Monday, January 31, 2011

Canadian Pensions Surge Ahead?

Ten days ago, CNW reported, RBC Dexia survey: Canadian Pensions Surge Ahead of Pre-Crisis Levels (HT: Bruce):
Strength in Canadian equities have helped Canadian pension plans surge ahead of their pre-financial crisis levels of 2008, according to a survey just released by RBC Dexia Investor Services, which maintains the industry's most comprehensive universe of Canadian pension plans and money managers.

Within the $340 billion RBC Dexia universe, pension assets earned 4.3 per cent in the quarter ending December 2010, improving the full year performance to 10.4 per cent, making this a second consecutive year of double digit returns.

Despite the volatility in the global markets during the past ten years, Canadian pension plans have achieved an average annualized return of 5.4 per cent. "What the last decade has taught us is that diversification and disciplined investing is key over the long run," noted Fay Coroneos, Global Head of Risk & Investment Analytics for RBC Dexia.

Canadian equity markets flourished as nine out of ten TSX sectors experienced double digit annual gains. Even though Canadian Pension plans underperformed the index by 0.4, "it was encouraging to see strong returns not only in energy and materials but also in industrials and the consumer discretionary sectors" added Coroneos.

Foreign equities increased 6.3 per cent over one year. "Returns were muted by the soaring loonie, which gained significantly against the US dollar and was one of the best performers among major world currencies," reported Coroneos. The MSCI World index in local currency increased 10.0 per cent for the year, but was reduced to 5.9 per cent when translated into Canadian dollars.

For the year, domestic bond holdings within Canadian pension plans advanced 7.8 per cent, surpassing the DEX Universe index by 1.1 per cent. "Long-term bonds, with maturity of over ten years, continue to dominate short-term and mid-term bonds in 2010," said Coroneos.

"The growing focus on asset-liability matching has resulted in pension plans shifting into the longer end of the yield spectrum, increasing demand for long-term bonds. In light of this, we believe a governance structure which includes the use of a liability-based benchmark will be of great interest for pension plans in 2011."

The growing focus on asset-liability matching has increased pensions' demand for long bonds. Meanwhile, Canadian pensions enjoyed the benefits of a strong Canadian stock market. I was surprised to read nine out of ten TSX sectors experienced double digit annual gains in 2010. That "beta boost" helped Canadian pensions surge ahead from pre-crisis levels.

And On Monday the S&P/TSX composite index jumped 114.41 points to 13,551.99 led by energy as political unrest in Egypt raised worries about a disruption in oil supplies and pushed crude prices higher:

Crude has surged almost eight per cent over the last two sessions on worries that the Suez Canal, a key route for oil tankers and cargo ships, may be closed and that the unrest could spread.

“The market doesn’t know quite what to make of it,” said John Stephenson, portfolio manager at First Asset Funds.

“I think energy and financials are moving higher (because) Canada is a safe haven and commodities is a store of value. If there’s some problem with oil, it may be good for Canadian producers, Canada’s stock index but it’s not good for the U.S. economy broadly.”

The energy sector rose 2.74 per cent as Cenovus Energy shares gained $1.24 to C$34.60 while Suncor Energy (TSX: SU) climbed $1.42 to $41.46.

Imperial Oil Ltd. (TSX: IMO) reported that its net income increased 50 per cent in the fourth quarter to $799 million, or 94 cents per share. That’s up from $534 million, or 64 cents per share, a year earlier on higher oil prices and improved operations and Imperial shares rose $1.95 to $44.65.

There is increasing talk of Canada as a "safe haven". I'm not so convinced but global investors are buying up Canadian assets and the Canadian dollar. Just how much of this is speculative flow and how much of it based on fundamentals is very hard to ascertain, but there is no reason to believe the uptrend won't continue. In fact, I wouldn't be surprised to see the S&P/TSX make new highs in 2011. If it does, Canadian pensions will continue riding the beta wave higher.

But even if Canadian pensions ride the beta wave higher, they're not out of the woods because liabilities grew faster than assets. It was last April that the Certified General Accountants Association of Canada (CGA) said that Canadian pension funding deficits have risen from $160 billion in 2003 to an estimated $350 billion in 2008 and continue to grow. Moreover, the CGA said that the number of defined benefit pension schemes that are in deficit has doubled over the past five years to stand at 92% of the total, making retirement prospects bleak unless changes were made. Other experts are also sounding the alarm on pension deficits. So all this talk of "surging ahead" should be put in proper context.

Sunday, January 30, 2011

Private Equity Rewards Pensions?

Ellen Kelleher of the FT reports, Private equity rewards pensions:
The private equity holdings of the world’s largest public-sector pension funds outperformed most other asset classes in the short and long term, new research suggests.

The 20 largest public pension funds now have an estimated $224bn allocated to private equity deals – or 5.5 per cent of their capital on average.

Their investment have provided strong returns, according to a study by Preqin, an independent research house that focuses on alternative assets.

The study of the financial statements of more than 150 public pension funds from North America, Europe and the UK suggests the returns on their private equity investments and also their fixed income holdings in many cases, outshone hedge funds, real estate and listed equities.

As of the second quarter of 2010, private equity and fixed income were the only investment types to generate positive median returns across one, three, five and 10-year periods; the other asset classes fell into the red for at least one of the periods, the study shows.

All asset classes show positive returns across five and 10 years, but only fixed income and private equity showed positive returns across the three-year period, reporting respective gains of 7.6 per cent and 0.6 per cent.

“Private equity investments provide diversity within the pension funds’ investment portfolios, and have the potential to yield high returns,” said Tim Friedman, head of communications at Preqin.

As overall mergers and acquisitions activity starts to rebound this year, bankers expect it to throw up opportunities for private equity groups to team up with big corporate groups, either by financing bids or buying non-core subsidiaries.

A return in force to dealmaking in Europe last year by private equity firms came in spite of continued tight supply of finance.

The value of company buy-outs almost trebled in Europe from €18.3bn ($25bn) in 2009 to €49bn last year.

I take this research from Prequin with a grain of salt. Sure, private equity did perform well over the last 10 years but does this automatically imply that it will continue to outperform over the next 10 years? I know public pension funds like OMERS are aggressively moving into private markets, and while it might make sense for them because they have the internal expertise to do so, it certainly doesn't make sense for every pension fund.

A few days ago, I wrote on Carlyle's acquisition of AlpInvest, a European private equity fund of funds owned by Dutch pension funds APG and PGGM. A senior pension fund manager shared these thoughts with me on this deal:

A scenario:

AlpInvest will enable Carlyle to go public, and thereafter I bet will merge with Blackstone or some such, creating a mega private equity/hedge fund firm.

The private equity asset class will roar ahead unabated based on the publicity and related hopes and dreams of institutions, and all this will come to a reckoning in 2013/14 or so (when the wall of debt refinancing comes home to roost). Then the slow, grinding diminution of an overdone industry will unfold for the decade thereafter. Handfulls of firms and institutions will end up with positive IRR for the full length of their programs.

Mercer has already promoted PE going forward as having expected returns less than public markets. They are not wrong.

I also worry that PE returns will disappoint public and private pension funds in the next decade. There is a tsunami of liquidity flowing into private markets as every single consultant is touting the "benefits of private equity" (and other private markets) without understanding the nature of the asset class and how its performance is linked to that of public markets. Moreover, studies have shown that performance persistence of private equity is concentrated in the top funds and that the "illiquidity premium" doesn't exist if you invest in average funds.

The question that all investors should think hard about is will private equity continue to outperform public markets and other asset classes in the future? If so, in which countries and in which sectors? Do they have internal expertise to do direct deals and co-investments? If not, then why bother tying up capital in an illiquid asset class which might very well underperform public markets?

Saturday, January 29, 2011

Arab World's Berlin Moment?

