Monday, February 28, 2011

OMERS Earns 12% in 2010 But Deficit Swells

Tara Perkins of the Globe and Mail reports, OMERS boosts return, funding deficit swells:
The Ontario Municipal Employees Retirement System has posted a 12.01-per-cent rate of return for 2010, up from 10.6 per cent in 2009. But its funding deficit has tripled to $4.5-billion as its pension benefit obligations have increased.

OMERS released a summary of its financial results Monday, with detailed information to follow later this month. The fund, which provides pension services to more than 400,000 people, is grappling with a shortfall in the wake of the recession.

Temporary contribution increases and benefit reductions are part of the strategy to return it to balance. It requires a 6.5-per-cent annual return to bring itself back into a surplus position in 2025.

“Based on our asset mix policy and active investment strategy, we believe we can generate average returns of 7 per cent to 11 per cent annually over the next five years,” said chief financial officer Patrick Crowley. “Doing so would return the plan to surplus between 2015 and 2020 - five to 10 years ahead of schedule.”

OMERS’ net assets rose to $53.3-billion last year, up from $47.8-billion the prior year. Its 12.01-per-cent return compares to a benchmark portfolio return of 11.47 per cent. RBC Dexia Investor Services Ltd. has estimated an 11.25-per-cent median return for large pension funds in 2010. Earlier this month, the Caisse de dépôt et placement du Québec posted a 13.6-per-cent return for the year.

OMERS is in the midst of working to shift its portfolio away from stocks and bonds towards private market investments, such as private equity, infrastructure and real estate. Its private equity portfolio delivered returns of 22.21 per cent last year (the benchmark return was 28.05 per cent). Infrastructure returned 10.10 per cent, compared to a benchmark of 8.5 per cent, while Oxford Properties returned 7.51 per cent, compared to a benchmark of 6.65 per cent.

OMERS released this press release on their website:

Today, OMERS announced its net assets rose to $53.3 billion as of December 31, 2010, up from $47.8 billion the year before. The total rate of return in 2010 was 12.01 per cent, compared to 10.6 per cent in 2009. The Plan’s growth in net assets for 2009 and 2010 combined was $9.9 billion.

“OMERS achieved excellent investment results in 2010, supporting our mission of creating surplus wealth for plan members and sponsors,” said John Sabo, Chair of the OMERS Administration Corporation Board of Directors. “Our performance, which stems from our asset mix shift to world-class private market investments, and strong market investment returns driven by the recovery of the global financial markets, reflects our focus on risk-adjusted returns, which is designed to manage volatility and respond to our long-term liability profile.” In the seven years since OMERS adopted a policy shifting its asset mix more heavily into private market investments, the Plan has earned an annualized return of 8.11% which includes the investment return of -15.3% in 2008.

Like many other pension plans, OMERS continues to face a funding shortfall caused by the 2008 global economic downturn. The Plan’s 2010 funding deficit was $4.5 billion, versus $1.5 billion a year earlier. These amounts are included in OMERS financial statements, which will be available later in the first quarter of 2011. Actuarial assumptions indicate OMERS requires an investment return of 6.5% annually to keep assets and liabilities in balance. That rate of return, combined with temporary contribution increases and benefit reductions, will see the Plan return to surplus in 2025. “Based on our asset mix policy and active investment strategy, we believe we can generate average returns of 7% to 11% annually over the next five years. Doing so would return the Plan to surplus between 2015 and 2020 – five to 10 years ahead of schedule,” said Patrick Crowley, OMERS Chief Financial Officer.

OMERS also continues to advance programs requested by various stakeholders and codified in the OMERS Act 2006 and the Plan text. The first of these programs, Additional Voluntary Contributions (AVCs), allows members to invest their registered retirement savings in the OMERS Fund, effective January 1, 2011. Other specific capital-raising programs will be launched in 2011.

OMERS was named 2010 and 2011 Global Pension Fund of the Year, Canada, by World Finance magazine. This award is based on excellence in member service, innovation, risk management and investment performance. OMERS was also named one of the country’s best employers for the third year in a row, ranking 13th on Aon Hewitt’s 2011 list of the 50 Best Employers in Canada.

For a more detailed breakdown, click here to view the fact sheet. The returns came from both public and private markets but I did notice that even though private equity returned 22.2%, it underperformed the benchmark which returned 28%. Borealis Infrastructure returned 10.1% beating its benchmark by 160 basis points while Oxford Properties and OMERS Strategic Investments marginally beat their benchmarks. OMERS Capital Markets (public markets) delivered decent returns, outperforming the benchmark by 93 basis points (the fact sheet doesn't provide further details on fixed income and public equities).

The funding deficit is serious but they're trying to address it by temporarily raising contribution rates and reducing benefits. As for assuming 7% to 11% over the next five years, I think this is achievable but it won't be easy. OMERS is betting big on private markets to achieve these returns. We'll see if they can deliver them in what will certainly prove to be treacherous markets.

Finally, Tara Perkins also reported in CTV, OMERS wants in on private pension plans:

Pension funds want Ottawa to let them in on the new private-sector retirement savings pools, allowing the funds to compete head-to-head against banks and insurers.

The desire to cater to small businesses and self-employed savers signals a shift in the way big funds operate, and comes as the country’s retirement system enters a period of massive reforms.

Some big funds want the federal government to allow more players to administer the new pooled registered pension plans (PRPPs), Michael Nobrega, chief executive officer of the Ontario Municipal Employees Retirement System told reporters in Toronto on Monday.

Federal Finance Minister Jim Flaherty signalled in December that the government will push forward with the development of PRPPs to help allay a looming retirement savings crisis. Ottawa said the PRPPs, which are designed for people without company pension plans, will be administered by “regulated financial institutions.” The institutions will essentially offer pension plans that small businesses or self-employed people can sign up for. The idea is that through regulations and new laws, governments will ensure that plan administrators charge lower management fees than are currently available.

“Right now, it’s insurance companies and the banks,” Mr. Nobrega said. “I would suspect that the federal government would be wise to include a broader range of providers other than simply the banks and insurance companies, because the pension funds do have the muscle and investment systems to do it.”

Financial institutions, and especially life insurers, lobbied for the creation of PRPPs as an alternative to expanding the Canada Pension Plan. Ottawa backed the idea because it was leery of taking more money off paycheques during the economic recovery, and did not have the necessary provincial support to expand the CPP, though it is still considering doing so.

Under the PRPP proposal, plan administrators would be responsible for receiving contributions to a plan from individuals and employers, and responding to enquiries from them.

“Consultations are still in their early stages,” Bram Sepers, a spokesman for Ted Menzies, minister of state for finance, said Monday. “As of today, no decisions have been made. Pension funds are only one of the stakeholder groups being consulted for the development of PRPP legislation.”

The establishment of PRPPs comes as a number of pension funds are seeking new avenues for profit and growth. Last month, OMERS launched “additional voluntary contributions,” a program in which its members can elect to invest additional money with the fund.

“We are seeing millions of dollars coming in,” said Jennifer Brown, OMERS’ chief pension officer. So far, close to 2,000 people have signed up for the program, she said.

The Ontario government gave OMERS the ability to provide third-party investment management services in 2009. Like other major funds, OMERS is shifting its asset mix, taking more control of its investments, and seeking ways to boost its relevance in the retirement market.

OMERS reported its 2010 financial results on Monday, showing an annual return of 12.01 per cent or $5.4-billion, up from 10.6 per cent or $4.3-billion in 2009. For the first time since the financial crisis, the fund’s assets exceeded their 2007 level, and now amount to $53.3-billion. However, its funding deficit still tripled to $4.5-billion as its pension benefit obligations have increased.

The run-up in equity markets last year is helping pension funds to recuperate. Last week the Caisse de dépôt et placement du Québec, which has been looking to offer its depositors more tailor-made investment strategies, posted a 13.6-per-cent return.

“It really was the product of a lot of things that we started doing in 2009: simplifying, taking our leverage down, getting out of complex derivatives,” Caisse CEO Michael Sabia said in an interview Monday. The pension manager was able to sell a number of assets it was looking to shed, including complex real estate debt, into a relatively strong market.

