Friday, September 17, 2010

Can Risky Illinois Pension Fund Investments Be Made Invisible?

After we published "How Risky Are Illinois Pension Funds?" as a follow-up to a segment on our radio show, a spokesperson for the Illinois Teacher's Retirement System wrote a rather long op-ed piece entitled "Facts about pension system alleviate uncertainty for teachers" in the State Journal-Register on September 8th in which the pensions funds are assured to be safe, that pension payments of $2.7 billion paid in 2008-2009 created a $4 billion stimulus in the economy, and assets are being sold in 2010 as they were in 2009, because the State of Illinois in the General Assembly has failed this year and over the years to adequately fund Illinois pension funds as required.  We have previously had Laurence Msall of the Civic Federation of Chicago on our radio show in the past to discuss the underfunding of Illinois pensions and what the State must do if it is avert disaster in the future.  We have also written on the need of the State to properly fund pensions and address many years of poor government which may leave no choice but a tax increase, despite a slow economic recovery from a recession which is flirting with a double dip, which is normally a time in which a tax increase is not economically desirable or prudent, because the cuts, without a revenue increase, necessary to balance the budget going forward would be destructive of public safety and welfare.

Our article had discussed the proposed 2010 asset sales by the Teacher's Retirement System (possibly $3 billion), the State Universities Retirement System (possible $1.2 billion), and of the Illinois State Board of Investment (possibly $840 million), which invests for the other Illinois pension funds, as reported by Crain's Chicago Business and other news sources..

Our article had also discussed Alexandra Harris' Medill Reports article "Illinois pension fund use OTC derivatives to recoup returns, jeopardizes pensions", which was published in June but has gotten no main stream media attention in Chicago or Springfield, which we can find.  When the Teacher's Retirement System spoke person's op-ed appeared in the State Journal-Register, we immediately emailed the editor with a link to our article.  We did not get even the courtesy of a response; just silence.  Such an unprofessional lack of response got us wondering why and we did some research to see if there had been other posts on blogs and found two on Pension Pulse.  The first referenced a zero hedge post which accused the Teacher's Retirement System of being dangerously risky and the second referenced a demand by the Teacher's Retirement System spokesperson to remove the zero hedge comments.  I had both zero hedge posts on the subject of the Teacher's Retirement System, including an earlier zero hedge post on the Medill Reports article, which I had missed when it was published.  I concentrated on Harris' article and the Illinois Auditor General's audit report of the Teacher's Retirement System.

Further research led me to the disparagement of current economic research still in process by Joshua Rauh at Northwestern University on state pensions.  Rauh's research is still in the form of working papers and a continuing project.  Earlier in May we had discussed his research on the underfunding of state pensions on the radio show.  The Teacher's Retirement System disparagement was part of an Issues Update in which the TRS defended itself on many issues, even asserting that the fiscal year ending June 30, 2010, will have a return of 19% and defended it's use of derivatives.  The disparagement of Rauh concentrated on a NPR very brief condensation of state pension systems ranking the Teacher's Retirement System as the fourth riskiest in the country and the classification of investments as risky if they were not fixed income or cash.  The TRS argues that all investments are risky to one degree or another, no analysis of individual category risk was made, and the TRS manages risk.  To me it appears that the general finance classification of risk was used, because fixed income bonds were not classified as risky, although they can be risky and lose money.  Bottom line, the disparagement is smoke exhaled as a screen to obfuscate rather than enlighten with specific risk management procedures and substantiation of acceptable fiduciary risk.

To demand removal of comments, to disparage in general, and to benefit from media silent refusal to print or comment on the issue of investment risk is pretty heavy weight political magic.  It made me even more curious.  It caused me to re-read the Medill Reports article two more times, review the TRS audit report investment category by category, review the audit report of the Illinois State Board of Investment, review the audit report of the State Universities Retirement System, review the Teacher's Retirement System website information, review the State Universities Retirement System website, and review the Illinois State Board of Investment website information.

On the websites, I found investment information as of 6/30/2010 for the Illinois State Board of Investment showing a FY2010 return of 8.9%; investment information as of 7/31/2010 for the State Universities Retirement System showing July return and FY 2010 return of 16.7%; and investment information as of 3/31/2010 for the Teacher's Retirement System (the information used in the Medill Reports article) with no FY 2010 as of fiscal year end 6/30/2010 investment return information.  In the Medill reports article the TRS spokes person stated there would be a $158 million gain in the derivatives category by June 30, 2010 with $5 million from CDS, swaps, and swaptions out of a projected return of $627 million.  The other pension systems could post their FY 2010 (ending June 30) investment return, but the Teacher's Retirement System has not been able to do so as of this day in September.  Why?

