Courtesy of the New York Times, we have, "Pension Officers Putting Billions into Hedge Funds." This is just a bad situation getting worse. Defined benefit pension plan sponsors are in a hole and continue to dig--someone should take away the shovel. Let's be clear from the onset:
1) I do not have any major issues with defined benefit pensions per se. If corporations want to sponsor them and workers will accept them in lieu of cash wages, then so be it. My own research contradicts the widespread perception that DB pensions offer the typical worker a better retirement outcome than DC pensions, given the way people contribute to them and invest them. They also make the firm's financial statements a bit more complicated.
2) I do not object to corporations making investments in hedge funds, if that's what the shareholders want to do. It is not my preference, because the impact of the investments on the firm's financial statements might make performance evaluation more difficult. But that's a small complaint.
3) I do not object in principle to PBGC insurance, but I do object to the way it is implemented. The insurance premium is too low on average, is inadequately related to the amount of underfunding, and is completely unrelated to the investment mix of the fund's assets. That premium structure, combined with lax funding standards, is what has put the PBGC in its current predicament, even without hedge fund investments.
The cocktail comprised of equal parts (1) - (3) is a vile brew. And the interaction with the political process will be a disaster. From the article:
While most pension plans have modest stakes in hedge funds, others have invested more than 20 percent of their assets. Weyerhaeuser, the paper company, has 39 percent of its pension fund's assets in hedge funds. In Congress, there has been a push for amendments that would make it easier for hedge funds to manage even more pension money, without having to comply with the federal law that governs company pensions.
Such a bad idea. So now the PBGC won't be able to figure out whether it is offering portfolio insurance to Long Term Capital Management? Continuing with the article:
Weyerhaeuser's big position has significant benefits for the company. Accounting rules let companies factor expected pension returns into their operating income; Weyerhaeuser's hedge-fund-laden portfolio allows it to claim expected annual returns of 9.5 percent. By comparison, the 100 largest companies that sponsor pension funds predicted last year that their average long-term returns would be 8.5 percent, according to Milliman Inc., an actuarial firm.
For Weyerhaeuser, each 0.5 percent increase in the expected rate of return is worth an additional $21 million to the company's pretax income this year, according to S.E.C. filings. Weyerhaeuser did not respond to phone inquiries about its hedge fund investments, but said in S.E.C. filings that its actual pension investment returns more than justify its assumption of 9.5 percent.
The article is missing the point here--the higher the rate of return the company can assume on its pension assets, the lower the contributions it needs to make today. Note that funding rules do not require any reserve to be accumulated to protect against the extra risk associated with the higher returns, nor do PBGC insurance premiums go up due to the added risk. So to the corporation, this looks like free money.
And finally, more bad news from Congress:
In Washington, despite concerns over the health of the nation's pension system, there has been little discussion of pension plans' growing use of nontraditional investments. Even as Congress has been working to shore up the pension system and strengthen the Pension Benefit Guaranty Corporation, a provision to relax the pension law for hedge funds has been proposed.
The provision would raise the limit on how much pension money a hedge fund can handle before it is deemed a fiduciary under the pension law, which would require it to be more prudent and careful than is required under securities law and would bar some trades entirely. The provision was added to a broad pension bill in the House shortly before the Committee on Education and the Workforce approved the legislation.
Currently a financial institution becomes a pension fiduciary when more than 25 percent of its assets consist of pension money; the bill would raise that to 50 percent.
That's just sad. We should be heading in the other direction: pushing corporate DB sponsors to use a term-structure of riskless Treasuries to value and fund their liabilities. At some point, somewhere, someone is going to have to pay the true economic cost of their activities.