Sunday, November 2, 2008

Pension Funds Need a Reality Check

The big story over the weekend was that Canada’s largest pension fund manager, the Caisse de dépôt et placement du Québec, said it is now following a more cautious investment strategy to cope with a squeeze on its returns because of the global financial crisis:
The fund said Friday it currently has enough cash to meet its commitments to depositors and business partners, and deposits will exceed withdrawals for many years.

But like all institutional investors, the pension fund has lost money on the stock market in recent months and said it must take a more cautious approach to its investments to preserve its financial health.

The Wall Street financial meltdown earlier this year has spilled around the world and battered stock and credit markets, intensifying fears of a global recession.

The Toronto Stock Exchange, for example, has lost 35 per cent of its value since a mid-June record high, a loss of more than $600 billion in stock value of the companies listed on the senior Canadian market.

"This uncertainty has prompted the Caisse to manage with strategies that emphasize caution, preservation of capital and risk reduction," said Richard Guay, president and chief executive of the fund, which manages the pensions of Quebec public sector employees.

At the end of 2007, the Caisse had net assets of more than $155 billion, with about 36 per cent invested in the stock market, approximately 29 per cent in bonds and currencies and around 35 per cent in private equity and real estate.

The proportion of investments in the stock market generally ranges between 40 per cent and 60 per cent among institutional investors, the Caisse said.

The stock market decline has increased the weighting of all the other asset classes so the Caisse said it’s becoming more rigorous in assessing and approving new private equity and real estate investments.

"We will come through this crisis as we have come through the other crises that have occurred in the history of the Caisse," Guay stated, recalling that, after the tech bubble burst in 2002, the fund’s net assets doubled to $155.4 billion from $77.7 billion. That reflected $63.1 billion in investment returns and $14.6 billion in new contributions from fund members.

Now, as I wrote in this blog when he was nominated back in September, Richard Guay was the best choice to lead the Caisse during these tough times.

The truth is that anyone who took over the reigns in the midst of this financial crisis will have a tough job ahead of them.

Prior to his nomination, Mr. Guay was the Executive Vice-President, Risk Management and Depositors’ Accounts Management at the Caisse, leaving him eminently qualified to lead the fund during these tough times.

However, I do think he is being too optimistic in his assessment of "coming through the crisis," but he needs to put a positive spin on the current situation given the political dimensions of the Caisse.

The structural nature of this crisis will take many years to work its way through the financial and economic system.

The other big story this weekend was that Finance Minister Jim Flaherty told Bloomberg television that Canada's government may double its purchases of distressed loans among steps being considered to aid banks and private pension funds:

``I had more discussions with the private sector about what they might have to do in terms of the capital requirements for their funds,'' Flaherty said, after an interview with Bloomberg Television. ``We took steps in 2006 to allow more time for capital infusion, so that is something we could possibly do again.''

Flaherty said he plans to raise the issue with his provincial counterparts when they meet in Toronto on Nov. 3.

He also plans to renew his push for a single securities regulator, replacing 13 provincial and territorial agencies. Provinces including Quebec and British Columbia oppose a national regulator.

``The circumstances emphasize the importance of doing this,'' he said. ``I sense some softening'' from the provinces because of the global financial crisis.

A single securities regulator is badly needed here in Canada where the current securities laws are woefully inadequate as highlighted by the ongoing ABCP fiasco where thousands of investors lost their life's savings and are still waiting to be compensated.

In a letter that appeared in Le Devoir over the weekend, Members of the Coalition for Protection of Investors, are now asking that the Bank of Canada provide liquidity support for pension funds that fell victim to this asset-backed paper just like they did for the banks to refinance their mortgage portfolio (to the tune of $25 billion).

In the United States, U.S. corporate pension funds are getting slammed by the stock market’s downturn, squeezing profits and prompting some employers to drop their pension plans or make other cuts to offset losses:

“We’re going to have a very bad year,” said Howard Silverblatt, an analyst with Standard & Poor’s, a financial research firm based in New York. “Companies are going to have to put significant amounts of money in [pension funds] this year.”

Silverblatt estimated that S&P 500 companies started the year with $63 billion more in pension assets than they needed to meet future payments. But after this year’s market debacle, Silverblatt said, they will probably end the year in worse shape than in 2002, when pensions were underfunded by $219 billion.

Another research firm, Milliman Inc., predicted the 100 largest pension plans sponsored by public companies in the United States would end the year with a $40 billion deficit, even if stocks are flat during the fourth quarter. That compares with the $101 billion surplus the plans enjoyed in 2007.

To stem the losses, some companies have decided to drop or scale back their traditional pension plans, which guarantee workers a fixed retirement income, in favor of 401(k) plans, where employees manage their own investments and face the risk of market downturns.

According to a survey this month by the consulting firm Watson Wyatt, 11 percent of 248 companies said they have frozen or closed pension plans as a result of the financial crisis and another 4 percent plan to do so in the next year. Companies aren’t allowed to revoke pensions that employees and retirees have already earned, but can “freeze” or halt the accrual of additional benefits.

And it's not only private corporate plans that are reeling from the turmoil in stock markets. U.S. public pension funds continue to struggle in this environment:

The Alaska Permanent Fund reported a 8.5 percent loss on its investment across all sectors at the end of September, with real estate the only asset class reporting any gain whatsoever.

The $29.5 billion pension fund, which manages income from the state’s oil and mineral resources, said public and private real estate investments overall returned 0.2 percent for the first quarter of the fiscal year, compared to losses in stocks, bonds and hedge funds.

