Monday, November 24, 2008

Unlike Citi, Pension Funds Fell Asleep!


The markets were on fire today as Wall Street went on a buying spree after the U.S. government bailed out Citigroup:

Wall Street barreled higher Monday for the second straight session, this time in a relief rally over the government's plan to bail out Citigroup Inc. -- a move it hopes will help quiet some of the uncertainty hounding the financial sector and the overall economy. The Dow Jones industrials soared nearly 400 points and the major indexes all jumped more than 4.5 percent.

The advance gave the market its first two-day advance since Oct. 30-31. Although investors sensed last week that a rescue of Citigroup was forthcoming, investors nonetheless were heartened, even emboldened, by the U.S. government's decision late Sunday to invest $20 billion in Citigroup and guarantee $306 billion in risky assets.

Wall Street's enthusiasm surged not only because the bailout answered questions about Citigroup but also because many observers saw the move as offering as a model for how the government might carry out other bank stabilizations.

"This could be the template for saving the banks," said Scott Bleier, founder of market advisory service CreateCapital.com.

"The government has taken a new quill out, they've gone to where they didn't go before in terms of trying to secure the system," Bleier said. "Some of that vulnerability seems to be gone now."

Citi rescue did cause a stampede into stocks, but before you rejoice, I warn you, this rally is not the beginning of a new bull market. While I am a secular bull on the solar sector and a few others (biotech, infrastructure, companies like Priceline which will perform well in a deflationary environment), I am concerned that the economy will flounder for many years.

Listen to Peter Schiff to understand why the crisis is just beginning. Also, like Peter, some people think this rally is not going to last because a lot of people have to deleverage and sell into the upticks.

I am sticking with my vested interests theory which states that pension funds, mutual funds and hedge funds will keep bidding this market up going into year-end. But when it comes to short-term moves in stock markets, who knows what will happen next.

As far as long-term moves, I am still very concerned about a protracted, slow and grinding episode of debt deflation. President-elect Obama announced his economic dream team today and they have their work cut out for them.

As far as pensions are concerned, Citi's bailout buoyed BCE's stock as it increased the likelihood that the buyout will happen. But don't kid yourself, we still do not know all the clauses attached to Citi's bailout (like kill all pending private equity deals!).

There is a bigger issue than Citi brewing. Canadian newspapers are finally waking up to the fact that it is time to address pension issues:

In normal times, talk of pensions can end a conversation as eyes glaze over and ears tune out.

But we live in interesting, turbulent times. Pensions are now on the biggest roller coaster ride in recent memory in the wake of stock market plunges that have wiped billions of dollars from portfolios. Some pension plans have been badly underfunded since long before the crash. And for two out of three Ontario workers, talk of pensions is just talk – because they lack access to an employer pension plan.

Now, those severe economic challenges offer an opportunity to start a new conversation on pensions.

When the Ontario government set up an Expert Commission on Pensions headed by Harry Arthurs in 2006, a market meltdown wasn't on the horizon. But the long-term outlook for pensions was still gloomy: the number of workers covered by private pensions had declined from 40 per cent in 1985 to less than 35 per cent today, and the trend was inexorably downward because of the steady decline in unionized and industrial jobs.

Moreover, the traditional "defined benefit" pensions that paid out a promised amount have also declined as employers opt for "defined contribution" plans that don't leave them on the hook.

In a report submitted last week, Arthurs makes several proposals to encourage new or expanded pension plans by private firms. But in today's severe economic times it is hard to fathom many firms making fresh pension commitments.

Arthurs argues persuasively there may be another alternative: reinventing the Canada Pension Plan that was one of Lester Pearson's pioneering social reforms.

His report examines "an expanded or two-tier CPP" that has drawn support from both business and labour groups. It could increase the benefit (now 25 per cent of a worker's best years) and/or increase the maximum pensionable earnings (now limited to $44,900, roughly the average wage). Another option would be to let workers and employers voluntarily make extra contributions, which would be handled by the CPP and provide better benefits.

The great advantage to a bigger, better CPP plan would be the critical mass that such a massive, diversified pension plan offers to retirees. More than 12 million Canadian workers contribute to the CPP and some 3.4 million retirees get benefits. The CPP Investment Board now has $120 billion in funds available for investment, managed by 400 analysts. Arthurs is right to say that this concept – or an Ontario-only version – deserves further study, possibly at a national pension summit.

Many of his other recommendations also deserve the Ontario government's support: a separate Ontario Pension Agency; a provincial pensions czar to shine a spotlight on the issue; improved portability for workers who change jobs several times in a lifetime; and greater flexibility in keeping pension plans fully funded when market swings can make even the most diligent employer fall behind.

