Friday, September 22, 2017

Prepare For The Worst Bear Market Ever?

Barbara Kollmeyer of MarketWatch reports, Jim Rogers says ETF holders will get mauled by ‘the worst’ bear market ever:
Now that the Fed has finally started to peel off the quantitative-tightening Band-Aid, things should start getting back to normal.

That's a good one, given no one really knows what normal is these days. A pullback from the record highs of yesterday looks to be in store, and gold bugs should cover their eyes, because the market has been playing catchup to Fed rate-hike hints.

We’re diving right into our call of the day, which comes from Jim Rogers. In a sweeping interview with RealVision TV, the veteran investor warns another bear market is coming, and that it will be “horrendous, the worst.” It’s the level of debt across global economies that will be to blame, he says.

And retail investors who have been piling into exchange-traded funds will be particularly vulnerable to that next big mauling. For those ETF owners — who are all in on easy S&P plays right now — here’s his message:
“When we have the bear market, a lot of people are going to find that, ‘Oh my God, I own an ETF, and they collapsed. It went down more than anything else.’ And the reason it will go down more than anything else is because that’s what everybody owns,” he says.
Like others, the chairman of Rogers Holdings is worried about bond and stock valuations right now, and about breadth in the market — that is, the number of stocks moving higher versus those heading the other way.

But within this disaster in the making, he sees one opportunity.

“If somebody can just take the time to focus on the stocks that are not in the ETFs, there must be fabulous opportunities in those stocks because they’re ignored,” he says. “Some of them have got to be doing very, very well. And nobody’s buying them, because only the ETFs buy stocks.”

What does Rogers like? Overlooked and hated markets — agriculture and Russian stocks — and he remains a fan of Chinese stocks. The Singapore-based investor owns gold, but says the metal isn't hated enough to buy right now and it’s going to get “very, very, very overpriced” before the current run is over.

It’s a fascinating interview, chock-full of advice. Check it out on Real Vision here.

Final note here, if you were paying attention, you would have heard Rogers‘s prior warnings about dire collapses and crashes over the summer. Here’s another look at some of his crash predictions.
Ah, Jim Rogers is at it again, scaring people on markets with his dire predictions and telling them to find refuge in commodities, agriculture, Russian and Chinese stocks.

Roger's claim to fame was being the co-founder of the Quantum Fund along with George Soros and he still has a very wide following of devoted fans even though he's been utterly wrong on so many of his dire macro calls. He's partially right above and I will get to it in a minute.

It's Friday folks, it's time to sit back, relax and write about what I love most: markets, markets, MARKETS! No more discussions on pension storms from nowhere, whether fully-funded US pensions are worth it or rants on Bridgewater's culture and principles.

Today, we take a deep dive into markets so all my cheap broker buddies who absolutely hate pensions but love my market comments can stop whining like little girlie men and gain some much-needed macro insights (I tell them, if you don't like the content of my blog, pay up and then we can talk about it).

Alright, where is Jim Rogers right and where is he wrong? Like most market participants, Rogers doesn't understand the baffling mystery of inflation-deflation, because if he did, there is no way he would be recommending agriculture (DBA), commodities (GSC), Russian (RSX) or Chinese (FXI) stocks.

In fact, if Rogers understood that global deflation is gaining strength and headed for the US, he would be terrified and shorting the crap out of all these stocks he publicly recommended.

Where is Rogers right? In my recent comment on pension storms from nowhere, going over John Mauldin's dire warning on pensions, I wrote this:
I have been covering America's public and private pension crisis for a long time. It's a disaster and John is right, it's only going to get worse and a lot of innocent public-sector workers and retirees and private-sector businesses are going to get hurt in the process.

But it's even worse than even John can imagine. With global deflation headed to the US, when the pension storm cometh, it will wreak havoc on public and private pensions for a decade or longer. At that point, it won't just be companies breaking the pension promise, everyone will be at risk.

Importantly, if my worst fears materialize, this isn't going to be like the 2008 crisis where you follow Warren Buffett who bought preferred shares of Goldman Sachs and Bank of America at the bottom, and everything comes roaring back to new highs in subsequent years.

When the next crisis hits, it will be Chinese water torture for years, a bear market even worse than 1973-74, one that will potentially drag on a lot longer than we can imagine.

This will be the death knell for many chronically underfunded US public and private pensions for two reasons:
  1. First, and most importantly, rates will plunge to new secular lows and remain ultra-low for years. Because the duration of pension liabilities is much bigger than the duration of assets, any decline in rates will disproportionately hurt pensions, especially chronically underfunded pensions.
  2. Second, a prolonged bear market will strike public and private assets too. Not only are pensions going to see pension deficits soar as rates plunge to new secular lows, they will see their assets shrink, a perfect double-whammy storm for pensions. 
No doubt, some pensions will be hit much harder than others, but all pensions will be hit.
So, I agree with Jim Rogers, the next bear market will be a lot worse than anything we have seen before. And lot of unsuspecting retail and institutional investors riding the Big Beta ETF wave higher and higher are in for a very rude awakening in the years ahead.

What else? Let there be no doubt, exchange-traded funds (ETFs) are driving the market higher, along with central banks and companies buying back shares like there's no tomorrow.

Ben Carlson, publisher of A Wealth of Common Sense blog, recently wrote that saying there's a bubble in ETFs makes no sense, pointing out the following instead:
Closet indexing was the real bubble that is currently popping. You’ve never heard about it because the fund companies could extract such high fees in these funds.
No doubt, closet indexing was the real bubble, and I've discussed this before on my blog, but if Ben thinks the $3 $4 trillion shift in investing isn't a bubble in the making, he too is out to lunch.

Importantly, while Bitcoin is a glaring bubble to me (don't touch anything you can't hedge against!), there is a huge passive beta bubble going on in recent years that has effectively displaced and swamped the previous active alpha bubble and when it breaks, it will  wreak unfathomable damage to markets (overall indexes) for a very long time. ETF disciples will be crushed for years.

Equally important to remember, there is a symbiotic relationship between active and passive investing which Jack Bogle is well aware of. One cannot exist without the other and when everyone jumps on any investment bandwagon -- be it stocks, bonds, commodities, ETFs, etc. -- it doesn't bode well for future returns.

I rolled my eyes this morning when I read Pimco, BlackRock see a multi-year rally for emerging markets. Good luck with that trade, in a deflationary world, I recommend being underweight or even shorting emerging market stocks (EEM) and bonds (EMB).

It was interesting to see bank stocks surge higher this week as the yield curve collapsed but in a deflationary world, I'd be cautious on financials (XLF), they will perform miserably for a very long time.

Of course, the big news this week was the Federal Reserve and the 'great unwinding' of its balance sheet. The Fed didn't raise rates but hinted that rate hikes are coming and that it will proceed with an orderly but significant reduction in its balance sheet (read the FOMC statement here).

And I thought the Bank of Canada is flirting with disaster. The Fed is either oblivious to deflation headed to the US or it's terrified and wants to try to shore up big banks to prepare them for the catastrophic losses that lie ahead (ironically, this tightening will prop up the US dollar, lower import prices and exacerbate deflationary headwinds but it's a race to shore up banks before deflation strikes to mitigate the damage).

Maybe I'm wrong on deflation. This week, my friend Fred Lecoq sent me a comment from Pennock, A Possible Secular Bottom For Inflation, which you can all read here.

And my former colleague from the Caisse, Caroline Miller who is now the Global Strategist of BCA Research, put out a conference call titled "Should Bond Bears Come Out of Hibernation Or Will They Face Extinction?". You can watch it for free here.

Is the Maestro right on bonds? I don't think so. I respect Caroline a lot but I remain firmly in the deflation camp and following the Fed's statement, the bond market remains unimpressed and unconvinced that growth or reflation is coming back anytime soon.

In fact, I even called out bond king Jeffrey Gundlach on Twitter after he tweeted something silly following the Fed's announcement (click on image):


I think what is going on right now is the bond market is waiting for some announcement on tax cuts but it will be too little too late. Tax cuts will provide temporary relief but by the time they work through, the US economy will be well on its way to recession.

Again, let me be crystal clear here on my top three macro conviction trades going forward:
  1. Load up on US long bonds (TLT) while you still can before deflation strikes the US. This remains my top macro trade on a risk-adjusted basis.
  2. A couple of months ago I said it's time to start nibbling on the US dollar (UUP) and it continued to decline but I think the worst is behind us, and if a crisis strikes, everyone will want US assets, especially Treasuries. I'm particularly bearish on the Canadian dollar (FXC) and would use its appreciation this year to load up on US long bonds (TLT).
  3. My third macro conviction trade is to underweight/ short oil (USO), energy (XLE) and metals and mining (XME) as the global economy slows. Sell commodity indexes and currencies too.
Admittedly, oil prices are stubbornly hovering around $50 a barrel, and the higher they go, the better for energy, commodities and commodity currencies but I would be very careful here, this isn't another major reflation trade like in early 2016, it's just a counter-cyclical move in a major downtrend. 

What about tech stocks (XLK) and biotech stocks (XBI)? They look toppish to me and while there are some fantastic moves in individual biotech shares, I would tread carefully here too. 

Again, I'm not worried about when the tech bubble will burst. I'm far more worried about deflation headed to the US, wreaking havoc on the global economy and public and private risk assets for years to come. 

Be very careful in these markets. there is no question there is plenty of liquidity and trading opportunities abound. Every day, I look at ETFs and thousands of stocks I track and even my personal watch list and see lots of green and red (click on images): 



But I'm still in full-on defensive mode, all my money remains in US long bonds (TLT) and I'm undecided on whether I'm going to get back into trading biotech and tech companies for the remainder of the year.

These are markets for traders but you need to be good and take huge risks to make the big coin, buying the right stocks on big dips which sounds easy until you get caught and get your head handed to you.

Going into the end of the quarter, I expect some window dressing from big funds, there will be trading opportunities but you need to be very careful here, the US economy is definitely slowing. A lot of this slowdown has been reflected in the weak USD but as the rest of the world also slows, you will see their currencies sell off relative to the greenback.

Stay sharp, don't get too excited, sweep the table when you see profits, and be prepared for the worst bear market we have yet to experience (forget all your trading and investment books, read Hegel, Marx, and Nietzsche instead).

