Thursday, February 12, 2009

Pension Darwinism?

Thursday was the 200th anniversary of the birth of Charles Darwin, the British naturalist whose theory of evolution revolutionized the telling of human history:

Darwin is most famous for his book, On the Origin of Species, which asserts that humans evolved over millions of years from apes.

The theory took shape on a journey through the Pacific islands off Ecuador, where Darwin collected thousands of specimens of rocks, fossils, insects and birds.

From his observations, he developed the idea that all species of life have evolved over time from one or a few common ancestors through the process of natural selection. Although the theory originally shook the belief that Earth was created by a higher power, it is now widely accepted.

Still, skeptics remain. A public opinion poll released in the United States this week by the Gallup organization reports that only 39 percent of Americans believe in evolution.

Although I believe in evolutionism, I must admit that I have my moments where I doubt the human species has evolved much from our ape ancestors.

Take for example, financial engineering. All those super smart PhDs in Mathematics, Physics and Financial Engineering who designed sophisticated instruments and programs to "hedge" all sorts of risks.

When I was working in the pension world, I called it the "tyranny of quants" because I found it ridiculous how people were so impressed with "quants". For years all you had to say is "I am a quant" and you commanded respect and a high salary on Wall Street, Bay Street and in the increasingly complex world of pension funds.

Now, I am all for quantitative analysis, but I am a born skeptic who believes that rigorous qualitative analysis should always complement any quantitative analysis.

While in university, I thoroughly enjoyed my honors courses in economic methodology, trying to understand the philosophical underpinnings of economic theory. I read the important parts of Keynes' Treatise on Probability and tried to understand the limits of quantitative analysis, especially when applied to social sciences.

Those of you who want to read more on this fascinating subject should pick up a copy of Omar Hamouda and Robin Rowley's book, Probability in Economics. Robin taught me econometrics and economic methodology at McGill University.

I enjoyed both courses, but I was more interested in economic methodology because it was intellectually more stimulating. One of the more interesting discussions in Keynes' Treatise on Probability and later in The General Theory, was the distinction between risk and uncertainty, particularly in the theory of interest.

Keynes did not provide a theory of uncertainty, but he did make some enlightening remarks about the direction he thought such a theory should take:

As Keynes repeatedly stressed, investment is not like a game of chance where the expected results are known in advance. And this is part of the explanation for the extreme instability in investment levels compared to other economic variables.

The state of long-term expectation ... does not solely depend on the most probable forecast we can make. It also depends on the confidence with which we make this forecast (GT: 148).

Human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist ... it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance (GT: 162-3).

Keeping the above discussion in mind, let's switch back to pension investments. The OECD calls for pension expansion despite $5.4 trillion loss:

Private pensions across the world lost $5.4trn (€4.2trn) by the end of December 2008, up from $5trn in October, driven mainly by returns on US pension funds, the Organisation for Economic Cooperation and Development (OECD) has revealed.

At the launch of the first edition of the OECD Private Pensions Outlook 2008, Juan Yermo, principal administrator for private pensions in the financial affairs division at OECD, confirmed the financial crisis had led to an average pension fund return of -23%, albeit long-term pension fund performance – over 15 years – was "still very positive".

That said, the OECD noted the greatest concerns resulting from the economic turmoil are sponsor solvency in defined benefit (DB) plans and the impact on larger, more mature defined contribution (DC) systems, such as the US and Australia, where there are a number of older workers with high equity exposure in their accounts.

Findings from the research also showed the funding level of DB schemes across the OECD has "dropped from already low levels", with all of the schemes sampled classed as underfunded, with an average of -25% of liabilities, although it admitted because some countries operate book reserve systems and/or offer insolvency protection, figures do not show "the whole picture".

Recommendations for policy measures put forward by the OECD included the introduction of 'counter-cyclical' funding or solvency rules for DB schemes – as funds "need to have better buffers in the good times and more flexibility in market turmoil".

The OECD said the need for a better design of default investment strategies in DC plans, with the suggestion governments should do more to promote the use of lifecycle approaches and guarantee products such as annuities.

Overall, Yermo suggested there is a need for further expansion of private pension provision, although he acknowledged "it might seem counter-intuitive" given the economic conditions, because public pensions remain unsustainable and in some cases are "in a much worse position" than before the financial crisis.

