Friday, March 29, 2013

America's $124 Billion Secret Welfare Program?

Jordan Weissmann of the Atlantic reports, Disability Insurance: America's $124 Billion Secret Welfare Program (h/t, Suzanne Bishopric):
Imagine for a moment that Congress woke up one morning, realized that the United States was suffering from a paralyzing long-term unemployment crisis, and, in a moment of progressive pique, decided to create a welfare program aimed at middle-aged, blue-collar workers.

The one thing everybody could probably agree on is that it should help all those jobless 50-somethings find employment, right?

Well, as NPR's Planet Money argues in an eye-opening story, it turns out there already is a "de facto welfare program" for those struggling Americans. The problem is, instead of getting the unemployed back on their feet, it pays them to give up work for good.

I'm talking about Social Security's disability insurance program, which over 20 years has quietly morphed into one of the largest, yet least talked about, pieces of the social safety net. Since the early 1990s, the number of former workers receiving payments under it has more than doubled to about 8.5 million, as shown in Planet Money's graph below. More than five percent of all eligible adults are now on the rolls, up from around 3 percent twenty years ago. Add in children and spouses who also get checks, and the grand tally comes to 11.7 million.

That rapid, under-the-political-radar expansion has turned the program into a massive budget item. As of 2010, its monthly cash payments accounted for nearly one out of every five Social Security dollars spent, or about $124 billion. In 1988, by comparison, it accounted for just one out of eight Social Security dollars. Because disabled workers qualify for Medicare, they also added $59 billion to the government's healthcare tab.

Are disabilities just becoming more common? According to economists such as MIT's David Autor, the evidence says no. The workforce is indeed getting older, and thus more ailment prone. But Americans over 50, who make up most disability cases, report much better health today than in the 1980s. And demographers have found that the percentage of Americans older than 65 suffering from a chronic disability has fallen drastically since then. In the end, economists Mark Duggan and Scott Imberman estimate that, at most, the graying of America's workers explained just 4 percent of the increase in the rate of disability program participation for women, and 15 percent for men, through 2004.

Instead, it seems two things have happened: Qualifying for disability got easier, and finding work got harder. As the Planet Money piece puts it, "there's no diagnosis called disability." According to the letter of the law, disability recipients must prove they are too physically or mentally impaired to hold a job. And early in the program's life, the most commonly reported ailments were easy-to-diagnose problems such as heart-disease, strokes, or neurological disorders. But after the Reagan administration began trying to thin out the program's rolls in the early 80s, an angry Congress reacted by loosening its criteria. Suddenly, subjective measures like self-reported pain or mental health problems earned more weight under Social Security's formula. Today, the most common diagnoses are musculo-skeletal issues, such as severe back pain, and mental illnesses, such as mood disorders -- health problems where the line between a disability and a mild impairment is far blurrier.

Just as the bar for disability fell, the economy turned on the working class. Factories laid off their assembly workers. The service sector picked up the slack. Wages stagnated for anyone without a college diploma. These changes have made disability more attractive for reasons both obvious and subtle. Although program's payments are small -- the average benefit is a bit over $1,000 per month -- they're not much worse than a minimum wage job. Better yet, they're indexed to inflation, meaning they sometimes rise faster than wages, and come with generous government healthcare. For former blue-collar workers who feel they've lost all hope of finding employment, or who don't want to spend their last years leading to retirement standing all day at McDonald's, disability isn't a bad offer.

It's little surprise then that, as MIT's Autor notes, disability applications tend to rise and fall with the unemployment rate (as shown in his chart below), or that most applications come from workers who have recently lost jobs.
If you're a conservative, the reasons to worry about all this are obvious. There are probably a couple million people who could work if absolutely necessary, and are instead choosing to subsist on taxpayer money. The system, from that perspective, is simply being abused.
But the failures here should be obvious to liberals, too. If the job market is so miserably weak that these workers cannot find jobs -- that they are choosing to live in government-guaranteed poverty rather than take a chance on the labor market -- we need to find a better solution than paying them to sit while their skills atrophy. As of now, that's all we seem to be doing. Despite Clinton-era changes to the program that made it possible for participants to ease back into the work force without losing all their benefits, less than one percent of Americans who go on disability ever leave the program.

Moreover, that program, is headed for bankruptcy. As of last year, Social Security's disability trust fund was on pace to run dry by 2016, which would lead to an automatic 21 percent benefit cut affecting all of the program's participants, including the millions who truly can't work because of their impairments.

Like I said, even if we wanted a new welfare program for the struggling poor, this wouldn't be the way to run it.
The surge in the numbers of Americans who are now living off of Social Security's disability insurance program is troublesome. But it reflects the harsh reality of an ongoing jobs crisis that is leaving millions of people unemployed or under-employed, barely scraping by, desperate to find work or better jobs.

Conservatives will point out that incentives are all wrong but liberals will point out the real problem is gross inequality, lack of jobs and affordable healthcare as the U.S. government panders to the financial elite, like big banks and rich private equity fund managers who made off like bandits in the fiscal cliff deal, leaving millions of people struggling in this economy to collect disability checks.

But what really worries me is that even those Americans who are working and managing to save something on the side, their retirement dreams are evaporating, and many of them will likely have to enroll in this "de facto welfare program" before they reach retirement age.

And the real losers in all this are the unemployed, under-employed and especially persons struggling with a disabling condition who need this insurance program to survive. As the program heads for bankruptcy, they will get hit harder than anyone else.

Also, one of the comments to the Atlantic article above struck me:
Keep in mind that some disabled people WANT to work but employers are less than willing to make accommodations. I'd love to work. I HAVE worked. I'm currently in school so that I can get a great job. The problem is that most employers aren't willing to work around my "absences" related to my illness. They hear chronic, frequent atypical migraine and freeze up. If more employers were open to telecommuting and flexible work hours, there would be less of a need for disability for pain related absences for people who WANTED to work.
The sad fact is that far too many employers treat persons with disabilities as a liability instead of an asset. I bet you many truly disabled people on Social Security's disability program would much prefer to work for an employer who can accommodate their disability and recognize the value they can bring to their workforce.

Finally, while I'm happy to see the unemployment rate for people with disabilities dropped to a four-year low as the job market improves, the latest from Allsup points out the discrepancy in the unemployment rate between people with disabilities and those with no disabilities is concerning:
The fourth quarter 2012 unemployment rate for people with disabilities dropped to its lowest level since the fourth quarter of 2008. The number of people with disabilities applying for Social Security Disability Insurance (SSDI) also reached a four-year low, according to a study by Allsup, a nationwide provider of SSDI representation and Medicare plan selection services.

While this may seem to indicate that the worst of the economic crisis has passed, the unemployment rate for people with disabilities was still 70 percent higher than for those with no disabilities during the fourth quarter of 2012, according to the Allsup Disability Study: Income at Risk. The full study is available at

Specifically, the unemployment rate averaged 12.4 percent for people with disabilities and 7.3 percent for people with no disabilities during the fourth quarter of 2012. This compares to 13.7 percent for people with disabilities and 7.9 percent for people with no disabilities during the third quarter of 2012. These figures are based on non-seasonally adjusted data from the U.S. Bureau of Labor Statistics.

"The discrepancy in the employment rate between people with no disabilities and people with disabilities is concerning," said Tricia Blazier, personal financial planning manager for Allsup. "If more people with disabilities capable of working were provided the opportunity to do so, the trust fund for the Social Security disability program would be stronger. These individuals would be paying into the trust fund just as other workers do."

Beginning in 2013, the projected assets of the Disability Insurance Trust Fund will fall below 100 percent of the annual costs, according to the 2012 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (2012 OASDI Trustees Report). The DI Trust Fund is projected to exhaust its reserves in 2016.

At that time, revenues from payroll taxes will cover only 79 percent of benefits. This means there would be a 21 percent cut in benefits to the millions of people with disabilities so severe they are unable to work, as well as to their families. At year-end 2012, more than 8.8 million disabled workers received an average monthly benefit of $1,130.34, and nearly 2.1 million children and spouses of disabled workers relied on average monthly benefits of nearly $334.

SSDI Applications Continue to Decline

While the unemployment rate for people with disabilities is still significantly higher than for people with no disabilities, the number of people with disabilities applying for SSDI has declined for the second year in a row.

The Allsup Disability Study: Income at Risk shows that 638,223 people with disabilities applied for SSDI during the fourth quarter of 2012, down from 726,026 for the previous quarter. The quarterly number of applications has not dropped below this level since the fourth quarter of 2008, when there were 577,306 applications.

