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Illinois Borrowing Costs To Rise In Wake of Ruling Overturning Pension Reform

Illinois already has the lowest credit rating of any state in the country. But it could see its borrowing costs rise further after a court law week overturned the state’s pension reform law.

From Bloomberg:

Illinois bonds are set to weaken after a judge struck down a plan to address the biggest pension deficit among U.S. states, according to Wells Capital Management.

Illinois 10-year obligations yield 3.68 percent, or about 1.4 percentage points above benchmark municipal debt, data compiled by Bloomberg show. At that yield spread, the smallest since July, the debt isn’t attractive given the legal developments and the potential financial strain, said Robert Miller, who helps oversee $35 billion of munis at Wells Capital.

The lowest-rated U.S. state plans to appeal the Nov. 21 ruling that its constitution protects cuts to public pensions, which face a $111 billion shortfall. The decision marks the latest challenge to emerge for the incoming governor, Bruce Rauner, who takes office Jan. 12. He also has to grapple with a $2 billion budget hole from expiring increases to income-tax rates.

“You would expect on this news that spreads would widen out,” said Miller, who’s based in Menomonee Falls, Wisconsin. “The pension is definitely a looming problem and something they need to deal with.”

Some Illinois bonds weakened after last week’s pension decision. Taxable debt maturing in June 2033, the state’s most frequently traded securities, changed hands Nov. 21 at yields as high as 5.42 percent, Bloomberg data show. The debt’s spread to Treasuries was about 0.3 percentage point more than the average for the past five months.

If history’s any guide, the court decision will keep inflating the state’s relative borrowing costs. In July, Illinois yields surged after a separate court ruling signaled the 2013 pension fix might be in jeopardy. The law would save an estimated $145 billion over 30 years by reducing cost-of-living adjustments and raising the retirement age.

The state is appealing the circuit court’s decision to the Supreme Court.

Video: The Modern Pension Dilemma

This video takes a look at the evolution of Germany’s public pension system over the last century — and how that system is emblematic of the pension funding issues being experienced across the world.

Judge: Illinois Pension Reform Law Is Unconstitutional

A Circuit Court judge ruled Friday afternoon that Illinois’ sweeping pension reform law is unconstitutional.

Judge John Belz said in his ruling that the Illinois constitutional makes a promise to protect employee pension benefits.

The ruling will be appealed and will soon head to the state Supreme Court.

From Crain’s Chicago Business:

Sangamon County Circuit Court Judge John Belz ruled today that the state’s pension reform law is unconstitutional, setting up an immediate appeal to the state’s highest court.

“The State of Illinois made a constitutionally protected promise to its employees concerning their pension benefits,” Belz said in his seven-page ruling. “Under established and uncontroverted Illinois law, the State of Illinois cannot break this promise.”

While the state lost this round, the constitutional question ultimately has to be resolved by the Illinois Supreme Court. The longer the case takes to get there, the longer state finances remain in limbo and the longer any “Plan B” for pension reform goes undiscussed.

“Seven people will decide this at the end of the day,” said Illinois Sen. Daniel Biss, D-Skokie, one of the principal co-authors of the pension reform law. “It’s a victory for the state to get it to the Supreme Court faster. The state suffers from uncertainty. Ultimately what matters most is how we resolve this problem eventually.”

The decision was widely expected, given the state Supreme Court’s ruling in Kanerva vs. Weems, a similar case in July testing whether retiree health care benefits can be reduced. The justices ruled that the state constitution’s pension protection clause is “aimed at protecting the right to receive the promised retirement benefits, not the adequacy of the funding to pay for them.”

Proponents of the reform law called today’s ruling “significant”, but not a be-all-end-all judgment by any means. That’s because the Illinois Supreme Court, who will hear arguments on the law at some point in the coming months, will have the final say.

The state has 30 days to appeal the ruling up to the Supreme Court.