In the investments of the Illinois Board of Investment, they use puts, calls, futures, and foreign currency contracts but they do not use collateralized mortgage obligations (CMO), credit default swaps (CDS), swaps, or swaptions.  While collateralized mortgage obligations are on the balance sheet, none were listed as remaining as of 6/30/2009.  In the investments of the State Universities Retirement System, derivatives are thrown into fixed income but listed currency, CMO, swaps, swaptions, and CDS (both buy and sell protection).  Currency forward contract positions, futures, puts, and calls are more traditional, older derivatives.  CDO (collateralized debt obligations), CMO, CDS, swaps, and swaptions are securitized derivatives that date from approximately 1997-98 with J. P. Morgan for all practical purposes, although some limited but marginal use existed in the early 1990's, and are far more risky and dangerous.  The Teacher's Retirement System uses puts, calls, futures, currency contract both buy and sell, CDS buy and sell, CMO, CDO (other two systems do not use), swaps, and swaptions, which make them look more like an unfocused trading hedge fund.  The derivatives loss in 2009 for the TRS was $381, 367, 366 with a net derivatives category loss of $6,848,438 which means they had approximately $755,886,294 invested in derivatives in FY2009,  which was a year (July 2008 - June 30, 2009) in which they lost $4.4 billion.  One derivatives trader was quoted in the Medill reports article saying, " TRS basically sold insurance and now it has an enormous short volatility position."  They are making bets on long term Treasury yield curves and global interest rates.  In the Medill Reports article Dale Rosenthal, a former hedge fund strategist, characterized the TRS portfolio as primed for speculation, because, if they were hedging investments or mitigating risky investments, they would be on one side of the swaptions and CDS rather than buying and selling.  They even buy and sell within the same currency forward contracts.  Yet, the TRS spokes person said TRS the derivatives are spread across each asset class as complimentary positions, which means that no one manager or separate group of managers are directly responsible for derivatives investing.  Frank Partnoy, a law and finance professor who worked as a derivatives structurer on Wall Street, said TRS is not investing smart but chasing returns and not maintaining prudent, effective internal controls.  Rosentahl is also quoted in the Medill Reports article as comparing the TRS portfolio with the disastrous hedge fund Magnetar.

The Yale Endowment has often been characterized as aggressive with its use of illiquid investments for higher return but there investment allocation is actually more conservative than the TRS and other two Illinois pension systems with respect to domestic and foreign equity exposure.  If you look at actual Yale allocations in 2009 (on PDF page 7), you will see only 7.5% for domestic equity, 9.8% for foreign equity, 4.0% for fixed income, absolute return 24.3%, private equity 24.3%, real assets 32.0% and cash <1.9%>.  Obviously, Yale is not taking substantial risks in domestic or foreign equity and has chosen to forgo less risky fixed income which is itself a material risk.  TRS has 30.5% for domestic equity, 20.3% for foreign equity, 17.5% for fixed income, 3.6% for absolute return, 8.3% for private equity, 9.6% for real assets, and .9% for short term investments.  This would appear to be risky with such high allocations for domestic and foreign equities.  The Illinois State Board of Investment is very similar equity allocations but with more fixed income (appears to be too much).  The State Universities Retirement System also has similar equity ( PDF page 4) allocations and a fixed income allocation which is perhaps at the top of an appropriate range, but it also has 24.8% of its allocations in passive investments.  In chasing returns, the Illinois pension funds have chosen to chase returns in the equity markets with higher allocations which are consequently more risky however liquid.  All three systems have target returns of 8.5%.  Yale has chosen more sophisticated, albeit more illiquid, investments for higher return (they got burnt in 2008 with the global financial crisis seizing up liquidity).

We ask again where are the Teacher's Retirement System FY2010 returns, both total and by category?  When will the main stream media start picking at the pungent facts?  How long will this story remain suppressed?  Are the investment policies of the Teacher's Retirement System too risky in the performance of its prudent fiduciary duty?  If the staff is not concerned, should the Board, in the performance of its fiduciary duty, be concerned?

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1 comment:

  1. Thank you for doing this work. I'm not sure what to do now, but I see much reason for concern here.

    Concerned teacher in a family of teachers

    ReplyDelete

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