Wednesday, July 31, 2013

U.S. Carmakers Climb Out of Pension Abyss?

The Windsor Star published an article by Craig Trudel of Bloomberg, Big improvement in pension plays, GM and Ford say:
While drawing car buyers and praise from the likes of Consumer Reports, General Motors Co. and Ford Motor Co. are getting a grip on pensions that will free up cash to develop future hits.

Over the long term, this should allow more spending on the core business and less on retirees. That in turn creates a brighter outlook for the companies, which are already delivering more competitive cars like the Chevrolet Impala and Ford Fusion, and better-than-estimated profits.

"It's one less thing investors have to worry about on the risk side," said Michael Razewski, a New York-based principal at Douglas C. Lane & Associates, which oversees $3.1 billion, including Ford shares. "The less Ford has to focus on funding the pension, the more they can focus on driving innovative products and services and meeting customer demand."

"We won't have to allocate as much capital to pensions as we have the last couple of years and certainly this year," Bob Shanks, chief financial officer of Dearborn, Mich.-based Ford, said. "That will give us the ability to take the cash that we're generating and invest it in other parts of the business that can support further growth."

Ford's pension plans were underfunded by $18.7 billion last year. Only Detroit based GM, with a shortfall of $27.8 billion, General Electric Co. and Boeing Co. had bigger holes at the end of 2012, according to data compiled by Bloomberg.

"We've made good progress since the end of last year from a pension-funded position perspective, given the rise in interest rates that's clearly helped our overall funding position," GM CFO Dan Ammann said. On a conference call he said the stronger fund "gives us more rather than less flexibility."

Both automakers have taken big steps to contain their pension costs for salaried workers. A year ago, GM said it would spend as much as $4.5 billion to shift salaried retirees to a group annuity handled by a unit of Prudential Financial Inc. The annuity, and lump-sum buyout offers to 42,000 retirees, was forecast by GM to shave $26 billion from its pension load.

Ford is also offering lump-sum buyouts to salaried retirees. The automaker has said it wants to eliminate remaining shortfalls in its pension funds by mid-decade.

For several years, GM and Ford could blame Treasury yields, a benchmark in their pension calculation, for at least part of their shortfalls. Yields plunged after the 2008 financial crisis as the Federal Reserve embarked on unprecedented bond-purchase programs to lower borrowing costs and encourage spending.

Interest rates have risen the last two months after Federal Reserve Chairman Ben Bernanke said the central bank may reduce its asset purchases this year and stop in the middle of 2014 if economic growth meets policy makers' projections.

The increase in rates will help reduce the funding needs at all types of pensions, whether run by corporations or governments. Detroit, long dubbed the Motor City, this month filed the largest municipal bankruptcy in U.S. history and is struggling under a large unfunded pension obligation that could lead to benefit cuts for 30,000 current and former city workers.
Detroit's cries of betrayal are not being felt by the car companies which took the decision to offload pension risk to insurers so they can focus on their core business. Others will follow their lead.

A deeper analysis is provided by Deepa Seetharaman of Reuters who reports Ford could close its U.S. pension funding gap by the end of 2014:
Thanks to rising rates and an injection of cash, Ford Motor Co could be in a positions that would have been unthinkable only a few years ago - with a fully funded U.S. pension fund.

Ford, which went through a searing restructuring in 2006, but avoided the bankruptcy route of its rivals General Motors and Chrysler, could cut its U.S. pension shortfall by half or even more by the end of this year from $9.7 billion at the end of 2012, according to securities analysts and Reuters calculations.

And the gap could be eliminated by the end of 2014 provided interest rates rise as economists expect and the stock market remains robust. That may give Ford added resources to pay down debt, invest in its businesses, or boost dividend payments, analysts said.

"It is a true obligation of the company right now and it's taking quite a bit of capital," Ford Chief Financial Officer Bob Shanks said of the automaker's pension gap in an interview.

"Once we get it fully funded, de-risked and sort of put it in a box, it gives us the ability not to worry about it so much and take future cash flow and put it wherever we want," he said.

If Ford fully funds its U.S. pension plan by the end of next year that would be quicker than many analysts had expected. GM could be about one to two years behind Ford in closing its U.S. pension gap, said Guggenheim Securities LLC analyst Matt Stover.

But critical to this scenario is that interest rates used to calculate retiree pension obligations continue to rise. Ford would also have to be willing to contribute at least $1 billion in 2014 to close its U.S. pension gap, analysts said.

Eliminating the shortfall is "possible by the end of 2014 and it's going to be because interest rates climb," said Stover, who predicts Ford's U.S. pension plans will be underfunded by about $4 billion by the end of 2013.

Ford's U.S. pension obligation was $52 billion at the end of last year, while GM's was about $82 billion.

GM was the first of the U.S. automakers to establish a pension plan in 1950 as part of the "Treaty of Detroit," a contract negotiated by legendary United Auto Workers union leader Walter Reuther. Ford and Chrysler followed suit.

But by the mid-2000s, pensions and other retiree benefits became an ever-increasing liability that automakers said added as much as $2,000 to the cost of a vehicle and put them at a disadvantage against foreign rivals.

Since then, GM and Ford have both taken steps to "de-risk" their pension plans by closing off their plans to new participants, offering lump-sum buyouts and shifting to more conservative investments.< Last year, GM cut $29 billion, or one-fifth, of its global pension liability when it shifted management of white-collar pension plans for 118,000 salaried retirees to a unit of Prudential Financial Inc. But underfunding remains an issue, partly because that shortfall is viewed by credit ratings agencies as debt.

Ford plans to inject $5 billion cash into its global pension plans this year to help reduce the underfunding - though some of that will go towards pension plans elsewhere in the world.

To put the underfunding and Ford's cash injection in context, the automaker spent $5.5 billion in 2012 on product development, building factories and other capital expenditures.

A $4 BILLION BOON
Companies calculate the present value of their future pension liabilities using a so-called discount rate, which is based on corporate bond rates. A higher rate means lower liabilities, meaning that a company doesn't have to set aside as much cash now to pay retirees in the future.

Based on the most optimistic scenario laid out by actuarial firm Milliman, higher rates alone could narrow Ford's pension gap by about $4 billion by the end of 2014. Stover said higher rates could close about half of Ford's U.S. pension shortfall.

"The auto companies have always been associated with having these big pension liabilities," Citi analyst Itay Michaeli said. "It becomes a frustration for investors to deal with more volatility on top of already volatile industry dynamics."

Closing the U.S. pension gap "takes an element that has arguably weighed on investor sentiment and just takes that issue away," Michaeli added.

The discount rate, which is based on corporate bond yields and is used to determine the present value of payments they make over the life of their plans, has risen this year to 4.74 percent in June from 3.96 percent in December, according to Milliman.

By the end of 2013, the discount rate could be as high as 5.04 percent, and by the end of 2014 it could be up to 5.64 percent, Milliman estimates.

A smaller pension gap would likely pave the way for Standard & Poor's to upgrade Ford's credit ratings upgrade to investment grade, Michaeli said. That would allow the automaker to fund the remaining U.S. pension gap with unsecured debt.

"By issuing debt, what you're doing is freeing up free cash flow," he said, adding that could be used to boost dividends, develop new vehicles or pay off debt.

For Ford, a one percentage point increase in the discount rate alone could lower its U.S. pension liability by $2.3 billion, Shanks said during Ford's second-quarter earnings call.
Rising rates are critical for restoring the funding gap of public and private pension plans. Once the carmakers' plans get back to fully funded status, the increase in their credit rating will allow them to issue debt to free up cash flow which can be used to boost dividends, develop new vehicles or pay off debt.

The improvement in their pension plans is one of the reasons behind the outperformance of Ford and GM vs. the S&P 500, with their shares almost doubling over the last year  (click on image):


Going forward, the critical issue will be whether rates continue to rise at a steady pace. Rising rates will help restore the health of underfunded private and public plans. While some very smart people like AIMCo's Leo de Bever see the end of the bull market in bonds, the folks at Hoisington Investment Management argue persuasively that the secular low in bond yields has yet to be recorded. If that turns out to be true, there will be more pension pain ahead.