But Mr. Sabia is quick to point out that one year’s returns don’t make a trend, and he is working to position the fund for the long term. Having removed some of its key risks, the Caisse is now embarking on the second chapter of Mr. Sabia’s turnaround plan, in which it will decide what investment areas to focus on in the future.

“The business we’re in is a marathon, it’s not a sprint,” Mr. Sabia said.

Mr. Nobrega is right, PRPPs cater to banks and insurance companies but defined-benefit plans like OMERS, OTPP and the Caisse which is a fund not a plan, should also be allowed to compete in this space as they offer better products which invest in both public and private markets.

I covered the Caisse's 2010 results last week. They were exceptionally strong, returning 13.6% and beating the overall benchmark by 410 basis points (13.6% vs 9.5%). This came after two tough years which included the 2008 disaster. But as I stated last week, it's going to be tough for anyone else to beat these results. And even though OMERS performed well compared to other large Canadian pension funds, they didn't perform better than the Caisse in 2010. I doubt anyone did.

Sunday, February 27, 2011

The Blame Game?

William S. Lerach reports in the Huffington Post, Blame Wall Street, Not Hard Working Americans, For The Pension Funds Fiasco:

The confrontations in Wisconsin and other states are the opening salvo of a political blame game -- who is responsible for the gigantic public pension fund deficits that threaten states' solvency and workers' retirement savings? The conservative spin machine blames public employees, claiming their greedy unions extorted extravagant and now unaffordable benefits which justify pension cutbacks and union-busting. This is a false. The real cause of the pension fund debacle is the greed of Wall Street and its corporate allies. It's a result of their dismantling of our nation's regulatory safeguards and Wall Street's capture and abuse of America's public pension funds -- charging them huge management fees, while losing trillions of dollars of pension fund assets in risky investments.

Wall Street developed with no regulation. Abuses abounded. Financial markets were corrupt. Then came the 1929 Crash, a wealth destruction event that ended the dreams of an American generation. The Pecora hearings exposed self-dealing and fraud by Wall Street bankers. Wall Street faced ruin. But instead of wiping out Wall Street or nationalizing the banks, we chose to save capitalism and protect investors -- by creating a new system of highly regulated financial markets.

Congress created the SEC to oversee stock exchanges, require honest accounting and disclosure by corporations and broke up (and strictly controlled) the Wall Street banks. In time, this new regulatory framework created the greatest age of economic growth and prosperity in history. Despite periodic recessions and bear markets -- there were no more investor wealth destruction events.

As the U.S. became the world's financial powerhouse, no one got more powerful than the Wall Street banks and their corporate allies. Then they set about undoing the very regulatory framework that had saved them. As politics came to depend on massive infusions of cash, no one provided more of it than corporations and Wall Street banks. They complained that regulation was restricting American competitiveness and economic growth -- our citizenry was seduced by promises of greater growth and prosperity. Government, which had actually been the key to the solution, became portrayed as the problem. They captured Congress. And then came the regulatory teardown.

Congress deregulated the S&Ls. Then it enacted severe cut backs on investor protections and curtailed their right to sue. Glass-Steagall was repealed -- allowing the long forbidden financial giants -- investment and commercial banks -- to recombine. The Wall Street/ Corporate alliance used its power to see that regulatory agencies passed into the hands of appointees who were hostile to the regulations they were supposed to enforce. Investor protection rules were diluted. A pro-corporate Supreme Court curtailed suits against banks and corporations. The result was behemoth banks, less regulatory oversight and less accountability.

So, what came from this era of de-regulation? Increased competitiveness, economic growth, wealth and prosperity? No -- instead we got repeated waves of financial fraud and wealth destruction events.

First came the S&L blowup of the mid-1980s. Over 3,000 S&Ls collapsed. A few years later it was the 2000-2001 meltdowns epitomized by WorldCom and Enron. Most recently, our major financial institutions were rocked by scandal -- the worst crash since 1929. Investors lost over $20 trillion in these three massive wealth destruction events, which were the result of the teardown of the regulatory framework that had been erected over the prior 70 years to control our financial markets and protect investors. America's public pension plans -- guardians of the life savings of countless working people -- were the biggest victims of these wealth destruction events.

A pension system is a bet on the future -- some money is set aside currently, but not enough to pay all the promised benefits. So, how pension funds are invested and safeguarded is key. Originally, many states required pension funds to invest in safe, interest-bearing bonds. But Wall Street could not make a lot of money from that, so it bank-rolled initiatives and legislation to repeal these protections and permit pension funds to be invested in the stuff they make big profits by peddling. Then Wall Street money managers captured pension funds' investment portfolios by assuring trustees that ever-higher stock prices would pay for the retirement promises. Charging enormous fees, they made risky stock market bets, putting up to 80% of pension plan assets in the stock market. The Wall Street wisdom that ever-rising stock prices would fund pension plan promises was wrong. In fact, we have seen three major equity wealth destruction events in last 20 years.

As a result, the financial situation of our public employee pension funds is precarious. These funds lost hundreds of billions in the S&L disaster and the 2001-2002 market crash. After the 2001-2002 wipeout -- guided by Wall Street -- fund trustees took much greater risks to try to make up for the prior losses. They poured billions into hedge funds, private equity, speculative real estate and that special Wall Street invention -- collateralized debt obligations. Then, in the 2008-2009 financial crisis, the losses of public funds were stupendous. 109 state funds lost $865 billion in about one year. CalPERS lost $72 billion! Now virtually all of these funds are now grossly under-funded. New Jersey and Illinois are each over $50 billion underwater.

Why are our public pension systems and plans in such precarious financial condition? Of course there are some examples of excessive pensions, of double-dipping and of "gaming" the system to "goose" the pension amount. But these are few in number. And, even in the aggregate, the financial impact of these excesses pale in comparison to the gigantic investment losses of these pension funds. So let's place the fault where it really belongs -- not with working people -- but with Wall Street banks. Who made money on these risky investment gambles? Who takes pension fund trustees to play golf and on so-called "educational" junkets at lush resorts to enjoy lavish dinners? Wall Street.

The inappropriate investments that caused these massive pension fund losses were not an accident. The pension fund field caught the Wall Street contagion -- financial corruption. It's called "Pay to Play." The SEC saw it years ago but, controlled by anti-regulation political appointees, it did nothing. So a nationwide system of political contributions to elected officials who sit on fund boards and payoffs and kickbacks to politically well-connected "Placement Agents" to steer fund money to Wall Street became widespread. Not surprisingly, the investments obtained by "pay-to-play" kickbacks and contributions have generated horrific losses.

An investment officer of the California Public Employee Pension Fund was forced to resign -- he got an all-expense-paid trip to NYC from an investment group that got $600 million from the fund. The middle men on that deal -- two former top CalPERs officials -- got some $20 million to arrange this placement. Two other former CalPERS officials have been sued by the Attorney General for taking $50 million in placement fees to steer pension investments. CalPERs lost hundreds of millions on such investments. Alan Hevesi -- the former head of the New York State Fund -- pleaded guilty to doling out billions in that Fund's assets to favored managers in return for benefits. The SEC has finally outlawed this system of bribes and kickbacks. But too late -- the damage has already been done to the pension funds. Nationwide, public pension funds lost billions on these types of corrupt investments with Wall Street types.

The horrible deficit numbers funds admit to actually hide a far more terrible reality. To determine how well a fund is "funded" it uses an assumed rate of return. It estimates how much the fund will earn on its investment portfolio in the future. For decades, public pension funds have assumed 7.5%-8%, even 9% annual growth, i.e., over 100% compounded over 10 years. Fat chance!

Today, pension funds are engaged in massive deceptions to conceal the true extent of their funding deficits. They are concealing the massive black holes that haunt public budgets. These ridiculous 7.5%-9.0% assumed rates of return are not "little white lies" -- they are Everest-sized whoppers. If the three big California Public Funds used a 4.5%-5% rate of return instead of the 7.5%-8% they now use, these funds would be $500 billion under-funded -- 10 times the $50 billion shortfall they admit to. Since this is a nationwide deception going on in virtually all public plans, try extrapolating that out. Public employee funds are probably $3 or $4 trillion underwater. The massive shortfalls we now face exist despite prior "Bull Markets" and the current rally. And the next round of excess of a still under-regulated Wall Street will produce another wealth destruction event that will erase recent gains.

