How Much For Those Eggs? Yes, Give Me The Sperm Too!

I love this Wall Street Journal article about Social Security benefits!  Apparently, depending on the state, children born posthumously receive social security benefits as surviving child of their parents.  This has developed into a serious issue because of fertility technology.

This should massively impact the secondary market for eggs and sperm!  Can you imagine going to the sperm bank for a donor:

Bank Teller: How may I help you?

Potential Customer: My God!  Mr. Jones must have had a PhD from MIT, been 6' 5" and very handsome. $132,000 for some sperm??

Bank Teller: No, ma'am, that's not quite right.  He had an IQ of 87, and mopped floors in the California state house for 53 years. Mr. Jones actually retired at age 72, only six months ago.  He then, tragically, I am sure, dropped dead immediately.  His children will each receive social security benefits and a California state employee pension until they turn 18.  We expect that a family of four can comfortably live in most major metropolitan areas once they birth his child.  A bargain, really. 

Potential Customer: Hmmm...that's a bit out of my price range.  Do you have something in a reasonably old, moderate health who is likely to die before I have to pay for the child's college?

I see a new business line for Wall Street: We can combine the demonized "stranger owned life insurance" products with a fertility operation!  Insurable interest abounds if you own the eggs or sperm of some elderly individual!

One last thought that I know is nagging my siblings: What if we clone our parents?  Do we immediately start collecting survivor benefits because of our grandparents?

Dear CALPERS...and a Lesson on Recursion

State pension plans have an endless list of problems.  Start with those I discuss here: Politics allows those responsible to monkey with the numbers, meaning most of them are broke.

Today the Wall Street Journal reports about CALPERS new governance program.  The pension plan intends to develop a bench of potential directors to improve governance at the companies in which they hold significant positions.  this is not a terrible idea.  It's a complicated idea.

For years I've been a fan of CALPERS activist investing.  In a nutshell, they took the view that they own all the companies in the United States, so the only way to "outperform" was to make those companies perform better, via better governance.  There's good evidence that well-governed companies perform better.  This led them to invest with many activist equity managers.  These managers earned their living enhancing shareholder value, acting as a proxy for CALPERS.

CALPERS taking on direct governance responsibility has serious risks.  How will this program be governed?  My suggestion to CALPERS: Establish and independent board with the charge of ensuring that CALPERS governance program selects directors to enhance shareholder value. Neither the pension plan nor the taxpayers of California can risk political shenanigans corrupting the process of creating value for the plan.

Of course, I would gladly serve on this board.  I may even be qualified.  Or, should I choose to serve on the independent board that governs the independent board overseeing the governance program?  You see where I'm going with this?

Hmmm...so maybe CALPERS should stick with the old plan of outsourcing governance to individuals who govern for shareholder value.

Paying Governors

Previously I wrote about the New Jersey pension crisis.  Admittedly, this was not about the New Jersey pension crisis, but about how tax laws around pension plans amount to a massive wealth transfer to hedge funds.

Yesterday's NYT article raises a different "crisis"--that public pension plans have portfolios with what the author perceives as much higher risk.  (Notice the careful wording.  I'm not judging the risk, I am expressing the author's view.)

There's an interesting single sentence paragraph in the article.  Buried in a parenthetical statement toward the end the author states: "Corporate plans do their calculations differently, and for them, investment returns are a less important factor."  Interesting statement, to say the least.

Why are they different?  States play games.  They think they can tax endlessly to cover shortfalls.  They routinely buy votes by expanding benefits.  Imagine a company that transferred all its profits to it's employees in the form of retirement benefits.  Shareholders would flee.

Alternatively, CEO's need to generate profits.  They're paid (in stock) to generate growing, stable earnings.  Too much pension volatility and they torpedo their own compensation.  Too generous benefits (think GM, Chrysler and Ford) and they destroy their earnings potential over time.

Let's start paying governors long term incentive contracts based on the growth of their state economy, and we'll see far less monkey business with pensions.  Oh, and don't let them move out of state!

My Take On "The Looming Pension Disaster"

I could give you a list of a thousand problems on this topic.  I won't.  I'll pick one, maybe two.  I wrote a while back about the problem in New Jersey.  New Jersey hardly has a monopoly on pension problems.  Here's another nice one by Alan Sloan at Fortune.

