Thursday, December 11, 2008

Deals Blowing Up Everywhere

Stocks tumbled this afternoon on worries that the auto bailout will not happen. Well now it's official, the $14 billion auto bailout died in the Senate.

Get ready for some rock & roll tomorrow as the market opens lower:
“The potential bankruptcy of U.S. automakers has huge ramifications for the many companies that depend on them, from steelmakers, tiremakers to the car dealers,” said Daphne Roth, the Singapore-based head of equity research at ABN Amro Private Bank, which manages about $27 billion of Asian assets. “It’s a bleak scenario.”
Bleak? Is that all? Try downright catastrophic. Millions of good jobs are at stake here and these people are going to have a hard time getting back on their feet if they lose their jobs.

Another death that hit the news wire today was the death of the Bell Canada (BCE) deal. It's official: the largest leveraged buyout deal in history is dead and a battle now looms over the break-up fee:

The crumbling of the takeover, which would have been the world's largest leveraged buyout, is the latest in a string of buyouts that have fallen amid the deep freeze in credit markets and the global economic slowdown.

BCE confirmed the buyout would not proceed and said it would demand a C$1.2 billion breakup fee from the buyers, a group of private-equity firms led by the Ontario Teachers' Pension Plan. The buyers prematurely delivered their notice to terminate, Montreal-based BCE said.

The buyers, meanwhile, said it was "very clear" that neither party owes a termination fee to the other.

"It is most unfortunate that BCE is threatening litigation over the failure of a mutual closing condition that the company insisted be included in the original acquisition agreement," the buyers said in a statement.

"Should BCE commence such baseless litigation, we are confident that it would not succeed."

The conflicting views on the break fee set the stage for a fight that could either end up in court or result in a settlement, said Troy Crandall, an analyst at MacDougall, MacDougall & MacTier.

Who wants to make a bet that the break-up fee will be paid? One senior pension fund official put it to me bluntly: "nobody will ever want to do business with Teachers' if they do not pony up the break-up fee."

I agree. Teachers' got itself into this mess and now they should put their tail between their legs and pay the break-up fee. Egos are bruised but they should count themselves lucky that they escaped a sinking ship.

As far as collateral damage, the Globe and Mail wrote that hedge funds are still holding an enormous stake in Canada's largest phone company, but my industry contacts tell me hedge funds bailed a long time ago.

But I will tell you who did get burned on this deal. Both the Caisse and PSP Investments got trounced betting that the deal would go through.

According to MFFAIS:

Caisse De Depot Et Placement Du Quebec potentially lost $-12,087,483 on changes made with Bce Inc (BCE) buying shares when price went down.

Public Sector Pension Investment Board potentially lost $-12,530,079 on changes made with Bce Inc (BCE) buying shares when price went down.

[Board of Directors should ask why the exposure to this deal was so high!]

Most Canadian pension funds are sinking this year. According to a new report by the OECD, cited in the Financial Post, of the 30 richest countries in the world, Canadian private pension funds are in the bottom three in terms of performance this year:

In a new report looking at fund performance between January and October this year, Canadian private pensions funds have seen a 22% drop in nominal returns -- less than the OECD average. The only countries that fared worse were Ireland and the U.S. with a 30% and 23% drop in nominal returns respectively.

The reason: the drop in investment returns were greatest in countries where equities represent over a third of total assets invested in. Ireland, for example, has a 66% exposure in equities.

The Czech Republic, Korea and Turkey saw a slight increase in their nominal rate of return whereas Italy, Germany and Greece saw only modest drops. [they have more government bonds in their pension plans!!]

Some of these countries have younger pension plans. In addition, their citizens are not yet confident about their equity markets so they don't take much risk, said Juan Yermo, who co-edited the report for the organization.

He adds that other countries such as Denmark and Germany are culturally more conservative.

According to the report, private pension funds among the OECD nations registered losses of nearly 20% on their assets, which is equivalent to US$5-trillion. While equities exposure was to blame for most of the downturn, the report states that "toxic" structured products and asset-backed securities accounted for as much as 3% of total assets under management.

"These are the first comparative numbers produced in a standard way, and they are pretty reliable, more than two-thirds of the countries reported in," says Mr. Yermo.

Defined benefit and defined contribution plans have both been hit hard by the global credit crisis, and as the rate of company insolvencies increases, benefits may be cut, according to the report.

