Maryland's state retirement pension system is currently $19 billion in the hole, even after earning a credible 14 percent during the 2010 fiscal year. Much of the unfunded actuarial liability can be attributed to the pension fund's abysmal investment performance during the 2007-2009 bear market, when the portfolio lost 20 percent of its value. The plan's current investment strategy doesn't appear to be structured to perform any better in the next recession, perhaps because plan returns are actuarially "smoothed" to diminish the impact of such a terrible year. Protecting capital is not one of the stated objectives of the plan as set forth by the Board of Trustees.
The success of the plan's current asset allocation depends heavily on its investments in global growth. As of June 2010, it invested just over half of total plan assets in equities, with 61 percent of the equity allocation to global and international stock funds and the remainder with U.S. equity managers. The plan employs a staggering number of equity money managers in order to invest in U.S. and international stock markets, listing 33 different equity managers on its roster, excluding about 100 more in its Terra Maria program for promising smaller or developing managers. Notably the plan actually used passive or index funds (requiring little management) for about half of the allocations to U.S. and international equity.
If the U.S. economy were to hit another rough patch and financial markets tanked, what could we expect the 131 equity managers in the plan to do about it? In reality, very little. Most institutional stock fund managers are required to stay fully invested in stocks, regardless of the climate. They will deliver negative returns in a bear market, and if the emerging managers in the Terra Maria program perform poorly, the plan's stock allocation may do worse than simply owning the market index. In fact, there are so many equity managers owning so many stocks that the plan may have created its own market index — not such a good thing when the market craters.
What about cash and bonds, the traditional asset classes owned by institutional investors to defend against portfolio volatility? The plan allocates only 19 percent to traditional fixed-income holdings and 2 percent to cash, and also had a little over 3 percent of its assets in credit/debt strategies (targeted to grow to 10 percent of total plan assets over the next few years). Fixed-income investors defending against a recession want to own high-quality bonds and underweight credit risk, yet the plan only puts 11 percent of its portfolio into U.S. Treasury securities that offer the highest returns in a recession. That is not much defense when the next recession-driven bear market arrives.
Instead, the plan imitates what most institutional investors do these days and relies on "alternative investments" to defend against bear markets and out-earn fixed-income assets during periods of global growth. The allocation to alternative or nontraditional investments last year made up 24.4 percent of the portfolio. The class includes hedge funds, private equity, and real estate partnerships. Once again complexity reigns supreme: The plan invests in 123 different private funds and partnerships sold by the elite firms on Wall Street. These deals carry very high fees in exchange for the promise of hedging a traditional portfolio of stocks and bonds. How did the plan alternative investments do during the last bear market? Real return (-3.7 percent) and absolute return (-6.4 percent) held up just fine, but private equity (-22.3 percent) and real estate (-31.6 percent) got destroyed. We are left to hope that this large allocation to alternatives will do better the next time the markets turn sharply lower.
Can the Maryland Pension Plan earn the 7.75 percent annual return needed to meet long-term actuarial funding expectations? Considering that the plan paid $2 million in consultant fees and $163 million of investment advisory fees last year alone, I certainly hope so. All of the actuarial accounting games in the world won't hide the impact of another repeat of plan's horrific 2008-2009 performance.
Many analysts believe that the stock market and the bond market will deliver less than their historical average returns from current valuation levels for the remainder of the decade. In such an environment, it's unlikely that the plan will hit its long-term performance objectives, regardless of asset allocation. The plan is not invested to protect against a steep market decline in the short term and has made a big bet on global growth and potentially higher interest rates/inflation in the future. Whether the money spent on equity managers, alternative investments and credit-oriented fixed income deals is worth it remains to be seen. But if we suffer a double-dip recession, we should not be surprised by a repeat of the 2008-2009 performance debacle.
Kenneth Solow is chief investment officer of Pinnacle Advisory Group, Inc., a private wealth management firm in Columbia. He is the author of "Buy and Hold is Dead (Again), the Case for Active Portfolio Management in Dangerous Markets." His e-mail is firstname.lastname@example.org.