Friday, February 27, 2009

The Model That's Killing Pension Funds?


Terence Corcoran of the Financial post wrote an excellent article, The model that's killing pension funds:

This week's big losses at the Caisse de depot et placement du Quebec triggered the usual round of calls for the heads of the organization's top executives to be set out on platters. While public decapitation of investment experts who make mistakes is entertaining work, it hardly gets to the real issues exposed by the Caisse's 25% loss in value.

Those issues are, in no special order: 1) Why does the Caisse exist in the first place? 2) Why are pension managers risking taxpayer money on volatile equity markets and even more problematic investments? 3) How long will average voters put up with public pension operations that nationalize savings and, in many cases, reward a few and pass the risk on to taxpayers when things go wrong--as they will?

The Caisse, moreover, isn't the first, nor will it be the last, big name public pension plans to reveal disastrous investment returns and loss of value over the last year. The same questions could be asked of OMERS, one of Ontario's two pension giants, which reported a 15.3% loss for 2008. OMERS represents 380,000 unionized municipal and other public sector workers.

Ontario Teachers' Pension Plan doesn't disclose its disaster until later. The Canada Pension Plan Investment Board, which is relatively new to playing the stock market and other high-flying investment risks, reported a 13.7% plunge in investment returns for the first three quarters of its latest fiscal year. That comes after a zero-return clunker the year before and doesn't include a breakdown of the "fair value" writedown of its non-marketable investments.

As the Financial Post's Karen Mazurkewich reports today, these and other public pension managers could report cumulative losses totalling $100-billion for the year. They will all blame bad markets and the global financial crisis. None will look at the possibility that they are operating under faulty investment models and wonky actuarial theories. In the view of many economists who study pension funds, these plans are time bombs of risk whose losses taxpayers will inevitably have to pay for.

But first, the question is why do these giant public pension plans exist? They are, essentially, wealth confiscated by governments. The CPPIB and parts of the Quebec Caisse invest funds to provide basic pensions for all citizens, using money taxed from all their constituents. The rest of the public pension investment activity is on behalf of unionized monopoly government service providers --hydro workers, police, municipal employees, teachers. All are set to receive relatively lavish pensions paid for by Canadian taxpayers who have no comparable pension plans.

That gap is serious enough. But when it turns out that taxpayers will have to bail out the lavish union pension plans, or that their government pensions will require higher and higher cross-generational premiums, the morality of the gap widens even further.

At the heart of the pension meltdown is the investment model. The investment managers who led the Caisse into its 2008 meltdown were simply following the dominant investment theories of our time: Equity markets theoretically will provide solid average returns over the long term. Judicious stock picking can help a fund get better-than-average returns. More recently, all fund managers also came to believe that still higher returns could be found in other fields, including asset-backed securities and private investment markets.

As we've noted in this space many times over the last few years, in the view of financial economists the first part of the model -- that equities provide guaranteed returns over the long term -- is untenable.

Among the leading debunkers of the conventional model are U.S. consultants Lawrence Bader and Jeremy Gold. In a relatively recent paper, The Case Against Stock in Public Pension Funds, published in the Financial Analysts Journal in 2007, they warned that government pension operations are engaging in risky investment strategies. "Current funding and investment practices are costing taxpayers dearly," they wrote. By investing so heavily in equities, pension managers were putting taxpayers at risk on the assumption that long-term gains would overcome short-term meltdowns. Such equity premiums, they say, do not exist with any certainty.

As shown during the stock market crunch earlier this decade, the risks are large. The Ontario teachers plan is still being bailed out this year and next as the Ontario government pays close a $1-billion directly into the fund in part to cover past losses.

Pension funds will have to cover their equity losses, plus make up for losses from their more recent investment fads, namely, the theory developed in the U. S. that even bigger investment gains could be squeezed out of private investment deals. Equities were overvalued, they said, and the real money would now be made buying real estate in Munich, sewer systems in Brazil and private companies that had no trading value. Now that theory is also under a cloud.

