Tuesday, March 3, 2009

Pension Fiasco: Another Trillion Dollar Bailout?


Deborah Solomon and John Hilsenrath of the Wall Street Journal report that the 'Bad Bank' Funding Plan Starts to Get Fleshed Out:
The Obama administration, filling in some of the blanks in its bank bailout, is considering creating multiple investment funds to purchase the bad loans and other distressed assets that lie at the heart of the financial crisis, according to people familiar with the matter.

The Obama team announced its intention to partner with the private sector to buy $500 billion to $1 trillion of distressed assets as part of its revamping of the $700 billion bank bailout last month. It's central to the administration's efforts to unglue credit markets, alongside a Federal Reserve program aimed at spurring consumer lending in areas such as credit cards and home loans that will be officially launched Tuesday.

No decision has been made on the final structure of what the administration is calling a private-public financing partnership, but one leading idea is to establish separate funds to be run by private investment managers. The managers would have to put up a certain amount of capital. Additional financing would come from the government, which would share in any profit or loss.

These private investment managers would run the funds, deciding which assets to buy and what prices to pay. The government would contribute money from the $700 billion bailout, with additional financing likely coming from the Federal Reserve and by selling government-backed debt. Other investors, such as pension funds, could also participate. To encourage participation, the government would try to minimize risk for private investors, possibly by offering non-recourse loans.

The public-private partnership grew out of the "bad bank" concept, an idea popular among some economists that would have required the government alone to buy up the troubled assets.

The Obama administration jettisoned that idea after running into the thorny issue of pricing. To help banks, the government must pay enough so that firms don't have to suffer additional losses from selling or writing down the value of other similar assets. But there is little public tolerance for overpaying with taxpayer money.

Instead, the government wants to encourage private investors to buy up the assets in a way that would come closer to setting a market price where no market currently exists. Some within the administration believe establishing multiple funds could help with that goal. The funds would most likely target all types of assets, such as mortgage-backed securities, rather than focusing on one specific type of distressed security.

Many details remain unclear, in particular, how the government and the private sector will share the risk. An administration official said a key goal is to provide investors with "price safety" so they feel safe enough to get back into the market.

Under the Fed's program to jump-start consumer lending, known as the Term Asset-Backed Lending Facility (TALF), investors, including many hedge funds, will get access to cheap loans from the Fed to purchase securities backed by consumer debt like car loans and credit-card receivables.

The Treasury has agreed to provide up to $100 billion of capital to the TALF, and the Fed will lend up to $1 trillion through the program.

The Fed and the Obama administration also are mulling whether to expand the TALF to existing distressed assets, also known as legacy assets. Such a move could allow the Fed to provide low-interest loans to investors who use the money to purchase distressed mortgage-backed securities or commercial real-estate loans. But such a move also would raise many new questions, among them the amount of protection the Treasury would offer against such risky assets. As a result, the idea might not move forward.

The TALF, which was announced in November, has taken months to get off the ground. To date, no deals have been done under the program. The first is expected to be launched later this month.

Officials and some investors see great promise in the effort to jump-start securities markets. "What the Fed has done, and I think it will be effective, is to provide a balance sheet to finance assets for investors who identify credit risks they're willing to take," said Curtis Arledge, co-head of U.S. fixed income at Blackrock.

Still, other investors have raised questions about the TALF. For example, issuers of asset-backed securities that benefit from Fed financing must be willing to submit themselves to new Treasury Department limits on executive compensation. Some issuers could be reluctant to travel down that road.

Fed officials have spent months sorting out these and other details with market participants. Earlier this year, they had pledged to launch the program by February, but missed the goal.

Late this afternoon, Bloomberg reports that the Federal Reserve and U.S. Treasury eliminated executive-compensation limits for companies that bundle loans accepted under a new $1 trillion program, indicating the rules may have hampered efforts to start the plan.

In one broad stroke, the Obama administration is trying to revive the securitzation, hedge fund and private equity bubble. I wish them luck. As I have written before, a deflated balloon can't bounce.

