Tuesday, April 21, 2009

Pension Hearings at Parliament Hill

I was invited to Ottawa today to speak at the Standing Committee on Finance on matters relating to pensions.

I was there as an independent analyst. This was the first time I ever attended one of these committees so I was a bit nervous. I had lots to talk about and it had to be condensed in a short five minute speech. I was feeling under the weather but determined to show up and talk about pension governance.

Joining me was a prestigious panel including Claude Lamoureux, the former president and CEO of Ontario Teachers' Pension Plan. Mr. Lamoureux was there as a Special Advisor to the Canadian Institute of Actuaries to present the actuarial profession's views on the long-standing issues that continue to challenge the retirement savings system in Canada.

Other speakers included Susan Eng, Vice-President, Advocacy at the Canadian Association of Retired Persons and three speakers representing the Federally Regulated Employers - Transportation and Communication (FETCO): Siim Vanaselja, Executive Vice-President & Chief Financial Officer at BCE and Bell Canada; Brian Aitken, Chief Financial Officer at NAV Canada; and John Farrell, FETCO's Executive Director.

FETCO has been pushing Ottawa for pension reforms so I knew what to expect from them. Mr. Lamoureux is widely respected in the pension industry and his presentation was solid. The person who impressed me the most was Ms. Eng, the only non-pension expert at the panel because she was eloquent, well prepared and offered proposals that merit serious consideration.

James Rajotte chaired the committee and several members were present including Thomas Mulcair, Wayne Marston, John McCallum, Ted Menzies, Jean-Yves Laforest, Daryl Kramp, Carolyn Bennett, Massimo Pacetti, Maxime Bernier, Bob Dechert and Mike Wallace. There were other members present.

You can click here to watch the entire two hour hearing and transcripts will be available once the translation is completed.

I was the last speaker of the guests, rushing to beat the world record in speed talking. In case you did not hear everything clearly (I have a tendency to mumble), you can read my full comment below:

Thank you for inviting me. I’m grateful for the opportunity to be here today.

I would first like to emphasize that I am here as an independent analyst who is very concerned about the current pension crisis. The views and opinions expressed today are solely mine and do not represent those of my current employer or any other organization.

Let me begin with a brief introduction on my background. I was a senior investment analyst at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). My experience allowed me to gain valuable knowledge across traditional and alternative investments such as stocks, bonds, hedge funds, private equity and commodities.

In 2007, I completed a detailed report for the Treasury Board Secretariat of Canada on the governance of the Public Service Pension Plan (the ‘Plan’). This report was an independent review of the Plan’s governance structure to address some concerns raised by the Office of the Auditor General of Canada.

* * *

Let me now get to the matter at hand. Last year was a particularly difficult one for global pension funds as very few funds escaped the stock market rout. The OECD-weighted average ratio of private pension assets to the area’s GDP reached 111.0% in 2007. By October 2008, total OECD private pension assets were down to about US 23 trillion, or about 90% of the OECD’s GDP.

The impact of the crisis on investment returns has been greatest among pension funds in countries where equities represent over a third of total assets invested, with Ireland the worst hit as it was the most exposed to equities, at 66% of total assets on average, followed by the United States, the United Kingdom, and Australia.

For their part, Canadian pension funds suffered the steepest decline on record with an average loss of 15.9%, according to RBC Dexia Universe. The Office of the Superintendent of Financial Institutions (OSFI) released the results of its latest solvency testing of federally regulated private pension plans. The results show that the average estimated solvency ratio of federally regulated defined benefit private pension plans at December 31, 2008 was 0.85, a decrease from 0.98 as reported in June 2008.

The financial crisis exposed some serious governance gaps among Canadian private and public pension funds. I will now outline some of the more important governance gaps and make some recommendations on how we can address them.

* * *

By governance, I am referring to the system of structures and processes implemented to ensure both the compliance with laws and the effective and efficient administration of the pension plan and fund.

The six key governance areas in a pension plan are: oversight, compliance with legislation, plan funding, asset management, benefit administration, and communication. Given the time constraints, I will focus on three of these key areas: oversight, asset management and communication.

Pension oversight has always been important, but perhaps never more so than today. Several public and private pension plans are in financial trouble, the regulatory environment is rapidly changing and market volatility is constant.

At the large Canadian public pension plans, pension oversight is the responsibility of the plan sponsor who nominates an independent board of directors to oversee all activities of the pension funds. The integrity of the nomination process varies, but the intent is to keep political interference out of key investment decisions by public pension funds.

The cornerstone of pension oversight is risk management, defined in the broadest sense to take into account investment, operational legal and fraud risks. The board of directors oversee the investment activities of internal and external investment managers and they must make sure that controls are in place to mitigate against all these risks.

In order to do this, the board of directors need to have the requisite knowledge on all these risks as such risks can expose a fund to serious material losses. Importantly, the board of directors have a fiduciary responsibility to ensure that activities are being conducted in the best interests of the key stakeholders.

* * *

The failure of diversification strategy in 2008 highlighted the consequences of incomplete or poor oversight. The significant losses suffered at the large Canadian defined-benefit plans are the consequences of poor risk controls and compensation packages that rewarded speculation or performance based on bogus benchmarks.