In 2012, 2.82 million people filed SSDI applications, compared to 2.88 million in 2011. Applications are now down 3.92 percent from the record high of nearly 2.94 million SSDI applications in 2010. The average age of people applying for SSDI is 53.

"The average age of SSDI applicants is about midway in the baby boom generation, so it's likely SSDI applications will remain elevated," Blazier said. "Because of this, more is needed to educate people with severe disabilities about their SSDI benefits. It's also important people understand their options for rejoining the labor pool if their condition improves in the future."

Many people confronted with a disabling condition wait longer than they should to apply for SSDI benefits. Often, Social Security disability applicants must wait several months or years before they receive their benefits. For example, nearly 1.89 million SSDI claims are pending with an average cumulative wait time of more than 800 days, according to Allsup's analysis of the Social Security disability backlog.

Blazier recommends individuals understand the following:

1. Who is covered by Social Security disability insurance?

To be covered, a person must have worked and paid into the SSDI program through payroll taxes (FICA) for five of the last 10 years. They also must be disabled before reaching full-retirement age (65-67) and must meet Social Security's definition of disability. Generally, this means being unable to work because of a verifiable mental or physical impairment expected to result in death, or which has lasted, or is expected to last, for at least 12 months.

2. When should someone with a severe disability apply for SSDI benefits?

Anyone with SSDI coverage who is unable to work because of a severe disability expected to last 12 months or longer or is terminal should apply as soon as possible. It can take two to four years to receive benefits, during which time many people struggle financially as a result of lost income and, often, mounting healthcare costs. The sooner someone applies the sooner he or she may begin to receive monthly benefits. They also are eligible for Medicare 24 months after they start receiving SSDI cash benefits.

3. Is SSDI representation needed?

Individuals can apply for SSDI on their own. However, there are several advantages to having a Social Security disability representative. This is especially true at the initial application. For example, more than half of Allsup claimants are awarded benefits at the initial application level compared to just 34 percent nationally.

4. Can someone with SSDI benefits ever return to work?

Yes. If a person's condition improves to the point where they can return to work, Social Security offers a trial work period, which allows someone to test their ability to work over at least nine months and receive full SSDI benefits no matter how high their earnings. In addition, Social Security's work incentives include the extended period of eligibility, which lasts 36 months. Once someone's benefits stop because they have substantial earnings, they still have five years in which benefits can be reinstated without going through the SSDI application process again -- if they must stop working because of their disability. This is known as expedited reinstatement. Additionally, it's possible to continue Medicare coverage for up to 93 months.

Individuals can determine their Social Security disability benefits using Allsup's free online Social Security benefits calculator. For a free evaluation, or for more information about eligibility for Social Security disability benefits, contact Allsup's Disability Evaluation Center at (800) 678-3276.

Allsup is a nationwide provider of Social Security disability, veterans disability appeal, Medicare and Medicare Secondary Payer compliance services for individuals, employers and insurance carriers. Founded in 1984, Allsup employs more than 800 professionals who deliver specialized services supporting people with disabilities and seniors so they may lead lives that are as financially secure and as healthy as possible. The company is based in Belleville, Ill., near St. Louis. For more information, go to or visit Allsup on Facebook at
I provided the information above for people who are confronted with a disabling condition and need help applying for disability insurance. If you're confronted with a disabling condition, inform yourself and know that you have every right to collect disability insurance and even work during this time if you feel capable.

Below, Fox News hypes the high number of people receiving federal disability benefit payments to push myths about the program and suggest many recipients are "moochers" and "takers." In fact, a majority of applicants are denied benefits, and experts agree the higher levels of disability recipients are a direct result of the recession and an increased number of women receiving benefits (if video doesn't work, click here).

And CNBC's resident claptrap, Rick Santelli, screams it's all about incentives, propagating more myths on Social Security's disability program. If you want to know the truth, read this comment on Media Matters for America.


Thursday, March 28, 2013

Does Blame Predict Performance?

Jason Hsu of Research Affiliates wrote an interesting research comment, Does Blame Predict Performance?:
As an econometrician and a fund-of-funds portfolio manager, I spend much time researching quantifiable metrics to help me identify managers who can outperform consistently. There is, in fact, a rich body of literature exploring different manager selection criteria.
Academic papers have considered portfolio manager attributes, such as tenure, the CFA designation, advanced degrees, and even SAT scores; they have also examined fund characteristics, such as portfolio turnover, expense ratios, and assets under management. Practitioners, especially investment consultants, have additionally focused on more nuanced and qualitative elements such as investment philosophy, compensation scheme, turnover of key professionals, ownership structure, and succession planning.

Ironically, perhaps, most people have given up on the hope that past positive alpha can predict future outperformance with any reliability (see endnote #1). Some might even go as far as asserting that manager outperformance is mean-reverting due to cyclicality in styles and “luck.”

Some of the above-mentioned attributes may provide very incremental information on the true quality of the manager. However, most econometricians, asset owners, and investment consultants confess (although not all publicly) that effective methods for picking top quartile performers remain elusive. As one of my friends at a large Middle Eastern sovereign wealth fund famously proclaimed, “We are convinced that managers who can consistently deliver alpha exist. We are, however, also convinced that we do not know how to find them.” Perhaps, then, the science of manager selection really is about winning what Charley Ellis calls “the loser’s game.”

As my high school basketball coach was fond of reminding me, “If you can’t improve your shooting mechanics, you can still improve your field goal percentage by not forcing bad shots.” His advice is equally relevant to the investment industry: To improve your odds of outperforming, screen out the negative alpha managers. If an investor focuses on eliminating the lower quality managers from his selection universe, the odds for achieving outperformance, in the long run, would be much improved—even if hiring the best managers from the screened short list is still a crapshoot.

So, how does one win in a loser’s game? In this article, I argue that you can significantly improve your odds by employing simple rules for identifying and eliminating underperforming managers.

Predicting Long-Term Underperformance

First of all, we already know quite a bit about the predictors of poor long-term investment performance. High portfolio turnover, high expense ratios, and low active weights (Cremers and Petajisto, 2009; Sebastian, 2013) are quantifiable metrics that tend to predict underperformance in the long run. Qualitatively, anecdotes suggest that high turnover in the professional ranks, lack of organizational alignment due to poor compensation design, or deficient inter-generational transition planning also hurt long-term investment results. Both finance academics and investment consultants have been working hard on identifying quantitative and qualitative attributes which might predict underperformance.

However, given the reported negative median and average underperformance for active managers, investors will have to work much harder in screening out low quality funds and managers just to get the expected alpha for the screened universe up to zero. For example, the average mutual fund underperforms by 1.6% net of fees; screening out high fee funds merely brings the average active return above −1%. Additionally, many low quality investment organizations are savvy enough to respond to RFPs and interviews carefully so as to tick most of the boxes on a consultant’s due diligence report. The cynical perspective is that asset managers are far more adept at solving the challenge of gathering assets from asset owners than solving the challenge of producing alpha for asset owners.

Importance of Culture

So, how do we spot the lower quality asset managers who fly the colors of high quality managers? Are there other attributes predictive of long-term underperformance that cannot so easily be masked? I believe there are.

Over the past five years, Research Affiliates has engaged outside experts to learn about the transformative power of a positive and healthy corporate culture (see endnote #2). As a quant, I initially approached this new age touchy-feely voodoo magic with a great deal of suspicion. Over the years, I have come to understand and deeply appreciate the enormous impact that culture can have on the individuals who come together as a collective to drive organizational success. As I interact with different organizations and manage my own team, I have discovered that one of the most toxic culture elements for investment management organizations is the culture of blame.

Blame has many brothers, including fear, defensiveness, and self-righteousness. When the four horsemen are present, personal accountability, creativity, openness, and learning go into exile. From what I have heard and seen, when blame lives in an investment organization, professionals take joy in second-guessing investment decisions after poor short-term performance. Whether it is the board blaming the investment staff at a pension fund, or the client facing team blaming the portfolio management group at an asset management firm—the modus operandi is often righteous indignation seeking to assign fault. The logical moves for the investment professionals, in this environment, are either to get defensive and deflect blame onto others or to proactively hide poor results.

Most academics are bewildered by the existence of year-end and quarter-end window dressing of portfolios—it seems too absurd to believe that such ridiculous behavior could persist in the investment industry, where delivering alpha is the only thing that supposedly matters. But to practitioners, buying popular winners at high prices and selling the cheap beleaguered dogs are as natural as can be when one has to deal with reproachful board members or client account managers. When Apple is trading at $800 a share, they question why the portfolio manager did not buy the stock; everyone knows that Apple will take over the world. And when Apple craters to $400 a share, they proclaim that any fool knows the company is only half its former self without Steve Jobs.