This is no academic matter. The time to keep the retirement promises is now upon us. In the next several years, some 77 million U.S. baby boomers -- including millions of teachers and public service workers -- will enter retirement. Unfortunately, the U.S. public pension system has become a fraud-infested house of cards. Wisconsin shows us this house of cards is starting to collapse, sparking a major political battle.

The conservatives will "scapegoat" public employees as a privileged -- protected -- class. But it was not firemen, cops, clerks, or teachers (or their unions) who lost trillions of dollars in risky investments in an under-regulated stock market over the past 20 years. The Wall Street money managers lost it in investments acquiesced in by the pension fund trustees they had wined and dined. It's the same old story. The bankers pocket gigantic fees. The privileged few get fat. Ordinary people get run over. And now are even to be blamed -- even punished -- for a mess they did not create.

We cannot allow these public pension plans to collapse. Nor can we break our promises to workers who relied in good faith on promised pensions. Fortunately, there is a solution that could help protect retirees and at the same time help finance our huge federal deficit -- if we act fast.

  • First -- stop allowing Wall Street money managers to speculate with workers' retirement savings in risky equities and other crazy investments.
  • Second -- create a new 7% or 8% inflation-indexed U.S. Treasury bond only for retirement funds, in staggered 10-30 year maturities. Require all pension plans to buy and hold these bonds. To allow an orderly transition -- require that over the next seven years -- 80%-90% of all pension plan assets must be put in these safe, high-yield bonds.
These bonds will provide low-cost returns for pension funds. This will stop Wall Street's gouging the funds with huge fees and speculating with workers' retirement savings. This solution will also help finance our huge federal deficit. While the interest rate is high -- we taxpayers are going to end up paying to solve this problem one way or the other. And, at least this way, the interest payments will go to support our fellow retired citizens -- not the Chinese. It's a simple, elegant solution -- but Wall Street and the politicians they control will never permit it.
While I empathize with the spirit of this article, Mr. Lerach fails to mention a few things. First, an agreement between the Clinton administration and congressional Republicans, reached during all-night negotiations on October 22, 1999 introduced the most sweeping banking deregulation bill in American history. It's simply wrong to blame "Conservatives" for deregulation of the American financial system. Both major parties catered to the financial elite to introduce sweeping banking deregulation.

Second, as I wrote back in January, while a large part of the blame lies with Wall Street, it's too easy to use greedy bankers as scapegoats for the pensions fiasco. Poor governance, rosy investment assumptions, bad asset management (which didn't focus on protecting the downside) and bad political decisions all played a role too. Nobody forced pension fund managers to buy the crap Wall Street was aggressively peddling to them and other institutional investors. So many people fell for the utter nonsense that the Street was selling back then. They hired "rocket scientists" to slice and dice risky mortgage debt, turn it into "AAA" tranches which the rating agencies certified and presto, these investments became eligible for pension fund managers to invest in (sigh!). Anyone who's read Michael Lewis' The Big Short must be appalled at how pension fund managers totally abdicated their fiduciary duties by not questioning what was actually backing these "AAA" investments.

Third, while I like the idea of introducing more inflation-sensitive US Treasury bonds, I don't like the idea of forcing pension plans to invest the bulk of their assets in these bonds. This idea has been floating around for years (I believe Zvie Bodie came up with it), but it flies in the face of good governance and exercising fiduciary responsibility. There are no guarantees that inflation-sensitive bonds will outperform in the future, especially in a deflationary environment. That's why it's better to invest in a diversified portfolio of private and public markets.

Finally, as I mentioned in an update to my last comment on California pensions, there is a concerted effort going on right now to weaken public pension plans or abolish them altogether. I'm of the school of thought that this is pure fear mongering and total nonsense. While Wall Street continues to enjoy record bonuses, private and public pension plans are getting decimated. But instead of blaming people, we got to get on with it and start introducing meaningful regulations and reforms which will bolster pensions and the financial system.

The damage is done. We're not going to change the past, so let's focus on building the future. We can address the pension funds fiasco as responsible adults, recognizing that changes will require sacrifices from all stakeholders, or we can continue down this ridiculous path of public and private pensions attrition ensuring more pension poverty down the road. Keep this in mind as the political rhetoric on pensions heats up.

Friday, February 25, 2011

Day of Reckoning on California Pensions?

The LA Times posted an editorial, Day of reckoning on pensions:
The housing bubble and subsequent Wall Street collapse wreaked havoc on the nation's retirement savings, as many pension funds and 401(k) plans suffered losses of 30% or more. State and local governments are now facing huge unfunded pension liabilities, prompting policymakers to scramble for ways to close the gap without slashing payrolls and services. But a new report from the Little Hoover Commission in Sacramento makes a more troubling point: Many state and local government employees have been promised pensions that the public couldn't have afforded even had there been no crash.

The commission's analysis of the problem is hotly disputed by union leaders, who contend that the financial woes of pension funds have been overblown. The commission's recommendations are equally controversial: Among other things, it urges state lawmakers to roll back the future benefits that current public employees can accrue, raise the retirement age and require employees to cover more pension costs. Given that state courts have rejected previous attempts to alter the pensions already promised to current workers, the commission's recommendation amounts to a Hail Mary pass. Yet it's one worth throwing.

A bipartisan, independent agency that promotes efficiency in government, the Little Hoover Commission studied the public pension issue for 10 months before issuing its findings Thursday. Much of the 90-page report is devoted to making the case that, to use the commission's blunt words, "pension costs will crush government." Without a "miraculous" improvement in the funds' investments, the commission states, "few government entities — especially at the local level — will be able to absorb the blow without severe cuts to services."

The problem is partly demographic. The number of people retiring from government jobs is growing rapidly, and longer life expectancies mean that a growing number of retirees will collect benefits for more years than they worked. But the report argues that political factors have been at least as important in driving up costs, starting with the Legislature's move in 1999 to reduce the retirement age for public workers, base pensions on a higher percentage of a worker's salary and increase benefits retroactively. The increases authorized by Sacramento soon spread across the 85 public pension plans in California.

Compounding the problem, the state has increased its workforce almost 40% since the pension formula was changed and boosted the average state worker's wages by 50%. Local governments, meanwhile, raised their average salaries by 60%. Much of the growth came in the ranks of police and firefighters, who increased significantly in number and in pay.

There's nothing inherently wrong with generous pension plans. Pensions, after all, are just a form of compensation that's paid after retirement, not before. The problem, particularly for local governments, is that the plans are proving to be far costlier than officials anticipated or prepared for. By their own reckoning, the 10 largest public pension systems in California had a $240-billion shortfall in 2010.

When the funds don't have enough money to cover their long-term liabilities, state and local governments are compelled to increase their contributions. In Los Angeles, the report says, the city's retirement contributions are projected to double by 2015, taking up a third of the city's operating budget. It projects that governments throughout the state will have to raise their contributions by 40% to 80% over the next few years, then maintain that higher rate for three decades.

The more tax dollars governments have to devote to pensions, the more they'll have to take from other programs or from taxpayers. That means more layoffs or pay cuts for public employees, higher taxes, fewer services, or all of the above.
The situation won't be so dire if the plans earn more on their investments than expected. But with the plans typically counting on annual returns near 8%, or twice the "risk-free" level suggested by some analysts, it seems just as likely that they'll earn less than that, forcing local governments to contribute even more.

The Legislature and some local governments have sought to ameliorate the situation by reducing benefits for new hires and persuading current workers to contribute more to their pension funds. The commission's report, however, argues that these moves aren't sufficient. The savings from the lower pensions for new employees won't be realized for many years, and the increased contributions aren't nearly enough to close the funding gap.

The only real solution, the report contends, is to reduce the benefits that current employees are slated to earn in the coming years. That's hard to do. California courts have held that pensions for current employees can be increased without their approval, but not decreased unless they're given a comparable benefit in exchange. Nevertheless, the commission calls on the Legislature to give itself and local governments explicit authority to trim the benefits that current employees have not yet accrued, without touching the amounts they have already earned. It also calls for a hybrid retirement plan that combines a smaller pension with a 401(k) plan and Social Security benefits, as well as the elimination of a variety of loopholes used to inflate pensions.

