Tuesday, March 31, 2015

Transforming Hedge Fund Fees?

Stephanie Eschenbacher of the Wall Street Journal reports, Swiss Investor Calls for Big Cut in Hedge Fund Fees:
One of Europe’s biggest hedge fund investors, Unigestion, is pushing hedge funds to scrap management fees in place of a bigger slice of profits as investors attempt to crack down on high charges.

Nicolas Rousselet, head of hedge funds at the $16.7 billion investor, which has $1.9 billion invested in hedge funds, said that a zero management fee in exchange for a higher performance fee of 25% was “a great fee structure”. Hedge funds typically charge a 2% management fee and a 20% performance fee although better performing, more established managers can charge much higher fees. These top managers tend to attract investors easily, often having to turn away new ones, and can dictate terms to investors.

Mr. Rousselet said Swiss-based Unigestion had been pushing for a “transformation of fees”, that his team had successfully negotiated lower management fees with some hedge fund managers last year, and in two instances secured rates of lower than 1%.

Among those were both newer managers and more established ones that wanted to work with Unigestion on a new share class or fund.

Mr. Rousselet said: “If [a hedge fund manager] truly believes in his ability to perform, he should take my deal.” However, he acknowledged that low fees could pose a business issue for the hedge fund manager and conceded that the main challenge for investors was that the best-performing funds were oversubscribed.

He said that this transformed fee structure encouraged hedge fund managers to take on more risk, but that hedge fund investors like Unigestion needed to ensure that funds were prepared to take some risks. The aggressive stance is the latest development in a long-running fee debate between hedge funds and investors.

Data released earlier this month by Deutsche Bank Global Prime Finance showed that the success rate of fee negotiations was only gradually improving: some 37% of investors that negotiated fees were successful in one out of every two negotiations. This rate has increased from 35% a year ago, and 29% the year before that.

Investors are usually able to negotiate fees if they can commit a larger investment, and agree to invest for the longer term.

Deutsche Bank said that the most successful negotiators interviewed for its survey, which spanned 435 investors who have $1.8 trillion worth of investments in hedge funds, had an average of $5.6 billion invested in hedge funds. They agreed to invest on average $70 million for at least one year.
Institutional investors are finally openly discussing hedge fund fees and terms. Earlier this month, Ian Prideaux, CIO of the Grosvenor Family Investment Office, Marc Hendricks, CIO of Sandaire Investment Office and Simon Paul, Partner at Standhope Capital, wrote a letter to the FT on how the hurdle rate should apply to hedge fund industry as it does in private equity:
Sir, Sir John Ritblat makes a good point regarding hedge fund fees (Letters, March 2). Hedge fund managers should only be rewarded with an incentive fee for delivering performance that exceeds a “normal” hurdle.

For internal benchmarking purposes, many investors use an absolute return measure such as the return on short-dated Treasury bills plus 4 per cent. We should like to see a hurdle at a similar level adopted by the hedge fund industry generally, which by so doing would accept that it expected to deliver a “super return” in exchange for its incentive fee, as its highly talented managers no doubt consider themselves capable of producing. Otherwise investors can find themselves in the depressing position of paying an incentive fee on any positive performance however small.

If one assumes the “standard” — but by no means ubiquitous — 2 per cent plus 20 per cent fee structure, then a 5 per cent gross return to the fund is whittled down to a 2.4 per cent net return to the investor. A hurdle rate — typically of 8 per cent — is standard in the private equity fund sphere and only when the manager has delivered this return to the investor can he help himself to a share of the surplus. Why should the hedge fund industry not follow suit?
Good point, hurdles for hedge funds is something I discussed back in October, 2014. As far as fees, you know my thinking, it's about time a lot of overpaid hedge fund managers follow other wiser managers and chop fees in half.

I know there is still plenty of dumb pension money piling into hedge funds, especially the larger ones all those useless investment consultants are in love with, but the gig is up. Hedge funds have been exposed by none other than Soros and Buffett as outrageously expensive money managers that typically underperform the market.

I can hear hedge fund managers protesting: "Leo, Leo, Leo, you don't understand! We have 'niche strategies' and mitigate against downside risk. We need to charge hefty fees to all those dumb pension and sovereign wealth funds you mention on your blog so we can maintain our lavish lifestyle and make it on the Forbes' list of the rich and famous. It's expensive competing with Russian oligarchs and royalty from the Emirates for prime real estate in London and Manhattan. Not to mention the cost of Ferraris, yachts, private jets, fine art, and plastic surgery for our vain trophy wives is skyrocketing up in a world of ZIRP and QE!!"

Oh, cry me a river! When I was investing in hedge funds at the Caisse, one of the running gags was if we had a dollar every time some hedge fund schmuck told us he had "a niche strategy that's uncorrelated to the market," we'd all be multi-millionaires!

Thank god I'm no longer in that business because I'd be the biggest pension prick grilling these grossly self-entitled hedge fund prima donnas charging alpha fees for leveraged beta. And most hedge funds are still underperforming the market! No wonder hedge funds saw their worst year in closures since 2009 last year and a few top funds don't want to be called hedge funds anymore. Most hedge fund managers absolutely stink and should follow Goldman's fallen stars and pump away!

Alright, enough ranting on crappy hedge funds. Let's get serious. I think it's high time we critically examine what hedge funds and private equity funds offer pensions and other institutional investors. And by critically examine, I don't mean some puffy article written in Hedgeweek, extolling the virtues of hedge funds using sophisticated and (mostly) irrelevant mumbo jumbo. I mean "where's the beef baby?" and why should we pay these guys (it's still an industry dominated by testosterone) all these hefty alpha fees so they become nothing more than glorified asset gatherers on their way to becoming part of the world's rich and famous?

As far as fees are concerned, I don't fully agree with Unigestion's Nicolas Rousselet. I don't want hedge funds to be compensated for taking bigger risks, I want them to be properly compensated for taking on smarter risks. There's a huge difference and incentives have to be properly aligned with those of investors looking to consistently achieve some bogey, however illusory it might be.

As I've stated, there's a bifurcation going on in the hedge fund and private equity industry. The world's biggest investors are looking for "scalability" which is why they're increasingly focusing on the larger funds and using their size to lower fees. But they're still paying huge fees, which takes a big bite out of performance over the long-term.

As far as the smaller funds, they typically (but not always) focus on performance but they need to charge 2 & 20 to survive. Big pension and sovereign wealth funds aren't interested in seeding or investing in them, which is a shame but very understandable given their limited resources to cover the hedge fund universe. Typically, smaller endowment or family offices or a former hedge fund billionaire boss are their source of funding.

If I can make one recommendation to the Institutional Limited Partners' Association (ILPA) as well as the newer Alignment of Interests Association (AOI) is to stop schmoozing when you all meet and get down to business and come up with solid recommendations on hedge fund and private equity fees and terms.

What do I recommend? I think hedge funds and private equity funds managing multi billions shouldn't be charging any management fee -- or they should charge a nominal one of 25 basis points, which is plenty to pay big salaries -- and the focus should instead be on risk-adjusted performance. The alternatives industry will whine but the power isn't with them, or at least it shouldn't be. It should be with big investors that have a fiduciary duty to manage assets in the best interests of their stakeholders and beneficiaries.

I still maintain that most U.S. public pension funds are better off following CalPERS, nuking their hedge fund program. They will save big on fees and avoid huge headaches along the way. And forgive my bluntness but most pensions don't have a clue of the risks they're taking with hedge funds, but they're all following the herd, hoping for the best, managing career risk even if it's to the detriment of their plan's beneficiaries.

On that note, I leave you with something else to chew on. Neil Simons, Managing Director of Northwater Capital's Fluid Strategies sent me a comment on operational risk, A Hedge Fund Manager, an Astronaut and Homer Simpson walk into a bar…:
We would like to propose a question to you: Is it possible for an investment management firm to operate with the same level of precision and reliability found in industries where failure is simply not an option?

