Friday, November 29, 2013

Is Canada on the Right Path?

Jack Mintz, Palmer Chair in Public Policy at the University of Calgary, wrote an op-ed for the National Post, Affluent Canadians don’t need more government help in providing security for their old age:
With the federal-provincial-territorial Ministers of Finance meeting coming up in December, the semi-annual build-up for CPP reform comes to a head. The latest is a proposal by Prince Edward Island to expand the CPP for “modest” income recipients.

Although it is not easy to find a public version of the PEI proposal, my understanding is it would double the pensionable earnings limit, increase the replacement rate from 25% to 40% for incomes between $26,000 and $52,000 and bring in a new replacement rate of 15% for earnings between $52,000 and $104,000. Employer and employee payroll taxes jump to 3.1% of earnings over the $26,000 threshold. And to make the benefits fully funded, the benefits are increased over time so that the young are not paying for new benefits paid to an older generation – existing retirees will see no increase.

So far, governments are concerned about hiking taxes when the economy is still in a moribund state — that’s the main opposition against CPP expansion at this time. However, it might be useful to ask whether CPP expansion makes sense at all since Canadians will be forced to contribute more money into the CPP fund, putting them on the hook for any future shortfalls.

To begin, a serious question has to be raised regarding the state’s role in providing replacement income for high-income households. Most young households have two-earners so when they retire they will have access to Old Age Security and CPP as well as pensions, RRSPs, TFSAs, housing equity and other taxable assets. Just taking OAS and CPP alone, elderly couples will have at the maximum close to $37,500 in total payments, amounting to a 60% replacement rate for last year’s working income up to $62,000. This is a bit shy of average family income but reasonable once other retirement assets are included.

The PEI proposal would provide replacement income for earnings up to $104,000 per individual. For married couples, this would be over $200,000 in family income. I suspect most would agree that the state should not guarantee replacement family income for earnings well above the average since people have various means to ensure income security during their own planning. The question is, up to what family income level does the state need to provide support? Surely it is not $200,000.

After all, people have to make many choices to ensure that they have adequate retirement income. Most Canadians save enough for retirement — a recent Statistics Canada study suggests that 60% of Canadians actually save too much for retirement. Young people have the pressure of raising families and buying a new home (generally a Canadian’s most valuable retirement asset net of taxes). Increased CPP payments can therefore crowd out other important saving decisions.

Those in the middle class paying more into the CPP rather than holding other tax-sheltered assets earning the same implicit return will be worse off. The current personal income tax provides a miserly tax credit for CPP contributions at the low-income tax rate with the future benefits taxed at higher tax rates for middle and high income families. By forcing people to pay more into the CPP and reducing other investments like housing equity, RPPs, TFSAs, and RRSPs, they lose tax deductions under the personal income tax (I do wonder if union members understand this tax cost to them since RPPs are often integrated with the CPP). This could be fixed by making CPP contributions deductible from income but at a significant cost to governments.

Caution is called for. I personally supported some expansion in the CPP that would help those with modest middle incomes as well as reduce future GIS payments for those currently protected from poverty. I am no longer convinced that CPP expansion is the right focus for policy. Here is why.

As a result of earlier studies, we’ve all become convinced that we have solved the poverty problem for the elderly. Perhaps that is true for couples but not singles.

Phil Bazel, a research colleague, and I have looked at incomes of elderly families of different types. Almost 40% of the total elderly population are married couples (both 65+) with a poverty rate of only 1.9% (based on an average low-income cut-off income of roughly $20,000 — which is net of taxes and includes government transfers. But another third of the elderly population population are singles living alone. Among those singles, about 20% are below the low income cut off of $16,000.

In my mind, this suggests the real financial problem facing older Canadians occurs when they are alone. Females dominate the single elderly need since many raised families and thus have logged fewer years of work. Males also typically die at a younger age. When a mate passes away, an OAS payment disappears and CPP spousal benefits are reduced to 60% of the spouse’s CPP benefits (GIS payments at least provide a buffer).

CPP expansion therefore inefficiently deals with income security since many two-earner families have less need for support. Public policy should focus on the single-elderly, whether by revamping the GIS for singles, increasing CPP spousal benefits or some other policies. And governments should get on the right track before forcing people to put more money into something they may not need.

Protecting Canadians from poverty is a legitimate role for the state; helping above-average-income families protect their incomes is not.
I thank Jack Mintz for publishing this article and actually agree with him on one issue, Canada is failing miserably to support single elderly women during their retirement years and the focus should be on this subset of our population. And he's right, CPP expansion would do little to help these women get out of poverty.

But I disagree with his other comment that expanding the CPP is bad because it forces people to pay more into the CPP, reducing other investments like housing equity, RPPs, TFSAs, and RRSPs, and they lose tax deductions under the personal income tax. So what? I think this is a good thing. RRSPs are a miserable failure and even though I personally love TFSAs (tax free gains are the best!!!), they are a failure too because most Canadians are not saving and when they do contribute, they get eaten alive on fees by closet indexers.

As far as Canada's housing bubble, it keeps defying gravity but this too will come to an abrupt end. I know, there are millions of rich Chinese, Russian and Middle Eastern immigrants that will keep buying luxury condos for their kids to study in Canada and second homes for an insurance policy, but they will get clobbered along with everyone else investing in Canadian real estate at these prices.

Yesterday, I attended a conference in Ottawa sponsored by the University of Calgary's School of Public Policy and CIRANO. The speakers included Jean Charest, the former Premier of Quebec who now works at McCarthy Tétrault, and David Dodge, one of the best Governors the Bank of Canada ever had (although I think Steve Poloz will be another great one). Among the attendees, I saw Bob Baldwin, a former board of director at PSP Investments, Jean-Claude Ménard, Canada's Chief Actuary, Alain Giguère, an NDP member of Parliament, Bernard Morency, the Caisse's Executive Vice-President, Depositors, Strategy and Chief Operations Officer, and Henri-Paul Rousseau, the former President and CEO of the Caisse (Rousseau had tears of joy when he saw me or more likely, a bad Caisse of heartburn).

I sat next to Bernard Dussault, Canada's former Chief Actuary, and the most knowledgeable person on pension policy in our country. If you're a union or government wanting to reform your pension plan for the better, you should contact him via email ( as he does independent consulting work. What I like about Bernard is that apart from being an outstanding actuary, he's highly ethical and will never renounce his principles no matter what. He also has a great sense of humor.

We shared quite a few personal anecdotes and realized that we have a lot in common. He also promised to write a blog comment with his thoughts on improving our pension system. He told me that New Brunswick's pension reforms are not shared risk. "What the government calls risk sharing is more risk dumping" (Bernard is referring to the cost of living clause the reforms introduced).

It was a great little conference and I was disappointed not to see any current presidents of Canada's top ten (think many of them were in Toronto for Jim Leech's retirement party). Bob Baldwin told me he saw Gordon Fyfe, PSP's President and CEO, on Wednesday at PSP's annual public meeting 2013. Bob made me laugh so hard when he said "all three of us attended" (actually, it's sad that nobody attended but PSP did a lousy job advertizing it. If I knew, I would have attended. Guess they didn't want tough questions on their hefty payouts, which were merited but obscene by the standards of most Canadians and federal government civil servants).

I think the presentation that got a lot of us thinking was the one by Kevin Milligan, an associate professor of economics at the University of British Columbia. He argued convincingly that lower income Canadians are better off in retirement now and forcing them to pay more into the CPP will leave them worse off. You can read the paper he co-authored with Tammy Schirle of Wilfrid Laurier University by clicking here. The two main conclusions of their paper are:
1) CPP reform that expands coverage for lower earners can do them harm--it transfers income from a period they are doing poorly (while working) to one in which they were already doing better (retired).

2) An expansion of the CPP that simply expanded the year's maximum pensionable earnings (YMPE) upwards would have nearly the same impact on combined public pension income as the PEI proposal, but with greater simplicity.
Fabrice Morin of McKinsey & Company presented thorough bottom-up evidence on which group of Canadians are ready to retire. You can download McKinsey's paper, Are Canadians Ready For Retirement?, by clicking here.