It will be interesting to see how many pension funds line up to buy these distressed assets either directly or through hedge funds and private equity funds.

Meanwhile, Fed Chairman Ben Bernanke was telling lawmakers today that insurer AIG operated like a hedge fund and having to rescue the insurer made him “more angry” than any other episode during the financial crisis.:

“If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG,” Bernanke told lawmakers today. “AIG exploited a huge gap in the regulatory system, there was no oversight of the financial- products division, this was a hedge fund basically that was attached to a large and stable insurance company.”

Bernanke’s comments foreshadow tougher oversight of systemically important financial firms, and come as President Barack Obama seeks legislative proposals within weeks for a regulatory overhaul. The U.S. government has had to deepen its commitment to prevent AIG’s collapse three times since September as the company accumulated the worst losses of any U.S. company.

The company “made huge numbers of irresponsible bets, took huge losses, there was no regulatory oversight because there was a gap in the system,” Bernanke said. At the same time, officials “had no choice but to try and stabilize the system” by aiding the firm.

AIG is getting as much as $30 billion in new government capital and relaxed terms on its bailout announced yesterday.

There is a mammoth legal battle brewing as AIG responding to a lawsuit filed by former Chief Executive Maurice "Hank" Greenberg, said he was "directly responsible" for the creation of the financial-products unit that led to the company's near collapse.

Those financial products are credit default swaps (CDS) and that is why the Fed Chairman is angry, because he knows that without government oversight, AIG's failure could well torpedo banks and pension funds:

And that $30 billion is on top of $150 billion in rescue funds approved since September to keep AIG afloat. Some financial experts tell The Wall Street Journal and The New York Times that billions more may be needed to save AIG.

Talk about your Catch-22 dilemma. Americans are growing impatient with taxpayer-funded bailouts that threaten to reach into the trillions when all of it seems far removed from their plights. Worse, nothing seems to yield success.

Plus, it’s hard not to feel anger at AIG, which played fast and loose in the risky subprime mortgage industry that finally popped the housing bubble, upending our nation’s financial and housing sectors, sucking many Americans into a black hole that hurt their livelihoods and savings.

The temptation is to give in to the Darwinian view, let greedy institutions such as AIG perish and leave their bloated corpses out as examples for all others. The only problem is AIG is like some monster octopus, its tentacles snaking into key financial sectors involving everything from pensions to banks.

Americans are right to disdain our government’s de facto nationalization of AIG. Even before this weekend, the government owned 79.9 percent of the insurance giant’s holding company through prior interventions, including a $60 billion loan, a $40 billion purchase of preferred shares and $50 billion for troubled assets.

And yet, on occasion, we sometimes have to put our cherished principles aside, especially in a crisis. It’s somewhat like maintaining a beautiful yard, one you steadfastly keep both man and beast off. If your house is afire, you’d be wise to set aside your concerns about the lawn and let firetrucks and firefighters onto your grass to save the house.

Our nation’s financial institutions are on fire, and the only course more dangerous than trying to shore up AIG is abandoning it, risking greater economic calamity and devastation here and abroad.

We only hope our leaders demand sharp restructuring and viable solutions to ensure that our dollars aren’t ill spent. Because we’re running out of time, money and patience.

Not to add to taxpayers' angst, but AIG wasn't the only one "operating like a hedge fund." Some of the largest public pension funds in Canada, in the US and around the world were engaging in equally risky activities, betting big on hedge funds, private equity, real estate debt, commodities, CDOs and even selling CDS, just like AIG!

Back in August, I wrote that AIG's dismal results spell trouble for pension funds that were highly exposed to alternatives and toxic debt. Today, Bloomberg reports that the hidden pension fiasco may foment another trillion dollar bailout:

The Chicago Transit Authority retirement plan had a $1.5 billion hole in its stash of assets in 2007. At the height of a four-year bull market, it didn’t have enough cash on hand to pay its retirees through 2013, meaning it was underfunded to the tune of 62 percent.

The CTA, which manages the second-largest public transit system in the U.S., had to hope for a huge contribution from the Illinois state legislature. That wasn’t going to happen.

