News: CJ Exclusives

Cowell Hoping Junk Bonds Will Spur Greater Return on Pensions

North Carolina Treasurer Janet Cowell is hoping that the General Assembly’s plan to add investments like junk bonds and commodities to the state pension portfolio will boost investment returns and erase what could be a $3.3 billion hole in funding.

A new law, signed by Gov. Beverly Perdue in June, lets the state treasurer put up to 5 percent of the pension’s assets into junk bonds and another 5 percent into inflation-resistant assets including commodities, timberland and securities tied to the Consumer Price Index.

“It’s my hope that we will at least have a fighting chance,” Cowell said.

North Carolina’s action is similar to those taken by other states such as California that are betting on high returns in a faltering economy.

“The higher returns are illusory,” said Edward Siedle, president of Benchmark Financial Services in Ocean Ridge, Fla., which audits pension plans. “The strategy allows you to pursue the dream of higher returns. It doesn’t mean you’re going to get them.”

Barclays Global Investors, which was paid $10.5 million in fees last year by the treasurer’s office, projected that the state’s current investments would deliver a return of 6.92 percent, falling short of its 7.25-percent target.

The Barclays report says the failure to reach the 7.25 percent target “requires an immediate contribution of $3.3 billion” to fully fund the pension’s retirement portfolio.

North Carolina has traditionally had one of the best-funded state pension plans. But Cowell said she wouldn’t immediately have asked lawmakers for more money if the law hadn’t passed.

“If we consistently year after year did not hit 7.25 percent, we would be asking for more taxpayer dollars,” she said.

The state Teachers’ and State Employees’ Retirement System is already in a fix because of the recession. Pension assets dropped by 14.2 percent to $60.2 billion during the fiscal year that ended in June.

There is no immediate danger that the retirement system, which covers more than 820,000 current and retired state employees, will be unable to pay benefits to retirees. But the shortfall has to be made up, either with higher contributions from taxpayers or better investment returns — or by reducing benefits.

The more pension fund managers assume their investments will make, the less they require in contributions from employees or the legislature, an enticing proposition in tough financial times.

Cowell has asked the General Assembly to contribute an extra $29 million in the new fiscal year and $329 million more in the following year to shore up the pension fund. Those requests were based on the pension fund earning 7.25 percent from its investments, a lower target than that set by many other state pension funds.

Some lawmakers have questioned whether the 7.25 percent goal is realistic. TSERS has met this goal seven of the last 12 fiscal years. The annualized median 10-year rate of return for public plans with assets greater than $1 billion is 2.85 percent, according to Wilshire Associates, a California consulting firm.

“It’s not a good thing to change our investment strategy in such a volatile market,” said state Rep. Darrell McCormick, R-Yadkin. “Maybe we should lower our expectations.”

Investor Warren Buffett noted in his 2007 annual report that the annual growth rate of the stock market during the last century was 5.3 percent and questioned the assumptions by pension fund managers.

“Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers,” Buffett wrote. “Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed.”

Susan Mangiero, the CEO of Pension Governance, Inc. in Trumbull, Conn., says junk bonds may not be a good investment choice if issuers are unlikely to repay principal and interest.

“The recent market rout proves once again that best intentions do not necessarily generate anticipated outcomes,” Mangiero said. “More than a few traditional investment hedges were adversely impacted by the fear and uncertainty that dominated market trades. Historical correlations provided little guidance about future performance in 2008 and early 2009.”

Moreover, Mangiero added, investing in higher risk securities often means that issues such as valuation and liquidity become even more important to consider and manage.

State officials, including those in the treasurer’s office, say the new asset mix is expected to be slightly less risky than its current investments. The law was endorsed by both the North Carolina Banking Association and Duke Endowment President Gene Cochrane.

“In some sense, this might allow them to act more prudently than they do now,” said Deborah Lucas, a professor at Northwestern University’s Kellogg School of Management. “Junk bonds are much less risky than common stocks. A bond, no matter how junky, always has less risk than the stock of the same company because it has higher priority.”

North Carolina’s pension fund, the ninth-largest public pension in the country, is invested more conservatively than the typical fund, which has about 70 percent stocks. TSERS has about 41 percent of its investments in stocks and about 47 percent in bonds. It has outperformed the median return for public plans with assets of more than $1 billion in five of the last 10 fiscal years.

Cowell has the authority to decide how the money is invested, an unusual amount of power. In most other states, a retirement board or board of directors chooses how to invest.

“There’s no one else in the state who has the power that the treasurer of North Carolina has,” said Ardis Watkins, the legislative affairs director for the State Employees Association of North Carolina. “That’s just immense power.”

That discretion was an issue for Cowell’s predecessor, Richard Moore, who was criticized for receiving campaign contributions from people connected to hedge funds that got business after Moore pushed for a previous change in the state’s investment policy.

That change, in 2001, let the treasurer invest up to 5 percent of pension fund money in alternative investments such as hedge funds. Fees paid by the pension fund tripled after the change because hedge funds typically charge higher fees. Management fees last year were 0.33 percent of the fund’s assets.

Cowell has received more than $211,000 in campaign contributions this year and last year from people and political action committees connected to funds the state invests in. One of her contributors was Edward Dale of Barclays Capital, who contributed $500 last year.

Cowell supports a law that would provide public financing of the treasurer’s race. “I feel like it’s the best way to ensure that there is equal access for all candidates,” she said.

Senate Bill 20, a bill establishing such a system, died in the recently concluded session of the General Assembly.

Sarah Okeson is a contributor to Carolina Journal.