Or you can relax and listen to the Oracle of Omaha who recently predicted the Dow will hit 1 million and that may actually be pessimistic. He may be right but he won't be around to witness this and neither will you or I.

In the meantime, I'm with the former New York City mayor who said Tuesday in an interview with CBS News' Anthony Mason: "I cannot for the life of me understand why the market keeps going up."

The reason why the US market keeps going up is that it's the best and most liquid market in the world and after the USD slide, it's relatively cheap (on a currency, not valuation basis) but not without risks.

Second, take the time to watch the FOMC press conference from earlier this week. Madame Chair doesn't understand why inflation expectations aren't picking up yet. I suggest she and everyone else read this comment on retail sales and the end of reflation as well as my comment on deflation headed to the US. Does anyone else think Neel Kashkari should be named the next Fed Chair?

Lastly, the New York Times published a nice article last weekend, False Peace for Markets?, profiling a young 38-year old trader, Christopher Cole who runs Artemis Capital, and is betting big that volatility won't stay at historic lows for long. Watch him below discussing taking the long road with volatility.

I've already covered the silence of the VIX in great detail and it's worth noting Mr. Cole could come out of this a hero or a big zero depending on when markets break down. He could be right, and I myself am defensive right now, but markets can stay irrational longer than you can stay solvent.



Thursday, September 21, 2017

Are Fully-Funded US Pensions Worth It?

John J. McTighe, Jim Baross and David A. Hall wrote an op-ed for The San Diego Union-Tribune, Why full funding of pensions is a waste of money:
Stark headlines have appeared over the past few years proclaiming that public pension plans in California are woefully underfunded and that basic services like police, parks and libraries may suffer as a result.

In fact, full funding of public pension plans isn’t necessary or even prudent for their healthy operation, according to a recent analysis by Tom Sgouros of the Haas Institute in Berkeley.

In the private sector, pension systems need to be 100 percent funded to protect the pensions of workers in case of bankruptcy. In the public sector, however, while governments may encounter periodic budget ups and downs due to economic cycles and fluctuating revenues, they are not going away. Public employees are hired and begin contributing to the pension system during their working lives. Their contributions help pay the benefits of retirees who worked before them. Once they retire, contributions from employees who replace them will help pay their retirement benefits, and so on, indefinitely.

Full funding of a public pension plan amounts to covering the total future benefits of all current workers. The Hass Institute analysis describes this as a waste of money because it equates to insuring against a city or county’s disappearance. According to the report, the real question of a pension plan’s fiscal viability is whether it can continue to pay its obligations each year, in perpetuity — not whether it can cover all future obligations immediately. This is why some fiscal credit rating agencies consider a 70-80 percent funded ratio adequate for public pension systems.

Imagine you sign a lease to rent an apartment for 12 months at $1,000 a month. Your ultimate obligation is $12,000, but should the landlord refuse to rent to you if you can’t show you have $12,000 available at the outset of the lease (100 percent funding)? No, the landlord simply wants assurance you can pay your rent each month.

If you’re a homeowner, you probably have a 30-year mortgage. Your mortgage allows you to own your home without fully funding the purchase. If, for example, you have a $300,000 home with a $150,000 mortgage, it might be said that your homeownership is at a 50 percent funded ratio. That’s not reckless; it’s prudent use of debt.

Each of these examples involves an ultimate obligation to pay off all the debt by a specific date. Public pensions are different in that the obligation is open ended, but so are the income sources.

Let’s consider a pension fund that has 70 percent of what it needs to pay all retirees decades in the future. During any given year, the pension fund must pay promised benefits to current retirees. Provided that annual contributions from the employer and current employees, combined with investment returns, are equal to benefit costs, the fund operates at break-even.

If at the end of the year the fund is at 70 percent, it’s a wash. The fund can go on indefinitely under these conditions. According to the Haas report, America’s public pension systems were, on average, 74 percent funded as of 2014.

There are two strong reasons not to move to 100 percent funding.

First, doing so would require significant, unnecessary expense to employees, employers and taxpayers.

Since public pensions can exist indefinitely at 70 percent or 80 percent funding, why not use those funds for more immediate needs?

There’s a larger concern, though.

Historically, when pensions in California approached 100 percent funding due to unusually high investment returns, policymakers reduced or skipped annual contributions, under the flawed assumption that high market returns were the new normal. They also increased benefits without providing adequate funding, again expecting investment returns would cover the cost. When investment returns returned to normal, these decisions had long-term negative consequences.

Some people speculate that future investment returns will be lower than past returns, requiring higher contributions from workers and taxpayers to sustain pension funds. In truth, no one knows.

The prudent course is to review returns each year and make gradual course corrections, as needed. That’s why independent auditors regularly evaluate and advise public pension funds on necessary course corrections.

So when you hear concerns about public pensions being underfunded, understand that ensuring 100 percent funding isn’t critical to the healthy functioning of a public pension system, and it can be very expensive.

Both the city and county of San Diego pensions systems are quite stable at a 70-80 percent funding ratio.

Wouldn’t the tax dollars required to get them to 100 percent funding be better spent on other needs — like police, parks and libraries?

*****

McTighe is president of Retired Employees of San Diego County. Baross is president, City of San Diego Retired Employees’ Association. Hall is president, City of San Diego Retired Fire and Police Association.
Back in February, Ryan Cooper of The Week wrote an article on this, Public pensions are in better shape than you think:
The beleaguered condition of state and local pension plans is one of those ongoing disaster stories that crops up about once a week somewhere. The explanation usually goes something like this: Irresponsible politicians and greedy public employee unions created over-generous benefit schemes, leading to pension plans which aren't "fully-funded" and eventual fiscal crisis. That in turn necessitates benefit cuts, contribution hikes, or perhaps even abolishment of the pension scheme.

But a fascinating new paper from Tom Sgouros at UC Berkeley's Haas Institute makes a compelling argument that the crisis in public pensions is to a large degree the result of terrible accounting practices. (Stay with me, this is actually interesting.) He argues that the typical debate around public pensions revolves around accounting rules which were designed for the private sector — and their specific mechanics both overstate some dangers faced by public pensions and understate others.

To understand Sgouros' argument, it's perhaps best to start with what "fully-funded" means. This originally comes from the private sector, and it means that a pension plan has piled up enough assets to pay 100 percent of its existing obligations if the underlying business vanishes tomorrow. Thus if existing pensioners are estimated to collect $100 million in benefits before they die, but the fund only has $75 million, it has an "unfunded liability" of $25 million.

This approach makes reasonably good sense for a private company, because it really might go out of business and be liquidated at any moment, necessitating the pension fund to be spun off into a separate entity to make payouts to the former employees. But the Government Accounting Standards Board (GASB), a private group that sets standards for pension accounting, has applied this same logic to public pension funds as well, decreeing that they all should be 100 percent funded.

This makes far less sense for governments, because they are virtually never liquidated. Governments can and do suffer fiscal problems or even bankruptcy on occasion. But they are not businesses — you simply can't dissolve, say, Arkansas and sell its remaining assets to creditors because it's in financial difficulties. That gives governments a permanence and therefore a stability that private companies cannot possibly have.

The GASB insists that it only wants to set standards for measuring pension fund solvency. But its analytical framework has tremendous political influence. When people see "unfunded liability," they tend to assume that this is a direct hole in the pension funding scheme that will require some combination of benefit cuts or more funding. Governments across the nation have twisted themselves into knots trying to meet the 100-percent benchmark.

While all pensions have contributions coming in from workers, the permanence of those contributions is far more secure for public pensions. Plus, those contributions can be used to pay a substantial fraction of benefits.

Indeed, one could easily run a pension scheme on a pay-as-you-go basis, without any fund at all (this used be common). That might not be a perfect setup, since it wouldn't leave much room for error, but practically speaking, public pension funds can and do cruise along indefinitely only 70 percent or so funded.

This ties into a second objection: How misleading the calculation for future pension liabilities is.

A future pension liability is determined by calculating the "present value" of all future benefit payments, with a discount rate to account for inflation and interest rates. But this single number makes no distinction between liabilities that are due tomorrow, and those that are due gradually over, say, decades.

Fundamentally, a public pension is a method by which retirees are supported by current workers and financial returns, and one of its great strengths is its long time horizon and large pool of mutual supporters. It gives great leeway to muddle through problems that only crop up very slowly over time. If huge problems really will pile up, but only over 70 years, there is no reason to lose our minds now — small changes, regularly adjusted, will do the trick.

Finally, a 100-percent funding level — the supposed best possible state for a responsible pension manager — can actually be dangerous. It means that current contributions are not very necessary to pay benefits, sorely tempting politicians to cut back contributions or increase benefits. And because asset values tend to fluctuate a lot, this can leave pension funds seriously overextended if there is a market boom — creating the appearance of full funding — followed by a collapse. Numerous state and local public pensions were devastated by just this process during the dot-com and housing bubbles.

I have skipped past several more technical objections from Sgouros (whose paper is really worth reading). But the fundamental point here is fairly simple. Accounting conventions are supposed to help people think clearly about their financial health. But in the case of public pensions, they have warned of partly imaginary danger, pushing governments to stockpile vast asset hoards that are much larger than is necessary, and created a goal which is itself rather dangerous. The next time you see someone complaining about a pension funding shortfall, check the details carefully.
Let me begin by directing your attention to Tom Sgouros's paper, Funding Public Pensions, where he examines whether full pension funding is a misguided goal (click here to read it).

I too think this paper is well written and well worth reading as it raises many excellent points. First, public pensions are not private corporations and the solvency rules shouldn't be as onerous on them as they should be for companies which can go bankrupt.

In my last comment, I went over Boeing's huge pension gaffe, funding its pension with its company shares. Boeing has a funding ratio of 74 percent, which according to this study is no big deal if you're a public pension plan, but it's more concerning if you're a private corporation.