Professor Jim Davies of the University of Western Ontario, spoke on payroll taxes and their effects on the economy. He shared this with me:
If CPP enhancement has effects on the macroeconomy they will come through impacts on saving and employment. Empirical studies in Canada, the U.S. and Europe suggest that for every dollar of contributions to an unfunded mandatory public pension system, private saving declines by about 30 to 40 cents. Since the general expectation is that CPP enhancement would be funded, this displacement effect will be more than offset by increased public sector saving that will channel funds to the CPPIB. For a dollar of new contributions we can expect that national saving will rise, perhaps by 60 - 70 cents.

This should lead to a higher capital stock and more growth in the long-run, assuming that a reasonable share of the extra CPPIB funds are invested in Canada. Employment effects can be expected in the short-run if, as has always been the case, higher contributions are split between employers and employees. In the long-run, empirical studies indicate, the employer portion will be almost completely shifted onto workers. But in the short-run unit labour costs will rise, causing some reduction in employment. Fortunately the effect is relatively small, and can be reduced by phasing increased contributions in slowly over a number of years.
The afternoon session featured speeches by David Dodge, Jean Charest and Janice MacKinnon, the former Minister of Finance of Saskatchewan who is now a professor of fiscal policy at the University of Saskatchewan.

David Dodge said he was all for DB plans and emphasized the importance of risk sharing and multi-employer plans to address pension portability. I agree with risk sharing, not risk dumping as Bernard Dussault calls it, but I'm not a big fan of hybrid or multi-employer plans. 

Importantly, if we get companies out of the business of managing pensions and enhance the CPP, pension portability wouldn't be an issue and we wouldn't need these multi-employer plans which severely underperform our large Canadian public pension funds.

Ms. MacKinnon praised the earlier presentations and basically concluded that we shouldn't tinker with the CPP. She is an advisor to Jim Flaherty, Canada's Minister of Finance, who is way behind the curve when it comes to pension reforms. He should stop pandering to the financial services industry and heed the warnings of Ontario Premier Kathleen Wynne.

Mr. Charest spoke eloquently about the reforms his government introduced in Quebec to help older workers remain in the workforce and allow more women to enter the workforce. His government also implemented reforms to improve daycare and support parents raising their young infants. He said the birth rate in Quebec is now the highest in the country which is why he's the "father of a nation" (Haha! Wish he was still our leader instead, more charter of values nonsense!)

Mr. Charest also made an excellent point that Canadians are not only living longer, but the quality of life has drastically improved for our seniors and this is redefining the way we view retirement. He said that the provinces basically run the country and that policy must encourage older workers to stay in the workforce.

I told all three of the afternoon speakers that I agree with Bernard Dussault that we overly complicate pension policy instead of keeping things simple. Canada has some of the best public pension funds in the world and we should build on their success, not try to reinvent the wheel or introduce policies that are doomed to fail. Also, we need to recognize the benefits of DB plans to our economy and bolster them for all Canadians.

Again, I think all the speakers and attendees of this conference need to take the time to read The Third Rail, the book Jim Leech co-authored with Jacquie McNish. I gave my personally autographed copy to Jean Charest at the end of the conference and told him to read it and spread the word. If I had more copies, I would have given one to David Dodge and Janice MacKinnon.

I will edit this comment as needed over the next few days. I really liked the concluding remarks from Jack Mintz and hope to add them here.

Below,  Jim Leech, President and CEO of the Ontario Teachers' Pension Plan, discusses the three fundamental changes needed to drive meaningful pension reform. Listen to him carefully and make sure you buy The Third Rail. It's too bad Jim isn't running for office, he would make a great Minister of Finance.

Wednesday, November 27, 2013

Crown Corporation Pensions in Trouble?

Vanessa Lu of the Toronto Star reports, Canada Post faces $1B pension shortfall:
Canada Post warns it will need a significant cash infusion by the middle of next year to meet pension payment obligations estimated at $1 billion.

“Based on our current financial projections, we believe we are going to require additional liquidity by mid-next year,” said Canada Post spokesman Jon Hamilton. “We’re talking to the shareholder, the government, about options to address the challenge.”

Hamilton had no specifics about what that might entail, whether it would be increased borrowing or a subsidy, though Hamilton said Canadians have made it clear they don’t support such government subsidy.

The warning about a cash shortfall was tucked inside the corporation’s third quarter earnings, which were released Thursday. The Canada Post segment lost $129 million, before tax, in the third quarter, an improvement from last year’s $161 million, in the same period.

The improvement was attributed to labour savings, as the company adopts changes to delivery methods, including having one carrier deliver both parcels and letters in a small van.

For Canada Post, the obligations of the pension plan are a growing concern, in part due to low interest rates. While the plan has assets with a market value of $17 billion, its pension solvency deficit – the amount needed to meet obligations if it were wound up – is estimated at $5.9 billion as of the end of 2012.

Canada Post has been making its current service contribution to the pension plan, with $203 million paid in the first three quarters of the year, estimated at $269 million for the year, plus special payments of $28 million.

According to the management discussion & analysis report, in 2012, the federal government allowed Canada Post to delay making back payments to top up the deficit until June 2013, but then extended it again until June 2014, but it will be on the hook for $1 billion in 2014.

“These options include seeking additional pension regulatory relief and securing additional financing,” the report says. “Canada Post is also looking for support to restructure its business model and pension plan framework to assure its long-term financial sustainability.”

Canada Post is trying to figure out how to reinvent itself in the age of email, texting and Skype. Letter mail volumes keep falling, dropping 7 per cent – or 73 million fewer pieces -- in the third quarter, compared to the same period a year ago.

Parcel revenues were up by $32 million, or 11 per cent in the third quarter, thanks to increased online shopping. Volumes were up by more than 1 million items from the same period last year, but it wasn’t enough to offset the drop in mail demand.

Canada Post is looking at ways to cut costs including looking at ending door-to-door delivery or alternate-day delivery, though it has no timelines of when it will put forward a proposal.

“Our focus is on transforming the business to serve the future needs of Canadians,” said Hamilton. “There is a lot less mail and a lot more parcels.

“We have been gathering feedback from Canadians so that we can put forward the changes that are needed,” he added.

It is unclear what the federal government will do. In March, Air Canada, which was also facing a whopping pension solvency deficit, won an extension to stretch out its outstanding payments.

Under that deal, the airline promised to pay at least $150 million a year, with an average of $200 million a year, totaling at least $1.4 billion until 2021. In return, Air Canada had to cap executive pay and is barred from issuing any dividends or share buybacks

Transport Minister Lisa Raitt is in charge of Canada Post, and her office declined to say what measures are being discussed, emphasizing Canada Post is responsible for its own operational decisions.

“Since 1981 Canada Post has had a mandate to operate on a self-sustaining financial basis. We are very concerned that they are posting significant losses,” the statement said.
My advice to Canada Post is to immediately stop delivering mail every day. Traditional mail should be delivered only three times a week, on Monday, Wednesday and Friday. Exceptions can be made for business parcels and important registered mail, but Canada Post needs to cut costs and compete more effectively with UPS and FedEx.

Canada Post's Pension Plan is headed by Doug Greaves who has an impressive resume:
Doug Greaves, Vice-President Pension Fund and Chief Investment Officer, has extensive investment management experience in bonds, equities and alternative investments. Doug joined Canada Post at the inception of its Pension Plan in 2000, and was responsible for developing and implementing the Plan’s investment strategy, hiring all Plan employees and establishing Plan administration and investment operations. Today, Doug is responsible for managing all aspects of the $15-billion Plan, including pension investment and plan member administration activities.

Doug has broad investment experience managing Canadian and U.S. equity and bond portfolios as well as private equity and real estate investments. Prior to joining Canada Post, he held senior investment positions with Workers Compensation Board, Ontario Municipal Employees Retirement Board and North American Life Assurance Company.

