Bush Deficit Widens to Record as Treasuries Deter U.S. Pensions

By Daniel Kruger and Sandra Hernandez


March 3 (Bloomberg) -- Philadelphia's $4 billion pension deficit is causing the city's retirement-fund manager to shun Treasuries at a time when the Bush administration needs him most.

Yields on 30-year U.S. bonds that fell to a record low of 4.10 percent this year are forcing pension funds to favor equities, corporate debt and commodities in an attempt to cover unfunded liabilities and meet return objectives of about 8 percent. Even the federal government's own Pension Benefit Guaranty Corp. said on Feb. 19 that it plans to shift $15 billion to stocks from debt.

``The reality is there's not a lot we can do'' other than buy high-risk securities to close a pension shortfall in a short period, said Chris McDonough, chief investment officer of the Philadelphia Pensions Department. The sixth-largest U.S. city will probably also issue debt, he said.

Fixed-income holdings at 1,100 funds fell to 23 percent in 2006 from 27 percent in 2003, said Dev Clifford, a consultant at financial market research firm Greenwich Associates in Greenwich, Connecticut. Results of a survey covering 2007 will be released this month and likely show that funds own an even smaller percentage of bonds, he said.

Philadelphia's predicament couldn't come at a worse time for George W. Bush, whose administration forecasts a $410 billion budget deficit for this fiscal year ending Sept. 30, approaching the record of $413 billion set in 2004. The figure may eventually reach as much as $800 billion, according to Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co. in Newport Beach, California.

Supply Swamp

The budget shortfall will force the Treasury Department to increase its borrowing by 145 percent from $163 billion, according to UBS Securities LLC, swamping the market just as longer-maturity debt turns into a money-loser for investors.

Treasuries due in 30 years, a favorite of the $7.8 trillion pension industry because they allow managers to best match assets and liabilities over time, fell 0.66 last month, after returning 2 percent in January and 10.4 percent in all of 2007, according to Merrill Lynch & Co. index data.

Pension funds hold about $44 billion, or 20 percent, of the $205 billion in Treasuries maturing in 20 years or longer, Greenwich Associates estimates.

``In the long run I don't know if there's going to be too much value'' in Treasuries, said Jeremy Wolfson, who oversees $8.5 billion as chief investment officer at the City of Los Angeles Department of Water and Power Pension Fund. He said the fund will pare its debt holdings to 25 percent from 35 percent and raise its holding of non-U.S. assets such as international stocks to 24 percent from 15 percent over the next four years.

Declining Demand

The yield on the benchmark 4 3/8 percent bond due in February 2038 fell 17 basis points last week to 4.40 percent after Federal Reserve Chairman Ben S. Bernanke told Congress that central bankers are ready to reduce interest rates further to keep the economy from a recession. The U.S. began regular sales of 30-year Treasuries in 1977.

More pension officials are hiring outside managers who favor alternative investments to run their funds, indicating ``the proportion in something like Treasuries would be going down,'' Clifford said.

The $240 billion California Public Employees' Retirement System, the largest U.S. pension plan, agreed at a Feb. 19 board meeting to hold between 0.5 percent and 3 percent of its assets in commodities, spokesman Clark McKinley said. Calpers, facing pressure from state and local governments to boost returns, would reduce its bond holdings to 19 percent from 26 percent.

$731 Billion Short

U.S. states owe an estimated $2.73 trillion in pension and benefit payments to retirees over the next 30 years, according to a December report from the Pew Center on the States. They are short almost 27 percent, or $731 billion, of that amount. The Government Accountability Office said last week that 58 percent of 65 large state and local pension plans were adequately funded in 2006, down from 90 percent in 2000.

Such studies may overstate the health of pensions because they are allowed to include expected returns in determining their funding gap, said Mark Ruloff, director of asset allocation at Arlington, Virginia-based consultant Watson Wyatt Worldwide Inc.

That gives them further motive to ``get rid of Treasuries'' and buy stocks, he said.

Credit Crisis

Declines this year in stocks, hedge funds and other investments make those assets too dangerous, said Chriss Street, treasurer of Orange County, California, which has a $2.3 billion plan that is 71 percent funded. The Standard & Poor's 500 Index is down 9.4 percent this year.

``This is the worst credit crisis in the last 25 to 30 years and that's not going to change,'' said Street, who has recommended the fund buy five-year Treasuries. ``It's a good time to own bonds.''

Falling Treasury yields have made other fixed-income investments more attractive, said Barbara Novick, vice chairman and head of the account management group in New York at Blackrock Inc., which manages $513 billion in fixed-income assets.

Investment-grade corporate bonds yield 2.47 percentage points more than Treasuries on average, up from 0.89 percentage point a year ago, according to Merrill Lynch indexes.

``Yield spreads have widened to such a great extent, this is exactly the time to go into other things,'' Novick said.