In June, I covered how GE botched its pension math and last month, I covered America's corporate pension disaster where I stated the following:
A few observations from me:
  • Pensions are all about matching assets and liabilities and since the duration of assets is much lower than the duration of liabilities, the decline in rates has disproportionately hurt private and public pensions because liabilities have grown a lot faster than assets.
  • Unlike public pensions which use an assumed rate-of-return of 7% or 8% to discount future liabilities, corporate pensions use a market rate based on corporate bond yields (see below). This effectively means that the way American corporations determine their future liabilities is a lot stricter and more realistic than the way US public pensions determine their liabilities.
  • Companies hate pensions. Instead of using money from corporate bonds to top up their pensions, they prefer using these proceeds to buy back shares, rewarding their investors and propping up executive compensation of their senior managers.
  • The pension crisis is deflationary and will only ensure low rates for a lot longer. Shifting out of defined-benefit plans into defined-contribution plans will only exacerbate pension poverty.
Now, let me thank Mathieu St-Jean, Absolute Return Manager at CN Investment Division, for bringing the top article to my attention. I commented on his LinkedIn post but lost it and there was a very nice actuary who corrected me, stating the discount rate corporate pensions use is A or AA, not AAA bond yields.

The point is that corporate pensions use a market rate, not some assumed rate-of-return based on rosy investment assumptions. Some argue this is way too stringent while others argue it is far more realistic and if US public pensions used this methodology, their pension deficits would be far worse than they already are.
In a more recent comment on how new math hit Minnesota's pensions and drastically impacted their funded status from just a year ago (from 80 percent to 53 percent), Bernard Dussault,  Canada's former Chief Actuary, shared this with me after reading that comment:
As you may already well know, my proposed financing policy for defined benefit (DB) pension plans holds that solvency valuations (i.e. assuming a rate of return based on interest only bearing investment vehicles as opposed to the return realistically expected on the concerned actual pension fund) are not appropriate because they unduly increase any emerging actuarial surplus or debt of a DB pension plan.

Nevertheless, while assuming a realistic rate of return as opposed to a solvency rate would decrease the concerned USA DB pension plans' released debts, any resulting surplus would not appear realistic to me if the assumed long-term real rate of return were higher than 4% for a plan providing indexed pensions.
I think Bernard is on the same page as Tom Sgouros, but he too raises concerns over the use of an inappropriate long-term real rate of return higher than 4%.

This week, I discussed US pension storms from nowhere, going over John Mauldin's dire warning on public pensions where I stated the following:
I have been covering America's public and private pension crisis for a long time. It's a disaster and John is right, it's only going to get worse and a lot of innocent public-sector workers and retirees and private-sector businesses are going to get hurt in the process.

But it's even worse than even John can imagine. With global deflation headed to the US, when the pension storm cometh, it will wreak havoc on public and private pensions for a decade or longer. At that point, it won't just be companies breaking the pension promise, everyone will be at risk.

Importantly, if my worst fears materialize, this isn't going to be like the 2008 crisis where you follow Warren Buffett who bought preferred shares of Goldman Sachs and Bank of America at the bottom, and everything comes roaring back to new highs in subsequent years.

When the next crisis hits, it will be Chinese water torture for years, a bear market even worse than 1973-74, one that will potentially drag on a lot longer than we can imagine.

This will be the death knell for many chronically underfunded US public and private pensions for two reasons:
  1. First, and most importantly, rates will plunge to new secular lows and remain ultra-low for years. Because the duration of pension liabilities is much bigger than the duration of assets, any decline in rates will disproportionately hurt pensions, especially chronically underfunded pensions.
  2. Second, a prolonged bear market will strike public and private assets too. Not only are pensions going to see pension deficits soar as rates plunge to new secular lows, they will see their assets shrink, a perfect double-whammy storm for pensions. 
No doubt, some pensions will be hit much harder than others, but all pensions will be hit.

This brings me to another point, how will policymakers address this crisis when it really hits them hard and they can't ignore it because pension costs overwhelm public budgets?

Well, Kentucky's public pensions may be finished but I am truly disheartened by the moronic, knee-jerk response. Tom Loftus of courier-journal reports, Kentucky pension crisis: Are 401(k) plans the solution?. I note the following passage:
Keith Brainard, research director for the National Association of State Retirement Administrators, said risk doesn't disappear under a 401(k) plan.

"These proposals shift that risk from the state and its public employers and taxpayers and put it all on the workers. In fact, there’s going to be more risk because they are no longer in a group that can manage the risk much better," he said.

Whether the moves actually will save the state money is a question being hotly debated.

Jason Bailey, executive director of the Kentucky Center for Economic Policy, of Berea, said, “Moving employees into 401(k)-type plans are actually more expensive … and harms retirees while making it much more difficult to attract and retain a skilled workforce.”
I will keep hammering the point that moving public sector employees to a 401(k) plan shifts retirement risk entirely onto employees, leaves them exposed to the vagaries of public markets, and ultimately many of them will succumb to pension poverty just like private sector employees with DC plans. Moreover, the long-term effects for the state of Kentucky are not good, they will raise social welfare costs and cut economic growth as more people retire with little to no savings.

Another point I need to make to the John Mauldins of this world, the pension crisis is deflationary. Period. I don't care if it's DB or DC pensions, a retirement crisis putting millions at risk for pension poverty will exacerbate rising inequality and necessarily impact aggregate demand and government revenues (collect fewer sales taxes).

Don't get me wrong, the US has a whole host of problems with their large public DB plans, and chief among them is lack of proper governance. Sure, states aren't topping them up, pensions still use rosy investment assumptions to discount future liabilities, but the biggest problem is government interference and their inability to attract and retain qualified investment staff to manage public and private assets internally.

On top of these issues, some decently-funded US pensions are getting hit with brutal changes to accounting rules. I recently discussed how this new math hit Minnesota's pensions but as other states adopt similar rules to discount future liabilities, get ready, they will get hit hard too.

This is why on top of good governance which separates public pensions from the government, I believe we need to introduce some form of risk-sharing in public pensions so when the plans do experience a deficit, contribution rates increase and/ or benefits are cut until the plan regains fully-funded status again.

In my recent conversation with Jim Leech on pensions and Canada's Infrastructure Bank, the former President and CEO of Ontario Teachers' shared this with me on how OTPP regained its fully-funded status:
Basically, there are two levers Ontario Teachers' Pension Plan uses when the plan goes into deficit to restore fully-funded status:
  • It partially or fully removes cost-of-living adjustments (conditional inflation protection) and
  • It raises the contribution rate from the base of 9% to an agreed upon rate (a special levy)
After the plan ran into deficits after the 2008 crisis, the contribution rate was increased to 13% and since it is a jointly sponsored plan, both teachers and the government needed to contribute this rate.

However, unlike 1997 where benefits were increased, now that the plan is fully-funded,  the new agreement is simply to restore full inflation protection and reduce the contribution rate back to the base case of 9% (can never go lower).

The key here is there are no increases in benefits, it's simply restoring full inflation protection and reducing the contribution rate going forward to the base rate of 9%.
Lastly, a dire warning to John Mauldin and residents of Dallas. All roads lead to Dallas. The great state of Texas will survive and rebuild after Hurricane Harvey but get ready for major increases in property taxes when the pension storm cometh and deflation hits the US.

And there will be no escape (to where? Illinois, New Jersey or Kentucky?!?). The pension storm will strike us when we least expect it and it will wreak havoc on the US and global economy for a very long time.
Now, I want to be careful here, the United States isn't Greece, it can print its reserve currency and in theory inflate its way out of debt or keep servicing its debt in perpetuity as long as long-term growth is decent.

But there are limits to debt and there are a lot of reasons to believe growth will be very subdued over the next decade, which means interest rates will remain at ultra-low levels for a very long time, especially if my worst fears of deflation hitting the US come true.

It's also worth noting that public pension liabilities are long-dated and unlike corporate pensions, there is no solvency threat to treat them the exact same way as their corporate counterparts.

Equally important to keep in mind that in the past when US public pensions reached fully-funded status, state and local governments stopped topping them out, took contribution holidays and increased benefits to buy votes just (like they did in Greece!!). This too exacerbated pension deficits which is why I would make contribution holidays illegal and enshrine it in the constitution.

There is plenty of pension blame to go around: governments not topping out pensions, unions who want to stick to rosy investment assumptions and refuse to share the risk of their plan, and huge myths on just how widespread the US public pension crisis truly is.

John Mauldin's warning on the pension storm is informative but he too perpetuates myths because he has a right-wing agenda in all his comments just like those union members above have a left-wing agenda in writing their comment.

Ironically, I'm probably more of an economic conservative than John Mauldin. I hate Prime Minister Justin Trudeau's new tax plan because it's dumb policy and hypocritical on his part but when it comes to health, education and pensions, I believe the federal government must offer the best solution in all three because it makes for good economic policy over the long run.

I've said this before and I will say this again, expanding and bolstering large, well-governed public pensions in Canada and elsewhere is good pension and economic policy over the long run.

Period. I don't care what John Mauldin or Joe and Jane Smith think, I know I'm right and the proof is in our Canadian pudding!

Now, let me get back to Tom Sgouros and the articles above because I'm not going to give them a free pass either. They're right, US public pensions can be 70 or 80 percent underfunded in perpetuity but funded status matters a lot and things can degenerate very quickly.

Importantly, when the funded status declines, governments and workers need to contribute more to shore up public pensions, and this will necessarily mean less money for other services.

Also worth noting rating agencies are increasingly targeting US public pensions, and as their credit rating declines, state borrowing costs go up.

There is something else that bothers me, apart from the fact that a lot of US public pensions would be chronically underfunded if they were using the discount rate Canada's large public pensions use to discount future liabilities, there are no stress tests performed on US public pensions to see just how solid they really are.

For example, the Federal Reserve stress tests banks but nobody is looking at the health of large US public pensions and what they can absorb in the form of a severe deflationary shock (to be fair, nobody is doing this in Canada or elsewhere either).

Now, let's say your US public pension is 70 percent funded, and a huge deflationary shock that lasts a very long time sends long bond yields to zero or even negative territory. I don't need to perform a stress test, I know all pensions will get clobbered but chronically underfunded and even "decently" funded pensions will be at risk of a death spiral they simply will never recover without huge increases in contributions along with huge haircuts in benefits.

"Come on Leo, over the very long run, pensions can withstand whatever the market throws at them, they have a very long investment horizon." True but some pensions are in much better shape than others to withstand financial shocks.

Last February, Hugh O'Reilly, CEO of OPSEU Pension Trust (OPTrust) and Jim Keohane, CEO of Healthcare of Ontario Pension Plan (HOOPP), wrote an op-ed, Looking for a better measure of a pension fund’s success, where they underscored the importance of a pension plan's funded status as the ultimate measure of success.

