Sunday, December 14, 2008

Time for Inquiries into Public Sector Pensions?


An article that appeared in the London Times caught my attention today. The Confederation of British Industry (CBI) , a lobby group for British business, wants an independent commission to review the cost of public sector pensions:

The CBI is pressing the Government for greater accountability and transparency on public sector pensions, especially the unfunded retirement provisions for up to five million nurses, teachers and civil servants.

The lobby group for British business wants an independent commission to review the cost of public sector pensions, which it estimates will be more than £915 billion by 2050. It is floating the idea of increasing the retirement age for public sector workers from 60 to 65 and has demanded that the Government use up-to-date projections for how long people live after they stop work.

John Cridland, the CBI's deputy director-general, said companies in the private sector had already had to face up to the burgeoning cost of their pension obligations and it was time for the Government to do the same. He said that private sector employers wanted a level playing field in pension provision, arguing that private companies securing government outsourcing contracts often found they had to double pension contributions to the transferring staff.

“The cost of balancing the books needs to be in the public domain in a way that it is currently not,” he said.

Mr Cridland said that the Government's most recent estimate in March 2006 that its pension liability was £650 billion was wildly out of date.

He also said it was no longer true that wages in the public sector lagged behind those of private companies, a traditional explanation for strong public sector pension provision.

The CBI's call for a commission was aimed exclusively at the Government's unfunded pension obligations, where contributions were fed directly into Treasury coffers rather than managed separately by City funds, he said.

The business group insisted it had no agenda over public sector pension reform and was not calling for the end to final-salary pension schemes for civil servants.

But its comments set it on a collision course with unions, which see a strong pension scheme as central to employment rights.

Brendan Barber, general secretary of the TUC, dismissed the CBI as “behind the times”. Mr Barber said that unions had agreed substantial reforms, including increasing the retirement age beyond 65 in some circumstances.

He contrasted this with the “gold-plated” pension arrangements agreed in company boardrooms, while private sector final-salary schemes were being shut in droves because they are seen as too expensive.

Now, I am not sure whether or not the CBI has an "agenda" behind this call for an inquiry, but I definitely think it is time we had some serious inquiries into the state of public sector pension plans around the world.

The Financial Times reports that pension fund assets in the OECD suffered a 20% fall:

Pension fund assets in countries belonging to the Organisation for Economic Co-operation and Development fell by 20 per cent over the year to October, representing about $3,300bn (£2,213bn, €2,464bn) of losses. Adding losses in private pension savings takes the loss to $5,000bn.

However, the good news is, over the longer term, returns are positive. The average annual real rate of return for pension funds in the US and UK was 6.1 per cent over the past 15 years to October 2008, while for Sweden it was 8.5 per cent, the OECD said.

Pension funds should be judged on their long-term performance, according to the OECD, because they have such a long time horizon. They also have a low requirement for liquidity in relation to their size. This means they can pay pensions and other expenses out of cash inflows from contributions and investment income, and do not need to sell assets to realise cash.

But there are exceptions: defined benefit schemes that have closed to future accruals for existing members, rely on running down assets to pay benefits. They may be unable to wait for a market recovery and be forced to sell at a loss.

Investment Solutions, a UK multi-manager specialist, says pension funds had an opportunity in July 2007 to lock in a strong improvement in funding levels.

Justin Taurog, director, says pension trustees need the ability to respond to changing investment conditions more quickly and to reduce risk as schemes get closer to 100 per cent funding.

“For example, a scheme that was 70 per cent funded and wanted to get to 100 per cent may have needed to earn gilts plus 2 per cent a year. As the funding level improved, it no longer needed that return and should have cut back equity exposure,” he says.

A few comments on this article. The next 15 years will be a lot tougher than the previous 15 years so it is "illusory" to look at past returns and say "over the long-term" returns will be positive.

On this last point, please take the time to listen to Charlie Rose's recent conversation with Nassim Nicholas Taleb. The path towards "Capitalism II" will be painful as deleveraging continues in the financial and household sectors.

Moreover, recent steep price falls in China have made deflation the new economic bogeyman. According to MarketWatch, Hong Kong is anxiously watching this unraveling in China as it tries to avoid being tipped into another painful deflationary cycle:

Businesses and government alike will remember the nightmare period of deflation in Hong Kong, spanning 1998-2003, with attendant asset-price collapses, credit contraction and budget deficits.

Unfortunately, nothing was done in the intervening decade to wean Hong Kong off its dependency on asset bubbles and property speculation. Now, Chief Executive Donald Tsang is up in Beijing again with his hand out for some policy favors to prop up the needy territory.

His trip comes as new data reveal the global financial crisis has not just winded China's exports, but also stopped prices in their tracks. In November, China's consumer price index rose just 2.4% from the year before, slowing from 4% inflation in October. Similarly, the producer price index decelerated from 6.6% to 2% in the same period.

Little wonder China's top banking regulator, Liu Mingkang, said over the weekend that the mainland economy was "very likely to slide into deflation mode."