To answer this question, we looked at operational practices in industries such as nuclear power, space travel, aviation and healthcare, which face the prospect of catastrophic failure on a daily basis and have the highest standards for reliability and quality – after all, failure in these industries is a matter of life or death. While the consequences of success or failure in the investment management industry may not be quite as extreme, we do believe that investment managers must treat their investors’ dollars with the same level of respect and thus operate to the same standards.

In this post, we explore what investment management would look if we applied the same level of operational excellence found in these industries. Investment management is a business of precision, yet far too often you hear rumours of ‘fat-finger’ execution errors, or other more serious issues due to operational failures. And these are only the failures that you hear about – what about the failures that go unreported to clients, or even worse, failures that the investment manager itself is not aware of? What it all comes down to is that errors in investment management, no matter how small, are a sign of a lack of quality, and with a lack of quality there is a potential for loss and deviation from strategy.

Are Current Best Practices Sufficient?


Most major operational deficiencies (lack of proper oversight and separation of duties, for example) can often be uncovered by traditional manager due diligence activities. However, many approaches to manager due diligence are conducted through the use of questionnaires which are often built around a series of “check boxes” to ensure that nothing large falls through the cracks. This process places little attention to the quality and repeatability of investment operations. Third party due diligence firms conduct more detailed reviews, but can only see so far into the manager’s processes.

Most practitioners would agree that the intricacies of processes are a potential source of operational risk. For example, frequent small errors could be a reason why a fund might deviate from its benchmark or intended strategy. These errors may also reflect a general lack of attention to detail in the manager’s organization. But most importantly, they conspire to provide the investor with something other than what they are paying for – quality service and predictability of returns.

The Next Level: Systematic and Detailed Examination


Passing a due-diligence audit is a good first step, but managers have the ability to hold themselves to a higher standard. When we at Northwater think about operational deficiencies, we look at all potential failures that can occur throughout the investment process, e.g., inside the details of reconciliation processes, trade execution and model updates. It is only at the finest level of granularity that one can assess errors that may go unnoticed. A systematic method is needed in order to investigate, prioritize and the resolve potential failures.

Failure Mode and Effects Analysis (FMEA) is one technique that we have implemented to assess quality and to reduce the probability of smaller errors, not just to prevent large, obvious ones. FMEA was originally developed by reliability engineers and is widely used today in many non-financial industries. To implement FMEA concepts, we have taken an in-depth look at our own processes to identify areas that can be improved, examine the potential results of errors that can occur, develop highly-documented processes to ensure accuracy and consistency, and continually review and improve these processes.

Nuclear power plants, airlines and hospitals have all adopted strict and well-documented quality control processes that prevent not just large errors, but the potential for a small error to propagate through a system with the potential to push a system beyond its tipping point.

Acknowledge the Human Element

Other industries explicitly acknowledge and manage the human factor and acknowledge that human error rates are not zero even for the simplest task.  Consider a study conducted by NASA to understand human error rates when performing relatively simple tasks; cognitive scientists have found that humans have base error rates in performing even the simplest tasks such as the classification of even vs. odd numbers or identification of triangles.

Despite the best intentions of employees, an underlying issue in investment management is that firms are made up of people and people make mistakes – it is inevitable. Even if the average employee isn’t Homer Simpson, the pilots from “Airplane!”, or the cast from TV’s “Scrubs”, the staff at these organizations face legitimate challenges such as time availability, stress levels, distractions, and even ergonomics and office culture. As such, a lot can be assessed from a review of the processes in place to manage the ‘human factor.’

At Northwater, we have explicitly acknowledged the human element within our processes as well as the performance shaping factors that can impact human performance. Automating processes is a standard method for minimizing the probability of an operational error. It is also possible to redesign processes to reduce complexity. This reduction in complexity helps to minimize the probability of error when a human is involved with a process. We believe that this is an important aspect of our approach to the minimization of operational risk.

By looking to other industries, investment managers can achieve a higher operational standard. If you are interested in learning more about our novel approach to understanding and minimizing operational risk, please contact us.
Neil followed up with these comments for my blog readers:
As discussed, we probably didn't go into sufficient detail in the post. We did quite a few things in our opinion to reduce operational risk.

One, as mentioned, was the implementation of the FMEA methodology. Requires all the people involved in daily trading (PM's, ops people, model people) to systematically map all processes and then brainstorm on how processes can fail. Then rank how failures can cause problems by severity and ultimately prioritize and implement changes to processes to eliminate or significantly reduce the probability of those failures.

FMEA is a standard practice in many other industries to assess operations but you don't seem to hear about it in finance.

We believe that standard op risk practices are important and useful for finding issues associated with investment management firms. They play an important role in helping investors. This topic is more about assessing quality and repeatability of operations. And achieving the highest possible quality, resulting in minimizing the probability of an operational issue associated with day to day portfolio management.

We believe that the third party operational risk firms can't ever go into as much detail as the management firm itself. It is only the people involved in the actual processes that can really understand how processes could fail. Benchmarking and big picture best practices are done well by the third party people but I don't believe they can do a good job at assessing the real quality of the processes.

Financial firms typically strive to implement industry best systems. However, at times, these systems require workarounds and spreadsheets. As well, many of these workaround can be operated by junior people and we believe they are accidents waiting to happen. It is just assumed that these people won't make mistakes or it is up to these people to show sufficient "attention to detail" to never make a mistake. But to us, that is an unrealistic assumption.

Humans make mistakes.

The next aspect that helped us was acknowledgement of the human side. Once you read some of the literature on how humans screw up simple things, you realize it is just a matter of time until someone makes a mistake while operating a process. Humans have small, but non zero error rates for even the simplest tasks. As task complexity increases, the error rate increases.

If a diligent person does 20 simple tasks per day and they do that every day for a year, then you should consider the potential error rate of those tasks. A 1 in 1,000 error rate will cause errors to become a reality for the case of 20 tasks per day for an entire year. If the potential consequences of one of those errors is severe then you have a real problem.

When humans are involved in a process, make their tasks as simple as possible. This accounts for increasing error rates that occur as task complexity increases.

Obviously automation is a well-known solution. Some tasks can’t be automated or at times, systems require some human intervention, and at times a human must intervene in the instance of an exception. These are the instances when the human element should be considered.

We have implemented many more checklists and improved existing checklists for clarity. Implemented many more double checks for tasks involving humans and have also strived to make the independent double checks truly independent. i.e., two people sitting beside each other looking at the same information at the same time is not an independent test since they will potentially influence one another and reduce effectiveness of what is supposed to be an independent check.

We have also implemented a daily pre-trading huddle with people involved with trading, model updates, operations in order to understand the portfolio management tasks for the day. This mirrors the huddles that are more frequently used in operation rooms before a procedure starts (see “Checklist Manifesto”, book by Gawande below).

Again other industries recognize some of these human elements and try mitigate. Finance doesn't seem to do that, most just assume that humans involved in processes perform their tasks perfectly.

We intentionally also modified our working environment. During portfolio management model updates and trading times we do not permit any interruptions of the portfolio management team. We place an indicator in the office that says tells other people in the office that the portfolio management process is taking place and to stay away and do not interrupt the portfolio management team (operations, model updates, reconciliation, trading). An open office (most trading rooms) is great for communication, sharing ideas, etc. but a disaster waiting to happen if you consider how humans perform when they are interrupted or bothered while performing tasks. Again, other industries are aware of these issues.

The FMEA process changes need to be considered within that context. Obviously automation is key, but humans are involved in most processes at some point along the line. Making the human involvements as simple as possible and having safety modes that can catch failures is also key. FMEA is a manner for understanding all of that.