Finally, no matter where bond yields head, there is a theme I keep referring to, namely, pensions should be treated as a public good and managed by well-governed public pension funds that operate at arms-length from the government. Companies like Ford and GM are doing the logical thing to "de-risk" their pension plans and focus on their core business but workers deserve the security that comes with a defined-benefit pension plan. As companies offload pension risk to insurers and shut down DB plans to new and existing workers, I worry that millions more will succumb to pension poverty down the road.

Below, Robert Shanks, chief financial officer of Ford Motor Co., talks about the automaker's second-quarter earnings, prospects for the company’s growth and the City of Detroit’s bankruptcy. Ford, the second-largest U.S. automaker, earned more than estimates and raised its full-year profit forecast as the Focus compact and Fusion sedan led a stable of more competitive cars from the Detroit Three. Shanks speaks with Adam Johnson on Bloomberg Television's "Street Smart."

Tuesday, July 30, 2013

The Hedge Fund Myth?

A few weeks ago, Bloomberg Businessweek published a piece by Sheelah Kolhatkar, The Hedge Fund Myth:
At the height of the financial crisis in 2008, a group of famous hedge fund managers was made to stand before Congress like thieves in a stockade and defend their existence to an angry public. The gilded five included George Soros, co-founder of the Quantum Fund; James Simons of Renaissance Technologies; John Paulson of Paulson & Co.; Philip Falcone of Harbinger Capital; and Kenneth Griffin of Citadel. Each man had made hundreds of millions, or billions, of dollars in the preceding years through his own form of glorified gambling, and in some cases, the investors who had poured money into their hedge funds had done OK, too. They were brought to Washington to stand up for their industry and their paychecks, and to address the question of whether their business should be more tightly regulated. They all refused to apologize for their success. They appeared untouchable.

What’s happened since then is instructive. Soros, considered by some to be one of the greatest investors in history, announced in 2011 that he was returning most of his investors’ money and converting his fund into a family office. Simons, a former mathematician and code cracker for the National Security Agency, retired from managing his funds in 2010. After several spectacular years, Paulson saw performance at his largest funds plummet, while Falcone reached a tentative settlement in May with the U.S. Securities and Exchange Commission over claims that he’d borrowed money from his fund to pay his taxes, barring him from the industry for two years. Griffin recently scaled back his ambition of turning his firm into the next Goldman Sachs (GS) after his funds struggled to recover from huge losses in 2008.

As a symbol of the state of the hedge fund industry, the humbling of these financial gods couldn’t be more apt. Hedge funds may have gotten too big for their yachts, for their market, and for their own possibilities for success. After a decade as rock stars, hedge fund managers seem to be fading just as quickly as musicians do. Each day brings disappointing headlines about the returns generated by formerly highflying funds, from Paulson, whose Advantage Plus fund is up 3.4 percent this year, after losing 19 percent in 2012 and 51 percent in 2011, to Bridgewater Associates, the largest in the world.

This reversal of fortunes comes at a time when one of the most successful traders of his time, Steven Cohen, founder of the $15 billion hedge fund firm SAC Capital Advisors, is at the center of a government investigation into insider trading. Two SAC portfolio managers, one current and one former, face criminal trials in November, and further charges from the Department of Justice and the SEC could come at any moment. The Federal Bureau of Investigation continues to probe the company, and the government is weighing criminal and civil actions against SAC and Cohen. Cohen has not been charged and denies any wrongdoing, but the industry is on high alert for the possible downfall of one of its towering figures.

Despite all the speculation and the loss of billions in investor capital, Cohen’s flagship hedge fund managed to be the most profitable in the world in 2012, making $789.5 million in the first 10 months of the year, according to Bloomberg Markets. His competitors haven’t fared as well. One thing hedge funds are supposed to do—generate “alpha,” a macho term for risk-adjusted returns that surpass the overall market because of the skill of the investor—is slipping further out of reach.

According to a report by Goldman Sachs released in May, hedge fund performance lagged the Standard & Poor’s 500-stock index by approximately 10 percentage points this year, although most fund managers still charged enormous fees in exchange for access to their brilliance. As of the end of June, hedge funds had gained just 1.4 percent for 2013 and have fallen behind the MSCI All Country World Index for five of the past seven years, according to data compiled by Bloomberg. This comes as the SEC passed a rule that will allow hedge funds to advertise to the public for the first time in 80 years, prompting a flurry of joke marketing slogans to appear on Twitter, such as “Creating alpha since, well, mostly never” (Barry Ritholtz) and “Leave The Frontrunning To Us!” (@IvanTheK).
I will let you read the entire article here but it ends off by stating the following:
As their returns have fallen, the biggest hedge funds have started to seem more like glorified mutual funds for the wealthy, and those rich folks might start to take a harder look at whether they’re getting their money’s worth. This could be an encouraging development for the world economy, considering that hedge funds provided huge demand for the toxic mortgage derivatives that helped lead to the financial collapse of 2008. At the same time, the tens of billions that pension funds have plowed into funds such as Bridgewater’s All Weather Fund—down 8 percent for the year as of late June, according to Reuters, compared with a 10.3 percent rise in the S&P 500—mean that the financial security of untold numbers of retirees could be threatened by a full-scale hedge fund meltdown.

For the moment, that possibility seems remote. The age of the multibillionaire celebrity hedge fund manager may be drawing to a close, but the funds themselves can still serve a useful purpose for prudent investors looking to manage risk. Let the industry’s recent underperformance serve as a reality check: No matter how many $100 million Picasso paintings they purchase, hedge fund moguls are not magicians. The sooner investors realize that, the better off they will be.
Similarly, Dan McCrum of the FT reports that hedge funds are gripped by a crisis of performance:
While many hedge funds fared better than the stock market during the financial crisis, and rode the 2009 recovery back to health, they have been confounded by sometimes violent market moves over subsequent years.

Since January 2010 the average equity hedge fund has produced profits for its investors, after fees, of just 14.5 per cent, according to the research group HFR.

Over the same period an investor in the S&P 500 earned, with dividends, a 55 per cent return: a total which 85 per cent of equity hedge funds have failed to match, finds HFR.

Stock trading specialists at hedge funds fared even worse than their peers managing humdrum mutual funds – 83 per cent of mutual fund managers who invest in large-cap stocks and try to beat the S&P 500 have failed to do so, according to the research group Lipper.

Among all mutual funds investing in stocks, one-third are ahead of the market, and the average investor return is 44.5 per cent from the start of 2010 to the end of June this year, Lipper finds.

The comparison may be unfair to some funds which do not aim to beat the market. Some within the industry argue that hedge funds are behaving as they should, performing better as markets plunge, but lagging behind as they steadily rise.

“We haven’t changed our advice,” said Edward O’Malley, hedge fund consultant for Cambridge Associates, “In the same way . . . we weren’t advising clients to exit hedge funds in favour of long-only funds after the crisis.”

While mutual funds are restricted to simple activities such as choosing cheap companies, hedge funds typically try to use leverage to magnify returns. They may also use hedging to mitigate losses, or sell short stocks in the anticipation of falling prices.

As pension funds embraced the use of cheap index funds over the last decade, such advantages were pitched as a way for hedge funds to improve portfolios.

Yet the poor performance of the last three years now far outweighs hedge funds’ resilience through the worst of the crisis. Over the past five years the S&P 500 with dividends has delivered average annual returns of 7 per cent, while equity hedge funds have produced just 1.7 per cent, according to HFR.
Most hedge funds are struggling but this doesn't shock industry veterans. Talk to Ron Mock, the next president and CEO of the Ontario Teachers' Pension Plan, and he'll tell you he saw this coming years ago. 

We can argue about the structural changes that explain why hedge funds are struggling in this environment but one big reason is that institutional investors have been indiscriminately plowing billions into hedge funds since the crisis erupted, expecting the best of both worlds, ie., high returns and mitigation of downside risk. 

In fact, Jason Zweig of the WSJ wrote an article, Plenty to Blame for High-Pressure Hedge-Fund Culture, where he notes the following:
...some big investors seem to buy hedge funds much the way the rest of us pick hotel rooms or buy breakfast cereal.

According to a global survey by Deutsche Bank in December, a third of big investors don't require hedge funds to have a track record before investing in them. Three-quarters of pension funds—and half of insurers and endowments—hire outside consultants to conduct due diligence on their hedge funds instead of doing it themselves. Some pension funds, I am told, even decline to review the exact holdings in their hedge funds because they don't want to be held accountable for the quality of their analyses.


