Gambling To Fix Pensions Can Lead To A Bigger Bind

The owners of Stuyvesant Town in Manhattan abandoned the property to their creditors in January. i i

hide captionThe owners of Stuyvesant Town in Manhattan abandoned the property to their creditors in January. The original purchase was funded in part by outside investors, including two state retirement funds.

Seth Wenig/AP
The owners of Stuyvesant Town in Manhattan abandoned the property to their creditors in January.

The owners of Stuyvesant Town in Manhattan abandoned the property to their creditors in January. The original purchase was funded in part by outside investors, including two state retirement funds.

Seth Wenig/AP

When the owners of Stuyvesant Town and Peter Cooper Village in Manhattan decided to abandon the properties to their creditors in January, residents were left in a kind of legal limbo, worrying about what would happen to the place they called home.

They weren't the only ones who felt the blow.

As it turned out, the $5.4 billion purchase of the two complexes had been funded in part by outside investors, including Florida's public pension fund and the California Public Employee Retirement System (or CalPERS), which is said to have invested about $500 million in the deal.

"Hindsight tells us clearly that that was gravely in error, and frankly the people who were responsible for that decision aren't at CalPERS anymore," says Joe Dear, CalPERS' chief investment officer. And Stuyvesant Town was only one of several bad investments for CalPERS, which saw its real estate portfolio lose half its value during the recent mortgage meltdown.

A Change Of Strategy

With $200 billion in assets, CalPERS can absorb the loss, but the collapse of the Stuyvesant Town deal says boatloads about how much public pension fund investing has changed over the past few decades. Once, public pension funds put their money into the safest of investments, like Treasury bills. But in the 1980s, many began shifting into stocks, which tended to have better returns over time.

When the dot-com bubble burst, many funds took a big hit, says Keith Brainard, research director of the National Association of State Retirement Administrators.

"A lot of these funds came out of the 2002 market decline believing they needed to further diversify their holdings," he says.

Today, pension funds like CalPERS put their money in a wide range of assets, like foreign and domestic stocks, corporate bonds, real estate, commodity futures, private equity funds and hedge funds. By putting their money into lots of different assets, pension funds lower the risk that they will be adversely affected by the ups and downs of the market, Dear says.

"The most certain, time-tested risk management tool in pension investing is diversification. That means diversification among types of assets, among geographies and among managers' styles," he says.

By investing more broadly, pension funds can reap big rewards in the long run, and many now project average annual returns of 8 percent or more over time. But they can fall well short of those goals in down times — like the recent recession.

When Desperation Leads To Growing Risk

Meanwhile, there's a danger that some funds will go too far.

Many state and city governments have failed to fund their pension systems adequately over the years, leaving them far short of the money they'll need to pay retirement benefits they've promised their employees. The problem has grown worse during the recent recession, which has left governments scrambling for ways to meet their obligations.

As a result, many pension funds are falling under greater pressure to take risks as a way of compensating for the pension shortfall, says Joshua Rauh, associate professor of finance at Northwestern University's Kellogg School of Management.

North Carolina's General Assembly recently approved a law allowing its pension fund, long known for conservative management, to invest 5 percent of its assets in riskier assets, like junk bonds. Pension funds in states like Florida have racked up losses from collateralized debt obligations tied to subprime mortgages.

"Many funds are investing in strategies that people might classify as risky," Rauh says. "They're investing money in private equity and other investment vehicles that may have a higher expected return on average, but also more risk."

He adds, "One of the reasons they are trying to do this is they are trying to gamble their way out of the problem."

Most pension funds still have plenty of money to keep writing checks for retirees for the foreseeable future. But as the collapse of the Stuyvesant Town deal makes clear, funds are also growing comfortable with a level of risk that might have been unthinkable a few decades ago.

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