Tuesday, July 31, 2018

Exporting The CDPQ Infra Model?

Maxime Bergeron of La Presse had a good interview with the Caisse's President and CEO, Michael Sabia and Macky Tall, President and CEO of CDPQ Infra. The interview is in French and is available here but I tried to translate it below using Google so bear with me as I did my best to tidy it up (and it's far from perfect):
The news went under the radar last May. Just a few weeks after the groundbreaking of the Réseau express metropolitain (REM), held in the shadow of the skyscrapers of downtown Montreal, the Caisse de depot et placement du Quebec has quietly embarked on the first stages of a similar light rail system project in Auckland, New Zealand.

This multi-billion dollar project, if it comes to life, could mark the first milestone in a brand new export model of the institution's know-how in complex infrastructure projects. In an interview with La Presse, Michael Sabia, the Caisse's boss, and Macky Tall, president and CEO of the subsidiary CDPQ Infra, confirm that their phone has been ringing a lot since the beginnings of REM in 2015. The calls come from United States, Europe, English Canada and Oceania.

"The world is looking for new ideas, new ways to finance and structure infrastructure projects," explains Michael Sabia. In the world, there is a deficit of at least $ 1,000 billion a year in infrastructure. All experts in this field understand that it is impossible for governments to have all the financial resources to invest. "


The Caisse has obviously made an impression with its recent - and pronounced - turn towards infrastructure. Following an agreement with the Quebec government in 2015, the pension fund manager created CDPQ Infra to study two public transit projects that had been making strides for decades: a rail link to Montréal airport -Trudeau and another to the South Shore.

After eight months of accelerated analysis: the surprise. Rather than two separate sections, CDPQ Infra suggested building a single automated network of 26 stations spread over 67 km, which would connect several sectors of the metropolitan area. A project of 6.3 billion with a commissioning scheduled for 2021.

The Caisse proposed to act as majority investor, prime contractor and long-term operator of the network, which it will also own.

This unprecedented business model has earned many critics in Quebec, but so far, it works pretty much according to plans.

The REM is under construction, two years and dust after its initial announcement.

The pressure for the Caisse is enormous today.

"I think we have now demonstrated our ability to develop the idea, to plan the project, to work with governments and to choose world-class suppliers, but now, we have to demonstrate that we are able to monitor the implementation. the construction of a project of this magnitude, "admits Michael Sabia.

"If I can give you a sentence, it's proof of concept," he continues. In the CDPQ Infra model, REM is this proof of concept. That's why we have to deliver the goods. Show that it's not just an idea, not just a plan, but you have to make it real, realize that idea."


If the Caisse proposed the REM's bold project, it is convinced that it can derive stable and predictable profits for the benefit of Quebec savers. It believes it can generate a minimum return of 8% on its investment, threshold at which the two minority shareholders - Quebec and Ottawa - can expect to receive royalties.

If the plan works as planned, both levels of government should ultimately recover their capital investment ($ 1.3 billion each), as well as the financing costs incurred. Montréal, for its part, will inherit a state-of-the-art transportation system that could attract 160,000 users a day - and relieve some of its oversaturated roads and subways.

If construction costs explode along the way, or passengers shun the REM, the Caisse will look bad. Michael Sabia, however, indicates that his confidence level is "very high" and that he is "very comfortable" with the level of risk of the project.

"There is no guaranteed return, and that's why we've done detailed studies to make sure our financial projections are realistic and reasonable," said Macky Tall. And we are confident of achieving this return."

Mr Tall recalls that all the Caisse's investments in transport infrastructure are generating profits at the moment. The institution's portfolio of infrastructure assets has returned 10.3% over the last five years, resulting in a gain of $ 5.4 billion for Quebec savers.

The Caisse is a shareholder in the Eurostar and the Heathrow Express in Europe, as well as in the Canada Line in Vancouver. Jean-Marc Arbaud, who successfully piloted the Vancouver light rail project in the 2000s, was recruited as project leader for the REM.