I can tell you without a doubt that HOOPP, OPTrust, Ontario Teachers' Pension Plan, OMERS and other large Canadian pensions will get hit too if another financial crisis hits us but they're in a much better position to absorb this shock because of their fully-funded status. Also, some of them (HOOPP and OTPP) have adopted a shared-risk model which means they can increase contributions and/or decrease benefits if their plan runs into trouble in the future.

I keep stating pensions are all about matching assets and liabilities but more importantly, they are about fulfilling a pension promise to allow plan beneficiaries to retire in dignity and security.

So, if you ask me, there is no doubt that the funded status of a public pension matters a lot. Maybe US public pensions can't attain the fully-funded status of their Canadian counterparts but there is a lot of room for improvement, especially on the governance front and adopting a shared-risk model.

Demographic pressures are hitting all pensions, we simply cannot afford to be complacent about the funded status of large public pensions or else we risk seeing Kentucky's pension problems all over the US.

No doubt, we need to be careful when looking at the US public pension crisis, not to overstate it, but it's equally irresponsible and dangerous if we understate it and think they're on the right path and their funded status is much ado about nothing.

In my last comment on Boeing's huge pension gaffe, I stated flat out:
It's high time the United States of America adopts a single payer healthcare system like Canada and the rest of the civilized world has done and privatize and enhance Social Security for all workers, adopting the Canadian governance model to make sure it's done well.
There will be tremendous opposition to these much-needed reforms from healthcare insurers, insurance companies, and mutual fund companies but it makes good economic sense to go through with them whether you're a Democrat, Republican or independent.

Below, an older clip where Tom Sgouros discusses the wealth flight myth (2011). He's obviously very bright and I agree with him on the wealth flight myth and think you should all take the time to read his paper, Funding Public Pensions, keeping my comments above in mind.

If you have anything to add, feel free to email me at LKolivakis@gmail.com and I will gladly post them in an update to this comment.

Update: Tom Sgouros was kind enough to share this with me after reading my comment:
"Thanks for the note and the kind words. I'm with you on the discipline question, by the way. I just think the current system of discipline -- which is mostly just about people yelling at the mayor if he makes a bad pension decision -- isn't working very well. Discipline isn't consequences a decade down the line. Discipline is having your checks to retirees bounce or your budget not balance in the very near term. The closer we can get to a system like that, the better off systems will be in the long term, in my opinion."
I thank him for sharing his feedback on this post.

Also, Jim Leech, the former President and CEO of Ontario Teachers' Pension Plan shared his thoughts on the second article at the top of this post:
This article has two fundamentally flawed assumptions:

1. It assumes that the public employer sponsor will never become insolvent/bankrupt ie taxpayers will always pay higher and higher taxes to fund pension promises - NOT. There is a practical limit to how much property, income and other taxes can be levied, public services cut and public infrastructure deteriorates before the economic viability of a municipality/state is destroyed and everyone leaves town.

2. As important, there is a serious intergenerational equity issue that is ignored. When a fund is in:
  • A. Balance - there is enough $ (comprising existing assets, future contributions and future earnings on the funds) to pay for past earned benefits and future benefits yet to be earned
  • B. Surplus - the current generation of retirees/employees/taxpayers have overpaid for the benefits (earned and to be earned)
  • C. Deficit - the current generation of retirees/employees/taxpayers have underpaid for the benefits; future generations of taxpayers/employees will have to pay more than the value of the benefits. ie the next generation is saddled with a debt for nothing. This is particularly troublesome as longevity increases, ratio of retirees to employees increases and workforces (plan members) shrink.

But the biggest "false news" is the example used (mortgage debt). Of course the bank does not require the borrower to have 100% of the principal and future interest payments in cash upfront. But the bank sure as heck wants some proof that the borrower can realistically meet the future payment stream (proof they ask for is: net worth statement, insurance, income verification, etc)

That is the same for the pension fund valuation. You need to show that net worth (assets on hand) plus future inflows (contributions and earnings on fund) are sufficient to meet the future payment stream.
I thank Jim for sharing his wise insights with my readers and highly recommend you read our recent discussion on pensions and the Canada Infrastructure Bank.

Suzanne Bishopric, the former CIO of the UN Pension Fund, echoed some of Jim's concerns in her comments which she shared with me:
The pay as you go system is likely to create intergenerational inequities because:
  1.  Demographic changes in recent years have meant the next generation is likely to be smaller (think of China and Finland), so a higher proportion of the tax revenue is required from one generation to the next, to cover the retirement benefits of retirees. Do we want to exploit our children this way?
  2.  Income generating opportunities are not uniformly distributed across time. One generation (think of Southern Europe today) may have higher unemployment rates and less stable working opportunities than did their parents' generation. If each generation sets aside money as they earn it, for example, via payroll deductions, they will support themselves without placing further burdens on the next generation. Our children should not have to be responsible for our generation, which has not left better opportunities for them.
  3. Market volatility being what it is, one generation could have the misfortune of needing funds to support their retirement right when the market has reached a nadir. This is an especially severe problem in the USA, where most retirement funds are segregated into small personally managed individual accounts. When combined with low interest rates, amateur expertise, lack of access to higher returning asset classes and limited scope for competitive pricing contribute to the underfunding of retirement assets.
I thank Suzanne for sharing her thoughts with my readers.

Wednesday, September 20, 2017

Boeing's Huge Pension Gaffe?

Katherine Chiglinsky, Julie Johnsson, and Brandon Kochkodin of Bloomberg report, Down $20 Billion, Boeing Stuffs Pension Fund With Its Own Shares:
Like so many companies in America, Boeing Co. has largely neglected the gaping deficit in its employee pension as it doled out lavish rewards to shareholders.

What’s raising eyebrows is how it plans to shore up the retirement plan.

Last month, Boeing made its largest pension contribution in over a decade. But rather than put up cash and lock in the funding, the planemaker transferred $3.5 billion of its own shares, including those it bought back in years past. (The administrator says it expects to sell them over the coming year.)

It’s a bold move, and one cheered by many on Wall Street. Yet to pension experts, it isn’t worth the risk. After a record-setting, 58 percent rally this year, Boeing is betting it can keep producing the kind of earnings that push shares higher. If all goes well, not only will the pension benefit, but Boeing says it will be able to forgo contributions for the next four years.

But if anything goes awry, the $57 billion pension -- which covers a majority of its workers and retirees -- could easily end up worse off than before.


“It’s an irresponsible thing to do certainly from the perspective of the plan participants,” said Daniel Bergstresser, a finance professor at the Brandeis International Business School. “Ideally, you would like to put assets in the pension plan that won’t fall in value at exactly the same time that the company is suffering.”

Under Chief Executive Officer Dennis Muilenburg, Boeing’s pension shortfall has widened as the Chicago-based company stepped up share buybacks. The $20 billion gap is now wider than any S&P 500 company except General Electric Co. And relative to earnings, Boeing shares are already trading close to the highest levels in a decade, a sign there might be more downside than upside.

‘Good Value’

Boeing disagrees and sees the strategy as a win-win.

“We continue to see Boeing stock as a good value,” spokesman Chaz Bickers said. “This action further reduces risk to our business while increasing the funding level of our pension plans. Our employees and retirees benefit as well since this action provides funding earlier, giving the plan sponsor more flexibility to grow the plans’ assets.”

It’s too early to tell how things will play out -- especially for a company whose shares have historically been sensitive to the ups and downs of the economy -- and early returns are mixed. Gains have slowed markedly since Boeing transferred 14.4 million shares to its pension on Aug. 1, but the 2.4 percent advance is still more than the S&P 500. (The plan has the option to dispose of the shares at any time.)

Analysts see Boeing climbing to $262.86 a share in the coming year, supported by a near-record $423 billion backlog of jet orders that’s equal to about seven years of factory output. That would be good for a 7.2 percent gain from Thursday’s price of $245.23, and roughly in line with analysts’ estimates for the broader market. In the previous 12 months, Boeing stock nearly doubled.

Price Targets

Of course, Boeing isn’t the only company to opt for stock instead of cash when it comes to its pensions. GE’s plan holds more than $700 million of shares and IBM had about $28 million of stock in its U.S. pensions. But Boeing’s transfer is notable because it was one of the largest in recent memory and happened just one day after the company’s shares reached an all-time high.

Pension experts and academics have long debated how much company stock is too much for retirement plans, particularly because workers’ livelihoods become even more intertwined with their employer’s fortunes when they own shares. The dangers came into full view when Enron’s collapse a decade ago saddled its employees with millions of worthless shares in their 401(k)s.

With pensions like Boeing’s, the risks to the company can be greater when share prices plunge because employers are on the hook to cover any shortfall. And for Boeing, the deficit is already considerable.

“It would have been a cleaner decision to contribute cash to the pension,” said Vitali Kalesnik, the head of equity research at Research Affiliates. “Boeing to a degree is a very cyclical company.”

Boeing’s pension went deep into the red after the global financial crisis in 2008 hurt aircraft sales, while delays in its 787 Dreamliner program burned up cash. Record-low interest rates in the years since hurt pension returns across corporate America, and made it hard for Boeing to claw its way out.

Pension Freeze

At the end of 2016, its pension had $57 billion in assets and $77 billion in obligations -- a funding ratio of 74 percent, data compiled by Bloomberg show.

Boeing froze pensions for Seattle-area Machinist union members last year under a hard-fought contract amendment. It also switched non-union workers to a defined contribution plan.

And the stock transfer last month, combined with a planned $500 million cash payment this year, would be equal to all the company’s contributions during the previous five years. Nevertheless, it still leaves Boeing with roughly $15 billion in unfunded pension liabilities, although the shortfall should gradually shrink over the next four years, according to Sanford C. Bernstein & Co.

To be clear, Boeing has the money. In the past three years, the company generated enough excess cash to buy back $30 billion of its own shares.

But using equity instead of cash does have its advantages. It allows Boeing to conserve its free cash flow -- a key metric for investors -- by transferring Treasury shares that were repurchased at far lower values than today’s prices. In addition, Boeing will get a $700 million tax benefit, which will offset the cost of its $500 million cash contribution.

Risk Strategy

The strategy shows how Boeing can “look at risk differently, be proactive and manage that today, and take that uncertainty out over the next five years,” Greg Smith, Boeing’s chief financial officer and chief strategist, told an investor conference on Aug. 9.

