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The Effect of Age On Portfolio Choices

Does a person’s willingness to hold risky assets diminish as they grow older and get closer to retirement? How does aging affect portfolio choices?

A paper published in the October issue of the Journal of Pension Economics and Finance aims to tackle those questions.

The authors analyzed administrative data from an Italian defined-contribution plan spanning 2002-08. Here’s what they found:

We studied investors’ portfolio choices in a very simple real-world setup. Some results prove quite robust across all the empirical exercises we performed. In particular, we found a pronounced tendency to choose safer portfolios as people age. This effect is still there after controlling for several demographic factors, for time effects, and for the sub-fund chosen in the previous period. This result is broadly in line with other micro-evidence from the US market, and is consistent with models of life-cycle rational portfolio allocation.

[…]

The effect of age is more pronounced in the last years of the sample. This might be due to the fact that investors learn form the experience of their colleagues. Indeed, in our sample there have been periods of disappointing stock market performance. Having seen that people who retired during these bear market periods have been severely hit might have pushed investors toward a more active behaviour. A better understanding of this form of learning appears to be an interesting issue for further research.

But not all plan participants reduced risk as they approached retirement. From the paper:

Not all elderly people in our sample reduced their exposure to risk. Looking at the ones present in the sample from the start, it turns out that more than 30% of the elderly workers who were exposed to stock market risk in 2002 were still exposed to it in 2008. As the stock market events of the last decade show, an elderly worker taking risk on the stock market could pay a high price if stocks fall. This evidence suggests that life cycle funds could be a valuable instrument, given that they automatically bring all the participants toward less risky allocations as they get near to retirement (Viceira, 2007). In the Chilean system, for example, a lifecycle fund is the default option for all the workers. Moreover, the riskiest sub-funds are closed to individuals older than a certain age.

The authors also found that job position and education are factors that play into people’s risk choices:

People with a higher position tend to take more risks. This tallies with previous empirical analyses and can be consistent with optimal portfolio allocation. We also found that education has no clear impact on portfolio choices, even if it slightly increases the likelihood of switching for those in the zero-shares sub-funds. The weakness of this effect could be due to the easy set up provided by the fund, and/or to strong social interaction effects, in which the financial skills of the educated employees who make up most of our sample also benefit the few uneducated participants.

Read the entire paper, titled “the effect of age on portfolio choices: evidence from an Italian pension fund”, here.

Photo by www.SeniorLiving.Org

CalSTRS: Financial Risk of Climate Change “Very Real” For Institutional Investors

CalSTRS has been one of the most active (and vocal) pension funds in the world this year when it comes to exploring the financial risk of climate change.

The fund announced last month it was joining forces with Mercer and a handful of other pension funds to study the market impact of climate change.

Now, CalSTRS has commented on a new report showing the “profound lack of preparedness” for climate change among the nation’s insurance companies.

The pension fund calls for institutional investors to be “more mindful of market exposures to environmental risks.”

From a CalSTRS release:

The Insurer Climate Risk Disclosure Survey Report & Scorecard: 2014 Findings & Recommendations was released today by Ceres, a nonprofit sustainability organization mobilizing business and investor leadership on climate change and other sustainability challenges, ranks property & casualty, health, and life & annuity insurers that represent about 87 percent of the total U.S. insurance market. Ceres found strong leadership on the issue in fewer than a dozen companies nationwide.

“Environmental, social and governance risks and issues such as climate change are very real for CalSTRS. This new report enables large institutional investors to be more mindful of market exposure to environmental risks through our insurance investments,” said CalSTRS Chief Executive Officer Jack Ehnes. “More importantly, the report gives us better perspective on how well, or not, insurance companies are responding to climate change risk.”

The report states, “… insurers are on the veritable ‘front line’ of climate change risks, and there is compelling evidence that those risks are growing. Rising sea levels and more pronounced extreme weather events will mean increasingly damaging storm surges and flooding. Hurricane Sandy alone resulted in over $29 billion in insured losses.”