The commission is right about the importance of reducing the liabilities posed by current employees. And though picking a fight with unions over unilateral reductions in pensions probably isn't the solution, the report should persuade both sides to do more at the negotiating table to prevent pension costs from swamping state and local budgets. As the commission notes, public employees in California enjoy some of the most generous pension plans in the country. Those plans won't do them much good, however, if their employer can't afford to keep them on the payroll.
You can read the Little Hoover Commission's report for details. It basically sounds the alarm on pensions and states outright: "pension costs will crush government". From the report:
The problem, however, cannot be solved without addressing the pension liabilities of current employees. The state and local governments need the authority to restructure future, unearned retirement benefits for their employees. The Legislature should pass legislation giving this explicit authority to state and local government agencies. While this legislation may entail the courts having to revisit prior court decisions, failure to seek this authority will prevent the Legislature from having the tools it needs to address the magnitude of the pension shortfall facing state and local governments.

The situation is dire, and the menu of proposed changes that include increasing contributions and introducing a second tier of benefits for new employees will not be enough to reduce unfunded liabilities to manageable levels, particularly for county and city pension plans. The only way to manage the growing size of California governments’ growing liabilities is to address the cost of future, unearned benefits to current employees, which at current levels is unsustainable. Employers in the private sector have the ability and the authority to change future, unaccrued benefits for current employees. California public employers require the ability to do the same, to both protect the integrity of California’s public pension systems as well as the broader public good.

Freezing earned pension benefits and re-setting pension formulas at a more realistic level going forward for current employees would allow governments to reduce their overall liabilities – particularly in public safety budgets. Police officers, firefighters and corrections officers have to be involved in the discussion because they, as a group, are younger, retire earlier and often comprise a larger share of personnel costs at both the state and local level. Public safety pensions cannot be exempted from the discussion because of political inconvenience.
There is no doubt that pension reforms are needed in California and elsewhere in the US. But all stakeholders need to do their part. It's not just about cutting benefits. How about amalgamating all these dinky underfunded city plans into one large defined-benefit plan and introducing better governance on existing large plans, including better compensation for pension fund managers.

Finally, I invite readers to carefully go through a recent presentation by Jean-Claude Ménard, Chief Actuary of Canada, to the Board of Directors of the Canada Pension Plan Investment Board. I quote Mr. Ménard: "Overall, the results confirm that the current legislated rate of 9.9% is sufficient to sustain the Plan over the long term, with assets projected to accumulate to $275 billion by the year 2020."

If US states want to bolster their public pension plans, I urge them to contact the Office of the Chief Actuary of Canada. I consider this to be one of the best departments in the federal government of Canada made up of truly top-notch professionals who take great care in researching their findings. Moreover, they are transparent and welcome exchanges with actuaries from around the world. There is no reason why US public pensions can't be fixed. All the doomsayers who want to scrap public pension plans are just peddling fear and nonsense.

***Update and clarification***

Bill Tufts who maintains the blog, Fair Pensions for All, shared these thoughts with me:
I think you are a little off in trying to compare the CPP with public sector pensions in California.

I had a chance to go to the conference that Jack Dean (of sponsored last week. There is a big difference between a 70% of final salary pay for the California system and the 25% that the CPP tries to replace. If we assume that the CPP costs 9.9% of pay for 25% replacement income the California plans replacing 70% would require close to 30% contributions. This is close to the 34% cost that the CD Howe estimates and this number is backed up by
Keith Ambachtsheer.

The CPP assumes that workers will be paying CPP until age 65 or even 75, with the new late retirement rules. The public security workers in Canada and the US can retire with as little as 25 years of service or age 50. The CPP expects workers to draw pensions for about 14 years currently and the California pensions will have to support pensioners for almost 30 years. This is a big difference.

A big problem in the US is that many workers pay nothing into the pension plans so the total cost is on counties and cities to fund the pensions. Also with the severe financial challenges that the state of California is facing, they are expecting that the state will be reducing its public workforce by about 150,000 in the next several years. This means no new employees coming on board to fund the ponzi style pension schemes. This contrasts with Canada for example, where we are bringing in 300,000 foreign workers a year. The foreign workers are paying into the CPP and have no expectation of getting any pension benefits from it. The CPP is based on all future workers in Canada paying into the fund.

The CPP is based on a constantly growing workforce contributing into the plan the California system will probably have a shrinking system paying into the plan.

The average CPP payout is a little over $6,000 per year and this is funded by workers paying in 9.9%.

The CPP report shows that by 2019 the actuarial liability on the CPP plan will have grown to $1.3 Trillion and have accumulated assets of $ 258 Billion. That is a long ways out there and a lot has to go awfully smooth for us to get there. There has not been any contingency plans built into it. I am no actuary but most tell me the CPP seems secure based on current funding formulas:

There are a whole lot of assumptions on the CPP plan for it's continued success.
  • Fertility rates
  • Migration and immigration
  • Mortality rates
  • Working age population
  • Labour participation rates
  • Unemployment and job creation
  • Inflation/CPI (flat inflation at 2% forever)
  • Earnings assumptions
  • Investment returns
    • Bonds
    • Equities
    • Private equity
  • Asset mix assumptions
  • Contribution rates
In other words if all these conditions match the assumptions that are made in the pension plan the CPP will be solvent forever. If we truly thought that this wold be the case over the next 40 years we are not very good students of history!

One other big challenge coming to the state that the LA times article did not address is the cost of future other post-employment benefits (OPEBs). Many of the experts at Jack's conference are expecting the shortfalls in OPEBs to be even bigger than the pension shortfalls.
I thank Bill for sharing these comments with me. First, let me clarify, I'm not making a direct comparison between CPP, a partially funded plan, and state pension plans that are fully funded plans suffering severe deficits. There are obvious differences, many of which Bill outlines above. What I was trying to convey is that pension reforms are not just about cutting benefits to existing and retired workers. There are ways to bolster pension plans and it requires concessions from all stakeholders, including taxpayers. I know this will not please people but states have to assume their responsibility in this pensions mess because they too went years without topping up their pension plans.

Second, I have confidence in the assumptions the Office of Chief Actuary of Canada (OCA) uses for the CPP over the long-term fully recognizing that things can drastically change here in Canada and around the world in the near term. The Canadian economy is highly leveraged to global growth and it's vulnerable if things go awry again. But the OCA knows this and they have models which project outcomes for various possible scenarios, including dire economic and financial scenarios.

Final point I really want to make here. There is a concerted effort going on right now to weaken public pension plans or abolish them altogether. I'm of the school of thought that this is pure fear mongering and totally ridiculous. Yes, we have to reform public pension plans in the US and across the world, to bolster them, not to weaken or abolish them. I understand the frustration of taxpayers who saw their private retirement savings get hammered after the 2008 crisis. But why take it out on public sector workers who accepted lower paying jobs for the security of a stable retirement income? (There are abuses but they're not the norm).

In the meantime, Wall Street continues to enjoy record bonuses. They couldn't care less about what is going on with private and public retirement systems. In my opinion, they should care and they should be very concerned about what is going on right now. But in their myopic world, all that counts is the last trade. That shortsighted mentality is going to end up costing them trillions down the road.

***Additional comments by Bernard Dussault***

Bernard Dussault, the former Chief Actuary of Canada, provided these additional comments, which I share with you:
Any social insurance program like the CPP is not basically different from any public program such as the California system. They are both defined benefit pension plans providing retirement benefits. The main two not basic areas of differences are generally benefit design and financing. The following analysis pertains exclusively to defined benefit (as opposed to contribution) pension plans.

Benefit design

Social programs (covering essentially all workers of a country) generally include anti poverty-related measures, such as the CPP drop-out provisions, i.e, a few (about 8 out of 47) years of lowest employment earnings being disregarded for the determination of the retirement pension benefit rate. Surprisingly, public pension plans (covering goverment employees), like most private plans, generally drop out an even larger number of years of lowest pensionable earnings by considering only the last five years or so of earnings for the determination of the retirement benefit rate. This looks as if private plans had more anti poverty measures than social programs, which is true to a certain extent but the irony is that these measures are in some cases more beneficial to richer participants.