Back in May, I asked if Greek protests are going global? With the recent events in Egypt, it looks like we are heading for another round of geopolitical tension. Market participants are very anxious because the global repercussions of this latest episode can be significant.

While some in the media are proclaiming this the "Arab world's Berlin moment", I'm very skeptical. Spero News had an interesting interview with George Friedman, founder of STRATFOR, asking whether the end of Mubarak will lead to democracy or disaster (added emphasis is mine):
For more than 30 years, the geopolitics of the Middle East has been built on the American-Egyptian-Israeli relationship. STRATFOR founder Dr. George Friedman contemplates current events in Egypt and the prospect of the end of an era.

For more than 30 years, the geopolitics of the Middle East has been built on the American-Egyptian-Israeli relationship. Much of that time, the lynchpin has been Cairo and Egyptian President Hosni Mubarak. Is this era about to end?

Welcome to Agenda and joining me this week by telephone from New York is George Friedman. George, it seems probable the Mubarak era is now passing. What impact will it have on the Middle East?

George Friedman: Well, certainly, Mubarak is coming to the end of his days. And it’s not yet clear what, if anything, it is going to do to the Middle East. It really depends on what the successor’s regime is going to look like. He was hoping that his son Gamal was going to replace him; that’s increasingly unlikely.

There are demonstrations going on in Egypt. How widespread is hard to tell, and of course the Western media is immediately assuming that these are democratic reformers out there because they talk to the ones who speak English and they tend to be democratic reformers.

We don’t know what the Muslim Brotherhood is doing, or capable of doing. So we don’t know if we’re going to get a military coup to replace Mubarak, we don’t know if we’re going to get a Islamic government, or if we’re simply going to have a succession, fairly orderly, when he passes on or even before then. But whatever happens can have enormous significance, depending on which way it goes.

What’s the significance of the return to Cairo by Mohamed ElBaradei?

George Friedman: Well, ElBaradei is the Gorbachev of Egypt. Gorbachev is deeply loved by Americans and profoundly loathed by the Russians. I wouldn’t go so far as to say that Elbaradei is loathed, but he hardly has deep and effective political roots in the country. Remember that the Army has been the dominant force in Egypt since 1956; that Gamal Abdel Nasser, Sadat, Mubarak all come from the military, and that the military is among the more modern capable forces inside the country. So, the default thinking is that, regardless of these demonstrators are doing, it will be some military person coming on and succeeding Mubarak.

The second possibility is that what’s going on in the streets now will kick off an Islamic revolution in the same way that the Iranian Revolution in 1979 started out as appearing to be opposed the Shah’s oppressiveness and had the wide support Western human rights groups, only to be taken over under control of a radical Islamist regime under the title of Ayatollah Amini. That’s a possibility, although it’s not visible right now. But the real question that comes out of all of this is very simply: Egypt has been a pro-American country with a peace treaty with Israel have been quite effective for 30 years.

Now are we going to enter a period in which Egyptian policy will change in which peace treaty with Israel breaks down and a situation in which Israel goes from a country that it is enormously secure from foreign threat to one that is again at risk from Egypt, particularly if Egypt begins re-arming. Second, what is the effect of a Islamist Egypt on the American position in the region?

Egypt is the center of gravity of the Arab world — by far the largest country — and more than a match for Saudi Arabia or Iran or anyone else should should it choose to be. If this becomes an Islamist country, then the United States is entering a new phase in its war against the jihadists. Now, is it about to become a jihadist government in Cairo? I don’t think so but that’s really what the question is: what’s going to happen. And the least likely thing to happen is a long-term reformist democratic government.

Much media comment is focused on what they call the “Tunisia effect,” spelling the end of dynasties in the East. Mubarak is under threat now, others may be tomorrow.

George Friedman: In the case of Mubarak, he’s not, he’s dying by all accounts, I mean he’s certainly going to disappear. And we’ve been talking for several years about the succession. So it may be that what happened in Tunisia influenced what’s happening a bit in Egypt but Tunisia is the tail to Egypt’s dog. It’s also important to bear in mind the huge difference between francophone North Africa and anglophone North Africa - that of course is dominated by the English and the French.

Tunisia and Egypt are widely separated. It certainly is possible to encourage some people to demonstrate but in none of these countries outside of Tunisia have we seen these demonstrations are particularly significant or effective. The press is immediately speaking — I saw one headline about the Egypt being on fire — uh, no, it’s not. It may become, we can’t rule that out, but we have to remember the example of the Green Revolution in Iran a couple of years ago (2009). When the media was all over “what a transformation is taking place and how the government is staggering” — the government was very effective in putting it down and we haven’t heard much of it since. So much is uncertain of what’s happening but let’s be certain of this much: what happens in Tunisia matters little to the world, what happens in Egypt is a towering significance.

If this is a military coup or an army officer steps up to the plate, what then?

George Friedman: Well, the military is in power in Egypt. Mubarak is a military man. Sadat was a military man. Nasser was a military man. If the military stays in power, in selecting one of its own to be president, I think everything stays in place and that would mean that the regime survives. It’s far more significant if the normal succession within the framework of the military doesn’t happen. One of the reasons that Gamal Mubarak was not going to be allowed by the military to take power is that he wasn’t part of the military the same way his father was. He wasn’t trusted by them. So, the issue here is a succession within the framework of the military.

A sort of military coup in which case the military takes much more direct and open power, which it really doesn’t need to. So what we’re really asking here is the geopolitics of the Middle East has been built on the American-Egyptian-Israeli relationship certainly since 1977 — and perhaps before that. Is that about to change? If that changes, it has enormous consequences. But at this moment, I mean we know that the media will get breathlessly excited over any demonstrations anywhere especially that include twittering, that doesn’t mean anything yet.

The crisis in Egypt is significant but what exactly does it mean for markets? Over at Zero Hedge, RobotTrader posted a comment asking whether the market topped out on Friday, highlighting the following checklist:
1) QQQQ and IWM breakdown? Yep, they cracked big.

2) Financials breaking down? Not quite yet.

3) Retail stocks breaking down? Not quite yet.

4) Commodity "Midnight Massacre"? No.

5) Fleeing to USDX as carry trades unwind? Not yet.

6) Emerging market status? Blowtorched.

7) VIX going vertical? Yep.

8) Summation Index and McClellan Oscillator going down? Yep.

The "all important 21-day" keenly eyeballed by the mo-mo crowd is about to break. One more day, or a gap down on Monday will seal the deal.

Seal the deal? In my opinion, it's way too early to speculate on where markets are heading. Obviously, in the short-run, with all this uncertainty the easy trade is RISK OFF, close your risk trades and wait and see how all this plays out in the weeks ahead. Some participants will be actively shorting the market but that strategy is extremely risky and could easily backfire in these volatile markets. Others will use this selloff as another opportunity to scoop up more risk assets (my bias remains to buy every dip that comes our way).

What we do know is what David Patten of Newsmax reported on, namely, that as Egypt explodes, oil is set to skyrocket:

The wave of unrest in the Middle East that began with the Jasmine Revolution is now having repercussions around the globe.

After the recent fall of governments in Tunisia and Lebanon, angry marches in Yemen, and the brutal crackdown in Egypt that has left seven dead and hundreds wounded, analysts worry that the governments of Algeria and Jordan could be next to see disturbances.

Radical extremists see the turmoil as their opportunity to institute the region-wide, anti-Western Muslim caliphate or union that they have dreamt of for centuries.

Some analysts believe Morocco also could be at risk, as well as the kingdom of Saudi Arabia, a key U.S. ally in the war on terror that boasts the world’s largest oil reserves.

The financial impact of the uprising in Egypt has already begun to ripple around the globe. Middle East currencies are under attack by speculators, the Egyptian equities market and emerging-market stocks have nosedived. But the big question for the West is what will happen to Saudi Arabia, which like Yemen and Egypt has been under pressure from radical, anti-American extremists.