The report also argued public pension reserve funds (PPRF) such as Ireland's National Pension Reserve Fund (NPRF), or the Swedish national pension funds, AP1-4 and AP6, have an important role to play in protecting Pay-As-You-Go (PAYG) systems from market shocks.

Figures showed the total assets in PPRF's covered by the report – excluding those classified as sovereign wealth funds (SWFs) such as the Norway Government Pension Fund – Global – had increased to $4.3trn in 2007 from $2.6trn in 2001.

The OECD also revealed PPRFs "embarked on a major reallocation towards riskier assets between 2001 and 2007", more so than normal pension funds, the result being that the Irish NPRF was the worst performer in 2008 as it had the highest equity allocation.

However, Yermo suggested pension funds and regulators are likely to wait for more clarity on the financial situation before making any big decisions, as schemes are unlikely to make any significant asset allocation changes in the "middle of the crisis", and it is expected that "asset allocation will be set for a few years" as the OECD claimed it has not seen any sudden changes.

Instead, he suggested pension funds are approaching risk reduction in terms of "flexibility in plan design rather than asset allocation" on both the contribution and benefits side, which could be seen to be driven in countries such as the Netherlands, Norway and Denmark through a regulatory focus on solvency levels.

Additional research from the report, which will be published every two years, revealed while the proportion of employed people covered by voluntary private pensions is more than 50%, this is unevenly distributed with younger people and those on lower incomes less likely to have savings.

The report also noted there are 10 countries within the OECD where employees are not getting a replacement rate of more than 60% - based on combined public and private pension benefits - and if the typical replacement rate is assumed to be between 70-75% of final salary then even more countries, including Ireland, Germany, France and DC schemes in the UK, do not reach that level.

Research into costs and fees of running private pensions revealed countries with many small pension funds, such as the UK, have higher operating costs, so the OECD suggested this could be reduced through consolidation of occupational schemes, or centralising account management in countries with personal account systems.

The findings also highlighted a wide variety of administrative fees paid by plan members in DC systems, ranging from about 2% of assets under management in Hungary, to less than 0.5% in Sweden.

Pablo Antolin-Nicolas, principal economist for private pensions at the OECD, said: "Fees and costs are a very important issue and the wide variety of fees charged across countries show that something can be done to address this."

Figures showed the wide differences in fees – up to 1.5 percentage points – can result in large benefit gaps, and the report claimed that if Hungarian pension funds were to charge the same fees as the Swedish PPM system the benefits would be 30% higher.

As a result the OECD recommended, "structural changes in the way private pensions are managed, regulated and promoted", and also calls for the adoption of policy actions "in line with the long-term horizon of private pensions".

According to Watson Wyatt, the funding levels of U.S. corporate pension plans tumbled $445 billion in 2008, reaching historically low levels as drops in the debt and stock markets hurt asset values:

The sharp losses wiped out the $78 billion over-funded surplus from 2007 and left companies with a combined $366 billion pension funding deficit, the study of pension data by consulting firm Watson Wyatt Worldwide Inc showed.

The study looked at pension plans at 450 Fortune 1000 companies, representing some of the largest U.S. companies.

The funding drop was largely caused by a 24 percent fall in the value of pension plan assets, according to the study. Adding to the problem, pension plan liabilities also rose due to an increase in bond rates, Watson Wyatt said.

The firm said it expects that 61 percent of pension plans will have funding levels of only 50 percent to 70 percent for 2008. By contrast, at the end of 2007, 46 percent of pension plans were between 90 percent and 110 percent funded and only 5 percent had funding levels in the 50 percent to 70 percent range.

"Changes in funded status are wreaking havoc with the projections companies have made," Alan Glickstein, senior retirement consultant at Watson Wyatt, said in a statement.

"Large and unexpected pension contributions will require companies to divert funds they had earmarked for other business activities into their pension plans precisely when they can least afford it."
Interestingly, a poll conducted by pension consultant Hewitt revealed that global fund managers have raised questions over whether investments in a broad range of asset classes work in the short term:

According to the poll more than 40 percent of 100 fund managers said that last year's fall in returns across asset classes and greater than expected inter-connection between markets "had negatively impacted the rationale for diversification in the short term".