"I think this is the best chance in a generation to improve Ontario's pension system," Arthurs said last week. At a time of significant economic challenge, the opportunity for pension reform may be one consolation.

My take on this is that cosmetic changes will not suffice. You need one pension regulator in each country who is staffed with experienced people who know how to perform in-depth operational, investment and risk management due diligence. These regulatory bodies should communicate with each other to understand global trends in the pension industry.

But fat chance that will ever happen unless of course a catastrophe strikes to spur government action.

I am, however, glad to read that some pension funds were not as exposed to the fallout in global equities:

Nova Scotia’s major public pension plans keep taking hits from brutal markets just like pensions everywhere, but one of them is fending off the storm a little better than the others.

The latest bulletin updating the Nova Scotia Teachers Union plan doesn’t have quite as gloomy an outlook as the one for the Public Service Superannuation Plan.

"Your pension is safe," says an Oct. 30 bulletin from the teachers’ trustees. "Although the recent market declines have impacted the plan’s performance, the plan remains in sound financial condition. The plan is diversified and managed in a disciplined fashion with a long-term focus. It is able to meet its long-term commitments to its members."

Steve Wolff, CEO of the Nova Scotia Pension Agency, said the teachers pension plan is in better shape than the public service plan because of demographic differences such as the ages of active plan members and their expected retirement dates, and changes to the plan’s indexing provisions approved in 2005.

The plan’s unfunded liability was almost $456 million as of Dec. 31, 2007, in the last annual financial statement. It was 91 per cent funded and had $4.6 billion in assets.

The Public Service Superannuation Plan, on the other hand, is now the subject of talks for shoring up. The last bulletin about the plan in October said there would have to be changes to contributions and/or benefits.

Its funded status dipped below 80 per cent in June, and its $912-million unfunded liability has grown. A union pension committee member said last month that the plan had lost about 10 per cent of the $3.6 billion in assets it had held April 1.

Both pension funds posted similar losses of about 7.7 per cent for the quarter ending Sept. 30, and for the 12 months ending that date both were down about 9.3 per cent.

The agency has more recent numbers, but the plans’ trustees only release them quarterly, Mr. Wolff said. But there’s no doubt the picture looks worse, he said.

"October was a challenging month for both the plans, as has been November, just as a result of what we’re seeing globally in the markets," he said.

"They’re well diversified, not into hedge funds or commodities, but the markets have been pretty tough."

The latest updates on the plans’ performances reflect what pension services company RBC Dexia found nationally in a survey released last month. It reported pension values declined 8.6 per cent in the third quarter and 10.1 per cent for the year to date.

The markets have tumbled further this quarter. Toronto’s S&P/TSX composite index was down 17 per cent in October and about another 16 per cent this month.

As of the end of September, a little more than one-fifth of the assets of both plans were Canadian equities. Mr. Wolff said the teachers plan had just reduced its Canadian stock holdings this summer because they were coming off relative highs.

Just under 20 per cent of the assets in the plans were international equities, and about 15 per cent were U.S. equities. The teachers plan had about 35 per cent fixed securities and the public service plan 33 per cent. Canadian real estate accounted for almost seven per cent of the assets, and about three per cent was in the money market.

Mr. Wolff said the asset mixes change daily, but that breakdown is still a rough indication of the allocation.

Finance Minister Michael Baker said he’s confident in the pension agency’s ability to manage the plans through the current economic turmoil.

"These are very difficult times for pension plans: private, public, Nova Scotia to British Columbia, and beyond," he said. "We will do the very best that we can for plan members and the public."

Mr. Baker announced Oct. 30 that people in the public service plan eligible for a full pension on or before March 31, 2014, don’t have to worry about plan changes.

Joan Jessome, president of the Nova Scotia Government and General Employees Union, which has about 12,000 of the public service plan’s 16,000 active members, said she’s convinced changes would have come sooner than 2014 if the union hadn’t gone public with concerns about benefit changes.

Ms. Jessome said her union and the Canadian Union of Public Employees have hired an actuary to go over the pension numbers in hopes of fending off cuts to benefits.

Mr. Baker said he doesn’t see government bailing out the plan, which taxpayers and plan members fund 50-50.

He said he’s not sure when a decision will be made on changes to the plan, which has about 27,500 active and retired members.

I end this comment by warning all pension fund managers to start thinking very hard about asset allocation going forward. You should be thinking about the unthinkable and adjust your overall asset mix accordingly to focus in on long-term themes (alternative energy, infrastructure, biotech, healthcare, and deflation).

My title above is sarcastic. We all know Citi fell asleep and piled on tons of toxic debt. Today it got some breathing room, but it is far from being out of the woods.

I just hope pension funds will wake up now and take the appropriate measures to shore up their balance sheets.

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