“If this spreads, democracy in the Middle East spreads, the United States could take a huge hit,” predicted CNBC’s Erin Burnett on MSNBC’s Morning Joe program Friday morning. “Because democracy in a place like Saudi Arabia, you've talked a lot about who might come into power, what that means for oil prices — they're going to go stratospheric."

The Obama administration is already taking heat from both sides of the aisle for its policy of avoiding any public confrontation with Middle East regimes over their abysmal record of repression, torture, and corruption.

Unlike the Bush administration, which made a public push for democratization, the president has preferred to express its concerns in a more low-key manner.

The reality is that US officials are walking a tightrope. On the one hand they publicly support a widening of civil liberties in the region, but on the other they know that democracy will open the door to even more chaos.

Either way, everyone will be watching developments in Egypt this weekend and investors will be pricing in Egyptian risk on Monday. What remains to be seen is whether the world is heading into a long period of heightened political uncertainty and how this will impact the global political landscape, economy and financial markets.

I leave you with a thought provoking interview with William Engdahl on Russia Today discussing how this crisis was orchestrated by the US and how it might shape the "new Middle East" and destabilize Europe.

Thursday, January 27, 2011

Will Pension Woes Hurt State Ratings?

Lisa Lambert of Reuters reports, Pension issues may hurt state ratings: Moody's:

Some U.S. states face so much pressure to fund pensions for public employees that it could hurt their credit ratings, Moody's Investors Service said on Thursday.

As concerns grow over the financial health of many states after the 2007-2009 recession and how they will cut spending to cope, the ratings agency combined pension and debt data to rank the liabilities of each state.

In the past, Moody's evaluated credit risks from pensions and debt levels separately. Lower credit ratings could raise the costs to states of borrowing money.

Connecticut, Hawaii, Illinois, Kentucky, Massachusetts, Mississippi, New Jersey and Rhode Island, along with Puerto Rico, have the largest debt-and-pension loads, Moody's found.

Nebraska and South Dakota have the lowest.

"Large and growing debt and pension burdens have been, and will continue to be, contributing factors in rating changes," Moody's said.

Problems with pensions -- which states have underfunded by at least $700 billion -- include weak returns on investments, not enough money set aside, impending retirements of "Baby Boomers" born in the late 1940s through mid-1960s, and Americans living longer, Moody's said.

New York, Delaware and California are often cited for large debt burdens but do not have the highest combined long-term liabilities, Moody's analyst Ted Hampton said in a statement.

"In general, states' rankings for debt and pension combined parallel their rankings for debt alone," Hampton said but he added: "not all states with large debt burdens also suffer from weak pension funding."


The $700 billion underfunded figure is a conservative estimate for how much money states will need to cover the pension promises they have made to their employees.

But $3 trillion could be nearer the mark, one study warned last year. States expect too generous a return on investments made by their pension funds, said the study by Joshua Rauh of the Kellogg School of Management at Northwestern University.

Regardless of the exact amount, states have to find a way to adequately fund pensions.

"More and more, it's going to take up a larger share of their ... budgets," said Kil Huh, director of research at Pew Center on the States, which has been closely following the pension issue.

Money flows from three major sources into pension funds: employee contributions, the employing governments and investment returns.

"Employee contributions have gone down and, at the same time, employer contributions because of the fiscal crisis haven't been there," Huh said.

Moody's, too, says the problem is getting bigger.

"Unfunded pension liabilities have grown more rapidly in recent years because of weaker-than-expected investment results, previous benefit enhancements and, in some states, failure to pay the full annual required contribution," the report said.

"Moreover, pension liabilities may be understated because of current governmental accounting standards," it added.

The Moody's report "will shed more light upon the states which have eliminated or underfunded their yearly contributions for pension liabilities simply as a way to manage their finances," said Thomson Reuters Senior Market Strategist Daniel Berger.

One dramatic solution to the pension problem would be allowing states to declare bankruptcy, which some congressional Republicans want. Then, they could renege on pension promises made to employees.

After being criticized for missing risks in the housing boom, Moody's is showing with this report it's "not asleep at the wheel" on the pension threat, said Richard Larkin, senior vice president and director of credit analysis at Herbert J Sims & Co. in New York.

But, the report also showed the liabilities are manageable, he added. For example, Moody's found Hawaii's pension-and-debt load is equal to 16.2 percent of its gross domestic product, the biggest proportion of all the states.

Even though the liabilities are in the billions of dollars, "when you compare them to GDP it's still low numbers," Larkin said.

"And it's still relatively much lower than these problem countries people keep comparing them to," he said, referring to recent fears that California or Illinois will soon be plunged into troubles similar to those Greece or Ireland are facing.

In a separate article, Simone Baribeau of Bloomberg reports, Moody's Says Massachussetts Among States With Highest Debt, Pension Burden:

Moody’s Investors Service provided a combined measurement of debt and pension liabilities for the first time to analyze U.S. states’ creditworthiness after “rapid” growth of their unfunded retirement obligations.

The joint figures released today make it easier to compare fixed costs among states and with corporate-bond issuers, Moody’s said. The company previously included pension liabilities separately in evaluating states. It revised municipal ratings in April to make them more compatible with corporates.

“Greater comparability and transparency” will come from the new metric, Robert A. Kurtter, managing director for public finances at New York-based Moody’s, said in a telephone interview. “In a corporation, you look at them together. As a government, we would look at them together also as the fixed costs that the government has to pay.”

Less than half the 50 state retirement systems had assets to pay for 80 percent of promised benefits in their 2009 fiscal years, according to data compiled by Bloomberg. Two years earlier, only 19 missed the mark. Illinois covered just 50.6 percent in 2009, the lowest ratio, which actuaries say shouldn’t be less than 80 percent.

Hawaii, Massachusetts and Connecticut are among the states with the largest combined debt and pension obligations relative to their economies and revenue, Moody’s said today.

Parallel Rankings

In general, states’ rankings for debt and pensions combined parallel their rankings for debt alone, it said. Hawaii, Massachusetts and Connecticut also have the largest ratios of bonded debt to personal income, Moody’s said.

“Not all states with large debt burdens also suffer from weak pension funding,” Ted Hampton, a Moody’s analyst, said in the release accompanying the report. New York, Delaware and California -- states with comparatively large debt burdens -- are not among the states with the highest combined long-term liabilities.”

Moody’s said that states may understate their pension liabilities and that pressure to fund retirements will continue to have a “negative impact” on state ratings.

“We’ve become more concerned about the unfunded pension liabilities and the costs they’re creating for governments at a time when they’re already stressed,” said Kurtter, who was among the authors of today’s report.

For some states, such as Illinois, which is rated A1 and has a negative outlook, growing debt and pension burdens have already contributed to rating changes, Moody’s said.

States’ control over revenue and spending may help them address the growth in pension liabilities, the report said. As a group, states are still “highly rated” at A1 or higher, it said, because of their tax and budget powers.

On its website, Moody's put out this press release:

A new report by Moody's Investors Service presents combined net tax-supported debt and pension liability figures for the U.S. states, providing a clearer view of how each factors into the evaluation of states' total current liabilities.

"Pensions have always had an important place in our analysis of states, but we looked separately at tax-supported bonds and pension funds in our published financial ratios," says Moody's analyst Ted Hampton. "Presenting combined debt and pension figures offers a more integrated -- and timely -- view of states' total obligations."

Given the level of fiscal stress being felt by most states and the prospects for sluggish economic growth and slow revenue recovery, pension funding pressures will continue to have a negative impact on state credit quality and state ratings. Moody's also recognizes that, as currently reported, pension liabilities may be understated.