It’s not the first time Boeing has plowed stock into its underfunded pension. In 2009, the company contributed $1.5 billion. The shares jumped 27 percent that year and 21 percent in 2010. By 2011, the plan had cashed out.

But this time, Boeing’s valuation is much higher. With a price-earnings ratio of 23, the stock is more than three times as pricey as it was at the start of 2009. Given the nature of Boeing’s business, its earnings could be vulnerable to geopolitical shocks or an economic slowdown that saps demand for air travel.

What’s more, the longer its pension remains under water, the more expensive it becomes to maintain. The Pension Benefit Guaranty Corp., a government agency that acts as a backstop when plans fail, has tripled its rates for companies with funding deficits, and more increases are on the way.

There’s a limit to how long Boeing can put off underfunded liabilities. Over the next decade, the company expects to pay out about $46 billion to retirees.
In June, I covered how GE botched its pension math. Last month, I covered America's corporate pension disaster.

Just when I thought I can't read anything else that shocks me, this little gem of an article appears over the weekend.

Let me begin by stating while Boeing (BA) is a great company and part of the Dow, this is a stupid and highly irresponsible idea. Not only does it violate the prudent investor rule, it makes you question whether Boeing's senior managers are utterly clueless when it comes to managing their pension plan in the best interest of all their stakeholders.

Please indulge me for a minute. Have a look at the 10-year weekly chart of Boeing (BA) below (click on image):


No doubt, following that big dip in 2008, Boeing's shares have surged to record highs, and the company did a good move funding its pension with shares in 2009, even if it was equally irresponsible.

But if Boeing's senior managers and all those genius analysts on Wall Street think shares are going to continue marching higher at a time when deflation threatens the US and global economy, they're in for a rude awakening.

Importantly, and let be crystal clear here, now is not the time to load up on Boeing shares or the shares of Industrials (XLI) which have done extremely well since 2009 led by Boeing (click on image):


Now is the time to take your profits and run and for speculators and short-sellers to start shorting the crap out of these companies.

I know, Boeing isn't married to this position, it can get out of it at any time, but if you ask me, it's a lazy and highly irresponsible way to allocate risk. Boeing should look at what HOOPP, OTPP and other large well-governed Canadian pensions are doing in terms of allocating risk intelligently across public and private markets all over the world.

I'm actually shocked Boeing's unions accept this mediocre handling of their pension plan. If you work at Boeing, make sure you're saving and diversifying away from your company. You don't want to end up like Enron and Nortel employees who suffered a massive haircut to their pension.

One by one, companies are breaking their pension promise. Will Boeing be next? Probably not but if they continue with this nonsense, even this giant will be breaking its pension promise.

More worrisome, it already shifted non-union workers to a defined-contribution plan and it will be a matter of time before it shifts all workers to a DC plan. And you know what I think about DC plans, they are terrible, shift retirement risk entirely onto employees and exacerbate pension poverty.

It's high time the United States of America adopts a single payer healthcare system like Canada and the rest of the civilized world has done and privatize and enhance Social Security for all workers, adopting the Canadian governance model to make sure it's done well.

Companies should solely focus on their core business; most of them (not all) are completely inept at managing pensions.

Below, Prime Minister Justin Trudeau dropped the gloves Monday in his fight with Boeing, saying the government won't do business with a company that he's accusing of attacking Canadian industry and trying to put aerospace employees out of work.

I disagree with our PM on many issues but I agree with him here and think Boeing's allegations relative to Bombardier are utterly ridiculous. Boeing can crush Bombardier like a little bug, it's a much bigger and better-managed company and doesn't need to resort to frivolous lawsuits.

As for its latest move on funding its pension, a year from now, you will all realize how right I was to call this Boeing's huge pension gaffe.

Tuesday, September 19, 2017

HOOPP's New CLO Risk Retention Vehicle?

Kirk Falconer of PE Hub reports, HOOPP partners with CIFC in new risk retention vehicle:
Healthcare of Ontario Pension Plan (HOOPP) has formed a strategic partnership with CIFC LLC, a U.S. private debt manager specializing in U.S. corporate and structured credit strategies. HOOPP has committed a “substantial” undisclosed amount to a new risk retention vehicle, CIFC CLO Strategic Partners II (CMOA II), which will purchase the majority equity positions of CIFC’s new issue collateralized loan obligations. CIFC has committed US$75 million. CMOA II is expected to support about US$7.5 billion of the firm’s incremental new issuance over the next several years. Toronto-based HOOPP oversees more than $70 billion in assets.

(Correction: It was previously reported that HOOPP committed US$75 million to CMOA II. The commitment was actually undisclosed.)

PRESS RELEASE

CIFC Partners with Healthcare of Ontario Pension Plan to Form New Risk Retention Vehicle

Healthcare of Ontario Pension Plan Commits to CIFC CLO Strategic Partners II

September 14, 2017

NEW YORK–(BUSINESS WIRE)–CIFC LLC (“CIFC” or the “Firm”), a U.S. private debt investment manager specializing in U.S. corporate and structured credit strategies, today announced that it has entered into a strategic partnership with the Healthcare of Ontario Pension Plan (“HOOPP”) to form CIFC CLO Strategic Partners II, a new capitalized manager-owned affiliate of CIFC (“CMOA II”). CMOA II intends to purchase the majority equity positions of CIFC’s future, new issue Collateralized Loan Obligations (CLOs) to comply with U.S. and E.U. risk retention rules.

Under the terms of the partnership, HOOPP has made a substantial, single external investor commitment to CMOA II, with CIFC committing up to $75 million. CIFC has issued a total of $2.9 billion in new CLOs, making the Firm the largest issuer by assets this year. CMOA II is expected to support approximately $7.5 billion of CIFC’s incremental new issuance over the next several years.

Oliver Wriedt, Co-CEO of CIFC, said, “We are thrilled to partner with HOOPP, a well-recognized thought leader within the Canadian pension fund community and a long-standing, active participant in the CLO market. We are pleased that HOOPP has chosen CIFC to help it gain access to the new issue CLO opportunities that lie ahead and look forward to a mutually beneficial strategic relationship for years to come.”

David Long, Senior Vice President and CIO of HOOPP, added, “CIFC has a strong and consistent track record, making the Firm our choice with whom to partner to access new issue CLO opportunities. As we embark on this partnership, we look forward to leveraging CIFC’s deep expertise as one of the top CLO managers in the world.”

About CIFC

Founded in 2005, CIFC is a private debt manager specializing in U.S. corporate and structured credit strategies. Headquartered in New York and serving institutional investors globally, CIFC is an SEC registered investment manager and one of the largest managers of senior secured corporate credit in the United States. As of August 31, 2017, CIFC has $15.7 billion in assets under management. For more information, please visit CIFC’s website at www.cifc.com.

About HOOPP

With more than $70 billion in assets, HOOPP is one of the largest DB pension plans in Ontario, and in Canada. Our proven strategy and track record of investment returns drive our plan performance, making HOOPP a leader among its global peers. HOOPP is fully funded which means it has more than enough assets to pay pension benefits owed to members today, and in the future. HOOPP is a defined benefit pension plan that is dedicated to providing a secure retirement income to more than 321,000 workers in Ontario’s healthcare sector. More than 500 employers across the province offer HOOPP to their employees. For more information, please visit HOOPP’s website at www.hoopp.com.
Last week, I contacted HOOPP's President and CEO, Jim Keohane, to ask him about this deal. Jim told me to talk to David Long, HOOPP's Senior Vice President & Chief Investment Officer, ALM, Derivatives & Fixed Income.

David and I spoke on Monday and went over this deal. First, let me thank him for taking the time to talk to me. David handles most of the investment decisions in Public Markets and his colleague, Jeff Wendling, Senior Vice President & Chief Investment Officer, Equity Investment, oversees HOOPP's Public and Private Equities and Real Estate investments (you can read all about HOOPP's executive team here).

Let me begin by referring you to a Guggenheim paper David sent me as a background, Understanding Collateralized Loan Obligations (CLOs). You can downliad the PDF version here.

The two critical points are the following:
  • Collateralized loan obligations have many investor-friendly structural features, a history of strong credit performance, and characteristics that seek to provide protection in a rising interest-rate environment
  • Historically, CLOs have experienced fewer defaults than corporate bonds of the same rating, a testament to the strength and diversity of the underlying bank loan collateral
Take the time to read the entire paper here as it provides you with a great background to this post. You will learn what CLOs are all about and why they have important characteristics that offer investors great risk/ reward opportunities not found in traditional credit markets.

Let me also begin with a definition of a CDO and CLO from Pluris:
Collateralized Debt Obligations (CDO) were first issued in 1987 to allow investors the opportunity to invest in the underlying collateral indirectly. The underlying collateral assets and securities are typically comprised of various loans or debt instruments and financed by issuing multiple classes of debt and equity. CDOs either have a static structure or an active structure that is managed by a portfolio manager. With a static deal, investors can assess the various tranches within the CDO. With an active deal, a portfolio manager will actively manage the CDO by reinvesting the cash flow by buying and selling the assets. Portfolio managers perform coverage tests for the protection to the note holders and an event of default may be triggered if collateral values fall too low.

CLO, also known as Collateralized Loan Obligation, is a special purpose vehicle (SPV) with securitization payments in the form of different tranches. Financial institutions back this security with receivables from loan portfolios. CLOs allow banks to reduce regulatory capital requirements by selling large portions of their commercial loan portfolios to international markets, reducing the risks associated with lending.

CDOs and CLOs are similar in structure to a Collateralized Mortgage Obligation (CMO) or Collateralized Bond Obligation (CBO).
Anyway, David is super sharp and he explained to me that HOOPP committed a substantial amount (think he said $300 million or he used it as an example) to invest in the first loss tranche of CIFC's future CLO deals.

Now, I'm going to refer you to this Nomura paper, Tranching Credit Risk, which examines the different tranches in a collateralized debt obligation (CDO). Keep in mind, CDOs are sometimes classified by their underlying debt. Collateralized loan obligations (CLOs) are CDOs based on bank loans, which is what we are discussing here.

Different tranches within a deal's capital structure present different degrees of risk and have differing performance characteristics. What is important to remember is the first loss equity tranche has the most risk and the most reward. More senior tranches are less sensitive to changing the level of assumed recovery rate.