What makes big investors so willing to close one or two eyes—and pay through the nose for the privilege—is the pipe dream of safety and outperformance.

Everyone wants double-digit returns in a world of paltry bond yields. Trillions of dollars are chasing the few managers who can earn high returns on a few billion dollars apiece. Clients pay on average up to 2% of assets and 20% of profits—and occasionally as much as 3% and 50%, as the government alleges at SAC.

"You should pay hedge-fund managers all that extra money so they don't lose you a lot of your capital in bad markets," says Elizabeth Hilpman, chief investment officer at Barlow Partners, which invests exclusively in hedge funds. "But many institutional investors want it all: They want the downside protection and the huge outperformance."

Big institutions are among the most desperate performance-chasers on the planet. "The consultants tell them they can get 8% [annual returns] by playing the same game that's being played by everyone else, if they just play it better," says Keith Ambachtsheer, an expert on pension strategy at KPA Advisory Services in Toronto. "But the math doesn't work."

Many hedge-fund managers, such as Seth Klarman of the Baupost Group, James Simons of Renaissance Technologies and George Soros of the Quantum Fund, have made their clients rich. But only one in 10 institutions reported earning at least 10% on hedge funds in 2012, according to the Deutsche Bank survey. But one-third expect their hedge funds to return at least 10% this year.

So far at least, that doesn't look likely. The HFRI Fund Weighted Composite, an index of hedge-fund performance, gained 3.55% in the first half of this year; it was up 6.36% for all of 2012.

Despite their recent trailing returns, most hedge funds still charge the same high fees. As the great economist Tibor Scitovsky explained decades ago, when sellers of a complex product or service are the only ones who fully understand what they are selling, buyers can't objectively distinguish quality. The result: an automatic oligopoly in which sellers compete on the appearance, not the reality, of high quality.

Perhaps we should be indicting—not criminally, but intellectually—an entire ecosystem. Yes, plenty of hedge funds are guilty of exploiting their clients with lavish fees for flaccid performance; some might even be breaking the law. But their clients are far from blameless: "Sophisticated" institutional investors still insist on believing in a Tooth Fairy that can somehow miraculously provide market-beating returns for everyone. Maybe that is the biggest crime of all.
I don't believe in the Hedge Fund Tooth Fairy and think many institutions investing in hedge funds don't have a clue of the risks they're taking. In most cases, they're getting raked on fees, expecting some sort of magical returns once markets turn south. They're in for a nasty surprise.

To be sure, there are and will always be excellent hedge funds, but picking them isn't easy and yesterday's superstars can turn out to be tomorrow's losers. This is why it's insane to chase performance without understanding why some strategies outperform in some environments and why few managers can consistently deliver stellar outperformance.

What are some of the trends which will shape the hedge fund landscape going forward? Here are a few of my thoughts:
  • The rise of alternatives powerhouses: Take a look at how Blackstone has evolved from a private equity giant to an "alternatives powerhouse," investing in PE, real estate and hedge funds. Other private equity giants are following suit but Blackstone remains the leader in alternatives and is best poised in a rising rate environment. As assets get increasingly concentrated in the hands of these alternatives powerhouses, they will play a key role in influencing industry trends.
  • More direct investments in hedge funds: While many pensions will invest in hedge funds via the Blackstones of this world, others are shunning funds of funds and investing directly into hedge funds. Sophisticated Canadian pension funds like Ontario Teachers, the Caisse, and CPPIB, have been investing directly in hedge funds for years and so do other Canadian funds. The same will happen in the United States where investors' first foray into hedge funds might be through a Blackstone but eventually they want to build internal capabilities to invest directly. Of course, there will always be legal concerns at some U.S. public pension funds which will prevent them from investing directly into hedge funds. These public pension funds will never invest directly. 
  • Lower alpha, lower fees: Hedge funds aren't dead but lower alpha will put increasing pressure on the industry to lower fees. It's already happening as many hedge fund managers realize to stay competitive and align interest with their investors, they need to lower fees. Big institutions writing big tickets are negotiating hard on fees and so they should. The last thing they want is to pay hedge fund managers "2 and 20" (2% management fee and 20% performance fee) so they can beef up their marketing group and become large, lazy asset gatherers sitting comfortably on billions.
  • Start-ups are dying: Some of the world’s biggest hedge funds, including Marshall Wace, Millennium Management, CQS and BlueCrest Capital Management, are among firms that are capitalizing on a difficult environment for start-ups, hiring potential managers who might once have considered setting up on their own. I think it will become increasingly difficult for hedge fund start-ups. Having said this, sophisticated institutions will work with top funds of funds to invest in a portfolio of start-ups. Also, large family offices and established hedge fund managers will be a source of new funds for start-ups. 
Hope you enjoyed reading this comment and if you have any thoughts, feel free to contact me directly (LKolivakis@gmail.com). Once again, institutional investors and individuals looking to support my blog can do so by subscribing or donating at the top-right side under the banner. I thank all of you who have supported my efforts.

Below, Tiger Management's Julian Robertson and Tiger Ratan's Nehal Chopra discuss the hedge fund myth on Bloomberg Television's "Lunch Money."

And Lawrence Schloss, New York City's chief investment officer and deputy comptroller for pensions, talks about the city's pension fund returns and investment strategy. He speaks with Scarlet Fu on Bloomberg Television's "Money Moves."


Monday, July 29, 2013

The Unsteady States of America?

The Economist reports, The Unsteady States of America:
When Greece ran into financial trouble three years ago, the problem soon spread. Many observers were mystified. How could such a little country set off a continental crisis? The Greeks were stereotyped as a nation of tax-dodgers who had been living high on borrowed money for years. The Portuguese, Italians and Spanish insisted that their finances were fundamentally sound. The Germans wondered what it had to do with them at all. But the contagion was powerful, and Europe’s economy has yet to recover.

America seems in a similar state of denial about Detroit filing for bankruptcy (see article). Many people think Motown is such an exceptional case that it holds few lessons for other places. What was once the country’s fourth-most-populous city grew rich thanks largely to a single industry. General Motors, Ford and Chrysler once made nearly all the cars sold in America; now, thanks to competition from foreign brands built in non-union states, they sell less than half. Detroit’s population has fallen by 60% since 1950. The murder rate is 11 times the national average. The previous mayor is in prison. Shrubs, weeds and raccoons have reclaimed empty neighbourhoods. The debts racked up when Detroit was big and rich are unpayable now that it is smaller and poor.

Other states and cities should pay heed, not because they might end up like Detroit next year, but because the city is a flashing warning light on America’s fiscal dashboard. Though some of its woes are unique, a crucial one is not. Many other state and city governments across America have made impossible-to-keep promises to do with pensions and health care. Detroit shows what can happen when leaders put off reforming the public sector for too long.

Inner-city blues

Nearly half of Detroit’s liabilities stem from promises of pensions and health care to its workers when they retire. American states and cities typically offer their employees defined-benefit pensions based on years of service and final salary. These are supposed to be covered by funds set aside for the purpose. By the states’ own estimates, their pension pots are only 73% funded. That is bad enough, but nearly all states apply an optimistic discount rate to their obligations, making the liabilities seem smaller than they are. If a more sober one is applied, the true ratio is a terrifying 48% (see article). And many states are much worse. The hole in Illinois’s pension pot is equivalent to 241% of its annual tax revenues: for Connecticut, the figure is 190%; for Kentucky, 141%; for New Jersey, 137%.

By one recent estimate, the total pension gap for the states is $2.7 trillion, or 17% of GDP. That understates the mess, because it omits both the unfunded pension figure for cities and the health-care promises made to retired government workers of all sorts. In Detroit’s case, the bill for their medical benefits ($5.7 billion) was even larger than its pension hole ($3.5 billion).

Some of this is the unfortunate side-effect of a happy trend: Americans are living longer, even in Detroit, so promises to pensioners are costlier to keep. But the problem is also political. Governors and mayors have long offered fat pensions to public servants, thus buying votes today and sending the bill to future taxpayers. They have also allowed some startling abuses. Some bureaucrats are promoted just before retirement or allowed to rack up lots of overtime, raising their final-salary pension for the rest of their lives. Or their unions win annual cost-of-living adjustments far above inflation. A watchdog in Rhode Island calculated that a retired local fire chief would be pulling in $800,000 a year if he lived to 100, for example. More than 20,000 retired public servants in California receive pensions of over $100,000.

