Monday, April 6, 2009

Have Pensions Learned From Market Disaster?

Terence Corcoran of the National Post reports that pensions learn little from market disaster:
The Ontario Teachers’ Pension Plan released its 2008 annual report last week, ominously titled “Let us explain.” Reflecting the plan’s heavy equity portfolio and risky dips into fancy investment products, the OTPP followed other Canadian public-sector pension operations into a sea of red ink. The decline of 18% at the Teachers compares with 15.3% at the Ontario Municipal Employees Retirement System, 25% at Quebec’s Caisse de dépôt et placement and a 13.7% loss at the Canadian Pension Plan Investment Fund.

Private corporate defined-benefit pension funds faced equally challenging returns through 2008. The result is a nation of pension plans under water. The long-term survival of corporate plans, now under review in Ottawa, is in doubt. At the big public plans, survival isn’t an issue. The issue is who will pay for the blunders and losses — taxpayers or pensioners.

Teachers, which only last September renegotiated benefits to make up for a previous $12-billion actuarial shortfall, is now already short another $2.5-billion and heading for bigger declines in coming years as the big loss for 2008 — more than $19-billion — is spread out over future years. Unless the plan’s managers find some new miracle investment strategy, or the markets dramatically rebound, Ontario’s teachers and the province are going to have to cover the shortfalls by paying more or getting less.

Still more losses could emerge at the public pension plans as they continue to determine the market value of assets that are not traded. For example, Teachers had no losses in its $16-billion real estate portfolio in 2008, despite a declining real estate market.

The bigger question, though, is whether they have learned much from the meltdown. Apparently not, judging by the eagerness with which the operators of the major public funds plan to sail forth into the future in the same old leaky ship. Not only do they have continued faith in the power of equities to deliver superior returns over the long term, they seem to have even more confidence in their ability to beat the markets, despite staggering evidence to the contrary.

They have no choice. Under the actuarial models on which they are based, these big government plans must not only expose their pensioners and funding governments to high risk equity markets, they must also go out and find investment strategies that will generate even higher returns. At OMERS, the annual report puts it this way: “To fulfill the pension promise to our current and future retirees, we must produce investment returns that exceed the benchmarks for the asset classes in which we investment within an acceptable risk tolerance.”

There’s double jeopardy in all this. First, there’s the dubious premise that in the long run, equities produce higher returns than would be available if pension monies were invested in, say, federal government bonds. Second, evidence across the financial world is clearly stacked against the idea that money managers, no matter how big their portfolio and global their reach and clever their strategies, can beat the risks and generate solid returns. From Warren Buffet on down, investing is a dangerous business.

No insurance company would — or could — sell annuities based on pension model assumptions regarding equities. If the stock market were a sure thing, somebody would be selling investment products that guarantee a 6% real return. Nobody does, outside of Bernie Madoff’s world.

So why do we entrust, as taxpayers and pensioners, vast sums of money to pension managers who are expected to produce fat returns while operating in a hostile environment where no such fat returns exist? Because that’s the system the actuarial profession created — a system that is based on unsound and risky principles.

The risks and flawed assumptions have been known for some time, especially among financial economists. Pioneers in exposing the risks include Jeremy Gold and Lawrence Bader, U.S. pension actuaries who have long argued that the standard pension funding models understate the risks in equity investments and underestimate the costs of pension liabilities.

As described in their commentary in FP Comment, that leaves us with a risk-filled system that covers those risks by passing the costs on to taxpayers or future generations of pensioners. They propose a stark alternative for public pensions: All bonds, little or no equity.

There is some evidence pension plan managers have at least learned some lessons from the 2008 meltdown. At Ontario Teachers, the aim is risk reduction. “In response to 2008, we have decreased risk. We reduced our exposure to equity and credit markets and increased our allocation to inflation-sensitive assets that are well matched to paying pensions.” The equities portion of its assets will be set at 40% instead of 45%. Exposure to credit markets and hedge funds will be cut to 15% from 22%.

The push for higher returns and risk continues, however. At Teachers, managers are paid more if they can beat market benchmarks, a pay-for-performance approach that increases risk to the plan. At the Canada Pension Plan Investment Board, which currently invests more than $100-billion to secure the government pensions of all Canadians, managers are paid bonuses to earn “excess returns from active management programs.”

Adding even more incentive to take risks and raise compensation, the CPPIB plans to borrow money on the market to give it greater leverage as it scours the globe in search of excess returns in private deals, infrastructure projects and other assets. Teachers is reportedly looking at doing the same thing.

The future of Canada’s pension plans, public and private, remains at risk, despite the lessons offered by the 2008 meltdown.
The article got me curious about Ontario Teachers' real estate portfolio. If you read carefully the 2008 Annual Report, it clearly states on page 40 that real estate portfolio lost money:
The real estate portfolio totalled $16.2 billion at year end compared to $16.4 billion at December 31, 2007. The portfolio returned -4.3% compared to a benchmark return of 7.0%, or $1.8 billion below the benchmark. On a four-year basis, these assets generated an 11.7% compound annual return, outperforming this category’s four year benchmark by 4.9 percentage points for $2.1 billion in total value added.

Real estate is considered a good fit for the pension plan because it provides strong, predictable income. These assets are managed by our wholly owned subsidiary, Cadillac Fairview. Its aim is to maintain a well-balanced portfolio of retail and office properties that provides dependable cash flows.

The real estate portfolio earned income of $936 million in 2008 primarily from lease arrangements for retail and office space. At year end, the occupancy rate of the retail space was 95%, while the office occupancy rate was 94%. In addition, new investments and development activities were undertaken during the year.

Despite these results and activities, the overall portfolio value decreased in 2008 as the global slowdown forced property valuations lower worldwide. Publicly-traded real estate investments also declined along with equity markets.
But I missed something in my last comment on Teacher's disastrous results. The math simply doesn't add up. If the portfolio was valued at $16.2 billion at year end compared to $16.4 billion at the end of 2007, then that represents a 1.2% loss compared to a benchmark return of 7%, or $1.34 billion below the benchmark (8.2% of $16.4 billion). Then why does Teachers' claim they lost -4.3% or $1.8 billion below the benchmark? Shouldn't the portfolio be valued at $15.7 billion if it lost 4.3% in 2008?

[Note to Teachers': If I am missing something, I'll be glad to hear Teachers' "explanation". One reader wrote me back that one possible explanation is that "they may have injected additional monies into the portfolio and lost all the new money."]

But leaving this error aside for now, Mr. Corcoran's larger point is more important. The focus is on higher returns so they beat market benchmarks, a pay-for-performance approach that increases risk to the plan.

Ontario Teachers', CPPIB and even PSPIB are all borrowing money on the market to give them greater leverage as they scour the globe in search of excess returns in private deals.

You might want to stop here and reflect on this. Why are these funds borrowing on the market? Yes, it's cheap, but do they really need the added leverage on their balance sheets?

I think it all boils down to taking more risk so that they can ensure they beat those bloody benchmarks and collect their big bonuses at the end of the year.

A while back, these "sophisticated" pension funds figured out they weren't going to beat the benchmarks in public markets, so they focused their attention on private markets where they can create bogus benchmarks out of thin air and collect huge bonuses while they boast of adding significant value added.

This worked very well for years while the sun was shining. But now that the alternative investment Ponzi scheme is imploding (as it was almost exclusively built on leverage), this game plan isn't working any longer.

So what will pension fund managers do? My bet is that they will tinker with the benchmarks in private markets so that they can easily beat them, allowing them to collect huge bonuses once again.

One small problem. The game is over, maybe for good.

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