Sunday, November 30, 2008

OECD Will Release New Pension Guidelines


According to the Organisation for Economic Co-operation and Development (OECD), companies should help staff make the right investment decisions as employees play an ever larger role in managing their pensions:

In a review of its pension fund governance guidelines expected next month, it will recommend employers and financial supervisors fill a "governance vacuum" in pension schemes known as defined contribution (DC) schemes.

Under these schemes, the final lump sum accrued through investments depends on the contributions set aside and the market and employers no longer guarantee a fixed outcome.

These schemes are growing quickly in the UK and are the main offering in most continental European countries already, because they are cheaper to finance.

"Although in theory it (the scheme) is an individual contract, it is the employer who selects the provider and what the investment choices are," said Fiona Steward, who is an pension expert at the OECD.

The new OECD guidelines are expected to be approved by the OECD Working Party on Private Pensions next week and published by the end of the year.

While these guidelines address defined contribution plans, the current OECD guidelines to pension fund governance offer important recommendations for defined benefit plans on pension fund governance (most public plans are DB plans while most private plans are DC plans).

Let's examine a few key recommendations but first, I want to bring to your attention the importance of the governing body of the pension fund:

The central figure in pension fund governance is the governing body that is the person, group of persons or legal entity responsible for the management and safeguarding of the pension fund.

Where the pension fund is established as a pension entity, such entity's governing body will normally also be responsible for the management of the fund. Where the fund consists of a separate account, the financial institution that manages the account is the governing body of the fund.

In some countries, only dedicated financial institutions (pension fund managing companies) are permitted to manage pension funds.

So who is the governing body for these big public pension funds? The OECD states the following:

Every pension fund should have a governing body vested with the power to administer the pension fund and who is ultimately responsible for ensuring the adherence to the terms of the arrangement and the protection of the best interest of plan members and beneficiaries.

The responsibilities of the governing body should be consistent with the overriding objective of a pension fund which is to serve as a secure source of retirement income.

The governing body should not be able to completely absolve itself of its responsibilities by delegating certain functions to external service providers. For instance, the governing body should retain the responsibility for monitoring and oversight of such external service providers.
For most of the big public pension funds, the governing body is the board of directors because they are ultimately accountable for the final investment decisions taken by senior pension fund officers.

But having prepared, presented and defended several documents to the Board of Directors at PSP Investments when I was working there as a senior investment analyst, I can tell you that the board of directors rely a lot on the input of senior pension officers.

This isn't necessarily a bad thing. The only other option for the board of directors is to outsource the work to external consultants who typically charge an arm and a leg for their reports and they often do not add any additional insight.

The OECD guidelines clearly favor expert advice if the board requires it:

Where it lacks sufficient expertise to make fully informed decisions and fulfil its responsibilities the governing body could be required by the regulator to seek expert advice or appoint professionals to carry out certain functions.
In the U.S., board of directors heavily rely on external consultants to cover themselves in case something goes wrong. Most of these pension consultants were spewing out the same packaged advice to all their pension fund clients: diversify into alternative investments to counter the meager returns of public equities.

Unfortunately, many of these consultants were not independent, recommending funds that they were investing with to their pension fund clients.

When it comes to pension consultants make sure they are truly independent and aligning their interests with your pension fund's return objectives and risk tolerance.

You might be asking why is the board of directors the governing body if the supervisor is the government? The problem is that while the government is ultimately responsible for the pension plan, the pension fund is managed independently to minimize political interference in pension investments.

This makes perfect sense, however, the latest pension debacle clearly illustrates that if you give pension funds too much leeway, they might screw up in a spectacular way.

This is why I have been arguing for a different governance model - one that respects the independence of the pension funds that manage pension investments - but that also takes into account the supervisory role of governments that need to make sure taxpayers are not at risk if a pension fund blows up.

In Canada, most of the large public pension funds have been investing in all sorts of complex investments including ABCP, CDOs, CDS, private equity, real estate, infrastructure, commodity derivatives, leveraged loans, private debt, complex hedge fund strategies and other structured products.

I am telling you straight out, even the most experienced board of directors cannot keep up with everything that is going on in these new "improved" pension funds on steroids. They are overwhelmed and they rely heavily on what their senior pension officers tell them. For the most part, they receive good advice from their senior pension fund managers, but they also receive some specious advice too.

From stakeholders' point of view, this is why it makes sense to conduct external, independent performance and operational audits of all internal and external investment activities at least once a year. The board of directors and pension fund managers need to be evaluated by an objective independent body that reports to the Auditor General's office or some government pension regulator.

I have already written about the need for independent performance and operational audits. There is a way to respect the independence of the governing body with the supervisory role of governments and the right of stakeholders to know what is going on in public pension funds.

Let's look at one other important recommendation from the OECD on disclosure:

The governing body should disclose relevant information to all parties involved (notably pension plan members and beneficiaries, supervisory authorities, etc.) in a clear, accurate, and timely fashion.

I think we can all agree that quarterly results must be the norm and that the minutes of the board of directors, including how each board member voted on big investments must be made public. A great example of this is the Alaska Permanent Fund Corporation who publishes board minutes on their site.

Disclosure also includes a detailed and clear discussion of the benchmarks governing each and every investment activity. Importantly, we can't continue paying senior pension officers at public pension funds millions of dollars based on bogus benchmarks that do not reflect the risks of the underlying investments.

I keep hammering away at this last point because it represents a true scandal of modern day pensions. Teachers, nurses, doctors and public servants all work hard to earn a living and they deserve to know that public pension funds are appropriately remunerating senior investment officers based on merit and not some sham benchmark that does not reflect the risks and beta of the underlying portfolio.

Finally, I was quoted in the National Post over the weekend in an article discussing how public plans stay quiet on rumours of losses:

Leo Kolivakis, a former analyst with PSP Investments, says that after the market declines in October and November, many big public sector pension plans are facing enormous challenges, largely because of forays into risky alternative markets that have suddenly turned bad.

"This is a huge crisis in the making," says Mr. Kolivakis.

He argues the crux of the problem is lack of transparency. Many pension money managers are partly compensated based on how well their investments perform relative to benchmark returns. Alternative markets often offered the best opportunities for big returns and a chance to beat the benchmarks. But they also contained hidden risks.

"The biggest scandal is how these pension funds moved public assets from public markets to private markets, claiming they are adding [a better return] but what they were doing is taking a lot more risk," says Mr. Kolivakis. [claiming they are adding diversification benefits was what I said]

I want to make something very clear. I am not against real estate, private equity, infrastructure or hedge funds. They can offer important diversification benefits and downside risk protection to traditional stocks and bonds.

The problem is that you need to invest with the best funds to achieve meaningful diversification benefits and downside risk protection. The dispersion of returns between the top funds and the median funds is so wide that it simply didn't make sense for most pension funds to invest in these asset classes (because they couldn't secure capacity in the top funds). Most are just better off investing in a portfolio of stocks and government bonds and using plain vanilla option strategies to hedge against equity risk.

Worse still, once every pension fund started piling into these investments, the returns started falling (no shock there!) and they fed the bubble in alternative investments.

I saw this coming from a mile a way and so did smart investors like Jeremy Grantham of GMO. I went to conferences where the big investment banks were all peddling the "benefits of alternative investments." In hindsight, they were feeding business to their big hedge fund and private equity clients, fattening up their own pockets in the process.

There is no free lunch. If you want to make money in alternative investments, you'd better reflect carefully about where these markets are heading over the next five to ten years and think hard about where and how you are going to invest in different segments of alternative investments.

The worst mistake you can make is to invest looking at last year's returns. This is plain stupid because I can guarantee you that last year's winners will not be next year's winners.