Money (That’s what I want)

Cleaning up the mess in local and state government will take time. Circumstances vary widely from place to place, but a good starting-point would be to abandon the accounting tricks. Only when the scale of the problem is made clear can politicians persuade voters of the need for sacrifice.

Public employees should retire later. States should accelerate the shift to defined-contribution pension schemes, where what you get out depends on what you put in. (These are the norm in the private sector.) Benefits already accrued should be honoured, but future accruals should be curtailed, where legally possible. The earlier you grapple with the problem, the easier it will be to fix. Nebraska, which stopped offering final-salary pensions to new hires in 1967, is sitting pretty.

Yet sooner or later, some of these problems will end up in Washington, DC. In Detroit, a judge ruled this week that federal bankruptcy law trumps a state law that makes it impossible to reduce pensions. But the issue will arise again, and will not be truly settled until it reaches the Supreme Court. Many places like Detroit will surely have to break some past promises—and rightly so. And given the size of many of the black holes, the state or federal government may have to help out. Taxpayers should not bail out feckless local governments or investors who should have known the risks. But they should help pensioners left stranded through no fault of their own. Some state and municipal workers do not qualify for the federal Social Security system; they get only the pensions promised by their employer. If these do not materialise, there should be a backstop to ensure that they receive at least a basic pension.

Americans in virtuous states and cities will be just as furious about their tax dollars flowing to Detroit and other distressed places as Germans are about euros going to southern Europe. But the truth is that America’s whole public sector still operates in a financial never-never land. Uncle Sam offers an array of “entitlements” that there is no real plan to pay for. Barack Obama is on his way to joining George W. Bush as a president who did nothing about that, while Republicans in Congress imagine they can balance the books without raising taxes. The government spends more on health care than many rich countries and still does not cover everyone. America’s dynamic private sector is carrying on its back an unreformed Leviathan. Detroit is merely a symptom of that.
Last week, I covered Detroit's cries of betrayal and stated:
"Sadly, what is happening in Detroit will happen in many more U.S. cities struggling with crippling public debt. The articles serve as a painful reminder that public pensions are not as sacred as people think. When the money runs out, pensioners face huge cuts to their pensions as cities try to assuage bondholders to keep lending them money."
It's foolish to think that this problem is unique to Detroit. But The Economist article is overly alarmist. While the financial crisis and years of neglect (governments not topping out state plans) have hit state pension funds, the recovery in the stock market and rise in interest rates means the deterioration in slowing.

Still, there is no denying many U.S. local and municipal pensions face the same dire outcome that Detroit now faces. When cities can't cut public services or raise taxes, they will cut public pensions. Moreover, while The Economist is right that public sector employees should retire later and pension abuses must be halted, the shift to defined-contribution schemes will only ensure more pension poverty down the road.

And while the focus is on the United States, Don Pitts of the CBC reports that Detroit's meltdown is a wake-up call for Canadians:
Detroit pensioners woke up last Friday to shattered retirement dreams, and the haunting question that people around the world are now asking themselves is, "What about mine?"

In its bankruptcy filing last week, the city declared its pension and benefit commitments to be part of its debt, leaving a Federal judge to decide how to distribute Detroit's remaining assets between pensioners and other creditors.

From a business point of view it is all quite rational. Over the years, the city government made more promises than it could possibly afford to pay. About $18 billion more.

But there's more happening here than rational business decisions. In bankruptcy, when there just isn't enough money to go around, each of the creditors takes a share of the hit. This time they are expected to get between 10 and 20 cents for every dollar they are owed — and that includes the city's pensioners.

People who have worked a lifetime for the city, responsibly choosing a job and sticking with it because they knew it included a safe pension, abruptly have to think again.

They could have taken their skills and commitment elsewhere, taken risks and pursued more adventurous jobs, sailed around the world or lived cheap on the beaches of Goa, or taken a flyer on a career as an actor or novelist. In other words, they could have lived like the grasshopper instead of the ant in the Aesop's Fable — making enough for a roof and entertainment week to week but never setting a penny aside for the long winter ahead.

And eventually relying on social assistance in their old age. As the Wealthy Barber author David Chilton has said, people without a pension generally don't save enough.

But the pension contributors in Detroit weren't the fabled grasshoppers, they were the ants. They were the responsible ones who considered the future and planned ahead so they could pay their own way. They chose jobs with salary agreements that included the promise of a fund for their retirement.

Every month money was taken from their pay. Every month, the paperwork showed that their employer had added its share to the pension pot. Periodically a form would arrive in the mail telling them how much they would get if they continued working until the age of 65. But all the time the paperwork was a lie.

And as I mentioned last week, there is a growing view that the crisis in Detroit may not be unique, that there are more public-sector bankruptcies to come. Others have weighed in on the subject since, some seeming to blame pensioners for the growing potential financial crisis, saying they are taking more than their share.

The point they're missing is that pensions are crucial to a healthy economy.

As everyone keeps telling China, until the country develops a reliable social safety net, a consumer-led society can never take off. Employees must be able to trust their pensions will actually be there when it comes time to draw on them, or their ant-like personalities will force them to hoard even more when they're working, instead of recirculating that cash into the economy.

And safe pensions do exist. The best ones are those that money managers give themselves.

In this type of blue ribbon pension there is no promise to pay on some future day. The money is set aside in a separate account. It is well managed in diversified investments. Its future value, and thus the amount added to the fund each year, is determined by realistic long-term rates of interest. It is not based on a 30-year-old promise by some now-defunct politician and subject to the whims of whoever is calling the political shots today.

Detroit has shown that the promises of politicians don't last 30 years. And neither do the promises of companies.

Canada's own Nortel, the airlines and the Detroit auto makers themselves are just a few of the private firms proving that promises given years ago to inspire loyalty when workers were desperately wanted are worth nothing when the workers are no longer needed.

As the blue-ribbon pensions show, money actually set aside and invested wisely over a 40-year working life provides a reliable retirement income. Stocks really do return 8 per cent over the long term. Bond returns are low now, but many years in the last 40, bonds were paying double-digit rates.

But as with those blue ribbon pensions, the secret is that the money must actually be set aside and invested by honest, qualified professionals. Pension funds that do that, like the Ontario Teachers Pension Plan, or the Canada Pension Plan, provide reliable returns.

Without that, a promise to pay is only as good as the changing fortunes of the organization making the promise.

Pensions backed by promises from governments with relatively low debt, like Canada's, are safe for now. And as CBC's Amber Hildebrandt has reported, in Canada cities are backed by their respective provinces if things go sour.

Other governments and companies are not in such good shape. In the wake of Detroit, employees and unions making deals with healthy governments and private sector employers must learn not to accept promises. They must demand that cash be set aside now, placed in a well-run fund, and managed for the long term.

Either that or the ants might as well join the grasshoppers. Buy a sailboat, and don't come home till you are old and sick and looking for social assistance.
What we need in Canada is to stop dithering and build on the success of Canada's top ten. We need to rethink our pension system and improve it by enhancing the Canada Pension Plan for all Canadians. That is the ultimate wake-up call from Detroit's meltdown for us Canadians.

Finally, take the time to read John Mauldin's latest, A Lost Generation. It is superb and highlights the problem of how U.S. monetary policy has disproportionately boosted the fortunes of the financial and wealthy elite while the younger generation struggles to find full-time employment. "We may be seeing a new underclass develop, which has disastrous implications for the country."

Indeed, class warfare is alive and well in the United States and despite the rhetoric, politicians from both parties aren't addressing this issue. The young generation can't find work and retirees living on meager fixed incomes are facing cuts to their pensions. This is the real "Unsteady States of America" that The Economist and the financial media willfully ignore.

Below, Mark Binelli, a Detroit native and contributing editor at Rolling Stone magazine and Men’s Journal, discusses Detroit's bankruptcy with Amy Goodman of Democracy Now.

Friday, July 26, 2013

UK Ruling Puts Pensioners Above Creditors?