Ideally, any pension plan, be it private, public or social, should be fully funded.
  • Private and public pension plans are generally designed and meant to be fully funded, as their contributions rates are required by local government to be determined in such fashion. Therefore, their funding ratio should theoretically be at any time at least 100%. However, funding ratios can hardly not avoid getting under 100% at times due mainly to the normal statistical fluctuations in market values of investments. It happens that most private and public plans' funding ratios get too often and too much under 100% because of contribution holidays beign inappropriately taken by the plan sponsors as soon and any time the funding ratio exceeds 100%.
  • Social pension plans are rarely, if never, fully funded or even designed to be so. However, following the CPP 1998 reform, any amendment to the CPP shall now be financed in a fully funded basis. The CPP was implemented on a partial funding basis and, despite the 1998 reform, does and will remain a partially funded scheme. Before 1998, the CPP funding ratio was about 7%. With the reform, it is projected to increase gradually to no more than 20% and to stay so for ever. If the CPP had been implemented on a fully funded basis in the first instance in 1966, its contribution rate would now need to be only about 6% rather than 9.9%. In other words, all current and future contributors now have to compensate for the insufficient amount of contributions made by cohorts of contributors from 1966 to about 1996.
Clarifications of certain points raised by Bill Tufts
  • "This is close to the 34% cost that the CD Howe estimates and this number is backed up by Keith Ambachtsheer." If the CPP were fully funded, increasing its benefit rate from 25% to 70% would require a contribution rate of about 16.8% (rather than 30% or 34%), i.e. the above-mentioned CPP full-cost rate of 6% times the ratio of 70% over 25%. The CD Howe 34% rate rather pertains to its estimated cost of the Canadian fedeal public service pension plan (PSPP). This CD Howe's 34% estimate of the PSPP is grossly overestimated because it assumes that all PSPP assets would be invested in bonds, while a large portion of PSPP assets are actually invested in the private markets (equities, real estate, etc.). The PSPP cost is more appropriately and realistically estimated at about 19% rather than 34% in the triennial statutory actuarial reports prepared by the Office of the Chief Actuary.
  • "The CPP assumes that workers will be paying CPP until age 65 or even 75, with the new late retirement rules". CPP contributions are required only until age 65. Contributions may be made from age 65 to 70 (not 75), in which case the CPP retirement benefit rate is thereby increased two-fold, fristly to account for the shorter period over which benefits are paid and secondly to account for any CPP contributions made over age 65.
  • "The public security workers in Canada and the US can retire with as little as 25 years of service or age 50. " Under the Canadian PSPP, any plan member is entitled to an unreduced pension only if the plan participant is either:
    • at least 60 years of age and has at least two years of pensionable service
    • at least 55 years of age and has at least 30 years of pensionable service
  • "The CPP expects workers to draw pensions for about 14 years currently and the California pensions will have to support pensioners for almost 30 years." As shown on page 17 of the latest (25th) actuarial report onf the CPP (, the average life expectancy at age 65 combined for men and women is about 21 years rather than 14 years.
  • "This contrasts with Canada for example, where we are bringing in 300,000 foreign workers a year. The foreign workers are paying into the CPP and have no expectation of getting any pension benefits from it. The CPP is based on all future workers in Canada paying into the fund. " Net immigration to Canada is less than 300,000 and does not include exlusively workers. Moreover, not all immigrating workers do find a job in Canada. The CPP partial financing approach relies on all Canadian workers contributing 4.95% of salary up to YMPE, minus the YBE, and the employer contributing the same amount. Like any other CPP contributors, foreign workers paying into the CPP will receive CPP retirement benefits consistent with contributions made to the CPP as for any other CPP contributors.
  • "The CPP is based on a constantly growing workforce contributing into the plan. The California system will probably have a shrinking system paying into the plan." If a plan is financed on a fully funded basis, as should be the case for the California plan, a gradually shrinking proportion (as opposed to number) of participating contributors to the plan has essentially no effect on the funding ratio and solvency of the plan. As the CPP is not fully funded, a growing workforce should help improving its funding ratio or reduce its required constant contribution rate of 9.9%. However, as shown in Table of page 19 of the 25th CPP actuarial report, the ratio of population in age group 20-64 to that in age group 65+ is projected to decrease gradually from 4.6 in 2010 to 2.1 in 2075. If it were projected to remain at 4.6 or to increase, the estimated required constant contribution rate of 9.9% would be lower.
  • "The average CPP payout is a little over $6,000 per year and this is funded by workers paying in 9.9%." The CPP 9.9% contribution rate is shared equally by workers and employers (i.e. 4.95% each).
  • "I am no actuary but most tell me the CPP seems secure based on current funding formulas." The CPP is secure to the extent that:
    • the long-term economic and demographic assumptions upon which rests the contribution 9.9% contribution rate will be realized
    • future employers and contributors will remain willing to pay the required contribution rates
    • provisions of the existing plans remain unaltered
In this vein, the Chief Actuary claims on page 6 (under the heading Open Group) in his Actuarial Study number 8 on the CPP ( that the CPP is fully funded if the actuarial projections are made on an "open group" basis because under such projection basis the present value of projected benefits is equal to the projected value of projected contributions. I already indicated to the Chief Actuary that this is a seriously inappropriate actuarial statement because it infers that the CPP could also be claimed to be fully funded if it were financed on a pay-as-you-go basis (i.e. if if where not funded at all), as under pure paygo financing contributions are equal to benefits in any year.
As always, I thank Mr. Dussault for providing me with his excellent comments.

Thursday, February 24, 2011

Caisse Gains 13.6% in 2010

Bertrand Marote of the Globe and Mail reports, Caisse posts 13.6% return:

The Caisse de dépôt et placement du Québec posted a robust 13.6-per-cent return on its investments last year, solidifying its ongoing recovery from a disastrous 2008 loss.

The results for 2010 beat the 11.25-per-cent median return of large pension funds in 2010 as estimated by RBC Dexia Investor Services Ltd.

The Caisse - Canada's largest public pension fund - said it outperformed its own benchmark index by 4.1 per cent for the year ended Dec. 31, 2010.

At the end of 2010, the Caisse's net assets stood at $151.7-billion, up from $131-billion in the previous year.

The increase was due to net investment results of $17.7-billion plus $2.4-billion in net deposits.

The Caisse is now almost back to pre-2008 levels. It posted a staggering 25-per-cent loss - $40-billion - on its investments in 2008.

Last year, the Caisse had a 10-per-cent return, below the 15.48 per cent median return of its peers.

“In a year marked by turbulence, Europe's sovereign debt crisis and fears of a slowdown in the U.S., the Caisse generated strong results on many fronts,” Caisse chief Michael Sabia said in a news release Thursday.

“Our teams successfully repositioned the Caisse to focus on its core business and select quality holdings, while managing the portfolios prudently to take advantage of hard-to-predict market conditions.”

Real estate, infrastructure and bonds - one of three major asset classes at the Caisse - turned in a 16.3 per cent return in 2010, while equities delivered a 14.6 per cent return.

Private equity performed particularly well, with a 26.7-per-cent return.

Infrastructure alone posted a 25.4-per-cent return.

But Canadian equities underperformed. The Canadian equity portfolio generated a 15.7-per-cent return, 1.9 per cent below its benchmark. The results were largely due to the portfolio's being overweight in large-cap companies and the dramatic outperformance of small-caps in 2010, the Caisse said.

"The Caisse is back in good health. We have rejoined the race. But the race is a marathon. The race is not a sprint," president and chief executive officer Michael Sabia said at a news conference after the results were unveiled.