“Meaningful change in the recognition of climate risk to the investment portfolio will come from an alignment of interests, and who better to take leadership this effort than the insurance industry,” added Ehnes. “The foundation of the insurance model is based on risk analysis, so ignoring the risk of climate changes seems most imprudent. Clearly, more action on the part of the insurance sector is needed.”

Last month, CalSTRS announced plans to double down on its clean energy investments.

Chart: How Did Kentucky’s Pension System Become So Underfunded?

Here’s a chart of the funding situations of Kentucky’s largest public pension funds as of 2012. At 27 percent funded, the KERS non-hazardous fund was considered among the unhealthiest in the country. Since 2012, its funding ratio has dipped even further. But the entire system is experiencing big shortfalls.

How did they get this way? Pension360 covered earlier today the system’s lackluster investment performance — but the state’s funding shortfall has been influence by a confluence of factors.

One of the largest reasons for the shortfall is the state failing to make its actuarially-required payments into the system:

Chart credits: Pew Charitable Trusts

Arizona’s Largest Pension May Boost Retiree Benefits, Lower Employee Contributions

The Arizona State Retirement System (ASRS) says there could be a permanent benefit increase on the horizon—the first since 2005. System officials also indicated that public workers could see their contributions decrease.

ASRS is 77 percent funded – but officials say higher investment returns, better cash flow and reduced liabilities have opened the door for the potential benefit increases.

From the Arizona Republic:

Paul Matson, chief executive of the $32 billion Arizona State Retirement System, said he expects retirees could see a permanent benefit increase, of undetermined size, sometime in the next three or four years. The last increase for the pension fund and its more than half-a-million members came in 2005. Benefit hikes are made possible by excess investment earnings, largely from the stock market, he said.

Similarly, an improving financial backdrop for the pension system also could mean that more than 200,000 public-sector workers in Arizona — along with the cities, counties, state agencies, school districts and other entities that employ them — could start paying slightly lower contributions to support the system, Matson added.

[…]

At a time when public pension programs including the Arizona State Retirement System remain significantly underfunded, Matson’s assessment was surprisingly upbeat. But recent fixes and long-term trends have put the system in much better shape, he said.

“We have a strong, healthy system that’s fully sustainable on the retirement and health sides,” he said in an interview with The Arizona Republic. The program provides retirement, health and long-term disability benefits.

In an interview with the Arizona Republic, ASRS chief executive Paul Matson expounded on the reasons behind the proposed benefit increase:

Matson cited three main reasons for the improvement:

– Changes in certain benefit formulas have reduced the system’s liabilities. Working with the Legislature over the past decade, the Arizona State Retirement System has closed loopholes and made other adjustments. One involved new workers joining the system. In prior years, many new hires were allowed to purchase retirement-service credits at a cost of about 40 cents on the dollar. That unsustainable practice and about a dozen others have been restricted or eliminated, Matson said.

– Contribution increases have boosted the system’s cash flow and assets. Employees and their employers each currently make contributions into the system equivalent to 11.6 percent of worker salary. That’s up from an unsustainably low 2.5 percent a dozen years ago. As noted, the recent trend of contribution hikes eventually will be followed by modest decreases, before contributions level out around 6.75 percent many years down the road.

– Higher investment returns have bolstered the system’s assets. The stock market has been on a tear, rising about 200 percent between the bottom in early 2009 and the recent peak in September of this year. Although prices have retreated over the past few weeks, the trend for most of the last five years has been favorable. The Arizona State Retirement System generated an average yearly compounded return of 14.2 percent over the five years through June 2014, including a gain of 18.6 percent in the most recent year. Those returns are after expenses.

Matson did say he doesn’t expect investment performance to be quite as good, year in and year out, as it has been the previous 5 years.

ASRS has 551,000 members and manages $32 billion of assets.

Kentucky Pension CIO Talks About “Challenging Start” To Fiscal Year As Investments Decline

The first quarter of fiscal year 2015 ended last month, and investment performance at the Kentucky Retirement Systems came in below benchmarks for the period.

Including October, KRS investments are down 3 percent since July 1.