By shifting assets out of safe government bonds, first into equities and then alternative investments like hedge funds, private equity, real estate, commodities and other risky investments, pension funds have contributed to systemic risk of the global financial system.

This process is what I have dubbed the global pension Ponzi scheme because pension funds were investing billions into alternative investments, ignoring the securitization bubble and without due consideration of how their collective actions are affecting the soundness of the global financial system.

Pension funds claim that the shift into alternative investments was done for diversification purposes, to “smooth” overall returns and to deliver absolute returns. However, there was another reason behind the shift to alternative investments: it allowed senior executives at pension funds to game their policy benchmarks so they could collect huge bonuses, claiming they are adding value to overall returns. This is of critical importance because such executives have clear fiduciary responsibilities, and that is to their plan sponsor and beneficiaries.

The reality is that senior executives are able to reap huge bonuses because they are beating bogus benchmarks that are not reflecting the risks of the underlying investments. Bonuses are based on, and awarded annually, on achievement versus benchmark. However, these bonuses are never clawed back when in subsequent years these investments fall well short of expectations.

Most of the abuses in benchmarks are concentrated in private markets like private equity and real estate, but similar abuses are also present in other alternative investments like hedge funds.

Illiquid asset classes are typically valued infrequently by external (and in some cases internal) auditors. With few exceptions, the benchmarks used to evaluate the performance of these asset classes do not reflect the risks of the underlying investments. For example, leverage is commonly used to boost the returns of illiquid assets (private equity, real estate, and infrastructure) and yet the benchmarks used to compensate senior executives at public pension funds do not reflect these risks.

Benchmark abuses also occur in public markets. The case of non-bank asset-backed commercial paper (ABCP) was an example of how some pension funds invested in assets which allowed them to handily beat performance benchmarks in their cash reserves, ignoring important liquidity risks that arise between the ABCP conduit’s assets and liabilities. Hedge fund benchmarks that do not take into account liquidity risk or leverage of underlying strategies are another example of abuses occurring at public pension funds.

Worse still, some pension funds used government balance sheets to sell credit default swaps (CDS), which are basically insurance policies on credit default obligations. Unlike AIG, they did not sell CDS on subprime mortgages, but once the credit crisis spread to all credit tranches, including tranches with AAA credit ratings, it exposed these funds to material losses.

* * *

In a recent speech, the Governor of the Bank of Canada, Mark Carney, stated that “as liquidity in many funding markets has dried up, so has embedded leverage in many pension funds”. I submit to you that the opaqueness of many of the large public pension funds, and their increasing exposure to complex derivatives and internal and external investment strategies, is hiding the true embedded leverage of these funds.

In conclusion, I want to end with a series of recommendations.

First and foremost, we need to legislate greater transparency in both public and private pension funds. In particular, there should be full disclosure of benchmarks used to evaluate all internal and external investment activities; performance results in public markets need to be reported every quarter and results for private markets on a semi-annual basis; finally, the minutes of the board of directors should be publicly available for public pension funds.

Second, financial audits conducted by auditors need to be augmented by comprehensive performance, operational and fraud audits by independent industry experts. These audits should be conducted on annual basis and the results should be publicly available.

Third, pension plans need to implement sound risk management policies. Plan sponsors have a responsibility to communicate their risk tolerance for the overall fund, focusing on minimizing the downside risk in the policy portfolio. Importantly, pension fund managers should get compensated for active risk based on clear benchmarks that reflect the risks of the underlying investments – i.e. risk-adjusted returns.

Fourth, whistleblower policies need to be strengthened so whistleblowers are encouraged to come forth and disclose any wrongdoings at public pension funds.

Fifth, regulatory authorities need to augment their resources to deal with the challenges at private and public pension funds, as well as other institutions of the “shadow banking system” (e.g. insurance companies and unregulated hedge funds). It is time for the Canadian government to invest more in bolstering regulatory bodies so they can attract more qualified people who understand the increasingly complex investments that these institutions are investing in.

Finally, I have not discussed my thoughts on dealing with the crisis at private pension plans , but my thoughts are that we need to seriously consider scrapping private defined-benefit and defined contribution plans, replacing them with a series of large public defined-benefit plans that are subjected to highest governance standards.

I thank you for your time, and welcome your questions and comments.

There were a few excellent questions but the format of these committees is such that it's hard to really get into all the complex issues governing pensions.

For example, I think it is crucial to complement financial audits with independent performance, operational and fraud audits. I was surprised that members did not ask questions on that.

Importantly, financial audits fail to address serious governance gaps at large public pension funds, and until this is addressed, pension funds remain vulnerable to abuses.

Mr. Mulcair asked me about the regulatory framework and the composition of the boards of directors. As I have argued in this blog, you need to have qualified independent board of directors.

The problem now is that the boards at most public pension funds are populated by financial industry people who scratch each other's back. It's one big club and this is a huge problem because they all have vested interests to maintain the status quo of compensation levels.