Similarly, cases studies have questioned why pension funds and portfolio managers do not rebalance into risk assets after large price declines, given the documented long-term price mean-reversion pattern (Ang and Kjaer, 2011). Most practitioners would readily acknowledge that the driver of this behavior is based in organizational politics rather than investment conviction. In 2009, the ex ante sensible investment decision to rebalance into financial stocks and high yield bonds simply carried too much risk of ex post blame.

When blame prevails, toxic fear becomes the main motivator of behavior. In that culture, people tend to hide problems and/or to be uninvolved, unaware, and unaccountable with regard to anything that might look like a problem. They will not be identifying or solving problems. And a special few might just be too willing to point fingers with righteousness and, of course, with hindsight. It is difficult to imagine long-term investment success from an organization rooted in blame.
On the other hand, we would believe that superior long-term investment results can be produced by an organization which (1) unflinchingly identifies problems, (2) debates them with openness and without blame, (3) emphasizes fixing them, and (4) focuses on learning to avoid similar mistakes in the future.

Investment Organization and the Blame Game

The investment management industry, for better or for worse, is one where the short-term investment results experienced by clients provide little or no information on the true quality of the product. This might be especially true in volatile asset classes like equities where noise is especially prevalent. Given the dearth of actionable information contained in short-term performance, it is simply mind-boggling that so much acclaim and blame can be apportioned on the basis of short-term performance.

A culture of blame in an environment where outcomes are random can only lead to the most perverse behavior. When the organization’s sport is to blame, it hardly matters that the assignment of fault is based on a metric (short-term performance) with no actual informational content. Whatever ceremonial committee meetings occur to conduct the post mortem, proclaim the faults, and distil the supposed lessons—the actual learning can only be naught. After all, how can someone take true responsibility for a random bad outcome and improve his investment process to assure positive random draws in the future?

Learning agility is the most valuable currency for long-term organizational performance in a dynamic environment where new facts are constantly being discovered and new theories are proposed to account for them. However, organizations plagued with fault-finding will often perceive “needing to be right” as more important than learning. Indeed, perhaps we blame others precisely to satisfy the ego’s need to be right. Research finds that the highly intelligent and competitive people often have the greatest need to be right. The investment industry certainly has no shortage of smart, highly competitive people. When investment professionals debate in order to prove themselves right and others wrong, it eliminates the possibility for learning and so the possibility for improvement. When research analysts and portfolio managers focus on appearing to have the truth, they are implicitly committed not to seek the truth but merely to look for confirming evidence.

In my experience, a blame-oriented organization is often one that demands accountability for randomly unfavorable short-term outcomes. A by-product is wasting resources on developing skills to improve the odds of flipping heads on a fair coin. Prolonged exposure to this culture may eliminate creativity and true personal responsibility and replace them with a cynical commitment to the art of covering one’s arse. When an organization’s energy is devoted to CYA instead of creating value, it is difficult to imagine that it could deliver superior long-term investment results. Thoughtful people who build organizations for the long-term don’t tolerate a culture of blame.


In the end, I am an economist, not an organization behavior researcher. My biggest issue with blame in an investment organization is that it seems to be strongly positively correlated with a genuine lack of comprehension for statistics at the most senior level. Blame-oriented investment organizations revel in the drama of short-term performance—there is always something to “hold someone accountable for” (code word: blame) the next quarter. It is difficult to imagine that using short-term results to direct organizational energy and resources would create outputs of substance. If an investment management organization is dominated by people who aren’t wise enough to understand that short-term results are largely random, there can be no hope that this particular organization will be winning the loser’s game.

My advice is to avoid investment organizations with a culture of blame. They are likely very bad at statistics.


1. Paradoxically, many asset managers continue to be hired and fired based on recent three-year performance, despite all evidence pointing to the harm of such a practice. See Towers Watson’s (2011).
2. We have been working with Jim Dethmer’s Conscious Leadership for the past five years on learning and building a strong corporate culture.
This is an excellent comment, one that all organizations should read, understand and act upon. The culture of an organization is the single most important determinant of long-term success. And Hsu is right, when an organization’s energy is devoted to CYA instead of creating value, it will never deliver successful long-term results.

When Jim Keohane, president and CEO of the Healthcare of Ontario Pension Plan (HOOPP) spoke to me about HOOPP's stellar 2012 results, he specifically highlighted the importance of that organization's culture in delivering superior long-term investment results.

What makes HOOPP's culture so successful? Beyond hiring the right people at senior levels -- extremely sharp, dedicated professionals with no egos -- I think it's the entire mindset which promotes an exchange of ideas from all employees and focuses on organizational success.

One hedge fund manager told me this about HOOPP: "They run the place with the flexibility of a multi-strategy hedge fund and leverage their long-term investment horizon in a way that other pension funds cannot seem to do consistently."

All I can tell you is that culture differs across organizations and often differs across investment teams within an organization. I've worked in enough places and allocated money to many hedge funds and private equity funds to see firsthand what a difference culture makes in determining an organization's success.

Importantly, good organizations care about their culture and are extremely proactive in promoting and maintaining the right culture. For example, when I worked at the Business Development Bank of Canada on contract as a senior economist, I saw how important confidential employee surveys were taken by senior management and the Board.

The surveys weren't perfect but they were very good and tried to gauge the engagement and happiness of all employees and determine whether their manager was doing a good job in communicating team and organizational goals. And these surveys played an important part in bonuses, so everyone took them seriously.

Conversely, I've seen how a toxic environment can negatively impact corporate culture. It's often related to toxic individuals (not just truly horrible bosses) but it can also be related to a failure to properly communicate organizational goals and values, breeding insecurity and complete disengagement among demotivated employees fearing for their job. This is the worst culture to work in as it creates all sorts of organizational issues that can kill the collective drive for long-term success. A high turnover rate is typically the key metric in understanding a bad culture but it's not the only one.

Luckily, cultures are not stagnant. They change over time because the leadership changes or because the leaders in place demand change at all levels and hold their senior staff accountable for delivering and maintaining the right culture.

Finally, I can't tell you how important it is to promote true diversity in the workplace. I see far too many organizations that lack diversity and keep hiring people after their HR department (now euphemistically called "talent acquisition and development team") checks off all the boxes using a lame cookie-cutter approach (some are better than others but for the most part, it's pathetic).

Diversity for me isn't just about hiring black, brown, yellow, female, gay, or disabled people. It's much more than that. It's about hiring the right people with the right attitude who constantly think outside the box and aren't afraid to bring different ideas to the table. It's about placing senior managers at key positions where they promote this behavior and engage everyone in their team, sharing their successes and failures with them.

Below,  Daniel Denison PhD, CEO of Denison Consulting, discusses what corporate culture is and why it matters so much.  Also embedded a clip where he explains the pillars of the Denison model. Like what he says about creating the right mindset in an organization.

Wednesday, March 27, 2013

Golden Age For Pension Lawyers?

Jim Middlemiss of Canadian Lawyer Magazine reports, Bracing for the pension time bomb:
Fred Headon and the in-house labour law team at Air Canada have learned more about pension law in the last 18 months than most lawyers will learn in a career. Over the last decade, Canada’s national airline has been steadily hit with a series of economic hardships — from the New York terrorist attacks in 2001 to the SARS crisis in 2003 and the credit crunch in 2008 — which decimated air travel and led to a series of restructurings.

During 2011 and 2012, Canada’s national airline was locked in bargaining and arbitration with its unions, which Headon, assistant general counsel, labour and employment law, says “had a major pension component.”

The company sponsors a number of defined-benefit and defined-contribution pension plans, which were a major sticking point. Under a DB plan, the employer guarantees a set pension and is on the hook for any shortfall, making it riskier than a DC plan, where employees make investing decisions and their pension depends on the performance of those investments.

In the beginning of 2012, Air Canada’s 10 DB plans were running a $4.2-billion solvency deficit and the company was making past service catch-up payments under federal regulations. It needed to deal with pension issues to move forward.

“Through that process, about three of us — on a pretty full-time basis — were involved in the bargaining given the role that pensions played. We were plugged into the discussion in a way that took up a fair bit of time.”

“It’s an area of law that not many of us studied or specialized in,” says Headon. “When you are in-house, you need to master it quite quickly.”

The legal department’s efforts paid off for the airline. “We secured approximately a $1-billion reduction in solvency liabilities [which at press time were subject to regulatory approval]. We have a template with the unions to get there.”

