-die performance requirements, in the sense of “make X percent or you are dead.”
It doesn’t look so good lagging the S&P, of course. But if the S&P is dead flat and these guys finish up a little better or on par with flat, they will probably be okay.
Not so with pension funds. Pension funds have a target they must hit.
We can thus characterize the mandates of the three groups — mutual fund managers, hedge fund managers, and pension fund managers — like this:
- benchmark return (matching or beating the relevant index)
- absolute return (positive performance, not losing money)
- assumed rate of return (the return target that was promised)
Consider the following on Calpers, the largest pension fund in the United States, from a 2010 Bloomberg piece (emphasis mine):
Scoring in the capital markets has long driven the economics of these funds. By assuming investments will earn 7 to 8 percent every year, the elected officials and union leaders who run state retirement systems can ask for fewer upfront contributions from government workers and the agencies that employ them. In 1999, Calpers, flush with profits from the dot- com boom, won passage of legislation that retroactively boosted benefits for retirees at the same time it lowered contributions. The pension vowed to finance the higher payouts with investment gains.
“You could get return without much risk — that was the seduction — and it wasn’t just Calpers that acted on that belief; it was public sector plans around the country,” says Teresa Ghilarducci, an economics professor at the New School in Manhattan and author of When I’m Sixty-Four: The Plot Against Pensions and the Plan to Save Them (Princeton University Press, 2008).
As Calpers’s returns faltered during the next decade, California taxpayers paid $2.3 billion a year to cover the pension’s benefits, more than five times the $450 million originally projected in 1999, according to David Crane, Governor Arnold Schwarzenegger’s senior economic adviser.
“It’s perverse,” Crane says. “Calpers could lose every penny tomorrow, but the only people who wouldn’t be adversely affected are its beneficiaries because the state contractually owes them the money.”
These monster funds — who run tens to hundreds of billions, Calpers in the neighborhood of $230 billion — are not like the other guys. They have to hit their assumed rates of return.
There is a scene in Goodfellas where Henry Hill describes what it is like to be “partners” with crime boss Pauly. The catch-phrase of the scene is “F– you, pay me.” No matter what happens, good, bad or ugly: “F– you, pay me.”
This is, roughly speaking, how Calpers and countless other giant pension funds stand in relation to their legally binding payout obligations. They have to make good on the checks no matter what.
Furthermore, a pension fund is required to monitor asset levels based on assumed rate of return. If the assumed rate of return falls, more assets have to be gathered to cover obligations.
Were Calpers to switch things up and say “You know, we can only realistically project a 5 percent rate of return, not 7.75 percent,” that would mean a big shortfall. The math of paying off X retirees at X dollars per month would cease to add up.
Political mayhem, and possible accusations of insolvency, would ensue.
So what these mammoth pension funds do is keep their assumed rates of return unrealistically high — between 7 and 8 percent in the above example — and then go out into the real world and hope like heck they can actually make those returns.
But do you know how hard it is to make 8 percent on +$230 billion? Prudently and conservatively? In a zero interest rate environment?
What the Federal Reserve has done is to force these guys way, way out onto the risk curve.
The alternatives to “making the nut” are extremely ugly: Forced capital contributions (making angry retirees pony up more cash); a diminishing capital pool as payouts eat away principal (shrinking dollar returns yet further); or worst of all, touching off a fiscal / legal / political crisis that engulfs the state.
Bond yields are pitiful. Equities are a big step up the risk ladder. Private equity and other ‘illiquids’ went tapioca in 2008. So what is a Calpers manager (or whomever) to do?
In a weird way, these entities that are supposed to max out on responsibility — holding the savings of teachers, cops, firemen and the like — have been forced into the classic gunslinger “go big or go home” scenario.
You’ve heard the basic plotline:
The manager of XYZ fund is down 18 percent in the quarter and hasn’t reported yet. If he changes nothing, he is dead — the investors will blow him out when they find out. So he is incentivized to take a major gamble before the reporting period ends. If the gamble pays off, he gets back in the black and things are okay. If the gamble leads to a catastrophic loss of client funds, well… he was facing a personal Waterloo anyway, so why not go out with a bang.
Pension funds, the biggest investment beasts on earth apart from Sovereign Wealth Funds, have a dilemma of similar flavor. They can stretch to hit their unrealistic targets or they can face slow-bleed catastrophe. For the underpaid (by Wall Street standards) managers in question, the alternative to “reaching for yield” is reaching for a pink slip.
Is it any wonder, then, that paper assets are being chased higher? To the degree that pension funds are taking on excessive risk out of necessity, rather than choice or prudent assessment of opportunity, their buying bids are like a deep bullish tide beneath the surface of the market ocean.
As long as the self-reinforcing feedback loop is in place, the game works. The Federal Reserve is using not just Quantitative Easing, but the absence of conservative return options in a “how low can you go” setting to gin up appetite for risk. And as of this writing — as attested by a surging Dow and S&P, with a new spotlight on quality blue chip names — things continue to go swimmingly.
But if this pension fund force is genuinely powerful, then it is also deeply distorting. Managers who buy because they have to — who edge out onto the risk curve because they have no choice — are not likely to be considering market valuations, profit margin regressions, or top down inflation threats in their investment decisions.
Instead, they are blindly and forcibly contributing to yet another Fed-engineered bubble that will be enticing as long as it lasts… yet unleashing new castrophe when it bursts.