Then the authority found an answer.

“We’ve identified the problem and a solution,” said CTA Chairman Carole Brown on April 16, 2007. The agency decided to raise money from a bond sale.

A year later, it asked Illinois Auditor General William Holland to research its plan. The state hired an actuary, did a study and, on July 17, concluded that the sale of bonds would most likely result in a loss of taxpayers’ money.

Thirteen days after that, the CTA ignored the warning and issued $1.9 billion in bonds. Before the year ended, the pension fund was paying out more to bondholders than it was earning on its new influx of money. Instead of closing its funding gap, the CTA was falling further behind.

Public pension funds across the U.S. are hiding the size of a crisis that’s been looming for years. Retirement plans play accounting games with numbers, giving the illusion that the funds are healthy.

The paper alchemy gives governors and legislators the easy choice to contribute too little or nothing to the funds, year after year.

30 Percent Shortfall

The misleading numbers posted by retirement fund administrators help mask this reality: Public pensions in the U.S. had total liabilities of $2.9 trillion as of Dec. 16, according to the Center for Retirement Research at Boston College. Their total assets are about 30 percent less than that, at $2 trillion.

With stock market losses this year, public pensions in the U.S. are now underfunded by more than $1 trillion.

That lack of funds explains why dozens of retirement plans in the U.S. have issued more than $50 billion in pension obligation bonds during the past 25 years -- more than half of them since 1997 -- public records show.

The quick fix for pension funds becomes a future albatross for taxpayers.

In the CTA deal, the fund borrowed $1.9 billion by promising to pay bondholders a 6.8 percent return. The proceeds of the bond sale, held in a money market fund, earned 2 percent -- 70 percent less than what the fund was paying for the loan.

The public gets nothing from pension bonds -- other than a chance to at least temporarily avoid paying for higher pension fund contributions. Pension bonds portend the possibility of steep tax increases.

‘Very Risky’

By law, states must guarantee public pension fund debts.

“What appears to be a riskless strategy is actually very risky,” says David Zion, director of accounting research for New York-based Credit Suisse Holdings USA Inc. “If the returns on the pension bond-financed assets don’t exceed the cost of servicing the debt, the taxpayers bear the brunt.”

With the recession that started in December 2007, cities and states are running huge deficits, which they’re closing by cutting services and firing employees. The economic downturn gives state legislatures another reason to cut back on funding pensions.

Government retirement plans nationwide don’t calculate their shortfalls based on market values of their assets and liabilities, says Orin Kramer, chairman of the New Jersey State Investment Council, which oversees that state’s pension fund.

Paper Over Losses

Fund accountants resort to a grab bag of tricks to get by. They set unrealistically high expected rates of return to reduce governments’ annual contributions. And they use smoothing techniques to paper over investment reverses so they make losing years look like winners.

Accountants do that by averaging gains and losses, usually over a five-year period -- sometimes for as long as 15 years of investment returns.

That means actual results of any one year aren’t used to calculate how much a state legislature contributes, which can delay governments catching up with losses for more than a decade.

This ruse can pass the buck to future taxpayers, who will pay for the retirement benefits of today’s government workers.

“There are accounting gimmicks in pension land which create economic fictions and which disguise the severity of the real problem,” Kramer says. “Unfortunately, pension board members don’t have much of an appetite for disclosing inconvenient truths.”

Calpers’ Numbers

The Teacher Retirement System of Texas, the seventh-largest public pension fund in the U.S., reports each year that its expected rate of return is 8 percent. Public records show the fund has had an average return of 2.6 percent during the past 10 years.

The nation’s largest public pension fund, California Public Employees’ Retirement System, has been reporting an expected rate of return of 7.75 percent for the past eight years, and 8 percent before that, according to Calpers spokesman Clark McKinley.

Its annual return during the decade from Dec. 31, 1998, to Dec. 31, 2008, has been 3.32 percent, and last year, when markets tanked, it lost 27 percent.