San Diego County Pension Weighs Major Governance Changes After Expert Recommendations

San Diego City Employees Retirement System is on the cusp of firing its controversial outsourced chief investment officer and bringing more investment management in-house. But that’s not the only change that could be coming for the fund.

The fund’s former CIO spoke to the board of trustees on Thursday and suggested major changes to its governance model. The trustees were extremely receptive to the suggested changes.

More details from the San Diego Union-Tribune:

David Wescoe, who stabilized the San Diego City Employees Retirement System after an underfunding crisis nearly bankrupted the city a decade ago, said the county should have a single person report to the board — not one for administration and one for investments, as it has now.

“I’m strongly for the linear model,” Wescoe told pension trustees during a two-day retreat that began Thursday. “The board should have one direct report.”

Under its current governance model, the San Diego County Employees Retirement Association has two people who report directly to the board: CEO Brian White and outsourced portfolio strategist Lee Partridge.

[…]

Wescoe also said the fund would be much better served by recruiting and hiring its own lawyer as well, rather than an outside contractor.

“It’s an absolute necessity for a very well functioning management team,” Wescoe said. “They can prevent little issues from becoming big issues.”

[…]

After Wescoe’s presentation, at least two trustees said they were ready to begin implementing his suggestions.

“I would love to see the board adopt the recommendations you put forward,” said Supervisor Dianne Jacob, who represents the county Board of Supervisors on the retirement panel. “We have an opportunity to bring the same kind of changes here for SDCERA, and I think we should take advantage of it.”

County Treasurer Dan McAllister, who also serves on the board as part of his elected duties, said he hopes trustees can schedule a debate on Wescoe’s recommendations as soon as next month.

“We owe it to ourselves to discuss those issues,” McAllister said.

Wescoe also addressed the potential hiring of a new CIO to internally manage investments. From the UT:

Wescoe, who oversaw the city pension fund from 2006 to 2009, said he knew many local investment professionals who would relish the chance to manage the $10 billion county portfolio for around $200,000 a year.

“It’s the professional opportunity of a lifetime,” he said.

Partridge and his company, Salient Partners of Houston, Texas, are paid more than $10 million a year.

His predecessor, an in-house chief investment officer, was paid $209,000 a year. The position was outsourced to allow for higher pay. Despite that, Salient’s investment returns have not kept pace with those of peer pension systems.

The pension fund is also missing its internal benchmark for earnings. For the 12 months ending Oct. 31, the most recent available, the agency’s benchmark was 9.1 percent and the fund earned 8.22 percent, according to a preliminary report by Salient.

Last month, the board of trustees informally voted to fire their outsourced CIO, Lee Partridge and his firm Salient Partners.

The vote was not official.

Pennsylvania Auditor General Urges State Pensions to Pull Back From Hedge Funds, “Dramatically” Reduce Risk

Pennsylvania Auditor General Eugene DePasquale has been vocal in the past about his desire for the state’s pension systems to decrease their allocations to hedge funds.

He doubled-down and expanded on that stance Thursday, saying the state-level pension funds’ risk appetite needs to be “dramatically pulled back”.

He also called on the pension systems to reduce investment fees and change funding models.

DePasquale made these announcements after examining the pension system of Montgomery County, which uses a low-cost investment approach that includes investing heavily in passive index funds. The approach represents a stark contrast with the state-level pension systems.

Montgomery County Commissioners Josh Shapiro explains how his county’s pension fund operates:

Historically the county invested money from the pension fund with Wall Street money managers, Shapiro explained.

“What we found was that they just were simply not getting the returns our retirees needed,” Shapiro said. “We, as a pension board, worked hard at looking at different models of funding our pension system that would work better than what we historically had.”

Shapiro said the county began investing 90 percent of the fund in Vanguard two years ago and has since has seen a return of 16.23 percent while saving more than over $1 million in fees.