Doug received his Honours in Business Administration (HBA) from the Richard Ivey School of Business, University of Western Ontario, and is a CFA Charterholder. Doug is a member of the Pension Investment Association of Canada, the Canadian Coalition of Good Governance and the Institute of Corporate Directors. Doug is also a member of the Investment Committee of the United Church Pension Fund.
You can review the report to members here. The 2012 Report to Members contains a stern warning from Deepak Chopra, Canada Post's President and CEO:
“Defined benefit pension plans across Canada are facing unprecedented challenges. The size of (the) demographic and economic shift can no longer be managed by investment returns alone. Even with a healthy Plan sponsor, in the absence of meaningful changes to the pension plan, the Corporation simply cannot sustain the Plan’s funding requirements.
Not all Crown corporations suffer the same fate as Canada Post in terms of their pension plan. The CBC, another Canadian Crown corporation, has an excellent pension plan. You can view highlights from the CBC Pension Plan's annual reports on their website. I checked out the highlights of their 2012 Annual Report and note the following:
  • Net Assets have increased for a 5th straight year to $5.3 billion at December 31, 2012 (2011: $5.1billion);
  • The Going Concern surplus is now in excess of $1 billion (2011: $947 million) and results on a Going Concern funding ratio of 124% (2011: 123%);
  • The Solvency deficit increased to $(519) million (2011: $(385) million) and results in a Solvency funding ratio of 91% (2011: 91%);
  • 2012rate of return was 8.1% vs. the asset benchmark of 7.5%;
  • 4-year annualized rate of return was 12.5% vs. the asset benchmark of 11.9%;
  • Benefit payments totalled $254 million in 2012 (2011:$238million);
  • Fund administrative costs were $21 million and equates to 30.2 cents(2011:42.0 cents) per $100 of average assets which is less than the benchmark comparative of 65.9cents per $100;
  • Overall member service satisfaction levels of the Pension Benefits Administration Centre remain high with 93% (2011:92%) of the members surveyed rating services as excellent or good.
Debra Alves, the Managing Director and CEO of CBC's Pension Plan, and her small team are doing an outstanding job managing the plan. Their solvency deficit doesn't really concern me and even though they're not part of Canada's top ten, their four-year annualized rate of return is among the best for Canadian public pension plans.

Now, it's not fair to compare Canada Post's Pension Plan directly to CBC's Pension Plan and that is not the purpose of my post. I'm sure Doug Greaves and his team are doing a great job and the billion dollar pension deficit is not their fault. Canada Post has been hemorrhaging  money and a pension plan is only as strong as its sponsor.

But that brings me to my topic du jour. There are a bunch of Canadian Crown corporations that have their own defined-benefit pension plan and we know little or nothing about the state of these pension plans unless disaster strikes and they run to the federal government asking for money to plug the hole.

I was told the Treasury Board is reviewing the pension plans of all Crown corporations and will release a similar report to the one it did reviewing their governance framework. Such a report, as well as a separate one from the Auditor General of Canada, is long overdue. Canadians deserve to know the state of the pension plan of every single Crown corporation. They should adopt the same transparency as CBC and Canada Post, publishing annual reports on their pension plan.

One thing I do know is that some Crown corporations have moved away from defined-benefit plans, much to my disappointment. For example, the Export Development Corporation (EDC), one of the oldest and most important Crown corporations in Canada, no longer offers DB plans to its new employees, only a DC plan. The Business Development Bank of Canada (BDC) still offers a DB plan to its employees and last I heard, its plan is in very good shape (still, the BDC should publish a separate annual report on its pension plan like the CBC).

As far as CPPIB and PSPIB, the two giant Crown corporations managing pensions, their employees are offered defined-benefit plans but they are not allowed to invest in their own fund. I remember complaining about that to Gordon Fyfe when I was working at PSP but he told me the rules were put in place to reduce conflicts of interest (pretty stupid rules because you want your pension fund managers to have skin in the game!!!).

Anyways, all this to say we need a hell of a lot more transparency on the pension plans of Crown corporations and I think CBC is the model to follow in this regard. Canadians are fed up with the lack of transparency in the federal government and they deserve to know a lot more about what is going on with their Crown corporations. The Treasury Board should publish an annual report on Crown corporation pension plans.

Below, a CBC interview with Denis Lemelin, the national president of the Canadian Union of Postal Workers, on the future of Canada Post (September, 2013).

Tuesday, November 26, 2013

OECD's Pensions at a Glance 2013

Julian Beltrame of the Canadian Press reports, OECD warns pension safety net fraying as poverty among seniors rises in Canada:
An international think-tank warns that poverty among Canadian seniors is on the rise and that current pension safety nets may be inadequate to address the problem.

For instance, as poverty rates were falling in many OECD countries between 2007 and 2010, in Canada they rose about two percentage points.

As well, the report notes that public (government) transfers to seniors in Canada account for less than 39% of the gross income of Canadian seniors, compared with the OECD average of 59%, meaning more Canadians depend on workplace pensions to bridge the gap.

Meanwhile, public spending on pensions in Canada represents 4.5% of the country’s economic output, compared with and OECD average of 7.8%.

Canadian seniors depend on income from private pensions and other capital for about 42% of their total.

“As private pensions are mainly concentrated among workers with higher earnings, the growing importance of private provision in the next decades may lead to higher income inequality among the elderly,” the report warns.

“Those facing job insecurity and interrupted careers are also more exposed to the risk of poverty because of the lower amounts they can devote to retirement savings.”

The report notes that rising poverty among Canadian seniors, although still relatively low, is most acute among elderly women, especially those who are divorced or separated.

“Higher poverty among older women reflects lower wages, more part-time work and careers gaps during women’s working lives,” the report said while also noting “the effect of longer female life expectancy … for which many women have not been able to save enough.”

The OECD says Canada’s current pension support, both private and public, replaces only about 45% of average pre-retirement gross income, well below the two-thirds that may experts recommend.

Among lower income Canadians, however, the replacement rate is 80%.

Some provinces, particularly Ontario and Prince Edward Island, have been putting pressure on the federal government to move ahead with expanding the Canada Pension Plan which, along with Old Age Security, represents the main source of public transfers to seniors in the country.

But federal Finance Minister Jim Flaherty has so far rejected the approach, saying the economy is not strong enough to withstand the added premiums on firms and individuals expansion would entail.

Last year, the federal government also cut back on the OAS program by raising the age of eligibility to 67 from 65 effective in 2023.

Canada’s approach is not unusual, however. The report notes that following the 2008-09 crisis, pension reform has been widespread throughout the OECD, with many moving to a higher retirement age of 67.

“Some countries have gone even further, moving to 68 or 69 years, though no other country has gone as far as the Czech Republic, which decided on an open-ended increase of the pension age by two months per year,” the OECD adds.

Another innovation being adopted by some countries is tying future benefits with demographic and economic growth projections.

The OECD notes that many if not all countries are facing challenges with aging population, slow economic growth and governmental fiscal concerns.
Elsewhere, Phillip Inman of the Guardian reports, OECD praises UK pension reforms:
Britain has one of the most comprehensive pension reform programmes in the developed world, according to the Organisation for Economic Co-operation and Development.

While other countries have focused on tackling the growing burden of future pension costs by raising the state pension age or improving incentives for older workers to stay in the jobs market, the UK has pursued every avenue to both improve the lives of older people and cut the cost of providing them with a decent income, said the OECD.

The Paris-based organisation said the UK had raised the average incomes of people above the retirement age and introduced plans to expand coverage through the workplace pension savings scheme Nest, which is expected to expand private saving to 10 million more workers over the next three years.

But it said the knock-on effect of policy reforms, many of which protect the benefits accrued by older workers at the expense of young employees, was that in many OECD member countries younger workers were now more at risk of poverty than retirees.

"Pension reforms made during the past two decades lowered the pension promise for workers who enter the labour market today. Working longer may help to make up part of the reductions, but every year of contribution toward future pensions generally results in lower benefits than before the reforms," it said.

"The reduction of old-age poverty has been one of the greatest social policy successes in OECD countries. In 2010, the average poverty rate among the elderly was 12.8%, down from 15.1% in 2007, despite the Great Recession. In many OECD countries, the risk of poverty is higher at younger ages."

The report Pensions at a Glance 2013, says many countries have failed to construct adequate protection for low earners. In the UK, the voluntary Nest scheme, which has proved popular with employees in the small number of companies to use it so far, could leave many people without the top-up retirement provision experts believe will be needed to have a decent standard of living in 20 or 30 years time.

The OECD points out that personal pensions based on stock market returns favoured by British politicians have inherent risks and may fail to deliver adequate returns over the longer term.

It said Poland and Hungary had ditched schemes that rely on stock market returns while the UK, the Czech Republic and Israel have expanded them.

In many countries older workers have come to see their homes as a potential source of income in retirement, whether following a sale or through equity release. The OECD said it was not clear how prevalent or effective housing would be to boost incomes and countries needed to "explore in greater detail how housing and financial wealth can contribute to the adequacy of retirement incomes".

The thinktank also highlighted the benefit of public services to retirees and especially lower income groups. It said governments needed to win public support for public service provision that allows older people to continue working and living a decent life.