‘It’s Pitiful’

“It’s pitiful, isn’t it?” says Frederick “Shad” Rowe, a member of the Texas Pension Review Board, which monitors state and local government pension funds. “My experience has been that pension funds misfire from every direction. They overstate expected returns and understate future costs. The combination is debilitating over time.”

Rowe, 62, is chairman of Greenbrier Partners, a private investment firm he founded in Dallas 24 years ago.

Texas teacher retirement fund spokesman Howard Goldman and Calpers’s McKinley declined to comment on Rowe’s views.

Most public pension funds, like the one in Chicago, were already treading water before the 2008 stock market crash. Now they’re closer to sinking.

State government pension fund assets in the U.S. fell 30 percent in the 14 months ended on Dec. 16, losing $900 billion, according to the Center for Retirement Research.

Fund managers don’t have many options for increasing assets. They need adequate funding from state legislatures, which in many cases they don’t get. Beyond that, they’re at the mercy of financial markets.

Easy Money

Typically, public pension funds put 60 percent of their assets in stocks, 30 percent in fixed income, 5 percent in real estate and the rest in riskier investments such as hedge funds and commodities.

That mix requires the nonbond assets to earn double-digit gains in order to reach expected rates of return.

The easiest way for retirement plans to increase cash is to issue pension obligation bonds. For the funds, that means borrowing money at no risk -- because the bonds are backed by taxpayers.

A government retirement plan can’t go bankrupt, even if it’s insolvent; state treasuries must put up the money if a fund runs dry.

What for retirement plans in the U.S. has been a simple solution -- issuing $50 billion in pension bonds --has become a growing headache for the public.

‘Where Did The Money Go?’

“When the actuary is finished with his magic, where did the money go?” asks Jeremy Gold, who was one of the first actuaries to work for a Wall Street firm when he joined Morgan Stanley in 1985.

The answer, he says, is that future taxpayers may cover what fund administrators had hoped to get from investment returns.

For investors, these debt sales are similar to ordinary municipal bonds. Because both forms of debt are ultimately backed by taxpayers, credit rating firms give them high grades for safety. The difference for bondholders in states is that pension bonds aren’t tax-exempt.

General obligation bonds are typically used to pay for construction of schools, hospitals and other public works; pension bonds just fund needy retirement plans. For that reason, Congress decided in 1986 that pension bond income should be subject to federal income taxes.

Government officials say they issue pension bonds believing that their fund managers can earn more money from investing the proceeds than what they have to spend in interest payments to bondholders.

‘Risk Is Minimal’

The government of Puerto Rico borrowed $2.9 billion through pension bonds in 2008, betting that it could reap annual returns of 8.5 percent investing the money, while paying its bondholders 6.5 percent.

“The risk is minimal,” says Jorge Irizarry, who was chairman of the Employees Retirement System of Puerto Rico from August 2007 through December 2008.

A political appointee, he departed after his party lost the governorship in November. Before working for Puerto Rico, Irizarry was an executive on the island at PaineWebber Group Inc., now UBS Puerto Rico, from 1986 to 1998.

So far, Puerto Rico’s wager isn’t paying off. The 8.5 percent expected rate of return has instead been a loss of more than $200 million, according to a Dec. 12 presentation by fund administrators to legislators.

‘Turned Against Us’

“It was an arbitrage transaction, and the market has turned against us,” says Carlos Garcia, former president of Banco Santander Puerto Rico, who replaced Irizarry as chairman of the pension fund in January. “I don’t know if the benefits intended will be realized.”

Actuaries consistently permit public pension funds to report artificially high expected rates of return -- most often 8 percent and as much as 8.75 percent. That’s more than the 6.9 percent billionaire investor Warren Buffett sets for his Omaha, Nebraska-based Berkshire Hathaway Inc.’s pension fund.

“Public pension promises are huge and, in many cases, funding is woefully inadequate,” Buffett wrote in his 2008 letter to shareholders. “Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that the problems will only become apparent long after these officials have departed.”

Determining how much expected rates of return should be isn’t complicated, says Rowe, who oversees Texas pension funds.