Headon is not alone in facing pension problems. Management is increasingly calling on in-house lawyers to help deal with pensions. It’s not just solvency issues that organizations and their in-house counsel face. Canada is undergoing an extraordinary round of pension reform at the provincial level, and almost every province has some sort of initiative underway. That, coupled with companies looking to reduce risk or possibly convert from DB to DC plans, has legal departments scrambling to keep up with the change and bring their boards up to speed on developments around pension risk.

Pension reform ‘tsunami’
“There’s a tsunami of pension reform that has been happening in the last couple of years,” says Melissa Kennedy, general counsel and senior vice president of corporate affairs at the Ontario Teachers’ Pension Plan.

As a result she is “being corralled”more and more by her general counsel colleagues and asked about pension reforms. “They are talking about pensions more than the general counsel community ever did.”

Elizabeth Boyd, a pension lawyer at Blake Cassels & Graydon LLP, agrees, adding “there has been a dizzying array of changes. It’s tough to keep up.”

Experts say there are three key areas general counsel and their legal teams need to consider when it comes to pensions: tackling solvency issues around DB plans, keeping abreast of pension law reform, and helping their company de-risk its pension obligations and mind its fiduciary duties.

Facing the solvency crunch
The biggest challenge organizations are grappling with is the growing deficits in their DB plans. At the end of 2011, 93 per cent of federally regulated DB plans were under-funded according to the Office of the Superintendent of Financial Institutions — a far cry from the early 1990s, when many ran surpluses. But that’s only part of the story — most DB plans are provincially governed and face similar problems. It’s not clear what the total liability is for underfunded DB plans in Canada. The Canadian Federation of Independent Business suggests public DB plans alone are $300-billion in deficit. Factor in billions more in red ink from private sector plans and the number starts to get very large, creating a ticking pension time bomb.

Pension deficits are not isolated to Canada. An August 2012 study by credit rating agency Dominion Bond Rating Service Limited looked at 451 major corporate DB plans in the U.S. and Canada, including 65 north of the border. It found funding deficits of US$389 billion. DBRS noted more than two-thirds of plans were “underfunded by a significant margin” and heading into a “danger zone,” the point at which reversing the deficit becomes difficult. It believes 80 per cent “is a reasonable funding threshold.”

The problem for organizations facing solvency deficits is they are required under pension law to make special funding payments to eliminate that shortfall over a tight time frame, in addition to making regular pension contributions. The money comes out of existing cash flow, which puts extra strain on balance sheets as the economy muddles along, and places companies at a disadvantage compared to competitors that do not have underfunded pension obligations.

It’s not just the private sector that’s impacted. Public pensions face the same solvency pressures. Take the Ontario Teachers’ Pension Plan, which pays out more than $4.5 billion a year to pensioners. It is considered one of the best, with more than $117-billion in assets under management, and invests around the world. In 2011, it returned 11.2 per cent, earning $11.7-billion, making it one of Canada’s most profitable entities. Its rate of return since 1990 has been 10 per cent.

Despite that performance, Teachers’ had a funding deficit in 2012 of $9.6-billion and currently its expected pensions costs over the next 70 years are growing faster than the projected value of pension assets. Teachers’ is not alone. OMERS, another big public plan, is expected to have a $9-billion deficit this year and many other public plans are in the same boat.

In fact, Manuel Monteiro, a partner at pension consulting company Mercer’s financial strategy group, estimates only one in 20 DB plans are fully funded on a solvency basis, which is a stress test pension regulators impose on plans.

He said pension deficits are not a big deal for healthy companies. “If a plan is in a deficit position, the company is required to fund that deficit. It’s not a big deal if the company you are working for is strong. If you work for a weak company that has a deficit you have to question if you will get a pension.” Take Nortel, which sought creditor protection in 2009 — a deficit in the plan means pensioners receive reduced payments.

Yves Desjardins-Siciliano, chief legal and corporate affairs officer at VIA Rail, which oversees a $1.7-billion DB pension plan that has a deficit, notes solvency is “an actuarial calculation and not an impending threat. It is an area that requires serious management attention, even at the board level.” Like many companies, he says VIA is looking at ways to address its deficit.

Low interest rates a problem
Experts say the deficit problem is twofold. First, low interest rates are the biggest contributor. Plans simply can’t keep up with the growing liabilities, because fixed-income investments — the lion’s share of most plan assets — are generating such low returns. The DBRS report notes the discount rate, which pension plans use to calculate the present value of future pension obligations, has been plummeting since 2008 and are unlikely to rise anytime soon — though they are bottoming out.

DBRS estimates if the discount rate rises by 2 per cent, the funding gap of almost US$400 billion would be eliminated. It’s certainly achievable given the average discount rate in 2011 was 4.84 per cent compared with 6.27 per cent in 2008.

Since companies cannot control interest rates, it means they must fund shortfalls using voluntary payments, such as BCE did in late 2012, dropping $750-million into its plan. Corporate Canada has an estimated $600-billion sitting on its balance sheet, but the reality is few companies have the luxury of writing a billion-dollar cheque like BCE did.

In fact, experts say companies are reluctant to kick extra money into pension plans because the expectation is interest rates will soon start to rise and much of the funding problem will vanish. Many simply rely on letters of credit to satisfy regulators’ concerns about shortfalls. Monteiro says, “The problem with pension plans is that once you put it in, you can’t get it back easily.”

There are also companies required by pension regulators to make catch up payments and some of those are seeking relief. Take Air Canada. It made $433 million in pension plan funding payments in 2012, which included a special past service catch-up payment of $173 million. For the last three years, Air Canada, whose pensions are federally regulated, has been making catch-up payments under special three-year pension relief regulations passed by the federal government following the credit crisis.

Air Canada projects another past service payment of $221-million in 2013. However, its Q4 financial statement notes the three-year regulation is set to expire in 2014 so Air Canada, with the agreement of five labour groups, is now asking the federal government to cap the past service payment at “acceptable levels” over the next decade or until the plans are no longer in deficit.

Under the recent negotiations with its labour groups, Air Canada secured amendments to existing plans that will reduce liabilities and will put in place a hybrid
pension regime for new employees consisting of both a defined-benefit and defined-contribution component, putting the airline at the forefront of pension reform that is bubbling through corporate Canada.

“We had an awful lot of learning to do,” says Headon. “Issues coming out of pension reform touch a large number of stakeholders.” That meant making sure the large team, which included non-lawyers such as actuaries, tax experts, and managers, were kept up to speed on negotiations.

“Lawyers are in a very good position to play a role to make sure the team has the information they need and are pulling in the same direction.”

Companies seek pension relief
Air Canada is not alone in seeking relief from hefty catch up payments. A group of six Canadian companies — which include telcos, railways, and some former Crown corporations — have long lobbied the federal government for greater solvency relief including the way calculations are made to assess pension solvency and an extension in the amount of time companies can fund their deficits. Michel Benoit, a lawyer at Osler Hoskin & Harcourt LLP who has worked with them, says, “They didn’t get what they wanted. It’s a dead issue right now.”

Canada is at a competitive disadvantage on that front. The U.S. recently modified its rules to allow a 25-year average for calculating the discount rate, rather than confining it to the past few years, which has been artificially low and leads to higher pension obligations. Some European countries are doing the same as the U.S.

Companies seem to have more luck seeking relief from provincial regulators. For example, in Ontario employers can seek to spread deficit funding out over 10 years if employees agree, so a number of companies have recently sought co-operation of their unions to take advantage of that. Some have been successful, others haven’t.

Plan design needs to change
The second primary issue driving deficits is age. Many plans were designed three or four decades ago, when the life span of Canadians was much shorter than it is today. The only way around this is to address the structure of the plan and that could mean hiking retirement ages or looking to move to a DC plan.

“Like other companies have done, we are going to look at changing the design of the plan,” which could mean moving to some type of hybrid plan or a defined contribution plan, says VIA’s Desjardins-Siciliano.

“We are looking at re-designing the plan for new employees going forward in a way that not only preserves or makes it more financially viable, but reflects the reality of the new workforce.”

He notes that while VIA has many employees with 35 or 40 years of service, the average tenure at a Canadian company today is between four to seven years and a defined-benefit plan doesn’t have the draw it did when they were set up in the 1960s and 1970s.

In fact, DB plans are declining in the private sector, largely because of the risk they entail. In a November 2012 pre-budget consultation document presented to the Senate of Canada, lobby group Fair Pensions for All points out that 57 per cent of the Canadian workforce is not covered by pensions. Defined-benefit membership coverage is declining in the private sector, dropping to 1.5 million in 2011 from 2.2 million in 2001, while in the public sector it increased over the same period to 2.9 million from 2.3 million.