“We knew we were creating a template that could be used by other municipalities and maybe even by the state,” Castor said. “The obligation that we have to our retirees is to make sure the funding is there today, tomorrow and 40 years from now. The health of that plan is part of the covenant we have with the people who do the work here at Montgomery County and at the state.”

DePasquale then suggested that the state-level pension systems could learn from the successes of Montgomery County, according to the Times-Herald:

DePasquale said the state needs to emulate Montgomery County, where the pension funds are invested in a stock index fund.

“Before you get there we have to reduce our exposure into the hedge fund area,” he said.

According to DePasquale, the public school retirement system has 10 percent of its investments in hedge funds, while the state employee retirement system has approximately 6 percent of investments in hedge funds.

“That risk needs to be dramatically pulled back,” DePasquale said.

A final point DePasquale made about the state pension system is that the fees going to private equity and hedge fund managers need to be reduced.

“Pennsylvania is a large state,” he said. “We have a huge leverage tool in the amount of money that we have in our pension system. For some reason our Public School Employment Retirement System and our State Employment Retirement System refuses to use that leverage to negotiate lower fees.”

This isn’t the first time DePasquale has asked the state’s pension funds to pull back from hedge funds.

That led pension officials to defend their hedge fund investments. The chairman of the Pennsylvania’s State Employees Retirement System board of trustees said this in September:

Industry experts generally agree that while hedge funds are not for every pension system, the unique needs of each system must shape their individual asset allocation and strategic investment plans. Therefore, the actions taken by one system may not be appropriate for all systems. Investors need to consider many factors including their assets, liabilities, funding history, cash flow needs, and risk profile.

[…]

To date, the strategy has been working. As of June 30, 2014, our diversifying assets portfolio, or hedge funds, made up approximately 6.2 percent of the total $28 billion fund, or approximately $1.7 billion. In 2013, that portfolio earned 11.2 percent or $197 million, after deducting fees of $14.8 million, while dampening the volatility of the fund. That performance helped the total fund earn 13.6 percent net of fees in 2013, adding more than $1.6 billion to the fund.

Photo by Paul Weaver via Flickr CC License

Pension Funds Criticize Excessive Private Equity Fees; More Look To Direct Investing

Pension fund officials from Canada and the Netherlands expressed their frustration with private equity fees during a conference this week.

The chief investment officer of the Netherlands’ $220 billion healthcare pension fund said it needs “to think about” the fees it is paying, according to the Wall Street Journal.

Ruulke Bagijn, chief investment officer for private markets at Dutch pension manager PGGM, said a Dutch pension fund for nurses and social workers that she invests for, paid more than 400 million euros ($501.6 million) to private-equity firms in 2013. The amount accounted for half the fees paid by the PFZW pension fund, even though private-equity firms managed just 6% of its assets last year, she said.

“That is something we have to think about,” Ms. Bagijn said.

Among the things pension officials are thinking about: bypassing private equity firms and fees by investing directly in companies. From the Wall Street Journal:

Jane Rowe, the head of private equity at Ontario Teachers’ Pension Plan, is buying more companies directly rather than just through private-equity funds. Ms. Rowe told executives gathered in a hotel near Place Vendome in central Paris that she is motivated to make money to improve the retirement security of Canadian teachers rather than simply for herself and her partners.

“You’re not doing it to make the senior managing partner of a private-equity fund $200 million more this year,” she said, as she sat alongside Ms. Ruulke of the Netherlands and Derek Murphy of PSP Investments, which manages pensions for Canadian soldiers. “You’re making it for the teachers of Ontario. You know, Derek’s making it for the armed forces of Canada. Ruulke’s doing it for the social fabric of the Netherlands. These are very nice missions to have in life.”

But an investment firm executive pointed out that direct investing isn’t as cost-free as it sounds. From the WSJ:

[Carlyle Group co-founder David Rubenstein] warned that investors who do more acquisitions themselves rather than through private-equity funds will have to pay big salaries to hire and retain talented deal makers.