Of the 50 states, those with the highest debt and pension funding needs include Connecticut, Hawaii, Massachusetts, and Illinois, the report finds.

"In general, states' rankings for debt and pension combined parallel their rankings for debt alone," says Hampton.

Hawaii, Massachusetts, and Connecticut -- the three states with the largest ratios of bonded debt to personal income -- are also among states with the largest combined debt and pension obligations relative to their economies and revenues.

"Not all states with large debt burdens also suffer from weak pension funding, however," Moody's Hampton adds. "New York, Delaware, and California -- states with comparatively large debt burdens -- are not among the states with the highest combined long-term liabilities."

Some states, notably Maryland and South Carolina, have strong credit ratings despite relatively high debt and pension burdens, underscoring that these liabilities are only one of many factors that contribute to state ratings.

Moody's presentation of combined debt and pension figures as part of a more integrated view of states' total obligations follows a period of rapid growth in unfunded pension liabilities.

"Pension underfunding has been driven by weaker-than-expected investment results, previous benefit enhancements, and, in some states, failure to pay the annual required contribution to the pension fund," says Hampton. "Demographic factors -- including the retirement of Baby Boom-generation state employees and beneficiaries' increasing life expectancy -- are also adding to liabilities."

Moody's says that the evaluation of current and projected pension liabilities is an important area of focus in its rating reviews. For some states, such as Illinois, which is rated A1 and has a negative outlook, large and growing debt and pension burdens have already contributed to rating changes.

States as a group are highly rated -- currently A1 or higher -- because of their control over revenue and spending that may help address the recent growth in their pension liabilities.

"Many states are beginning to respond to this growing challenge by increasing contribution requirements, raising minimum retirement ages, and undertaking other reforms," Moody's Hampton concludes.

The report, "Combining Debt and Pension Liabilities of U.S. States Enhances Comparability," is available at

Moody's earlier reports on public pension liabilities covered specific aspects of the subject area, including increasing government pension contributions, the cost pressures on state and local governments, and the impact on pension funding of stock market declines. The effect of pension obligations on state and local government credit ratings will be the subject of further reports from the rating agency in coming months.

Unfunded pension liabilities will continue wreaking havoc on state finances, forcing politicians to take bold measures to shore up these pension plans. I welcome Moody's new initiative focusing on current and projected pension liabilities and taking a more integrated approach in evaluating state finances. I would take it a step further and start evaluating all aspects of pension fund governance, analyzing which state pension plans are following best practices and which are most vulnerable to further deterioration in the future.

Wednesday, January 26, 2011

Carlyle Acquires AlpInvest

Robert Van Daalen and Paul Hodkinson of Dow Jones report in the WSJ, Pension Funds Sell Equity Arm to Carlyle:
AlpInvest Partners, Europe's largest private-equity investor, has been sold to Carlyle Group and the AlpInvest management in a move that looks set to shake up Europe's buyout landscape.

Carlyle and AlpInvest have entered into a joint venture that separates the investor from its Dutch pension-fund owners, APG and PGGM, the parties said Wednesday. A purchase price wasn't disclosed.

The sale gives the pension-fund managers more room to invest their clients' money in private-equity funds other than AlpInvest, PGGM Chief Executive Martin van Rijn said. "We have multiple clients, and a sale of AlpInvest gives us the opportunity to provide our clients with various choices to invest in private equity," he said.

PGGM and APG control the money of two of the Netherlands' largest pension funds. They have committed an additional €10 billion ($13.68 billion) in funds as part of the deal, Mr. van Rijn said.

"APG has committed around €7 billion, while PGGM granted an additional €3 billion in investment mandates," he said. The funds will be granted in the period from 2011 through 2015.

AlpInvest manages €32.3 billion in funds, mainly on behalf of APG and PGGM.

"Expanding the scope of our global asset-management business will create new opportunities for Carlyle investors who seek a proven fund-of-funds platform," said David Rubenstein, managing director at Carlyle.

The transaction, which is subject to regulatory approval, is expected to close in March.

"Carlyle is a strong, long-term partner for AlpInvest. This is critical given the €32 billion in commitments we already manage today on our investors' behalf," said AlpInvest Chief Executive Volkert Doeksen, adding that Carlyle's global network and respected brand will help AlpInvest broaden its investor base and product scope.

With about €265 billion of assets under management, APG is one of the world's largest pension-asset managers. PGGM manages more than €100 billion of pension assets on behalf of some 2.3 million participants.

The AlpInvest board will comprise equal numbers of members from Carlyle and AlpInvest's management. It will be chaired by Mr. Doeksen and will include AlpInvest members Paul de Klerk and Tjarko Hektor.

Some observers have questioned whether conflicts could be an issue for the joint venture as AlpInvest has access to a large amount of information on Carlyle's rivals.

However, the firms said they have taken specific measures to ensure sensitive information won't be shared. The firms have put in place a firewall that will mean Carlyle executives will avoid having access to sensitive information on firms, funds and specific deals. It means the Carlyle executives sitting on AlpInvest's board will need to ensure the conversation is kept to macro issues.

In addition, no Carlyle executives will sit on AlpInvest's investment committees. This means AlpInvest's management excluding Carlyle executives will have full independence in deciding which firms to commit to, therefore lessening any ability Carlyle might have in hurting rivals.

AlpInvest has also agreed not to invest in Carlyle's future funds. This effectively removes any problems that could arise if disagreements arose between the firm and the investor on performance, strategy, commitment defaults and a host of other areas.

Carlyle has already contacted many of its rivals to gauge their reaction to such a move, according to one source close to the process, and the rivals were happy as long as the above safeguards were in place.

Other mooted bidders for the operation had included U.S. fund of funds HarbourVest Partners and U.S. fund of hedge funds Grosvenor Capital Management.

Martin Arnold of the FT reports that Mr Rubenstein predicted that rival groups would follow Carlyle’s move into the fund-of-funds industry, adding that Goldman Sachs had shown how to invest both directly in deals and in rival funds without difficulty:

“Just as Goldman Sachs runs a secondaries private equity fund as well as a direct principal investment business, we are doing the same thing, and there has never been a problem there,” Mr Rubenstein told the Financial Times.

To address any conflict of interest fears, he said AlpInvest would be banned from investing in future Carlyle funds and from sharing any information with its new parent that is provided by the other funds it backs.

The deal, valuing AlpInvest at several hundred million dollars, cements Carlyle’s position as the world’s biggest private equity group by assets under management. Before the deal it managed $97.7bn of assets in 76 different funds.

AlpInvest, which invests on behalf of millions of Dutch civil servants, teachers and healthcare workers, has secured a commitment from APG and PGGM to grant it €10bn of further investment mandates over the next five years.

AlpInvest’s managers, led by chief executive Volkert Doeksen, are investing their own money to take a 40 per cent stake. The managers will split voting rights 50:50 with Carlyle.

No Carlyle executives will sit on its investment committees.

PGGM and APG decided to sell AlpInvest last year after public criticism in the Netherlands over the high pay packages received by some of its top executives.

AlpInvest paid €32.6m in salaries and wages to its 118 staff in 2009, of which 71 were investment professionals, after making €60m of revenues from management fees and carried interest – a share of profits.

Carlyle has been expanding its product offering and last year it bought a 55 per cent stake in Claren Road Asset Management, a $4.5bn hedge fund.

The Washington-based group – which once employed George H W Bush, the former US president, and the former British prime minister John Major as advisers – is expected to go public as early as this year, provided market conditions improve.

APG and PGGM were advised on the deal by Credit Suisse and Catalyst Advisors.