So far, there are no signs that public pension funds are ready to reshape their basic approaches to pension management. The new losses are just a blip, they say, the function of a global financial crisis. You need to focus on the long term. Financial economics suggests this is the long term.

Bravo! I couldn't have said it better myself. The pension model is broken and along with it the "culture of equities" and the broken dreams of lifelong absolute returns from alternative investments.

The biggest problem with alternative investments is how pension funds value them. Karen Mazurkewich of the Financial Post writes for pension plan results, look to valuations:

The Caisse de depot et placement du Quebec saw its assets under management plummet $40-billion and the total tab for public pension losses last year could top $100-billion, but how much of that is subjective?

As it turns out, a whole lot.

In the case of the Caisse, more than 56% of the writedown is unrealized or paper losses that are based on an estimated value of the assets the plan is holding. Although the Caisse is not selling most of those assets, it still recorded significant losses based on a valuation.

And it ends up valuations on private companies and real-estate holdings have a lot of magic to go with the mathematics.

Which brings us to the yearend results posted by two pension funds this week. In announcing its losses, the Caisse recorded significant writedowns of 31%, 22% and 44% in its private-equity, real estate and infrastructure portfolios, respectively.

By contrast, Ontario Municipal Employees Retirement System (OMERS) , which announced its yearend results, registered a more modest return of negative 15.3%. While the plan notes a 13.7% decline in private equity, it posted 6% growth in real estate (meaning it had no write-downs) and a positive 11.5% return for its infrastructure arm.

It's hard to imagine that two pension plans, each with widely diversified portfolios, would have such huge disparity in their results. While some of that gap could be explained by leverage ratios and other factors, another factor is valuation strategies.

"When it comes to valuation, there's a huge amount of discretion that can be applied," says one Toronto-based private-equity manager.

Auditors prefer to determine the value of a company by comparing it to similar publicly listed firms, but the problem is that they have to choose which companies to compare themselves to.

Other ways to value a company or assets are to use a calculation based on future cash flows, simply use the last purchase price, or even a combination of all of the above.

Auditors have the latitude to use different techniques.

Says one chief financial officer of a large Canadian privateequity firm, you could take the same portfolio and get a 20% range in the valuation.

And that is one of the reasons the pension plan gaps may be so large.

Take the private-equity portfolio of OMERS. Patrick Crowley, the chief financial officer, says his group arrived at its 13.7% writedown by analyzing its own direct investments, and by interviewing 60% of the privateequity funds where it has investments who gave them an up-to-date-valuation on their funds. These include such firms as Onex Partners, Kohlberg Kravis and Co. and Apax Partners Ltd. They then prorated those interviews with the rest of their outside managers to arrive at their figure.

The Caisse, by contrast, determined the value of its private-equity portfolio using a complicated index, but 60% of it was made up of the battered S&P 500. It took a much bigger hit.

Then, there is the question of agendas. For the new top executives at the Caisse, it makes more sense to write down a greater part of the assets and start fresh.

OMERS executives, however, may be less inclined to take a conservative approach to valuation.

So what does the magical mystery tour of valuation all mean to the average pensioner?

The bad news is that it's difficult to compare institutional funds' performances. The good news, if you are a pensioner in Quebec, is that a chunk of that $40-billion loss is a figment of some auditor's imagination.

It isn't a figment of some auditor's imagination because if they absolutely needed to sell those assets today to pay for pension benefits, I can assure you that $40 billion might have been closer to $50 billion.

But Ms. Mazurkewich has caught on to the valuation tricks that senior pension fund managers love to play. Mr. Rousseau and other presidents were good at this game of taking massive write-offs on some assets one year, only to write them up the following year when markets recovered. Presto! Instant "alpha" with the magical stroke of some accountant's pen.

Finally, the Financial Post's Jonathan Chevreau writes Pension envy no more:

The revelation that Canada's largest pension fund -- Caisse de Depot et Placement du Quebec--lost a quarter of its $155-billion pension fund assets in 2008 is a timely reminder that even retirees in cushy defined-benefit plans should worry about the financial crisis.