“Why do they choose high expected rates of return?” he says. “The only reason is to sneak through promising a lot to pensioners -- which means worrying about it later. It’s madness.”

The Rules

The Governmental Accounting Standards Board, a nonprofit group that provides guidance for accountants, has rules for financial reporting by public pension funds.

A study commissioned by the U.S. Senate Finance Committee, released on July 10, 2008, found that GASB guidelines could be meaningless.

“GASB operates independently and has no authority to enforce the use of its standards,” the report said. Each state sets its own rules. The GASB rules don’t mention pension bonds.

Illinois sold the largest pension bond issue ever, $10 billion in 2003, to shore up its state pension funds. In 2007, former Governor Rod Blagojevich proposed an even larger, $16 billion pension bond issue, as the state’s unfunded pension liability exceeded $40 billion.

The legislature impeached Blagojevich in January after he allegedly sought bribes in return for filling President Barack Obama’s vacant U.S. Senate seat.

Ignoring Advice

When the Chicago Transit Authority decided to issue debt in 2008, it did its own calculations.

The CTA concluded it could borrow $1.9 billion, paying an interest rate of 6 percent to bondholders, and invest the proceeds to receive its expected rate of return of 8.75 percent. Such an annual return would add $52 million a year to bolster the fund.

The CTA chose to ignore not only Illinois’s auditor general but also its own actuarial firm, Detroit-based Gabriel Roeder Smith & Co. The company had determined there was just a 30 percent chance of earning 8.75 percent.

“We executed the best transaction we could, given the legislative and political restraints,” says CTA Chairman Brown, who is also co-head of municipal finance at Chicago-based Mesirow Financial Inc.

Credit Crunch

Since the bond sale, the authority has held the money as cash, earning 2 percent. And, with the credit crunch forcing municipal bond interest rates up to attract buyers, the CTA wasn’t able to sell bonds with a 6 percent return.

A team of underwriters, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley, sold the CTA bonds in August 2008, at a yield of 6.8 percent, so the fund had to pay bondholders more than it had expected.

“There is negative arbitrage,” Brown says. “It’s better than having dumped the money into the equity market.”

The one group that benefits from the pension bond sales is the CTA’s retirement plan members. The authority is responsible for contributing more than twice as much to the fund as its employees. Thus the retirees are virtually certain to enjoy pension contribution savings from the pension bonds, the auditor general’s report says.

Puerto Rico Mistakes

Neither workers nor the government are thrilled with the public pension system in Puerto Rico. As of 2005, the Caribbean island’s government pension, with 278,000 participants, had assets that totaled just 19 percent of its long-term liabilities. That made it less funded than any state retirement fund in the U.S., public records show.

Puerto Rico’s pension system is a model for common mistakes made by public funds across the U.S.

Puerto Rico, a U.S. commonwealth with a population of 4 million, has underfunded its main public pension fund since 1951 to save cash.

The island, whose capital building in Old San Juan is as close to the turquoise ocean waves as are the tourists taking photos on the edge of the beach, is far from being a financial paradise.

The legislature has repeatedly ignored annual suggested contributions calculated by its own actuaries, according to the Employees Retirement System’s records.

Boosting Benefits

Puerto Rico’s legislature raised pension benefits without funding the increased expense 30 years ago. Edmund Garza, the retirement system’s administrator from 1992 to 1996, says pensions were boosted from 45 percent of average salary to 75 percent after 30 years of employee service.

“They didn’t prepare a detailed actuarial analysis to see the financial impact of this decision, but definitely it was huge,” Garza, 47, says.

The government skipped nearly $2 billion in contributions urged by its actuaries from 2000 to ‘05, according to fund records. The pension system continued a course toward insolvency as it paid out more in benefits than it took in.

By 2005, the Employees Retirement System had $12.3 billion of pension obligations with just $2.3 billion of assets. Puerto Rico itself has a BBB- credit rating, one notch above junk, from Standard & Poor’s.