"Public support is set to play an increasingly important role in preventing old-age poverty among people requiring health and long-term care services," it said.

On most measures used by the OECD, the UK falls into the bottom half of the table. Public expenditure on pensioner benefits as a proportion of GDP is lower than the average along with pensioner living standards. Italy has the highest spending as a proportion of GDP whereas the Netherlands, which has a large private and workplace pensions top up, has the highest standard of living for retirees.

A rise in the retirement age to 67 in the UK means state expenditure is only expected to increase by 0.5% over the next 40 years to 8.2% of GDP, well below the +295 average of 11.7%.
Of course, while some are praising their reforms, the Express notes that Britain's state pension is one of the worst in the world as Britons on average wages can expect a pension worth just 33 per cent of their final salary when they retire.

You can download the OECD report, Pensions at a Glance 2013, by clicking here. The findings are worrisome for Canada because of the rise in poverty among seniors and the fact that public and private pensions replace about 45% of pre-retirement gross income, well below the two thirds experts recommend.

This report provides more ammunition for politicians warning of Canada's huge pension crisis and puts the pressure on the federal government to wake up and finally start taking pension reforms seriously. Importantly, the time has come to expand the Canada Pension Plan and enhance the retirement security of all Canadians.

Having said this, the OECD report should be taken with a grain of salt. The findings are very similar to those of the Melbourne Mercer Global Pension Index, which compares 20 countries with major retirement schemes. I covered that report in my comment on the world's best pension spots, and blasted it for placing Australia among the top spots to retire (I seriously don't understand why experts are extolling pension lessons from Down Under).

One thing everyone agrees on is the Dutch are way ahead of everyone else when it comes to pensions. Below, as cities and states across the U.S. grapple with their pension programs, PBS travels to one country -- The Netherlands -- that seems to have its pension problem solved. Ninety percent of Dutch workers get pensions, and retirees can expect roughly 70% of their working income paid to them for the rest of their lives.

Olaf Sleijpen of the Central Bank of the Netherlands says "I think what makes it successful is that you basically force people to save for their old age." I agree, and even though Dutch pensions are on the decline, the Netherlands is years ahead of most countries when it comes to ensuring retirement security for most of its citizens.

Monday, November 25, 2013

The Wall Street Code?

Jeffrey MacIntosh, Toronto Stock Exchange Professor of Capital Markets, Faculty of Law, University of Toronto, and author of C.D. Howe Institute’s “High Frequency Traders: Angels or Devils?” wrote a special for the National Post, In praise of high frequency traders:
On Thursday, the Investment Industry Regulatory Organization of Canada (IIROC) is scheduled to release its much-awaited study on high frequency traders. The standard image of the high frequency trader (HF trader) is that of a slavering troll working assiduously to destabilize world stock markets and laughing gleefully while prying gold fillings out of retail traders’ mouths. In the minds of many, HF traders caused or greatly contributed to the infamous U.S. “Flash Crash” of May 2010, when the Dow Jones plunged (and then recovered) 1000 points (roughly 9%) in a matter of minutes. HF traders also stand accused of increasing trading costs for both retail and institutional traders.

Academic evidence, however, suggests that HF traders sport toes, not cloven hoofs. Indeed, as noted by the European Commission, “HFT is typically not a strategy in itself but the use of very sophisticated technology to implement traditional trading strategies.” The essence of the “sophisticated technology” is speed. HF traders use highly refined computer algorithms to wade through reams and reams of data, spot profit opportunities, and execute trades to exploit these opportunities. HF traders also use “co-location” to enhance speed. This refers to the now-common practice of paying for the privilege of locating one’s servers in the same building as a trading venue’s computer matching engine (where trades actually get executed). This reduces system “latency” (the time it takes for a message to travel from the HF trader’s computer to the trading venue’s computer, and vice-versa) to a bare minimum.

The HF trader’s speed advantage in general, and co-location in particular, have been much vilified. But superior speed is neither new nor objectionable. Savvy stock traders have long enlisted the latest information technologies to gain an advantage over their rivals. At one time, carrier pigeons and optical semaphore systems were the preferred tools.These gave way, in succession, to the telegraph, the telephone, the Internet, dedicated data lines, and now, co-location. Being the first in line has been a source of profit as long as there have been tradable assets. That goes back not merely decades or centuries, but millennia.

While the clay-footed are never amused to see more fleet-of-foot rivals steal their business, a simple self-help strategy awaits – go out and get your own carrier pigeons. And indeed, more and more traditional players, such as sell-side institutions, are doing just that, putting their own servers in co-location facilities and competing head-to-head with HF traders.

But in any case, the corpus of academic evidence suggests that both retail and institutional traders have benefited from the presence of HF traders. Market making is a case in point. HF traders effectively “make a market” in particular stocks by posting limit orders to buy and sell on the books of various trading venues. However, they are able to quote much narrower bid/ask spreads than traditional market makers.

This is a direct result of their speed. HF traders have no interest in holding stock overnight. As soon as they purchase shares in a given company, they look to sell these shares, and often do so within milliseconds. The extremely short interval between the two legs of any round trip transaction (buy/sell or sell/buy) minimizes the extent to which the HF trader is exposed to what economists call “adverse selection risk,” which is the risk of adverse price movements between the first and the second leg of the round trip. This enables them to effectively quote very tight bid/ask spreads. The academic studies are virtually unanimous in suggesting that when HF traders arrive, bid/ask spreads shrink by a material amount. This benefits all other traders, whether retail or institutional.

HF traders have benefited from the now common practice of “maker/taker” pricing. This involves paying a rebate to the “passive” side of a transaction (the party who enters a limit buy or sell order on the books of a given trading venue) and charging a fee to the “active” side (a later-arriving order that is matched to the passive order, resulting in a completed trade). Speedy HF traders are more likely than others to be on the passive side of a transaction, and thus go home with the lion’s share of the trading rebates.

On the other hand, many non-HF traders (i.e. the ones who now disproportionately end up on the active side of the transaction) have seen their trading costs increase. Nonetheless, it is not clear if this increased trading cost is passed on to the client, as opposed to being partly or wholly absorbed by the market professional (as we would expect in a competitive market). But even if all of the cost is passed on to the trading client, reductions in bid/ask spreads more than compensate.
HF traders are associated with other improvements in market microstructure. For example, studies show that HF traders are more likely to be “informed” traders, and that their presence in a given market improves price discovery (the rapidity with which new information is impounded in the public share price). As against the charge that HF traders make financial markets more volatile, the studies show that when HF traders come calling, intraday price volatility (the degree to which stock prices fluctuate during the course of the day) actually diminishes.

And what of the Flash Crash? The Crash was triggered when a single U.S. mutual fund decided to liquidate $4.1-billion of something called the E-Mini S&P 500 (an equity futures contract based on the value of the S&P 500). Initially, HF traders absorbed some of this volume. However, when it came to executing the second leg of the round trip and selling the E-Mini to someone else, there was trouble. The volume of the mutual fund’s sale order was so large that it exerted a continual downward pressure on the price of the E-Mini. HF traders – just like traditional market makers – found that they could not buy cheap and sell dear. Many withdrew from the market, causing E-Mini liquidity to dry up. Even worse, the liquidity drought was transmitted broadly throughout the market, since the falling value of the E-Mini implied lower values of the stocks underlying the E-Mini contract – namely, the entire S&P 500. These stocks (and others) also went into a death spiral. The imbroglio was ended by a trading halt. Five minutes later, trading was restored, and the market recovered and marched stoically onward.

The Flash Crash is in indictment of HF traders only if we can conclude that they bailed from the market faster than traditional market makers. In fact, the evidence is precisely the opposite; some HF traders hung in until the bitter end. Moreover, numerous studies show that HF traders are slower than traditional players to run for the exits when the going gets rough. A market populated only by traditional market makers would not have avoided the Flash Crash.

Despite all of the favourable academic reviews, many institutional traders swear up and down that HF traders engage in a bevy of manipulative or otherwise unfair trading practices. One Canadian study by Cumming et al., however,finds that HF traders reduce the incidence of end-of-day price manipulation. A U.S. study finds that HF traders do not “front run” institutional orders, as has often been alleged. Nonetheless, the empirical record in this respect is not well developed, and there is certainly anecdotal evidence of dirty tricks being played by HF traders. Academics need to sharpen their pencils in this regard and Canadian regulators need to stay sharp and devise means of detecting these dirty deeds and punishing them accordingly.