Miles Costello and Alex Spence of The Times report, Supreme Court victory for Lehman and Nortel pensioners:
The Supreme Court has ended three years of uncertainty for thousands of members of the Lehman Brothers and Nortel pension schemes as it ruled that they had a fair claim on the collapsed companies’ assets.

In a landmark case that has implications for all future insolvencies, the Court ruled that the schemes had an equal claim on assets alongside other creditors.

Had the case gone against them, the Lehman and Nortel members could have been forced below other creditors in the repayment queue at collapsed companies and set a precedent for administrators across the board.

The outcome was hailed by experts and those involved in the wrangle as a “victory for common sense” that shored up the rights of 40,000 members of Nortel’s scheme and 4,000 former staff at Lehman.

Experts also said it was more likely that both schemes would avoid being forced into the Pension Protection Fund, the lifeboat for retirement funds that pays out less to retiring members.

Nortel, a Canadian telecoms company, collapsed in 2009 leaving a pensions deficit that at the last count stood at £2.1 billion. It followed the spectacular demise the previous year of Lehman Brothers at the height of the financial crisis, with a deficit in its UK pension scheme of £148 million.

The complex case centred on a so-called “financial support direction” issued by the Pensions Regulator in 2010 after administrators were brought in at both companies.

A financial support direction is a demand that companies or their administrators have to stand behind a scheme financially and is ordered if the regulator thinks is a danger that current and future pensioners will not be paid.

In some cases this can involve an injection of cash, or even shares or other assets.

In a joint claim, the administrators argued that the regulator’s demand should be disregarded as an “unprovable debt” as it was issued after the administration.

In response, the regulator said that the financial support direction should be treated as an expense or debt, meaning that the pension scheme had a priority claim on assets or would rank as an equal, unsecured creditor.

Jonathan Land, a partner at PwC who advised the Nortel scheme trustees, said: “This ruling determines once and for all that FSDs will rank alongside other unsecured creditors in UK administrations.

“This is the fairest result and after three years of litigation UK pension schemes and insolvency practitioners will be thankful they finally have clarity on the issue.”

Tony Bugg, global head of restructuring and insolvency at law firm Linklaters, which advised Lehman’s administrators, said: “The concern before today’s decision was the Pensions Regulator had the power to boost the ranking of its claim simply by waiting for a target company to enter administration. The Supreme Court unanimously agreed that Parliament [under the 2004 Pensions Act] cannot have intended such an unfair and arbitrary result.”

The Pensions Regulator welcomed the ruling and said it had never had any intention of frustrating the process of administration. Had the financial support direction been ruled as having no effect, the liability would fall down a “black hole”, the regulator said.

Experts said that the ruling, which overturned a 2011 judgment by the Court of Appeal, would also simplify other company restructurings and future corporate insolvencies.

There had also been a concern that the Pension Protection Fund would have come under considerable strain if it had been forced to take on the liabilities of the Nortel scheme.
Is this really a win for pensioners or creditors? In her article, Norma Cohen of the FT reports, Supreme Court rules pension plans do not rank above other creditors:
Claims from a corporate pension scheme should not rank above other creditors in insolvency proceedings, the Supreme Court ruled on Tuesday, overturning lower court judgments that put pensioners’ interests ahead of others.

The original case was brought in 2010 by administrators to Lehman Brothers and Nortel Networks. They challenged the pensions regulator’s right to bring a legal proceeding, known as a financial support direction, to stand alongside those of other creditors’ claims on the proceeds after a corporate insolvency.

Lower courts had decided they must either rule that pension debts are an administrative expense to be paid ahead of unsecured creditors, or risk the unravelling of legislation designed to protect benefits. Their rulings gave priority to the pension claims.

But legal experts warned that if the lower court judgments stood, as a knock-on effect, companies with defined benefit pension schemes would have to pay much more to access credit.

Kevin Pullen, a partner at law firm Herbert Smith, which represents the Nortel creditors, said that the challenge was made because the regulator did not have a formal claim outstanding seeking a set sum, on the date that Nortel sought administration.

For its part, the regulator’s procedures do not require it to specify an amount when it seeks an FSD. It merely needs to show why an entity should be responsible for offering financial support to a scheme.

The pension scheme was Nortel’s largest unsecured creditor with a deficit of £2.1bn – representing the cost of buying annuities for its pensioners. The comparable figure for Lehman is £148m.

The Regulator argued it could not have made such claims because they take months to prepare and it did not have access to the information to compile them.

Mr Pullen said that despite Wednesday’s ruling, the Nortel administrators will continue to challenge the regulator’s right to bring the financial support direction, and will ask for the matter to be aired before the regulator’s tribunal.

But legal experts welcomed the decision, saying it clarifies where pension debts rank in insolvency proceedings.

Charles Maunder, partner and head of the banking, restructuring and insolvency team at law firm Michelmores, described the judgment as “a victory for common sense and fairness to all creditors”.

Stephen Soper, the pensions regulator’s executive director for defined benefit funding, welcomed the Supreme Court ruling.

“This will be welcome news for many thousands of pension scheme members and will provide clarity to insolvency practitioners on how to treat a pension scheme liability,” he said.

“In this case, the regulator was forced to defend against arguments that an FSD issued against an insolvent company would be ineffective and disappear down a ‘black hole’.”

Such a ruling would have posed serious threats to the finances of the Pension Protection Fund which insures the underfunded schemes of insolvent employers, he added.
Similarly, Richard Dyson of The Telegraph reports, 'No priority' for pensions when companies go bust:
The verdict was the result of a case brought by the administrators of the UK divisions of investment bank Lehman Brothers and Canadian telecoms group Nortel, and is viewed as a "landmark" because of its implications for other companies that go bust where pension schemes are in deficit.

Nortel, the Canadian firm which collapsed in 2009, had a £2.1bn shortfall in its European scheme. The pension entitlements of more than 40,000 workers were implicated. The funding gap at the UK division of failed investment bank Lehman was far smaller at £148m.

UK pensions watchdog The Pensions Regulator had submitted a claim when Nortel and Lehman went into insolvency asking for pension members to be paid ahead of other claims. It used a mechanism known as a "Financial Support Direction" (FSD) to do this. But the Supreme Court yesterday ruled the pensions should not be ranked above other unsecured creditors in an insolvency.

The FSD, introduced in legislation in 2004, is designed to protect employees in under-funded schemes by trying to ensure companies support their pension promises. But, according to insolvency practitioners and lawyers close to the case, FSDs create uncertainty for scheme members and inadvertently increase the chance of schemes being pushed into the Pension Protection Fund, the "lifeboat" arrangement for funds of failed businesses which are in deficit.

PwC, adviser to the trustees of the Nortel UK pension funds, said it was a "great result for members of pension schemes", enabling insolvency practitioners "to make quicker distributions to all creditors".

Lenders to companies whose schemes are in deficit, or others seeking to restructure such firms, are expected to be reassured. Giles Frampton of R3, the insolvency trade body, said: "The Nortel decision is to be welcomed in that it appears to restore a fair balance between the rights of pension funds and other creditors in administrations."
Finally, in her article, Charlie Thomas of aiCIO reports, Lehman, Nortel, and a More Certain Future for Bankrupt Company Pensions:
Chasing pension money from parent companies who have gone bust has been materially weakened, after the Supreme Court ruled that the UK Pensions Regulator's financial support directions (FSDs) and contribution notices no longer have priority in a line of creditors.

Overturning a previous Court of Appeal judgment from 2011, Lord Neuberger, Lord Mance, Lord Clarke, Lord Sumption, and Lord Toulson concluded that the Pensions Regulator does not rank ahead of any creditors, including unsecured creditors, banks, and bondholders, and should instead be considered pari passu: that is, equal.

The ruling, which happened this morning, in the matter of the Nortel Companies, in the matter of the Lehman Companies, and in the matter of the Lehman Companies (No. 2), has widely been heralded as a success for common sense. If the court had decided to uphold the Court of Appeal's findings, any large pension deficit would likely have swallowed up all assets recovered after an insolvency, leaving all other creditors with nothing.

Another unintended consequence of the original judgment was that businesses with final salary pension schemes may have found it more difficult to borrow money, as the decision of the lower courts saw liabilities ranking as an expense, increasing the costs of lending. This should also have been dealt with by the court's decision today.