The difference between the previous investments of the Caisse in infrastructure and the REM project is that it is part of a blank sheet - or almost - in this file. The CDPQ Infra team has developed the technical and financial aspects of the project from A to Z, and the Caisse's subsidiary will oversee its construction and operation. A "greenfield" investment, very different from an equity investment in an existing project or a traditional public-private partnership.

Without wanting to replicate the REM to infinity in all the major cities of the planet, the Caisse's executives hope to be able to export the "one-stop-shop" model developed in the Montréal light rail project.

"You bring all the elements: make the financial package, manage the construction, do the long-term operation and, yes, invest too, says Macky Tall. There are benefits to this model, because since most capital costs are financed, it gives the option that the project is off the government's balance sheet, which is not the case for the very, very large majority transport projects. "


While the Caisse has received dozens of expressions of interest in the REM model, it has only been in recent months that it has dispatched teams abroad to concretely study a handful of potential investments.

"We now have the ability to ask our planning people to look at other opportunities," says Michael Sabia. We are open, but since very, very recently. Since the beginning of the construction process [of REM]. "

NZ Super Fund, the New Zealand equivalent of the Caisse de dépôt, has identified CDPQ Infra as a potential partner to develop a light rail system of about 60 kilometers in the city of Auckland, valued at around 5.3 billion. In the spring, the group submitted an unsolicited offer to the government of that country to study the financial viability of a commercial investment in the transportation system, which was struggling to be achieved through traditional channels.

"This is a project that is at a preliminary stage, comparable to where REM was two or three years ago," said Macky Tall. The partnership was the subject of a press release and several articles in New Zealand, but the Caisse ignored it in Quebec.

For now, CDPQ Infra is studying "four or five" infrastructure projects outside Quebec in a slightly more serious way. They are mostly in the United States and "directly or indirectly" related to transportation, confirms Michael Sabia. The leader was invited to present the Board's business model to the White House in 2015 under the administration of Barack Obama before several governors.


The Caisse has not had any new discussions with the White House since the election of Donald Trump in 2016, confirms Michael Sabia. But he does not believe that the protectionist aims and the policy of "America First" advocated by the president will hinder the participation of the Quebec group in a possible project on US soil. Especially since decision-making is more at the level of cities and states in the infrastructure sector.

"In the few states we are working with now, some governors are Republicans, others are Democrats, not an overly partisan issue," says Macky Tall. It refuses to name the states concerned since the discussions are still preliminary.

The Caisse's strategy will be based from now on a gradual "intensification" of the export efforts of the CDPQ Infra model, says Michael Sabia.

"For now, the focus and priority are here, because I repeat, you have to deliver the goods. We will intensify our work outside of Montreal, but for at least a year, the priority remains the REM because we have to deliver this 67 km project. It's not simple."

The Caisse's main investments abroad in transport infrastructure

The Caisse de dépôt et placement has been involved in several projects or transport companies in recent years outside Quebec.

Canada Line

The Caisse has been one of the main investors in the construction and operation of this 20 km light rail link in Vancouver, which connects the airport to downtown. The line carries 120,000 passengers a day, beyond the initial forecast of 100,000.

Heathrow Express

The Québec institution is a shareholder of this rail link that connects Paddington Station in central London with Heathrow Airport (of which the Caisse is also one of the minority shareholders). The steep train line attracts 5.8 million passengers a year.


The Caisse is one of the two shareholders of Keolis, a public transport operator operating in 16 countries, which each year welcome more than 3 billion passengers, including by train, coach and tram. The Quebec group owns 30% of this business, which posted a turnover of 5.4 billion euros (8.2 billion CAN) last year.


Since 2015, the Caisse holds a 30% stake in Eurostar, which operates high-speed trains in Europe, including the only rail link between London and Paris. Eurostar carries about 10 million passengers a year.