The Caisse provides a full press release and combined financial statements on its website covering the 2010 results. The annual report will be available in April but the press release contains all the relevant information on performance. A summary of the results is provided below (additional information is available here):

The performance in private markets was very strong, but so was that of public markets, especially Fixed Income. Key points from the release:
  • The Bonds portfolio achieved an 8.4% return, 1.6% above its benchmark index. The drop in rates of government bonds, with maturities of five years or more, and the additional yield on corporate bonds, relative to government securities, accounted for most of these results.
  • The Real Estate Debt portfolio also benefited from declining rates, posting a 17.1% return. Falling mortgage rates in Canada, the U.S. housing market recovery and the sale of U.S. assets, conducted as part of the portfolio refocusing announced in 2009, largely explain the performance of the portfolio, which outperformed its benchmark index by 10%.
  • The Real Estate portfolio achieved a 13.4% return, outperforming its benchmark index by 1.8%. This performance is mainly due to the strong performance of retail properties in Canada and office buildings in Canada, the U.S. and Europe.
  • The 25.4% total return of the infrastructure portfolios for the year is due to the resilience of energy assets in the face of market turbulence and the recovery of airport service assets after the financial crisis. These portfolio assets possess strong fundamentals that have improved throughout the year.
  • In total, the Equity portfolios represent $72.4 billion, approximately 48% of the Caisse’s net assets, including $19.3 billion in the Canadian Equity portfolio, $14.3 billion in our Global Equity and Québec International portfolios, $21.3 billion in international stock market index portfolios and $17.5 billion in the Private Equity portfolio.
  • The Canadian Equity portfolio generated a 15.7% return, 1.9% below its benchmark. This underperformance is primarily due to the portfolio’s overweight on large-capitalization companies with strong fundamentals and the dramatic outperformance of small-cap companies in 2010.
  • The Global Equity and Québec International portfolios slightly outperformed their benchmark indexes, with returns of 7.3% and 14.0%, compared to index returns of 7.0% and 13.7%, respectively. These results reflect the strength of international markets and timely active management picks in energy, industrials and consumer goods.
  • The index-managed U.S. Equity, Foreign Equity and Emerging Markets Equity portfolios produced returns in line with their benchmark indexes.
  • The Private Equity portfolio, which achieved a return of 26.7%, significantly benefited from the global recovery in mergers and acquisitions and the rebound of financings in this area. The sharp rise in asset valuations during the year mainly reflected improvements in operating performance, debt reduction and an increase in the profitability of Private Equity portfolio companies. Accordingly, more than two thirds of the 2010’s return is the result of activities in leveraged buyout and development financing.
Importantly, on operating expenses, the press release states the following:
  • In 2010, the Caisse continued to improve its efficiency, paying close attention to its operating expenses and external management fees. As a result, it achieved its budgetary reduction goal of $20 million announced in spring 2010. Achieving this objective enabled the Caisse to continue to decrease total operating expenses and external management fees, which stood at $269 million in 2010. The ratio of operating expenses to total assets therefore decreased from 22 basis points (bp) in 2009 to 19.4 bp in 2010, a level that compares favourably to best-in-class manager standards.
Finally, the press release quotes Michael Sabia, President and CEO of the Caisse:
"There are many uncertainties remaining: the situation in North Africa and the Middle-East is evolving rapidly and the sovereign debt crisis in Europe has not been resolved. Moreover, in the United States, employment levels stagnate, the housing crisis persists and, at the same time, the exit strategy for expansionary monetary and fiscal policies is far from finalized," said Mr. Sabia.

"We posted solid results in 2010, but we know we have much work to do to provide good long-term returns to our depositors — given the current uncertainty and market volatility that will prevail in the coming years," added Mr. Sabia.
This is the consistent message Mr. Sabia has been delivering ever since he took the helm after the 2008 disaster. Despite the solid performance, he knows there is a lot of work ahead and now is not the time for complacency. His senior team and the employees have been instrumental in helping the Caisse achieve these strong results in a year that wasn't particularly easy. 2011 will prove to be even more difficult.

The Caisse is the first of the large Canadian pension funds to announce their 2010 results. Others will announce in the weeks ahead. They got a tough act to follow. Below, a CBC-RDI interview (in French) with Michael Sabia.

Wednesday, February 23, 2011

GPIF Worried About Japan's Public Debt?

Chikafumi Hodo and Hiroyasu Hoshi of Reuters report, Japan's giant pension fund warns on nation's debt:

Japan's $1.4 trillion Government Pension Investment Fund (GPIF), the world's largest pension fund, warned the country needs to resolve its debt problems, although, for now, it is sticking to its basic investment strategy.

GPIF Chairman Takahiro Mitani said in an interview with Reuters that Japan's bulging public debt -- the largest among developed countries at double the size of its $5 trillion economy -- would reach a crucial point in five to 10 years if the problem is not resolved.

The GPIF, whose asset size is larger than both the Canadian and Indian economies, is a major force in the Japanese government bonds (JGB) market, where it parks two-thirds of its assets.

The GPIF plans to diversify its portfolio, however, by investing in emerging markets, where its hopes to start channeling funds in the financial year that starts in April.

"We are not thinking of changing our basic portfolio as a result of ratings changes by credit rating companies," Mitani said on Wednesday.

Moody's Investors Service changed the outlook on Japan's Aa2 sovereign rating to negative from stable on Tuesday, warning that government policies may be insufficient to rein in the country's huge public debt.

That warning followed Standard & Poor's downgrade of its rating on JGBs last month, its first such cut in nine years.


Bond markets showed a muted reaction to Moody's action on the view that high domestic savings will provide ample funding for the government for now.

"I don't think investors are making investment decisions based on credit rating companies' actions. Rather, they are watching overall fund flows into JGBs to make their decisions," Mitani said.

Still, it is important for the Japanese government to resolve its fiscal problems, Mitani said, adding that he shared the credit rating firms' views that the country cannot leave the debt situation as it is. He did not elaborate.

The GPIF, which invests the reserves of national and corporate pension plans, held total assets of 117.6 trillion yen as of September.

Its performance in the six-month period to September was a negative 1.5 percent, compared with a positive 7.91 percent for the whole financial year that ended last March.

The fund's performance up until September lagged other major overseas counterparts, such as California Public Employees' Retirement System (Calpers) which posted a positive return of 3 percent, while the Canada Pension Plan Investment Board produced a bigger return of plus 5.2 percent.

Besides Japanese government bonds, the fund also has exposure to domestic shares, foreign bonds and foreign equities.


Mitani said the GPIF was in no hurry to move into emerging equity markets, which have recently lost steam.

A tender to pick fund managers for GPIF's emerging market equities investments closed in December and it has completed its first round of screening, he said.

He expected the entire selection process could take about one year as the fund received a large volume of applications.

The fund decided to take on exposure to emerging markets as they are growing rapidly and offered great potential for future growth, he added.

"We don't have to rush in now as emerging market (equities prices) are in a corrective phase," he said.

"We want to take more time and we want to be more selective in choosing managers."

Mitani said the fund's investments in emerging markets would be gradual and the initial amount would be small.

The GPIF will use the MSCI main emerging market stock index .MSCIEF as its benchmark.

As of September, about more than 9 percent of the GPIF's total assets were in foreign equities.

Maybe Mr. Mitani is looking for a serious correction before plowing billions of dollars in emerging markets (EM). I don't know but I can introduce GPIF to a very experienced emerging markets manager I know here in Montreal who will be glad to consult them for a fraction of the cost they're going to be paying these EM managers they're currently reviewing.

Back to the topic in the article. Kip McDaniel of aiCIO reports, Japan's GPIF Calls on Gov't to Rein in Mounting Public Debt:

Chairman Takahiro Mitani of Japan's $1.4 trillion Government Pension Investment Fund (GPIF), the world’s largest and thus first on aiGlobal 500 listing of the world's largest asset owners, has called on the government to help rescue the nation from its growing debt before it reaches a critical point.

"We are not thinking of changing our basic portfolio as a result of ratings changes by credit rating companies," Mitani told Reuters, noting that the fund aims to diversify its portfolio by increasingly investing in emerging markets. In the six month period to September, the performance of GPIF, which has an asset size larger than both the Canadian and Indian economies, was negative 1.5%, compared with a positive 7.91% for the entire financial year that ended last March.

The statements by Mitani over Japan's burgeoning public debt, amounting to double the size of its $5 trillion economy, follows the decision by Moody's Investors Service to change the outlook on Japan's Aa2 sovereign rating to negative from stable. It also comes about a month after Standard & Poor’s downgraded the government’s sovereign debt rating, with both Moody's and the S&P asserting long-term fiscal unsustainability of the country's debt.

Late last year, the fund came under fire from an Organization for Economic Co-operation and Development (OECD) report. The report, focusing on both governance and investment strategy issues at the GPIF, followed a set of 2006 reforms at the fund. “While much improved,” the report states, referring to previous reforms, “the new governance structure still falls short of international best practices and in some aspects does not meet some of the basic criteria contained in OECD recommendations.”