“These certainly aren’t easy times,” said Michael Burns, chief executive officer, in a statement. “Our board sets an allocation for the long term, and accepts that volatility will come in the short term. Our job now is to hold to our long term plans, and not be tempted to change course in the middle of the storm.”

However, according to documents on the fund’s website, the pension is over-weighted in its allocations to private equity real estate by more than 2 percent. According to monthly performance returns as of the end of September, Alaska had committed 10.5 percent of its total assets to private equity real estate fund managers against a target of just 8 percent. It has a target allocation range of 3 percent.

The fund has relationships with CB Richard Ellis, Kennedy Associates, L&B Realty Advisors, LaSalle Investment Management, Sentinel Real Estate and Simpson Housing Limited Partnership. In the three months to September, private equity real estate returned 0.56 percent gains against 9.2 percent in the past year and 14.73 percent over the past five years.

The report went on to say the market value, as of the end of September, for the assets was $3.58 billion against a cost of $2.9 billion. Public real estate investments had decreased in value over the past year, the pension said, losing 15.4 percent in the past year alone.

Alaska’s sole private equity investment – with Pathway Capital Management – had increased slightly in value as of the end of September, with a market value of $795 million compared to an initial investment of $776.2 million.

Like other institutional investors, Alaska has suffered from the so-called denominator effect, whereby the plummeting value of an investor’s public equity programme causes its actual real estate allocation to rise as a percentage of the fund’s overall assets under management.

The Oregon Public Employees Retirement Fund, which has watched its actual allocation to real estate to the upper limits of its target range, said today it would also likely forgo any new relationships with its private equity managers in 2009 because of such concerns.

Amid all the reports of public pension funds losing money, some are now openly criticizing the big bonuses that these pension funds are paying their investment officers:

The turmoil on Wall Street has sucked billions of dollars out of Ohio public-pension systems, but many of the pension employees who are paid to invest retirees' money still will reap tens of thousands of dollars in bonuses.

This year, 10 investment officers for the State Teachers Retirement System pulled in bonuses of $200,000 or more, and two crossed the half-million mark in combined salaries and bonuses.

Thirteen investment officers for the teachers' pension could reach $500,000 in total pay next year under a bonus plan approved by the pension board, although many will fall short unless the market recovers.

While a depressed market will pinch the performance bonuses somewhat, it doesn't necessarily spell the end of six-figure jackpots for pension officers who oversee declining portfolios. A pension officer whose assets lose value -- but less value than average for a comparable portfolio -- still qualifies for a bonus, in some cases reaching into tens of thousands of dollars.

In all, the State Teachers Retirement System paid nearly $6 million in bonuses to 89 investment officers this year, most of whom have base salaries of $100,000 or more.

The pension fund affects 449,000 people, including about 180,000 active teachers, 140,000 retirees and 120,000 beneficiaries. Some retired teachers are fuming about the bonuses at a time when their pensions are bleeding value.

"When retirees are struggling to pay for groceries, there's so much insensitivity to see millions and millions of dollars going to pay for bonuses," said Molly Janczyk, a retired Columbus school teacher. "No one faults them for bonuses, but it kind of rubs salt in the wounds to see these kinds of bonuses during the economic downturn."

The bonuses have touched off a brush fire of criticism among members of a group called Concerned Ohio Retired Educators, which formed in late 2003 in response to perceived extravagances at the teachers' pension system.

A Web log run by a member of the activist group, retired Columbus teacher Kathie Bracy, has been abuzz with comments on the bonuses.

"Retirees think it's only fair that (investment officers) pull in their belts the way we all have to pull in our belts," Bracy said.

Unfortunately, both private and public pension fund investment officers in the U.S. and Canada are not pulling in their belts and some are just getting away with murder.

If you think the compensation in the U.S. is out of whack, wait until Canadian public pension funds report their results in 2009. Pay attention to the last pages of their annual reports where they report executive compensation. I guarantee you it will raise a few eyebrows.

This brings me to my final point which was addressed in this opinion letter in the Globe and Mail under the title, Pension-fund angst and anger:

At the end of an unprecedented 15-year boom in the markets, I have difficulty understanding how - even before the current financial meltdown - half the pension funds regulated by the Office of the Superintendent of Financial Institutions (OSFI) could have been in a "shortfall position," a quaint euphemism for having insufficient assets to cover their liabilities ('Disaster' Unless Ottawa Offers Pension Relief - front page, Oct. 29).

Since all bear markets come to an end, the failure to balance the books during the boom courted an inevitable disaster, as fund managers knowingly diverted pension contributions to general revenues, where they served to boost stock value and executive bonuses. That this was permitted by a loophole that allowed them a five-year grace period to make good on such shortfalls does not excuse it, although it does make the regulatory agencies complicit in this incomprehensible folly and short-sightedness.

Given the extent of the suffering that will now follow on these misjudgments, there ought to be less talk of bailouts and more focus on determining whether criminal prosecution for pension-fund embezzlement, which I always thought was a felony, is warranted.

Prosecuting pension fund managers or their Board of Directors will not bring back the billions that were lost in the last few months. Pension fund managers and their supervisors need to stop burying their heads in the sand, hoping that things will get better.

They have a fiduciary responsibility to make sure they are safeguarding the pension contributions of their depositors and it's high time they undertake a reality check and prepare for the worst in 2009, focusing on mitigating downside risks on all their investment activities.

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