A further caveat is that HF trading has led to an increasingly intense arms race with a view to shaving not merely milliseconds, but microseconds off system latency. At some point, the commitment of ever-larger sums of money to slicing ever-smaller fractions of time off trading times, just to be first in line, becomes socially counter-productive. In other words, the last chapter on HF trading has not yet been written.
On the same subject, Matt Levine, a Bloomberg columnist reports, High Frequency Traders Are a Little Too Slow:
High frequency trading is a wonderful subject for study because nobody agrees on what would make it Good or Bad. So academics and practitioners can write papers about how it is Good, or how it is Bad, and they don't particularly contradict each other because they measure different things and the actual thing that one wants to measure is hard to nail down and would probably be hard to measure even if you knew what it was.

So here we are with an interesting European Central Bank working paper from Jonathan Brogaard, Terrence Hendershott and Ryan Riordan about high frequency trading.* They're mostly for it, which has naturally gotten them some attention. They think that the things you should measure are along the lines of "does high frequency trading improve market price discovery?" and "does it provide liquidity?" and I guess if they thought it was Bad, they'd be asking different questions. But they answer yes to their questions: They find that high frequency trading improves price discovery, and that it does not cause instability by withdrawing liquidity during volatile periods.

You can quibble with these points if that's what you like to do with academic papers, and I don't know what else one would do with them, really. The "improves price discovery" thing comes with the important caveat, "for about three or four seconds"; after that the information is incorporated into the market. So HFT makes markets three seconds more efficient. Is that good?That question plummets quickly into metaphysics and, thus, into this footnote.**

You can quibble with the instability point too, but not up here.***

But here is an oddity. The authors look at what happens when negative macroeconomic news is announced, and then draw this chart (click on image below):

So: Starting about one second before the bad news is announced, HFT firms are actively selling (that is, demanding liquidity to sell shares -- red line). Starting at around the same time, stock prices are going down (gold line, right axis). On the other hand, starting about two seconds before the bad news is announced, HFT firms are passively buying. That is, they're supplying liquidity: They've posted bids and offers, and their bids are getting hit. That's the gray-green-blue-whatever-ish dotted line. The blue dashed line is the net HFT activity. In aggregate, HFTs buy on negative macro news, and would seem to lose money doing so.

The opposite happens on positive news: HFTs end up selling into positive news and losing money. As with negative news, the price changes and HFT liquidity demand occur about a second after the HFT liquidity supply (click on image below):

This is broadly consistent with the authors' view of HFT as a useful provider of liquidity -- basically, HFT firms are acting like market-makers here, taking the opposite side of trades that people want to make on news -- but the timing is quite weird. The apparent interpretation is that HFT firms are being beaten to the punch on economic news, by about one second, and losing money because of it. They leave their bids and offers up going into the news, and someone gets the news just before they do,**** and that someone trades against them and makes money off of them.

An important function of high frequency traders, apparently, is to get taken advantage of by people who are just a bit faster than them.

So that's odd, no?

But it seems to be basically true. The authors' sample of "HFT" is a Nasdaq data set of 26 large independent high frequency trading firms, which excludes big broker-dealers like Goldman who have some HFT strategies, as well as proprietary algorithmic trading firms that trade quickly but don't make a business out of trading constantly. Those firms might be more likely to react to fundamental news than the big pure-HFT firms, who trade based mainly on statistical-arbitrage-type market data (prices and order books) than on actual news releases.***** So the speedy algo traders profit off the ever-so-slightly-less-speedy-in-this-particular-case HFT traders.

What can you conclude from that? Well, for one thing, if your view of "high frequency trading" embraces "anyone who trades real fast with a computer," then you may not find this paper's positive conclusions about HFT entirely soothing. They're really about only one category of high frequency traders -- and the other category seems to be trading against them. If this paper's fast computer traders are Good, then it stands to reason that the fast computer traders on the other side might be Bad. The net effect remains murky.

Also, though, we have talked before about enforcement efforts to crack down on the sorts of fast computer traders who get economic data milliseconds before everyone else. At the time I found that crackdown puzzling, since it seems to protect not individual investors but other, slightly slower fast computer traders. If information comes out at 2 p.m. and your computer gets it at 1:59:59.999 and you try to buy with your information advantage, the only person who's selling to you at 2:00:00.006 is another computer. The little guy or Fidelity portfolio manager or whoever is actually reading the news with human eyeballs is whole seconds behind and thus totally safe.

And here you go. The people getting picked off by "high frequency traders," in the loose sense, when news is announced, are "high frequency traders," in the strict sense. Algorithmic market-makers get picked off by algorithmic speculators. A whole financial-markets drama occurs in the blink of an eye, and all you have to do to avoid it is blink.

* Like a lot of things in financial academia, this has been floating around online for a while in various forms, but it came out today under the ECB's quasi-imprimatur, which is a valuable quasi-imprimatur, so now we are talking about it.

** From the paper:

The fact that HFTs predict price movements for mere seconds does not demonstrate that the information would inevitably become public. It could be the case that HFTs compete with each other to get information not obviously public into prices. If HFTs were absent, it is unclear how such information would get into prices unless some other market participant played a similar role. This is a general issue in how to define what information is public and how it gets into prices, e.g., the incentives to invest in information acquisition in Grossman and Stiglitz (1980).

You might wonder what fundamental research HFT firms are doing to ferret out new information and make it public.

A thought experiment might be, if you delayed HFT access to economic events by three seconds, would they still have three-second advantage over non-HFT traders? What if you delayed them by five minutes?

*** The authors look at HFT behavior in the top 10 percent most volatile days, compare it to the bottom 90 percent most volatile days, and find that HFTs provide similar amounts of liquidity. A plausible model of HFT might be "volatility is profitable but blind panic is bad," meaning that you'd supply more liquidity in the 90-to-99.5 tranche of days but much, much less in the top 0.5 percent. That model would lead to yearly, not biweekly, flash crashes, which is kind of what happens, but the paper looks at the more modest top-10-percent-of-volatility-days thing.

**** And before it comes out? The authors use Bloomberg time-stamps to measure second 0 (the time the news comes out), so arguably second -1 or whatever is the actual time it comes out and it takes some time to get up on Bloomberg, but the trading 2 seconds before the measured announcement time does seem weird.

***** I owe this point to a conversation with Terrence Hendershott, one of the paper's authors. Incidentally, if you accept that HFT firms react only to market prices and orders, and not to fundamental news, then that Grossman-Stiglitz point in footnote ** gets especially metaphysical.
William Barker and Anna Pomeranets of the Bank of Canada also published a brief research paper back in June 2011, The Growth of High-Frequency Trading: Implications for Financial Stability, and concluded:
HFT is playing a significant role in markets today. It began in equities and rapidly spread to other asset classes, such as FX, linking these markets through cross-asset-class trading strategies and heightening  concerns about its relative merits.Yet the overall impact of HFT on financial markets and its ability to penetrate further into financial systems remains unclear.

Although there are benefits associated with HFT, its effects are not yet fully understood, in terms of either growing market penetration or stressed markets. HFT has therefore created new challenges for public policy-makers, who will have to monitor and address the potential risks that HFT poses to financial markets and financial stability. While self-regulated markets may be more likely to address these risks independently, other markets may require a regulatory push in either case, public input and coordination between various financial markets.
Finally, Chris Sorensen of Maclean's reports, The dangers of high-frequency traders:
Greg Mills, the co-head of RBC Capital Market’s global equities division, is sitting in a dimly lit conference room in the bank’s downtown Toronto headquarters. He’s attempting to demonstrate how high-frequency traders, or HFTs, frustrate even the most routine of RBC’s stock trades. “Are you ready?” he asks. Mills taps the spacebar on his MacBook Air and launches a simulation of a hypothetical buy order. Dozens of little squares, each representing a bid or ask order, suddenly begin to fly around the screen.

Mills explains that HFTs launched a flurry of split-second trades the moment RBC hit the send button. “In some instances, the HFTs who we had expected to buy stock from, bought stock ahead of us, and then began to sell stock back to us,” Mills says. The take-home point is RBC paid a fraction of a penny more for each share than it expected to—and that can quickly add up. “We’re trading hundreds of millions of shares a day, and this implicit tax is constantly being extracted,” he says. “It’s being extracted from real investors.”