So what to make of this deal? In general, I'm not a big fan of hedge fund of funds or private equity fund of funds. Double layer fees chew up a lot of returns. Of course, AlpInvest is one of the better managed fund of funds in Europe. Carlyle is expanding its global presence to cash in when it goes public later this year. Does this mean private equity is about to peak? Not necessarily but they're obviously trying to time the markets right once they go public. If all goes smoothly, Carlyle executives will make a mint off the public offering. What remains to be seen is how well AlpInvest and Carlyle investors fare in the future.


A senior pension fund manager shared these thoughts:

A scenario:

AlpInvest will enable Carlyle to go public, and thereafter I bet will merge with Blackstone or some such, creating a mega private equity/hedge fund firm. The private equity asset class will roar ahead unabated based on the publicity and related hopes and dreams of institutions, and all this will come to a reckoning in 2013/14 or so (when the wall of debt refinancing comes home to roost). Then the slow, grinding diminution of an overdone industry will unfold for the decade thereafter. Handfulls of firms and institutions will end up with positive IRR for the full length of their programs.

Mercer has already promoted PE going forward as having expected returns less than public markets. They are not wrong.

Tuesday, January 25, 2011

SEC Probes Illinois Pension Statements

SEC probes Illinois pension savings projections:

When Gov. Pat Quinn signed pension reform legislation in April, he estimated the new law would save taxpayers more than $200 billion over nearly 35 years.

And the relief would be immediate, lawmakers projected at the time. They estimated that $300 million to $1 billion could be trimmed from the state's required pension contribution in fiscal 2011, which began July 1.

Now, the Securities and Exchange Commission is conducting an inquiry into the state's projected savings, the governor's office confirmed Tuesday.

The probe, which began in September, is looking into "communications relating to the potential savings or reductions in contributions by the state," the state disclosed in preliminary documents related to the planned sale Feb. 17 of $3.7 billion in pension obligation bonds. Proceeds would fund the state's pension contributions for this year.

"This is not an investigation; this is an inquiry," said Kelly Kraft, Quinn's budget spokeswoman. "The SEC has stated this is not an indication of any violation. We feel our disclosures have always been accurate and complete."

Quinn said the SEC inquiry won't affect the planned bond sale.

"It's a nonpublic confidential inquiry. They wanted to just look at the (pension reform) bill that we passed ... and the pension borrowing," Quinn said. "But I don't see any problem there at all."

SEC spokesman Kevin Callahan declined comment.

The new pension law increases the retirement age and places a cap on the salary level on which pension benefits are based. The changes apply only to new hires and took effect Jan. 1.

The reduction in future benefits "will cause an immediate reduction in the amount the state will be required to contribute to the retirement systems," the state said in its bond offering document, dated Jan. 21.

An accompanying table shows estimated reductions in annual contributions through 2045. The reductions begin later and are more modest initially than projections for the same period made last summer by the Legislature's bipartisan Commission on Government Forecasting and Accountability.

The table in the bond document shows a reduction in the state's contribution beginning in fiscal 2012, shaving $83 million from the tab that year. The table does not give a total cost-reduction estimate through 2045.

The legislative commission's projections from last summer show reductions in contributions amounting to $488 million this fiscal year and another $868 million in fiscal 2012. Through 2045, reductions in state contributions are estimated at $71 billion.

The SEC is looking into how the state values pension reform savings and how it applies them to the present, said Robert Kurtter, managing director for state and local government ratings at Moody's Investors Service. Moody's noted the SEC inquiry in a report it issued late Monday on the state's debt rating.

Illinois employee pension funds are severely underfunded, and the situation continues to deteriorate, according to the Moody's report. The funded ratio for the five plans dropped to 45 percent from 50 percent in the last fiscal year, as combined liabilities grew to $138 billion from $126 billion, Moody's stated.

The state has been paying a premium in its borrowings because of its fiscal crisis, and the news of the SEC inquiry could worsen the situation, some observers say.

"Any bad news will put more pressure on prices of existing bonds and put interest rates higher than for a state that doesn't have those self-inflicted dilemmas," said bond portfolio manager and author Marilyn Cohen, president of Envision Capital Management Inc.

Others say, given Illinois' ongoing woes, the news may not matter much.

"In this case, negative headlines are a given," said Matt Fabian, managing director at Municipal Market Advisors, an independent research firm. "It's like smelling something bad at the zoo. You know it will smell, no matter how many times the elephant goes."

Quinn, on the other hand, said investors may be more receptive now that the state has hiked income taxes for the next four years, creating an increased revenue stream.

"We've never had a problem going into the market and getting plenty of bidders to lend money to Illinois, and I think that'll be even more so in light of our most recent action," Quinn said.

In fact, the state got a bit of positive news from Standard & Poor's Ratings Services on Tuesday, when the rating agency removed Illinois from its credit-watch status, citing the tax increases.

The SEC has been focusing greater attention on the municipal bond market. In August, it accused New Jersey of not adequately disclosing that it was underfunding its two largest pension funds when it sold $26 billion in municipal bonds. New Jersey agreed to settle without admitting or denying the SEC's findings.

"The New Jersey action was a warning to all states that they ought to look carefully to their documents in selling their securities," said David Ruder, a former SEC chairman who is a professor at Northwestern University's law school.

Quinn's budget spokeswoman said the New Jersey case led Illinois to be cautious in its disclosures.

"In light of the New Jersey order, and prior to being contacted by the SEC, the state took proactive steps to update its disclosures, and we now feel our disclosures exceed the new, more rigorous standards," Kraft said.

Meanwhile, Mary Williams Marsh of the NYT reports that the SEC may be looking into Calpers:

Federal regulators are examining disclosures by Illinois about its unorthodox pension funding method, trying to determine whether the state misled bond investors about the risks.

The Securities and Exchange Commission has said it has a special team devoted to investigating public pensions, and last year it brought its first case ever against a state, accusing New Jersey of securities fraud for claiming to have pension assets that did not really exist.

If the commission decides at some point to bring a case against Illinois, it would send another warning.

Some other states, including Arkansas, Ohio, Rhode Island and Texas, have used variations of Illinois’s method, which reduces their annual contributions to their pension funds. The effect is to save money at a time of tight budgets, but it can also weaken the pension funds.

The S.E.C.’s inquiry was disclosed in a prospectus for a $3.7 billion bond offering planned by Illinois for February. The state wants to use the proceeds from the sale to make its annual contribution to its pension funds, which are among the most poorly funded in the country. Illinois must sell bonds to come up with the cash because the state is low on money.

The prospectus said that the S.E.C. contacted the state last September and that Illinois was cooperating with the inquiry.

The state also disclosed that even before it heard from the S.E.C., it had decided to improve its pension disclosures. The prospectus said officials had made that decision as a precaution last August, after the S.E.C. accused New Jersey of securities fraud for making false statements about its pension fund. The New Jersey case was the S.E.C.’s first enforcement action against a state, and the state settled without admitting any wrongdoing.

“We feel our disclosures have always been accurate and complete,” said Kelly Kraft, a spokeswoman for the Illinois governor’s office of management and budget, which handles communications with the capital markets.

The S.E.C. contacted Illinois after an article appeared in The New York Times about an unusual actuarial technique the state had been using to save money by shrinking its annual pension contributions.

The method, enacted last year, is based on sharp cuts in benefits for state workers who have not yet been hired. Although the cuts will not produce an appreciable savings until far in the future, Illinois has begun funding its plans as if its current workers were already earning the smaller benefits of the future.

For more than a decade, Illinois failed to put into its pension funds the amount needed to cover the promised benefits. The gap between how much is needed and how much is actually in the funds has grown so big that the state is overwhelmed by the required contributions. The benefit cuts were presented by state officials last year as a reform that would get the situation under control.

Some actuaries who have studied the funding method have said they doubt it meets the standards of their profession. Some have called it reckless when used by a state with a severely stressed pension system, like Illinois. That is because it deprives the pension fund of the substantial yearly contributions it needs now, to pay for the benefits already earned by today’s workers.