Are DB plans dead?
Kennedy, for one, believes in the DB Plan, and says there are “a number of ways of dealing with the solvency issues without throwing the baby out with the bathwater” and moving to a DC plan.

She notes states like Rhode Island and provinces like New Brunswick are developing new plans that aim to provide the upside of a DB plan while limiting exposure, known as shared-risk or targeted plans.

“I think that’s the key. There needs to be shared risk.” To address its deficit issue, Teachers’ has raised contribution rates and lowered benefits and continues to look for ways to address the deficit and provide sustainable pensions.

While studies show DB plans are being shunned and DBRS even predicts their demise in 40 years, Kennedy says DB plans have advantages. “They are a lot cheaper… because you are pooling the risk.” As well, she says, a DC plan puts the risk “totally on the employees” and that may have negative long-term social policy issues if DC plans fail to provide adequate retirement resources. “You’re going to have to pay the piper at some point — if it’s not today, it’s tomorrow.”

Shared risk plans
The key, she says, is building flexibility into the plan. The low-interest rate environment and underfunding is prompting more discussions around creating hybrid plans. New Brunswick, for example, which has had a negative experience with DB plans that have gone belly up leaving pensioners with a shortfall, has introduced shared risk pension plans which attempt to combine the best features of a DB and DC plan.

They remove absolute guarantees, such as indexing, and require both employers and employees to share in the risk, as opposed to the employer assuming all the risk for shortfalls. The plans provide basic benefits, and contributions can increase or decrease depending on the performance of the plan. Additional benefits, such as indexing, depend on whether the plan meets or exceeds expectations. In a stress test of more than 1,000 scenarios, basic benefits under an SRRP were achieved in 97.5 per cent of cases and the average indexation reached at least 75 per cent of CPI. Contributions were also stable, requiring no increases above 1 per cent of payroll.

Currently, some New Brunswick public pensions are converting to the SRPPs. The age for retiring without a reduction in pension will bump from 60 to 65.

Pension law reforms
In terms of provincially governed plans, there are a number of minefields awaiting in-house counsel. Many provinces are introducing changes to their provincial pension laws. As well, the Canadian Association of Pension Supervisory Authorities has introduced an agreement respecting multi-jurisdictional plans, which Quebec and Ontario have signed.The goal is to simplify the administration of plans that operate in more than one jurisdiction and reduce oversight red tape.
Blake Cassels’ Boyd says, “We’re only now starting to understand some of the implications of what they have agreed to.” She explains the “tricky thing” with pension plans is the home jurisdiction for regulating them depends on plurality of members in a plan. That can change as the business grows and acquires or divests operations. There are also hitches in provincial laws when it comes to meeting family law obligations in a separation or divorce.
Grow in rights
Boyd says another thing to watch for in Ontario is “grow in rights,” which are contained in recent Ontario pension reforms. Now, a pension automatically vests once a person joins a plan, as opposed to after two years. As well, if a person who has accrued 55 points (age and service exceed 55) is involuntarily terminated, then they must be allowed to “grow in” to a plan’s early retirement subsidies, which Boyd says can significantly increase the cost of a plan. She adds it’s not clear what happens if someone is fired for willful misconduct. There are also issues to be determined around a voluntary versus involuntary dismissal.

Companies look to de-risk
Ian McSweeney, a pension lawyer at Osler Hoskin & Harcourt, says there is a “spectrum of possibilities,” when it comes to de-risking pension plans. At one end is managing risk through investment and making sure the investment strategy aligns with the execution and matches liabilities. In the middle is the plan design and issues such as whether a DB plan is still feasible or should a company convert to a DC. He says “conversions gets you there over time, but you still have a legacy deficit.” At the other end of the specturm is getting rid of the risk entirely through lump sum payments or annuities.

Desjardins-Siciliano says achieving better pension results can be as simple as reigning in plan costs. VIA started by applying “rigorous management oversight” of expenses related to managing the fund and it reduced cost to 30 basis points from 50, a big savings when you are managing millions of dollars. VIA is also requiring employees to contribute more of their earnings to the pension fund. Employee contribution was 30 per cent and will move to a 40-60 split.

Beware of fiduciary duties
One area where Desjardins-Siciliano says “lawyers really have to be careful and diligent is on the issue of governance.” There is a fiduciary duty on the part of the company to make sure the plan is properly managed. He says in-house lawyers have to limit the risk of conflict when it comes to hiring fund managers or plan administrators. “The obligation is one that requires lawyers at the board level to be very diligent in making sure that all the steps are taken so that — especially in a deficiency or insolvency environment — if you should, god forbid, run out of money, no one can go back and say you are negligent.” It’s the same with things like making decisions on taking contribution holidays.

Larry Swartz has seen both ends of the pension challenge. He is counsel to Morneau Shepell and a principal at the HR consulting firm, which provide pension and benefit administration services. As a lawyer, he is involved in advising his firm on its DC and DB plans and providing clients with advice on theirs.

He says one of the biggest challenges for companies is communicating with employees about their pension options in DC plans in a way that meets the employer’s obligations as a fiduciary. The role of the lawyer in pensions, he says, is helping the company manage risk. For DC plans, that risk can be in deciding how far a company goes in communicating about investment options for its employees. “You need an understanding of trust laws and fiduciary duties so that you can help realize it’s not just company money, you are providing a service for the company that is ultimately for the benefit of the employees.

“It’s an area where the more financial knowledge a general counsel has, the better they can be serving their client.”

It’s taken a while for the economy and corporate Canada to dig the current pension hole and the problem won’t be solved overnight, especially if interest rates don’t start climbing soon. Air Canada’s Headon says while there is light at the end of the tunnel, “pensions are going to remain a pretty significant part of our time for a few years yet.”

Indalex ruling clears air on priority
Employers and financiers can breathe a sigh of relief following a ruling by the Supreme Court of Canada that restores order over debtor-in-possession loans in restructurings. Normally under a CCAA application, a DIP financier is granted a super priority over other creditors, meaning they are first in line to get repaid before secured and unsecured creditors.

By granting that priority, it ensures DIP financiers will get paid, which encourages lenders to loan the much needed money to keep companies operating while buyers are pursued or to re-float financially impaired companies. Without that guarantee, lenders would be reluctant to loan money or would only do so at a higher interest rate to offset the risk they might not be repaid, notes Osler Hoskin & Harcourt LLP lawyer Ian McSweeney. “No one will lend money unless they are certain they will get it back.”

However, an Ontario Court of Appeal threw the traditional view about priorities out the window in Sun Indalex Finance LLC v. United Steelworkers and held company pensioners had priority to repayments of the DIP money by the employer.

The Appeal Court ruled Ontario’s pension laws created a deemed trust for pension shortfalls on a wind-up and there was a constructive trust, which put pensioners at the front of the line when it comes to payback. “The Court of Appeal changed the way everyone thought and the pension legislation concept of a deemed trust,” McSweeney says.

That ruling raised eyebrows among corporate and insolvency lawyers, who were waiting for the Supreme Court of Canada to weigh in. The court did that in early February in a 160-page ruling.

In a complex 5-2 decision — the judges were all over the map on some of the issues — they overturned the Ontario Appeal Court and sided with the financiers over the pensioners. McSweeney says the SCC resolved the case by ruling that a judge appointed under the federal CCAA “can make a super priority charge that trumps out the provincial deemed trust.”

McSweeney notes the case also discusses important issues, such as when an employer who acts as a plan administrator is facing a conflict of interest between the corporate interests and the fiduciary duties it owes to the employees, when a wind-up deficiency is subject to a deemed trust and discussion around constructive trusts. “There is something for everybody in that case,” McSweeney says. “[The judges] cross-agreed with each other on various points.”
This is a great article, packed with excellent insights from lawyers dealing with complex pension issues. I've already covered the Supreme Court of Canada's Indalex decision in a comment last month, Pensioners lose the battle but win the war.

I've also covered whether Air Canada deserved a pension lifeline and updated that comment looking at how Air Canada bonuses are now tied to pension payments. Also, Reuters reports Air Canada pension deficit estimate falls on higher plan returns:
Air Canada said a preliminary estimate of its pension solvency deficit has dropped to C$3.7 billion ($3.6 billion) from C$4.2 billion a year ago, reflecting a better-than-expected 14 percent return on plan assets.