In the FT today, there's a piece about securitizing pension risks. Before I tell you what the heck this means, I'll tell you it cannot work.  Too many regulatory problems.  The risk cannot be unloaded or hedged.  This all ties back to my moving and storage piece, (which, by the way, I will continue to link as frequently as possible, because if you haven't read it, you don't get half of what I'm saying!)

Securitizing pension risks means figuring out a way for another party to hold the risk that people live longer than expected.  Put another way, construct a security that allows large groups of people to hedge the risk that they live longer than expected.  Let's think about buyers of this security.

New Jersey's pension crisis...Congress's fault? First take.

This is so cliche that the state of NJ has a pension problem. It's like saying Illinois has a governor problem. Here's the latest word.

Why is it Congress's fault? Well, not entirely of course, but here's a convoluted start. UBIT. Unrelated Business Income Tax. What, you say? UBIT is a federal tax that prevents retirement plans (pension plans, your 401(k), etc.) from using leverage. In a nutshell, if these typically not taxed investment entities use leverage (that is, borrow money to fund their investing) they suddenly become taxable. Because, apparently, financing investments is an unrelated business to investing, which is the business of a pension plan.

What does this mean? In order to juice returns via leverage, rather than borrow money themselves, pension plans make investments in partnerships that may use leverage. These leverage using partnerships are normally called "hedge funds." The hedge funds hide the leverage within the partnership so everyone can comfortably say "this pension plan uses no leverage."

How does this work in practice? Suppose you are a completely competent pension plan manager who does not invest in hedge funds. You invest in a diversified, globally balanced portfolio of lots of different assets. You manage to earn, over time, for your pension plan 6%-9% annually with not very much volatility. Remember, you are highly diversified across asset classes and geographies.

Guess what: You don't exist! If you did exist, you'd do the following: You'd take your same investment strategy, leverage it up 2x-3x, making it riskier, but still attractive, you'd call yourself a hedge fund, and you'd own a 20% performance fee on what you used to do for $250k/yr.

Let's look at the math: Say the strategy has a 7% expected return, with 4% volatility. That's not bad. Suppose you borrow at 3%. Thus, you leverage the portfolio 3x, you now have a 7% + 2 x (7%-3%) = 15% expected return strategy. Yes, you have 3x the risk too. But, you've just hit the hedge fund sweet spot. Anyone who has ever met with a hedge fund manager knows they have to claim 15% gross returns to get in the door. It's in the hedge fund marketing manual. You now have a hedge fund with "higher expected returns than the equity market, and lower risk."

How's that you say? Well, the 20% performance fee means your performance, net of 2% management fee and 20% performance fee is still 10.4% [=(15% - 2%)x 0.80]. This easily beats the target your old pension plan guys need to meet their goals, so they are in! And, it gets better. That 20% performance fee, (or, as I like to say 20% at the money call your investors give you) actually reduces the volatility of the outcomes, which makes your 3x leveraged strategy not really look quite that volatile. (The performance fees "dampen" the upside volatility you see.)

Now, suppose instead you could use leverage without having to hide it in a hedge fund. Well, if that not particularly credit worthy hedge fund can borrow at 3%, say whatever you like about NJ, but it is more credit worthy than that fund. So, let's say it borrows at 2.5%. Oh, and it doesn't have to pay hedge fund fees anymore to get it's leverage. Let's go crazy and say the management fees are cut in half (only) and the performance fees are cut in half (only!) That makes for seriously well paid, highly qualified pension staff, trust me! (Remember, good investment people all HATE their clients, no matter what they say. They like investing, they don't like talking to clients. So, one big client beats many small ones...especially when the one big one is captive!)

Do the math again: 7% + 2 x (7% - 2.5%) = 16% gross return, and a (16% - 1%) x 0.9 = 13.5% net return. So, same strategy, same risk, generous fees to boot, picks up 3.1% incremental return. Assuming no UBIT.

Oh, and as a side effect, hedge fund fees come down, as HFs lose their lock on providing leverage to pension plans and the landscape becomes more competitive.

In another post, we'll go into why this same analysis should apply to pension plan's evaluation of their decisions to invest in hedge funds.