State Pension Problems

Monday, 14 September 2009 13:32

For decades, the large state pension funds, including New Jersey’s, were conservatively invested – mainly in bonds and what used to be called “blue chip” stocks – such as AT&T, General Motors, and Xerox.  Usually these funds increased steadily, but at a low yield.  In New Jersey, pension eligibility expanded, the number of people covered increased, and entitlements grew.  At several points, some governors and legislatures suspended contributions and raised payments.  As Alexis de Tocqueville once observed – the greatest threat to any democracy is the tendency to bridge the people with their own money.

Rather than readjust the pension contributions and rein-in eligibility, the state continued merrily on the path of fiscal irresponsibility.  Periodically, commentators would warn about the gap between the resource base and the projected payouts.   But what interested actuaries did not interest politicians.  As it is still, the pension systems – here and across the nation – were able to ignore the projections because of the general increase in the stock market.

Still, one could at that time see periodic downturns in the market, reminding wise observers that the market is not totally a bull environment.  In the 1980s, the market exhibited for example a higher drop in value due to the collapse of the dot.com stocks.  The growth of new communication technology was held up as a coming wave of future prosperity and economic re-orientation.  The communications revolution was compared to the industrial revolution that changed the very nature of the West and its societies.  But eventually the communications stocks suffered an enormous drop, and some pensions systems including New Jersey’s public system experienced a major loss.

Suddenly the gap between pension worth and projected outlays was graphically revealed.  One of the most salient pledges Candidate Jon Corzine made was to face that harsh reality.  As governor he proposed some strong medicine to deal with the underfunded pension fund – gradual and steep toll increases for some of the major roads in the state.

The state contributions to the pension fund increased, but nowhere near the expected schedule of payouts.  The state investment commission decided to adopt a more speculative strategy, as it invested more of its assets in private equities and hedge funds.  That strategy was not unique to New Jersey.  One of the most successful investment groups in the nation, the management of Yale University investments, grew astronomically each year, reaching at times 25% per annum.  Yale and other colleges adopted programs, personnel and policies that spent funds at a higher rate than every before.  Massive increases in wealth not only led to conspicuous consumption, but to an expansion of cultural and social welfare institutions.

Too much of that paper wealth, however, was due to unorthodox financial instructions of pyramiding assets or to buying too extensively on the margin.  Then came the major collapse.  In the fiercely competitive world of investment and hedge funds, investigators showed that high powered intermediaries often position themselves between the pension funds and hedge funds.  Often those intermediaries used political influences to garner customers and clients in the public sector.  The reaction has been typically American – outlaw those people and end the use of intermediaries in such transactions.  But that simple response has unforeseen consequences.

Large hedge funds and houses can afford to “embed” in their own organizations what we call intermediaries as paid full time employees.   That means that public investment funds are not likely to have the ability to hire smaller firms, which may be better at investing parts of their portfolios.  Recently the chief investment manager of Yale concluded that his successful institutional strategy did not work well with private investors.  One of the major reasons was that private individuals could not get sound advice from brokers.  Even sophisticated observers of the market have to admit that being big is not the same as being correct in investment decisions.  The real irregularities can be dealt with by legislation which bans wrong doing and influence peddling, and not to exclude a whole category of intermediaries.  In essence, these intermediaries are the choice of smaller investment companies.

Investment commissions, such as in New Jersey are sensitive to the practice of pay to play, the practice in which contributors give to political campaigns in order to do business with the state agencies.  With the massive increased in federal involvement in the day to day lives of Americans, the addition of new bailouts for companies and states, one should look at banning contributions to federal candidates for those who do substantial business with the states and localities.  The consequences will be that the donor base will be smaller and the impetus for free public funding will increase.   The world of investment is changing; so too must the world of politics.