“In your lifetime, the idea of the efficient frontier will go the way of the dodo bird.”
So said Charlie Munger, Warren Buffett’s lifelong right-hand man. This prediction was made in a private conversation nearly a decade ago. The notion that the efficient frontier, the accepted framework for creating diversified investment portfolios, is headed for extinction may be blasphemous. It could just be Munger has a way with words; after all he’s best known for being quotable. But what if he’s right? What if the efficient frontier is not destined to survive?
There’s a good chance Munger wasn’t banking on the Fed accelerating the demise of one of finance’s pillar theories. But then who could have foreseen interest rates being pinned to the mat for so long? One of the gravest consequences of prolonged periods of Fed-enforced low interest rates is the damage wrought on presumably well-constructed portfolios. When markets eventually wrest control from the clutches of central bankers, correlations between historically diverse asset classes will align too quickly for investors to take cover. Now consider the fact that the markets have never experienced a period of ultra-loose monetary policy as protracted as the current era. The implications for investors of all stripes are dire. It is the risk to the weakest links in the U.S. public pension system, however, that is mortal; some municipal bonds would unquestionably be imperiled given the weight of pensions bearing down on the fiscal health of issuers.
To be sure, it’s critical to disclaim that most municipal bonds are money good. For starters, a fresh report by Standard & Poor’s finds that in 2013, the latest for which data are available, 26 states either maintained or increased their pensions’ funded ratio. That’s over double the number of states that reported the same in 2012. As an added bonus, the market disruptions sure to prompt future negative headlines will present buying opportunities for the overwhelming majority of solid credits. When asked where to invest in today’s minefield of financial markets, a safe answer is always a good, seasoned municipal bond manager
But hear me well. The fact is good municipal credits may be one of the only places for investors to hide during the next market upheaval. If that smacks as alarmist, consider the 24 states whose funding levels declined in 2013 despite the magnificent rally across the full spectrum of asset classes, commodities notwithstanding. The deterioration in funding status across weak state pensions was significant enough to outweigh the 26 states whose funds saw improvement. Or, taking a longer view, last year, only 41 percent of state and local pensions received their full contributions, down from 65 percent in 2008.
So what’s an underfunded pension to do? Apparently, swing for the fences.
A bit of pension accounting before continuing: Pensions operate under assumptions about future returns. The median assumed rate of return these days is 7.75 percent. Without getting too deep in the weeds, if a pension fails to hit this target – year in and year out — they’ve got to make up for the shortfall some way, somehow.
Suffice it to say, with a yield of about 1.5-percent, parking the bulk of pension assets in Treasury bonds won’t do the trick. Nodding to this reality, pensions have been reducing their holdings of these so-called risk-free assets. At about three percent, corporate bonds offer a bit more in the way of return, but not much.
The gulf between the return on safe investments and the rate of return assumed presents the industry that advises pensions with an ethical dilemma. These well-heeled consultants could acknowledge the elephant in the room — the fact that prudent investing on behalf of current and future pensioners will never result in a 7.75-percent return over the long haul. They’ve read the reports. They know that a recent survey of fund and asset managers projected the average return over the next 10 years on a portfolio of 70 percent stocks and 30 percent bonds to be 5.9 percent.
Rather than own up to the odds against their ability to deliver, in which case they’d be out of a job, advisors pull out their efficient frontier software. Into it they pour rosy assumptions about the diversification capabilities of this and that alternative asset class. And voila! Out springs a portfolio that hugs the efficient frontier, a suite of asset classes that, when combined, perfectly satisfy the accountants, the actuaries and most importantly, the politicians.
Detect anything wrong with this happy ending? Surely all is well when the advice costs as much as it does?
Brian Reynolds of New Albion Partners has been tracking pension allocations for several years. The headlines he shares in his missives would be pure entertainment if they weren’t so disturbing. Here’s a small sample, all from the end of June:
The Pennsylvania public school pension allocated $300 million to an opportunistic levered loan fund and $250 million to an opportunistic credit fund that targets distressed debt and direct lending.
The South Carolina pension is putting $125 million into a debt fund specializing in problematic companies.
The Alaska pension is allocating $200 million into high-yield commercial real estate mortgages.
You just can’t make those headlines up. And according to Reynold’s latest tally, there are 650 other similarly cautionary headlines that he’s archived since embarking on this revelatory journey 34 months ago. Over that span, a distinct trend has emerged. What started out as generic allocations to private equity funds has turned into a stampede into private equity real estate funds.
Could it be that private equity commercial real estate has been crowned the new ‘it’ girl asset class? This new darling of pension advisors was the fastest growth area in private equity funds raised last year, up 16 percent over 2013, a good clip faster than buyout funds’ 11-percent rate. By the end of June 2015, global funds earmarked for private equity real estate had surged ahead of December’s levels by 37 percent to a record $254 billion. As if on cue, 79 percent of recently surveyed active investors plan to increase their allocations to private equity real estate funds in 2015. This will “attract the largest capital inflows this year of all alternative asset classes.”
And state pension fund managers are true believers. The wise souls shepherding Illinois’s state pensions are abiding by their ever efficient frontier’s directives. In their well-compensated wisdom, they’ve just allocated $30 million to a private equity fund and another $30 million to a private equity real estate fund. Rest easy. Their models tell you you’re in good hands.
The inevitable downfall in asset allocators’ well laid plans is that crowding-in and diversifying tend to move in opposite directions. The more an asset class is chased to hedge a portfolio’s risky holdings, the less potent its power to diversify.
As for pensions’ prospects, the insult to injury is borne of the illiquid nature of private equity investments. As damaging as fire sales can be in times of market meltdowns, the inability to sell at all promises to prove more painful still. The unsettling fact is many pensions have ventured too far out on both the risk and liquidity spectrums. But please don’t share this disconcerting news with Grandma. She might not sleep well tonight.
Pension holdings demand deep exploration. A recent relaxation of Japanese pension law allows up to 50 percent to be allocated into stocks with the balance held in bonds. Meanwhile, British law caps the assumed rate of return at 3.5 percent. And yet, the average U.S. public pension allocates 72 percent to risky assets, including stocks and alternative investments, and assumes a rate of return more than double that permitted in the U.K. Reforms aimed at making pensions less dependent on unrealistic assumptions would be an obvious first step on lawmakers’ parts, one that would begin to safeguard the nation’s 19.5 million current and future beneficiaries’ retirement assets.
In a recent study, the 50 states were ranked according to their fiscal health. Illinois came in last in no small part due to its deeply underfunded pensions. Illinois based Allstate has been validating the findings of the 50-state study by divesting itself of its home state’s municipal bonds. When prompted for an explanation, the insurer’s CEO answered by asking the following: “If you don’t like the income statement, the balance sheet or the governance, why would you loan them money just because they never defaulted before?”
Illinois may be the extreme example. Be that as it may, reforms of the magnitude we should be contemplating, coupled with realistic accounting, would give a whole new meaning to “underfunded.” It’s best we find out now.