Because the calculations are esoteric, it is hard for anyone besides a seasoned actuary to see that a program that Illinois ushered in as a reform could be harmful.

Actuaries have also expressed concern that other states and cities will adopt methods like the one Illinois is using, because many of them are cutting benefits for future workers, to save money and close budget gaps.

Rather than cutting benefits of existing workers, governments usually cut benefits for future workers. Laws and state constitutions make it very hard to do otherwise.

Illinois’s method does not appear to comply with current governmental accounting standards, but governmental accounting rules are voluntary.

The S.E.C. has no direct jurisdiction over public pension funds and cannot order a government to follow any particular funding method. Its interest is in protecting investors, and making sure they have enough information to make well-informed decisions. It appears to be trying to determine whether Illinois adequately explained its method to bond buyers, giving them an understanding of how the reduced contributions may ultimately affect the state’s finances.

News of the S.E.C.’s Illinois inquiry comes at a sensitive time. Many economists have been reviewing public pension disclosures and challenging the way governments calculate their obligations, saying the method in use tends to hide debt. The governments have generally responded that their accounting methods are correct and that long-term obligations should not be measured the same way as bills the states must pay right away.

Moody’s Investors Service issued a report on Monday holding the state’s rating steady, with a negative outlook. Along with its long-term pension funding problems, Illinois is grappling with a short-term budget deficit, largely stemming from reduced revenue, that it is trying to close in part with big tax increases.

Members of Congress have recently begun looking into whether a new chapter of the federal bankruptcy code, or some other legal framework, could be created to allow states with the most troubled finances to restructure their long-term debts.

The California state treasurer, Bill Lockyer, on Monday held a conference call in which he took issue with the critics of the current pension system. “They’ve confused the near-term budget shortfalls with the long-term funding obligations, and grossly inflated the size of the long-term liabilities,” he said.

Mr. Lockyer, who has a seat on the board of California’s big public pension funds, is also responsible for signing the state’s disclosures to investors. California does not use the unusual Illinois method that is drawing attention from regulators. But the S.E.C. has been looking into disclosures by the state’s biggest pension fund, known as Calpers, under the tenure of a previous state treasurer, according to officials with knowledge of the inquiry.

It's not just Illinois and California. Reuters reports that Loop Capital Markets recently said half of the 50 states were unable to make full contributions to their pension funds in fiscal 2009, and New Jersey put in the smallest amount -- 9 percent of its expected contribution.

State pension woes are fast becoming the political topic of the day. The concerns are understandable, but I think that politicians like to blow things way out of proportion (what else is new!). In the end, it's not state pension plans that will bring down state budgets (try healthcare costs), but the politicization of pensions will continue as states scramble to contain costs.

Monday, January 24, 2011

Insider Probe Impact Felt by Pension Funds?

Steve Eder of the WSJ reports, Insider Probe Impact Felt by Pension Funds:

The federal insider-trading probe is being felt beyond the world of hedge funds and "expert network" firms in New York and Silicon Valley. Investors in some of the hedge funds involved are struggling to get information and decide whether to sell their positions.

The scandal hit close to home for the $10 billion School Employees Retirement System of Ohio: The pension fund is invested in two hedge funds raided as part of the investigation. Soon after the news of those raids broke in November, executives of the pension fund flew to New York to question the two firms, Level Global Investors LP and Diamondback Capital Management LLC.

A contact at Diamondback told them the fund's managers would be limited in what they could say about the investigation but offered to provide an update on the fund's portfolio. The pension executives balked. "We have to do our job. I don't want a portfolio update," one of the pension fund's investment executives, Phil Roblee, wrote to another employee in an email on Dec 6.

Level Global and Diamondback, which haven't been accused of wrongdoing, have told investors they aren't targets in the probe. Spokesmen for Diamondback and Level Global declined to comment for this article.

Details of the exchanges between Diamondback and the Ohio pension fund offer a look inside the relationship between a hedge fund and a big client during a period of turmoil. The information was obtained by The Wall Street Journal as part of a public-records request made to the Ohio pension system.

As part of the three-year investigation, U.S. officials are investigating whether consultants and employees for so-called expert-network firms, among others, illegally funneled nonpublic information to hedge funds and other firms. In exchange for a fee, expert-network firms connect investors looking for an information edge with employees at public companies.

In early December, Mr. Roblee, head of alternative investments at the Ohio pension system, and Jason Naber, investment officer for hedge funds there, went to New York and Connecticut and met with principals of Level Global and Diamondback in their offices.

A day before the meeting with Diamondback, its head of marketing and client services, Vickram David, told Mr. Naber during a phone call that the hedge fund principals' "won't be willing to answer a lot of detailed questions about compliance in the meeting tomorrow as they are still cooperating with the government and would not want to 'front run that process,' " Mr. Naber wrote in an email to Mr. Roblee summarizing the call, adding that Mr. David had suggested they could do a portfolio update.

In the Dec. 6 email, Mr. Roblee told Mr. Naber that a portfolio update wouldn't be good enough.

Mr. Roblee, in an interview, told the Journal that he found both meetings to be useful and that the managers were "up front" in terms of their response to the investigation.

So far, the Ohio fund hasn't sought to withdraw assets from Level Global or Diamondback, Mr. Roblee said. Nor have several other public pension funds, including New York State Common Retirement Fund, invested with both Diamondback and Level Global, and the New Jersey Division of Investment, invested with Level Global, spokesmen said.

Representatives at several funds say they have been talking to consultants, watching the news, and communicating with their boards as the investigation wears on.

Should a hedge fund or its executives be charged by civil or criminal authorities in the matter, that would likely prompt pension funds to seek to withdraw assets, according to people within the industry.

In Philadelphia, the Public Employees Retirement System is holding onto its investment in Diamondback, which has been a top performer with a 15.3% cumulative return since the system invested $20 million with the manager about two years ago, said Francis X. Bielli, the system's executive director.

"We invested for the return, and quite frankly, our return with Diamondback has been very good," Mr. Bielli said.

Some pension funds said they are getting accustomed to bad news, since the financial crisis and more recent insider-trading cases. "You have to be prepared for stuff like this. Sometimes the knives are falling and we get stabbed," said Joelle Mevi, the chief investment officer of New Mexico's Public Employees Retirement Association, in an interview shortly after the November raids.

The association has $44 million invested in Diamondback and no plans to redeem, a spokesman said.

Newer investors in the hedge funds may not be able to withdraw money quickly, due to requirements that they invest for a minimum period of time. Nor may they want to, especially if the manager is delivering strong performance.

Some investors are looking to leave. Diamondback recently told clients that investors had so far asked to pull $400 million ahead of a mid-February deadline to request quarter-end redemptions, and that it is unclear how much more might be withdrawn, people familiar with the matter said.

Level Global has more than $4 billion under management and Diamondback has more than $5 billion, according to people familiar with them.

Diamondback this month has offered investors a management-fee cut—offering to reduce the annual flat fee to 1.75% of assets invested from its current 2%—as an enticement to keep clients' money in place, the people said.

Diamondback told clients that the firm will hold back 1% of whatever they withdraw in order to fund a reserve account, one person said. The account would be used if Diamondback funds eventually have to disgorge profits it has made as a result of the probe, the person said.

Diamondback also told investors that the management company, not investors, has paid all expenses related to the investigation and will do so this year as well.

Pension funds have been investing aggressively in hedge funds and that leaves them exposed to operational and reputation risk on top of investment risk. Nonetheless, in regards to this particular case, there is no use jumping the gun and redeeming funds before the investigation is over. If civil or criminal charges are laid, then they can reassess what course of action to take (even then, redemptions might not be necessary depending on who is charged).