The system’s chief investment officer, David Peden, revealed the performance data at a board meeting on Tuesday.

Reported by the Lexington Herald-Leader:

Hedge funds and other alternative investments are the only assets currently gaining value for the Kentucky Retirement Systems, however controversial they might be otherwise.

For the first quarter of fiscal 2015, ending Sept. 30, its investments declined 1.41 percent overall, worse than the comparable benchmark, David Peden, chief investment officer for Kentucky Retirement Systems, or KRS, told the Public Pension Oversight Board on Tuesday.

“It’s been a challenging start to the year,” he said. “October hasn’t helped any. It’s actually a little worse — down by about 3 percent if you include October.”

After the meeting, Peden said KRS’ worst losses were in public equities — traditional stocks and bonds, especially those based in other countries. By contrast, he said, hedge funds were up 0.74 percent, private equities were up 1.49 percent and real estate was up 2.03 percent.

[…]

Experts consider KRS the weakest state retirement system in the country. It faces $17 billion in unfunded liabilities due largely to inadequate state payments for most of the past 15 years, starting during Gov. Paul Patton’s administration.

[…]

Jim Carroll, co-founder of the advocacy group Kentucky Government Retirees, told the board that KRS needed a massive infusion of cash, possibly from a pension bond that would require legislative approval. KRS now has so little money that even a booming stock market isn’t enough to prop it up, Carroll said.

“Over the last three years, the fund has exceeded its assumed rate of return and yet lost a staggering $952 million,” he said. “In other words, positive market performance has become disconnected from asset growth. The run-out date — the date when the fund would be depleted if there were no more assets coming in — has shrunk to two years and 10 months.”

KRS investments returned 15.5 percent in fiscal year 2013-14.

How Would Phoenix Officials Handle The Up-Front Costs of Proposition 487?

In two weeks, Phoenix voters will decide the fate of Proposition 487 – the ballot measure that would close off the city’s defined-benefit plan from new hires and shift them into a 401(k)-style plan.

The plan, if passed, would cost the city millions up front – but the tradeoff, proponents of the plan say, is a more sustainable pension system.

There are ways to offset the initial cost of the plan. One option is to eliminate deferred compensation for workers.

Would city officials support eliminating deferred compensation as a cost-saving measure?

The Arizona Republic asked them:

We asked: If Prop. 487 is approved, would you support removing deferred compensation without providing employees its value in another form? Please explain.

“It is important to provide employees fair compensation and to ensure the city remains a competitive employer. With that said, should Prop. 487 pass, the city will comply with the law and not provide deferred compensation. However, I would not want to presume what the end point or other forms of compensation could or could not be. We are required to negotiate in a fair and neutral manner per our Meet and Confer ordinance and to do so without a predetermined outcome. The city would negotiate in good faith with employee groups as required and practice good labor relations practices.”

— Michael Nowakowski,District 7, southwest Phoenix and parts of downtown

“Yes. Prop. 487 lets current employees choose between their pensions or deferred compensation. They get to keep what they earned, but going forward, they can’t have both. Pensions are out of control — costs ballooned from $56 million in 2003 to $240 million in 2013. ‘Yes’ on Prop. 487 saves over $400 million by eliminating pension spiking and secondary retirement. This year, taxpayers saw a new water tax and cuts in police, after-school programs, seniors and libraries to fund the ballooning pension costs and $19 million in pension spiking. Prop. 487 treats employees and you fairly. Ask yourself, what do you get?”

— Sal DiCiccio, District 6, Ahwatukee and east Phoenix

“I support 487. We must end pension spiking, and the prohibitively expensive status quo. I have voted against all final labor contracts as a councilman. By the time the initiative kicks in, the current contracts would have 18 months to run. I believe we must honor the voters’ decision and meet our contractual obligations (even though I voted against the contracts) by re-opening the contracts to mitigate loss of deferred compensation. In subsequent negotiations in 2016 and beyond, we should take a much more realistic approach to negotiations. The ‘we’ve always done it this way’ approach to negotiation must stop.”