“Some public pension funds will just not pay, in the United States particularly, very high salaries and will not be able to hold on to people very long and get the most talented people,” Mr. Rubenstein said at the conference. “I don’t think there are that many people who will pay their employees at these sovereign-wealth funds and other pension funds the kind of compensation necessary to hold on to these people and get them.”

[…]

Mr. Rubenstein had a further warning for investors seeking to compete for deals with private-equity firms. “If you live by the sword you die by the sword,” he said. “If you are going to do disintermediation you can’t blame somebody else if something goes wrong.”

Pension360 has previously covered how pension funds are bypassing PE firms and investing directly in companies. One such fund is the Ontario Municipal Employees Retirement System. The fund’s Euporean head of Private Equity said last month:

“The amount of fees that we were paying out for a fund, 2 and 20 [percentage points] and everything that goes with that, was a huge amount of value that we were losing to the fund,” Mr. Redman said. “If we could deliver top quartile returns and we weren’t hemorrhaging quite so much in terms of fees and carry that would mean that we would be able to meet the pension promise.”

Photo by http://401kcalculator.org via Flickr CC License

Norway’s Largest Pension Divests From Coal, But Sees Risks in Exiting Other Fossil Fuels

KLP, Norway’s largest pension asset manager, said it plans to divest from coal companies and increase investments in renewable energy.

The divestment from coal comes even as KLP remains heavily involved in oil and gas investments. That’s because an internal study suggested that divesting from all fossil fuel companies would pose big risks for KLP and harm future returns.

From IPE Real Estate:

It said it was doing this to contribute to the “urgently needed” switch from fossil fuel to renewable energy.

KLP defines coal companies as coal mining companies and coal-fired power companies that derive a large proportion of their revenues from coal.

At the very least, KLP will exclude those with 50% of revenues from coal-based business activities.

The names of the companies to be excluded will be published in an updated KLP list on 1 December.

KLP’s divestment from coal companies also applies to the KLP funds.

The public service pensions provider said preliminary estimates showed the divestment would lead to the sale of shares and bonds worth just under NOK500m.

[…]

The KLP Group, with total assets of NOK470bn, is already a major investor in renewable energy, with NOK19bn invested in Norway alone.

Last year, it also established a partnership with Norfund for direct investment in renewable energy and finance.

The additional NOK500m will be used for direct investments in increased renewable energy capacity in emerging economies, where KLP considers the need to be greatest.

The pension manager will not be divesting from oil and gas companies after a study suggested that doing so would diminish future returns. Details on the study from IPE Real Estate:

At present, the divestment does not apply to oil and gas companies.

KLP said this was because coal companies were considered to have the largest negative impact, both in terms of carbon emissions per unit of energy produced and local pollution in the vicinity of the coal-based facilities, even though there are significant variations between the different types of oil, gas and coal.

But KLP also said a withdrawal of investments in oil and gas companies would probably have a material impact on future returns, unlike the retreat from coal company stocks.

At the request of the Norwegian municipality of Eide, one of its customers, KLP carried out an assessment on the feasibility of pulling its investments out of oil, gas and coal companies without affecting future returns, in order to contribute to a better environment.

The report found no support for the “stranded assets” hypothesis, which posits that investments in companies with major fossil fuel reserves represent a greater financial risk than is normal for this type of undertaking.

It said: “On the contrary, a divestment from all fossil fuel companies would significantly increase KLP’s risk, particularly with respect to Norwegian shares.

“However, depending on the definition applied, divestment from coal companies alone would not represent any significant financial risk for KLP.”

KLP manages about $45 billion in pension assets.

Former Governors: Colorado Pension Benefits Are “Skewed”, Insufficient

Two former Colorado governors penned a column in Friday’s Denver Post that raised questions about whether too many employees were getting the “short stick” regarding pension benefits.