Less fortunate members of defined-contribution corporate pensions, or those who run their own pensions in the form of RRSPs, know how much the worldwide bear market has hurt their retirements. Desjardins Financial found most Canadian workers have pushed back their retirement by almost six years.

I've used the phrase "pension envy" to describe how pension "have-nots" feel about the fortunate few seemingly insulated against market risk: In defined-benefit plans, employers absorb market risk and in public sector plans like the Caisse, the ultimate backstop is taxpayers.

Most experts do not believe Caisse pensioners are in danger of suffering shortfalls in benefits. "That thing will be here long after our great, great, grand kids are dead and buried," says Gordon Lang, chief actuary for Calgary-based Gordon B. Lang&Associates Inc.

Far less rosy are the prospects of corporate definedbenefit plans that are not as gold-plated as their public-sector counterparts.

Robert Brown, professor of actuarial science at the University of Waterloo, estimates a dozen corporate pension plans may have to tap Ontario's Pension Benefits Guaranty Fund (PBGF). They include the Canadian units of Detroit's big three auto makers and close-to-bankrupt former giants like Nortel. Mr. Brown says governments may face political headwinds if the proposed bailouts of auto makers includes salvaging those pensions -- the 79% of taxpayers who do not enjoy Cadillac employer pensions would most likely be outraged subsidizing those that do.

Mr. Brown would not worry if he were a Quebecer expecting his Caisse pension, but he definitely would if he were a Nortel retiree. Bankruptcy doesn't mean pensioners get stiffed, since pension assets are held separately in trust.

"What's happening is we're realizing some of these companies we thought would go on forever could actually go bankrupt," says Brian Fitzgerald of Capital G Consulting Inc. If a pension is only 70% funded and the employer runs out of cash, the issue is how to make up the deficiency. "The risk of losing all your pension is extremely remote," Mr. Fitzgerald says. "Typically, the risk is you get only 90% of what you were promised."

In Ontario, the PBGF tops up deficiencies to a maximum of $1,000 per month per pensioner, but there are limits to how many pensions it can bail out. Mr. Brown says Algoma Steel already took a $330-million loan from the fund.

Malcolm Hamilton, an actuary with Mercer's, says all pension funds had bad results in the past year. "The fact the biggest fund has the worst loss isn't surprising." The CPP Investment Board lost just 13.7% for the last nine months of 2008. The Caisse loss of 25% was proportionately worse because of exposure to asset-backed commercial paper.

There is a continuum of individual exposure to pensions. Federal government defined-benefit plans are unaffected because the ultimate backstop is the taxpayer. Ontario teachers are supported by the province, but members share the pain if higher contributions are required. Those in union-sponsored multi-employer pension plans may see lower benefits if returns sag.

There are two camps of single-employer defined-benefit pensions, Mr. Hamilton says. At strong firms, shareholders take the hit as employers make up pension deficiencies. But those in plans sponsored by financially weak companies are vulnerable since the employer may not be around to make up the deficiency.

An example is automaker General Motors Corp. Depending on its funded status, pensioners might get just 50¢ or 60¢ on the dollar, says Keith Ambactsheer, president of Toronto-based KPA Advisory Services Ltd. Ironically, if that occurred, that would put them in the same position as individuals who have lost 30% or 40% in their RRSPs.

If markets don't recover soon, even public pensions may not be able to keep their pension promises. Mr. Ambactsheer cites the dire straits some U. S. state and municipal pensions are in.

In the end, all pensions depend on a healthy economy and stock market. Despite talk of diversifying among alternative assets, the pension game is still tied to capitalism and the idea of "stocks for the long run."

The system could sustain another year or two of huge losses, but if the recovery doesn't kick in after that, all bets are off and pension envy will be a thing of the past.

If so, we'll have bigger problems to deal with than worrying about a leisurely old age.

Unfortunately, the pension crisis is here to stay. It's the reason why I started this blog and why I strongly feel that we need to radically change the governance at public pension funds.

The current model is killing them and unless something is done, taxpayers will be called upon to bail out public pension funds.

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