Among the report’s complaints relating to governance, the GPIF still is not required to put its investment policy in writing, and there remains uncertainty surrounding the issue of whether the fund’s Board sets – or simply recommends – the investment policy. Also concerning to the OECD was the fact that the responsibilities of Chairman of the Board, Chief Executive Officer, and Chief Investment Officer all coalesce in one man – currently Takahiro Mitani. “The lack of a clear separation between operational and oversight roles within the fund is a major problem that goes against OECD recommendations,” the report stated before recommending that the roles be distinct. Furthermore, the report asserted, a more robust staff should be hired.

I'm a stickler for pension governance and believe in transparency, so I don't understand why GPIF's investment policy isn't made public. But when you're the biggest fund in the world, you don't want to start telegraphing your moves in advance. In fact, you can argue that GPIF is too big and needs to be cut into several large funds (Mr. Mitani rejects such proposals). A senior pension fund manager told me that ABP, the large Dutch pension fund, is struggling with economies of scale due to its size. It's not easy for these mega-funds to deliver returns once they cross a certain asset threshold (I've seen this with hedge funds).

As for Mr. Mitani's influence, I believe that it's crucial to segregate senior functions. The President & CEO of a pension fund doesn't have time to be the Chief Investment Officer. I've seen it firsthand and think it's too much responsibility for one person to handle. You want your CIO to be dedicated full-time to investments. Presidents & CEOs have to handle the board and stakeholders on top of heading the fund, leaving them little time to follow markets closely and make tactical investment decisions.

There is little doubt that Mr. Mitani is one of Japan's most powerful men. If he's expressing concern over Japan's mounting public debt, it's because he's worried about what the future holds. There are legions of hedge fund managers salivating at the thought of making a fortune shorting JGBs. Most of them have been slaughtered over the years and will continue getting slaughtered betting against JGBs.

In November 2009, Richard Katz, editor of the Oriental Economist Alert, wrote an op-ed in the WSJ, Now Is Not the Time to Fret About Tokyo's Debts. I quote the following:

Deficit hawks assert that the Bank of Japan will soon lose its ability to keep rates low, arguing that the struggle between the government and private borrowers for limited funds will send interest rates skyward.

The evidence says the opposite: There is no crowding out. The government has not even borrowed enough to offset the decline in private borrowing. Corporate net debt peaked at 117% of GDP in 1990. By 2007, corporations seeking to shed nonperforming loans had reduced their debt to 70% of GDP. Household gross debt, meanwhile, fell to 70% of GDP in 2007 from 82% of GDP in 1999. As a result, the total combined private and government debt peaked in 2000 at 276% of GDP, and has since declined to 244% as of 2007, the latest data available.

Nor is there any lack of buyers for new government bonds, 95% of which are held by domestic investors. The banks need to buy this paper to offset the decline in their core lending business. From 1998 through 2009, outstanding bank deposits rose 17% but bank loans fell 13%. How could the banks pay interest to their depositors unless they bought bonds to earn interest?

The real danger from Japan's debt buildup is not a potential crisis in the government-bond market but corrosion in the real economy. The Bank of Japan will retain both the need and the ability to keep long-term rates very low for the foreseeable future. But this method of avoiding fiscal crisis causes enormous collateral damage.

By lowering the hurdle rate for investment, this action leads firms to pour capital into wasteful projects that temporarily boost demand but end up hurting long-term growth. Consider this decade's binge in new supermarkets, even though total supermarket sales have been flat for years. Then there are all the "zombie" firms kept in business by very low interest rates; 20% of bank loans charge less than 1% interest while 5% charge less than 0.5%.

Japan has been here before. In 1997, a similar debt scare led Prime Minster Ryutaro Hashimoto to raise consumption taxes, plunging the country into deep recession. In 2003, similar panicky storylines spooked the markets. It's easy to see why investors are having déjà vu; Tokyo today is headed toward a budget deficit that's 10% of GDP, and the ratio of outstanding government debt to GDP has hit a record high.

Japan is certainly a deficit addict. Ever since the mid-1970s, a structural shortfall in private domestic demand has compelled the government to sustain decade after decade of deficit spending to make up for that shortfall. Japan's new government says it wants to solve that problem by using government money to raise household disposable income. Yet, fearing today's deficits, policy makers are waffling on that program. Virtually every day various ministers come out with a new and conflicting message on fiscal policy.

Japan's top fiscal priority today should be to use large budget deficits—spent on the right things, such as child care allowances, free high school tuition, connecting suburban houses to sewage lines and consumer-oriented tax cuts—to ensure recovery. With many economists anticipating economic softness in the first half of 2010, perhaps even a quarter of negative growth, this is hardly the time for premature withdrawal. Once recovery is in place, that's the time to address the deficit and, more importantly, its underlying causes.

Even though that article was written over a year ago, it's worth keeping in mind that Japan's net debt profile isn't as bad as doomsayers portray it to be. More recently, Lindsay Whipp of the FT reports, Japan’s debt gives investors unlikely opening:

The distant chimes of alarm bells are going off about Japan again.

Just a month after Standard & Poor’s downgraded the government’s sovereign debt rating, Moody’s on Tuesday warned that it might follow suit, both agencies citing long-term fiscal unsustainability of its growing debt pile.

The political deadlock that could delay the passing of budget-related bills and progress on comprehensive tax reform to pay for rising welfare costs is certainly not helping confidence.

Tom Byrne, Moody’s senior vice-president, said that his view “takes into account intensifying political challenges facing the [Naoto] Kan government, which may heighten policy formulation and execution risks”.

Domestic investors, which make up 95 per cent of the Japanese government bond market, are watching developments closely.

While they do not envisage a worst-case scenario, whereby the government will be unable to issue a huge mountain of refinancing bonds, and they certainly do not expect a bond and currency crisis in the medium term, the opacity of the current political turmoil is creating confusion.

“Risk seems to be more skewed towards the downside on domestic investors’ confidence on the political will for fiscal austerity,” says Tomoya Masanao, a Tokyo-based portfolio manager for Pimco.

“This means I should remain cautious about the JGB market. But we are not in the camp that JGBs are going to blow up because of the fiscal situation.”

The long-term sustainability of Japan’s growing debt pile is a touchy subject that has oftendivided domestic and overseas investors. Mistiming a JGB bond and yen crisis or expectations for a spike in yields have caused numerous foreign investors pain. But that has not stopped some placing a small chunk of their assets on a bet that, as Tokyo’s fiscal stability deteriorates in the future, there are huge gains to be made.

And Kyle Bass of Hayman Capital Management, a well-known JGB bear, this month reminded his investors of a looming bond market crisis in Japan.

Investors are well versed in the numbers and they are not pretty. To name a couple, Japan’s gross debt is set to grow to more than twice the size of the economy this year. Its debt burden is estimated to reach Y997,700bn by the end of March 2012. In addition, new bond issuance is set to exceed tax revenues for the third year running in the fiscal year 2011.

But Tokyo can rely on the huge pool of domestic funds to buy up JGBs for now, particularly as there are few other options for investors in yen. Public and private institutions’ capacity for soaking up JGBs minimises the government’s funding costs.

Benchmark 10-year yields may have risen nearly 50 per cent since the beginning of October to 1.27 per cent, in line with gains in US Treasury yields, but they still remain the world’s lowest.

Nevertheless, there have been signs of movement out of JGBs from the public sector. Japan Post Bank’s outstanding JGB holdings dropped Y6,167bn to Y149,724bn between March and December, amid an increase of just over Y2,000bn in its holdings of dollar- and euro-denominated assets. There is a chance this is just an asset allocation adjustment but the buying fits with a call from Shizuka Kamei, a former minister in charge of the post office, to diversify funds.

Japan’s public pension funds were also net sellers of bonds for the first time in almost a decade last year amid deteriorating demographics, and that trend is only likely to continue. But for now, the bond market has shrugged its shoulders at the shift, partly because it remains incremental.

The most important investors last year were commercial banks, as corporate savings have made up for a slowdown in household savings rates. Signs of an improving economy have raised expectations for increased investment by companies using those savings, but one official at a Japanese megabank says that this is not happening.

“Even if Japanese companies’ profits have been good, it does not mean that the domestic economy is improving, because the growth is coming from external demand,” the official said. “I am not seeing a trend of yen-denominated corporate deposits being withdrawn or loan volume picking up,” he says.

