In my last post, I discussed how CalPERS is seeking to buy TARP holdings and Citigroup assets. I said that this carries enormous risks, especially if the recovery turns out to be very modest or even worse, it falters.
The U.S. government invited CalPERS and other large pension funds to take part in the new program to buy these assets from the banks with the help of hedge funds and private equity funds.
You might stop and ask why does any government get involved in the investment decisions of public pension funds? Consider the case of the National Railroad Retirement Investment Trust where stock losses may be a lesson:
A special pension fund for railroad workers that was given permission during the Bush administration to invest its assets in the stock market lost more than a third of its value during a recent 18-month period, a loss that could influence an ongoing debate about how to keep government-affiliated retirement programs solvent.
After the National Railroad Retirement Investment Trust initially made healthy gains by investing in the stock market, it was hailed by some lawmakers as a model for how to save Social Security - either by investing part of the Social Security trust fund in stocks or by creating private accounts and giving individuals a chance to do the same.
Senator Chuck Grassley of Iowa, at that time the Republican chairman of the Senate Finance Committee, was quoted in 2005 as saying that Congress should consider putting part of the Social Security trust fund into stocks "based upon the success of the railroad retirement fund." Many other members of Congress made similar comments, and then-President Bush launched an un successful campaign to give people the power to invest portions of their own Social Security funds in the stock market.
But since the end of 2007, the railroad fund's returns have crashed. The fund, which had previously been restricted by the government to investing in Treasury securities, put its assets into everything from foreign stocks to real estate to "opportunistic" investments. As a result of the losses, taxes may be raised on the railroad companies and their workers, as provided for in the law under which the trust was established.
"They just kept on investing more and more and more into the market," said Marvin Dickman, inspector general of the fund's parent agency, the federal Railroad Retirement Board. Dickman said in an interview he would like to know more about the investment strategy but has run into roadblocks because Congress classifies the board's trust fund as a separate, "nongovernmental" entity.
"There is a total lack of oversight," he said.
But the federal railroad board that oversees the program believes the strategy will pay off in the long run and it has no intention of halting the investments. Asked if he worried about the losses, Federal Railroad Board general counsel Steven A. Bartholow responded, "I would say that we don't have any overriding concern . . . you expect the market to go up and go down."
The railroad retirement program predates Social Security as a federally sanctioned retirement plan, having been created in 1934 - and becoming the model for the Social Security plan that President Franklin D. Roosevelt implemented a year later.
As a result, Congress created a special exception for railroad employees: They do not receive Social Security and pay no taxes for it. Instead, they pay taxes for a two-tier system that supplies benefits similar to Social Security, as well as a pension plan that is funded through the Railroad Retirement Investment Trust.
The government took pains to make sure the money wasn't lost on any risky investments, requiring that the assets be invested in conservative Treasury securities.
In 2001, however, the managers of the railroad fund pushed for permission to invest its assets more aggressively. At the time, proposals were being floated to allow the Social Security trust fund to be invested in the stock market. Former President Bill Clinton earlier had proposed putting a portion of the Social Security trust fund into the stock market, and an influential former Social Security commissioner, Robert M. Ball, had urged the measure as well, saying stocks would produce "a better return for the Social Security system" than bonds.
While Congress never approved putting Social Security funds into the market, it did make a bipartisan decision to allow the railroad retirement program's trust fund to be put into stocks and other investments - as long as the rail industry agreed to make up for any shortfall. The industry and its unions embraced the idea in the belief that it would enable them to have lower taxes but higher returns. If it worked for the railroad trust fund, backers reasoned, then it could be applied to other programs.
The fund says on its website that its target portfolio is to have 26 percent in US stocks, 22 percent in foreign stocks, 10 percent in private equity funds, 15 percent in real estate and commodities, and 27 percent in fixed-income - an investment strategy that some analysts consider too risky.
But the exact nature of the investments is difficult to determine. Congress gave the fund the authority to make its investments autonomously, exempting it from direct oversight by an inspector general. As a result, Dickman, the inspector general, last year took the unusual step of issuing a public "statement of concern," complaining that the program had "fewer safeguards than those established to protect the retirement investments of Federal and private sector workers."
The fund did well from 2002 to 2006. That prompted a number of politicians to say the idea should be tried elsewhere. In addition to Grassley's comment that the idea should be considered at the Social Security trust fund, Senator Ben Nelson, a Nebraska Democrat, said he "wondered why that suggestion hadn't been made by others" and was "anxious" for details, according to a 2005 article by Congressional Quarterly. Nelson said through a spokesman that he didn't follow up on the idea.
Grassley spokeswoman Jill Kozeny said the senator today would "approach that debate as he did in 2005, wanting to talk through every option in order to save the program."
While Congress never approved the proposal to invest Social Security trust funds in the market, the federal Pension Benefit
Guaranty Corp., which insures private pension plans, pursued the idea vigorously for its trust fund. Officials from the pension agency met with the general counsel of the railroad trust fund to learn about the idea, and then approved a similar investment strategy, which is now being implemented.