Implementing FMEA and also reading all about how humans make errors changes our way of thinking. We believe we have improved operational efficiency and minimization of operational risk.
Those of you who are interested in finding out more about the FMEA process and Northwater Capital's Fluid Strategies should contact Neil directly at nsimons@northwatercapital.com. As someone who has invested in many hedge funds, I can unequivocally tell you human mistakes happen more often than investors and funds want to acknowledge and there should be a lot more rigorous industry standards to mitigate against operational risk.

As always, feel free to contact yours truly (LKolivakis@gmail.com) if you have any insights you want to share on transforming hedge fund fees and mitigating operational risks. I don't pretend to have the monopoly of wisdom on these important topics and even though I come off as an arrogant cynical prick, I'm a lot nicer in person (just don't piss me off with your bogus niche strategy and if you ever want to meet me, the least you can do is subscribe or donate to my blog!).

One astute hedge fund investor shared his insights with me after reading my comment:
The challenge is that the managers who know they can deliver sustainable alpha (ie the only ones it is worth investing in under the current fee structure paradigm), are still not negotiable today unless you are prepared to write 10 figure tickets and underwrite business risk yourself. There is a considerable capacity shortage for quality alpha generators. In rare instances, 2% and 20% might not be enough!

However, in many instances, 0% and 25% is too much if you factor in all the operational risks that you face.

Unfortunately, the biggest problem brought by high fees is borne by managers as a whole in the form of abnormal attrition rates. High attrition rates exist partly because investors cannot tolerate drawdowns from high management expense ratio operation. That triggers a window dressing exercise, whether it is voluntary or policy driven.

I think if managers rewarded long-term investors by reducing the fee paid by an investor by a notch on each of its investment anniversary, attrition rates would stabilize. It would be less psychologically painful to re-underwrite a losing fund if the fee structure comes down every year. The only risk from the manager view point is that if he is really successful, after a few years, every investor stuck around and now its entire capital base is charged below market rates. But there are ways to circumvent that second order problem.

That's one approach we have tried to implement without success due to existing MFNs but we never lose an occasion to talk about that.

Ironically, MFNs signed by large investors who are members of high profile investor associations that supposedly promote better alignment of interest is what makes it almost impossible for managers to consider alternative fee structures where the economics are less skewed in favor of the manager.
Below, CNBC's Kate Kelly reports on the new players in hedge funds leading corporate activism. I've got a great young activist fund manager looking to get seeded in a world where everyone is hot and horny for big hedge funds. If you're interested, contact me directly (LKolivakis@gmail.com).

Second, a discussion on alternative investing strategies amid changing trends in interest rates, with Colbert Narcisse, Morgan Stanley Wealth Management head of Alternative Investments Group.

As my friend Brian Romanchuk points out in his blog, investors are making mountains out of molehills on the Fed lift-off. In his latest comment, Brian critically examines why the Fed is keeping rates low looking at former Fed Chairman Bernanke's first blog comment (for me, it's simple, raising rates now would be a monumental mistake but don't ever discount huge policy blunders!).

Lastly, Jamie Dinan, York Capital founder and CEO, shares his global economic forecast for Europe, Japan and China. He's a lot more optimistic than I am on Europe, Japan and China but I'm still playing the mother of all carry trades fueling the buyback and biotech bubbles everyone is fretting about.

As always, I work extremely hard to provide you with the very best insights on pensions and investments. The least you can do is show your financial support by donating any amount or by subscribing via the PayPal buttons on the top right-hand side (under click my ads pic). I thank those of you who have contributed and ask others to follow suit.



Monday, March 30, 2015

The China Bubble?

Laura He of MarketWatch reports, China stocks may be in serious bubble:
Some say that when the average “mom-and-pop” retail investors get back into the stock market, it could be time to get out. But what about when even teenagers start buying?

China has entered a new stock frenzy, like something out of America in the Roaring 20s or the dottiest days of the dot-com bubble, with trading volumes continuing to push to new record highs.

On Wednesday, combined trading on the Shanghai and Shenzhen markets hit 1.24 trillion yuan ($198 billion), the seventh straight session in which turnover surpassed the 1 trillion yuan mark. By comparison, the New York Stock Exchange typically saw $40 billion-$50 billion a day in trading during the first two months of this year.

The Shanghai Composite Index is hovering near its seven-year closing high of 3,691, hit on Tuesday when the index completed a 10-session winning streak.

For the year so far, the benchmark is up 13.8%, making it the best-performing major East Asian stock index of 2015 to date, though it still has a way to go to match 2014’s 53% surge.

The lure of flush times on the Shanghai market is sweeping in unlikely investors by the hundreds of thousands. This week, both the China Securities Daily and the Beijing Morning Post had dueling reports about recent college graduates and, yes, teenagers buying shares.

Typically these young investors speculate with money given to them by their parents, according to a Great Wall Securities broker quoted in the Beijing Morning Post story.

Yet another report, this time by the Beijing News newspaper, relates that at the Beijing trading halls of China Securities Co., “even the cleaning lady” has opened an account to play the market.

The data appear to agree with the anecdotes: Within the last week alone, 1.14 million stock accounts were opened in China, the biggest such surge since June 2007, according to China Securities Depository & Clearing Corp.
What does it all mean?

In a note this week entitled “The Worrying Sense of Calm in China,” analysts at Bank of America Merrill Lynch got right to the point: “Risk-Love (equity sentiment) in China’s equity market is in euphoria territory. It is time to book some profits.”

After holding an overweight rating on Chinese shares since August of last year, Merrill Lynch is now cutting the market to neutral, making it clear that economic problems — especially looming deflation — suggest the current environment doesn’t justify buying into stocks.

“China’s real interest rates remain too high, the currency is too expensive, fiscal policy is tight, and debt deflation is taking hold,” the analysts said.

“We are now concerned that the scale of monetary/fiscal easing required in China is so large, and so radically different from where policy makers’ assessments are, that an overweight [rating] is no longer tenable,” they said.

But of course, there are some bulls in the analyst community as well. Erwin Sanft, a China strategist with Australian investment bank Macquarie, says that despite the recent upsurge, valuations for Shanghai’s yuan-denominated stocks are still “normal ... [and] not at a bubble level.”

Speaking at a panel with financial journalists Wednesday in Hong Kong, Sanft said the climb in Chinese stocks is partly due to the fact that the Shanghai market has been moving off of an extremely low base over the past 10 to 20 years.

According to FactSet data, the Shanghai Composite’s milestones tell a story of Octobers: The benchmark turned 1,000 in October 1996, then peaked at just above 6,000 in October 2007, before crashing to a post-crisis low of 1,665 in October 2008. On Thursday, the index closed at 3,682.

Macquarie China economist Larry Hu, speaking at the same event, said Chinese stocks still have room to grow, if only because the country is in the process of reforming and developing its equity markets as a channel for companies to raise funds directly. Currently, Chinese companies mainly source funds through indirect means, such as commercial-bank loans.

Hu also said Chinese shares are benefiting from trouble in other asset classes. Trust products have turned risky amid the weakening economy, and the real-estate market is in decline, so stocks now look more attractive to Chinese households, he said.
With all due respect to Macquarie's Larry Hu, if he thinks there is no bubble in Chinese shares, he's blind as a bat. Sober Look just posted another sobering comment, discussing the frenzied speculative activity in China's equity markets, showing in a few charts just how whacky and parabolic things have gotten in Chinese shares. Just check out this chart of the Shanghai Composite index (click on image):


What does this remind me of? Ironically, it reminds me of the Greek stock market bubble of 1999. Back then, I remember visiting Greece in the summer and everyone was so consumed by the spectacular gains in the stock market. It was mass hysteria unlike anything you could imagine, to the point where I would walk in a store to buy clothes and the owners and employees were more preoccupied with what was going in the Athens Stock Exchange than servicing me.