Some pension funds are not able to invest in the first tranche because their investment policy doesn't allow them to invest in low-rated tranches, which is why they typically invest in higher, more secure tranches with high credit ratings (and less yield).

This isn't the case for HOOPP. David explained they actually like the first loss equity tranche and are comfortable with this investment citing three reasons:
  1. Senior secured loans are very attractive relative to other assets in the current market environment where credit spreads are at historic lows. Since these loans are the basis of this investment, they offer a better risk-reward option.
  2. Opportunity for HOOPP to engage in a strategic partnership with CIFC in a 'risk retention vehicle' where HOOPP is the sole partner (segregated account). This allows us to achieve an attractive price and scale of investment with a top-notch CLO manager.
  3. CLO equity tranche has a unique set of attributes different from the underlying portfolio of loans: Most importantly, the tranche allows an investor to access much of the income from a large loan portfolio but limits the downside risk to the amount invested.
David explained to me that following the 2008 subprime crisis, regulators forced CDO funds to take a big stake in their portfolio, effectively meaning they have a significant skin in the game so they have an incentive to carefully manage the risk in the debt instruments underlying their portfolio.

In this case, HOOPP gains access to a strategy that cannot be replicated in-house and CIFC gains a strategic long-term partner with extensive knowledge and experience. It is a segregated account which effectively means fees are negotiable and in the best interest of both parties.

Most importantly, David explained to me how this is a very effective way to allocate credit risk, giving me the following example:
"Let's say you have a $500 million loan portfolio managed by a CLO manager and you decide to invest $50 million in the first-loss equity tranche, you will receive the highest coupon and your downside risk is limited to the $50 million you put in. However, in order to gain the same return investing in corporate bonds or emerging market bonds, you need to allocate significantly more to generate the same return at a time when spreads are down at historic lows."
He added this:
"At HOOPP, we always worry about the risk of not generating enough return to meet out liabilities over the long run as well as the risk of negative returns in the short run. Our day-to-day operations consist of finding the best allocation of risk without necessarily increasing overall risk. Hypothetically, we can and likely will reduce our risk in other credit markets because of this deal."
Last week, I discussed how Canada's pension funds are levering up, stating the following on HOOPP:
Like Ontario Teachers', the Healthcare of Ontario Pension Plan (HOOPP) is no stranger to leverage. For quite some time, it has been using extensive repo operations to intelligently lever up its massive bond portfolio. Ontario Teachers' has been doing the exact same thing.

Jim told me once: "People think we are increasing risk by leveraging up but they don't understand there is more risk in a traditional 60/40 stock bond portfolio."
Basically, HOOPP leverages its extensive bond portfolio to do risk parity strategies in-house and it engages in a lot of arbitrage opportunities in-house (much like a multi-strategy hedge fund) to add value in the absolute return space.

[Note: Watch this BNN clip where KPA Advisory Services founder Keith Ambachtsheer discusses how the Healthcare of Ontario Pension Plan has a history of unconventional investment styles and risk management.]

David explained to me HOOPP does not invest in hedge funds for the simple reason that it cannot control risk and it can replicate a lot of the arbitrage strategies internally.

In this case, it has a strategic partnership with CIFC which will be actively managing a portfolio of bank loans and it has a big stake in the segregated fund. HOOPP is willing to pay for this service because it cannot replicate this attractive credit strategy in-house.

David told me he doesn't see CLOs as a separate asset class but part of an overall credit allocation. As I stated above, allocating to CLOs will mean reducing risk elsewhere in credit markets.

In terms of liquidity, he told me CLOs are a long maturity product (7-8 years) which made me ask him if part of the reason to invest was to gain a better match to HOOPP's long-dated liabilities. He told me he didn't think of it that way but to be sure, traditional credit markets have a much shorter duration.

On risks, take the time to read this Ares paper on investing in CLOs to understand key considerations and the risks of investing in these structured credit vehicles.

Lastly, I want to bring to your attention that HOOPP is launching a series of articles to deepen the conversation around retirement security and to bring awareness around the benefits of defined benefit (DB) pension plans. Please read the comment on why senior women are most at risk for pension poverty.

Let me end by thanking David Long for taking the time to explain this deal to me. If there is anything to change, I will edit this comment during the day (always refresh by clicking the big piggy bank image at the top of my blog).

Also worth reminding those of you who regularly read my comments to kindly donate/ subscribe as you simply wouldn't gain the insights you do without reading this blog. I thank those of you  who take the time to subscribe and/ or donate using PayPal on the right-hand side (view web version on your cell).

Below, Oliver Wriedt, CIFC Asset Management's co-chief executive officer, discusses the success story of the collateralized loan obligation (CLO) market with Bloomberg's Vonnie Quinn on "Bloomberg Markets" (May, 2017). This is an excellent discussion, listen to his insights.

Update: In a subsequent email, I asked David Long why CLOs provide protection in a rising-interest-rate environment, and whether they would under-perform traditional credit if deflation strikes America, and he responded:
They say that because the underlying loan portfolio is typically based on floating rates, e.g. a loan made at LIBOR + 4%.

Typically, CLO liabilities (the AAA, AA, etc. tranches) also bear a coupon of LIBOR +.

Because there is a smaller amount of CLO debt liabilities than loan portfolio value (at the beginning), a higher LIBOR will lead to a higher "residual" cash flow to the equity tranche.

At some point however, if the loan portfolio cash flow falls too far due to loan defaults, a higher LIBOR will lead to lower residual cash flow, hurting the equity tranche.

At a more macro level, a rising LIBOR (in the absence of offsetting effects like higher growth) will reduce borrowers' ability to make payments on their floating rate loans - thus tending to increase defaults and hurting every tranche potentially. The same effect would be felt in a floating rate (standard) loan portfolio.

Thus we can't be *overly* reliant on floating rate investments being "immune" to higher rates.

CLOs and floating rate loans will react differently from fixed rate bonds (or loans). In a falling rate scenario, the latter will generally perform better as the coupons will not fall as they will for floating rate products (floating rate loans and CLO tranches).

Since corporate loans frequently have “LIBOR floors”, typically at 1 or 1.5%, their coupons stop falling once LIBOR hits the floor. CLO debt liabilities typically do not have a LIBOR floor, so once LIBOR drops below about 1.5%, the residual cash flow to the CLO equity tranche increases as the payments made to the debt tranches decrease.
I thank David for sharing his wise insights with my readers.

Monday, September 18, 2017

US Pension Storms From Nowhere?

Over the weekend, John Mauldin wrote a comment, Pension Storm Warning (added emphasis is mine):
This time is different are the four most dangerous words any economist or money manager can utter. We learn new things and invent new technologies. Players come and go. But in the big picture, this time is usually not fundamentally different, because fallible humans are still in charge. (Ken Rogoff and Carmen Reinhart wrote an important book called This Time Is Different on the 260-odd times that governments have defaulted on their debts; and on each occasion, up until the moment of collapse, investors kept telling themselves “This time is different.” It never was.)

Nevertheless, I uttered those four words in last week’s letter. I stand by them, too. In the next 20 years, we’re going to see changes that humanity has never seen before, and in some cases never even imagined, and we’re going to have to change. I truly believe this. We have unleashed economic and technological forces we can observe but not entirely control.

I will defend this bold claim at greater length in my forthcoming book, The Age of Transformation.

Today we will zero in on one of those forces, which last week I called “the bubble in government promises,” which I think is arguably the biggest bubble in human history. Elected officials at all levels have promised workers they will receive pension benefits without taking the hard steps necessary to deliver on those promises. This situation will end badly and hurt many people. Unfortunately, massive snafus like this rarely hurt the politicians who made those overly optimistic promises, often years ago.

Earlier this year I called the pension mess “The Crisis We Can’t Muddle Through.” Reflecting since then, I think I was too optimistic. Simply waiting for the floodwaters to drop down to muddle-through depth won’t be enough. We face an entire new ocean, deeper and wider than we can ever cross unaided.

Storms from Nowhere?

This year marks the first time on record that two Category 4 hurricanes have struck the US mainland in the same year. Worse, Harvey and Irma landed directly on some of our most valuable and vulnerable coastal areas. So now, in addition to all the problems that existed a month ago, the US economy has to absorb cleanup and rebuilding costs for large parts of Texas and Florida, as well as our Puerto Rico and US Virgin Islands territories.

Now then, people who live in coastal areas know full well that hurricanes happen – they know the risk, just not which hurricane season might launch a devastating storm in their direction. In a note to me about Harvey, fellow Rice University graduate Gary Haubold (1980) noted just how flawed the city’s assumptions actually were regarding what constitutes adequate preparedness. He cited this excerpt from a recent Los Angeles Times article:
The storm was unprecedented, but the city has been deceiving itself for decades about its vulnerability to flooding, said Robert Bea, a member of the National Academy of Engineering and UC Berkeley emeritus civil engineering professor who has studied hurricane risks along the Gulf Coast.

The city’s flood system is supposed to protect the public from a 100-year storm, but Bea calls that “a 100-year lie” because it is based on a rainfall total of 13 inches in 24 hours.

“That has happened more than eight times in the last 27 years,” Bea said. “It is wrong on two counts. It isn’t accurate about the past risk and it doesn’t reflect what will happen in the next 100 years.” (Source)
Anybody who lives in Houston can tell you that 13 inches in 24 hours is not all that unusual. But how do Robert Bea’s points apply to today’s topic, public pensions? Both pension plan shortfalls and hurricanes are known risks for which state and local governments must prepare. And in both instances, too much optimism and too little preparation ultimately have devastating results.

Admittedly, public pension liabilities don’t come out of nowhere the way hurricanes seem to – we know exactly where they will strike. In many cases, we know approximately when they’ll strike, too. Yet we still let our elected officials make impossible-to-fulfill promises on our behalf. The rest of us are not so different from those who built beach homes and didn’t buy hurricane or storm surge insurance. We just face a different kind of storm.

Worse, we let our government officials use predictions about future returns that are every bit as unrealistic as calling a 13-inch rain in Houston a 100-year event. And while some of us have called pension officials out, they just keep telling lies – and probably will until we reach the breaking point.

