Fitch Downgrades Pennsylvania; “Weakened” Pension System Drives Demotion

Tom Corbett

Credit rating agency Fitch has downgraded Pennsylvania’s general obligation bonds one notch, from AA to AA-.

What’s more, Fitch changed the state’s outlook from “stable” to “negative” – meaning another downgrade could be coming if Pennsylvania doesn’t address the structural problems that led to this recent demotion.

The structural problems in question are largely linked with the state’s pension system. From the Fitch report:

CONTINUED FISCAL IMBALANCE DRIVES DOWNGRADE: The downgrade to ‘AA-‘ reflects the commonwealth’s continued inability to address its fiscal challenges with structural and recurring measures. After an unexpected revenue shortfall in fiscal 2014, the current year budget includes a substantial amount of one-time revenue and expense items to achieve balance and continues the deferral of statutory requirements to replenish reserves which were utilized during the recession. The commonwealth’s rapid growth in fixed costs, particularly the escalating pension burden, poses a key ongoing challenge, although Fitch expects budgetary planning and management to mitigate these pressures in a manner consistent with the ‘AA-‘ rating.

PENSION FUNDING DEMANDS: The funding levels of the commonwealth’s pension systems have materially weakened as a result of annual contribution levels that have been well below actuarially determined annual required contribution (ARC) levels. Under current law, contributions are projected to reach the ARC for the two primary pension systems by as soon as fiscal 2017, but the budgetary burden will increase, crowding out other funding priorities.

INCREASING BUT STILL MODERATE LONG-TERM LIABILITIES: The commonwealth’s debt ratios are in line with the median for U.S. states. However, the commonwealth’s combined debt plus Fitch-adjusted pension liabilities is above-average, and will likely continue growing given the current statutory schedule of pension underfunding for at least the next few years. Fitch views Pennsylvania’s long-term liability burden as manageable at the ‘AA-‘ rating so long as the commonwealth adheres to its funding schedule, or enacts reforms that do not materially increase liability or annual funding pressure.


Without structural expense reform, or broad revenue increases, pension costs will consume a larger share of state resources and limit the commonwealth’s overall fiscal flexibility. In fiscal 2015, commonwealth contributions will increase over $600 million from the prior year to $2.7 billion on a $30 billion general fund budget (9.1%). Based on the statutory framework and the pension systems’ historical data and actuarial projections for contributions, Fitch anticipates increases for fiscal 2016 and 2017 will be similar though somewhat lower. While substantial, Fitch views the anticipated increases in annual contributions and unfunded liabilities laid out in the current statutory framework as within the commonwealth’s capacity to absorb at the ‘AA-‘ rating level.

Moody’s downgraded Pennsylvania in July.

Professor: Pension Funds Need To Rethink Manager Selection

Wall Street

A few hours after news broke of CalPERS cutting ties with hedge funds entirely, one anonymous hedge fund manager opined: “I think it’s not hedge funds as an asset class [that are underperforming]. It’s the ones they invest in.”

But was it really manager selection that was the root cause of CalPERS’ disappointment with hedge funds?   Dr. Linus Wilson, a professor of finance at the University of Louisiana, thinks so.

Particularly, he thinks pension funds are ignoring data that suggests newer, smaller managers perform better than the older, larger hedge funds that pension funds typically prefer. He writes:

CalPERS and other institutional investors such as pensions, endowments, and sovereign wealth funds have ignored the wealth of data suggesting that their manager selection criteria is fatally flawed. Hedge Fund Intelligence estimates that on average hedge funds have returned 3.7% year to date. Yet the S&P 500 (NYSEARCA:SPY) has returned over 8% over that period.

Most institutions and their consultants implicitly or explicitly limit their manager selection criteria to hedge funds with a multi-year track record (three years or more) and assets under management in excess of $250 million. The AUM screen is probably higher; $1 billion or more. Unfortunately, all the evidence shows that choosing hedge funds with long track records and big AUM is exactly the way to be rewarded sub-par returns.

A recent study by eVestment found that the best absolute and risk-adjusted returns came from young (10 to 23 months of performance) and small (AUM of less than $250 million) hedge funds. My anecdotal evidence is consistent with this fact. My young and small fund, Oxriver Captial, organized under the new JOBS Act regulations, is outperforming the bigger more established funds.

More data on the performance of newer hedge funds:

One study eventually published in the top-tier academic journal, the Journal of Financial Economics, found that, for every year a hedge fund is open, its performance declines by 0.42%. The implication is that hedge fund investors should be gravitating to the new managers if they want high returns. Yet another study by Prequin found that even when established managers launch new funds, those funds underperform launches by new managers.

The Prequin study found that managers with three years or less of track record outperformed older managers in all but one of seven strategy category. The median strategy had the new managers beating the older ones by 1.92% per annum. Yet, that same study found that almost half of institutional investors would not consider investing in a manager with less than three years of returns.

Pension funds have repeatedly justified forays into hedge funds by pointing out the potential for big returns, as well as the portfolio diversification hedge funds offer.

Dr. Wilson doesn’t deny those points. But to truly take advantage of hedge funds, he says, pension funds need to rethink their approach to manager selection. That means investments in smaller, newer hedge funds.