“We are very near bankruptcy,” says economist Jose Villamil, speaking of the commonwealth. He is founder of Estudios Tecnicos Inc., a San Juan-based economics consulting firm. “The budget is out of control; the treasury is in sad shape.”

‘Continue to Deteriorate’

In 2007, the actuary for the Puerto Rico fund, Hector Gaitan of Buck Consultants LLC, recommended that the legislature make an annual contribution of $564 million.

“The financial status of the System will continue to deteriorate,” Gaitan said in a Feb. 12, 2007, letter to the pension board that urged a boost in commonwealth contributions.

The legislature ignored Gaitan’s warning. It chose to put $398 million into the pension fund. Just months after Gaitan suggested bigger government contributions to the retirement system, the pension board dismissed Gaitan and his firm.

“Those comments may have gotten us in trouble,” says Gaitan, seated at his desk in a small cramped office in a San Juan business park landscaped with palm trees. “We were terminated shortly thereafter.”

Irizarry, who chaired the fund’s board until Dec. 31, declined to say why the board dismissed Gaitan.

Outdated Mortality Tables

Gaitan says the retirement system’s underfunding may actually be an additional $1 billion or more than the fund reports, because the board relies on outdated mortality tables based on 1960s statistics to compute its future obligations. The shorter life spans in those outdated tables reduce the apparent size of the fund’s liabilities.

The legislature has taken one step to improve pension funding -- on the backs of employees hired after Dec. 31, 1999. New employees are denied fixed annual pensions. They must self- fund their retirement accounts.

The legislature diverts 9.275 percent of salary pension contributions for new workers to help scrape together the money needed to provide pensions for pre-2000 employees. By not making pension payments to employees hired after 1999, the pension fund will cut future liabilities.

The states of Alaska and Michigan, like Puerto Rico, have eliminated traditional public pension funds for new employees in the past 12 years.

Ana Reyes, an attorney in Puerto Rico, decided to take a job with the city of Caguas in 2008 so she could lock into a government pension.

‘My Insurance’

“I wanted to have a good life when I get old,” Reyes, 33, says. “That was my insurance.”

Reyes, who lives in the island’s Central Mountain Range 20 miles (32 kilometers) south of San Juan, says she didn’t know that new employees get no retirement payments funded by the government.

“If I’d known this, I might have made a different career decision,” says Reyes, who is the mother of a 2-year-old girl. “When I started here, they didn’t explain that.”

Even states that have had fully funded pensions --such as New Jersey in the 1990s -- now have retirement plans with fewer assets than future liabilities and aren’t moving to plug the gaps.

Jon Corzine

New Jersey Governor Jon Corzine, a former co-chief executive officer of Goldman Sachs, has proposed allowing government pension funds to put off half their pension contributions because of the state’s growing deficit during the recession.

Corzine’s suggestion follows a recent New Jersey pension track record of mistakes. When the state’s pensions were healthy in the 1990s, the state legislature eliminated nearly all of its annual pension contributions for almost a decade, while adding $4.6 billion of benefits.

New Jersey sold $2.75 billion of pension bonds in July 1997. Then-Governor Christine Todd Whitman said at the time that the bonds would save taxpayers $47 billion and make the system fully funded.

“You’d be crazy not to have done this,” Whitman said in a Bloomberg News interview in June 1997. “It’s not a gimmick. This is an ongoing benefit to taxpayers.”

Whitman’s prediction hasn’t held up. While the state pays pension bondholders a fixed 7.64 percent interest rate, the fund has earned 4.8 percent annualized since the bond sale, according to Tom Bell, spokesman for the New Jersey Treasury Department.

‘Outrageous Gimmick’

New Jersey’s pension bonds haven’t saved taxpayers $47 billion. To date, the state has lost more than $500 million on those bonds, according to state records.

“Governor Whitman came up with this outrageous gimmick in order to give people tax cuts,” says Kramer, chairman of the board that oversees New Jersey state pension funds.

As the global economic crisis deepens, public pension funds will lose more money. The solution shouldn’t be more accounting tricks, Kramer says.