To sum up, we need more transparency in public pension funds. We need to understand how these investments are being managed and how the board of directors compensates senior pension fund officers.

Hopefully the new OECD guidelines will provide more information on how pension funds can bolster their governance structure.

Friday, November 28, 2008

Pension Meltdown Will Only Get Worse


U.S. stocks gained, capping the biggest weekly advance for the Standard & Poor’s 500 Index in 34 years, on speculation that government bailouts will shore up the economy:
Citigroup Inc., which had $306 billion in troubled assets guaranteed by the government last weekend, rallied 18 percent for its fourth straight gain. General Motors Corp. climbed 8.9 percent and Ford Motor Co. surged 25 percent as the automakers considered cutting debt and labor costs to win federal aid. Target Corp. slumped 3.9 percent as retailers extended discounts to lure shoppers amid what is forecast to be the slowest holiday shopping season in six years.

“It’s going to be a really tough Christmas shopping season, but a lot of this is built into the stocks, and there is huge stimulus coming down the pipeline,” Alan Gayle, senior investment strategist at Ridgeworth Capital Management in Richmond, Virginia, said on Bloomberg Television. “We are cautiously bullish.” Ridgeworth manages $70 billion.

The S&P 500 climbed for a fifth day, adding 1 percent to 896.24 to complete its longest streak of gains since July 2007. The Dow Jones Industrial Average rallied 102.43 points, or 1.2 percent, to 8,829.04, while the Nasdaq Composite Index increased 0.2 percent to 1,535.57. Almost two stocks rose for each that fell on the New York Stock Exchange.

The S&P 500 surged more than 12 percent this week, its best weekly performance since 1974, as the Federal Reserve committed as much as $800 billion to help resuscitate lending markets and investors speculated President-elect Barack Obama’s economic team will bolster growth. Obama said Nov. 26 that he will implement plans to shore up the economy on “day one” of his presidency.

About 787 million shares changed hands on the NYSE in the slowest trading session of the year. U.S. exchanges were shut yesterday for the Thanksgiving holiday and closed at 1 p.m. today.
This Santa Claus rally will likely last till Christmas because hedge funds, mutual funds and pension funds are going to be in buy mode going into year-end, trying to salvage whatever they can from one of the most brutal years in stocks ever.

But before you warm up to stocks, listen to what professor Robert Shiller, author of Irrational Exuberance, had to say in a recent lecture:
The lecture kicked off with a quick recap of how we got to where we are. These were the highlights:
  • Psychological factors played a huge role. Irrational exuberance (a term coined by Alan Greenspan and borrowed by Shiller for the title of his 2000 book) caused bubbles to appear all across the world . Word spread that by simply buying stocks, or a house, you can become effortlessly wealthy. You can’t.

  • Genuine financial advice was only available to the wealthy. Anyone who gives you free or “affordable” advice isn’t really advising you at all. They’re trying to sell to you. Hence many subprime borrowers got in over their heads – basic questions like “Can you afford this?” “What if interest rates rise, or you lose your job?” were left unasked.

  • Individuals fell victim to Groupthink. Groupthink is where it’s in the interests of individuals to subordinate what they really think to what is acceptable to the consensus. Imagine a rating agency employee in 2006 saying to his boss: “I want to downgrade this debt. I think we’re going to have another Great Depression…” Not exactly a smart career move!

We were then shown charts of stock indices, p/e ratios and volatility going all the way back to 1870. Let’s start with the volatility.

There are only three points in history where we observe extreme volatility. One is right now. The others are 1987 and 1929.

The real terms p/e ratios chart was even scarier. The big bubble run up from 1982 to 2000 appears like the Matterhorn rising out of some hillocks. This, of course, is the bubble that’s now being corrected (for more on this see The Daily Reckoning, below).

In percentage terms, we’ve only ever seen such a bubble once before since 1870. Yep, you guessed it…before 1929!

Shiller told us that, in real terms, the S&P fell 80% in the 1930s. So far it is only down 54%.

This means you still have a once-in-a-lifetime opportunity to lose a lot of money very quickly. Will you take it? I for one hope you don’t…

Most of us have never been in this position at any time before throughout our lifetimes. Who alive today has first-hand experience of investing during a prolonged, worldwide, stock market and real economy Depression?

Moreover, there are disturbing signs that the meldown is far from over as a new mortgage crisis looms:

Black Friday's retail shoppers hunting for holiday bargains won't be enough to stave off what's likely to become the next economic crisis. Malls from Michigan to Georgia are entering foreclosure, commercial victims of the same events poisoning the housing market.

Hotels in Tucson, Ariz., and Hilton Head, S.C., also are about to default on their mortgages.

That pace is expected to quicken. The number of late payments and defaults will double, if not triple, by the end of next year, according to analysts from Fitch Ratings Ltd., which evaluates companies' credit.

"We're probably in the first inning of the commercial mortgage problem," said Scott Tross, a real estate lawyer with Herrick Feinstein in New Jersey.

That's bad news for more than just property owners. When businesses go dark, employees lose jobs. Towns lose tax revenue. School budgets and social services feel the pinch.

Companies have survived plenty of downturns, but economists see this one playing out like never before. In the past, when businesses hit rough patches, owners negotiated with banks or refinanced their loans.

But many banks no longer hold the loans they made. Over the past decade, banks have increasingly bundled mortgages and sold them to investors. Pension funds, insurance companies, and hedge funds bought the seemingly safe securities and are now bracing for losses that could ripple through the financial system.

"It's a toxic drug and nobody knows how bad it's going to be," said Paul Miller, an analyst with Friedman, Billings, Ramsey, who was among the first to sound alarm bells in the residential market.

Unlike home mortgages, businesses don't pay their loans over 30 years. Commercial mortgages are usually written for five, seven or 10 years with big payments due at the end. About $20 billion will be due next year, covering everything from office and condo complexes to hotels and malls.

The retail outlook is particularly bad. Circuit City and Linens 'n Things have sought bankruptcy protection. Home Depot, Sears, Ann Taylor and Foot Locker are closing stores.

Those retailers typically were paying rent that was expected to cover mortgage payments. When those $20 billion in mortgages come due next year – 2010 and 2011 totals are projected to be even higher – many property owners won't have the money.

Some will survive, but those property owners whose loans required little money up front will have less incentive to weather the storm.

Refinancing formerly was an option, but many properties are worth less than when they were purchased. And since investors no longer want to buy commercial mortgages, banks are reluctant to write new loans to refinance those facing foreclosure.

California, New York, Texas and Florida – states with a high concentration of mortgages in the securities market, according to Fitch – are particularly vulnerable. Texas and Florida are already seeing increased delinquencies and defaults, as are Michigan, Tennessee and Georgia.

The worst-case scenario goes something like this: With banks unwilling to refinance, a shopping center goes into foreclosure. Nobody can buy the mall because banks won't write mortgages as long as investors won't purchase them.

"Credit markets have seized up," corporate securities lawyer Michael Gambro said. "People are not willing to take risks. They're not buying anything."

That drives down investments already on the books. Insurance companies are seeing their stock prices fall on fears they are too invested in commercial mortgages.

"The system has never been tested for a deep recession," said Ken Rosen, a real estate hedge fund manager and University of California at Berkeley professor of real estate economics.

One hope was that the U.S. would use some of the $700 billion financial bailout to buy shaky investments from banks and insurance companies. That was the original plan. But Treasury Secretary Henry Paulson has issued a stunning turnabout, saying the U.S. no longer planned to buy troubled securities. For those watching the wave of commercial defaults about to crest, the announcement was poorly received.