Michael Sabia responds to critics

"It's not impossible"

Michael Sabia is agitated when he is reminded of the skepticism expressed by many when the Caisse announced its REM project in 2016. The leader, known for his sometimes boiling character, was visibly fed up with the "bullshit" that often surrounds the speeches about major structuring projects in the province. "At the beginning of this project, frankly, many, many people told us: it's impossible. Impossible. But we got here today, where people are building the project. Many people have told us that it is impossible in the next two or three years, to plan the project, to launch the tendering process, to look for all the approvals, impossible because it requires six, seven, eight years, usually. But it's done. So, frankly, when I hear, "oh, but in the other example, it does not work," or "oh, there's a problem here," my answer, frankly, is: bullshit. "

"We are capable"

Michael Sabia, who has spent most of the last 20 years in Montreal, first at the head of Bell Canada and the Caisse de dépôt, hopes that the REM project will act as a catalyst to restore Quebecers' confidence. "At one point, here in Quebec, we must be able to say that we are capable. We are not prisoners of history, we are not prisoners to deliver an infrastructure project that requires 10 years of planning and another 10 years of construction. We are capable and frankly, for me, another element of REM is to demonstrate here that we are capable of delivering world-class things, and within a reasonable time. "

"Inevitable" disadvantages

Critics of citizens affected by the $ 6.3 billion mega deal have begun to make their voices heard in recent weeks. Passengers on the Deux-Montagnes suburban train line, which will be replaced by an REM antenna, are already feeling the effects of the start of work. The digging of a huge hole on McGill College Avenue in downtown Montreal, to connect the REM to the subway, should also cause a lot of inconveniences. Michael Sabia says he approaches criticism with "a lot of collaboration and openness". Several modifications were made to the REM during the development of the project, such as the addition of connections to the Montréal metro. "That being said, you can not make an omelette without breaking eggs. This is not our goal, we will do everything to minimize these issues, but in the end, it is unfortunately inevitable that there are some issues. A forum will be held in the fall to explain in detail the different impacts, adds Macky Tall.

A "priority" performance threshold

The agreement between the Caisse and the Québec government provides for a "priority" performance threshold of 8% for CDPQ Infra, the project's prime contractor. This threshold must be met "to trigger the production of return for minority shareholders", namely Quebec and Ottawa, specifies a financial information note prepared by CDPQ Infra. Beyond this level, the dividends generated by the REM - if the project generates more profits - will be paid mainly to Quebec City and Ottawa, until the minimum level of return stipulated in the agreement for these projects is reached for these two minority shareholders (3.7%). This equates to the average cost of Quebec borrowing on all of its debt. "The REM project is the first public transit project for which the government will have a repayment of its capital investment and the average cost of borrowing," says one. Any excess dividends would then be shared among the three shareholders (CDPQ, Quebec and Ottawa).

The REM in numbers
  • 67 km automated network
  • 26 stations
  • Will connect downtown Montreal, the South Shore, the North Crown, the West Island and the airport.
  • In service 20 hours a day
  • Budget: 6.3 billion
  • Planned commissioning: 2021
  • CDPQ Infra: 2.95 billion
  • Government of Quebec: 1.3 billion
  • Government of Canada: $ 1.3 billion
  • Regional metropolitan transport authority: 512 million
  • Hydro-Québec: $ 295 million

Source: CDPQ Infra
Alright, so it's not a perfect translation but it captures the main points of the article.

I've already discussed the Caisse's greenfield revolution as well as the supposed $300 million REM cost overrun.

I have never seen so many "fake news" articles on a single project so I was pleasantly surprised when I read Maxime Bergeron's article.

Sabia is right, there's a lot of "bullshit" surrounding this REM project and there are many hidden agendas from unions and other special interest groups tryng to torpedo the project every chance they get by feeding garbage to sloppy reporters who don't bother to fact check what they print.

Even some astute blog readers of mine have questioned this project, the return assumptions and the governance surrounding it but I rebuff them and just tell them straight out: "You obviously have no idea of what you're talking about, stop reading garbage in Quebec newspapers and start researching and really understanding this project and its governance.'

If I were to venture a guess, and it's still early, the REM project will be a huge success which will transform Montreal's economy in a profound way.