Puerto Rico is a good example. The Commonwealth was already in deep debt before Irma blew in – $123 billion worth of it. There’s simply no way the island can repay such a massive debt. Creditors can fight in the courts, but in the end you can’t squeeze money out of plantains or pineapples. Not enough money, anyway. Now add Irma damages, and the creditors have even less hope of recovering their principal, let alone interest.

Puerto Rico is presently in a new form of bankruptcy that Congress authorized last year. Court proceedings will probably drag on for years, but the final outcome isn’t in doubt. Creditors will get some scraps – at best perhaps $0.30 on the dollar, my sources say – and then move on. We’re going to find out how strong those credit insurance guarantees really are.

“That’s just Puerto Rico,” you may say if you’re a US citizen in one of the 50 states. Be very careful. Your state is probably not so much better off. In 10 years, your state may well be in the same place where Puerto Rico is now. I’d say the odds are better than even.

Are your elected leaders doing anything about this huge issue, or even talking about it? Probably not.

As it stands now, states can’t declare bankruptcy in federal courts. Letting them do so would raises thorny constitutional issues. So maybe we’ll have to call it something else, but it’s going to end the same way. Your state’s public-sector retirees will not get what they were promised, and they won’t take the outcome kindly.

Blood from Turnips

Public sector bankruptcy, up to and including state-level bankruptcy, is fundamentally different from corporate bankruptcy in ways that many people haven’t considered. The pension crisis will likely expose those differences as deadly to creditors and retirees.

Say a corporation goes bankrupt. A court will take all its assets and decide how to divvy them up. The assets are easy to identify: buildings, land, intellectual property, cash, etc. The parties may argue over their value, but everyone knows what the assets are. They won’t walk away.

Not so in a public bankruptcy. The primary asset of a city, county, or state is future tax revenue from households and businesses within its boundaries. The taxpayers can walk away. Even without moving, they can bypass sales taxes by shopping elsewhere. If property taxes are too high, they can sell and move. When they take a loss on the sale, the new owner will have established a property value that yields the city far less revenue than it used to receive.

Cities and states don’t have the ability to shed their pension liabilities. They are stuck with them, even as population and property values change.

We may soon see an example of this in Houston. Here in Texas, our property taxes are very high because we have no income tax. Your tax is a percentage of your home’s taxable value. So people argue to appraisal boards that their homes are falling apart and not worth anything like the appraised value. (Then they argue the opposite when it’s time to sell the home.)

About 200 entities in Harris County can charge taxes. That includes governments from Houston to Baytown to Hedwig Village, plus 20 independent school districts.

There’s a hospital district, port authority, several college districts, the flood control district, a multitude of utility districts, and the Harris County Department of Education. Some homes may fall within 10 or more jurisdictions.

What about those thousands of flooded homes in and around Houston; how much are they worth? Right now, I’d say their value is zero in many cases. Maybe they will have some value if it’s possible to rebuild, but at the very least they ought to receive a sharp discount from the tax collector this year.

Considering how many destroyed or unlivable properties there are all over South Texas, I suspect cities and counties will lose billions in revenue even as their expenses rise. That’s a small version of what I expect as city and state pension systems all over the US finally face reality.

Here in Dallas I pay about 2.7% in property taxes. When I bought my home over four years ago, I checked our local pension and was told we were 100% funded. I even mentioned in my letter that I was rather surprised. Turns out they lied. Now, realistic assessments suggest they will have to double the municipal tax rate (yes, I said double) to be able to fund fire and police pension funds. Not a terribly popular thing to do. At some point, look for taxpayers to desert the most-indebted cities and states. Then what? I don’t know. Every solution I can imagine is ugly.

Promises from Air

Most public pension plans are not fully funded. Earlier this year in “Disappearing Pensions” I shared this chart from my good friend Danielle DiMartino Booth (click on image):


Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade. You read that right – not doubled, tripled or quadrupled: quintupled. That’s nice when it happens on a slot machine, not so nice when it’s money you owe.

You will also notice in the chart that much of that change happened in 2008. Why was that? That’s when the Fed took interest rates down to nearly zero, meaning it suddenly took more cash to fund future payments. Also, some strapped localities conserved cash by promising public workers more generous pension benefits in lieu of pay raises.

According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs. And that estimate is based on the aggressive assumptions of pension funds that they will get their predicted rate of returns (the “discount rate”).

Kentucky, for instance, has unfunded pension liabilities of $40 billion or more. This month the state budget director notified local governments that pension costs could jump 50-60% next year. That’s due to a proposed reduction in the system’s assumed rate of return from 7.5% to 6.25% – a step in the right direction but not nearly enough.

Think about this as an investor. Do you know a way to guarantee yourself even 6.25% average annual returns for the next 10–20 years? Of course you don’t. Yes, some strategies have a good shot at doing it, but there’s no guarantee.

And if you believe Jeremy Grantham’s seven-year forecasts (I do: His 2009 growth forecast was spot on), then those pension funds have very little hope of getting their average 7% predicted rate of return, at least for the next seven years.


Now, here is the truth about pension liabilities. Let’s assume you have $1 billion in funding today. If you assume a 7% compound return – about the average for most pension funds – then that means in 30 years that $1 billion will have grown to $8 billion (approximately). Now, what if it’s a 4% return? Using the Rule of 72, the $1 billion grows to around $3.5 billion, or less than half the future assets in 30 years if you assume 7%.

Remember that every dollar that is not funded today means that somewhere between four dollars and eight dollars will not be there in 30 years when somebody who is on a pension is expecting to get it. Worse, without proper funding, as the fund starts going negative, the funding ratio actually gets worse, sending it into a death spiral. The only way to bring it out of the spiral is with huge cuts to other needed services or with massive tax cuts to pension benefits.

The State of Kentucky’s unusually frank report regarding the state’s public pension liability sums up that state’s plight in one chart (click on image):


The news for Kentucky retirees is quite dire, especially considering what returns on investments are realistically likely to be. But there’s a make or break point somewhere. What if pension plans must either hit that 6% average annual return for 2018–2028 or declare bankruptcy and lose it all?

That’s a much greater problem, and it’s a rough equivalent of what state pension trustees have to do. Failing to generate the target returns doesn’t reduce the liability. It just means taxpayers must make up the difference.

But wait, it gets worse. The graph we showed earlier stated that unfunded pension liabilities for state and local governments was $2 trillion. But that assumes an average 7% compound return. What if we assume 4% compound returns? Now the admitted unfunded pension liability is $4 trillion. But what if we have a recession and the stock market goes down by the past average of more than 40%? Now you have an unfunded liability in the range of $7–8 trillion.


We throw the words a trillion dollars around, not realizing how much that actually is. Combined state and local revenues for the US total around $2.6 trillion. Following the next recession (whenever that is), the unfunded pension liabilities for state and local governments will be roughly three times the revenue they are collecting today, and that’s before a recession reduces their revenues. Can you see the taxpayer stuck between a rock and a hard place? Two immovable objects meeting? The math just doesn’t work.

Pension trustees don’t face personal liability. They’re literally playing with someone else’s money. Some try very hard to be realistic and cautious. Others don’t. But even the most diligent can’t control when the next recession comes, or when the stock market will crash, leaving a gaping hole in their assets while liabilities keep right on rising.

I have had meetings with trustees of various government pensions. Many of them want to assume a more realistic discount rate, but the politicians in their state literally refuse to allow them to assume a reasonable discount rate, because owning up to reality would require them to increase their current pension funding dramatically. So they kick the can down the road.

Intentionally or not, state and local officials all over the US made pension promises that future officials can’t possibly keep. Many will be out of office when the bill comes due, protected from liability by sovereign immunity.

We are starting to see cities filing for bankruptcy. That small ripple will be a tsunami within 7–10 years.

But wait, it gets still worse. (Do you see a trend here?) Many state and local governments have actually 100% funded their pension plans. Some states and local governments have even overfunded them – assuming they get their projected returns. What that really means is that the unfunded liabilities are more concentrated, and they show up in unlikely places. You think Texas is doing well? Look at some of our cities and weep. Look, too, at other seemingly semi-prosperous cities all over the country. Do you think the suburbs of Dallas will want to see their taxes increased to help out the city? If you do, I may have a bridge to sell you – unless you would rather have oceanfront properties in Arizona.

This issue is going to set neighbor against neighbor and retirees against taxpayers. It will become one of the most heated battles of my lifetime. It will make the Trump-Clinton campaigns look like a school kids’ tiddlywinks smackdown.

I was heavily involved in politics at both the national and local levels in the 80s and 90s and much of the 2000s. Trust me, local politics is far nastier and more vicious. And there is nothing more local than police and firefighters and teachers seeing their pensions cut because the money isn’t there. Tax increases of up to 100% are going to become commonplace. But even these new revenues won’t be enough… because we will be acting with too little, too late.

This is the core problem. Our political system gives some people incentives to make unrealistic promises while also absolving them of liability for doing so. It also places the costs of those must-break promises on innocent parties, i.e. the retirees who did their jobs and rightly expect the compensation they were told they would receive.

So at its heart the pension crisis is really not a financial problem. It’s a moral and ethical problem of making and breaking promises that profoundly impact people’s lives. Our culture puts a high value on integrity: doing what you said you would do.

We take a job because the compensation package includes x, y and z. Then someone says no, we can’t give you z, so quit and go elsewhere.

The pension problem is going to get worse as more and more retirees get stuck with broken promises, and as taxpayers get handed higher and higher bills. These are irreconcilable demands in many cases. It’s not possible to keep contradictory promises.

What’s the endgame? I think much of the US will end up like Puerto Rico. But the hardship map will be more random than you can possibly imagine. Some sort of authority – whether bankruptcy courts or something else – will have to seize pension assets and figure out who gets hurt and how much. Some courts in some states will require taxes to go up. But courts don’t have taxing authority, so they can only require cities to pay, but with what money and from whom?

In many states we literally don’t have the laws and courts in place with authority to deal with this. And just try passing a law that allows for states or cities to file bankruptcy in order to get out of their pension obligations.

The struggle will get ugly, and innocent people on both sides will be hurt. We hear stories about retired police chiefs and teachers with lifetime six-digit pensions and so on. Those aberrations (if you look at the national salary picture) are a problem, but the more distressing cases are the firefighters, teachers, police officers, or humble civil servants who served the public for decades, never making much money but looking forward to a somewhat comfortable retirement. How do you tell these people that they can’t have a livable pension? We will see many human tragedies.