Mills is far from the first to raise concerns about the impact of HFTs. Their controversial approach relies on super-fast computers and complex algorithms to make hundreds of rapid-fire trades in the blink of an eye, collecting a few pennies each time. Though the technique is most closely associated with firms like Citadel and Jump Trading, it’s also used by a host of other financial players, including RBC (although Mills argues that RBC doesn’t engage in any “predatory” behaviour). Either way, high-frequency trading has become a major force in the stock markets, accounting for about half of all trades in the U.S. and slightly less in Canada.

Yet, despite its rapid growth over the past decade, the impact of high-frequency trading on the overall market is poorly understood. HFTs have been blamed for exacerbating the 2010 “flash crash,” when the Dow briefly plummeted 1,000 points in just a few minutes, and they’re at the centre of a recent scandal involving Thomson Reuters, which was selling key market data to high-paying clients two seconds before everyone else. “Who’s going to invest knowing they’re set up to lose?” New York Attorney General Eric Schneiderman recently asked.

Proponents of the highly automated approach point out that HFTs mostly compete with other computers, and that the benefits HFTs bring—like increased liquidity—far outweigh any costs. A fraction of a penny, it’s argued, will hardly make a difference to average investors who measure returns in weeks, months or years. But the same can’t easily be said for the giant pension funds and mutual funds where most regular folks park their retirement savings. Equally troubling, the rise of HFTs has called into question the role of stock exchanges, which benefit from the huge volume HFTs trade on their platforms. “I would say the exchanges are complicit in enabling the activities of HFTs,” says Mills, who is one of several people proposing a rival stock market to the Toronto Stock Exchange that promises to clamp down on the practice. “It allows them to execute their strategies and give them an advantage over traditional investors.”

The stock market has always been a great place to lose one’s shirt, but the rise of HFTs offers yet another troubling example of how the system increasingly favours a few sophisticated insiders—more than likely, at the expense of ordinary investors.

High frequency traders employ a variety of strategies, but the common thread in their algorithms, or “algos,” is sheer speed. One common technique is latency arbitrage. It aims to capitalize on the fact it takes digital information longer to reach some places than others. It may take a few milliseconds more for trades on, say, the NASDAQ’s servers in New Jersey to be crunched by America’s clearing house for stock trades and reflected in the National Best Bid and Offer, which is the best available price for a given security. If the HFTs can grab the data and make the calculations before it’s posted on the NBBO feed, they are in a position to make a quick profit—especially if they do it a few thousand times.

How do they get the data before everyone else? For one thing, most HFTs pay big money to “co-locate” their servers in the same buildings as major exchanges, ensuring they have direct access to market information. They have also sparked an arms race in fibre optic and other electronic connections between major trading centres around the globe. Due to demand from HFTs and other electronic traders, new fibre optic cables were laid between Chicago and New York that went through the Allegheny Mountains instead of following railroad right-of-ways. HFTs are also increasingly looking to above-ground microwave transmitters to carry their signals since, unlike fiber-optic cables, microwaves promise a direct, line-of-sight route that avoids the curvature of the Earth. One company, Perseus Telecom, is even proposing a network of microwave transmitters over the Atlantic held aloft by a network of weather balloons—suggesting no idea is too crazy when there’s potentially millions to be made with little or no risk.

While the strategy—speed—is simple, HFTs’ methods can be complex. Rebate arbitrage takes advantage of the rebate incentives stock exchanges pay out to liquidity providers—anyone who stands ready to buy or sell securities at a quoted price. It doesn’t matter if the HFTs make money in the trades themselves—as long as they don’t lose more than the value of the rebate. Another approach attempts to quietly detect patterns—a big block of shares being unloaded in small chunks—and then rapidly trade on the information. Still others attempt to trick other computers into launching a flurry of trades in the hopes of capitalizing on a rapid price movement.

Of particular concern for securities regulators is whether all of this light-speed trading has increased the volatility of equity markets, contributing to reduced investor confidence. In addition to the “flash crash,” there have been a growing number of painful stock market glitches in recent years that were either related to, or exacerbated by, computers run amok. In August 2012, Knight Capital lost nearly $440 million after buggy software flooded the market with orders during a 45-minute period. Stuck with its huge position, Knight was later forced to unload the shares at a massive loss. The firm nearly went bankrupt and was bought by Getco Holding Co., another high-frequency shop, earlier this year. Then, in August, a trading glitch shut down the NASDAQ for three hours. Another NASDAQ glitch also marred last year’s Facebook IPO. “These events involved relatively basic, albeit serious errors,” Mary Jo White, the chairman of the U.S. Securities and Exchange Commission, said in a recent speech. “Many could have happened in a less complex market structure. But the persistent recurrence of these events can undermine the confidence of investors and public companies in the integrity of the U.S. equity market structure as a whole.”

That waning confidence may be among the reasons 2013 is shaping up to be the slowest year for stock trades since 2007, according to some estimates.

Not everyone agrees high-frequency trading is a problem that needs solving. Rishi Narang, a co-founder of high-frequency trading firm Tradeworx, argues that it makes no sense to denigrate HFTs and lionize investors like Warren Buffet for fundamentally doing the same thing: betting on the future of stock prices. “People have jumped to a very questionable conclusion that predicting further out into the future—à la Warren Buffett—is okay, while predicting into the extremely near-term future isn’t okay,” Narang told financial blogger Jeffrey Dow Jones. “There is a sort of ‘holier-than-thou’ attitude taken on by many people in the press, the public, and even the tax man about longer-term holding periods.”

Kevan Cowan, the president of TSX Markets and the head of TMX Group’s equities division, is similarly unconvinced that HFTs are fundamentally different than human traders. He points to the controversy surrounding latency arbitrage and notes that it’s been done for more than a century. Prior to the use of telegraph machines, he says, “brokers literally competed to hire the fastest physical runners to run their quotes from the floor to the broker.”

Even so, getting a grip on high-frequency trading has been difficult for both regulators and the public at large. In part, that’s because many of the strategies employed by HFTs are deliberately designed to be stealthy, and because most exchanges don’t share trading information widely. Canada has a unique advantage in that all of the country’s exchanges feed their trade data in real time to the Investment Industry Regulatory Organization of Canada, the industry’s self-governing body. Using that data, IIROC studied a three-month period in 2011 and found that HFTs accounted for 22 per cent of trading volumes, 32 per cent of the dollar value of shares traded and 42 per cent of all trades executed. Victoria Pinnington, IIROC’s vice-president of trading review and analysis, said the next phase of the study will focus on the impact of HFTs on investors. “We feel that studying the issue in depth will help us to shape a regulatory response,” she says.

Many in the industry don’t want to wait. RBC has joined with Barclays, CI Investments, IGM Financial, ITG Canada and PSP Public Markets to create a new stock market venture called Aequitas Innovations that would take steps to limit the impact of HFTs. That includes employing a electronic countermeasure system designed by RBC to slow down certain data transmissions to markets so that orders all arrive simultaneously, giving HFTs no opportunity to capitalize on latency issues. “If we do this at the exchange level, then every broker dealer that uses Aequitas for their clients can benefit,” says Mills, Aequitas’s chairman.

Not surprisingly, TMX’s Cowan takes issue with the suggestion that investors are ill-served by the current market structure. He says electronic trading, and efforts to promote it, have largely been a positive development because they’ve increased market liquidity and narrowed bid-ask spreads (the cost of buying and selling stocks). As for selling HFTs and other electronic investors direct access to the TSX’s servers, he stresses that such services simply acknowledge the reality of today’s stock market, arguing that in the absence of co-location opportunities, savvy traders would simply try to “lease or buy the building next door.”

Instead of banning HFTs outright or making it more difficult for them to operate, Cowan says a better approach is to identify when HFTs are behaving in a manipulative fashion and clamp down on them just like any other investor. “If somebody is looking to purposely move a market, that’s illegal under current rules and should be enforced,” he says. As for the larger question of electronic trading and volatility, Cowan adds that, “what’s important is investing in the tools to make sure we have the appropriate protections in place.”

Even so, investors can be forgiven for thinking the stock market increasingly resembles a casino—a place that holds equal amounts promise and heartbreak, and where the real money is made behind the scenes.
I'm glad to see PSP Investments is among the backers of the new stock exchange. Unfortunately, this will not make a significant difference unless it catches on all over the world and other big investors demand changes to limit the impact of HFTs on all major exchanges, including futures exchanges.