Rest assured, however, there will be problems along the way, every major infrastructure project around the world runs into some problems, but as it stands, the team at CDPQ Infra is more than capable of handling these problems.

The wild card of course is Quebec politics. If a new provincial governent comes into power and replaces Michael Sabia and puts an end to this project or significantly curtails it, then it will have an impact.

But I wouldn't place too much weight on this as any governent with half a brain will see the long-term benefits of this project and that the model is in the best interest of all stakeholders.

In other words, nobody will dare play politics with the REM project because it's well underway and all hell is going to break loose if they do scrap it for shady political reasons.

Now, as far as exporting this model elsewhere, there are certain logistics which make it more diffcult, like different laws, different vendors and subcontractors, etc.

Don't get me wrong, the financing part is definitely exportable, but the actual construction and operation will undoubtedly differ depending on the country and unique circumstances.

Still, the Caisse is right to explore infrastructure opportunities in a crowded market:
Cyril Cabanes, Head of Infrastructure investments, Asia-Pacific, CDPQ, shares his views on the Australian and Indian markets, his take on disruption and the Canadian pension fund manager’s new in-house expertise in infrastructure development and operation.

With all the debate surrounding driverless cars and the future of transportation, you could almost forget driverless trains have been a reality for some time now.

The first, fully automated line that operated without a driver present in the cabin was the Port Island Line, which opened in 1981 in Kobe, Japan.

Since then the list of fully automated train lines has been growing and Canada is set to add another track in the form of a light rail network, the Réseau électrique métropolitain (REM), a rapid transit system for the Greater Montreal area in Quebec.

It will be the fourth largest automated transportation system in the world and it is being developed by one of Canada’s largest pension funds, Caisse de dépôt et placement du Québec (CDPQ), while the Quebec and federal governments are both minority shareholders of the project.

From an institutional investor perspective, what makes the venture unusual is that as far as infrastructure projects go, this one is as green as greenfield projects come.

Historically, pension funds have shown a preference for more mature infrastructure projects, or brownfield projects, where the risks are better known and the objective is to capture an income stream rather than capital appreciation.

But CDPQ has chosen to build in-house expertise in infrastructure development and operation through a newly established subsidiary, CDPQ Infra.

“CDPQ Infra’s first focus is the REM, a C$6 billion project. But as the REM evolves, we will be looking at other projects. CDPQ Infra is not just set up for one project, it’s a solid team that is able to manage a project from start to finish,” says Cyril Cabanes, Head of Infrastructure investments, Asia-Pacific, at CDPQ.

As the infrastructure sector becomes more and more crowded for investors, the establishment of a dedicated infrastructure development arm will help increase CDPQ’s added value in its dealings with partners and should give it a competitive edge over its fellow institutional investors, Cabanes says.

“This is a pretty unique capability; we are going to be able to use those skills to develop projects and become a more efficient investor in greenfield projects.

“We are not trying to put out a message that we are going to control everything we do going forward; we are still about strategic partnerships. But we will be a more sophisticated partner.”


Since joining CDPQ in 2016, Cabanes has looked after infrastructure transactions in the Asia-Pacific region and is based in Singapore. But as he worked for several years in Sydney, he is very familiar with the opportunities in Australia. Today, he oversees CDPQ’s infrastructure activities in this market, including stakes in the Port of Brisbane, in Plenary, the largest specialist public-private partnership business in the region, and in Transgrid, the owner and operator of the electricity transmission network in New South Wales.

Often Australian pension funds lament what they see as the lack of a clear pipeline of infrastructure projects they can invest in. But Cabanes says this perception has probably more to do with the abundance of privatisations in the past, than with the current pipeline of projects.

“Historically, in Australia, people have been reactive, largely because the market has been throwing quite a lot of opportunities at people. So when investors say the pipeline looks thin, then what they are basically saying is that the privatisation pump is being turned off,” he says.

“Now that doesn’t mean nothing else gets done.

“The good thing about Australia is that it has always provided a fairly regular, reliable flow of transactions.