Alas, that didn't end well and neither will this spectacular China bubble. And even worse, as Mike Bird of Business Insider reports, China's house price crisis is creating a perverse bailout bubble for property companies:
China's house prices are sinking at the fastest pace on record, but you wouldn't know it by looking at the country's massive property companies.

Prices tumbled 5.7% in the year to February, falling across 66 of China's 70 biggest cities.

China's booming economy has driven a colossal supply of houses, including the ghost cities for which the country is now infamous.

But the country's growth is slowing considerably, falling to the lowest level in 24 years in 2014, and falling house prices raise the risk of a debt overhang — when households and businesses have more property debt than the buildings they own are worth. Rabobank's analysts suggest the crash "likely still has years to play out given the level of oversupply."

And you would think that would be bad for China's big property and real-estate companies. After all, residential and commercial buildings are what they sell to make their living, so falling prices certainly seem like a bad thing.

But shares of China Vanke, the country's largest property developer, rose by 4.04% on Wednesday.

It's a similar story for Poly Real Estate Group, another massive developer. Shares rose 5.05% overnight and are up by more than half in the past year. In fact, both companies easily outstripped the 2.13% rise in Shanghai stocks overall on Wednesday. But why?

The answer lies in the perverse incentives on offer — and the fact China's Evergrande Real Estate Group just got a $16 billion (£10.85 billion) lifeline from China's state-run banks.

Here's how The New York Times reported the effective bailout for the developer:
The Chinese leadership is concerned about the health of the country's property market because it is so deeply interconnected with other parts of the economy. Real estate is an important driver of steel consumption, loan growth and jobs for sales agents and migrant construction workers. A drop in home prices hurts ordinary Chinese because they tend to invest a disproportionate amount of their savings in real estate.
It's a more extreme version of the "good news is bad news" phenomenon that a lot of investors closer to home have complained about in recent years — that positive economic news is bad news for stocks because it's a sign that government or central-bank support could be pulled away more quickly. Property prices falling in China means more bailout money.

In fact, Kaisa Group, another property developer that defaulted on offshore bonds in January saw share prices surge Wednesday, up 9.52%. China's house price crash may well be bad news for China, but perversely, it's good news if you're a struggling property developer.
How concerned are China's leaders? Enough to cut rates earlier this month and to just announce they are loosening home-buying rules to counter the economic slump.

How concerned am I of what is going on in China? A lot more concerned than the big fat Greek squeeze being played out right now in that country's lose-lose game Soros and others are betting on.

Unlike the Greek stock market bubble, which was a fart in the winds of history, the property and equity bubble in China spell huge trouble for a world grappling with deflation. Importantly, a boom-bust scenario in China will pretty much ensure global deflation, which is why I maintain if the Fed goes ahead and raises rates, it will be making a monumental mistake.

Below, a discussion from The Economist's Buttonwood Gathering 2015 featuring Ashvin Chhabra, CIO of Merrill Lynch Wealth Management, Rebecca Patterson, CIO of Bessemer Trust and Kyle Bass, CIO of Hayman Capital Management (h/t, Zero Edge).

Take the time to listen to this discussion, it's very interesting. Ms. Patterson was the person that impressed me the most but Chhabra and Bass raise excellent points too. Interestingly, they waited till the last minute to discuss the China bubble, which is ridiculous given how important it is for the global economy.

And for all you biotech skeptics that razzed me on Seeking Alpha, including Mr. Bass whose fund is actively shorting biotech shares (he doesn't get it, just like his short JGB call), take the time to watch Sunday evening's 60 Minutes clip on killing cancer which discusses incredible advances in immunotherapy to treat a deadly brain cancer and possibly many other cancers (watch Part 1 and 2 here).

As I predicted back in 2008, the Age of Biotech has arrived and we will all benefit from amazing advances in the health sector. But once again, I'm not saying that a biotech bubble isn't possible or won't happen (it most certainly will) or that there isn't  lot of hype in some smaller biotech companies, or that this biotech secular bull won't be very volatile (it is and will remain very volatile), but I think investors ignoring biotechs altogether based on some irrational bubble fears just don't understand the sector or why traditional valuation methods are poor indicators of the strength of many smaller biotech companies (for example, fast cash burn rates are normal for smaller biotechs funding research trials).

This is why I recommend you focus on the biotech  ETFs (IBB and XBI) or just buy shares of the big biotech giants like Biogen (BIIB), Celgene (CELG), Gilead (GILD) and others which make up the top ten holdings of the iShares Nasdaq Biotechnology (IBB).

If you are looking to invest in smaller biotech shares, pay attention to what top biotech funds like the Baker Brothers, Broadfin, Deerfield, Healthcor, Orbimed, Perceptive Advisors, Fidelity and others I regularly track are buying. They all know a lot more about biotech than Kyle Bass and Hayman Capital.

Finally, know your personal risk tolerance. If you can't stomach huge swings in biotech shares, avoid investing in this sector altogether and stick to some relatively safe dividend ETFs like SDY or VIG but be aware that high dividend stocks will get whacked hard as the lift-off tantrum unfolds in the United States.

Of course, once the China bubble bursts wreaking havoc on the global economy and ushering in an era of global deflation, it will have a profound effect on all risk assets, so enjoy the liquidity party while it lasts because when the titanic sinks, it will destroy institutional and retail investors which are ill-prepared for the storm ahead (don't worry, despite the constant dire warnings of Zero Edge, Armageddon isn't at our doorstep yet).



Friday, March 27, 2015

A Buyback or Biotech Bubble?

Steven Davidoff Solomon, professor of law at the University of California, Berkeley, wrote a comment for the New York Times, General Motors’ Stock Buyback Follows a Worrying Trend:
General Motors' announcement that it will buy back $5 billion worth of stock raises the question of whether the stock buyback has turned into a shareholder activist shakedown.

G.M. did not open its coffers willingly. Harry J. Wilson, a former member of the auto industry crisis task force led by Steven Rattner, gave it a helping hand. A few weeks ago, Mr. Wilson announced a campaign to press G.M. to buy back $8 billion worth of stock, leading four hedge funds with a total stake of about 2 percent in the automaker. As part of this, Mr. Wilson was nominated to run for a board seat.

Because G.M. was bankrupt only a few years ago, it seems a bit foolhardy for the company to willingly part with billions of dollars of hard-earned cash. But in a world where stock buybacks and shareholder activism are all the rage, it makes perfect sense on paper, if not in reality.

As activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.

According to a report by the law firm Schulte Roth & Zabel, as recently as 2013, 13 percent of activist campaigns sought a cash return. The call to return cash is based on the fact that United States companies are extraordinarily profitable and are building cash mountains when interest rates are at record lows. With limited ability to earn decent returns, activists have pushed hard for companies to return the cash to shareholders.

Companies that want to return money to shareholders have a choice: They can pay a dividend or buy back shares. In the former case, the calculus is easy. Assuming that there are no big tax issues, a dividend is just a return of cash to shareholders. But buybacks do more by taking shares out of the market. A buyback does not create wealth; theoretically, the cash disappears with the shares. But it does increase earnings per share and usually lifts the stock price, giving the remaining shareholders a bigger piece of the upside.

Buybacks make sense if a company’s management thinks its shares are underpriced and thus thinks it is getting a bargain. The peril in any stock repurchase, of course, is that the company pays too much.

But when have executives ever thought their company’s stock was overpriced? So companies choose the buyback. According to a highly influential article criticizing buybacks in The Harvard Business Review by William Lazonick, 54 percent of earnings — $2.4 trillion — went to stock buybacks and 37 percent went to dividends for the 449 companies in the Standard & Poor’s 500-stock index that were publicly listed from 2003 to 2012. According to a Barclays report, stock buybacks totaled $535 billion for the year that ended September 2014.

But returning cash isn’t all that a buyback or even a dividend does. The core idea behind a share repurchase is that it will make the company more disciplined.