"He's created havoc in the marketplace by changing the rules," Rosen said. "It was the stupidest statement on Earth."

The Securities and Exchange Commission is considering another option that might ease the crisis, one that would change accounting rules so banks don't have to declare huge losses whenever the market declines.

But the only surefire remedy is for the economy to stabilize, for businesses to start expanding and for investors to trust the market again. Until then, Tross said, "There's going to be a lot of pain going forward."

The commercial real estate crisis will hit pension funds hard in two ways. First, through direct investments in commercial real estate and second, through their holdings of commercial mortgage-backed securities (CMBS).

Now, let's look at this recent Toronto Star article that states that Canadians can grow old knowing their pension plans are in good hands thanks to real estate investments:

What do landmarks such as First Canadian Place, Toronto Eaton Centre, The Fairmont chain of hotels, and Yorkdale Mall have to do with you?

Chances are, you may own them – or at least a share of them.

That's because Canada's leading pension funds, to which most working Canadians contribute, own much of the country's top office and retail properties.

And so, that makes Canadians the largest owners of major commercial real estate properties across the country.

"Historically, real estate has always been good for investors," explained Graeme Eadie, senior vice-president of real estate investments at the Canada Pension Plan Investment Board (CPPIB), an independent body formed in 1997 to manage funds for the Canada Pension Plan (CPP), which administers benefits.

"It is a source of good, long-term, stable income which is always good in terms of a pension plan's liability."

That is why major funds like OTPP (Ontario Teachers' Pension Plan), and OMERS (Ontario Municipal Employees Retirement System), in addition to CPPIB, all have significant holdings in real estate.

"Urban areas are showing continued growth and high quality real estate does not sell frequently because it is a valuable asset to any portfolio," Eadie said.

And, the value of such an investment is particularly evident to CPPIB since it only introduced the real estate class of assets in 2005. Already, though, it represents 6.2 per cent of its entire fund.

In other words, out of the complete fund, which is valued at $117.4 billion, real estate accounts for $7.2 billion and includes properties such as Toronto's First Canadian Place and Royal Bank Plaza, in addition to a collection of other office and retail properties across Canada.

According to Eadie, because the CPPIB was only formed a decade ago, it took some time to get it up and running and only then could new assets be moved into the program, such as real estate.

"It's a good pace," commented Eadie, "and my expectation is it will certainly grow."

By comparison, the OTPP has been investing in real estate for a longer period and, as of December 31, 2007, its net assets totalled $108.5 billion, of which $16.4 billion was in real estate investments.

According to OTPP director of communications Deborah Allan, since 1991 -– when the OTPP overhauled its entire pension plan by diversifying beyond a bond-only plan – real estate has represented a considerable share of the plan's overall assets.

By 1995, the OTPP acquired 20 per cent of its property manager, Cadillac Fairview Corp. Ltd., and by the year 2000, acquired the remaining 80 per cent. As of last December, real estate represented 17 per cent of the OTPP's total investment assets.

"Real estate falls under inflation-sensitive assets, so we have it as a hedge," explained Allan. "Our pensions have inflation protection so we require assets that correlate with that liability."

The OTPP's Top 10 holdings include Vancouver's Pacific Centre, Calgary's Chinook Centre and Toronto's Sherway Gardens, Toronto-Dominion Centre Office Complex and the Toronto Eaton Centre.

All plans, if looked at in their entirety, are diversified, and for good reason. They must be able to balance between private and public assets and be able to weather economic storms such as the volatility in the current financial market. The various pension fund managers interviewed said they are optimistic that their real estate assets will provide gains in the long term.

"My expectation is it will continue to grow," explained Eadie. "The current economy and other slowdowns in other markets gives us buying options we wouldn't normally see."

John Pierce, vice-president of corporate communications at OMERS – one of Canada's largest pension plans that provides retirement benefits to 380,000 members across Ontario – agreed.

"Real estate is an important part of our private asset investments and we're looking at moving more toward increasing those assets because of their long-term stability," he said.

With more than $52 billion invested in a wide range of companies and assets around the world, $10.9 million of OMERS assets are in real estate, representing 12.5 per cent of the entire fund, as of December 31, 2007.

Oxford Properties Group (Oxford), a wholly-owned subsidiary of OMERS, manages all of its real estate investments. Some of OMERS best-known properties are its hospitality real estate that includes 100 per cent of the shares in The Fairmont's Banff Springs, Chateau Lake Louise and Chateau Whistler, to name a few. It also holds shares in retail, office, industrial and residential properties.

Most funds, in addition to their considerable holdings in Canada, also invest globally. And with markets faring as they are, pension plan investors expect there to be greater buying opportunities outside Canada. Both the CPPIB and the OTPP own shares in U.S. real estate as well as in the United Kingdom, South America and elsewhere.

"We are always looking across the global market, " Eadie said.

During better economic times, the CPPIB bought little real estate in the United States because prices were too high, but now is a good time to look globally, according to Eadie, since properties are becoming more affordable.

Nevertheless, Canadian real estate remains predominantly in the hands of large pension funds and will remain as such since, as one banker put it, "land doesn't go away."

So, the next time you are shopping or banking or meeting at a high-powered attorney's office, consider that you are perhaps surveying the fruits of your labour, literally, since your pension plan investment has possibly made you part owner of that very location.

What this article neglects to tell you is that real estate can and will get whacked hard if this recession is deep and protracted. This decline will be unlike anything pension funds have ever seen before.

Another important thing you should keep in mind is that pension fund managers allocate to private asset classes like real estate claiming diversification benefits but the reality is that that they fudge the benchmarks in private markets to easily beat them, allowing them to reap big bonuses at the end of their fiscal year.

You should remain very skeptical about all these pension funds buying up commercial real estate at this time thinking there are "tremendous opportunities". Nobody knows how bad this recession could get and commercial real estate prices have lots of downside risk from these levels.

Amazingly, CNBC posted an article today stating if you are looking for upside, try commercial property bonds:

“Those bonds today are trading at 14-16 percent yields—it’s outrageous," Darrell Wheeler, a CMBS analyst with Citigroup. "I’d rather have that than a US Treasury—that’s how dislocated the market is.” [with good reason!]

...

But investors should drill down into these trusts' portfolios because the investment focus may have put them lower in the capital structure through purchases of subordinated debt or construction loans that may not have a recession full priced in, cautions Wheeler.

Indeed, JPMorgan cautions against overweighting Triple-A bonds “solely because of the wider spreads,” in part because “the year-end delevering still appears to have some legs.”

Here is my advice to you: never trust anything that is peddled on CNBC!

As I read about pension plans being disappointed with the federal government's relief proposal, I wonder if extending the pensions' top-up time by 20 years will be enough. If we get a Japanese style deflationary episode, commercial real estate prices can and will tank for a very, very long time.

Finally, you should read about how BCE Inc. and its retreating suitor Ontario Teachers' Pension Fund are feuding again, this time over a $1.2-billion termination fee:

Under the terms of Teachers' agreement to acquire BCE, the pension fund must pay what is known as a reverse break fee if its actions trigger the deal's collapse. Legal experts said that to win the fee, technically BCE would have to demonstrate that Teachers gave KPMG's auditing team incomplete or erroneous information for their solvency analysis.

KPMG concluded from data supplied by BCE and Teachers that the company would not meet a solvency test because its debts would exceed its assets after $32-billion of takeover debt was tacked onto the company. According to sources, KPMG estimated Teachers would have had to inject an additional $3-billion of equity to ensure BCE's solvency. BCE disputes the findings and a team of senior financial officers are reviewing the analysis with the auditing team.

