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Home > Cases > Pension Funds > Pension Funds Overview

Pension Funds: A Crisis In The Making

It was in early 2007, when defaults were rising in the U.S. housing market that Wall Street began to feel the repercussions of CDOs because they included derivatives built upon risky subprime mortgages and other mortgage-backed securities. Eventually, the market for the underlying assets in the CDOs disappeared, making it next to impossible to get rid of the subprime-mortgage derivatives and other securities held by the CDOs.

Since January, corporate, state and municipal pension funds across the United States have experienced massive losses totaling in the billions of dollars from exposure to subprime investments. Many state pension funds, in fact, are reporting portfolio values having fallen 25% or more, with additional losses likely following the disastrous state of the financial markets in the month of October.

For example, the California Public Employees' Retirement System, the largest pension system in the United States, has seen its investment fund shrink by 20% this year, or $50 billion.

Massachusetts reported a loss of $8 billion dollars in its fund, reducing the balance from $53.7 to $45.7 billion in the pension account. Connecticut's pension fund portfolio has shrunk by $2.5 billion. North Carolina's $66 billion public pension fund dropped 12% in value over the last year. Tennessee's $30 billion fund declined 10.7% since July 1, or more than $5 billion. Since Sept. 29, New Mexico's $9.7 billion public employee pension fund fell 10.2% and its $7 billion teacher retirement fund by 12.5%.

Florida's pension system lost nearly $350 million in September in securities of Lehman Brothers, AIG and Washington Mutual and Wachovia Corp.

Corporate pension funds are getting slammed, as well, by the financial market's downturn, prompting some employers to drop their pension plans altogether. As recently as mid-October, Lockheed Martin Corp. said its retirement investments had fallen 25% this year. Boeing Co. estimated its pension fund was down 20% this year. Raytheon Co. said it plans to boost contributions to its pension fund by nearly $100 million next year, partly because its pension fund has shrunk 20% since January.

Valuation Models

The problem for many pension funds stems from the valuation model used by fund managers to determine the value of the portfolio's assets. Specifically, many pension fund portfolios include a high concentration of hard-to-value and difficult-to-sell assets, including mortgage-related securities and other collateralized pools of debt. These investments do not readily trade on the secondary market. As a result, the value assigned to them often does not reflect their actual value.

Two decades ago, most state pension funds invested in safe, government securities such as bonds or U.S. Treasury bills. Now the reverse is true. Data from the Federal Reserve Board show that about 70% of state and local pension investments are in equities, compared to 62% in 2000 and 38% in 1990.

The Financial Accounting Standards Board rule, known as FASB 157, entails three classification levels to determine the underlying value of a fund's financial assets. They include:

  • Level 1 assets: These assets have readily observable prices and trade in active markets.
  • Level 2 assets: Values for these holdings are based on “observable inputs,” or prices of similar assets traded in the market.
  • Level 3 assets: These holdings, which include collateralized debt obligations, collateralized mortgage obligations, subprime-mortgage derivatives and other securities, are considered illiquid and rely on assumptions of management to gauge their value. Because of that subjectivity, Level 3 asset valuation is often called “mark-to-myth” or “mark-to-make believe.”

    • In the current economic environment, Level 3 assets in portfolios of large institutional investors - such as corporate and state pension funds - are on the rise, not because companies are adding them, but because the instruments are not trading.

    Even the Pension Benefit Guaranty Corporation (PBGC), which is the federal agency charged with backstopping pension benefits for nearly 45 million Americans, lost almost $5 billion from investments in stocks and equities this year. The company will lose 6% to 7% on its entire investment portfolio, according to PBGC Director Charles Millard.

    Moving forward, the PBGC's loss alone potentially foreshadows trouble ahead for corporate pension funds, state retirement systems and others that provide a financial backstop for millions of Americans.

    Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.

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