“It has always punched above its weight in terms of infrastructure relative to its GDP (gross domestic product) and population. That has been the case since at least the mid-‘90s, when the privatisation trend started.

“I guess it is expected that in the next few months or years there will be a slowdown, but we’ve seen this before, where we’ve had two years without privatisations and then the pump started again.

“We are still pretty excited about the pipeline in Australia. We’ve built a large portfolio and strong partnerships, which now give us more opportunities.”


CDPQ has also been very active in India, following the reforms introduced by Prime Minister Narendra Modi, and recently announced a number of deals in private equity and infrastructure in the logistics, specialised corporate finance and energy sectors.

“Infrastructure in India has a patchy history, but we are lucky that we are coming in as the second wave of investors in India,” Cabanes says.

“It is particularly attractive because of the reforms that the country has been introducing in recent years and we are starting to see the effects of that quite tangibly.

“For example, India has a very high rate of non-performing assets sitting on the banks’ balance sheets.

“It has been a long-held hope in terms of providing a source of deals, but it was only recently that reforms were introduced to facilitate the restructuring of those loans and the sale of those assets. We are starting to see those assets coming to market now.

“Now, this is literally a several-weeks-old phenomenon, but it is going to have a huge impact on that potential.”

Last year, CDPQ acquired a 20 per cent stake in the largest solar energy developer, Azure Power.

Investments in companies such as Azure are perfectly aligned with the pension funds manager’s recently announced climate change investment strategy, which includes a 50 per cent increase in its low-carbon investments by 2020, Cabanes adds.

Technological Advancements

Driverless technology and solar energy generation are areas that have benefited from the increasing pace of technological advancements. But Cabanes is not concerned this rate of advancement reduces the time horizon for infrastructure investments.

“When we invest, we invest for the long haul, so of course we look very closely at technology and increasingly so in the last few years, even for assets that are so-called boring and that you would think are not especially sensible to technology and disruption,” he says.

Energy transmission has come under scrutiny from some analysts, who argue solar and battery technology will lead to a disaggregation of energy transmission. But Cabanes says these new technologies form more of an opportunity than a threat to the incumbents.

“Take Transgrid, for example, it is the largest energy transmission grid in Australia and we’ve been invested in Transgrid for a couple of years now,” he says.

“A lot of people would think that technology has nothing to do with Trangrid. It is regulated and will go on for many generations. Don’t worry about it.

“But people who are more technology savvy would tell you that we are crazy; microgrids could destroy the value of these assets.

“But we need to look at this from a new angle.

“We spend a huge amount of time on assessing technology risk and rather than looking at technology as a threat, you also have to ask yourself: ‘Could it be an opportunity?’

“In the case of Transgrid, it clearly is.

“The company benefits from renewables, because when you build a wind turbine or a solar plant, you need to connect it to the grid, because often these plants are far from deload centres. This is additional revenue and value for us.

“These are not threats; they are opportunities. Disruption is always as much an opportunity as a threat and it all depends on how you respond to it.”
Good article and while it doesn't specifically focus on exporting the REM project to Australia or India, clearly the Caisse has a foothold in these countries and can approach the right partners to discuss a huge megaproject if there is an interest down the road.

But first, the Caisse needs to focus on its own backyard, the Montreal REM project which is proceeding nicely. Greenfield infrastructure projects of this scale take years to deliver and there are always problems along the way.

Still, the Caisse has the right people to deliver on this REM project and focus on other similar projects around the world.

Below, an older (December, 2016) interview where Michael Sabia spoke with Mutsumi Takahashi of CTV News Montreal on the REM project. I think this was one of his best interviews on this project.

Monday, July 30, 2018

Canada's Pensions in Great Shape?

Chris Butera of Chief Investment Officer reports, Why Canada’s Pension Plans Are in Such Good Shape:
In a post-financial crisis world, many US public pension plans are finally beginning to see a light at the end of the tunnel, but others are still at their wit’s end on how to crawl out of their obligatory holes.

Canada, on the other hand, is doing just fine.