It is understood that Teachers strongly disputes any wrongdoing, but the pension fund may opt to negotiate paying a lower break fee to BCE to avoid a messy and protracted legal dispute.

Also working in BCE's favour are the enormous legal costs and time its management devoted to preserving Teachers' bid in the face of legal challenges from bondholders and financial stresses weathered by banks backing the takeover. Indeed, BCE was so accommodating that the company helped its prospective buyer this year by cutting its dividend to conserve cash and bowing to its request for company executive George Cope to take the reins as chief executive officer.

“Teachers owes BCE. It bent over backward to make this deal happen,” said one person close to BCE.

My advice to Ontario Teachers is to suck it up, pay it and move on. Had they proceeded with this mega buyout, it would have cost them a lot more than this termination fee.

***Special Note on Profiting from the Real Estate Bust

I was reading David Spurr's comment on Displaced EMA where he sees a nice short setup on the Russell 2000. I agree that there will come a time when you want to short small caps again, but do not buy any ultra short proshares just yet.

Then I looked at the chart of the Ultrashort real estate proshares (SRS). I recommended it in early October at $84 and it popped up, reaching a high of $295 before selling off. It is now trading at $121.86 and you should keep an eye on it. If it falls anywhere near or below its 200-day m.a., start slowly building positions.

But I warn you, these ultrashort proshares are very, very volatile and are not to be bought for buying and holding puposes. Some of them are not very liquid, adding to their volatility. But if you like to swing trade on the long and short side, you should read more about proshares by clicking here.

Thursday, November 27, 2008

Bill Tufts, Pensions and Political Turkey


Tonight I have a treat for you. Bill Tufts of WB Benefit Solutions has graciously provided me with a commentary to share with you on my blog.

Before I get to Bill's commentary, I want to cover a few things. Today is Thanksgiving in the U.S. so the stock markets were closed in New York. The Canadian stock market was open and the S&P/TSX pushed higher for a fifth straight session:
The Toronto stock market finished higher for a fifth session Thursday as investors continued to flock to beaten-down commodity stocks, particularly those in the base metals sector.

"There seems to be some growing expectations that metal prices are going to continue to retrace some of the lost ground that they've seen and (they're) trying to climb their way back up again," said Fred Ketchen, manager of equity trading at Scotia Capital.

Investors have taken in news in the past week of lower interest rates and a stimulus program in China, raising hopes that demand for metals will pick up.

The S&P/TSX composite index was 110.25 points higher to 8,753.77 with the main index racking up just over one thousand points since last Thursday. The TSX Venture Exchange moved up 16.59 points to 748.23.

The Canadian dollar closed down 0.06 cent to 81.23 cents U.S.

American markets were closed for the U.S. Thanksgiving holiday.

China did slash its key rate yesterday because of growing concern about the global economic slowdown:

The impact of the global financial crisis on China's economy is deepening and a large interest rate cut announced Wednesday is essential to boosting slowing growth, the country's top planner said.

"This crisis is spreading all over the world and its impact on China's economy is deepening," Zhang Ping, chairman of the Cabinet's National Development and Reform Commission, said at a news conference Thursday. Zhang said economic indicators for November were showing an "even faster decline," though he gave no details.

A 1.08 percentage point reduction in the country's key one-year lending rate announced late Wednesday -- China's biggest rate cut since 1997 and the fourth in three months -- is "one of the essential measures to stimulate our economic growth," Zhang said.

Zhang said a 4 trillion yuan ($586 billion), two-year government stimulus package announced Nov. 9 should add about 1 percentage point to China's economic growth rate. That was below the 2 percentage point increase that independent analysts have forecast.

China's economic growth is expected to fall to about 9 percent this year, down from last year's rapid 11.9 percent rate. That would be the fastest of any major economy, but Chinese leaders worry about rising job losses, especially in export industries, and possible unrest.

Growing unrest in China will cause chaos in that country. Yesterday we saw how terrorists are threatening the social and economic fabric of India, another upcoming global powerhouse.

One by one, the BRICS are falling and let's hope that these aggressive measures will help stimulate growth. Unfortunately, I am not sure that they will do much to offset the decline in global demand.

As far as pension news, the media in Canada keeps focusing on Ontario Teachers' Bell Canada deal and on the Caisse where losses have become a major campaign issue for Liberal Leader Jean Charest.

Premier Charest is absolutely right not to politicize the Caisse. I hope he read my comment on "Quebec Inc." and will not allow opposition leaders to engage in that debate.

Again, where were these politicians when the Caisse needed governance reforms? They were all sleeping on the wheel, each and every one of them. As long as the Caisse was delivering results that beat their benchmark, they weren't the slightest concerned. Now that the Caisse will suffer huge losses just like the rest of its peers, they seize the opportunity to scream foul play to score political points.

But a pension fund shouldn't be a political football. I will repeat what I have stated many times in my blog: Richard Guay is the best person to lead the Caisse at this critical juncture and turn it around. Some may disagree with me and that is their right, but I stick with my claim and I will back him up knowing full well that just like Senator Obama, he inherited a mess which he now has to clean up.

Let's move on to Bill Tufts' commentary:

Hello

It has been a while since I wrote to you. I have been busy trying to calm my clients about their fears of the markets and most businesses seems to be tightening down expenses for the potential challenges in the economy ahead.

A lot has happened in the pension world.

We can begin with the meltdown that has occurred in pensions on the markets. This has heightened awareness of pension problems for the public sector plans and of course in the private sector as well. The automotive makers are saddled with huge legacy costs and it will be difficult to see how they can survive without government help. But some argue the markets should take their natural course and weed out the non-profitable entities. Why should you as a taxpayer bailout inefficient businesses who have mismanaged opportunities.

Speaking of bailouts there us much talk of bailouts for pensions funds. Unfortunately the only funds to be bailed are the public sector plans and the few large company plans remaining. We can see how the automakers are struggling. Here is a list of the Top Pension Plans in the country. They look like plans that have already received billions of tax dollars. Why dump more in? Who is going to bail out your pension fund?

As we watch the business world try and deal with pension meltdowns more and more people are speaking about the unfairness of our current system. The Pension Tsunami
is a watchdog across the US. As people investigate pensions more and more rot is discovered. This site discloses the waste of taxpayer dollars to the new special class of citizens the taxpayer has created.

The sins include double dipping, receiving a gold-plated pension at that same time working on the public dole. Pension boosting, the boosting of final pension income by working overtime. Bankrupted cities in California, almost bankrupted states, huge pension deficits and on and on. Ontario’s own Teachers pension shortfall was over $12 billion in April this year. That was before the huge losses in the markets this fall. The deficit is probably in the range of $30 billion today. This is more than $6000 for every Ontario resident.

On the research front the CD Howe Institute released their report that shows the huge unfairness of the public sector pension plans. The gold-plated pensions of the public sector are designed to replace 70% of final working income. A teacher retiring at $94,000 of income should expect government support of over $65,000 for life and indexed.

The CD Howe report compared the private sector and the public sector worker. A comparison was made between two workers each earning $50,000. The average private sector worker retires with $ 255,000 in his RRSP while the same public sector worker would have in excess of $1 million to fund his pension. The full report makes for very interesting reading for us who have absolutely nothing better to do!

To address the unfairness of the pension situation even the Canadian Chamber is on board with a report that makes the #1 Pillar in its Key Areas of Focus, Reforming Pension and Benefit Regimes. The report provides an excellent analysis of the key areas that Canada needs to improve to become competitive, from a labour perspective. This will be more important than ever for the future of Canada as we watch the continuing decline of the manufacturing sector and the rise of new economies based on technology, innovation and services.

It will be very interesting to watch how this pension situation progresses.