Richard D. Lamm and Bill Owens write:

The debate over the unfunded liability has overshadowed an equally critical issue.

What has gone largely unexamined — by PERA members, policymakers and the broader public — is the question of whether the state’s public retirement plan provides fair benefits to the majority of public servants and allows public entities to recruit and retain the highest-quality employees.

Given that virtually all public school teachers are PERA members — along with other state employees and many who work for Colorado municipalities and counties — this is a critically important question that impacts us all.

We put our trust and the safety of our families in the hands of these educators, state troopers, and snowplow drivers so it makes sense that we want to ensure that they’re treated fairly and that they represent the best and the brightest employees available.

The authors argue that, although Colorado’s average pension benefit appears more than adequate (over $3,000 a month), it masks the fact that many workers lose out. From the column:

Some PERA critics have argued that its benefits are too generous, outstripping what’s available to private sector employees. But the secret that goes unaddressed is that the vast majority of PERA members lose out under its current structure. For many of them, in fact, the benefits are insufficient to provide them with the retirement security they deserve.

Despite the buzz that it’s a 24-carat retirement plan, many of these public servants may end up with fool’s gold.

Why? While PERA highlights its average retiree benefits — $3,068 monthly, according to the latest data — this statistic hides the fact that a few retirees make far more than that and the vast majority make far less. Quite simply, the benefit structure, set by the state legislature, is skewed to benefit a minority of public employees at the expense of the rest.

Who are the rest who get the short stick under the current system? They’re employees who are more typical of the modern-day workforce — those who don’t stay at one job for the majority of their career. This could include those who move between the public and private sector or move in or out of Colorado, including, for example: a teacher who spends a half dozen years in the classroom before taking a private sector job; a public servant who follows his spouse out of Colorado — even if he continues a career in the public sector in another state; and a dedicated career Colorado public employee who wants to continue serving after becoming eligible for retirement.

Richard D. Lamm and Bill Owens are co-chairs of the Colorado Pension Project, “a group working to strengthen retirement security for Colorado public servants”.

Photo credit: “Denver capitol” by Hustvedt – Own work. Licensed under Creative Commons Attribution-Share Alike 3.0 via Wikimedia Commons

Moody’s: Public Pension Liabilities Declined in Majority of States in 2013

States paid more of their actuarially required contributions to their pension systems in 2013; coupled with “strong” investment performance, 27 states saw their pension liabilities decline in fiscal year 2013, according to a new Moody’s report.

From Pensions & Investments:

In a report released Thursday, “U.S. State Pension Medians for FY 2013,” Moody’s found that pension liabilities declined in 27 states, while 21 states with lagging valuations had an average increase of 38.9%. “We believe that states should continue to show improvement in their liabilities in fiscal 2014 due to continued strong investment performance,” Moody’s said in a statement.

The median annualized returns for the period ended June 30, 2014, was 16.1%.

In measuring actuarially determined contribution levels, Moody’s found that 34 states contributed 90% or higher in fiscal 2013 and 12 contributed between 60% and 90%, while only four states contributed less. New Jersey was the lowest at only 29% of actuarial determined contributions.

In terms of pension liability as a proportion of government revenue, the median ratio dropped to 60.3% from 63.9% in fiscal 2013, but 14 states were more than 100%. The highest ratios of pension liability to revenue were in Illinois (268.3%), Connecticut (236%), Kentucky (193.2%) and New Jersey (179.7%).

States with the lowest liabilities-to-revenue ratio included Nebraska (12.6%), Wisconsin (13.8%), Tennessee (20.9%) and New York (24.2%).

The report can be read here [subscription required].

First Ruling on Illinois Pension Reform Law Expected Friday

Sangamon County Judge John Belz spent Thursday hearing arguments for and against Illinois’ major pension overhaul.

On Friday, he is expected to release his ruling on the law. If he declares it unconstitutional, the debate could move to the halls of the Supreme Court sooner than later.