Canada's largest carrier said in a recently filed annual information form that the estimate, as of January 1, 2013, was hurt by a decrease in the solvency discount rate to 3 percent from 3.3 percent. Valuations to determine the actual deficit will be completed in the first half of 2013.

Earlier this month, the airline won an extension of the cap on special payments to erase its pension fund deficit. Under the plan, which smaller rivals had objected to, Air Canada will have to pay a total of C$1.4 billion over seven years, or an average of C$200 million a year, with a minimum payment of C$150 million a year.
14 percent is an outstanding return for 2012 but they still need help to tackle their pension deficit. Hopefully they will maintain these stellar returns in the years ahead and interest rates will rise enough to lower liabilities significantly.

Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), told me last week when discussing their spectacular 2012 results that David Long, HOOPP's CIO, knows the pension team at Air Canada well and thinks highly of them and the way they manage assets and liabilities. It's obvious that HOOPP and Air Canada Pensions follow similar approaches on asset-liability management and use arbitrage, bond repos, tactical asset allocation and long-term option strategies to add significant added value.

Finally, for all you flirting with employment law, read Melissa Leong's article in the National Post, Golden age for pension lawyers?. All of a sudden, it's cool to be a pension lawyer.

Below, General Motors Co., which regained the global auto sales lead, earned $9.19 billion last year, the largest annual profit in its 103-year-history, while also announcing it will end traditional defined-benefit pension plans for its white collar workers. Bloomberg's Suzanne O'Halloran reports on Bloomberg Television's "Money Moves."

Tuesday, March 26, 2013

CalPERS Moving to All-Passive Investments?

Kevin Roose of the NYT reports, Are Pension Funds Getting Smart About Passive Investments?:
Pensions & Investments ran a story yesterday about how the California Public Employees' Retirement System is considering moving to an all-passive portfolio. You probably didn't read it, because stories about pensions are boring.

But this story only looked boring. In fact, it was probably the most important Wall Street development you'll read this week. It's an undeniably good sign for people who care about the retirement funds of teachers, firefighters, and other public-sector employees. And it should strike terror into the heart of every hedge-fund manager and private-equity executive in midtown.

The backstory is that, for many years, public pension funds have had a love affair with so-called "active investments" — basically, hedge funds, venture capital funds, private-equity funds, mutual funds, and assorted other outside money managers who charge a fee for managing other people's money. Every year, pensions plow more and more millions of dollars into these funds, hoping for better returns than they could get by buying low-risk index funds and exchange-traded funds on their own. They're happy to pay through the nose for the privilege — most alternative asset managers charge at least a 2 percent management fee and 20 percent of profits — under the assumption that since these complex, active investments make better returns than simple, passive investments, the fees are worth it.

Except that they're usually not. In aggregate, and especially in recent years, most active management firms don't perform any better than a simple, passively managed index fund that costs nearly nothing to buy, and many expensive funds perform significantly worse. As P&I says:
Over the past 10 years, just 38% of large-cap-equity managers have beaten the S&P 500. Over five years, it shrinks to 31%, and over three years, it is just 18%, according to Morningstar Inc. Making things even harder for those trying to pick active managers is that just 9% of large-cap managers outperformed the S&P 500 over all three time spans.
Private-equity firms and hedge funds, in particular, tend to love pensions, which typically provide a majority of the money they manage. (In fact, many private-equity firms and large hedge funds couldn't exist without pensions.) But they haven't held up their end of the deal. Start with their subpar returns, and subtract their onerous fees, and you get a very bum deal for the average pension fund.

But CalPERS — a large and influential fund, which can act as a Pied Piper for lots of smaller pensions — is waking up to the fact that it's paying too much to active managers and not getting enough in return. After years of pushing for lower and lower fees from the private-equity firms and hedge funds who manage its money, CalPERS is considering saying, "You know what? Never mind," and giving up on active management altogether.

This would be a good thing! Most pension funds should not be in the business of selecting active managers, and I would cheer any pension fund that followed CalPERS's example and put more of their money in index funds and passive bond funds. Risky investing isn't always a bad thing, and it's true that some private-equity firms, hedge funds, and mutual funds have done well for their pension investors.

But if they want to handle the retirement money of America's retirees, these firms have to prove they're worth the fees they charge. And so far, they haven't measured up.
Investment News also covered this story, providing more details on trends in passive investing in their article, Passive investing: If it's good enough for CalPERS ...:
Passive investing has reached a watershed moment.

The second-largest pension fund in the United States is considering a move to an all-passive portfolio while at the same time, the largest brokerage firms are falling over themselves to push passively managed exchange-traded funds.

The California Public Employees' Retirement System's investment committee started a review of its investment beliefs last week, with the main focus on its active managers, according to sister publication Pensions and Investments.

CalPERS oversees about $255 billion in assets, more than half of which already is invested in passive strategies.

“It's sort of an exclamation mark on a trend that most are aware of,” said Chris McIsaac, managing director of the institutional investor group at The Vanguard Group Inc.

Fidelity Investments, meanwhile, has responded to the enthusiasm for passive strategies by doubling down on its agreement with BlackRock Inc.'s iShares unit. Fidelity increased the number of iShares ETFs that trade commission-free to its clients to 62, from 30, two weeks ago.

Fidelity's move came just a month after The Charles Schwab Corp. launched an ETF platform that offers investors more than 100 commission-free ETFs.

TD Ameritrade Inc., the third leg of the online brokerage world, has been offering more than 100 commission-free ETFs since 2010.

“We see don't see it as either passive or active, we see it as both. In a low-return environment, fees matter a lot,” said Scott Couto, president of Fidelity Financial Advisor Solutions.

“That's getting interest in passive investing over the short term. Over the long term, active management adds a lot of value,” Mr. Couto said.

“There will continue to be a growing interest in the passive side because cost matters to investors,” said Beth Flynn, vice president and head of third-party ETF platform management at Schwab.

“Virtually all our adviser clients use ETFs in some way, shape or form,” she said. “Usage is much lower on the individual-investor side, but growing at a pretty steady and rapid clip.”

More than 40% of individual investors plan to increase their use of ETFs over the next year, for example, according to a recent Schwab survey.

TD executives couldn't be reached for comment.


Passive investing is nothing new. Vanguard founder John Bogle launched the first index mutual fund in 1975. But the fund world has always been dominated by active management.

A decade ago, 86% of the $4.4 trillion in mutual funds and ETFs were in active strategies, according to Lipper Inc.

Investors' preference is clearly shifting, though. Active management's market share was down to 72% as of the end of last month, and passive funds clearly have all the momentum now.

As investors have gotten back into stocks this year, they have done so largely through passive funds. Passive funds took in $65 billion in the first two months of the year, while active funds took in $40 billion.

For anyone who has been watching fund flows over the past few years, the surge in passive strategies shouldn't come as a surprise.

Since 2003, investors have pulled $287 billion from actively managed equity funds, while investing just over $1 trillion in passive funds.

Even though the preference for passive strategies has been most dramatic in equity funds, passively managed bond strategies are gaining steam, as well.

Passive bond strategies have had $260 billion of inflows since the beginning of 2008. Between 2003 and 2007, they had $73 billion of inflows, according to Lipper.

“Indexing has proven to be a very compelling investment strategy, especially for investors with an extended investment horizon,” Mr. McIsaac said.

Costs have played a big part. They are, as Mr. Bogle likes to point out, the only thing that an investor really can control, and passive strategies are much cheaper than their active counterparts.

U.S. equity ETFs have an average expense ratio of 40 basis points, compared with an average expense ratio of 134 basis points for actively managed mutual funds, according to a recent Morgan Stanley Wealth Management research note.

What's more, a number of large-capitalization ETFs charge less than 10 basis points, while the cheapest actively managed large-cap fund charges 50 basis points.

Active managers haven't given investors much reason to stick around.

“Being active over the past 15 years has not been rewarding,” said industry consultant Geoff Bobroff.

The percentage of managers beating their benchmark has been shrinking.

Over the past 10 years, just 38% of large-cap-equity managers have beaten the S&P 500. Over five years, it shrinks to 31%, and over three years, it is just 18%, according to Morningstar Inc.

Making things even harder for those trying to pick active managers is that just 9% of large-cap managers outperformed the S&P 500 over all three time spans.

The inconsistency of actively managed returns is what prompted the review by CalPERS.

As P&I reported: “CalPERS investment consultant Allan Emkin told the investment committee that at any given time, around a quarter of external managers will be outperforming their benchmarks, but he said the question is whether those managers that are doing well are canceled out by other managers that are underperforming.”


Rick Ferri, founder of Portfolio Solutions LLC, ran into the same problem while he was working at a brokerage firm early in his career.