Think about a world where you can have all the doughnuts you want. You just might eat a few too many. If a company like G.M. has an extra $5 billion sitting around, the thinking goes, it might decide not to invest wisely in the business or make smart acquisitions but instead simply use the cash less efficiently, like paying higher executive salaries.

Mr. Wilson’s argument for a large stock buyback was based on this conceit. In an interview with CNBC, he said that in the auto industry, when “times are good, they overinvest and make bad acquisitions, they overspend.”

But buybacks can leave a company without needed cash. G.M. had many buybacks before the financial crisis, totaling $20.4 billion from 1986 to 2002. It certainly could have used the cash then. Mr. Wilson is aware of this issue and stated in the CNBC interview, “We have always agreed that the company should have enough cushion” but that it was “enormous.”

And there is always the risk of overpaying for shares, especially now. With zero-interest rates, the stock market is bound to be high, and buying now may not make sense. In fact, most buybacks these days tend to destroy value because of their inflated prices.

Other problems can arise with buybacks. Mr. Lazonick has argued that repurchases leave little for “productive investment” and should be banned. The Economist called them “corporate cocaine” and cautioned that some companies may be borrowing too much to pay for them. Companies may also end up using buybacks to manage expectations for earnings per share, especially when large numbers of stock options are outstanding.

Still, the noted valuation expert Aswath Damodaran asserts that much good could come from share buybacks and that banning or regulating buybacks falls “squarely in the feel-good but do-bad economic policy realm.”

The vibrant debate shows the pros and cons of share repurchases, but G.M. was apparently unswayed by the cons.

The automaker quickly capitulated to the $5 billion buyback, with Mr. Wilson agreeing to withdraw his candidacy for the board, despite disagreement from another large shareholder, Warren E. Buffett. In an interview with CNBC, he said, “I think the idea of trying to do something now that gets a little pop in the stock should not be on” G.M.’s agenda.

At the end of the day, G.M. decided it was better to retreat than to fight. The activists know that the companies are feeling defensive. Even though Mr. Wilson’s group owned just 2 percent of the company, a contest would have been difficult and expensive. The $5 billion turned out to be the cost of doing business. As Marketplace put it, “Please shut up and here’s some money.”

Going forward, G.M. will aim to keep $20 billion in cash on its balance sheet and return free cash flow beyond that to shareholders. It had built up about $25 billion in cash as its sales and profits rebounded after its 2009 government-led bankruptcy.

The G.M. episode may signal a turning point. In good times, it is easy to get too comfortable. Technology companies like Google and Microsoft are stockpiling foreign cash. Others are racing to buy back shares at high valuations. But the good times inevitably end, this time most likely led by the activist stampede.

The haste in which G.M. rushed to comply to Mr. Wilson’s demands, and they and other companies shed cash rather than fight, shows that the activist tide pushing the stock buyback may have gone too far. Let’s hope that it doesn’t wash out companies and shareholders.
The stock buyback bubble is something that receives little attention from the media but buybacks have soared to record levels, and by the way, it has little to do with the "activist tide" and everything to do with a compensation system run amok.

Yes folks, we can blame "evil" activist hedge fund managers but America's CEOs have never had it this good. Ultra low rates, cheap debt, record cash levels are allowing them to buy back shares at a record pace, artificially boosting their earnings-per-share and padding their disgustingly bloated compensation which also includes lavish pensions as they shed defined-benefit plans and jobs to cut costs and increase profits.

Forgive my sarcasm, but if this is the "golden era of capitalism," god help us all. And make no mistake, everyone is in on this buyback binge. I check out news articles on buybacks every day, and it shocks me to see how many big companies are buying back their shares. Yahoo (YHOO) just got approval from its board to buy back an additional $2 billion in company shares, and Merck's (MRK) board just approved a whopping $10 billion repurchase program.

And Apple's buyback activity may not be enough for Carl Icahn, but during the fourth quarter of 2014, it was good enough to top the S&P 500. According to a new analysis from financial research firm FactSet, Apple spent more in buybacks than any other S&P company — even as year-over-year buyback spending for the overall index declined:
FactSet reported that during the fourth quarter, aggregate share buybacks by S&P companies totaled $125.8 billion, down 4.4% compared to the same time in 2013 and down 13.5% over buybacks in the third quarter of 2014. Overall, 362 companies — 72% of the index — participated in buybacks during the final quarter of the year, a figure that is consistent with the average participation rate over the past five years.

On a company-by-company basis, Apple’s $6.1 billion in share repurchases during the quarter was the most of any company on the S&P. This figure marks a 20% increase year-over-year but a 64% drop quarter-over-quarter.

“In the previous quarter, Apple spent the second-largest dollar amount on share repurchases by an individual company in the S&P 500 since 2005 at $17 billion,” FactSet analyst John Butters wrote in the report Tuesday. “Over the past three quarters, Apple has spent $16.9 billion on share repurchases on average. As a result, on a trailing 12-month basis, Apple has now spent the highest amount on buybacks, $57 billion, of all the companies in the index.”

For perspective, that $57 billion spending total is four times higher than the next-highest total: the $13.4 billion IBM spent in buybacks over the same period. Behind Apple and IBM is Exxon, with its $13.2 billion in buybacks over the trailing twelve months, Intel, which spent $11 billion over the same period, and Wells Fargo with $9.1 billion.

While Apple did lead the index in overall spending during the fourth quarter, its $1 billion year-over-year increase in spending was not the largest in the index. Intel — whose $4 billion in buyback activity during the quarter was second only to Apple — increased its spending by $3.5 billion. Johnson & Johnson increased its buyback by $2.3 billion, while Wells Fargo and Yahoo both increased theirs by $1.9 billion.

But of course, since overall buyback activity did dip 4.4% year-over-year, more sectors decreased their buyback than increased it. Seven of the S&P’s 10 sectors recorded a decrease in share repurchases, with the 95.8% drop in telecomm buybacks the largest plunge of the pack.
To be sure, buybacks are no panacea and they have backfired on a few companies. Moreover, there is an increasing unease on how much of the extraordinary stock market gains since 2009 have been fueled by share buybacks. Institutional Investor just published a great article, Stock Buybacks Wrestle With an Aging Bull, which discusses the concerns companies should ponder before approving share repurchase programs.

But as Bloomberg notes, American companies are in love with themselves, and they're not afraid to show it by buying back their shares at a record pace:
Corporate America’s love affair with itself grows more passionate by the month.

Stock buybacks, which along with dividends eat up sums of money equal to almost all the Standard & Poor’s 500 Index’s earnings, vaulted to a record in February, with chief executive officers announcing $104.3 billion in planned repurchases. That’s the most since TrimTabs Investment Research began tracking the data in 1995 and almost twice the $55 billion bought a year earlier.

Even with 10-year Treasury yields holding below 2.1 percent, economic growth trailing forecasts and earnings estimates deteriorating, the stock market snapped back last month as companies announced an average of more than $5 billion in buybacks each day. That’s enough to cover about 2 percent of the value of shares traded on U.S. exchanges, data compiled by Bloomberg show.
No wonder big investors are openly worried and urging corporate titans to focus capital on the long term. Unfortunately, their warnings are falling on deaf ears and truth be told, many pensions are guilty of the same short-term behavior they're openly criticizing.

And while some claim that larger stock buybacks are a sign of increasing stock market efficiency, I agree with those who claim that buybacks are nothing more than a glorified accounting scheme to help boost corporate compensation spinning out of control.

The problem, of course, is that the share buyback bubble is an integral part of the rising stock market, dwarfing everything in the U.S. market. Just how important is buyback activity?  As Oliver Renick of Bloomberg reports, Buyback Blackout Leaves U.S. Stocks on Own Prior to Earnings:
U.S. stocks are entering part of the year when one of their biggest support systems is turned off.