On the other side will be homeowners and small business owners, already struggling in a changing economy and then being told their taxes will double. This may actually happen in Dallas; and if it does, we won’t be alone for long.

The website Pension Tsunami posts scores of articles, written all across America, about pension problems. We find out today that in places like New York and Chicago and Cook County, pension funds have more retirees collecting than workers paying into the fund. There are more retired cops in New York and Chicago than there are working cops. And the numbers of retirees just keep growing. On an individual basis, it is smart for the Chicago police officer to retire as early possible, locking in benefits, go on to another job that offers more retirement benefits, and round out a career by working at least three years at a private job that qualifies the officer for Social Security. Many police and fire pensions are based on the last three years of income; so in the last three years before they retire, these diligent public servants work enormous amounts of overtime, increasing their annual pay and thus their final pension payouts.

As I’ve said, this is the crisis we can’t muddle through. While the federal government (and I realize this is economic heresy) can print money if it has to, state and local governments can’t print. They actually have to tax to pay their bills. It’s the law. It’s also an arrangement with real potential to cause political and social upheaval that Americans have not seen in decades. The storm is only beginning. Think Hurricane Harvey on steroids, but all over America. Of all the intractable economic problems I see in the future (and I have a vivid imagination), this is the most daunting.
Hello! Welcome to Pension Pulse Brother Mauldin! Where have you been since June 2008 when I started providing daily coverage on pensions and investments, forewarning the world about a global pension crisis in the making? At least you did mention the great work Jack Dean has done on his site, Pension Tsunami, chronicling America's pension disaster.

I met John Mauldin over six years ago (or longer) right here in Montreal when he was in town for a conference and visiting his friend Martin Barnes of BCA Research.

We met at the bar at Sofitel hotel on Sherbrooke right across BCA's office. John came down to meet me wearing his jogging pants and a sleeveless very old T-shirt with a Ronald Reagan imprint "One for the Gipper". He was getting ready to work out so we chatted for a bit.

Back then, he was into hedge funds, providing alpha solutions to his clients. He's an interesting character, a red-blooded Republican Texan who loves markets, is a prolific author and covers a lot of market and economic topics.

He also has a wide following and many subscribers. People tell me I should pursue the Mauldin model to get properly compensated for the work I put into this blog but I have a philosophical problem charging people when I want to educate them first and foremost about pensions AND markets.

Thankfully, I have some very big and important institutional subscribers who value and support my efforts but it's not enough. At one point, I have to make a decision, keep writing on pensions and investments, or just focus all my attention on analyzing markets and trading stocks which is by far my biggest passion of all (I can do both but it's a lot of work).

Anyway, I'm glad John Mauldin has brought America's looming pension crisis to the attention of his million plus readers. Zero Hedge also reprinted this comment on its site and I think it's crucially important we have an open and honest debate on this issue now even if I feel it's already too late.

I have been covering America's public and private pension crisis for a long time. It's a disaster and John is right, it's only going to get worse and a lot of innocent public-sector workers and retirees and private-sector businesses are going to get hurt in the process.

But it's even worse than even John can imagine. With global deflation headed to the US, when the pension storm cometh, it will wreak havoc on public and private pensions for a decade or longer. At that point, it won't just be companies breaking the pension promise, everyone will be at risk.

Importantly, if my worst fears materialize, this isn't going to be like the 2008 crisis where you follow Warren Buffett who bought preferred shares of Goldman Sachs and Bank of America at the bottom, and everything comes roaring back to new highs in subsequent years.

When the next crisis hits, it will be Chinese water torture for years, a bear market even worse than 1973-74, one that will potentially drag on a lot longer than we can imagine.

This will be the death knell for many chronically underfunded US public and private pensions for two reasons:
  1. First, and most importantly, rates will plunge to new secular lows and remain ultra-low for years. Because the duration of pension liabilities is much bigger than the duration of assets, any decline in rates will disproportionately hurt pensions, especially chronically underfunded pensions.
  2. Second, a prolonged bear market will strike public and private assets too. Not only are pensions going to see pension deficits soar as rates plunge to new secular lows, they will see their assets shrink, a perfect double-whammy storm for pensions. 
No doubt, some pensions will be hit much harder than others, but all pensions will be hit.

This brings me to another point, how will policymakers address this crisis when it really hits them hard and they can't ignore it because pension costs overwhelm public budgets?

Well, Kentucky's public pensions may be finished but I am truly disheartened by the moronic, knee-jerk response. Tom Loftus of courier-journal reports, Kentucky pension crisis: Are 401(k) plans the solution?. I note the following passage:
Keith Brainard, research director for the National Association of State Retirement Administrators, said risk doesn't disappear under a 401(k) plan.

"These proposals shift that risk from the state and its public employers and taxpayers and put it all on the workers. In fact, there’s going to be more risk because they are no longer in a group that can manage the risk much better," he said.

Whether the moves actually will save the state money is a question being hotly debated.

Jason Bailey, executive director of the Kentucky Center for Economic Policy, of Berea, said, “Moving employees into 401(k)-type plans is actually more expensive … and harms retirees while making it much more difficult to attract and retain a skilled workforce.”
I will keep hammering the point that moving public sector employees to a 401(k) plan shifts retirement risk entirely onto employees, leaves them exposed to the vagaries of public markets, and ultimately many of them will succumb to pension poverty just like private sector employees with DC plans. Moreover, the long-term effects to the state of Kentucky are not good, they will raise social welfare costs and cut economic growth as more people retire with little to no savings.

Another point I need to make to the John Mauldins of this world, the pension crisis is deflationary. Period. I don't care if it's DB or DC pensions, a retirement crisis putting millions at risk for pension poverty will exacerbate rising inequality and necessarily impact aggregate demand and government revenues (collect less sales taxes).

Don't get me wrong, the US has a whole host of problems with their large public DB plans, and chief among them is lack of proper governance. Sure, states aren't topping them up, pensions still use rosy investment assumptions to discount future liabilities, but the biggest problem is government interference and their inability to attract and retain qualified investment staff to manage public and private assets internally.

Following my comment on CalPERS looking to outsource its private equity program to BlackRock, a former CalPERS' employee sent me this:
It's not as simple as compensation alone. You still need people to sign up. Lack of independence and bureaucracy in investment decision-making, reputation for being extremely slow in decision-making, the fact that there's one office in Sacramento and that will not be changing, the fact that Sacramento is a real stretch for anyone with a family living elsewhere, and don't forget the silly reporting on your personal life and myopic focus on expenses and gifts like coffee mugs and umbrellas. And flying economy on long-haul flights to do multi-billion dollar deals while paying thousands for free conferences. There are a lot of factors at play on why it's difficult for them to attract and retain people. Plus in certain areas like fixed income cronyism runs rampant.

All these factors deter highly sophisticated people from making the career risk. And the really good people that join end up staying for a limited time once they get the idea. So you're left with people who join to get a fat pension down the road. The sick thing about that level of high job security is it breeds mediocrity and also creates a false sense of loyalty. Loyalty is only good if a highly competitive culture can be maintained.
Whether or not you agree, there are a lot of statements there that are likely true. And CalPERS is one of the better large public pensions, imagine what is going on elsewhere.

On top of these issues, some decently-funded US pensions are getting hit with brutal changes to accounting rules. I recently discussed how this new math hit Minnesota's pensions but as other states adopt similar rules to discount future liabilities, get ready, they will get hit hard too.

This is why on top of good governance which separates public pensions from the government, I believe we need to introduce some form of risk-sharing in public pensions so when the plans do experience a deficit, contribution rates increase and/ or benefits are cut until the plan regains fully-funded status again.

In my recent conversation with Jim Leech on pensions and Canada's Infrastructure Bank, the former President and CEO of Ontario Teachers' shared this with me on how OTPP regained its fully-funded status:
Basically, there are two levers Ontario Teachers' Pension Plan uses when the plan goes into deficit to restore fully-funded status:
  • It partially or fully removes cost-of-living adjustments (conditional inflation protection) and
  • It raises the contribution rate from the base of 9% to an agreed upon rate (a special levy)
After the plan ran into deficits after the 2008 crisis, the contribution rate was increased to 13% and since it is a jointly sponsored plan, both teachers and the government needed to contribute this rate.

However, unlike 1997 where benefits were increased, now that the plan is fully-funded,  the new agreement is simply to restore full inflation protection and reduce the contribution rate back to the base case of 9% (can never go lower).

The key here is there are no increases in benefits, it's simply restoring full inflation protection and reducing the contribution rate going forward to the base rate of 9%.
Lastly, a dire warning to John Mauldin and residents of Dallas. All roads lead to Dallas. The great state of Texas will survive and rebuild after Hurricane Harvey but get ready for major increases in property taxes when the pension storm cometh and deflation hits the US.

And there will be no escape (to where? Illinois, New Jersey or Kentucky?!?). The pension storm will strike us when we least expect it and it will wreak havoc on the US and global economy for a very long time.

On that cheery Monday note, let me leave you with some more cheerful clips. First, the New York Times published a nice article over the weekend, False Peace for Markets?, profiling a young 38-year old trader, Christopher Cole who runs Artemis Capital, and is betting big that volatility won't stay at historic lows for long. Watch him below discussing Taking long road with volatility.

I've already covered the silence of the VIX in great detail and it's worth noting Mr. Cole could come out of this a hero or a big zero depending on when markets break down. Like I said in my last comment, it's not markets but Hugh Hendry that was wrong. Cole could be right, and I myself am cautious and defensive right now, but markets can stay irrational longer than you can stay solvent.

Second, OECD Economic and Development Review Committee Chairman William White discusses concerns he has about the economy. He speaks on "Bloomberg Markets: Middle East" and states he sees more dangers in the economy than in 2007. I'm afraid he's absolutely right, we have an insolvency problem that only governments, not central banks, can address properly (see Reuters article, BIS: Global debt may be understated by $13 trillion).

Lastly, Hoisington Investment Management's Lacy Hunt and CNBC's Rick Santelli discuss monetary tightening in an extremely over-leveraged economy. Excellent discussion, listen to his insights on why long bond yields are headed much lower (and pension deficits much higher).

All I know is while the timing of the next financial and economic crisis is a matter of debate, there is no debate the US and global pension crisis has already arrived. When it really hits us, you'll witness "fire and fury" unlike anything you've ever seen before.