— Jim Waring, vice mayor (District 2), northeast Phoenix

“If deferred compensation is contained in contractual minutes — and rightfully owed to city employees — the city will be required to renegotiate its contract and provide payment in the form of wages. Ultimately, courts will decide the outcome at significant cost to taxpayers.”

— Thelda Williams, District 1, northwest Phoenix

Florida Pension Looks To Hire Bank For Collateral Management

Nearly a dozen banks are pitching their services to the Florida State Board of Administration (SBA), the entity that manages assets for the Florida Retirement System.

Reported by the Securities Lending Times:

Multiple banks are competing to provide the State Board of Administration of Florida with prime and collateral management services, it has been revealed.

The State Board of Administration of Florida, which manages the state’s public employees’ retirement savings, has received pitches from CitiGroup, Deutsche Bank, Newedge, Bank of America Merrill Lynch and Pershing for prime services.

State Street, BNY Mellon and CitiGroup have submitted pitches to provide collateral management services following the State Board of Administration of Florida’s request for proposals.

A spokesperson said that a decision on the providers is expected by the end of this week.

An explanation of the services the SBA is seeking, from Pensions & Investments:

Prime services include prime brokerage in short-selling of securities, foreign-exchange prime brokerage, as well as clearing for futures, options and over-the-counter derivatives, including swaps, according to the solicitation.

Collateral management includes margin collateral custody and management services related to prime services.

The SBA manages $180.3 billion in assets.

Virginia Pension Commits $200 Million To Industrial Properties

The Virginia Retirement System (VRS) is committing $200 million to a joint venture with LaSalle Investment Management that seeks to build industrial warehouses in the United States.

From IPE Real Estate:

The pension fund told IP Real Estate it was committing $200m in equity to the LaSalle VA Industrial JV.

The partnership will develop industrial warehouses in select US markets. Virginia would not comment on which markets the venture would focus on.

LaSalle said it would focus on opportunities to develop and lease large, modern distribution buildings in major population centres with strong transportation infrastructure.

LaSalle recently announced it had been awarded a mandate from a large US public pension fund, an existing client.

Jason Kern, chief executive of Americas at LaSalle, said end-user demand for industrial real estate is “very strong”, driven by growing GDP and global trade, as well as the need for “modern buildings part of an efficient supply chain”.

According to the firm’s research and strategy team, the availability rate for industrial supply has dropped 2.2% since the end of 2012 and 4.2% since 2010. LaSalle is forecasting annual rental growth of 3%. Internet retailing and larger multinational retailers’ focus on improving supply-chain efficiencies are also improving demand.

Virginia has existing exposure to industrial real estate, with 15.6% of its private real estate portfolio invested in the sector at June this year.

Real estate assets make up 10.5 percent of the VRS portfolio. The fund manages $65 billion of assets.

Auditors: Jacksonville Pension Officials May Be Skirting Payout Rules

Auditors and watchdog groups are asking questions about the “questionable benefits” of some members of the Jacksonville Police and Fire Pension Fund.

This comes in the wake of a Florida Times-Union investigation that claimed some of the system’s top officials, and active members, were breaking city rules by participating in the Deferred Retirement Option Program (DROP) even if they weren’t eligible.

From the Florida Times-Union:

The long-time chairman [Bobby Deal] of the troubled Jacksonville Police and Fire Pension Fund will collect $610,000 more in retirement funds than a strict interpretation of the law says he is entitled to, a Florida Times-Union investigation found.

Even more alarming to City Council members, city auditors and independent analysts is that Deal is not alone.

There is also former fire chief Richard Barrett, who was allowed into DROP even though he had passed the point of eligibility. And there is Richard Lundy, a former fire captain and business partner of Deal’s. Together they stand to receive more than $1.8 million in questionable benefits.

They are among what is expected to be potentially more than 1,000 former police officers and firefighters who were allowed to skirt the rules and participate in the DROP either too early or — like Deal — for longer periods than city law allows.