Buybacks, which reached a monthly record in February and have surged so much they make up about 2 percent of daily volume, are customarily suspended during the five weeks before companies report quarterly results, according to Goldman Sachs Group Inc. With the busiest part of first-quarter earnings seasons beginning in April, the blackout is getting started now.

While the data isn’t conclusive, owning stocks during the five-week stretch when repurchases were curbed has generated a return that trails the market average over the past two years, according to data compiled by Bloomberg. That’s not surprising to Eric Schlanger of Barclays Plc, who says companies buying back shares have helped keep equities aloft.

“Blackout periods are on radar screens now because of valuations, the length of the bull market, and the consensus that buybacks have been a major part of the bull market,” Schlanger, head of equities for the Americas at Barclays, said by phone. “With the S&P up around 2,100, people are going to be more attuned to possible fractures or previous areas of support changing than they were at 1,400.”

Companies in the Standard & Poor’s 500 have spent more than $2 trillion on their own stock since 2009, underpinning an equity rally in which the index has more than tripled. They spent a sum equal to 95 percent of their earnings on repurchases and dividends in 2014, data compiled by S&P and Bloomberg show.
How can individual investors play this buyback bubble? It turns out there is an ETF, PowerShares Buyback Achievers ETF (PKW), which assembles companies buying back their shares. You can view the top ten holdings and chart of this ETF below:

(click on image)


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But if you ask me, you are better off investing in biotech ETFs (IBB and XBI) and stocks I recommended in my Outlook 2015 at the beginning of the year (read a comment in Seeking Alpha, A Bold Call For Biotech ETFs).

Importantly, I want you all to ignore the talking heads on CNBC and elsewhere warning you of a biotech bubble, and keep using any selloff in this sector to add to your positions just like I did last year during the big unwind and just as I did this week. Keep buying the major dips on biotech.

Here is just a small sample of over 200 biotech stocks I'm tracking (click on image):


Some of the smaller biotechs got whacked hard this past week. As I've repeatedly warned you, if you can't stomach huge swings of 20%, 30% or more either way, it's best to avoid the smaller biotech companies and just focus on the ETFs (IBB and XBI) or just buy shares of the big biotech giants like Biogen (BIIB), Celgene (CELG), Gilead (GILD) and others which make up the top ten holdings of the iShares Nasdaq Biotechnology (IBB).

As someone who suffers from Multiple Sclerosis, Biogen remains one of my favorite biotech companies.  It's an incredible company discovering amazing drugs for patients suffering from neurological diseases, including Alzheimer's disease, where there's nothing really good available.

One thing is for sure, all this talk of a biotech bubble about to burst is absolute rubbish spread by ignorant fools or big hedge funds and mutual funds that are looking to get in on the action. As far as I'm concerned, there is no biotech bubble and investors ignoring this sector will severely underperform their peers in the next few years (you read that right, never mind what Zero Edge claims).

But the buyback bubble does concern me in a market where Nobel laureate Michael Spence rightly notes, equities are overvalued. Of course, as Keynes reminded us a long time ago, "markets can stay irrational longer than you can stay solvent," so I'm comfortable playing this buyback bubble and especially comfortable playing the secular bull market in biotech shares which I foresaw back in 2008 in my comment, The Age of Biotech.

Once more, I remind my readers to support my blog by clicking on the ads and more importantly, by donating any amount via PayPal on the top right-hand side. Institutional investors can donate or subscribe via PayPal using one of the three options provided to them. Please take the time to support this blog, I work extremely hard to provide you with the very best insights on pensions and investments and appreciate your financial support.

Below, an older clip from the Harvard Business Review discussing profits without prosperity. Take the time to watch this clip and you'll understand why American companies are in love with themselves.

And one of my favorite portfolio managers, LMM Chairman and CIO Bill Miller, shares his market forecast, and view of the biotech and homebuilder sectors. Miller says we're in a long lasting bull market, and he really likes Pandora's (P) stock as well as Intrexon (XON), which remains one his largest biotech holdings.

Listen carefully to Bill Miller, he knows what he's talking about, which is more than I can say for most skeptics who are going to get crushed avoiding stocks and the red hot biotech sector.

Thursday, March 26, 2015

America's Pensions in Peril?

John W. Schoen of CNBC reports, Funding shortfalls put pensions in peril:
These days, a pension just isn't what it used to be.

For generations, a defined benefit pension—a fixed monthly check for life—provided an ironclad promise of a secure income for millions of retired American workers. But today, that promise has been badly corroded by decades of underfunding that have undermined what was one of the cornerstones of the American dream.

The safety net that millions of retirees spent decades working toward has been fraying for some time. The Great Recession, and the market collapse that wiped out trillions of dollars of investment wealth, weakened the pension system further, though some of the damage has been repaired since the stock market rebounded and the economic recovery took hold.

Hundreds of billions of dollars in defined benefits are still paid out every year to retirees. State and local public pension benefit payments reached $242.9 billion in 2013, according to the most recent Annual Survey of Public Pensions. And a Towers Watson study of more than 400 major companies that sponsor U.S. defined benefit plans estimated they paid out nearly $97 billion in benefit payments last year, and another $8.6 billion went toward lump sum payments and annuities.

But that's nothing compared to the private employers' projected benefit obligations last year, which climbed 15 percent from the previous year to a whopping $1.75 trillion, while plan assets grew by only 3 percent.

Disparities like that help explain why so many pensions are in peril. Simply put: Obligations have outpaced fund contributions and growth for private and public plans. That means that even workers who have paid into pensions for several years may not get the level of benefits they expect. And many younger employees may never have an opportunity to participate in a pension at all.

The result is that, unlike past generations of Americans, many workers today bear the brunt of the investment risk that underpins their hopes of income security once they are no longer able to work.

In 1975, some 88 percent of private sector workers and 98 percent of state and local sector workers were covered by defined benefit plans, according to a 2007 report by the researchers at the Center for Retirement Research at Boston College. By 2011, fewer than 1 in 5 private industry employees was covered by a pension that paid a guaranteed monthly check, according to the Labor Department.

That historic shift has been blamed by critics for an estimated deficit in retirement savings of more than $4 trillion for U.S. households where the breadwinner is between ages 25 and 64, according to Employee Benefits Research Institute.

"You have this hole in what private sector workers have for retirement. We're coming up on this place where all these people are not going to be able to retire," said Monique Morrissey, a researcher at the liberal Economic Policy Institute.

That shift away from a guaranteed pension check has been slower to take hold among public sector workers, where some 83 percent still have access to a pension that promises to pay monthly retirement income for life after a career of service. But that's changing.

Faced with rising health costs and retirees living longer than expected, many state and local governments are failing to keep up with the annual payments. A CNBC analysis of financial data for 150 state and local pension plans collected by Boston College's research center found that 91 had set aside less than 80 percent of the money needed to meet current and future obligations to retirees. Only six were fully funded.

One big reason: State and local governments aren't making the annual contributions required to fund those liabilities. Of the 150 plans tracked by the center, 47 paid less than 90 percent of what's needed to keep pension benefits funded and 79 paid more. (There was no data available for 24 of the 150 plans.)

"People appreciate services: They want cops and firefighters, they want teachers and all that stuff," said Morrissey. "But if you're a politician in a budget crunch, the one way to not raise taxes is to just not pay your pension bill. In the states and cities where there's a big problem, it's not because they underestimated cost. They simply didn't pay the bill."

In New Jersey, which has averaged less than half its required annual contributions for over a decade, a state judge last month ordered Gov. Chris Christie to make a court-ordered $1.6 billion payment into the state's public pension system after it was withheld from his proposed $34 billion state budget. Christie is appealing the ruling.

In New York, state lawmakers plan to defer more than $1 billion in required pension contributions over the next five years. In Illinois, the state's new Republican governor, Bruce Rauner, last month proposed more than $6 billion in spending cuts—more than a third of which would come from shifting government workers into pension plans with reduced benefits.

