Wednesday, November 5, 2008

On Fixing Broken Pensions


Stocks plunged today as traders sold the news of an Obama victory. I wouldn't get too worried, however, because the 5-day chart of the Dow Jones Industrial Average tells me they are retesting the 9,000 level before they bring it back up again.

By "they" I mean hedge funds, pension funds, and mutual funds that so desperately need some year-end rally to make up some percentage of the huge losses they incurred from mid-September to mid-October.

My hunch is that they were buying the dips today.


In other news, Japanese pension funds plan to increase their investments in alternative assets while reducing domestic equities in their portfolios, to diversify after the subprime shock:

Pension funds also plan to increase allocations of domestic bonds to hedge against the risk of falling share prices, a survey by the Japanese asset management arm of third-biggest U.S. bank JP Morgan showed.

"Pension funds are more concerned about the risk of a drop in share prices rather than the risk of a rise in interest rates," Hidenori Suzuki, a vice president of JP Morgan Asset Management Japan, told reporters in a briefing on the survey.

"Pension funds are now at a turning point and they are looking to diversify especially as the market environment has changed after the subprime problems," Suzuki said.

The survey showed that 69.7 percent of the 72 respondents indicated that they will cut equity allocations mainly in domestic shares, while 51.5 percent were planning to shift into alternative assets such as hedge funds and private equity.

Nearly half of the respondents held assets of more than 100 billion yen ($1 billion).

The survey was conducted between June and early October.

Pension funds' allocation plans for foreign equities were nearly balanced, with 33.3 percent of the respondents saying they will cut their allocations, while 27.3 percent said they will increase them.

The survey showed Japanese pension funds' investments in alternative assets were concentrated in absolute return products, such as funds of funds. The participation rate in absolute return products was 79 percent in Japan, sharply higher than 59 percent in the United States and 42 percent in Europe.

Private equity and real estate related instruments have not been commonly accepted in Japan, while they are more common in the United States and Europe, the survey showed.

Cash-rich Japanese pensions, however, are showing interest in allocating into alternative asset instruments linked to real estate, private equity, infrastructure and commodities, the survey showed.
My advice to these Japanese pension funds is to wait before they take the plunge, especially into real estate.

The same goes for hedge funds that are limiting withdrawals as illiquidity bites:

Mellon Global Alternative Investments suspended valuations on its Sanctuary and Sanctuary II funds.

Jamie Brookes, global head of asset management communications at Mellon, said: "The accumulation of exceptional market events has led to widespread, indiscriminate selling and unprecedented volatility of most financial investments. A number of the underlying hedge funds have invoked provisions that are intended for periods such as this where acute market illiquidity is coupled with extreme selling pressure."

Interestingly, citing illiquidity and extreme market volatility, hedge funds are returning to mark-to-model valuations of their portfolios:

James De Bono, managing director at Duff & Phelps, London, which helps hedge funds and banks value assets, told Reuters in an interview that funds are moving to marking to model because in illiquid markets the range of broker prices can be too wide to be very meaningful.

The valuation of hedge funds' holdings has become an increasingly important issue as liquidity dries up for some assets markets while hedge funds themselves face redemption pressures.

"Given there are less market prices within certain markets for certain products, we've moved onto marking to model ... Previously the effort was more to getting a market price," de Bono said.

"If there are prices, it should help you in calibrating that model."

When I hear words like "calibrating", I get really nervous. It reminds me of what my honors econometrics professor once told us a long time ago: "when in doubt, use sophisticated terminology and words like 'calibrate'. As long as you sound sophisticated, nobody will question you."

I still remember my favorite econometrics article written by Edward Leamer, Let's Take the Con out of Econometrics.

I now write every night so we can take the con out of hedge funds, private quity, real estate, commodities and all sorts of other pension investments that were misused and abused over the last few years under the guise of "alpha".

Finally, if you did not read it, Keith Ambachtsheer opined on Terence Corcoran's article in last Friday's Financial Post editorial entitled "Pension funds still gambling on stocks."

In his response, How to fix pension plans, Mr. Ambachtsheer writes:

So how do we solve the traditional DB and DC pension design problems that the recent stock market crash have made glaringly obvious? The answer is surprisingly simple. We must move beyond the current "either DB or DC" mindset to a more creative, integrative "best of both" mindset. We need a new pension design that permits younger workers with many years of retirement saving ahead of them to take equity risk in their personal pension accounts. These younger Canadians would be well-served if their pension savings were acquiring pieces of good companies, commercial real estate and infrastructure projects today at what are likely to be bargain prices.

At the same time, this new pension plan design must also recognize that older workers and pensioners need a steady stream of reliable pension payments that will continue as long as they live. Can the differing needs of younger and older workers be met under the roof of a single pension plan? And can we build institutions that can convert these needs in a manner that is expert and low-cost at the same time? The answer is a resounding yes.


The widely accepted theories of life-cycle personal finance, and of integrative investment intermediation, create a solid theoretical foundation. Their practical validity has been confirmed through empirical research, and their implementation in the Netherlands and Australia have made them the top two pension countries in the world. Even in North America the giant U. S. college pension system TIAA-CREF, and Saskatchewan's much smaller Cooperative Superannuation Society Pension Plan have operated successfully on these principles for decades.


A final question. If we know how to design and operate sustainable 21st-century workplace pension plans in Canada, why haven't we done it already? Because knowing is not enough. There must also be a consensus that the traditional DB and DC pension models should be discarded, and that the time has come to move to a model that is superior in both theory and practice. Malcolm Gladwell has observed that such change requires a tipping point. The confluence of three events is now creating a Canadian pensions tipping point.

The first is the stock market crash which has sharply focused minds on the flaws of current pension arrangements. The second is the imminent arrival of the recommendations of pension reform commissions in Ontario, Alberta-BC and Nova Scotia. This sets the stage for a Canadian Pensions Summit in 2009. The third is the recent C. D. Howe Institute commentary, The Canada Supplementary Pension Plan: Towards an Adequate, Affordable Pension for All Canadians, which sets out the better pension model in detail, and shows how it could be implemented at the national level to cover all Canadian workers without a pension plan. The commentary also points out that the same better pension model could be implemented at the regional, industry or even individual employer levels. Is there a role for equity investing in this better model? Absolutely. But only by those willing and able to bear the risks involved.

Mr. Ambachtsheer's discussion warrants further consideration if we are going to get serious about public policy regarding pensions. In fact, the supplementary pension plan is gaining steam.

The current pension models are inadequate and threaten the financial security of millions of retired workers that rely on fixed revenues to survive. Surely we can do better than what we are delivering now.

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