This is why I stated that you need to have some independent people, including academics with no ties whatsoever to the financial industry. At one point, Mr. Pacetti suggested some non-experts should be part of the board. I think he makes a good point since sometimes the non-experts have a lot more common sense then the so-called experts.

For its part, FETCO argued that Canada's solvency funding rules are too onerous and alluded to those of the U.S. and the U.K. to make their case for extending the amortization period of solvency funding from five years to ten years.

But as I have argued here, all this does is buy some time without dealing with the underlying structural deficiencies that are at the heart of pension deficits. Ms. Eng brought up the point that extending the deficiency funding rules troubles her because there is no "protection for pensioners".

Notice how FETCO neglected to mention the Netherlands which have the tightest solvency funding rules in the world. If a Dutch pension plan is underfunded, by law they have to present a detailed plan to their pension regulator on how they will reach fully funded status and over a certain defined period.

Speaking of pension regulator, both Ms. Eng and myself think it's high time to have a single national pension regulator. Ms. Eng also discussed a single national securities regulator and emphasized enforcing the actual securities laws.

FETCO argued that the discount rate for corporate pension liabilities should be based on AA corporate bond yields, not government of Canada bond yields. Because these rates are higher, they reduce the present value of future liabilities compared to a discount rate based on government of Canada bond yields.

[Note: This is just a mathematical PV formula where discounting using a higher yield lowers the present value of future liabilities. I say keep the government of Canada bond yield for everyone.]

Mr. Lamoureux brought up several excellent points, inlcuding the fact that young people are under-represented in pension plans, especially when members want to improve benefits. He also brought up an excellent point on how rules where you can only accumulate a surplus up to 10% of liabilities hindered the funding of many pension plans by exacerbating funding volatility. He advocates that this corridor has to be extended and then extend the amortization period.

Ms. Eng proposed a universal pension plan, stating that only a fraction of the population has access to a DB plan. She favors expanding the Canada Pension Plan - an idea proposed by Keith Ambachtsheer.

[Note: A new CARP poll finds members overwhelmingly support a universal pension plan. My only disagreement was that I am against expanding CPP and prefer to see many large defined-benefit plans that are capped at a certain size. After a certain scale, it becomes harder to deliver the required returns.]

She was questioned on the costs of this universal plan and she said this proposal will not be funded by taxpayers but by the employers and employees. Using estimates from Mr. Bernard Dussault, the former Chief Actuary of Canada, she said that the estimates are it will cost an additional 10% over current CPP contributions.

On the costs of the plan, Mr. Lamoureux brought up the segment on 60 Minutes discussing 401 (k) plans in the U.S. (the equivalent of defined-contribution plans in Canada), stating that they did not serve their members well. In Canada, fees on management expense ratios (MERs) and investment management fees (IMFs) have also eaten up most of the returns of defined-contribution plans.

Mr. Lamoureux was also quick to point out that Ontario Teachers' beat its benchmark portfolio over the last ten years, lowering the cost of the plan. Of course, Mr. Lamoureux neglected to mention that the value added was primarily concentrated in private markets (private equity and real estate) where benchmarks did not reflect the underlying risks of the investments.

At the end of the session, I introduced myself to Mr. Lamoureux outside the room and he mentioned that I got the compensation issue all wrong, and that "if you don't know what you are talking about, you should just shut up."

I was surprised he made such a rude remark in front of someone else representing public sector unions and a colleague of his (not to mention this was the first time he ever met me!), but I ignored it and offered him an opportunity to counter my points on bonuses based on bogus benchmarks in alternative investments by writing a guest commentary on my blog.

Mr. Lamoureux declined my offer stating that "he is too busy", but I obviously touched a deep nerve on benchmarks, compensation and clawbacks. Keep in mind that Mr. Lamoureux was the highest paid pension fund manager when he was at the helm of Ontario Teachers', reaping several million dollars a year in short-term and long-term compensation.

[Note to Mr. Lamoureux: My offer still stands. Any time you or any other pension fund president wants to write on how benchmarks in private markets and hedge funds accurately reflect the risks of the underlying investments, you are more than welcome to come here and post your comments.]

On the contentious issue of bonuses, I responded to a question by Mr. Mulcair stating that no pension fund should have doled out any bonus in 2008 given the catastrophic losses they suffered.

It's not only the size of the losses, but where they lost money and the risks they took. The Caisse did not pay bonuses following their disastrous 2008 results and I don't think any of the other pension funds should have either.

[Note: My father, brother and friends who are doctors can't claim that over a four year period they didn't screw up so they deserve a huge bonus. Neither can teachers, police officers or nurses and other hard working people.]

Let me end by thanking the members of the committee and the participants. I enjoyed today's meeting and I hope we can continue our discussion on pension matters in the future.

As I left, I noticed more than 30,000 supporters of the Tamil community in Sri Lanka gathered for a massive demonstration on Parliament Hill. I stood there for a moment and enjoyed watching this protest (see pics above).

I also wondered if in the future, hundreds of thousands of protesters will gather there to protest the cuts in benefits of their defined-benefit plans. Let's hope we never see that day.

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