With most of its pension plans at either fully funded status or close to it, Canadians have achieved a balance that the US has only seen in the corporate sector. In fact, some Canadian plans, such as the Colleges of Applied Arts and Technology ($8.3 billion) and the Healthcare of Ontario Pension Plan ($59.9 billion) have become overfunded.

Eight Canadian pension funds ranked in the top 100 global funds by size in a 2015 Boston Consulting Group study titled “Investing for Canada on the World Stage.” Three were in the top 20.

This begs the question: What do Canadian pension systems do that those in the US don’t?


One key element of what asset owners call the “Canadian model” is independent governance. Public US plans typically go through legislatures and governors’ offices to make changes. That brings a layer of politics into the picture. Canadian plans instead follow a structure free of government intervention, only having to go through their boards.

This is key, Jeff Wendling, senior vice president and chief investment officer, equity investments, of the Ontario healthcare plan, told CIO. “One is this independent governance idea, so you don’t have political bodies or agencies getting involved in how the assets are managed, or when contributions are made, or use of surplus, or all of those kinds of things.”

Result: Canadian funds can make faster investment decisions.

Another element is a more risk-aversive portfolio. Many US plans tend to focus on adding risk by investing in public equities or hedge funds. But Canadian pensions look to de-risk, making safer bets on bonds, private equity, and infrastructure. Many of these assets are also eco-friendly.

“There’s a lot of asset class diversification. There’s a lot of geographic diversification. Canadian funds are looking for opportunities—and a lot of that has been going on for quite some time, so I think that’s part of the story as well,” Wendling said. “Most of these plans here don’t just use private equity funds, they also have direct private equity investing capabilities in-house and also real estate.”

Also important: They keep the costs down by avoiding outside managers, preferring to handle their money in-house.


Despite the Canadian model’s success, it is relatively new. The pension concept began in the late 1980s and developed throughout the 1990s.

Before that, most Canadian pension plans were invested mostly or completely in domestic government bonds and were generally funded on a pay-as-you go basis. Plus, the public plans did not have independent governance. Muted investment returns, lack of future planning, and too much political influence was not an ideal mix. A 2017 report by Common Wealth and the World Bank Group on the model’s history called that approach an “error-prone fashion.”

Fears that the pension plans would fall short of meeting their obligations kicked off the reforms in 1987, leading to the creation of the Ontario Teachers’ Pension Plan as an independent institution.

To start, the government commissioned three reports on public pension structure, which agreed that Canadian public pension plans should move from the pay-as-you-go structure to a fully funded pension financing model. One suggested stakeholder consensus to develop reforms that would give the plans joint trusteeship and governance, joint sharing of risks and rewards between plan members and the government, investment of the plans’ funds in the market, and arms-length organizations that would operate independently of government. These and other changes were made over the next several years.

The Ontario Teachers’ Pension Plan, the king of the Canadian pension world, now controls nearly $200 billion in net assets, boasts a fully funded status, and has returned double digits every year since 1990. [Pension Pulse Note: This is patently false, get information here].

Not all the pension programs did well at the outset, though. The 1990s saw another slew of reforms to the new structure following the growing instability of the Canada Pension Plan, a contributory earnings-based social insurance program. The fund’s reserves were nearly depleted and its investments had been restricted to nonmarketable federal and provincial government debt. In 1995, Canada’s chief actuary issued a report on its perilous situation that was a call to arms. Otherwise, the fund may have perished.

The mid-1990s reforms raised the Canada Pension Plan’s contribution rates and reduced benefits, but also created the Canadian Pension Plan Investment Board (CPPIB), an agency tasked with handling the floundering plan’s assets. The founding legislation kept the board’s framework intact, splitting oversight between the federal government and provincial governments, a board with government-appointed directors as recommended by the minister of finance.

The investment board was also given a single mandate to maximize long-term task-adjusted returns on the pension plan’s assets. And the board was also required to produce accountability and transparency measures, which included regular public reporting. In the beginning, regulation restricted the board to passive investments in domestic equities, but this was soon nixed by the government following the organization’s inception.

