During the financial crisis, two real estate investments managed by the Wisconsin state pension fund lost 99 percent of their value, sinking from nearly $125 million in 2006 to less than $1 million by the end of 2009. One reason these investments did so poorly is that they used borrowed money.
Speculating is nothing new for pension funds. In 1995, for example, Wisconsin blew $95 million on derivatives, more than half of that loss coming from an untimely bet on the Mexican peso. But pensions using leverage, or borrowed money, in their own accounts to boost returns is less common. Wisconsin in 2010 became the first state in the nation to officially adopt the strategy, when state investment authorities decided to borrow the equivalent of up to one-fifth of the $76 billion pension fund to invest over the next three years.
Officials with the Wisconsin State Investment Board see leverage as a way to diversify away from riskier stocks and wring higher performance from safer fixed-income investments. The goal is to make pension investments less, not more, volatile. And it's worth noting that the state's fully funded pension is recognized as one of the best-run retirement plans in the country. Meanwhile, with interest rates so low, simply plowing funds into Treasury bonds may not generate a high enough return for pensions to meet their obligations to a growing number of retirees.
Money for nothing?
Yet just as leverage boosts gains when the market is up, it boosts losses on the way down. And good intentions didn't prevent Wisconsin pension funds from losing nearly $24 billion in 2008. The fear is that state pensions may not use leverage properly or will again fall prey to unforeseen risks, as they did during the housing bubble. As one money manager told the WSJ in January of last year after Wisconsin announced its new investment plan:
"When people reach for return with nontraditional approaches they can take on risks they don't fully appreciate," says Daniel Jick, head of HighVista Strategies, a Boston-based firm that manages money for small schools and other investors. As many investors found out in 2008, he added, "using leverage can force you to sell assets you'd rather not sell."It doesn't help that pension funds have a history of frittering money away in so-called alternative investments, such as PE, hedge funds and real estate. Over the course of roughly a decade starting in 2000, for instance, the 10 largest public pension funds shelled out more than $17 billion in fees to buyout firms in hopes of cashing in on the boom in LBOs. Yet returns over that period have been mixed, and typically well short of stellar.
Take the Pennsylvania State Employees' Retirement System. It pays private money managers some $250 million a year to handle the state's investments, roughly half of which are in PE, real estate, hedge funds and other non-traditional assets. Yet over the last 10 years the plan has earned an average annual return of only 4 percent. Although critics contend it's an unrealistic goal, big public pensions typically aim for annual return rates of 7.5-8 percent.
Calpers, the nation's biggest pension fund, said its PE and VC investments were the strongest part of its portfolio in 2010, with a 21.5 percent return. But that gain doesn't offset the massive losses suffered by the fund during the crisis, including $10 billion from land and housing investments. Calpers and other funds took a particular beating using leverage to invest in Manhattan real estate. Overall, state funds lost $865 billion during the bust -- in roughly a single year (see chart at bottom for data on some of the worst-performing states).
Seeking the new "new" investment
It's not only the size of pension losses that's alarming; it's the fact they keep recurring. During the '80s, pensions took a bath on junk bonds and savings and loans. When the Internet sector collapsed in 2001, they lost more than $150 billion, this time mostly on equities. Numerous state funds took big hits on the collapse of Enron and WorldCom during the tech crash, companies touted by Wall Street at the time as sure bets.
Like gamblers on a losing streak whipping out their bank cards, alpha-chasing funds keep rolling the dice with one asset class after another -- high-yield bonds, corporate takeovers, foreign equities, commodities, real estate, PE, hedge funds, derivatives, mortgage-backed securities. Each throw brings new Wall Street "consultants" preaching the latest can't-miss investment theory. Each setback forces funds to try to recoup losses, forcing money managers to push the envelope.
And each crisis brings promises from pension managers to be more careful next time around -- until the pressure to boost returns and the potential personal financial rewards of moving out on the risk curve again takes hold. Before its swaps-related losses in the mid-90s, for instance, the Wisconsin Investment Board said it used derivatives only to hedge other holdings, not to speculate. The state is now making similar noises as it experiments with a new investment tool, saying it will use only moderate leverage and take special precautions.
In other words, this time will be different. We'll see.