In Rhode Island, retirees are suing the state over a 2011 pension overhaul led by newly elected Democratic Gov. Gina Raimondo during her tenure as state treasurer. The reforms, which raised retirement ages and cut cost-of-living increases, were projected to save $4 billion over 20 years. (On Monday, the retirees accepted a proposed settlement that would reduce retirement benefits.)

With state and local politicians loathe to propose the tax increases needed to fund the shortfalls, many have overhauled their pensions systems instead by increasing the burden on public workers and retirees and cutting benefits.

"Nearly every state since 2009 enacted substantive reform to their retirement programs, including increased eligibility requirement, increased employee contributions or reduced benefits, including suspending or limiting (cost of living increases)," said Alex Brown, research manager at the National Association of State Retirement Administrators, a nonprofit association whose members are the directors of the nation's state, territorial, and largest statewide public retirement systems.

Those cuts range from about 1 percent for retirees in Massachusetts and Texas to as much as 20 percent in Pennsylvania and Alabama, according to a survey of state pension reforms last year by the association and the Center for State and Local Government Excellence.

For retirees like David Jolly, 90, that's mean getting by with a little less every year.

Jolly, who retired in 1986 as public works director for Island County, Wash., now lives with his wife on a combined monthly income of $1,888 from his state pension and Social Security. "Every time they try nibbling at it, it just makes it that much harder," he said. "They don't realize what the cost of living of older people is. ... It just keeps going up and the retirement pay just doesn't."

To close the pension funding gap, many state and local governments have also cut access to defined benefit pensions for new hires or increased contributions and minimum retirement age for active workers. "New employees can expect to work longer and save more to reach the benefit level of previously hired employees," according to a survey by the retirement administrators association.

While closing plans to new members may reduce benefit liabilities decades from now, it also cuts into the contributions from active workers to support retirees. For over a decade, the ratio of active workers to retirees has been falling, placing an added strain on the public pension system.

For workers and retirees in the private sector, where defined benefit plans are much less common, funding levels are generally in better shape.

Rising investment returns since the financial collapse of 2008 helped boost funding levels for private industry plans in 2013 to 88 percent of their liabilities, according to a survey of the latest available data by pension fund consultant Milliman. But that still left the 100 largest companies surveyed with a combined pension plan funding deficit of $193 billion.

The pension funding shortfall is even worse for a handful of so-called multi-employer pension plans, which typically cover smaller companies and unions and face a different set of financial challenges. Declining union enrollments, for example, mean there are fewer active workers to cover the cost benefits for retirees, many of whom are living longer than expected than when these plans were established.

Multi-employer plans also face the added burden of their pooled pension liabilities. When one member of the plan fails to keep up with contributions, for example, the burden on the other members increases.

About a quarter of the roughly 40 million workers who participate in a traditional "defined benefit" plan—those that pay retirees a guaranteed check every month—are covered by these multi-employer plans, according to the Bureau of Labor Statistics. In the last four years, the Labor Department has notified workers in more than 600 of these plans that their plans are in "critical or endangered status."

Last year, the Pension Benefit Guaranty Corporation, the government insurance fund for pension plans that go bust, reported that its program backing multi-employer plans was $5 billion in the red. It projected that unless Congress acted, there was about a 35 percent probability its assets would be exhausted by 2022 and about a 90 percent probability by 2032. (Single-employer pension plans are covered by a separate program that is on a much more solid financial footing.)

After funding shortfalls threatened the solvency of the governments' insurance backstop for multi-employer pension plans, Congress eased the rules allowing plan administrators to cut benefits last year. Proponents of the proposed pension guaranty corporation reforms argue that they will help prevent more multi-employer plans from going under and that retirees are better off with smaller monthly payments than none at all.

That's something beneficiaries of private and public pensions are hearing a lot these days.
As you can read above, America's private and public pensions aren't in good shape. There are a lot of reasons why this is the case and my fear is the worst is yet to come.

One thing I can tell you, the attack on U.S. public pensions continues unabated. Andrew Biggs, a resident scholar for the conservative American Enterprise Institute wrote a comment for the Wall Street Journal, Pension Reform Doesn’t Mean Higher Taxes:
The Pennsylvania State House held a hearing on Tuesday about reforms that would shore up the state’s public-employee pension program. The hearing was overdue. Annual required contributions to the state’s defined-benefit plan have soared to more than 20% of employee payroll from only 4% in 2008. Legislators in the state, like many elected officials nationwide, are looking for a way out.

State Rep. Warren Kampf has introduced a bill to shift newly hired government employees to defined-contribution pensions similar to a 401(k) plan. Defined-contribution pensions offer cost stability for employers, transparency for taxpayers and portability for public employees.

But the public-pension industry—government unions and the various financial and actuarial consultants employed by pension-plan managers—claims that “transition costs” make switching employees to defined-contribution pensions prohibitively expensive. Fear of “transition costs” has helped scuttle past reforms in Pennsylvania, as in other states. But the worry is unfounded.

The argument goes as follows: The Governmental Accounting Standards Board’s rules require that a pension plan closed to new hires pay off its unfunded liabilities more aggressively, causing a short-term increase in costs. Thus the California Public Employees’ Retirement System, known as Calpers, claimed in a 2011 report that closing the state’s defined-benefit plans would increase repayment costs by more than $500 million. Similar claims have been made by government analysts in Minnesota, Michigan and Nevada. The National Institute for Retirement Security, the self-styled research and education arm of the pension industry, claims that “accounting rules can require pension costs to accelerate in the wake of a freeze.”

But GASB standards don’t have the force of law; nearly 60% of plan sponsors failed to pay GASB’s supposedly required pension contributions last year. That includes Pennsylvania, where the public-school-employees plan last year received only 42% of its actuarially required contribution. GASB standards are for disclosure purposes and not intended to guide funding. New standards issued in 2014, GASB says, “mark a definitive separation of accounting and financial reporting from funding.”

In fact, nothing requires a closed pension plan to pay off its unfunded liabilities rapidly, and there’s no reason it should. Unfunded pension liabilities are debts of the government; employee contributions are not used to pay off these debts. Whether new hires are in a defined-contribution pension or the old defined-benefit plan, the size of the unfunded liability and the payer of that liability are the same.

More recently, pension-reform opponents have shifted to a different argument: Once a pension plan is closed to new hires, it must shift its investments toward much safer, more-liquid assets that carry lower returns. Actuarial consultants in Pennsylvania have claimed that such investment changes could add billions to the costs of pension reforms.

This argument doesn’t hold. It is standard practice for a pension to fund near-term liabilities with bonds and to pay for long-term liabilities mostly with stocks. A plan that is closed to new entrants stops accumulating long-term liabilities. As a result, the stock share of the plan’s portfolio will gradually decline. But that’s because the plan’s liabilities have been reduced. Plans would not be applying a lower investment return to the same liabilities. They would apply a lower investment return to smaller liabilities.

Many public pension plans apparently believe that a continuing, government-run pension can ignore market risk, while a plan that is closed to new entrants must be purer than Caesar’s wife. The reality is that all public plans, open and closed, should think more carefully about the risks they are taking. But the difference in investment returns between an open plan and a closed one should be a minor consideration for policy makers considering major pension reforms.