Despite the negative short-term news, the report points out that the pension funds have a long time to work through the crisis. Returns over the last 15 years were 11.8% in Sweden, 10.6% in the U.S. and 9.2% in the U.K.

The report warns that focussing on a single year's return gives a misleading picture of the ability of pension funds to deliver positive returns.

Focusing on a single year is misleading, but it will not be much better next year. Like many countries, Canada is facing a crisis in the private pension sector:

The immediate problem is that plans have suffered losses this year of 10 to 25 per cent. But there are deeper challenges. Coverage levels are declining, especially in the private sector.

And the quality of pension coverage is changing, as employers seek to buffer themselves from the risks of sponsoring a pension plan by shifting more of those risks onto employees and retirees.

In his Nov. 27 economic statement, the federal finance minister announced, for the second time this decade, emergency funding relief for defined benefit pension plans. He also launched a consultation process on other potential reforms. Significantly, two provincial reports were also released late last month, by the Ontario Expert Commission on Pensions and the Alberta-British Columbia Expert Panel on Pension Standards.

The challenges to the pension system are well recognized, but the responses to them are fraught with tough trade-offs. Because they are long-term arrangements, the pension choices we make now will bear directly on our retirement incomes in five, 10 and 20 years from now. And the options on offer today will affect different people in very different ways tomorrow.

Canada faces a crisis in the private pension sector. It is most severe for newer, so-called "defined contribution" pensions, in which employers commit only to fixed contributions, not the final payouts.

The growth of defined contribution plans is destabilizing retirement income security. Pension plan members have no predictability as to their retirement incomes. If contributions are inadequate, or investment returns are poor, or market conditions are adverse at the time of retirement, retirement may be impossible or significantly poorer than expected. This weakness of the system is clear today as asset values plunge.

In the defined benefit sector – in which members are guaranteed a fixed monthly pension – the crisis is not one of retirement income security. Instead, it is a "funding" crisis. A promise of a fixed pension has been made, and money must be set aside to provide for those pensions. Investment losses must be made up through higher contributions. Unfortunately, today's need for higher contributions coincides with a recession; hence, demands are afoot for pension funding relief.

Pension security, however, is the touchstone of the defined benefit system. Unless pension plans have the assets they require to pay the pensions they have promised, the defined benefit is illusory.

Our current rules require comparisons between a defined benefit plan's assets and its liabilities every three years. Any deficits must be paid over five years. While it is tempting to think that pensions are very long-term arrangements, and that no harm is done through temporary relieving provisions, we have seen a number of cases in which companies become insolvent before their pension deficit is paid off.

In its report, A Fine Balance, released Nov. 20, the Ontario Expert Commission on Pensions recommends a new process to address underfunded pension plans in hard times. Employers in distress would approach the representatives of affected plan members (a union or employee group). Together, the employer and the members would reach an agreement about the measures best suited to deal with the problem. The pension regulator would have the authority, under the commission's recommendations, to approve the deal and vary the funding rules as necessary.

The report also reviews the province's Pension Benefits Guarantee Fund. It currently insures pensions where the sponsoring employer becomes bankrupt and the pension plan doesn't have the money it needs to pay promised benefits.

The fund insures pensions up to $1,000 per month – a level that hasn't changed in almost 30 years. The commission recommends increasing this to $2,500 per month. Even then, Ontario's Pension Benefits Guarantee Fund would provide only about half the level of coverage provided by the Pension Benefits Guarantee Corp. in the U.S.

This may be controversial because it will entail additional cost. But the options available for secure retirement income don't come cheap or easy. We can adopt more defined contribution plans – but they provide no retirement income security. Or we can maintain defined benefit plans, with an insurance backstop.

Unfortunately, the Canadian federal government has no pension insurance system for the defined benefit plans it regulates. Without one, federal reform of pension funding rules should proceed with caution.

If it cannot provide retirement income security, then the private pension system itself is at risk.

Perhaps today's challenges are too great and the cost of security is too high. If so, we can look at enhancing the CPP, the largest and most efficient pension arrangement in the country.

Increasing CPP benefits may allow us to fix the private pension problem, not by paying more into those plans, but by shifting the pension obligations away from them and toward the national plan.

Ontario's Expert Commission has endorsed the call for a national pension summit. The time to choose between these alternatives is now.