“I spent a lot of time and money evaluating managers,” he said.

“It was a revolving door for most of them,” Mr. Ferri said. “You can't win unless you get very, very lucky.”

Mr. Ferri now runs an all-index portfolio for his clients' equity exposure. On the bond side, he still favors active management — when it is cheap.

“Sometimes that's the best way to get market representation,” Mr. Ferri said.

The $39.2 billion Vanguard Intermediate-Term Tax-Free Bond Fund (VWITX) owns 3,854 bonds and charges 20 basis points, for example. The $3.6 billion iShares S&P National AMT-Free Municipal Bond ETF (MUB), the largest municipal bond ETF, holds 2,196 bonds and charges 25 basis points.

CalPERS is expected to decide the fate of its active managers in about five months. At this point, it looks as though it could go either way.

Chief operating investment officer Janine Guilot told P&I that 27 preliminary interviews of CalPERS staff members, board members, money managers and external consultants showed a “wide disparity of views” on active management.

Mr. McIsaac isn't ready to write off active management altogether.

“There will come a period of time when active managers will do much better,” he said.

That is, if good active management can be found at a low cost.

“It's hard to find both,” Mr. McIsaac said.

The market ultimately will have the biggest say in the future of active management, Mr. Bobroff said.

“Is this the end of a trend?” he asked. “It depends where the market is going over the next five years. Your guess is as good as mine.”
Indeed, the future of active management does depend on where the market is going over the next five years. If it tanks or goes sideways, a few good active managers which don't gouge investors on fees will be in very high demand.

But if the bull market that gets no respect keeps trending up, the percentage of active managers that beat their benchmark will keep shrinking. This will be great news for large banks offering 'index solutions' to their clients but it will be bad news for the active management industry struggling to compete, especially after the 2008 financial crisis.

Will CalPERS move to an all-passive portfolio? While that would please those who are disgusted with the latest indictment involving their former CEO and a middleman charged with defrauding a private equity fund, doubt CalPERS will go all-passive.

Instead, I think CalPERS will reevaluate all their external managers in public, private and absolute returns strategies, scrutinizing the fees they've paid out and the value added (alpha) these funds have actually produced, net of fees and costs.

I can tell you that the biggest problem at CalPERS for the longest time was they wanted to invest with everyone. When you invest with everyone, you end up paying huge fees and getting back mediocre benchmark returns. This is what happened in their large private equity portfolio before Réal Desrochers joined a couple of years ago to clean it up. He's halfway done but still cleaning it up.

And this is what is going on in their large real estate and hedge fund portfolios. They're is a lot of cleaning up that needs to be done as these portfolios are dolling out huge fees and not getting the value added to justify such big allocations to external managers.

Think CalPERS can learn a lot from small and large funds. Last week, I wrote on HOOPP's stellar 2012 results where Jim Keohane, their president and CEO, stated that they add value internally by focusing primarily on arbitrage opportunities in fixed income markets and by engaging in trades -- like their long-term volatility strategy -- which just make sense but don't fall under benchmark or absolute return strategies.

CalPERS can also learn a lot from Ontario Teachers', CPPIB and other large Canadian pension funds which run active management internally but also invest with external managers where it makes sense, typically in strategies where they cannot reproduce the alpha internally.

Admittedly, this will be hard because CalPERS and other US pension funds are not governed the same way and do not compensate their managers as well as their Canadian counterparts but this doesn't mean they can't implement similar approaches to these Canadian funds.

Finally, CalPERS can learn from smaller US pension funds engaging in flexible approaches with their active managers. Dawn Lim of Money Management Intelligence recently reported, Philly Rethinks Approach On Hedge Funds, Seeks Flexibility:
The City of Philadelphia Board of Pensions & Retirement has rethought its approach to hedge fund investing and will seek to weave the funds throughout its $4.3 billion portfolio as a style rather than a separate asset class.

The more open framework, which was adopted after a portfolio review late last year, also calls for higher investment targets to private equity and hedge funds. The new portfolio mix is expected to be implemented this year.

“We have a more flexible model than most public plans that permits us to use hedge fund in real estate or bonds or equity,” CIO Sumit Handa said at IMN’s Public Funds Summit in Huntington Beach, Calif., last week. By introducing long-short strategies into buckets that have traditionally been long-only, the pension fund can more easily slot strategies to dampen volatility into its portfolio, documents indicate. 

Consultant Cliffwater played a role in the asset allocation review and will assist in the execution. The asset allocation review raised the fund’s hedge fund target to 12% from 10%.

While fund officials have as yet disclosed no manager searches in connection with the new strategy, they note that they have been in talks with managers to create special accounts. “We’ve tailored an opportunistic vehicle and we believe we have more coming,” Handa said. Private equity targets will get a boost to 14% from 9.75% and the pension plan is reviewing its pacing schedule.

Fund documents indicate that Philadelphia was working last year with managers to create private equity and hedge fund vehicles that will help it mitigate possible J-curve losses and get earlier distributions. Within the fixed-income bucket, the pension has also done away with the specificity of sub-asset classes such as “high yield,” “non-U.S.” and “emerging markets” and implemented broader categories such as “investment grade” and “non-investment grade.”

 In December, Philadelphia made a $30 million commitment to structured credit-focused Axonic Credit Opportunities Overseas fund, as the first public pension to commit to Axonic Capital, a $1.7 billion New York hedge fund that had previously only raised endowment and private pension dollars, fund documents indicated.

The pension is looking to reduce the number of managers for better risk control and higher returns. “We have too many positions for a $4.3 billion fund,” Handa said at the panel, “We’ll be scaling back on this.” The fund, which has 130 managers, has moved to make higher commitments, generally in the range of $30 million - $50 million. It also shifted 1% of portfolio assets in-house to be managed tactically. 

The latest fund manager Philadelphia disclosed it terminated was credit hedge fund manager Regiment Capital, axed in December for sitting on cash and failing to ride on the high yield and levered loan rally in 2012. Regiment didn’t immediately respond to queries.

The pension fund also restructured its real assets bucket as part of the portfolio overhaul. The target for master limited partnership was raised to 3% from 1.75%. The real estate bucket was reduced and brought under real assets; it had previously been a standalone asset class. In line with the new targets, the pension fund exited J.P.Morgan’s and INVESCO’s core real estate funds, in the view that the core real estate market was overvalued and it was time to redeem cash from both mandates.

Separately, a push to bring smaller managers into the portfolio may be brewing. “We are exploring methods to increase the number of women, minority, disabled and emerging managers into the areas of private equity, real estate and hedge funds,” according to an email from Executive Director Francis Bielli. There is currently no time frame for implementation, he stressed. 
Among pension consultants, Cliffwater provides excellent advice to its institutional clients and they know the  alternative investment space extremely well. There are a few others who provide equally sound advice.

One of them is Simon Lack, founder of SL Advisors and author of "The Hedge Fund Mirage," who recently appeared on CNBC stating that outsized risks by hedge funds and fees could imperil pensions.

You bet, these are treacherous times for hedge funds but in the pension world, memories are short and many have already forgotten about the pensions' alternatives albatross which hit them hard four years ago. They should listen carefully to Simon Lack below as he knows what he's talking about.

Monday, March 25, 2013

Is Retirement History?

Joseph F. Coughlin, director of the Massachusetts Institute of Technology AgeLab, wrote a comment on the Big Think blog, Is Retirement History? (h/t, Suzanne Bishopric):
Associated Press reports that two Americans are somehow still receiving Civil War veterans’ benefits. Although I’m guessing that a good deal of the media coverage devoted to this discovery will deal with the long-term economic costs of war, I’m fascinated for another reason: the Union Army plan was the first major, federal-level pension program in the United States. Today, as we wonder whether we’ll be able to continue to afford Social Security and Medicare in the decades to come, it’s astounding to discover that the original American entitlement program is still alive, and still paying out.

For those of us not currently reaping Civil War benefits, a little background: the Union Army pension originally covered those injured in battle, and in the late 1800s the program expanded to include veterans who became disabled off the battlefield as well. “Disability” was defined to include old age, and eventually veterans as young as 62, as well as their widows and children, could claim payments. Importantly, in the case of the two remaining pension recipients, children with disabilities would remain on the pension rolls even after they became adults. By 1900, the Union Army pension was the most widespread form of assistance to older adults in the United States, paying out to a quarter of the population 65 and over and accounting for almost 30 percent of the federal budget.