“Virtually every pension system has suffered losses in excess of 20 percent since they created the last set of artificial numbers,” he says.

The best step forward would be for states to negotiate benefits down, increase pension contributions and reduce the expected rate of return, Texas pension oversight board member Rowe says.

Public pension funds have to stop pushing the costs of retirement benefits for current workers into the future, actuary Gold says.

“You’re putting a bigger burden on your children,” he says. “It amounts to a transfer from tomorrow’s taxpayers to today’s employees.”

The burden that is being placed on future generations is enormous. From bank bailouts to pension bailouts, future workers will have to pay for these blunders and plunders.

This brings me to Keith Ambachtsheer's article that appeared in yesterday's National Post, Counterpoint: Pension funds are workers' best bet:

Last Friday, Financial Post Editor Terence Corcoran launched a full-scale attack on Canada’s public sector pension plans (“The model that’s killing pension plans,” Feb. 27).

Mr. Corcoran suggested that these plans represent “essentially, wealth confiscated by governments.” Further, he writes, at the heart of the current pension meltdown is an investment model that assumes that risk bearing will eventually pay off in higher returns, thus providing public servants, teachers and hydro workers alike with “relatively lavish pensions” at only modest cost. He notes that this investment model has now extended beyond simply investing in the stock market. “Recent fads” have included asset-backed commercial paper, a variety of private equity strategies, as well as “real estate in Munich, and sewer systems in Brazil.”

Mr. Corcoran’s assertions are more right than most politicians and public sector union leaders have cared to admit to date. The true cost of generous public-sector pension arrangements has indeed been systematically understated for many years. Younger and future workers, as well as taxpayers, have been the victims in these faulty public-sector pension models, although until recently, without being aware of it.

As I explained in a recent C. D. Howe Institute study (“The Canada Supplementary Pension Plan: Towards an Adequate, Affordable Pension for All Canadians"), we must move to pension models that work well for everyone, not just a select few. And make no mistake, getting there from here will take financial pain on the parts of older workers and pensioners too. Risks taken should be risks shared.

Having said this, I believe that by attacking the competence of the institutions that manage these faulty pension arrangements, Mr. Corcoran goes too far. Now he is shooting the messengers rather than the message.

[Note: In my opinion, Mr. Corcoran is not going far enough!!!]

Research I have been personally involved with found that the millions of Canadian workers who have been diligently depositing their RRSP contributions in retail mutual funds would be in far better financial shape today if they had instead had the opportunity to place their retirement savings with the pension funds Mr. Corcoran criticizes in his editorial.

The ratio I calculated was about two-to-one. That is, for a given stream of retirement savings over a worker’s career, the net returns produced by a typical pension fund will produce a twice-as-large pension compared to what a retail mutual fund with a similar investment mandate would produce.

Permit me to make a quite different comparison. Some of the most illustrious corporate names in global banking, insurance and finance from just a few years ago, are either not with us anymore, or are merely shadows of their former selves. This happened to Lehman, Merrill, RBS, UBS, AIG, Citigroup and many others because the leaders of these organizations lost track of their mission to produce sustainable value for shareholders.

Instead, they bet their entire franchises on highly complex investment instruments and new business models that, in their heart of hearts, they knew to be unsustainable. But as Citigroup’s Charles Prince said: “While the music is playing, you’ve got to keep dancing.” While a few pension funds, to their chagrin, got caught up at the edges of this deadly dance, most did not.

These observations do not mean that all pension funds walk on water. Like in other financial sectors, some pension funds perform better than others for good reason. On a global basis, large, well-governed, ‘arms-length’ pension funds with clearly defined missions outperform their counterparts without these attributes.

Canada is lucky to have a more than fair share of funds with these “high-performance” attributes. Does that mean they had great returns in 2008? Of course not! All forms of risk-taking got hammered last year. The important question is which pension funds will live to fight another day, and recover best from last year’s horrendous losses.