But the railroad retirement fund has done poorly in recent months. While the fund won't release cumulative figures, its reports indicate the fund dropped in value by more than one-third, and perhaps as much as 40 percent, from September 2007 to February 2009, after taking benefit payments into account. In the last quarter of 2008, for example, the fund said its investment performance was down 17.15 percent.
Dickman said the railroad fund's decline should serve as a warning to officials at Pension Benefit Guaranty Corp. He said it is "ludicrous" for the pension agency to be "investing one dime into the stock market at any time."
The idea of investing part of the Social Security trust fund in the markets remains a possibility - but on a much smaller scale than adopted by the railroad fund and the pension agency.
James Roosevelt Jr., whose grandfather implemented Social Security and who advises the White House on the issue, said he might support a test that put 5 percent or more of the fund into the stock market as long as everyone agreed to one principle: "As ought to be true of every investor, don't invest more than you can afford to lose."
Now, you might say "timing is everything" and the National Railroad Retirement Investment suffered the same bad luck that others did during 2008. But the aggressive shift in stocks was reckless and there was a total lack of oversight.
Over in the U.K., Jeremy Warner of the Independent writes that pensions make easy target as Treasury gets desperate:
According to the IFS, to plug the £39bn gap, the Government will in the absence of any further tax-raising measures need to reduce growth in public spending by 1.1 per cent a year. This would amount to a five-year real freeze in public spending. Could a Labour Government get away with such a draconian approach to the public sector? Even the Conservatives would blanch at the idea. Certainly no postwar government has ever achieved such a sustained squeeze.
Public spending is like the mythical Hydra - cut off one of its heads and another two grow back in its place. Its growth seems quite unstoppable, whatever governments do to curtail it, and this is not a government known for its cost-cutting zeal when it comes to public spending.
There are peripheral spending budgets that can quite easily be chopped, but they tend to be small beer, and, as with infrastructure spending, just the sort of thing you don't want to cut in a downturn. But making significant inroads into the big spending departments is much more difficult.
The demands of an increasingly health-conscious, ageing population mean that National Health Service spending will keep rising in real terms whatever the Government does to rein it in. Despite hair-shirted intentions, health spending has always grown in real terms right through the most intense of public spending squeezes. Even the Thatcher government, with its mandate to roll back the frontiers of the state, failed to dent the inexorable growth of health spending. There is no reason to believe future governments capable of breaking this pattern.
So if significant spending cuts are not an option, what of taxes rises? There are already quite a few of these in the pipeline, including the new 45 per cent rate for higher-income earners. To go further at a time when the whole purpose of policy is to restore confidence and demand would seem like folly. Demand would be further damaged by big tax hikes.
If front-line taxes rises are likely to prove counter-productive, what are the alternatives? You'd think that Gordon Brown had plain run out of road when it comes to stealth taxes. Such is his penchant for them that he must surely already have used them all up. Unfortunately, there is still a bit of low-hanging fruit left to pluck, most notably the higher-rate tax relief for pensions savings.
The very thought of it provokes a shudder and a strong sense of déjà vu among pensions providers, for it was pensions which were the subject of Mr Brown's first stealth tax – the abolition of tax credits on dividends. This has been worth a cumulative £5bn a year to the Treasury ever since, or around £60bn in total.
The gap it has filled in the public finances is equalled by the one left in Britain's once universally admired system of privately funded occupational pension schemes. These were probably going the way of the flesh regardless, but the Government's action in removing the tax break has certainly hastened them on their way, with virtually all final salary pension schemes now closed to new members, and crippling legacy costs for sponsoring companies.
In any case, with the public finances in such appalling shape, the insurance industry is more than usually alert to the possibility that the Government will be back for a second raid on the pensions piggy-bank. Certainly, the idea must be superficially attractive to a government as desperate as this one. For starters, the relief is worth a very considerable sum of money. According to the Pensions Policy Institute, the total cost of the relief for 2004/5 was an astonishing £37.7bn, or 2.9 per cent of GDP.
This sum includes £8.3bn of lost national insurance which would have been paid had employer pensions contributions been paid as salary together with some £15bn of pension contributions from employers, which presumably would be left largely untouched by any attack on higher- rate tax relief. I say presumably, but these are desperate times.
However, even netting these sums off leaves around £8bn of employee tax reliefs of which rather more than a half relates to higher-rate taxpayers. Call the sum that the Government could potentially save a nice round £5bn (eerily similar to the dividend credit raid), and you'd be in the right ball-park. Such a tax hit could quite easily be presented as "progressive" if accompanied by a more generous rate of basic tax relief available to all pension savers. Higher- income earners would lose out, but low earners would get extra relief.
Better still, it is one of the few effective tax increases that could be achieved without any substantial short-term impact on demand, since this is money that would otherwise be saved rather than spent.
