Friday, October 31, 2008

Pension Funds Go Trick-or-Treating

How fitting, this Halloween, to see pension funds go on a buying spree:
World markets rose Friday amid stock buying from pension funds balancing their portfolios at the month's end and a general sense that share prices may have hit a bottom. Asian shares had earlier closed mostly lower.

The Dow Jones index of leading U.S. shares was up 88.72 points, or 1.0 percent, at 9,269.41 despite further dreadful U.S. economic data.

Britain's FTSE 100 index was 85.69 points, or 2.0 percent, higher at 4,377.34 despite a 19 percent plunge in the share price of telecommunications company BT PLC after it issued a profits warning.

Meanwhile, the CAC-40 in France was 79.25 points, or 2.3 percent, higher at 3,487.07. Germany's DAX saw the biggest gains, having underperformed the other indexes all week. It was 118.67 points, or 2.4 percent, higher at 4,987.97.

Concerns about the global economy were stoked further Friday after the Commerce Department said U.S. personal spending fell by 0.3 percent last month, the biggest decline since June 2004. Combined with flat readings in both July and August, it led to the worst quarterly performance in 28 years.

And the Chicago Purchasing Managers Index, a measure of manufacturing activity, fell to a reading of 37.8 -- much worse than the 48.0 figure that analysts anticipated. But the University of Michigan's consumer sentiment data came in at 57.6, slightly better than the 57.5 expected.

However, Wall Street's reaction to the data was minimal given the downturn had already been priced when it was revealed Thursday that the U.S. economy contracted by 0.3 percent in the third quarter of the year.

Trading is complicated Friday by the fact that it is the end of the month and many investors, particularly pension funds, are looking to rebalance their holdings among stock sectors and other investments such as bonds to fit their investment approach, after what has been one of the most volatile trading periods in modern times.

Despite the month-end technicalities, there is a general feeling that the wild swings in stock markets seen in recent weeks may have come to an end, for now at least.

"We have certainly had to endure quite a high degree of volatility this week but on balance equity markets look as though they want to form a base," said Neil Mackinnon, chief economist at ECU Group.

However, it may yet be too early to say that volatility and downtrend is over.

"Investor confidence is still cautions and it is difficult to say the bear market is entirely over," said Mackinnon.

One reason stock markets have steadied somewhat this week is that central banks are cutting interest rates swiftly.

Most notably the U.S. Federal Reserve reduced its benchmark Fed funds rate by a half percentage point to 1.00 percent and the Bank of Japan lowered its main rate by 0.20 percentage points to 0.30 percent, its first cut in seven years.

The Bank's rate cut did little for Japanese shares though. The Nikkei index sank 5 percent to 8,576.98 amid persistent worries about earnings.

There are two months left in 2008 for pension funds to make up for some of the losses they suffered this year as equity markets got trounced.

Joining pension funds in this buying spree will be mutual funds and hedge funds. It will be a buying frenzy as they all try to make up lost ground, so in the short-run, BUY THE DIPS!

However, not everyone is sold on the idea of "stocks for the long-run".

In an interesting article, Terence Corcoran of the National Post openly questioned whether pension funds should be gambling on stocks:

The theory that equities provide superior long-term returns has been more or less demolished by some of the best minds in financial economics. In a major run at this subject in 2003, FP Comment presented the views of several debunkers of the equity myth, including Nobel winner Robert C. Merton, New York actuary Jeremy Gold and Boston University economist Zvi Bodie.

They concluded, based on unassailable economic logic, that pension funds which invest in equities are engaging in risky investment strategies that cannot be depended on over the long term.

Should pension funds, corporate or public, invest in equities? No, they contend. As Jeremy Gold said then: “Defined-benefit [pension plans] destroy value by investing in equities.” The main reason is that, over the long term, equities are risky and offer no certainty of return.

The pension industry acknowledged part of that message in recent years, when plans reduced their expectations of annual returns from equities. Where they used to run their pension models on the idea that equities would produce real returns of 6.5% above the consumer price index — implying nominal gains of more than 10% — more realistic returns of 8% and less are now common.

But even those new lower expectations will have to be lowered again in the wake of the latest collapse in equities. The application of market economics to the pension industry may take a little more time, but it eventually will force all participants to face up to the fact that the current non-market-based accounting and actuarial methods are a risky fantasy.

On the investment side, pension plans cover over their funding shortfalls first by assuming future returns on equities that, while possible, are not guaranteed. The assumption makes funds look healthier than they are, and drives their investments deeper into the stock market.

Mr. Gold, in a 2006 paper, said this business of “anticipating equity risk premia before the risks are weathered,” has a perverse impact. “The effect of swapping debt for equities within tax-sheltered pension plans generally destroys shareholder value.” When the equities fail to produce anticipated returns, pension funds face major shortfalls.

Another asset binge may also soon face mark-to-market tests. Pension funds have been sending more and more money off to Brazilian water systems, private corporate plays and real estate; returns on these private ventures are supposed to be higher than public market investments. When reports on this year’s pension fund performances land, how many of the funds will mark these non-market investments down by amounts that are comparable to the meltdown in market investments?

An even bigger uncertainty sits on the liability side of the pension balance sheet. If the true market value of payouts is accounted for, the funding gaps can be just as large and dangerous. In a joint paper earlier this year (The Case for Marking Public Pension Liabilities to Market), Mr. Gold argued government-backed pension funds should begin giving taxpayers and beneficiaries accurate market values of their looming pension liabilities.

No U.S. or Canadian pension plans, with the exception of the New York City Employees Retirement System, mark their liabilities to market. The New York plan found a $10-billion gap between the actuarial accrued liabilities and the market value of the same liabilities.

All defined benefit plans should mark their benefits to market, says Mr. Gold. Resistance to this idea comes in part because such calculations would increase volatility in costs. But such volatility is real: “The cost of providing benefits when market interest rates are 4% is significantly greater than when rates are 12%.”

Mr. Gold, and his co-author (Merrill Lynch research analyst Gordon Latter), called upon “actuaries to compute and upon accountants, plan administrators and elected officials to disclose market values for public pension liabilities.”

The failure of Canadian and U.S. pension plans, corporate and public, to remove the equity risk from their funds and to mark their liabilities to market, suggests the hidden risks in the pension industry are much greater than even the current crisis suggests.

The hidden risks in pension industry are scandalous. If you only knew a tenth of what I know is going on in some of the large public pension funds, it would leave you flabbergasted.

But the music will stop and all pension funds will once again face the ghosts that haunted them this year in 2009. The only thing that I am wondering is how many of them will be left holding the bag.

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