"The concern before today's decision was that the Pensions Regulator had the power to boost the ranking of its claim simply by waiting for a target company to enter administration. The Supreme Court unanimously agreed that Parliament cannot have intended such an unfair and arbitrary result," said Tony Bugg, global head of restructuring and insolvency at Linklaters, who also advised the Lehman Brothers' administrators.

"An insolvency pits employees, pensioners, suppliers and other creditors against one another each fighting for a share of a limited pool of funds. The Supreme Court rightly decided that only the clearest of legislative intent should enable one group of creditors to claim priority over another.

"In the context of an insolvency regime which already gives some creditors preferential treatment, it is right that these decisions should be for Parliament to decide."

A Pyrrhic Victory for the Regulator?

Jennie Kreser, partner at law firm Silverman Sherliker, told aiCIO the judgment meant the likelihood of recovery for pension schemes has been "somewhat reduced".

"The Supreme Court said that in coming to its decision, it has overturned a line of cases (which the court below couldn't do) as they were contradictory and not consistent with corporate insolvency situations, having been based on individuals who were insolvent.

"This will be a disappointment to the Pension Regulator and to the members of pension schemes who will, as a result, find their position weakened when trying to bolster schemes with significant deficits, who would otherwise look to other group companies for help."

But the Regulator's statement suggested it welcomed the clarity the Supreme Court had provided, and cheered the fact it had successfully argued against a suggestion that an FSD issued against an insolvent company would be ineffective and "disappear down a black hole".

The Regulator had originally pushed for FSD liabilities to be considered an administration expense or as a provable debt. Even though the administrative expense argument was ruled out by the Supreme Court, the regulator was happy to have the provable debt argument sustained.

Stephen Soper, the Pensions Regulator's executive director for defined benefit funding, said: "This will be welcome news for many thousands of pension scheme members and will provide clarity to insolvency practitioners on how to treat a pension scheme liability.

"Since the challenge was first made, we have made clear that we have no intention of frustrating the proper workings of the administration process. Today's judgment will provide clarity to the UK's restructuring and rescue practitioners that FSD liabilities have to be recognised in insolvent situations but do not have priority over administration expenses or secured debts."

Another potential downside was highlighted by law firm Allen and Overy: the surrounding legislation needed fixing in a number of areas, including in relation to overseas enforcement of FSDs.

"Because this decision now makes it work for FSDs in UK insolvencies, I can't see a root and branch reform of the FSD aspect being likely now," Jason Shaw, senior associate at the firm, said.

The Pension Protection Fund's head of restructuring and insolvency, Malcolm Weir, said the PPF had always argued FSDs and contribution notices should be treated as provable debts, and that the organisation would now look at the judgment to assess the implications for the Nortel and Lehman schemes, and any future recoveries it may make as an unsecured creditor.

The full judgment can be read here.

What does this mean for Lehman and Nortel Network's pension schemes?

In a nutshell, don't expect a swift happy ending.

Both schemes are currently in the Pension Protection Fund assessment period, with Nortel entering in March 2009, and Lehman Brothers' entering in two separate tranches in October 2008 and August 2009.

The Pensions Regulator has issued FSDs to target companies associated with both pension funds-Lehman Brothers' targets were issued with an FSD in September 2010 and Nortel's targets received their FSD on June 25, 2010.

Both sets of targets referred the matter to the Upper Tribunal court, contesting the grounds for the FSD issuance, and both cases were then stayed, awaiting the outcome of the Supreme Court hearing.

Following today's judgment, those Upper Tribunal cases can now resume, resulting in one of two options: either the Upper Tribunal sides with the Regulator and grants permission to hand down the FSD, or it sides with the targets.

Both results could also find themselves subject to appeal, if a point of law can be found, meaning the cases could escalate to the Court of Appeal. There's also parallel cases being heard in the US and in Canada to determine the claims of the Nortel trustees, which were submitted off the back of the FSD issuance. Those are listed to take place in January, 2014.

All of which means it's unlikely the members of both schemes will have closure on the ongoing legal rows for many months to come, if not years.
This landmark decision highlights the legal complexities of what happens when companies with defined-benefit schemes go under. The Supreme Court decision basically puts creditors and pensioners on equal footing, reassuring lenders to companies whose schemes are in deficit, as well as pensioners worried that creditors will have first claims on assets if a company goes under.

This case also highlights the need to reform pension systems. As I've stated many times, companies should worry about their core business, not pensions. Instead, pensions should be treated as a public good and managed by large public pension funds that operate at arms-length from the government and in the best interest of their contributors and beneficiaries. The sooner we realize this, the better off we'll all be.

Below, the legality of Detroit’s historic bankruptcy filing is being challenged in the courts. At issue are the unfunded pensions and health benefits promised to city workers. Retired Detroit policeman Don Taylor joins NewsNation’s Tamron Hall to discuss the hardships the city’s bankruptcy filing has imposed on him and other municipal employees. Sadly, Detroit's cries of betrayal are being heard all over the world and I fear a bleak future for private and public pensions.


Thursday, July 25, 2013

bcIMC Gains 9.5% Net in 2012-2013

The British Columbia Investment Management Corporation (bcIMC) released its results for 2012-2013:
The British Columbia Investment Management Corporation (bcIMC) today released its combined pension plan returns for the year ending March 31, 2013 as part of its 2012–2013 Annual Report. With a one-year annual return of 9.5 per cent, net of fees, the results exceeded a combined benchmark of 7.8 per cent and added $1.5 billion in value to bcIMC's pension plan clients.

“Our domestic real estate and public equities portfolios were the primary drivers of our positive results last year,” said Doug Pearce, Chief Executive Officer/Chief Investment Officer of bcIMC. “On behalf of our clients, we began significantly increasing asset allocations towards real estate and infrastructure in 2011, and this heavier weighting to real assets is beginning to drive investment returns.”

There were a number of highlights from the past year, including:
  • Committing $3.4 billion to investments that span real estate, infrastructure and renewable resources, which included the purchase of the Canada Post site in downtown Vancouver and Open Grid Europe GmbH
  • Creating a thematic investing strategy and adding four new funds to give exposure to themed assets, renewable resources, emerging markets and companies with high environmental, social and governance ratings
  • Becoming a Qualified Foreign Institutional Investor in China , which allows bcIMC to invest in companies listed on Chinese stock exchanges
  • Increasing internally-managed equity assets by over $1.5 billion and saving about $4.0 million in external manager fees
  • Being ranked first in North America, and sixth globally, by the Asset Owners Disclosure Project in its global climate investment index that assessed asset management and climate risk disclosure
  • Acquiring over 990 acres of developable land and completing six developments, adding over 876,400 square feet to our domestic real estate portfolio
  • Receiving an unqualified audit opinion on our Service Organization Controls Report (Canadian Standard for Assurance Engagements–CSAE 3416)
  • Increasing our global portfolio to $102.8 billion of gross managed assets, up by $7.3 billion from the previous year.
"I am also pleased with the investment returns for the 10-year period. bcIMC delivered an annualized return of 8.2 per cent against a combined benchmark of 7.8 per cent. As a result, our investment activities contributed $3.2 billion in added value for our pension plan clients," added Pearce.

As of year-end, bcIMC had over $100 billion in gross assets under management. The portfolio includes six major asset classes: Fixed Income (22.9 per cent or $23.6 billion), Mortgages (3.4 per cent or $3.5 billion), Private Placements (4.5 per cent or $4.6 billion), Public Equities (46.6 per cent or $48.0 billion), Real Estate (17.3 per cent or $17.8 billion), and Renewable Resources and Infrastructure (5.3 per cent or $5.4 billion).
bcIMC’s 2012– 2013 Annual Report is available here and the on-line version is available here. You can also read bcIMC's Business Plan 2012-2013 to 2014-2015 which is available here.

The results for 2012-2013 are very impressive. The 9.5% net return (net of expenses) represents $1.5 billion in value-added and exceeded the benchmark by 170 basis points (9.5% vs 7.8%).

As shown above (click on image), over a 10-year period, bcIMC has returned 8.2% net compared to 7.8% for its benchmark during that same period. And as shown below (click on image), the cumulative value added, net of fees, over a ten-year period is $3.2 billion.