I leave you with a fascinating thriller from VPRO about Haim Bodek, aka "The Algo Arms Dealer," a genius algorithm builder who dared to stand up against Wall Street (h/t, Ari Tagalakis). After watching this documentary, you will gain a better understanding of how "quants" have forever changed the financial landscape, for better or for worse, and how your pension contributions are their "dinner or low hanging fruit."

Kudos to Haim Bodek (@HaimBodek) for exposing the destructive effects of algorithmic trading and blowing the whistle on the Wall Street code. I suspect many "quantitative geniuses" making oodles of money on Wall Street will wake up one day and realize they've wasted their tremendous brain power on such trivial pursuits. By then it will be too late, they will be on antidepressants for the rest of their lives.

Friday, November 22, 2013

Bubble Anxiety On the Rise?

Michael Mackenzie of the Financial Times reports, Bubble fears as US stocks break records:
Markets have left milestones for dust. US stock prices are enjoying their best year since 1997, with investors apparently untroubled by the backdrop of a lacklustre economy and high unemployment.

The S&P 500 has barrelled through three century marks this year alone, from below 1,500 to this week’s intraday peak of 1,802 for a year-to-date gain of 25 per cent. The Dow Jones Industrial Average has finally breached the 16,000 threshold, after rising through 15,000 in October, while the Nasdaq Composite is looking to revisit 4,000 after an absence of 13 years since the dotcom bust of 2000.

As the Fed’s balance sheet approaches $4tn, its expansion in recent years neatly matches the rise in the S&P 500, creating unease that an equity bubble is surely inflating as was the case in 2007 and 1999.

Not so according to Janet Yellen, Federal Reserve chair-designate, who told Congress last week that the central bank does not see a bubble in equities based on the metrics of equity risk premium and price to earnings ratios. Ms Yellen also said there is no federal rule to support the stock market.

But in the absence of a strong economic recovery matched by rising incomes, this year’s rapid rise in equity prices is also seen reflecting the activist role of the Fed as it buys $85bn of bonds each month, suppressing interest rates and forcing investors to buy shares, corporate bonds and real estate.

While some investors argue the stock market has not reached a valuation tipping point, the concern is that unless the broad economy and incomes accelerate soon, the prospect of a major correction in equity prices looms.

“Even the most bullish investor would admit that sluggish economic growth, a lacklustre labour market, and political discord are hardly the logical bedfellows of a stock market at new highs,” says Nicholas Colas, chief market strategist at ConvergEx.

“The current market action of a year end melt-up coming after five years of truly solid returns for US stocks, seems at first blush to be irrational performance-chasing. And who knows, it may end up being exactly that.”

Certainly the return of money into US stocks after outflows in 2011 and 2012 has been one catalyst for outsized performance. According to Lipper, investors have pumped a net $285bn into US equity mutual funds and exchange traded funds in 2013, the best year for the market since their records began in 1992.

Among the winners, FedEx, Google, Amazon and Microsoft have rallied 40 per cent or more, while companies such as IBM and Apple are modestly negative in 2013.

Countering the concern of a bubble forming, barometers of the economy such as transport and small-cap stock benchmarks are up more 30 per cent this year, reflecting a general consensus of accelerating growth in 2014.

Richard Madigan, chief investment officer at JPMorgan Private Bank, says the current forward P/E multiple on the S&P 500 at about 15 times is well below the reading of 24 times seen in 1999 at the tail-end of a major bull run.

“From a historical perspective, that is roughly what we consider to be fair value. Looking ahead, animal spirits still seem ambitious, but neither hubris nor complacency has currently taken over investor behaviour.”

At the very least, with the Fed set to taper in the coming months, there is a concern that the market’s hefty gains in 2013 have borrowed from the future, particularly as revenues are expanding modestly for many companies.

“The current rally has robbed a bit of next year’s performance,” says Michael Kastner, managing principal at Halyard Asset Management.

Mr Madigan says: “Investing is going to get more complicated as most of the easy overweight investments have just about played themselves out.”

A looming question is whether some investors will take the opportunity to lighten equity exposure ahead of the taper and fiscal battles in Washington.

Tobias Levkovich, US chief equity strategist at Citi, still believes in the secular bull market, but says: “The market is vulnerable to a pullback here; if profit-taking sets in, no one wants to be the last one out of the door.”

As the equity market looks to chalk up more milestones in 2013, the worry remains that the new peaks could become a millstone for late bull run arrivals.

Mr Kastner says: “We seem to have moved from investing under sensible valuations to one of the greater fool theory, hoping there is another buyer willing to pay a higher price at these extended levels.”
All of a sudden, everyone is jumping on the bubble bandwagon. Just click here to check out the latest news on the stock market bubble.

It's actually quite comical reading some of the headlines. For example, Robert Lenzer of Forbes argues there can't be a stock market bubble in a stagnant economy. Really? That's news to me. In case you haven't noticed, global stock markets don't care about what's going on in the real economy.

In fact, as Jonathan Nitzan and Shimson Bichler so eloquently argue, capitalists and pensions can't afford a recovery. Capitalism thrives on inequality and nowhere is this more evident than the schism between the real economy and the financial economy. And as I told you last Friday when I went over the holdings of top funds during Q3, if you think 1999 was crazy, get ready, you ain't seen nothing yet!

The perverse effects of quantitative easing have punished savers and rewarded speculators. Astute readers of my blog will remember that over the last few years, I've been warning investors to get ready for the mother of all liquidity bubbles. I've repeatedly warned you the power elite will do whatever it takes to reflate risk assets and err on the side of inflation.

Forget Grexit, the euro crisis, Arab Spring, the U.S. fiscal cliff and never ending debt ceiling debacles, these are all circus shows which the media play up to instill fear on the masses while elite hedge funds and bank prop desks keep buying every pullback hard.

In fact, two years ago I discussed how extreme volatility is confounding investors, stating the following: I stated in my previous comment on withering risk assets, I remain positioned for La Dolce Beta and think that money managers and asset allocators are not reading the macro environment properly. Pensions in particular should be capitalizing on this extreme volatility by taking opportunistic positions in risk assets. Unlike hedge funds and mutual funds, pensions have deep pockets and long time horizon to take opportunistic bets. Problem is most of them are too busy chasing after hedge funds or worrying about Europe, which is why they too are victims of extreme volatility.
And in March of this year, I discussed confusion over volatility strategies, stating the following:
...getting back to these tail-risk hedging strategies, I've covered this topic last year in a comment on hedging against disaster, noting the following:
The market hasn't "priced in" a eurozone break-up for the simple reason that it won't happen. All these hedgies waiting for a "Lehman-style event" so they can score big are collecting 2 & 20, selling fear to their institutional clients.

The biggest and most powerful hedge funds in the world stand ready to pump up the jam. The black swan of 2012 remains a mild eurozone recession. When fears of a eurozone break-up dissipate, greed and massive liquidity will drive all risk assets much, much higher. That remains my prediction, and if I am wrong, God help us all!!
Well, it turns out I was right, all the managers that took a risk-off approach fearing the end of the world are the ones that underperformed most in 2012. Meanwhile, a few brave investors and a small Greek pension fund that nobody has ever heard of made a killing looking well beyond Grexit.
And now that fears of Grexit and a euro crisis have dissipated, investors are getting greedy again, chasing all sorts of risk assets, not just stocks. While everyone is fixated on whether stocks are in a bubble, the reality is there are bubbles sprouting up everywhere, including high yield bonds, leveraged loans, private equity, infrastructure and real estate. There are housing bubbles all over the word and the newest bubble is bitcoin, the alternative currency which has soared in value (Richard Branson is riding the bitcoin surge into space. Need I say more?).

In fact, according to the latest Bloomberg Global Poll, asset  bubbles are forming in Internet and social media stocks as well as in the housing markets of London and China. This is creating quite a bit of angst among investors who do not want to chase yield at any cost.

The problem is while some of these bubbles will pop before others, it's impossible to predict when this will occur. Investors betting against central banks have taken a beating and they'll continue to get clobbered as we move into the parabolic phase of the stock market bubble. There will be pullbacks but they'll be bought hard.

In fact, big banks are awash with cash and they're speculating on risk assets now more than ever. never mind the increased regulations, Basel III, the Volker rule, etc., the amount of money prop desks are making is obscene.

And now that there is talk of tapering, what did U.S. financials (XLF) do yesterday? They rallied hard and propelled the stock market into record territory. Banks will make a killing off spreads if the long end of the yield curve widens relative to the short end. Remember, banks profit off money for nothing and risk for free.