Most of the special arrangements allow employees into DROP prematurely, which has a negligible impact on the troubled pension fund. But others like Deal who participate longer than the city law states will end up costing taxpayers hundreds of thousands of dollars each in DROP payouts.

DROP payments are secondary pensions on top of regular pensions that sometimes stretch out for four to five decades.

Pension officials and city officials seem to disagree on what the rules have to say about DROP eligibility. From the Times-Union:

The police and fire pension fund’s executive administrator denies any favoritism or improper application of the law.

“It’s absolutely done properly,” John Keane said.

[…]

Under rules set up by the police and fire pension fund — and agreed to by the city in the late 1990s — an employee who already has worked 30 years is allowed to be in DROP for only three years. Workers with 20 years of service but fewer than 30 years are able to participate in DROP for the full five years. Those with 32 years of service may not participate in DROP at all.

Not so, says Keane.

Keane said it takes time to process paperwork and emphatically denies that rules were skirted for Deal or any other member.

“It’s like going out and catching an airplane; you have to go out and get a ticket before you can board the plane,” Keane said. “When you have 40 to 50 people signing up for the DROP, [all that paperwork] cannot be cleared in just a few days.”

[Jacksonville City Council auditor] Kirk Sherman said there is no quarrel about paperwork deadlines, only about eligibility and following the rules.

The Jacksonville Police and Fire Pension Fund is 43 percent funded.

Read the entire Florida Times-Union investigation here.

Alicia Munnell: Should Insurers Handle Public Pension Payouts?

Last month, Pension360 covered the Urban Institute’s ringing endorsement of a Congressional bill that would let local governments turn over the assets of their pension plans to insurance companies, who would then make payments to retirees.

Senator Orrin Hatch proposed the bill, called the SAFE Retirement Plan.

On Wednesday, another major pension player threw their opinion in the ring: Alicia Munnell, director of the Center for Retirement Research at Boston College.

She begins by outlining why the Urban Institute likes the plan, and why the Pension Rights Center doesn’t:

The folks at the Urban Institute think that this plan is terrific. They gave it an “A” under all seven of their criteria: 1) rewarding younger workers; 2) promoting a dynamic workforce; encouraging work at older ages; 4) retirement income for short-term employees; 5) retirement income for long-term employees; 6) making required contributions; and 7) the funded ratio.

Essentially it does not allow sponsors to underfund plans (items 6 & 7) and provides a more equitable distribution of benefits across participants’ age demographics. That is, young and short-term workers get more benefits and older workers have less incentive to retire than under a traditional defined benefit plan. With their criteria, the Urban Institute researchers would always give a higher grade to any type of cash balance or defined contribution plan than to the current defined-benefit plan.

The Pension Rights Center lumps the Hatch proposal with other de-risking activities, such as General Motors transferring its retiree liability to Prudential. In the private sector, such a transfer means the loss of protection by the Pension Benefit Guaranty Corporation (PBGC), and reliance on the strength of the insurance company to provide the benefits. Such a loss does not occur in the case of state and local plans, because these plans are not covered by the Employee Retirement Income Security Act of 1974 and therefore benefits are not protected by the PBGC.

Munnell then delves into her own opinion:

First, I am not quite sure how it would work. In the private sector, a company can spin off only fully funded plans. But few public sector plans are fully funded. Is the suggestion to close down the current public sector defined benefit plan and send all future contributions to the insurance company? In many states that path would be quite difficult given that employers cannot reduce future benefits for current employees. So I am not clear how a SAFE Retirement Plan would actually be adopted.

Second, I am very concerned about costs. One issue is that investments would be limited to those acceptable for underwriting annuities, a requirement that means essentially an all-bond portfolio. Trying to produce an acceptable level of retirement income without any equity investments requires a very high level of contributions. My other concern on the cost side is fees; insurance companies need a significant payment to take on all the risks associated with providing annuities.

In short, the SAFE Retirement Plan doesn’t seem like either a feasible or efficient way to provide retirement income. Fortunately, the plan is optional. So, I’m moving on to other topics!

Munnell runs the Center for Retirement Research and the Public Plans Database.

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