For those of you interested in a more technical aspect of pensions Leo has an interesting site with lots of information The Pension Pulse. [thanks for the plug!]

Oh by the way, I am planning on going to Mexico early next year to help a friend who has a chain of hearing clinics. Every year he goes to fit hearing aids on children in Mexico. It is a life changing experience for them. It is a vicious cycle because there is no social security system in Mexico. If the kids can’t hear they cannot learn to read, write or speak. Without these skills they cannot go to school. Without schooling in Mexico there is not much hope.


Last year we were in Tabasco, yes where the hot sauce is from. Over 50% of the population of Tabasco lives in poverty. Not like Canada’s poverty but real poverty where it is measured by having shoes to go to school, a roof over your head and one meal a day. We were able to help over 50 children hear, some for the first time. It is quite an experience to hear a child hear his name for the first time in their life and know that just maybe life can be different.

Hasta muy pronto.

I like the way Bill's message ended, focusing on the important things in life. Too many people in the financial world have lost the meaning of life.

As I told my former colleague on the plane ride coming back from Toronto a couple of days ago: "The only thing that matters in life is your family, your friends, your community and your health. The rest is bullshit".

And the true heroes in this world aren't the business billionaires, hedge fund or private equity titans you read about in the financial media, but ordinary people doing extraordinary things.

Tonight I spent a couple of hours watching CNN Heroes. If you want to understand the true meaning of Thanksgiving, go read up on these amazing individuals who selflessly devote their time and energy to make this world a better place.

Try and think about the billions of people out there are much, much worse off than most of us, and try to focus on doing your part to make this a better world.

Finally, you will notice that I removed my Google ads on the bottom right hand side and replaced them with links to worthy charities. If you know of any worthy charities that I should add to my list, please feel free to forward me the links.


Wednesday, November 26, 2008

The Final Bell?


The stock market bolted higher Wednesday, propelling the Dow Jones industrials and Standard & Poor's 500 index to their first four-day advance since last spring:

The market reversed losses from earlier in the session after President-elect Barack Obama pledged he would have a plan to deal with the nation's economic crisis on his first day in office. After filling more spots to his economic team, Obama stated that "help is on the way."

The major indexes built on their gains through the afternoon, but analysts warned that this latest advance came on light pre-holiday volume. The Dow is up 1,174 points, or 15.5 percent, during the past four days, and the S&P 500 is up 135, or 18 percent -- giving both indicators their biggest four-day rise since the Great Depression. The rally marks a string of gains that seemed impossible to achieve in the depths of selling that began in mid-September after the collapse of Lehman Brothers Holdings Inc.

Analysts saw encouraging signs in the rally, but they were still cautious given months of extreme market volatility.

"Sentiment has turned slightly more positive over the past few days with some of the government packages in the U.S. and the stimulus programs that have been announced," said Michael Sheldon, chief market strategist at RDM Financial Group. "That might help turn the tide."

The government's latest steps aimed at restoring the nation's financial system to health came Tuesday, when the Bush administration and the Federal Reserve pledged $800 billion to boost lending on credit cards, auto loans, mortgages and other borrowing.

Obama's remarks, meanwhile, calmed the market after the day's economic reports pointed to more weakness. The government reported that unemployment at recessionary levels, new home sales at their lowest level in nearly 18 years, another plunge in consumer spending, and factory orders for big-ticket items down by the largest amount in two years.

The volume is light but I think the buying will continue after Thanksgiving and all the way till the end of the year. Think about it like a boxing match and the final bell has rung. Pension funds, mutual funds and hedge funds need a good rally going into Christmas.

Speaking of the final bell, the big announcement today was that the Bell Canada deal may be in jeopardy due to solvency issues:

The largest leveraged buyout in history is unlikely to close after the Canadian telecom company BCE Inc. said Wednesday an audit has found the proposed $35 billion deal to take the company private may not meet solvency requirements.

An investment group led by the Ontario Teachers Pension Plan Board and several U.S. partners had expected to complete its deal for BCE, the parent of Bell Canada, on Dec. 11. It would have been the biggest takeover in Canadian history.

A preliminary review by accounting firm KPMG found that BCE would not meet the solvency tests of the privatization agreement, partly due to the amount of debt involved in the transaction and current market conditions, BCE said. The company must meet the solvency requirements for the acquisition to be completed.

BCE spokesman Mark Langton said if KPMG doesn't change its mind, the deal is unlikely to proceed because the auditor must clear it as a condition of closing.

"We are disappointed with KPMG's preliminary view of post-transaction solvency, which is based on numerous assumptions and methodologies that we are currently reviewing. The company disagrees that the addition of the (leveraged buyout) debt would result in BCE not meeting the technical solvency definition," BCE Chief Financial Officer Siim Vanaselja said in a statement.

BCE said it is working with KPMG and the proposed buyers to meet the closing requirements.

Shareholders overwhelmingly approved the buyout group's offer of 42.75 Canadian dollars per share ($34.50) in September of 2007.

BCE management had agreed to the deal in June 2007, just before credit markets began to unravel in North America.

U.S.-listed shares of BCE plunged $10.65, or 34.1 percent, to $20.63 in Wednesday trading. The stock has ranged from $25 to $40.44 over the past year.

If the deal doesn't proceed, the banks that agreed to finance it would be off the hook. Citigroup is directly on the hook for at least $11 billion of the $35 billion in loans backing the deal. The Royal Bank of Scotland, Toronto-Dominion Bank and Deutsche Bank were to provide the rest. The inability of the banks to finance the loans could have meant billions of losses for the banks.

Some analysts speculated the banks would try to get out of the deal. A spokeswoman for Citigroup declined comment.

Jeffrey Fan, an analyst with UBS, said in a report that underfunded pension liabilities at BCE might have been one of the reasons for KPMG's decision.

Elliott Soifer, vice-president of Desjardins Securities International, said he doubts the deal can be salvaged by altering terms.

"Given the market conditions and the amount of debt, the size of the deal and the number of parties involved it's going to be very difficult for them to come to some sort of agreement," Soifer said.

Michael Hlinka, an independent financial analyst and business commentator with CBC radio, said the economic outlook has changed fundamentally since mid-2007. U.S.-listed shares of Telus, one of BCE's competitor's in Canada, have fallen below $28 from a high of over $61 in June 2007.

"When the deal was originally struck the valuations for all publicly traded companies was fundamentally different than what it is now," Hlinka said. "I would be stunned if it goes ahead at this point. The market is voting with its feet right now about the likelihood of the deal. This was supposed to close in two weeks. The financiers are breathing a huge sigh of relief and I think they are in no hurry to come back and get this deal done."

Hlinka said it would have taken "a miracle" for the banks to sell the debt in debt markets.

"Citigroup, for all intents and purposes, is a liability of the U.S. taxpayer. The Royal Bank of Scotland, for all intents and purposes, is a liability of the taxpayers of Great Britain. It's so bizarre that its come to this but it has," Hlinka said.

The Toronto-based Ontario Teachers' Pension Plan -- with assets of $108 billion Canadian ($85 billion) in 2007 -- invests and administers the retirement funds for Ontario's 353,000 active, inactive, and retired teachers. U.S.-based Providence Equity Partners and Madison Dearborn Partners LLC are also involved in the proposed buyout. Teachers' spokeswoman Deborah Allan declined to comment.

I hate to say that I told you so, but I told you so this past Sunday. This deal was DOA and Teachers should count its lucky stars it is off the hook, cut its losses, and just walk away.