I still like U.S. banks and think they have better prospects going forward relative to their Canadian counterparts which recently surged to record territory (book your profits). All this talk of Fed tapering is premature and it won't happen until emerging markets are on more solid footing.

Importantly, the Fed and other central banks are still more concerned about deflation than asset bubbles. They will do whatever it takes to reflate risk assets and stoke inflation expectations all around the world. The last thing they want is an emerging markets crisis which will reinforce deflationary expectations. 

On that cheery note, enjoy the stock market bubble while you can. If you're a conservative investor, focus on solid companies with little to no debt that offer attractive dividends, but beware, all these interest rate sensitive stocks can get clobbered if rates start rising fast once again. The same goes for high-beta stocks which move up fast and coming crashing down hard when the algos go to risk-off mode.

My best advice for skilled investors is to look carefully at the Q3 holdings of top funds, there are some gems in there. And while some sectors are bubbly, others are not, and when you look at individual companies in all sectors and industries, there are tremendous investment opportunities. Despite all the talk of froth, there are plenty of great investments for stock pickers (it's not all just about beta).

Once again, let me remind you to contribute to this blog via the PayPal links on the upper right-hand side. The information I provide here is unique and worth a lot of money to intelligent investors. Please take the time to donate or subscribe (I know, I should just charge for my posts but want to make this blog accessible to everyone).

Below,  Adam Johnson, Julie Hyman, Olivia Sterns and Cristina Alesci go over top market stories on Bloomberg Television's "Street Smart" and discuss how bubble anxiety is on the rise.

And David Tepper, the hedge fund manager who runs Appaloosa Management LP, talks about the performance of U.S. equity markets, outlook and investment strategy. He speaks with Stephanie Ruhle at the Robin Hood Foundation's investors conference on Bloomberg Television's "Street Smart," discussing why stocks are not in a bubble.

Tepper has played the Fed put perfectly, making a fortune in the process. There will be a time when he too will get clobbered and fall from hedge fund grace, wiping that smug smirk off his face, but for now he and other hedge fund "legends" betting on risk assets are riding the beta wave higher and having fun flirting with Stephanie Ruhle (can't blame him).

Finally, David Einhorn, Greenlight Capital co-founder & president. Einhorn weighs in on the Fed and the market rally; and discloses where he is short. You can track Tepper and Einhorn's latest holdings and many other hedge fund gurus by looking at my recent comment on the Q3 holdings of top funds but take everything they say publicly with a shaker of salt.

Thursday, November 21, 2013

Battling New Brunswick's Pension Reforms?

The Canadian Press reports, New Brunswick to introduce changes to public sector pension plans:
New Brunswick’s finance minister says the provincial government has gained the support of the majority of unions that represent the civil service in its proposed public pension changes.

Blaine Higgs says he has signed a memorandum of understanding with unions that represent two-thirds of the bargaining positions within the public sector for pension legislation the government will introduce later today.

He says the unions include those that represent nurses, hospital workers and court stenographers.

The government wants to implement changes including moving to a shared-risk model for pensions in order to address a $1-billion deficit for the public service plan.

The provincial wing of the Canadian Union of Public Employees has expressed concerns over the changes, saying while they may work for some unionized workers, they don’t for others who have defined benefit plans.
And CTV Atlantic reports, N.B. government pushes ahead with pension reform:
Despite loud and growing objections, the New Brunswick government is pushing ahead with pension reform.

On Tuesday, New Brunswick Finance Minister Blaine Higgs tabled pension reform legislation that will bring about 30,000 current and former public service employees under a new shared-risk model for their pensions.

Higgs says the bill would see contributions from both the employer and employees rise in an effort to address a $1-billion deficit.

“We not only have a right to do this, we have an obligation to do it because if we don’t, the plan is in trouble,” says Higgs.

He says, of the almost 30,000 public servants - which doesn’t include teachers - more than 20,000 are now behind the shift.

“(New Brunswick Union) are part of that, the electrical workers are part of that so, all told, we have 70 per cent of the total (PublicService Superannuation Act) group, roughly two-thirds that are endorsing this change,” says Higgs.

However, some public sector unions remain at odds with the reforms. CUPE New Brunswick says it is still considering challenging the changes in court.

“The other thing we’re going to look at is the possibility of getting this reversed,” says Danny Legere of CUPE New Brunswick. “I’m not sure how we would have that done, whether other parties would entertain that, but that’s certainly an avenue we’ll be exploring for our members in the PSSA.”

“It’s not a good day for the future of the civil service because it’s going to be extremely hard to attract high, well-calibered talent into this province and to keep them here because they are not going to be willing to come with what this is,” says Bonny Hoyt-Hallett of the New Brunswick Pension Coalition.

The Oppositional Liberals wonder how far the reforms will reach, saying they have heard the target could soon shift to the teachers’ plan.

As for MLAs, the legislation that would move their pensions to the new shared-risk model wasn’t tabled on Tuesday, and may not be until next spring.
I've already referred to New Brunswick's shared risk model when I reviewed Jim Leech and Jacquie McNish's book, The Third Rail:
We then talked about solutions to the looming crisis. The key for Jim is to implement New Brunswick's shared risk pension model which was enshrined in legislation in July 2012 and draws from the Netherland's pension system. "This way, employees, employers and pensioners all have a say on pensions and they share the risk of their pension plan." Indeed, New Brunswick has become a pension trailblazer and risk sharing must be part of the solution going forward.
Now we read that members of CUPE New Brunswick are considering challenging the new reforms in court. Kevin Skerrett of CUPE recently tweeted me this message (click on image): 

And he retweeted my reply:

But there is some confusion over shared risk plans and I must admit, I too was confused. When I state that I am against hybrid plans, it doesn't mean that I'm against shared risk plans.

Importantly, as I've repeatedly stated in this blog, the sustainability of defined-benefit pension plans requires concessions from all the key stakeholders: unions, plan sponsors and taxpayers. There is simply no way the status quo can go on indefinitely without jeopardizing the sustainability of DB pensions.

As far as shared risk, I think the Task Force on Protecting Pensions did an outstanding job presenting what is wrong with New Brunswick's pension system and why shared risk is the way forward. Take the time to look at the Task Force's presentation by clicking here.

When explaining why moving to shared risk makes sense, the Task Force highlights these key points:
  • Changes are incremental over 40 years and go-forward
  • Past pension amounts do not change
  • Introduce legislation to allow pension plans to offer much higher benefit security
    • base benefits
    • are very strongly funded (97.5%)
  • extra benefits like cost of living increases are strongly funded (75%)
  • Shared risk pension plans must do annual in-depth stress-testing
And the Task Force stipulates the change is to “secure risk / reward sharing” from “guaranteed wishful thinking”:
  • If investment markets are bad, delay benefit increases
  • If investment markets are excellent,make up for missed benefit increases
  • Contributions are designed to be stable over the long term
I do not see shared risk as a hybrid model between defined-benefit and defined-contribution plans. I see it primarily as a defined-benefit plan which is realistic and designed to ensure the long-term sustainability of the plan. There may be cuts to ancillary benefits like cost-of-living adjustments and hikes in contributions but for the most part, it's still a DB plan where everyone shares the pain and gain.

This is why I believe CUPE New Brunswick would be making a grave mistake to challenge the new reforms in court. Unions must acknowledge that people are living longer and the old rules on DB plans must change to reflect the new environment. Shared risk models are already in place at the Ontario Teachers' Pension Plan, the Healthcare of Ontario Pension Plan and CAAT pension plan. And it's working great for them.

But I'm also going to warn governments that shared risk isn't enough. You've got to get the governance right, implement independent investment boards and compensate your pension fund managers properly or else you'll end up with the same problems down the road.

Below, as cities and states across the U.S. grapple with their pension programs, PBS travels to one country -- The Netherlands -- that seems to have its pension problem solved. Ninety percent of Dutch workers get pensions, and retirees can expect roughly 70% of their working income paid to them for the rest of their lives.

Olaf Sleijpen of the Central Bank of the Netherlands says "I think what makes it successful is that you basically force people to save for their old age." I agree, and even though Dutch pensions are on the decline, the Netherlands is years ahead of most countries when it comes to ensuring retirement security for most of its citizens.

Postscript: Make sure you read my follow-up comment, revisiting New Brunswick's pension reforms. You will find out why some unions fumbled up badly on this file.