Investors such as pension funds invest in mainstream classes such as equities, bonds and alternatives like private equity and hedge funds aiming to achieve positive returns at lower risk.

"The experience of last year has led some (pension fund) trustees to question the benefit of diversification," said John Belgrove, principal consultant at Hewitt Associates.

"Fund managers are not giving up on diversification, but in the short-term there have been a lot of question marks," he said.

Belgrove said diversification was "a proven mainstay" adding that Hewitt found pension schemes with such a strategy fared better in 2008 than those which stayed in equity and bonds.

Hewitt said it is beginning to advise pension schemes to move away from government bonds, which became a safe heaven for investors in the last few months in favour of corporate credit.

The poll highlighted that 38 percent of fund managers said corporate bonds will perform best over the next 12 months, versus 33 percent seeing global equity as the better investment choice.
Clearly the focus right now is on strategic asset allocation. According to Greenwich Associates, Canadian plan sponsors are revisiting their portfolio management principles, reviewing their asset allocation, scrutinizing their managers more closely, and strengthening due diligence processes.

But as I wrote yesterday, the precarious state of the U.S. and global economy makes this cycle far more uncertain than the previous cycles.

I have had excellent discussions with economists I respect who firmly believe that massive fiscal and monetary stimulus and quantitative easing will kick in to firm up the U.S. and global economy. Moreover, as one economist told me: "These measures will work with a lag. Also, people are underestimating the leverage on the Fed's balance sheets. As Goldman and other investment banks cut leverage, the Fed is picking up the slack, levering up like crazy."

For him, the end result of all these measures will be inflation. The latter outcome would be good for company profits and pension plans because stocks will rise, bolstering assets, and liabilities will fall as interest rate rise.

[One conspiracy theory states that the U.S. will inflate its way out of debt and pension liabilities.]

But others remain skeptical that inflation is a foregone conclusion, highlighting Irving Fisher's debt deflation theory and its relevance today. I would also caution you to pay attention to developments in China where imports fell 43.1% last month from a year earlier, their sharpest drop since 1995. Moreover, as inflationary pressures wane in China, another round of goods deflation might be headed our way.

More worrisome is that according to a confidential Brussels document, a bailout of the toxic assets held by European banks could plunge the European Union into crisis:

“Estimates of total expected asset write-downs suggest that the budgetary costs – actual and contingent - of asset relief could be very large both in absolute terms and relative to GDP in member states,” the EC document, seen by The Daily Telegraph, cautioned.

"It is essential that government support through asset relief should not be on a scale that raises concern about over-indebtedness or financing problems.”

The secret 17-page paper was discussed by finance ministers, including the Chancellor Alistair Darling on Tuesday.

National leaders and EU officials share fears that a second bank bail-out in Europe will raise government borrowing at a time when investors - particularly those who lend money to European governments - have growing doubts over the ability of countries such as Spain, Greece, Portugal, Ireland, Italy and Britain to pay it back.

The Commission figure is significant because of the role EU officials will play in devising rules to evaluate “toxic” bank assets later this month. New moves to bail out banks will be discussed at an emergency EU summit at the end of February. The EU is deeply worried at widening spreads on bonds sold by different European countries.

In line with the risk, and the weak performance of some EU economies compared to others, investors are demanding increasingly higher interest to lend to countries such as Italy instead of Germany. Ministers and officials fear that the process could lead to vicious spiral that threatens to tear both the euro and the EU apart.

“Such considerations are particularly important in the current context of widening budget deficits, rising public debt levels and challenges in sovereign bond issuance,” the EC paper warned.

Finally, and most importantly, take the time to read Michael Hudson's latest on trying to revive the bubble economy, Obama's Awful Financial Recovery Plan. Michael's analysis should give you plenty to worry about as you try to set your strategic asset allocation.

In order to survive, I recommend pension fund managers keep in mind Keynes' distinction between risk and uncertainty.

But most will ignore the structural changes taking place, which is why as the cancer in the financial system spreads, pension Darwinism will continue in 2009 and possibly for a lot longer than we can possibly imagine.

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