Of course, pension funds that invested in Bell thinking this deal will go through just got burned. Moreover, the Bell bombshell hit hedge funds hard:

Some event-driven hedge funds won’t have much to be thankful for tomorrow. Wednesday’s news that Bell Canada’s $50 billion leveraged buyout — the largest in history — is in jeopardy will likely hammer several big funds that were gaining confidence the deal would close on Dec. 11.

Among the big names that owned Bell Canada shares are hedge funds Paulson & Company, D.E. Shaw and S.A.C. Capital. An arbitrage fund run by BNP Paribas also held about $129 million worth of Bell Canada stock at the end of September, according to public filings.

Other funds that held a substantial amount of shares as of Sept. 30 included Chesapeake Partners, Mason Capital Management, York Capital Management and Highbridge Capital Management.

Bell Canada shares were down as much as 40 percent in premarket trading after the telecom giant said Wednesday that a preliminary report by the auditor KPMG found that “given current market conditions,” it would not remain solvent once it took on the $33 billion in debt needed to take it private.

Providence Equity Partners, Madison Dearborn Partners, the Ontario Teachers Pension Plan and Merrill Lynch agreed to buy Bell Canada last year for $42.75 Canadian dollars a share.

A failure of the Bell Canada deal would be the latest in a string of hits this year for hedge funds that bet on takeover deals. Across the globe, 297 deals were shelved in the third quarter, according to Dealogic.

As early as last week, investors were snapping up shares of Bell Canada, narrowing the gap between the stock price and takeover price to less than 10 percent. That gap was once as wide as 30 percent as investors grew fearful of deals falling apart.

Confidence that Bell Canada would close on time was bolstered last week after Providence Equity and Madison Dearborn made “capital calls” to their investors, signaling they were readying their checks to finance the deal. The government’s bailout of Citigroup, one of the lead lenders on the deal, also reassured investors that the deal would close.

Now imagine if a pension fund bought Bell Canada shares thinking the deal would go through and also invested with these hedge funds who thought the deal would go through. That is some significant exposure to the Bell Canada deal.

Oh well, let's see what round #12 will bring. Tomorrow is U.S. Thanksgiving and I will come back with a guest commentary by Bill Tufts from WB Benefit Solutions. I wish everyone down south a happy Thanksgiving.

Tuesday, November 25, 2008

Will Central Banks Backstop Pension Funds?


I just got back from Toronto. I flew with Porter Airlines, which I liked, but I simply hate the hustle and bustle of airports (note to self: next time you go to Toronto, take the train!).

I went to listen to the Canadian Business Outlook 2009 and to my surprise, I found it quite interesting (I usually dread these events and avoid them like the plague but duty called so I went).

There were several interesting presentations. Professor Roger Martin, Dean of the Rotman School of Management, opened things up with a discussion on creating conditions for prosperity.

He discussed productivity trends in Canada. He highlighted several interesting points, but the ones that stuck with me were that at in the 1990s, Canada started spending more on health and financed it by cutting back on spending on education. The U.S. kept up its spending on education and according to professor Martin, this explains a lot on the "prosperity gap" between Canada and the U.S.

He also noted that U.S. workers work more than anyone else. It used to be that Japanese workers worked more but as they prospered, they work less. The same for Canadians and most other countries, as they prosper, they work less.

On Canadian tax policy, professor Martin does not have a problem with the level of taxation but with the structure of taxation which he calls "stupid". For example, Canada has the highest level of taxation on the service economy in the industrialized world, which he thinks is ridiculous.

The following speaker was Andy Canham of Sun Microsystems. Mr. Canham discussed enhancing workforce productivity in a collaborative economy. He opened his remarks by stating propserity is just about working longer hours, it's also about being happy. Sun Microsystems has created a work environment were 50% of the work is home based.

Think about how much time we waste in traffic or getting to work and how we could better use that time to work from home. Sun has created a method to ensure the security of the data in a business and use computers that are linked to a few main servers to increase workplace productivity. He referred to the example of a hospital that used Sun to computerize the way they track patients at the hospital (Health Canada should implement this nation wide!).

He also stated that the most incredible revolution happening in the internet is open source code where peope can download computer code. Sun Microsystems bought MySQL and they noticed that the biggest use of open source code comes from emerging markets.

Importantly, when it comes to technology, Mr. Canham notes that productivity gains are non-linear, typically "jumping" from one period to another. Once people start implementing new technology and feel comfortable with it, then you see incredible productivity gains.

After a small break, Joe Chidley, editor of Canadian Business, moderated a discussion between Benjamin Tal of CIBC, David Wolf of Merrill Lynch Canada, and Derek Burleton of TD.

Mr. Tal got things rolling stating that economists like to use "first derivatives" when all else fails. He said that even though house prices are falling in the U.S., they are falling at a slower rate, which he thinks is encouraging.

He believes the recovery will be a U-shaped or W-shaped one and even though it will happen over the next 18 months, it will take years before we return to normal conditions.

Mr. Tal also thinks protectionism will come back under an Obama administration as he has already hinted to a carbon tax on Chinese goods, which has the "dual purpose of protecting the environment and U.S. jobs."

Mr. Wolf said for him the key indicator to look at is the confidence index. If confidence does not come back, neither businesses nor consumers will start spending again.

At one point, after their speeches, Sherry Cooper, Chief Economist of BMO Capital Markets, walked into the room to prepare for her closing keynote presentation. I stood up and asked them about the risks of global deflation.

All three economists saw little if any risk of a 1930s or Japanese deflationary episode. Mr. Burleton remarked that Fed Chairman Bernanke is a student of the Great Depression and has been quantitatively easing the money supply to buy back debt. "The Fed's own balance sheet has increased dramatically in recent weeks".

Mr. Wolf said that even though headline inflation in Canada and the U.S. will slip into negative territory next year, a long period of deflation is unlikely because of aggressive monetary and fiscal action.

Mr. Tal agreed stating that unlike in Japan, authorities responded quickly to this crisis. He sees a buying opportunity in commodities over the next six months.

Dr. Cooper said that U.S. consumers are tapped out and they are starting to save. This poses a challenge to authorities who want them to spend. She noted that the Treasury has created new facilities to lend as much as $200 billion on a non-recourse basis to holders of AAA-rated asset-backed securities backed by “newly and recently originated” loans, such as for education, credit cards, automobiles and loans guaranteed by the Small Business Administration.

"This is as close as you get to lending money to consumers".

Even if these measures fail to bolster confidence, Dr. Cooper notes that the Fed will do "whatever it takes" to avoid deflation. "If the Fed needs to start buying long bonds, it will, if it needs to buy corporate bonds, it will, if it needs to buy stocks, which it is already doing, it will".

But then she noted: "Who will pay for all this?" Like Mr. Tal, she said that in the end, there will be a run on the U.S. dollar and that will be inflationary.

I agree with many points. However, if inflation does come back into the system and rates rise too fast, that will put more pressure on over-indebted consumers, ultimately increasing the risks of debt deflation.

Moreover, any slowdown in China is deflationary. I wouldn't be surprised to see another round of goods deflation coming from China in mid-2009.

The other big kink in all of this is that we avoid a major war, which will guarantee hyper-inflation. Let's hope we do not reach that point.

There is another issue that I want you to think about. Who will bail out pension funds? Will the Fed and other central banks lend them billions of dollars to make up for their shortfalls? Don't laugh, it might reach that point.

Speaking of pension funds, Andrew Willis of the Globe and Mail reported that Caisse sold equities to shore up or shut down money-losing positions in areas such as currency hedging and derivatives, along with international real estate and private equity.