Even more interestingly, the pension provided a natural economic experiment: only some adults received payments, and their behavior could be compared with those, such as Confederate soldiers, who didn’t. My former MIT colleague Dora L. Costa (now at UCLA), after accounting for such variables as the health of the retiree, discovered that as of 1900, workers were vastly more likely to retire if they had the extra income boost of a Union pension. (More about this study, as well as most of the other Civil War-related information I’ve cited here, can be found in Costa’s incredibly detailed and exceptional book The Evolution of Retirement.)

The idea that people would retire if they could afford it may not seem extraordinary now, but in the years leading up to 1900, our modern concept of retirement wasn’t fully formed. Many delayed this step for as long as possible, in part because they would have no choice but to move in with their kids or extended family once their cash flow dried up. But around the turn of the century, retirement began to change. In addition to the Union Army pension, private pensions became increasingly common. More and more retirees were able to afford to live apart from their kids. Leisure started to become cheaper. And, in ever-increasing numbers, people retired who didn’t need to, in the sense that they were physically capable of work. Eventually, the idea that a “worker, after years of productive effort, has earned the right to rest” – even if that worker didn’t physically need it – would help inform the first iteration of Social Security, and, in turn, our current conception of retirement.

Today, little is known about the two remaining recipients of Union Army pensions, except that they live in North Carolina and Tennessee, and they’re almost certainly children of women who married Civil War veterans much older than them in the 1920s or ‘30s. Today, they each draw 876 dollars per year from federal coffers. It’s a price I’m happy we’re paying, if only to serve as a reminder that the way we live our lives is more malleable than we think. Whether we expect to go to high school, college, retire, or do anything else because we see our peers doing it, it’s always a good idea to stop and ask ourselves why. In the case of retirement, it’s eye-opening to discover that our current narrative is tied to a war that concluded 148 years ago.

As with many concepts that we now take for granted as a reality seemingly dictated by the laws of physics, the idea of retirement is a social construction that is subject to change. A combination of factors now challenge today’s notion of retirement. The changing nature of work, economic necessity, smaller and fragmented families, the capacity of public and private pension providers to ensure income that enables 20-plus years of not working for income as well as the desire of many retirement age people to continue working are eroding our expectations of what retirement is and should be. Sometimes big change happens slowly and is barely perceptible at any one moment. Retirement, as we know it today, is history. A new story is emerging – a narrative that will change how we individually plan and behave as well as the government and business institutions that are built to support the retirement we once knew.
True, retirement as we know it today is history because of all the factors Coughlin outlines above but there is also no denying Americans are bracing for a retirement crisis. Longer life expectancy, historic low bond yields, low investment returns, the demise of define-benefit pensions, higher cost-of-living and an ongoing jobs crisis are basically condemning the current and future generations to lifelong job insecurity and pension poverty in their not-so-golden years.

And while you'll read sensible articles on 3 ways to solve the retirement crisis and 11 things about 401(k) plans we need to fix now,  the truth is America's 401(k) nightmare continues despite the stock market hitting an all-time high. Now more than ever, millions of Americans are anxious about retirement and politicians are ignoring their plight.

This last point is underscored by Rick Ungar's excellent article published in Forbes, The Retirement Crisis Is Here For Millions-Income Inequality Now Set To Wreak Its Ugly Revenge:
The Employee Benefits Research Institute (EBRI) has today released its report highlighting the intense state of insecurity American workers are experiencing as they look forward—with ever increasing trepidation—to a retirement without sufficient money to see them through.

According to the data, American workers have very good reason to be afraid.

Per the survey conducted by EBRI, 57 percent of American workers currently have less than $25,000 in total savings and investments (excluding the value of their homes) put aside for retirement. In 2008, that number was 49 percent. As a result, almost 50 percent of the nation’s workers are either “not too confident” or “not at all confident” that they will have sufficient resources to cover the bills in their retirement—while many who are feeling a bit better about the future may just be kidding themselves.

What’s more, it’s getting worse every year.

In 2009, 75 percent of the nation’s working class had managed to put something away for retirement, even if the amount was insufficient to take care of them in a time of increasing prices and rising life expectancy. Today—just four years later—that number has fallen to just 66 percent of workers who have been able to set something aside for their sunset years.

These dramatic numbers should come as a surprise to nobody as the statistics have long made clear how badly worker income has stagnated in America since the 70’s.

As workers have increasingly struggled to pay their current bills, due to employee earnings remaining static at a time where the high end of the income scale rose to unprecedented heights, it has become all the more difficult for these people to set aside money for their retirement. Further, the decline of the private sector union movement and the end of the defined benefit retirement plans that were once provided to workers as a part of their employment package have only served to make the problem worse.

If you are somehow unaware of the historic stagnation in the wages paid to the American worker since the 70’s, these bullet points, compiled by the Center on Budget and Policy Priorities and based on the Census survey and IRS income reports, should open your eyes:
  • The years from the end of World War II into the 1970s were ones of substantial economic growth and broadly shared prosperity.
  • Incomes grew rapidly and at roughly the same rate up and down the income ladder, roughly doubling in inflation-adjusted terms between the late 1940s and early 1970s.
  • The income gap between those high up the income ladder and those in the middle and lower rungs — while substantial — did not change much during this period.
  • Beginning in the 1970s, economic growth slowed and the income gap widened.
  • Income growth for households in the middle and lower parts of the distribution slowed sharply, while incomes at the top continued to grow strongly.
  • The concentration of income at the very top of the distribution rose to levels last seen more than 80 years ago (during the “Roaring Twenties”).
  • Wealth (the value of a household’s property and financial assets net of the value of its debts) is much more highly concentrated than income, although the wealth data do not show a dramatic increase in concentration at the very top the way the income data do.
The point is further graphically made by the following CBO chart (click to enlarge):

As for the availability of the retirement plans that were once provided in return for years of service to one’s employer, the ERBI study notes that, in 1979, twenty-eight percent of American workers were the beneficiaries of defined benefit programs which guaranteed them an income from the day they retired until the day they died.

Today, that number is just 3 percent.

And then there is the decline of the private sector union movement that, in 1970, saw membership peak at 17 million Americans holding union cards. Today that number is just 7.2 million workers.

As all of these worker punishing factors began at roughly the same time as millions of Americans who are now reaching the age of retirement would have begun saving for their non-working years, should anyone be surprised that the average American is now facing a longer retirement without anywhere enough money to pay for it?

Still, what continues to amaze are the many Americans who will find themselves facing true economic disaster as they enter retirement and yet have, these many years, supported the policies of politicians that cheered the income inequality that has created this crisis as somehow being the true expression of American style capitalism. Worse still, these are the very politicians who now seek to cut social security benefits—already insufficient to cover the true costs of retirement—and Medicare.

Soon, millions of Americans will more fully understand the dreadful price to be paid for having backed the wrong horse as the country is left to deal with a serious senior crisis brought on by two generations of employers unwilling to properly compensate workers for their contributions and public policies that rewarded this greed.

You see, while Sarah Palin and friends were quick to declare legislation designed to solve a serious social problem (yes, I’m talking about Obamacare) as the coming of “death panels”, the true death panels—the faceless men and women who formulated the corporate greed policies that will send our seniors into retirement completely unprepared—have been at work in America for many years.

One of the greatest tragedies a decent society can experience is the abandonment of its elderly. We have set the stage for that tragedy to play out in America through policies that have denied millions the opportunity to properly save for their retirement.

The question is, what will we do now?
Unfortunately, nothing is being done to address America's new pension poverty. Both parties continue to pander to the financial elite, giving them tax breaks, bailouts and other forms of government subsidies, but nothing significant is being done to address the ongoing jobs crisis and the looming retirement crisis.

However, I'm no doom and gloom cynic, far from it. I'm bullish on America, think it will continue to lead the the world in the coming decades, but bitter partisan politics threaten to crack the foundations of its democracy and if politicians don't come together to hammer out bipartisan solutions, they will jeopardize the country's long-lasting economic prosperity. And a weak America isn't in anyone's best interests.

Below, radio talk show host, Leslie Marshall, discusses the survey just released by the Employee Benefit Research Institute revealing that 57% or the people nearing retirement have less than $25K in savings, and 28% have no confidence they'll have enough to retire. She speaks on Megyn Kelly's "America Live" (FNC 3/19/13), along with Melissa Francis, and Chris Plante.

Interesting discussion but some statements are factually wrong and totally biased. As I stated in a recent comment, think it's high time the United States does the unthinkable -- expand Social Security to bolster retirement benefits for all Americans and adopt the same management and governance standards as the Canada Pension Plan Investment Board and other large Canadian public pension plans.