As stated in the news release, domestic real estate and public equities portfolios were the primary drivers of their positive results last year. Doug Pearce, Chief Executive Officer/Chief Investment Officer of bcIMC, stated that  they began significantly increasing asset allocations towards real estate and infrastructure in 2011, and this "heavier weighting to real assets is beginning to drive investment returns."

Indeed, as shown below (click on image), domestic real estate was one of the primary drivers of bcIMC's strong results, returning 11.8% in 2012-2013, or 6.8% above its benchmark of Canadian CPI + 4%:


Over a 20-year period, bcIMC's domestic real estate portfolio returned 10.1%, exceeding its benchmark by 4.2 percentage points. I have a couple of points to add on this. First, while the spread over inflation is one way to gauge the performance of real estate, as I stated in my comment on AIMCo's 2012 record results, the REALpac/IPD Canadian All Property Index – Large Institutional Subset is a benchmark which better reflects the performance of this asset class.

Second, Canadian pension funds have enjoyed a great run in domestic real estate but how long will it last? I don't know but with Toronto breaking new real estate records, and the media praising Canada's hot commercial real estate market, I'm getting nervous and understand why real estate keeps Leo de Bever awake at night.

Still, real estate is an important asset class, and since 1991, bcIMC has been building a domestic real estate portfolio that has a long-term, comprehensive focus and is capable of generating consistent returns through varying economic cycles.

Once again, I urge my readers to carefully go over bcIMC's Annual Report for 2012-2013. There is a lot of information I simply cannot cover here. I like their thematic approach to long-term investing and think many pension funds should adopt a similar approach for investing in public and private markets.

I congratulate Doug Pearce and all the employees at bcIMC for delivering strong and consistent long-term results. You don't hear a lot about bcIMC but they've been doing a great job managing pension assets for their clients and the organization deserves its place among Canada's top ten.

Below, Dennis Friedrich, chief executive officer of Brookfield Office Properties Corp., and Mark Dixon, chief executive officer of Regus LLC, talk about the commercial real estate market. They speak with Tom Keene and Sara Eisen on Bloomberg Television's "Surveillance." Robert Albertson, chief strategist at Sandler O’Neill & Partners LP, also speaks.

Wednesday, July 24, 2013

Detroit's Cries of Betrayal?

Steven Yaccino and Michael Cooper of the NYT report, Cries of Betrayal as Detroit Plans to Cut Pensions:
Gloria Killebrew, 73, worked for the City of Detroit for 22 years and now spends her days caring for her husband, J. D., who has had three heart attacks and multiple kidney operations, the last of which left him needing dialysis three times a week at the Henry Ford Medical Center in Dearborn, Mich.

Now there is a new worry: Detroit wants to cut the pensions it pays retirees like Ms. Killebrew, who now receives about $1,900 a month.

“It’s been life on a roller coaster,” Ms. Killebrew said, explaining that even if she could find a new job at her age, there would be no one to take care of her husband. “You don’t sleep well. You think about whether you’re going to be able to make it. Right now, you don’t really know.”

Detroit’s pension shortfall accounts for about $3.5 billion of the $18 billion in debts that led the city to file for bankruptcy last week. How it handles this problem — of not enough money set aside to pay the pensions it has promised its workers — is being closely watched by other cities with fiscal troubles.

Kevyn D. Orr, the city’s emergency manager, has called for “significant cuts” to the pensions of current retirees. His plan is being fought vigorously by unions that point out that pensions are protected by Michigan’s Constitution, which calls them a contractual obligation that “shall not be diminished or impaired.”

Gov. Rick Snyder of Michigan, a Republican who appointed Mr. Orr, signed off on the bankruptcy strategy for the once-mighty city, which has seen its tax base and services erode sharply in recent years. But the governor said he worried about Detroit’s 21,000 municipal retirees.

“You’ve got to have great empathy for them,” Mr. Snyder said in an interview. “These are hard-working people that are in retirement now — they’re on fixed incomes, most of them — and you look at this and say, ‘This is a very difficult situation.’ ”

On Sunday, Mr. Snyder fended off the notion that the city needed a federal bailout. “It’s not about just putting more money in a situation,” the governor said on “Face the Nation” on CBS. “It’s about better services to citizens again. It’s about accountable government.”

Many retirees see the plan to cut their pensions as a betrayal, saying that they kept their end of a deal but that the city is now reneging. Retired city workers, police officers and 911 operators said in interviews that the promise of reliable retirement income had helped draw them to work for the City of Detroit in the first place, even if they sometimes had to accept smaller salaries or work nights or weekends.

“Does Detroit have a problem?” asked William Shine, 76, a retired police sergeant. “Absolutely. Did I create it? I don’t think so. They made me some promises, and I made them some promises. I kept my promises. They’re not going to keep theirs.”

Vera Proctor, 63, who retired in 2010 after 39 years as a 911 operator and supervisor, said she worried that at her age and with her poor health, it would be difficult to find a new job to make up for any reductions to her pension payments.

“Where’s the nearest street corner where I can sell bottles of water?” Ms. Proctor asked wryly. “That’s what it’s going to come down to. We’re not going to have anything.”

Officials overseeing Detroit’s finances have called for reducing — not eliminating — pension payments to retirees, but have not said how big those reductions might be. They emphasized that they were trying to spread the pain of bankruptcy evenly.

When the small city of Central Falls, R.I., declared bankruptcy in 2011, a state law gave bondholders preferential treatment — effectively protecting investors even as the city’s retirees saw their pension benefits slashed by up to 55 percent in some cases.

Detroit, by contrast, wants to spread the losses to investors as well as pensioners, and hopes to find cheaper ways to cover retirees through the subsidized health exchanges being created by President Obama’s health care law.

Bill Nowling, a spokesman for Mr. Orr, said the emergency manager’s restructuring plan would treat bondholders the same as retirees in bankruptcy.

“How can we tell pensioners or city workers that we’re going to have to adjust their payments on their pensions because of decisions that they didn’t make but that affect them, but that we’re going to pay more to people who made risky investments?” he said.

In recent years, public sector pensions have often emerged as a political point of contention, earning scorn from taxpayers who work in the private sector, where defined-benefit pensions providing a guaranteed stream of income in retirement have grown increasingly rare.

But the average pension benefit in Detroit is not especially high. The average annual payment is about $19,000, said Bruce Babiarz, a spokesman for the pension funds. And it is about $30,000 for retired police officers and firefighters, who do not get Social Security benefits, he said. Some retired workers get larger pensions, though: about 82 retirees who either worked many years or had high-salaried jobs are paid pensions of more than $90,000 a year, he said.

Among them is Isaiah McKinnon, who was the city’s police chief in the 1990s and whose pension is just over $92,000 a year. Dr. McKinnon said he and other officers earned their retirement money by serving in a dangerous profession. Dr. McKinnon was shot at eight times while on the job and was stabbed twice, and he has scars from the attacks on his neck and abdomen, he said.

Dr. McKinnon, who holds a doctoral degree in education administration, is an associate professor at the University of Detroit Mercy. He expressed concern about retired rank-and-file officers whose pensions were based on salaries far lower than his.

“We’re in this predicament, and everyone has to suffer to an extent,” Dr. McKinnon said. “But the predicament and the percentage — that has to be talked about.”

Many retirees expressed a feeling of powerlessness, a sense that they stand to lose the benefits they worked a lifetime for because of things beyond their control. Motor City has lost more than a million residents over the last six decades. When it shrank its work force, it left fewer current workers to contribute to pension funds that still had to pay benefits that were earned by large numbers of older retirees who had served Detroit when it was a bigger city.

Detroit, like many other cities and states, anticipates that its pension funds will earn about 8 percent in interest each year — a target that proved overly optimistic during the recent downturn, when it fell far short.

Laws allowing workers to collect pensions even when they retired at young ages proved expensive, as did adjusting benefits for inflation. And some of the accounting measures the funds used made them look healthier than they actually were. Mr. Orr recently announced that the funds, which had reported a shortfall of around $644 million, were in fact underfinanced by more like $3.5 billion, a figure that some dispute.

But other problems are unique to Detroit. Several pension officials were accused this spring of taking bribes and kickbacks to influence investment decisions, and Mr. Orr recently called for an inquiry into possible fraud, waste or abuse in the pension system.