The article cites a figure of $10 billion. I chuckled coming back from the airport listening to Michel Nadeau on the radio. I asked the cab driver to pump up the volume. The former second in command of the Caisse said that it was right to sell equities in October as equities declined more in November. Too bad Mr. Nadeau did not take the same steps with Nortel back in 2000 (I can't blame him, I and millions of others, got royally screwed with Nortel too!).

I also read another article in the Globe and Mail that Alberta Investment Management Corp. (AIMCo) chief executive officer Leo de Bever has recruited two former colleagues, George Engman and Brian Gibson, to join AIMCo as senior vice-presidents of direct private equity and equities, respectively:

"I need depth, I need experience, and I need people with a track record of being able to take opportunities and realize them," Mr. de Bever said yesterday in an interview, adding he plans to announce further hires in the coming weeks.

"Leo was given a mandate to build a top-class investment management organization and this is evidence he is executing on his mandate," said Keith Ambachtsheer, director of the Rotman International Centre for Pension Management at the University of Toronto.

As I have written in the past, Mr. de Bever is one of the most brilliant people I've met in the financial industry (contrary to popular belief, there aren't many brilliant people in finance) and AIMCo is lucky to have him as their leader. He is recruiting the right people to join him.

The sign of true leaders is that they are not afraid to recruit experienced people that challenge them. Conversely, dumb leaders who lack self-confidence surround themselves by "yes-people" who continuously stoke their fragile egos.

Let me end this post with a few thoughts on risk. After this morning's presentations, I hooked up with a buddy of mine for lunch.

We started talking about the Caisse and other pension funds that lost billions in the market rout. My buddy remarked that pension funds should have allocated a lot more to bonds and they should have protected their gains through the use of options.

"You'd think they would buy premium to protect their downside. Why didn't they sell call options to finance the purchase of put options?"

At the airport afterward, I ran into a former colleague of mine who echoed the same sentiments:

"These 'sophisticated' pension funds were buying all sorts of OTC complex crap and they couldn't figure out plain vanilla option strategies to protect their equity gains. It's ridiculous. That's what happens when you have theoreticians running investments instead of market guys who understand risk."

He told me that pension funds should start implementing option strategies to protect their gains. You can read more about using options to hedge equity risks in pension plans by clicking here.

One final note. Yesterday, I referred to an Expert Commission on Pensions headed by Harry Arthurs. In a report submitted last week, Arthurs makes several proposals to encourage new or expanded pension plans and argues for reinventing the Canada Pension Plan.

One professor of economics from McGill university sent me this comment:

Just a note on the Arthurs suggestion: one of the features of inter-generational PAYGO plans is that the first generation always benefits, and the last generation (yes, there must be a last generation some time!) is left holding the bag. Doubling the size of the CPP is turning the current generation into a first generation, and leaving some people down the road holding twice as big a bag.

The problem with all that is the demographic structure in most OECD countries makes PAYGO arrangements unsustainable at the intended level of real benefits in a reasonably short time. Why people like Arthurs are blind to the obvious, is not clear to me.

People are blind to a lot of things. They think that stocks will come back roaring and pension shortfalls will magically go away.

Not this time. As Dr. Cooper mentioned in her presentation, the new Goldman Sachs and Morgan Stanley will have leverage ratios of 10 to 1 - like most commercial banks - not 30 or 40 to 1. This means that the era of double digit index performance is over.

That leaves me to ask, who will bail out pension funds? The Fed? The Bank of Canada? Other central banks? If so, it's just another bailout of negligence that we will all end up paying.

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.

Sunday, November 23, 2008

Is Ontario Teachers' Heading for a Fall?


My last entry was about the Caisse and the major internal and external challenges it faces to come out of this crisis.

But as I stated, it isn't just the Caisse that is suffering; other large Canadian pension plans are also experiencing similar challenges.

One of those plans is Ontario Teachers. For years, those of us in the pension community were told to try and emulate Teachers.

Why? Because, as the saying goes, Ontario Teachers got it right. They took a page from the Harvard and Yale endowments, aggressively moving into alternative assets early on. They shoved billions into real estate, private equity, hedge funds, commodities, timberland, infrastructure and everything else that was supposedly not correlated to public equities.

Funny thing about correlations, they always break down when you need them the most. What you want want is for asset classes to be non-correlated when a crisis hits, not when the good times are rolling.

And in a systemic crisis like the one we are currently experiencing, only good old government bonds will help cushion the blow to the overall fund. When all asset classes are in a bubble, as is the case now, the unwinding is so fierce that only government bonds will mitigate the downside risks.


You would think this is simple to understand but so many pension funds fell victim to the illusion that risk was being managed properly by sophisticated models measuring value at risk (VaR), that nobody stopped to think about if all these asset classes are in a bubble, then what happens to our overall fund?

At Ontario Teachers, you got some exceptionally bright people working in all asset classes. But just like the Caisse, Teachers is going to get whacked hard this year and a lot of their riskier investments, especially the ones in private equity, are going to come back to haunt them.

One of the brightest people in the pension world is Bob Bertram. For many years, Mr. Bertram acted as the CIO of Teachers, helping Claude Lamoureux, their former president and CEO manage their pension investments.

This week, it was announced that Mr. Bertram will be stepping down to be replaced by Neil Petroff:

Jim Leech, President and CEO, today announced that Robert Bertram will retire as Executive Vice-President, Investments and Chief Investment Officer of the Ontario Teachers’ Pension Plan (Teachers’) at the end of 2008. Neil Petroff, currently Group Senior Vice-President, Investments, has been appointed his successor, effective January 1, 2009.

“Bob has built a world-class investment team that has been consistently recognized for its innovation in pension fund management,” said Mr. Leech. “Under his leadership, Teachers’ has achieved many firsts – gaining the right to use derivatives, buying a major operating real estate company and being early to invest in private equity, commodities, infrastructure and timber.”

“Bob brought a vision to Teachers’ that investment results could be delivered as well, or better, in-house,” continued Mr. Leech. “His success has changed the way pension plans the world over now invest their funds.”

Prior to joining Teachers’ in 1990, Mr. Bertram spent 18 years at Telus Corporation, formerly Alberta Government Telephone.

Mr. Leech noted that Mr. Petroff’s appointment reflects Teachers’ tradition of cultivating its talent internally. “We have always taken a comprehensive approach to succession. Over his career at Teachers’, Neil has served in progressively senior positions with broad exposure and management experience in a wide range of asset classes and investment products. This has prepared him to lead our investment program into the future, with its new market realities.”

Mr. Petroff has 25 years of experience in the financial industry, beginning his career in investing at Bank of Nova Scotia and continuing at Guaranty Trust and Royal Trustco. He joined Teachers’ in 1993 and has been a member of the executive management team for 13 years. He has led the international equity indexes, fixed income, foreign exchange, tactical asset allocation and alternative investment groups. More recently, as Group Senior Vice-President, Investments he has overseen all of Teachers’ asset classes and portfolios, including public and private equities, inflation-sensitive and fixed income portfolios.

Mr. Petroff earned a BBA and an MBA from York University and is a graduate of the Corporate Governance College. Together with former CEO, Claude Lamoureux and Mr. Bertram, he was recognized for innovative hedge fund portfolio management when Teachers’ was named Public Pension Fund of the Year by Alternative Investments News in 2007.

With $108.5 billion in net assets as of December 31, 2007, the Ontario Teachers' Pension Plan is the largest single-profession pension plan in Canada. An independent organization, it invests the pension fund's assets and administers the pensions of 281,000 active and retired teachers in Ontario.

A couple of observations here. Mr. Bertram was scheduled to retire a year after Mr. Lamoureux retired. And given the state of the markets, I am sure he is looking forward to move on and watch it all from the sidelines.