Every year, the insurance industry works itself up into a terrible lather over the possibility that the Government might attack this previously sacrosanct form of tax relief. To date, these fears have proved unwarranted. The industry has been crying wolf. Yet you can see why this time around they might seem more than justified.
Is the Government about to hit the button? It's all a question of what politically ministers think they might get away with. Not everyone who uses the higher-rate relief can be described as "well-off". With the higher-rate tax band kicking in at £36,000, a considerable cohort of middle-income earners would find themselves hit by the move.
It would also send out a powerfully negative message on pensions at a time when the Government is trying to encourage people to save for their old age so that they won't become a burden on the state. The Government could cynically choose to take the view that higher-income earners will save anyway; the problem of absent saving is rather one largely confined to low earners. All the same, it's difficult to impossible to remove an established tax relief without political consequences.
Kenneth Clarke, the last Tory Chancellor and now the shadow Business Secretary, once said that he gave up on that chronic obsession of chancellors – tax reform – after realising that whatever he did there would be winners and losers, and that inevitably he would be resented by the losers while gaining no credit whatsoever among the winners.
Politically, removing the higher- rate tax relief would have a very similar effect. It's dangerous stuff ahead of an election. Regrettably, it is going to be very hard to resist for any incoming government charged with cleaning up the present mess. Whatever the new government does is going to be unpopular. Despite the fact that removing the higher-rate relief would further discourage saving, might well further swell already burgeoning pension fund deficits, and would be a body blow to the personal pensions business of the insurance industry, it may well look like one of the least bad options.
In Canada, Boyd Erman of the Globe & Mail reports that the CPP lauds its protection from stimulus plans:
With national pension plans around the world being forced to provide money for government stimulus packages, the Canada Pension Plan Investment Board is betting that Ottawa's inability to do the same will be an advantage.
The Irish government pushed the country's pension fund to invest £10-billion ($18.05-billion) to help recapitalize the nation's ailing banks. Norway is using its pension fund to pay for a stimulus program, and Mexican funds are underwriting for infrastructure and housing projects. It's also happening in Russia and China.
Those moves may make it tougher for the funds to earn the returns they need to pay future pensions. They may also put the pension plans at risk of being perceived as sovereign wealth funds, something that makes it tougher to make acquisitions of politically sensitive assets such as ports and airports, CPPIB chairman Robert Astley said in his first interview since taking the office last fall.
But Canada's governments, both federal and provincial, can't force the CPPIB to use any of its assets - $109-billion as of Dec. 31 - to fund stimulus projects because of the arm's-length manner in which the pension plan was set up a decade ago.
Politicians shouldn't try to change that, Mr. Astley said, because it's a key advantage for the money manager, which has been a keen acquirer of infrastructure assets.
"It does matter, because some governments around the world are putting in restrictions on sovereign wealth funds," he said.
Should Ottawa or the provinces even begin to try to direct the CPPIB's investing decisions, "we'd be lumped in then with other national funds that are sovereign wealth funds, so, yes, it would be damaging to our perception outside the country," he said.
The money manager is protected by a mandate to focus foremost on returns, with no political aims whatsoever. It's tough to change that, requiring the approval of two-thirds of the participating provinces with two-thirds of the population. Given the history of interprovincial relations, that's a high hurdle.
And it should be difficult, Mr. Astley said, because it's not the governments' money - it belongs to citizens and companies that have contributed.
"They [the officials who created the fund] really anticipated that his might happen and so built into this structure all these constraints so that it wouldn't come," Mr. Astley said.
So far, he said, politicians have resisted any temptation to try to tap the fund to pay for many of the expensive programs that are being proposed to create jobs and fight the recession.
"It would be really easy for a politician to say, 'There's a big fund there, we ought to make use of it,' and, to their credit, they have not," he said.
Let me conclude with some of my thoughts. I believe that good governance requires that public pension funds operate at arms-length from the government. Governments should nominate qualified, independent board of directors to oversee these pension funds.
Having said this, the disastrous results in 2008 have put into question this governance model too. In particular, there was a clear failure of proper oversight from board of directors of various large public pension funds in Canada.
It is painfully obvious that some of them did not properly understand the risks of certain investments and almost everyone underestimated the systemic risk that was building up in the global financial system over the last six years.
If I were to consult governments on one thing, make sure your board of directors are not just made investment industry people. You should also put in one or two professors of economics or finance from the local universities - people who are unbiased and who understand the risks of the investments and of the total portfolio.
Is there a way to respect the arms-length relationship and to make sure board of directors are properly exercising their fiduciary responsibilities on pension oversight? Yes, there is. I have written about the importance of independent performance, operational and fraud audits that augment financial audits.
It's nice to say "we do not want government interference" but how do stakeholders know that board of directors are overseeing the funds in their best interest?
The reality is that you need to strike a balance between too much political interference and too much leeway given to these large funds. That's why I think my proposal makes sense.