Wednesday, August 31, 2016

A Long-Term Solution For Pensions?

Keith Ambachtsheer, Director Emeritus, International Center for Pension Management, Rotman School of Management, University of Toronto and author of The Future of Pension Management, wrote an op-ed for the Financial Times, Pension solution lies in long-term thinking:
If low investment returns are here to stay, those responsible for pension plans have a choice: wring their hands or fulfill their fiduciary duty by rethinking what it means for the design of their schemes.

Doing nothing is not an option. From 1871 to 2014 US equities produced an investment return, after inflation, of 6.7 per cent a year. Treasury bonds were good for 3 per cent.

In contrast, the Gordon Model — which calculates prospective returns from assumptions about growth and yields — suggests much lower returns are in prospect, a real equity return of 3.6 per cent and 0.6 per cent from Treasury bonds.

A recent Bank of England report, Secular Drivers of the Global Real Interest Rate , also supports this idea of the new normal. It shows the current low return regime correlates strongly with slowing economic growth, ageing populations, savings gluts in Saudi Arabia, China and other developing countries, declines in infrastructure investing, rising income and wealth inequality, and falling capital good prices.

Lower returns, meanwhile, make pensions more expensive. As rule of thumb, for every 1 per cent drop in annual returns contributions must rise 20 per cent. So how to squeeze higher long-term returns out of pension assets, while still providing retirees reasonable safety of payment?

Dutch economist and Nobel laureate Jan Tinbergen answered this question decades ago: achieving two economic goals requires two instruments, not one. For pension design this means separate instruments for achieving the higher long-term returns and the payment safety goals.

So the Tinbergen rule exposes a fundamental problem with traditional pension design, which attempts to meet both goals with one instrument. A confounding factor is the common practice of treating volatility in returns as a proxy for risk.

For most individuals, the dominant risk is the long-term rate of return will be too low. What is needed are sustainable long-term cash flows, such as dividends, which compound and grow over time.

Pension organisations that understand the need to distinguish between this long-term risk, and the danger of short-term fluctuations in asset prices, will split the assets in their care: into long-term return compounding and short-term payment-safety sub-pools.

Still, this is only the start of a solution. A big question remains about whether many pension managers truly understand pension economics.

The glass half-empty answer is that many organisations do not have the capability of finding long-term assets due to lack of scale, poor governance and improper staffing.

The glass half-full response is that there is a still small, but growing group of pension organisations with the requisite capabilities and the scale to exploit them. They have what Peter Drucker, the inventor of modern management, described as the dictates of organisational effectiveness: mission clarity, strong governance and the ability to attract talent.

Arguably, the reorganisation of Ontario Teachers’ Pension Plan in 1990 started this Drucker movement, from where it spread to other large Canadian funds and, more recently, around the world.

Today, these “Drucker funds” are poised to deliver an extra 2 or even 3 per cent per annual investment return on their long-term return compounding assets.

The rethink also made the old new again, recalling John Maynard Keynes 1936 attack on the destructive effective of short-termism when investing. Then managing the Cambridge university endowment fund, he wrote in his General Theory the behaviour of long-term investors will seem “eccentric, unconventional and rash in the eyes of average opinion”.

The logic is not hard to follow. Hire skilled and motivated investment professionals, and tell them to focus on acquiring and nurturing sustainable long-term cash-flows in the forms of interest, dividends, rents and tolls in a cost-effective manner.

Indeed, eight decades later long-termism is again showing it can generate above-market returns. Keynes outperformed the market by 8 per cent a year between 1921 and 1946. On a much larger scale, Ontario Teachers’ outperformed it by 2.2 per cent from 1990 to 2015.

Such crucial additional active returns will continue to be available as long as average opinion continues to think long-term investing is “eccentric, unconventional, and rash”.
When it comes to pensions, I like reading Keith Ambachtsheer's thoughts as he is widely regarded as an expert in the field. You can subscribe to the Ambachtsheer Letter at KPA Advisory services here and read more of his comments tailored to institutional investors.

You can also order Keith's book, The Future of Pension Management, on Amazon.ca or Amazon.com. I have not ordered this book yet but along with Jim Leech and Jacquie McNish's book, The Third Rail, I'm sure it's well worth reading if you want to understand the challenges confronting pensions on a deeper level.

(As an aside, in our phone conversation yesterday, Brian Romanchuck of the Bond Economics blog told me he is in the process of writing his third book. You can order all of Brian's books on Amazon here and trust me, they're definitely worth reading and a real bargain.)

