‘Be More Like Buffett’, LA Pension Told

(April 10, 2014) — The City of Los Angeles should adopt its own “Buffett Rule” in an attempt to curb its burgeoning pension problem, a think tank has suggested.

The Los Angeles 2020 Commission said the US’s second city should reduce its expected rate of return and discount rate used to value its pension liabilities to fall in line with those used by Warren Buffett’s Berkshire Hathaway.

“Can anyone in City Hall claim to know more about understanding future liabilities and how to budget today for them than Warren Buffett?” the think tank said in a statement yesterday. “Can anyone in City Hall make a credible case why City Hall is assuming it will do better on its investments over many decades than the world’s most successful investor?”

The commission, which is chaired by former US Commerce Secretary Mickey Kantor and former deputy mayor and investment banker Austin Beutner, said discount rates should be reduced from 7.75% to 4%, with the expected rate of return brought down from 7.75% to 6%. The lower numbers are those used by Berkshire Hathaway.

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“The current discount rate of 7.75% used by the City of Los Angeles is at the high end of the range which makes future obligations seem smaller, and raises the question whether sufficient savings are being put away today,” the group said. “Even based on the 7.75% discount rate, funding ratios for the City’s pensions have continued to drop over the past decade.”

The slice of the city’s budget spent on retirement has risen from 3% in 2000 to 18% today, the group said, adding it was forecasted to rise even higher.

Where corporate pension funds were made to adhere to strict rules under the Employee Retirement Income Security Act of 1974, municipalities were not, and this has led to problems for many, the group said.

“Municipalities across the country are still largely self-regulating, and many have established discount rates that are much higher than the federal standards imposed upon private business. The most straightforward solution would be for the City to adhere to the same federal standards that apply to private industry. To be clear, we are advocating smart regulation, not turning the City into a corporation.”

The public purses of Detroit, San Bernadino, and Illinois have all suffered at the hands of their pension obligations in recent years.

The report received support from senior members of the Los Angeles County Federation of Labor, ALF-CIO, and Los Angeles Chamber of Commerce. The organisations’ representatives said they agreed with some—but not all—of the report’s recommendations, and it provided a starting point “for the necessary steps our community must take to better the lives of all Angelenos”.

Elsewhere in the US, the state of New Jersey has been placed on a watch list by several asset managers partly due to its ongoing pension problems.

“They’ve had some pretty optimistic assumptions on the revenue side, which haven’t come to fruition,” Peter Hayes, head of municipal debt at BlackRock, told Bloomberg. “Barring any pretty big pension reform, I would not be surprised at all to see a downgrade before the end of the year.”

(April 10, 2014) — The European insurance and pensions regulator has ruled out recommending lower risk charges for infrastructure project finance.

The move by the European Insurance and Occupational Pensions Authority (EIOPA) has dealt a blow to investors’ hopes that infrastructure might carry a lower risk rating under Solvency II.

EIOPA Chairman Gabriel Bernardino wrote in a newsletter yesterday that despite evidence of the risk profile for infrastructure assets improving over time, the body had concluded lower risk charges for infrastructure project finance could not be recommended.

The regulator noted that a possible alternative would be to introduce reduced risk charges for individual infrastructure segments. There was evidence, Bernardino said, to support a slight reduction for unrated availability-based infrastructure debt, but there wasn’t enough evidence for EIOPA to recommend it.

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The lack of empirical evidence was a key theme in EIOPA’s statement, stressing that the dearth of publicly available data had made it impossible to offer any recommendations.

“We are confident that the current calibration will allow for a good alignment between risk and capital management and, therefore, can support the long term growth objectives in a prudent and sustainable way,” Bernardino wrote.

“A review should be made when further data would be available.”

The decision flies in the face of pleas from Pensions Europe Chair Joanne Segars, who last year called for regulators to reassess their views on infrastructure risk.

Speaking in September, Segars told aiCIO of her frustration at the regulations coming out of the EU.

“One of the more positive developments from the commission is the green paper directive on long-term investing, which puts pension funds at centre-stage of how they can help create jobs growth and held the recovery by investing for the good of the economy,” she said.

“There is now a willingness by trustees to look at a broader set of asset classes, including infrastructure. But there’s a mismatch here between what the trustees and CIOs want and should be able to invest in, and what the regulations are pushing them to do—they’re pushing for risk-free assets.”

JP Morgan Asset Management also believes the regulator has applied too broad a brush to infrastructure investment and its solvency requirements, adding EIOPA had over-estimated the capital requirements needed by insurers.

Investment in this area by insurers has been cautious to date: the proposed Solvency II regime requires insurers to invest in accordance with the “prudent person principle”. But ranking the assets against other alternatives is difficult as the funds are, for the most part, unlisted.

Due to its characteristics, infrastructure equity would generally be considered as “type two equity” under the standard formula and, as such, capital requirements are calculated using a potential 49% fall in market values (plus or minus any symmetric adjustment).

“The capital requirements for infrastructure debt are captured under the spread risk sub-module, irrespective of whether the debt is held in the form of bonds or where insurers are providing investment through long-term loans,” a white paper on the topic by JP Morgan Asset Management said.

“Under this, the capital requirements are calculated in relation to the duration and credit rating of the instrument. Where the infrastructure debt is unrated, the spread risk charge to be applied falls between that for A and BBB rated bonds and loans.”

EIOPA has fundamentally missed the fact that the volatility of infrastructure cash flows is materially lower than those of equities and property, that infrastructure cash flows are not highly correlated to those of equities and property, and that the cash flows of infrastructure assets grow faster than consumer price inflation, the paper continued.