I am betting on the funds with the “real estate in Munich and the sewers in Brazil.” Who are you betting on, Mr. Corcoran?
Mr. Ambachtsheer is a smart guy, but he disappoints me. The way he presents his argument is very misconstrued. He presents the choice between mutual funds or professionally managed pension funds diversified across traditional and alternative asset classes, but he neglects to mention the period of which his findings were generated. Nor is he honest about the risks or governance overlaps associated with alternative investments or the valuations games that pension fund managers play with these investments.

He should also come clean and cite who pays his bills. Is it those Canadian pension funds he's praising or the stakeholders who are getting screwed as senior pension fund managers use bogus benchmarks on alternative investments to reap huge bonus on "bogus alpha"?

When it comes to governance, Mr. Ambachtsheer can claim all he wants, but he knows the pension model is broken and that there is a need for independent performance and operational audits at our public pension funds.

And if I had at choice, in the age of deflation, I would bet on funds like South Korea's National Pension Service, which avoided losses on its 236 trillion won ($152 billion) of assets last year as bond investments countered losses in the fund’s equities holdings:

The fund’s local bonds posted an 11 percent gain last year, while the value of its Korean equities declined 38 percent as stock markets were roiled by the credit turmoil, the Ministry for Health, Welfare and Family Affairs, which oversees the pension fund, said in an e-mailed statement today. The fund had a gain of less than 0.01 percent last year.

The performance was crucial as bonds, which made up the bulk of its portfolio, offset losses in a year when pension funds worldwide reported declining returns after a global rout wiped out more than $28 trillion in stock values. The California Public Employees’ Retirement System, the second-largest U.S. public pension fund, posted a 26 percent drop last year.

Korea’s fund “performed relatively well, and that’s quite natural given its really high portion of safer assets,” said Kim Yong Tae, a fund manager at Yurie Asset Management Co. in Seoul, which oversees the equivalent of $1.9 billion.

The MSCI World Index slumped 42 percent, its worst year on record, while the Standard & Poor’s 500 Index lost 38 percent. Government funds worldwide also posted losses. Temasek Holdings Pte, Singapore’s state-owned investment company, reported a 31 percent drop in investments to S$127 million ($82 million) in the eight months through Nov. 30.

Asset Allocation

Korea’s benchmark Kospi index fell 41 percent last year, its worst annual performance since 2000, when the technology bubble burst. The drop was the first for the measure since 2002. The index rose 0.3 percent to 1,028.94 as of 11:11 a.m. on the Korea Exchange today.

“It turned out that the fund didn’t post heavy losses, compared with overseas pension funds, even amid a difficult environment from the global financial crisis,” its statement today said.

National Pension, which was set up in 1988 and which covers private-sector employees and those who are self-employed, had posted returns of more than 5 percent between 2003 and 2007. Last year’s return was its worst in its two-decade history.

Domestic stocks will account for 17 percent of its assets by the end of 2009, up from an estimated 12 percent in 2008, the fund said in December. That’s a drop from its initial target of 20.3 percent, it added.

Bonds will make up 69.3 percent of assets in 2009, down from an estimated 77.7 percent in 2008, it said at the time, raising the allocation from an initial 60.4 percent.

“This year presents a great opportunity to pick up stocks at bargains, and the fund should steer its portfolio into gradually lifting risky assets in order not to miss out on returns when markets start to recover,” said Yurie Asset’s Kim.

Even at 69% bond allocation, South Korea's National Pension Service is being managed far more prudently than other large global pension funds, focusing on protecting the downside risk.

As far as those pension funds investing in the sewers in Brazil that Mr. Ambachtsheer is betting on, they lost billions last year and they're still hiding dirty little secrets that stink. They should clean up their own governance before investing in sewers!

The pension fiasco will turn to another trillion dollar bailout and nobody seems to be taking it seriously or coming up with some serious long-term solutions. What is needed aren't more cosmetic changes, but a massive governance overhaul that introduces a lot more transparency, accountability, risk management and open communication where fund managers manage in the best interests of stakeholders, not to line their own pockets.

The longer we prolong this governance overhaul, the worse it will get. It's already a disaster. Can we afford to wait any longer?

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