What investors need to know is that hedge funds are making a comeback after getting creamed in the 2008 crisis. According to Svea Herbst-Bayliss of Reuters, Hedge fund industry assets swell to $1.92 trillion:

Hedge fund assets grew a record $149 billion during the last three months of 2010, according to new data released on Wednesday.

According to Hedge Fund Research (HFR), which tracks industry performance and asset flows, hedge funds around the world now invest $1.917 trillion.

Investors added $13.1 billion in new money during the last quarter after having put in $19 billion in the third quarter. In total, pension funds, endowments and wealthy investors added $55.5 billion in new money in 2010, the highest annual total since 2007. The rest of the increase during the last quarter came from market gains.

The increased flows came even as the industry delivered only lackluster returns of 10 percent, lagging behind mutual funds and the industry's own more impressive 19 percent gain in 2009.

The industry is almost back to its peak size of the second quarter of 2008, when assets hit $1.93 trillion, right before the height of the financial crisis.

But the flows also suggest investors are taking a more cautious stance by sticking with established players. The data show that 80 percent of net new assets went to big fund firms that oversee more than $5 billion in assets.

"The second half of 2010 was a historic time in the hedge fund industry, characterized by powerful and pervasive trends shaping the institutional landscape of the hedge fund industry", Kenneth Heinz, President of HFR, said in a statement.

"As the industry is positioned to surpass its previous asset peak, global investors are focused on the dynamics of inflation protection, strategic specialization, enhanced liquidity, improved structure and transparency for accessing hedge fund performance in coming years," he said.

Macro and relative value funds were the most popular with investors, as clients hoped those types of funds could best navigate volatile currency and interest rate markets.

Event-driven funds which focus on mergers and acquisitions were also popular, pulling in $14 billion during 2010.

But the industry's biggest category, equity hedge funds that can take long and short bets, failed to excite investors and added only $2.6 billion in new money during the year.

What do all these hedge fund assets mean? It means markets are getting primed for the next ramp-up. It's going to be volatile, but liquidity flows are pushing risk assets higher. I suspect a lot of cautious fund managers are going to get caught flat-footed in 2011 as the big hedge funds and banks ramp up. The first weeks of trading mean nothing but pay attention, I think we're getting a taste of what lies ahead.

Sunday, January 23, 2011

APG Buys Stake in Philippines Real Estate

N.J.C. Morales of BusinessWorld Online reports, Dutch pension fund manager invests in Century Properties:
High-end real estate developer Century Properties, Inc. has secured more than P2 billion in funding from a European asset manager to finance projects in the “premium” market segment.

The investment from APG will be used for expansion, Century Properties said, pointing to a favorable business environment.

“APG, one of the largest global pension asset managers based in the Netherlands, with €266 billion of assets under management, has invested P2.25 billion in Century Properties,” the property firm said in a statement yesterday.

“The investment of APG will allow Century Properties to capitalize on the current high-growth and low-inflation environment of the Philippines,” Jose E. B. Antonio, chairman and chief executive of Century Properties, said in the same statement.

Mr. Antonio said the cash infusion would “further expand [the company’s] business plan of catering to the premium segment of multiple markets.”

Patrick Kanters, managing director for global real estate of APG, said: “As a long-term strategic investor, APG has identified the real estate market in the Philippines as highly attractive.”

The Philippine real estate sector is enjoying brisk demand amid low interest rates that allow affordable financing.

The Philippines has a housing backlog of 2.5 million-3.5 million, government data show.

However, the entire property development industry produces only about 250,000 units per year, less than half the demand of 600,000 annually.

“We are confident that through our investment we contribute to the Century Properties team realizing [its] growth strategy,” Mr. Kanters said.

APG provides asset management services to pension funds. It manages more than 30% of all collective pensions in the Netherlands, making it one of the world’s largest pension asset managers, the company said on its Web site.

Early this month, privately held Century Properties broke ground for its $100-million, 28-storey Centuria Medical Makati -- an outpatient building that will have 500 clinics and targeting the medical tourism market.

The unlisted Century Properties is a 25-year-old real estate developer focused on the high-end residential condominium market.

As of end-September last year, Century Properties has completed 22 towers and manages 43 buildings totaling 1.9 million square meters.

Projects in its portfolio include the Essensa East Forbes and South of Market in Fort Bonifacio, and The Casitas and The Moderno at San Lazaro Leisure Park in Carmona, Cavite.
I bring this story to your attention because it shows where long-term growth lies, namely in Asia. It's not just the Philippines. One of my colleagues raved about a recent trip he enjoyed with his family in Vietnam. I asked him if it's booming and he told me ''absolutely incredible boom going on there''. APG is one of the largest global pension asset managers in the world. Investors should be paying more attention to where they're investing as it can provide them with clues on where opportunities lie.

Friday, January 21, 2011

The Swedish Pension Model?

Naomi Powell of the Globe and mail reports, In Sweden, pension problems are so 1989:

There’s no shortage of pension woes in Europe these days.

Everywhere, it seems, governments are hiking retirement ages, cutting benefits and quelling protests from outraged workers.

Not in Sweden.

It isn’t that the Swedes escaped the troubles now facing many of their European neighbours, they were just forced to deal with them a long time ago. Still, the economic crisis presented the first real test of the country’s pension reform, one it weathered relatively well.

In the late 1980s, the government realized that without a major overhaul, the public pension system would be bankrupt in about 20 to 25 years. The reasons are familiar: a rapidly aging population and a defined benefit system that would collapse without consistently strong economic conditions.

“You had this big tanker of pensioners who were going in one direction and you had pensions that had to be paid by law,” said Edward Palmer, a professor of social insurance economics at Uppsala University who helped design the system. “But you had an economy that could do anything. We had to get a system that would be resilient to both economic and demographic shifts and we had to get people to work longer.”

In a radical change, Sweden scrapped its traditional defined benefit pension for what's called a "notional defined contribution" plan (NDC). The notional account recorded each individual's contributions and a rate of return tied to the national per capita real wage growth. There was no "real money" in the account - as in traditional pension plans, contributions fund current retiree benefits – but the system provided a way of keeping score.

Swedes contribute 18.5 per cent of their pay to the system: 16 per cent to the NDC and 2.5 per cent to a private account where money is invested in mutual funds of their choice. The public pension is a significant portion of retirement income – responsible for 75 per cent of the average monthly benefit for men at 17,000 Swedish kronor ($2,562 U.S.) and women at 12,000 kronor. The rest comes from occupational pensions negotiated between companies and unions.

When workers retire, their annual benefits are calculated by dividing the account balance by the life expectancy rate and rate of return based on the growth of the economy. Benefits are adjusted each year taking into account changing life expectancies, inflation and the rate of return.

Workers can retire as early as 61, but the longer they stay in the work force, the higher their benefit upon retirement.

The bottom line? When the economy is strong, pensioners receive more than they might have under the old structure. But when the economy is weak pension payments automatically drop to ensure the fund’s stability.

The system was designed in part to take difficult decisions regarding benefit cuts out of politicians’ hands by allowing them to refer to a formula.

That was the theory anyway. No one really knew how well the system would perform until the global economic crisis.

Pensioners, who had enjoyed years of higher payments following the changeover to the new system in 1999, suddenly faced a cut of 3 per cent in 2010 and 4.3 per cent in 2011.

The government stood behind the system, though eventually politics did get involved. Taxes for pensioners were slashed to make up for the shortfall.

“The positive side is that Sweden now has one of the few public pension schemes that is in good shape after this crisis,” said Ole Settergren, head of research and development at the Swedish Pension Agency. “But one of the points was to isolate public finances from what happens in the pension arena. That didn’t happen.”

Perhaps the most controversial aspect of the plan is that it shifts the burden of fund shortfalls onto pensioners – though there is a basement for how low benefits can fall, at 7,000 kroner a month. And as the crisis proved, that burden can be significant.