Also, don't worry about Bob Bertram's retirement. For many years Ontario Teachers fought hard to compensate their employees just like the private sector. With his long-term incentive plan and generous retirement benefits, Mr. Bertram was among the highest paid pension officers in the world, collecting several millions in the last few years alone and being compensated almost as much as Claude Lamoureux.

But you got to keep in mind that compensation is tied into performance and performance is based on beating benchmarks. Unfortunately, Teachers' does not publish benchmarks for each and every internal and external investment activity and they lump investment activities together in broader categories like "inflation-sensitive" asset classes.

If you go to page 83 of the 2007 annual report, you'll see investment returns and related benchmarks, but read the fine print and check out the footnotes:

For example, footnote (1) states that fixed income includes currency policy hedge trading, internal absolute return strategy investments and alternative investments. Moreover, footnote (2) states that for the period January 1, 2006 to June 30, 2006, mezzanine debt was included in Canadian and Non-Canadian equities. Beginning July 1, 2006, mezzanine debt is included in Fixed Income due to a change in benchmark.

And what were the benchmarks for each of these investment activities and do they reflect the risks and beta of the underlying investments?

A bit lower on that page we read that effective January 1, 2007, certain benchmarks have been revised to reflect changes in investment strategy and objectives.

Huh? You are changing benchmarks and you are not publishing a separate report to explain in detail each and every benchmark you are using to evaluate and compensate your senior pension officers?

This is totally unacceptable for a public pension fund that invests billions on behalf of hard working teachers of Ontario who get compensated a fraction of what the Ontario Teachers' senior pension officers get in terms of compensation and retirement benefits.

I am making the latter point not because I have a problem compensating people for performance in investment management, but because for far too long compensation in these "sophisticated" pension funds was based bogus benchmarks that do not reflect the risks of the underlying portfolio.

My biggest beef is with private asset classes like real estate, private equity and infrastructure, but I also warn people to scrutinize the benchmarks used to evaluate external hedge funds and internal absolute return activities.

Importantly, in any investment activity, when you see someone trouncing their benchmark year in and year out, STOP AND THINK about whether that benchmark accurately reflects the underlying risks of the portfolio.

Unfortunately, we do not get enough transparency regarding benchmarks of each investment activity and financial audits by auditor generals or some accounting firm do not cut it.

Large Canadian public pension funds have become too "sophisticated" for their own good. Regulators are way behind the curve and we are in desperate need of major governance reforms to deal with the Mother-of-all crisis that is currently hitting pension funds.

Again, stakeholders need to first acknowledge their own shortcomings in properly supervising these large funds and they need to work on passing laws to increase transparency (performance results should be quarterly) and perform independent performance and operational audits on large funds at least once a year, if not twice a year.

The Ontario Teachers' investment and compensation models have been exported to other large Canadian and global pension funds, but unfortunately, so has the lack of proper disclosure on the benchmarks used to compensate senior pension officers.

Stakeholders should demand a separate document that clearly explains benchmarks and compensation for each and every internal and external investment activity. This document, along with the independent performance and operational audits, should be publicly available so that all stakeholders can view it and scrutinize how pensions investments are being managed.

Am I dreaming? Perhaps, but I can guarantee you that if we not move ahead to bolster the governance of these large funds, then taxpayers are going to be on the hook for billions of dollars.

Now, getting back to Teachers, this is going to be a very tough year. Apart from the drubbing in global equities, there are rumors of large losses in the fixed income department. I can't substantiate any of these rumors, nor can anyone else, but we do know that Sean Rogister, the former Senior Vice-President Fixed Income abruptly left the organization and was replaced by Ron Mock, the current Senior Vice-President, Fixed Income and Alternative Investments.

Ron is one of the sharpest guys I ever met in the pension world. Through our conversations, I learned a lot about operational and investment due diligence on hedge funds. One of the things that Ron taught me is to scrutinize operational risk, including the relationships among senior staff and when you see senior guys leaving a hedge fund, you got to immediately red flag it and ask why.

I think the same goes for pension funds. When you see senior pension officers abruptly leaving a major public pension fund with no press release explaining why, your antenas should be raised. It typically signals something is up and I believe stakeholders have a right to know exactly what is going on.

Then there is the Bell Canada (BCE) mega buyout deal. Boy did Teachers pick the wrong time to buy out BCE!

Forget about the fact that BCE's earnings crumbled in Q3, look at the current state of credit markets. As BCE recently launched a debt buyback, signaling that the deal may go through, junk bond yields subsequently soared to record levels as the global economy declines.

Add to this the issue of BCE's pension shortfall, which the Globe and Mail's Andrew Willis recently mentioned in his Streetwise blog:

As if investors didn't have uncertainties around the BCE buyout, there are new concerns that the telecom company's pension shortfall could undermine the deal.

BCE has already flagged the fact that its pension is under funded, and there are rumours on Friday is that the stock market's slide has made the problem much worse for buyers and lenders.

The nasty line of speculation goes like this: The under-funding problem is now so severe that BCE's auditors can't provide a solvency opinion on the plan.

The $35-billion takeover is being led by the Ontario Teachers Pension Plan, no stranger to funding shortfalls, with Citigroup and Deutsche Bank leading the lending group. BCE officials could not be reached for comment.

No one is saying the pension problem could derail the deal. In fact, experts are saying quite the opposite.

In a report on these issues at the end of October, when BCE published its shortfall, Scotia Capital told clients: “We do not believe an increase in required pension funding by BCE would in constitute a material adverse change.”

The investment dealer said a global issue such as a decline in the value of pension assets is not the kind of problem that lets buyers wiggle out of takeovers. In addition, Scotia Capital analyst John Henderson ran the numbers and found the funding shortfall could be repaid over up to 10 years without undercutting the security promised to lenders, or the returns expected by the buyers.

Quarterly results from Canada's largest phone company showed BCE is concerned with the funding its pension. Last year's annual report showed BCE had $14.8-billion in its pension fund, while actuaries say it needs $15.7-billion to pay the benefits promised to employees. So BCE started the year with a $900-million shortfall.

BCE's pension plan, known as BIMCOR, had 58 per cent of its assets in stocks at the beginning of the year. Canaccord Capital analyst David Lambert calculated in late October that the BIMCOR has likely incurred a $2.3-billion loss, and is now underfunded to the tune of $3.2-billion. Obviously, the recent market meltdown has made things even worse.

“While this pension plan shortfall may not qualify as a material adverse change according to the relevant clause in the definitive agreement, it could increase the deal risk,” said Mr. Lambert.

Increase the deal risk? More like torpedo it! This was a dumb deal in the first place and now that Michael Sabia, the former outspoken CEO of BCE has left that organization, what is the point of completing the deal?

Importantly, does Ontario Teachers really think they will turn a profit out of this deal or are egos driving this deal now?

It seems that the Caisse is betting the deal will go through. Canada's biggest pension fund manager bought more BCE Inc. stock last quarter as the price traded below the buyout offer from an investor group.

Good luck to both of them! If you look at recent activity on BCE shares, you can see that market participants are increasingly worried that this deal will not go through. I bet you that the big international banks that originally signed onto the deal are now seriously looking at break-up fees, ready to walk at any time.

Do you blame them? Look at the current environment - it's not exactly an environment ripe for mega buyout deals. In fact, I heard that things are so dire that two private equity titans recently met up in Libya of all places to raise funds!

In closing, Ontario Teachers is also going through its own issues. On top of suffering its own pension shortfall, Teachers is highly exposed to alternative investments that are cratering this year.

Looking at that picture above from their 2006 annual report, I can't help thinking that Teachers may be juggling more than it can handle and they are now going to stumble and crash like the rest of their peers who followed their lead.