Hong Kong now appears to face a converging range of deflationary pressures.

Property prices are following the equity market lower and are now 25% off last year's highs, with some transactions reportedly 40% lower. In the city-state's glitzy shopping malls, New Year sales began in November.

The currency peg to the U.S. dollar is another source of downward pricing pressure. As the Hong Kong dollar follows the greenback higher against the euro and a range of currencies in Asia, it is now faces a reverse in course by the yuan, feeding lower prices through the economy.

During Hong Kong's last bout of deflation, the peg meant that asset prices and economic activity bore the brunt of pricing adjustments to external shocks. Job cuts and salary cuts were the order of the day, as sales and tax receipts shrunk.

Thus far, Hong Kong has escaped many of the high-profile redundancies seen around the world in the current crises. In fact, the big tycoon-controlled companies have conspicuously lined up to rule out job cuts.

Henderson Land Development Chairman Lee Shau-kee last week was the latest to promise his company would not shed jobs and that his staff would get pay rises and bonuses despite the financial turmoil. Sun Hung Kai Properties made a similar pledge last month, and Li Ka-shing, chairman of Hutchison Whampoa, is also on record saying he has no plans for lay-offs and that his firms will not be cutting back investment.

But are they only delaying the inevitable and burying their heads in sand, or concrete?

Typically, debt becomes much more onerous in times of deflation -- revenues fall, making it harder to service that debt. Granted life's easier if you're operating in an oligopolistic market, but companies typically go into cost-cutting mode, which includes laying off staff.

But in Hong Kong, one difference for such big companies in such a small town is the consideration that their actions can have a big impact on sentiment.

If the property tycoons cut staff or salaries, many others may follow, accelerating deflation across the economy. Of course it's not all altruistic -- What chance have the developers of selling their pricey flats if salaries are shrinking?

The government is also an interested party because it can say goodbye to land-sales revenue if the developers cannot sell their concrete blocks. Attention will then turn to its ballooning wage bill at a time of deflation and plunging tax receipts.

So far, instead of tightening its belt, the government has announced a wave of new civil service hires and questionable building projects, such as a bridge to Macau.

A contrast in behavior is provided by HSBC, the biggest lender in Hong Kong. It has quickly reacted to the new environment by cutting staff and warning of further lay-offs, while at the same time tightening lending.

It seems we can forget easy money. Last month, HSBC raised its new mortgage rates by 75 basis points, the most in 10 years, and followed this by hiking interest rates on its local personal credit cards to 31.86% last week.

According to Citbank Research, the credit contraction cycle in Hong Kong is already upon us. Outstanding Hong Kong-dollar bank loans fell by HK$1 billion in October to HK$2.395 trillion, while foreign-currency loans dropped more sharply by HK$13.5 billion

If the banks are preparing for tough times ahead, maybe the developers and government should be watching.

As the Hong Kong government ponders its next move, it is worth remembering the bitter pill from deflation last time around came in the form of tax hikes for everyone to plug the deflation deficit. But in a new era of stimulus economics, it appears few governments think they have to do these simple sums anymore.

We will have to see if Beijing can dispense some treats to avert a deflationary cycle in Hong Kong, but for now that seems unlikely.

What does deflation in China and Hong Kong mean for OECD countries? It means get ready for another wave of goods deflation in 2009 and possibly well beyond that.

But this time goods deflation is happening at a time of financial deleveraging and credit contraction. This will wreak havoc in the global financial system and ignite one of the largest deflationary episodes since the Great Depression.

It's going to be particularly painful for pension funds that are highly exposed to equities and alternative asset classes like commercial real estate and private equity. Not only are asset values going to collapse, their liabilities are going to skyrocket as global interest rates head to all-time lows.

The Mother of All Financial Crises is going to wreak havoc among global public pension funds over the next decade. This will be the biggest public finance issue policymakers will need to address.

Unfortunately, all I see from governments and regulators is a culture of complacency. Hoping that things will improve over the long-term will not suffice. Immediate action is required to deal with a global crisis hitting retirement plans.

It is high time governments initiate independent public inquiries into the mismanagement of public pension funds and expose a lot of the nonsense that led us down this path of wealth destruction.

Why weren't equity exposures cut? Why did so many public pension funds drastically cut their exposure to government bonds to invest in alternative asset classes? Did they not realize that were fueling a massive bubble and that systemic risk was going to hit one day or did they all fall prey to what Taleb calls the "illusion of stability"? Why was the governance process of these public pension plans so weak? Why were regulators and supervisors asleep at the wheel?

Mark my words: in the not too distant future, there will be Senate inquiries in the U.S., Parliamentary inquiries here in Canada and inquiries around the world that will be asking some very tough questions to senior public pension fund managers and their board of directors.

[In regards to the tough questions that need to be asked, please refer to this past entry of mine].

And I might add, not a moment too soon. Taxpayers around the world are being asked to bail out global banks and crumbling industries. The last thing they need as the recession hits full throttle is to be asked to bail out public pension funds that recklessly invested their hard earned contributions.

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