I am not convinced that enhancing the CPP is the solution to the private pension crisis. Moreover, soon enough we will get a glimpse into the crisis at public pension funds in Canada.

If Nova Scotia is any indication, these public plans are reeling this year. Taxpayers and public servants there could both be paying more into the public service pension plan in the next five years to help the plan recover from this year’s nosedive:

Steve Wolff, CEO of the Nova Scotia Pension Agency, said Wednesday that the Public Service Superannuation Plan had a $1.3-billion unfunded liability at the end of September, and a funded ratio of 72 per cent. He said those numbers are worse now as stock markets plummeted through the fall.

Finance Minister Michael Baker reassured the plan’s 28,000 active and retired members in October that no changes would be made to the plan’s benefits — among the more generous of similar plans in the country, according to government — before March 31, 2014.

But deputy finance minister Vicki Harnish was clear at the legislature’s public accounts committee meeting Wednesday that changing contribution levels prior to 2014 is still an option.

"Contribution rates, we have not specified a commitment about protection at existing rates, but the benefits were basically frozen," Ms. Harnish told the committee.

The plan’s unfunded liability was $912 million in June, and the funded ratio was 79.6 per cent. The unfunded liability is basically the gap between the plan’s assets and its liabilities at a point in time.

The government had already started looking at the plan’s health in July, Mr. Wolff said. The options for improving that are limited — hope for better market returns, or increase contributions, decrease benefits or a combination of both.

"Should people be panicking?" asked Tory MLA Chuck Porter.

Mr. Wolff said no.

"It’s a defined-benefit plan backstopped by the province. So I think panic is not the right word. Interested and concerned are the right words," Mr. Wolff said.

He also told the committee there’s no risk the plan will not be able to pay the benefits of retirees in the next 30 years.

If that’s the case, the president of the Nova Scotia Government and General Employees Union wondered why there’s a relative rush for change.

"It’s kind of, ‘The sky is falling, the sky is falling, we’ve got to just destroy all the good things about the plan,’ rather than just sitting back and taking a deep breath and (realizing) markets bounce back," Joan Jessome said.

Ms. Jessome said the union plans to fight tooth and nail to keep its major benefits. They include annual indexing at the rate of the consumer price index, full pension eligibility using the "rule of 80" — age and years of service totalling 80 — and spouses receiving two-thirds of the plan member’s pension after the member dies.

A committee of government officials and union members is looking at options.

Mr. Wolff said there’s no timetable for making up the plan’s $1.3-billion funding shortfall. Private-sector plans regulated by the province have five years to cover their shortfalls, and a committee reviewing the Pension Benefits Act is recommending extending that to eight years.

Mr. Wolff would only say that he’s looking at longer than eight years for the public service plan.

Mr. Baker, who wasn’t available Wednesday, has said the government — taxpayers — and plan members fund the plan 50-50, so changes will be shared 50-50.

If the change is a reduction in benefits, Ms. Harnish said the government would contribute the cash value of the benefits reduction to the plan. She said that’s what government did when the Nova Scotia Teachers Union pension plan’s indexing provisions changed in 2005.

At the end of September, the teachers’ plan’s unfunded liability was about $1.1 billion, and the ratio was 80 per cent.

Ms. Jessome said she thinks government has been trying to get at the public service plan’s indexing benefit and rule of 80 ever since the teachers’ plan changed.

Ms. Harnish told the committee the increased unfunded liability will have an impact on next year’s budget.

"You will see an extra expense (next) year for pensions," Ms. Harnish said.

New Democrat MLA Maureen MacDonald said she needs more information from the province before taking a stand on whether contributions should change.

"Our concern is that we have a problem, but it’s compounded by the lack of information that the government is making available," she said.

Liberal MLA Diana Whalen said she’d like to see the government take steps to keep people working, and contributing to the plan, longer.

Ms. Harnish said there are about 2,100 public servants who could now retire with unreduced benefits, and about 600 more qualify each year. That amounts to about 5,000 by March 31, 2014.

Ms. Harnish said Mr. Baker put the five-year guarantee on benefits because he didn’t want to see a "mass exodus" of workers concerned about losing benefits.

As you can see, the state of public pension funds in Canada is hardly any better than the state of its private pension plans.

But don't panic, governments "backstop" public plans and my hunch is that they will "backstop" private plans too. If they need money, they'll just tax all of us more. We are all on the hook when it comes to bailing out private and public pension plans.

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