Now, I don't always agree with Keith Ambachtsheer and have openly questioned some of his views on my blog but this op-ed is a great, albeit abbreviated, introduction to what is plaguing many pension plans today.

Alluding to Tinbergen and Keynes, two well-known titans in the field of economics (you should read about their famous debate on econometrics here and here), Keith cleverly highlights the problem with traditional pension design and how pensions which have the right (ie., Ontario Teachers, now Canadian) governance can use their internal expertise, scale and very long investment horizon to their advantage to generate above-market returns over a long period.

(By the way, retail investors reading this comment can also learn about the importance of dividends, diversification and long term investing. In my comment on building on CPPIB's success, I mentioned books like William Bernstein's The Four Pillars of Investing and The Intelligent Asset Allocator and Marc Litchenfeld's Get Rich With Dividends to help you understand how to manage and build your nest egg over the long run.)

I can't really add much to what Keith is arguing in his op-ed except to point you to my recent comment on why US public pensions are crumbling where I stated
the following key points:
  • Global deflation isn't dead; far from it and anyone who doesn't take the bond market's ominous warning seriously is doomed (I would also add there is no bubble in bonds).
  • If deflation does end up coming to America -- aided and abated by the Fed who is still following an übergradual rate hike path, acutely aware global deflation presents the mother of all systemic risks -- then this means ultra low rates and possibly even the new negative normal are here to stay.
  • Even if global deflation doesn't hit America, the bond market is warning every investor to prepare for lower returns ahead, something I've been warning of for years.
  • Low returns are already taking a toll on US public pensions, which is why they're increasingly looking at alternative investments like private equity, ignoring the risks, to shore up their pension deficits (CalPERS has cited macroeconomic challenges in private equity returns but I've already warned you of private equity's diminishing returns).
  • But assets are only one part of a pension plan's balance sheet, the other part is LIABILITIES. Declining or negative rates will effectively mean soaring pension liabilities. And in a world of record low yields, this is the primary driver of pension deficits. Why? Because the duration of pension liabilities (which typically go out 75+ years) is much bigger than the duration of pension assets so any decline in rates will disproportionately and negatively impact pension deficits no matter what is going on with risk assets like stocks, corporate bonds and private equity. 
  • Faced with this grim reality, pensions are increasingly looking to invest in infrastructure which are assets with an extremely long investment lifespan. But even that's no panacea, especially in a debt deflation world where unemployment is soaring (infrastructure assets in Greece are yielding far less than projected following that country's debt crisis. Now the vultures are circling in Greece looking to pick up infrastructure, real estate and non performing bank loans on the cheap).
  • The key point is pensions need to prepare for much lower returns and stop relying on rosy investment assumptions to get them out of a deep hole. Stop focusing on assets and focus on growing liabilities in a deflationary world where people are living longer and introduce risk-sharing and better governance at your public pensions.
In his comment above, Keith rightly notes that as a rule of thumb, for every 1 per cent drop in annual returns contributions must rise 20 per cent. That is a big reason why US public pensions are so hesitant to lower their discount rate, namely, because if they do lower it, contributions will go up and employees and the state governments will need to pay more to shore up their public pensions.

However, in my comment on the big bad Caisse, I explained why with the passage of Bill 15 which forces plan sponsors in Quebec to share the risk of their plan, it was in the best interests of Quebec City's public sector workers to transfer their pension assets out of their city pension plan to the Caisse where they can collect better risk-adjusted returns at a fraction of the cost.

In my opinion, the solution to the global pension crisis is to follow Canada's radical pensions and adopt the governance model that has allowed them to thrive over the very long run.

That brings me to another giant in the field of economics, the great Paul Samuelson who once fretted the day everyone starts following Burton Malkiel's advice in A Random Walk on Wall Street.

I too fret the day every public pension and sovereign wealth fund in the world adopts the Canadian pension model because it will necessarily mean more competition and less future returns for our large Canadian pension plans.

Luckily, we're a long way off that point and as the pension Titanic sinks, some public pensions will sink a lot deeper than others and never come back to fully-funded or even adequately-funded status. But I guarantee you Canada's large, well-governed defined-benefit pensions will weather the storm ahead and lead the way forward, always focusing on the long term.

Below, Ontario Teachers’ CIO Bjarne Graven Larsen sat down with P&I reporter Rick Baert to discuss what attracted him to Ontario Teachers, how the “Canadian model” of governance differs from Denmark, and investments at the pension fund.

Also, take the time to listen to a panel session from the recent International Pension Conference of Montréal (IPCM) featuring Leo de Bever, AIMCo's former CEO.

I already went over the conference here but noticed this session was made public after my post. You can watch all the sessions here.

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