Not a perfect system then, but sustainable. And one that many countries, including Egypt, Poland and Brazil have considered as they try to fix their own pension schemes.

I'm not an expert of the Swedish pension system, but I know about the buffer funds:

Första AP-fonden’s mission is regulated by the Swedish National Pension Funds Act. The act (and preparatory work to the act) state that Första AP-fonden shall:

  • Function as a buffer in the pension system
  • Maximize long-term return with a low level of risk
  • Manage the funds without being influenced by prevailing government policies, whether industrial or economic
  • Give consideration to ethics and the environment without compromising the overall goal of attaining a high return
Första AP-fonden, also known as the First Swedish National Pension Fund or AP1, together with the Second, Third, Fourth and Sixth National Pension Funds (AP2, AP3, AP4 and AP6), is a buffer fund in the Swedish pension system. The capital of the buffer funds is used to even out temporary fluctuations during periods when pension contributions are not sufficient to cover pension disbursements from the income pension system.

According to the annual report, AP7’s investment returns in 2009 were its highest since the premium pension system launched ten years ago (2009 was a good year for everyone). AP1 also provides its 2009 annual report online and its latest semi-annual report. Both reports provide intricate details on the fund's performance, operations and cost structure.

I like the Swedish buffer funds and think they're worth looking into more closely. Even Canada should look at these buffer funds and set something similar up here (basically building on our existing defined-benefit plans). Other countries can also learn from the Swedish pension model and bolster their retirement system. At the very least, they should examine the pros and cons and see if there is anything they can adopt to improve on their existing pension system.

Thursday, January 20, 2011

OMERS Eyes Shift into Private Market?

Tara Perkins of the Globe and Mail reports, OMERS eyes shift into private market:

Michael Nobrega, chief executive of the Ontario Municipal Employees Retirement System, has to figure out how to deploy about $20-billion into private investments in the next five years.

It’s a tall order, and it explains why Mr. Nobrega and his colleagues are opening new offices and courting well-connected partners in places such as London and New York.

Wednesday, January 19, 2011

Overhaul for California’s Underfunded Pensions?

Alison Vekshin of Bloomberg reports, Brown to Propose Overhaul for California’s Underfunded Pensions:
California Governor Jerry Brown said he will propose changes to the most-populous U.S. state’s underfunded public-employee retirement plans.

Brown did not say specifically what facets of the two biggest pension systems he would like to alter. His administration will release ideas in coming weeks, Brown said today in a speech to the League of California Cities, a conference in Sacramento for mayors, city council members and administrators.

“It’s going to be a continuing process as we understand exactly what the stock market provides and what the stock market doesn’t provide,” said Brown, who was Oakland’s mayor from 1999 until 2007.

Public pensions across the U.S. face a gap of as much as $3 trillion between their recession-battered assets and promised retiree benefits, according to a June study by researchers at George Mason University’s Mercatus Center in Arlington, Virginia. That puts pressure on states, cities and counties struggling with a drop in tax collections.

The California Public Employees Retirement System, which covers state and local government workers, has no more than 70 percent of the assets it needs to pay for benefits over several decades, according to fund staff. The California State Teachers Retirement System as of June 30 could pay 78 percent of promised benefits, with an unfunded liability of $40.5 billion.

Brown’s proposals will be scrutinized, said Pat Macht, a spokeswoman for Calpers.

“Everyone who cares about pensions will be interested in the details,” she said in an interview.

Meeting Obligations

Fred Glass, a spokesman for the California Federation of Teachers in Alameda, said in a telephone interview that members expect their due.

“I’m assuming they are going to live up to the obligations that government has made over the years,” he said. “Public employees, including educators, typically earn less than their private-sector counterparts. The way they get close in compensation is by having strong pensions.”

Brown, a 72-year-old Democrat who took office this month, has proposed an $84.6 billion general-fund budget that calls for $12.5 billion in spending cuts, mostly to welfare programs and public universities, and $12 billion of additional revenue raised in part by asking voters to extend for five years higher income and sales taxes and vehicle-registration fees set to expire this year.

With an economy bigger than Russia’s, California has the deepest deficit of all U.S. states. The state has coped with $100 billion of budget gaps in the past three years amid the global recession.

I doubt he'll go as far as Utah, but once Governor Brown reveals the details, you can be sure the proposed overhaul of California's public pensions will be met with protests from unions. In a separate article, aiCIO reports, CalPERS Rebounds to Pre-Crisis Levels Following Lehman's Downfall:

The California Public Employees’ Retirement System (CalPERS), the largest US public pension, has rebounded from loses following the Lehman crash as taxpayers face increased costs.

Yet, the pension fund still has only roughly 70% of the money needed to cover benefits and as a result, CalPERS needs to demand more from taxpayers to cover those costs. “Taxpayers pay about 23 cents out of every dollar for the CalPERS’ retirement cost,” Joe Dear, the fund's chief investment officer, told Bloomberg. “That cost is going to go up slightly in light of the crisis, but that’s not an unreasonable amount and these pension liabilities stand like the state’s debt obligations, as an unavoidable commitment.”

Joe Dear, the chief investment officer of CalPERS, which lost 23.4% in the fiscal year that ended June 30, 2009, told the news service that there's no way to avoid liabilities which already exist. While the fund was fully funded at the start of the recession in 2007, it's now down to around 65%, Bloomberg reported.

The shortfall is not limited to CalPERS, as public pensions nationwide face massive shortfalls in the money needed to cover benefits promised to government workers. Lawmakers recently approved legislation that forces municipalities to pay more into pension funds over the next three decades in an effort to increase the funding level for pension schemes for local firefighters and police officers. Chicago officials worry that the new legislation will lead to increased costs and result in an up to 60% increase in property taxes. According to Bloomberg, Quinn said last week that he needs to analyze the bill, calling it an "important area of reform" imperative at the local level.

"Illinois is much like other states not keeping up with its annual payments to their fund," Pew spokesman Stephen Fehr told aiCIO in November. "They've been increasing benefits to public employees without thinking how they are going to pay for them in the future," he said. "It's not just the recession that caused this problem -- Illinois didn't manage their pension bill in good times and bad, and its not a problem that will get better anytime soon," noting that the pension deficit around the nation has led to severe underfunding in other state programs to make up for mismanagement.

The effects of public pension shortfalls will be felt as states cut back other programs to make up for mismanagement. Will pension deficits shrink in the coming years? That depends. Ideally, stock markets will continue rising along with interests rates so assets grow at the same time that liabilities fall. But that's no quick fix and hardly guaranteed, which is why California and other states are taking measures now to overhaul public pensions.

My biggest concern is that the shift into defined-contribution plans in both the private and public sector will end up costing states more down the road in terms of welfare costs. Somebody told me today that "I'm writing like a leftist" because I openly prefer professionally managed defined-benefit plans over defined-contribution plans.

This is total nonsense. My views are based on facts, not ideology. The fact is that defined-contribution plans have severely underperformed defined-benefit plans. They're aren't managed nearly as well (no alignment of interests), and they don't invest in public and private asset classes around the world. Worse still, the fees are much higher and they're more volatile because their performance is based mostly on beta, with hardly any alpha.

I end this comment by asking a simple question: why shouldn't workers enjoy the same pension benefits that their elective representatives have? If private companies and governments were smart, they'd be thinking hard about bolstering defined-benefit plans, not promoting defined-contribution plans because they cost less in the short-run (long-run is a different story). It's amazing how shortsighted we've become on one of the most important public policy issues of our times.


CalPERS says investments grew 12.5% in 2010. The smaller CalSTRS ends the year with a 12.7% return as the nation's two largest public pension funds get back on track after suffering steep losses during the recession. Read up on CalPERS' and CalSTRS' 2010 performance by clicking here.