Shifting public employees to defined-contribution retirement plans won’t magically make unfunded liabilities go away. Pension liabilities must be paid, regardless of what plan new employees participate in. But defined-contribution plans, which cannot generate unfunded liabilities for the taxpayer, at least put public pensions on a more sustainable track.
The problem with this Wall Street Journal article is it's factually wrong. Jim Keohane, CEO of the Healthcare of Ontario Pension Plan (HOOPP), sent me these comments:
I read the clip from the WSJ you included on your blog, and I thought you would be interested in a piece of research on the subject which was completed by Dr. Robert Brown (click here to view the paper). This is a fact based piece of research which looked at the cost of shifting from DB to DC. Proponents of a shift from DB to DC, such as this article, portray this as a win-win situation, but when Dr. Brown looked into the facts, what he found was that this is in fact a lose-lose situation. The liabilities in the existing plans are very long tailed and putting these plans into windup mode causes the costs and risks to go up, so there are no savings to taxpayers – in fact the costs go up, and the individuals are much worse off having been shifted to DC plans because they end up with much lower pensions.
When I read these articles in the Wall Street Journal, it makes my blood boil. Why? Am I a hopeless liberal who believes in big government? Actually, not at all, I'm probably more conservative than the resident "scholars" at the American Enterprise Institute (read my last comment on Greece's lose-lose game to understand the effects of a bloated public sector and how it destroys an economy).

But the problem with this article is that it spreads well-known myths on public pensions, and more importantly, it completely ignores the benefits of defined-benefit plans to the overall economy and long-term debt profile of the country. Worse still, Biggs chooses to ignore the brutal truth on defined-contribution plans as well as the 401(k) disaster plaguing the United States of Pension Poverty.

Importantly, pension policy in the United States has failed millions of Americans struggling to save enough money to retire in dignity and all these conservative think tanks are spreading dangerous myths telling us that DC plans "offer cost stability for employers, transparency for taxpayers and portability for public employees."

The only transparency DC plans offer is that they will ensure more pension poverty down the road,  less government revenue (because people with no retirement savings won't be buying as many goods and services), and higher social welfare costs to society due to higher health and mental illness costs.

And again, I want make something clear here, I'm not arguing for bolstering defined-benefit plans for all Americans from a conservative or liberal standpoint. Good pension policy is good economic policy. Period.

This is why I wrote a comment for the New York Times stating that U.S. public pensions need to adopt a Canadian governance model (less the outlandish pay we pay some of our senior public pension fund managers) in order to make sure they operate at arms-length from the government and have the best interests of all stakeholders in mind.

But the problem in the United States is that politicians keep kicking the can down the road, just like they did in Greece, and when a crisis hits, they all scramble to implement quick nonsensical policies, like shifting public and private employees into defined-contribution plans, which ensures more pension poverty and higher debt down the road.

Finally, while most Americans are struggling to retire in dignity, the top brass at America's largest corporations are quietly taking care of themselves with lavish pensions. Theo Francis and Andrew Ackerman of the Wall Street Journal report, Executive Pensions Are Swelling at Top Companies:
Top U.S. executives get paid a lot to do their jobs. Now many are also getting a big boost in what they will be paid after they stop working.

Executive pensions are swelling at such companies as General Electric Co., United Technologies Corp. and Coca-Cola Co. While a significant chunk of the increase is the result of arcane pension accounting around issues like low interest rates and longer lifespans, the rest reflects very real improvements in the executives’ retirement prospects.

Pension gains averaged 8% of total compensation for top executives at S&P 500 companies last year, up sharply from 3% the year before, according to data from LogixData, which analyzes SEC filings. But the gains are much larger for some executives, totaling more than $1 million each for 176 executives at 89 large companies that filed proxy statements through mid-March. For those executives, pension gains averaged 30% of total pay.

The gains often don’t represent new pay decisions by corporate boards. Instead, they reflect the sometimes dramatic growth in value of retirement promises made in the past. Nonetheless, they are creating an optics problem for companies at a time when executive-pay levels are under greater scrutiny from investors and the public. Companies now face regular shareholder votes on their pay practices that can be flash points for broader concerns, leaving them sensitive about appearing too generous.

New mortality tables released last fall by the American Society of Actuaries extended life expectancies by about two years. That, as well as low year-end interest rates, helped push pension gains higher than many companies had expected. The result is much higher current values for plans with terms like guaranteed annual payouts, which are no longer offered to most rank-and-file workers.

GE Chief Executive Jeff Immelt’s compensation rose 88% last year to $37.3 million. Meanwhile, excluding $18.4 million in pension gains, his pay actually fell slightly to $18.9 million.

The company says about half of the pension increase came from changes in its assumptions about interest rates and life span. About $8.8 million, however, comes from an increase of nearly $490,000 a year in the pension checks he stands to take home as his pay has risen and he approaches 60 years old, the age at which top GE executives can collect full pension benefits.

In all, Mr. Immelt’s pension is valued at about $4.8 million a year for life. The company puts its current value at about $70 million, up from around $52 million a year ago.

A GE spokesman said that much of the gain reflects accounting considerations and that Mr. Immelt’s recent salary increases reflect balanced-pay practices and board approval of his performance.

The SEC is particular about how companies report pay in their proxy statements. There is a standard table that breaks out salary, bonuses and pension gains, along with totals for the past three years, and other details. GE, encouraging investors to overlook the pension gains, added a final column to the table to show what top executives’ total pay would look like without them. The company says investors find the presentation useful in making proxy voting decisions.

Lockheed Martin is also asking investors to look past pension gains when considering its executives’ total pay.

At Lockheed Martin Corp., CEO Marillyn Hewson’s total pay rose 34% to $33.7 million last year, with $15.8 million of that stemming from pension gains. An extra column in the proxy statement’s compensation table strips out those gains, showing her pay up about 13% to $17.9 million.

Lockheed says that $5 million of the pension gains can be traced to changes in interest rates and mortality assumptions. Most or all of the remaining $10.8 million probably stems from increases in the payments she would receive in retirement: about $2.3 million a year now, up from about $1.6 million a year under last year’s proxy disclosure. Ms. Hewson’s pay rose sharply with her ascent to CEO in 2013 and chairman last year, increasing her pension benefit significantly.

Overall, the company’s obligation for future pension benefits for executives and other highly paid employees totaled $1.1 billion last year, up from $1 billion at the end of 2013.

A Lockheed Martin spokesman said the company broke out a nonpension compensation total in the proxy statement to provide more context for pay.

Executive pensions generally don’t consume the attention that pensions for the rank and file do. For years, as costs of traditional pension plans have risen amid low interest rates and longer lifespans, big companies have been closing them to new employees or even freezing benefits in place, often continuing with only a 401(k) plan for all but the oldest workers.

Last June, Lockheed Martin told its nonunion employees that it would stop reflecting salary increases in their pension benefits starting next year, and that the benefits would stop growing with additional years of work starting in 2020.

“It eliminates a lot of the variability that defined-benefit pension plans can create in our cost structure,” Chief Financial Officer Bruce Tanner told investors during a Dec. 3 conference presentation.

In 2011, GE stopped offering new employees traditional defined-benefit pensions and replaced them with 401(k) plans. At the time, Mr. Immelt cited recent market downturns and lower interest rates as being among the reasons for the shift.
In a cruel twist of irony, America's top CEOs are now enjoying much higher pension payouts while they cut defined-benefit plans to new employees and increase share buybacks to pad their insanely high compensation. I guess longer life spans are fine when it comes to CEOs' pensions but not when it comes to their employees' pensions.

Lastly, my comment on the 401(k) experiment generated a lot of comments on Seeking Alpha. Some people rightly noted that looking at 401(k) balances distorts the true savings because it doesn't take into account roll overs into Roth IRAs. When you factor in IRAs, savings are much higher.

While this is true, there is still no denying that Americans aren't saving enough for retirement and that 401(k)s are an abject failure as the de facto pension policy of America. It's high time Congress stops nuking pensions and starts thinking of bolstering and enhancing Social Security for all Americans, as well as implementing shared risk and serious governance reforms at public pensions.

Below, the pension terminator, Arnold Schwarzenegger, asks Warren Buffett his advice on how to handle unfunded liabilities of public pensions. Listen carefully to the Oracle of Omaha's reply, he understands the dire situation better than most people.