For some retirees, pension reductions would compound the other difficulties of living in Detroit.

Michael Wells, 65, retired in 2011 after working at the Detroit Public Library for 34 years. He said he still owed close to $100,000 on his house in Detroit, which was appraised recently at $25,000. “I’m totally underwater here,” said Mr. Wells, who is one of the plaintiffs in a union-backed lawsuit to stop the city from filing for bankruptcy and from reducing pension payments.

He said he viewed the pension as part of the overall pay he was promised. “It’s deferred income,” he said. “Had I not had a pension, perhaps I would have gotten several dollars an hour more and that would be O.K. I would have taken that money and invested it in some kind of mutual fund or stock.”

Paula Kaczmarek, 64, said that she had planned to retire from the Detroit Public Library in 2014, but that she decided to retire early because she was having health problems and she feared younger co-workers could be laid off if there were more rounds of staff cuts. (The city, which had 12,302 workers three years ago, now has only 9,560.)

“It’s not anxiety, it’s fear,” Ms. Kaczmarek said of the proposed cuts.

And many simply cannot believe that Detroit, which was once the nation’s fourth-largest city, could go bankrupt.

Dr. McKinnon recalled that when he was a young man in the police academy, he once asked a sergeant what would happen if the city went bankrupt. “ ‘The city won’t,’ ” he said the sergeant had replied. “ ‘And besides, there’s billions of dollars in the retirement fund.’ ”
Jeff Karoub of the Associated Press also reports, Detroit retirees worry about possible pension cuts:
K.D. Bullock had been retired from the Detroit Police Department for nearly 17 years and was working as a casino security supervisor when he encountered a problem last March —long accustomed to working on his feet, he suddenly couldn’t make it up a flight of stairs. After months of doctor’s appointments, he was diagnosed with rheumatoid arthritis, which makes it difficult for him to breathe. He not only left his job but had to begin paying others for the fix-up work he’d been doing on his historic six-bedroom house.

Now, he could be facing another hit, this time to his $2,400-a-month pension.

The pensions earned by more than 21,000 retired municipal employees have been placed on the table as Detroit enters bankruptcy proceedings with debts that could amount to $20 billion. Labor unions insist the $3.5 billion in pension benefits are protected by state law, but the city’s emergency manager has included them among the $11 billion in unsecured debt that can be whittled down through bankruptcy. A federal judge has scheduled the first hearing on the city’s case for Wednesday.

The prospect of sharply reduced pension checks has sent a jolt through retired workers who always counted on their pensions—who sometimes sought promotions just to sweeten the pot—and never imagined they could be in danger even as the city’s worsening finances finally led to its bankruptcy filing last week.

Bullock says he’s worried he’ll have to sell his home in Detroit’s historic Indian Village neighborhood, and others are wondering if they can afford a house at all.

“A number of things can happen. It just means our lifestyle is going to change — we have no way of knowing,” Bullock said of the choices facing him and his wife, Randye.

The average annual pension payment for Detroit municipal retirees is about $19,000. Retired police officers and firefighters receive an average of $30,500. Top executives and chiefs can receive $100,000. Police and firefighters don’t pay into the Social Security system so they don’t receive Social Security benefits upon retiring.

Bullock, 70, said the idea that his pension could be reduced is “a hard pill to swallow” after 27 years on the force working his way up. He said he was proud to be the first black commanding officer of the department’s communications system.

He said that pensions — and people — should be a priority over other city assets, such as artwork at the Detroit Institute of Arts, some of which could be sold to help satisfy the city’s staggering debts. But art patrons have protested the idea of auctioning off Old Masters in the museum collection. And investment funds have spoken up for the average people who could get only cents on the dollar for their investments in supposedly safe city bonds.

The ripple effects of the pension issue are touching people far beyond Detroit.

Glenda Dehn, 66, and her husband planned to spend winters in Arizona after his retirement from the police force, but since their recent divorce after 48 years of marriage, the home in Peoria, Ariz., is her permanent residence. Now she worries that she’ll have to move in with family members in Michigan.

“It would be a major life change for me and many, many others,” said Dehn, who also has a son on the force.

Likewise, police retiree Warren Coleman, 76, wonders if his other investments will be enough to support him. In his 27 years on the job before he retired as an executive lieutenant and moved to Ocala, Fla., he said he “put a whole lot of effort into getting promoted” with the rising retirement benefit in mind.

“I intended ... to do the best I could while I was there and get me in as nice a position as I could,” he said.

Not knowing what’s going to happen to the pensions — especially after paying into them and planning retirement around them— is the biggest concern for retirees right now, said Rose Roots, a 30-year city employee who retired in 1997 as a job-training specialist. She’s also the president of a retiree chapter of the American Federation of State, County and Municipal Employees. People want advice, she said, but there is little she can say.

“I’ve had some older retirees call me on the phone in tears because of their medical needs,” said Roots, 76. “I’ve never received calls like the calls I get now.”

Roots said her pension payment is “well below” the $19,000 annual average for municipal employees. “At this point I can’t even guess at what may happen that may force me to make changes,” she said.

Retirees are putting their hopes in state lawsuits filed by the pension funds. They argue that pensions are protected by the Michigan Constitution and should not be part of the bankruptcy process. The bankruptcy judge will likely rule on whether federal bankruptcy law supersedes the state guarantee.

The impact of the decision could fall heavily on retirees who had low-paying jobs and got small benefits checks.

Michael Woodson began receiving a disability pension of less than $500 a month after he said he fell off a truck while working for the sanitation department. The 57-year-old, who uses a walker, lives in a rugged neighborhood “in the heart of Detroit.”

“My concern is just (living) every day,” he said. “When you come from where I come from, things like this happen all through your life. ... I’ve been a blue-collar worker or less all my life. You learn to struggle.”

Coleman, the Florida retiree, said he’s not only concerned about his future, but also the city he served. He remembered working during the 1967 riots, and worries about the anger if thousands of people lose most of their income in the bankruptcy process.

“I see some big problems as a possibility,” he said.
Sadly, what is happening in Detroit will happen in many more U.S. cities struggling with crippling public debt. The articles serve as a painful reminder that public pensions are not as sacred as people think. When the money runs out, pensioners face huge cuts to their pensions as cities try to assuage bondholders to keep lending them money.

And Detroit's pension woes aren't only due to the decline of a once prosperous city. Bloomberg reports on how bad real estate deals haunt Detroit's pensions:
The city’s $2 billion General Retirement System lost $16 million in fiscal 2011 when it wrote off a housing development near Sarasota, Florida, that collapsed after the real-estate bubble burst, according to pension fund records. The $3.1 billion Police and Fire Retirement System lost about $15 million on 1,100 vacant acres 30 miles east of Dallas that was to be sold to homebuilders.

A 2006 loan guarantee for a Westin hotel and condos in downtown Detroit cost the funds $14 million.

That was just in real estate. The funds lost more than $20 million investing in a telecommunications company started by a Detroit businessman, $30 million on a cargo airline and almost $70 million on collateralized debt obligations -- derivative securities backed by a pool of bonds, loans and other assets. 
You read about these deals and wonder why wasn't there any proper governance to avert such questionable investments? These questionable investments are happening all over the United States, typically at local and municipal pensions which lack proper oversight.

The Pew Charitable Trusts just released a report on how states can adopt several practices to help municipalities in financial distress avoid having to file for bankruptcy protection. I recommend states look into consolidating local and municipal pensions at a state level. State pension plans are typically much better governed than local and municipal pension plans.

As I stated above, I fear that Detroit's cries of betrayal will be heard all over the United States where many cities are being crushed by crippling public finances. The plight of Detroit's pensioners is now being played out in the courts where a legal challenge is questioning the constitutionality of cutting pension payments.

No matter what the courts decide, it's clear this bankruptcy and others like it will impact public pensions and the lives of workers and retirees. What is happening in Detroit will happen elsewhere and is no different than what happened in Greece. When the money runs out, pensions get hit and people's lives are disrupted.

Below, Bloomberg Economic Editor Michael McKee examines whether Detroit's bankruptcy will unleash a wave of municipal filings as cities shoulder massive debts and pension obligations. He speaks on Bloomberg Television's "In The Loop."