Investors agree. Pimco’s Mr Masanao adds that corporate savings are not a temporary phenomenon because the slower growth and deteriorating demographics suggests that companies need to invest less.

“There may be some capital leakage overseas by large corporations, but it’s still a micro story more than a macro one,” he said.

This theme of falling investment is important when estimating the point at which Japan’s current account surplus could shift into deficit, a key moment for the JGB market, according to Société Générale.

Estimates for when that might happen vary widely, but SocGen says that it is possible that Japan could maintain its surplus for “decades to come”. It points out that despite the drop in the household savings rate the current account surplus appears to be on a rising trend over the past two decades, apart from the sharp drop during the financial crisis.

The alarm bells of Japan’s fiscal sustainability may still be distant but that does not mean domestic investors are happy with Japan’s fiscal situation. Ultimately, in the event of a debt and currency crisis, policymakers may be forced to step in and support the market.

“Japan continuing to enjoy a current account surplus does not necessarily mean the government can keep its high debt forever,” says Takuji Okubo, an economist at SocGen. “The more relevant concern . . . is whether the current strong home-bias of Japanese households would subside.”

“The Bank of Japan and Ministry of Finance need to have a sense of crisis,” says the official at the large Japanese bank.

Interestingly, Japan's trade balance swung into a deficit for the first time in almost two years as shipments to China lost steam, but economists say the central bank's forecast for an export-led recovery remains intact. We'll see how geopolitical events and rising crude prices impact their economy in the second half of the year.

Longer-term, demographic trends will put pressure on Japan's public debt. But Japanese policymakers have ample time to start thinking about how they're going to tackle this issue. Mr. Mitani has sounded the alarm, but I'm not sure anyone is paying attention, at least not yet.

Tuesday, February 22, 2011

Wisconsin’s Public Pension Problems?

Dan Bigman of Forbes wants to remind you Wisconsin’s Public Pension Problems Are Your Problem, Too. But are they really or is this more fear mongering? Zach Carter of the Huffington Post reports, Wisconsin's Pension Fund Among Nation's Healthiest:
While Wisconsin Gov. Scott Walker (R) has painted a dire picture of his state's pension obligations, Wisconsin's pension fund for public employees is among the nation's strongest, according to a report by the nonpartisan Pew Research Center*.

The Pew report, issued last year, concluded that Wisconsin is a "national leader in managing its long-term liabilities for both pension and retiree health care." Walker has cited the fund's lack of sustainability as grounds for his plan to revoke collective bargaining rights for state employees, but that proposal has sparked outrage among state employees and drawn tens of thousands of protesters to the state's capitol.

"We're going to ask our state and local workers ... to pay a little bit more, to sacrifice, to help to balance this budget," Walker said in a Sunday interview with Fox News' Chris Wallace, adding that he would be forced to lay off 5,000 to 6,000 state employees if his budget plan was not approved, as well as a comparable number of local public employees.

But the Wisconsin pension fund is simply not in fiscal trouble. Its managers weren't burned by subprime mortgage assets or mortgage-backed securities as the housing bubble collapsed. The fund also relies on an automated dividend system, which pays out benefits in years the system is making gains while restricting payouts in years when it takes losses. And while the pension fund had a rough year during 2008 due to stock market losses, it remains robust, both in terms of fundamental financial stability and in comparison to other state pension programs.

According to the Pew study, Wisconsin had about $77 billion in total pension liabilities in 2008. But according to that same Pew study, those liabilities were 99.67 percent "funded," giving Wisconsin one of the four-highest of such ratios in the nation. Other states had funding ratios as low as 54 percent. For comparison, expert analysts and the Government Accountability Office consider an 80 percent level to be a good benchmark for pension fund stability, while Fitch Ratings considers 70 percent adequate.

Pension accounting relies on a very long-term outlook. When the state calculates its pension liabilities, it adds up the total expected pension expenditures for the entire lifetimes of everybody currently receiving a pension and all employees expected to receive pensions. That outlook routinely eclipses 30 years, depending on the ages of state employees. A $77 billion liability is only a problem if the state has no realistic way of meeting those expenses over that 30-plus year timeframe. But the Wisconsin pension system actually does have the vast majority of that money -- in fact, in 2008, the pension fund had 99.67 percent percent of that $77 billion total on hand. If all of the assets in the fund had simply been sold at market values on June 30, the resulting cash would have been enough to pay 99.67 percent of the state's total pension payouts for decades to come.

According to the Wisconsin pension fund's own 2010 annual report, the system had $69.1 billion in total assets at June 30, 2010, while paying out $3.7 billion in benefits over the course of the previous year. The value of those assets has since risen. According to Dave Stella, secretary of the Wisconsin Department of Employee Trust Funds, the retirement system's assets were worth $79.8 billion at the end of last month. The most recent solvency test for the fund was conducted for the fund's operations at Dec. 31, 2009. At the time, the funding ratio was 99.8 percent. The next solvency test is scheduled for June of this year.

So while Wisconsin does face a $137 million budget shortfall this year, the source of that fiscal trouble is not the state's pension fund. Under the current plan, Walker hopes to generate $30 million this year by raising taxes on public employees -- the governor refers to this as increasing the "contribution" that state employees make to their pension funds.

But Walker could make the state's pension system bear the costs of a broader state budget shortfall -- one created almost entirely by lower tax revenues resulting from the economic downturn -- without raising taxes on public workers or eliminating public bargaining rights. All he has to do is cut a few ties with the financial-services industry.

According to the pension fund's 2010 report, the fund spends about 84 percent of its management costs on outside help -- highly-compensated fund managers who work for private-sector financial firms. While Wisconsin has made a concerted effort to bring more of its fund management in-house, it could do more.

In 2009, roughly half of the pension fund's total assets were managed by state employees, who were paid a total of $28.4 million for their work. By contrast, outside Wall Street professionals were paid $194.7 million to manage the other half of the fund's assets. Cutting Wall Street pay, or simply moving more fund management in-house, could easily generate the $30 million in new taxes Walker wants to assess on state employees.

Wisconsin accounts for its pension fund assets using "mark-to-market" accounting. That means that while the state often expects to hold its assets indefinitely, collecting interest payments until the assets expire, it can't simply add up those expected interest payments to determine the value of an asset. Instead, the fund can only say that the asset is worth what other investors are willing to pay for it at a given moment. If investors want to pay less than the future interest payments, that's too bad for Wisconsin.

While some accounting experts say this market-oriented accounting is a more honest and accurate way to represent asset values than other methods, U.S. corporations are often allowed much more lenient accounting standards. During the financial crisis, for instance, many banks balked at the suggestion that they be required to account for subprime mortgage bonds at the prices that people were actually willing to pay for them. Instead, they argued, banks should be allowed to account for these items based on secret company economic models. If Wisconsin and other pension funds were simply cut the same slack that the government cut for Wall Street, it's easy to imagine pension fund worries easing, even in states whose pension situations are more dire.

[*Correction: Sarah Jorgenson of The Pew Charitable Trusts sent me this correction: We saw your Wisconsin pensions article today and wanted to flag an inacurracy. Zach Carter of the Huffington Post misattributed Pew's report, "The Trillion Dollar Gap," to The Pew Research Center. The report was issued by The Pew Center on the States, a division of The Pew Charitable Trusts. The Pew Research Center is a separate, independent subsidiary.]

I agree with Mr. Carter, public pension funds should be cut some slack but in some cases like in Oklahoma where state Treasurer Ken Miller warned that state pensions are at a "crisis level", more drastic reforms need to be taken.

I also agree that Wisconsin's pension fund is in decent shape and they should move more assets
in-house to save some fees. On that front, I noticed that Wisconsin's public pension fund recently made its first investment in a hedge fund, allocating $100 million to Capula Investment Management. This might be because they don't have internal expertise to implement such a strategy but they can cut fees elsewhere.

'll also recall that Wisconsin leveraged up its bond portfolio, a strategy that others were tinkering with. If done properly, it can be a source of leveraged beta by ramping up fixed income to get equity-like returns, but it can also present additional risks that will come back to haunt them. Pensions should carefully think through the ramifications of implementing such a strategy.

Finally, state workers across the US are understandably worried about what's going on in Wisconsin (watch video below). As labour unrest spreads, expect some major showdowns ahead. This has the potential to get very ugly, very quickly.