The organization currently manages $317 billion in assets.

Over the next decade, other Canadian plans would adopt these rules, leading to an abundance of healthy pensions for retirees.


For US plans to get their funding levels up to snuff, Derek Dobson, CEO of the 118% funded Ontario-based Colleges of Applied Arts and Technology pension, suggests they begin with “overall inroad steps,” such as setting funding goals, getting all plan sponsors, taxpayers, employers, and members aligned with them, and then becoming “ruthless” in making sure “all of your key decisions point to the direction of making those goals happen.”

Dobson also said a “risk appetite statement” (the amount and type of risk an organization is willing to take to hit its targets) is needed to drive those funding goals. To meet the risk appetite, he said that transparency and trust in the boardroom table are “necessary components” to building it.

Oftentimes US plans will struggle with external management fees, but still continue to outsource fiduciary roles. While this does benefit some plans, Canadian plans are more partial to keeping everything in-house. This cuts costs, and also eliminates performance-based agendas outside managers may have.

“If you look at it from a cost perspective, there’s a business case to be made that if some of the large US plans move to an internal pension model, the actual cost or net returns would be higher, all things equal,” said Dobson. Yet controlling that expense is the real challenge, he said.

Wendling, the Healthcare of Ontario Pension Plan’s CIO, said this low-cost structure also helps with risk management because “almost everything is in-house now, so you can really understand your risks and where they lie, I think, much better than if you’ve got a lot of external managers or even hedge funds, where it sometimes even opaque in terms of what the risks really are.”

To bring things in-house, Wendling said plans need a scale as well as the ability to properly compensate their internal talent, an issue he said hits US public plans. “It’s hard to do if all of your investment management is outsourced,” said Wendling.

One US fund that is taking Wendling and Dobson’s advice and putting its own spin on things is the $147 billion Teacher’s Retirement System of Texas. CIO Jerry Albright’s “Building the Fleet” strategy started a decade ago. Now that it has the money to stay afloat, Albright is looking to cut costs as he gradually brings more internal staff to the fund’s investment division to create what he calls the “Texas Model.”

Also Canadian at heart are the classes Albright sees as the most ripe with opportunity. The Texas Teachers’ CIO is looking at private equity, energy, and natural resources allocations as well as watching the fund’s real estate portfolio.

“As we grow to $200 billion we need to maintain that level of real estate transactions and the real estate portfolio turns over quite frequently, so you have to be out there to replace the transactions that turn over,” Albright told CIO.

The fund also has an opportunistic portfolio that sits outside of the private markets team, which picks up assets that don’t quite fit the private bill.

Albright also has other plans for the Texas model that are not typically Canadian, such as looking for “additional authority in the future” where Texas Teachers’ could directly own businesses. “We could say…own subsidiaries that would have operating companies that would operate effectively directly,” he said.

Another American pension fund seeking to adopt Canadian elements is the $349 billion California Public Employee Retirement System (CalPERS), through its $13 billion CalPERS Direct initiative. The fund will set up two internal funds that will manage leveraged buyouts, cutting private equity management costs.

Despite changing times, pressures, and circumstances, Dobson warned CIOs that once they adopt Canadian measures, they should not stray from their strategies as plans have gotten into “real big trouble” by changing their objectives annually, losing massive amounts of credibility and assets losses as they move to “the flavor of the day.”

“Once you have those goals,” Dobson said, “I think everything else will follow from that.”
Good article, discusses some of the key elements behind the success of Canada's pension plans but let me delve a lot deeper here.

The problem with this article is it focuses on investment success and leaves out very important information on managing liabilities.

What do I keep telling you? Pensions are all about managing assets and liabilities. Period.

You can have the best investment team in the world -- and Canada's top pensions have excellent investment managers across public and private markets -- but if you don't get a handle on liabilities, you will never be able to attain a fully funded status.

So, let me break down why Canada's pensions are in such good shape by looking at what they're doing on assets and liabilities.

On assets, the aticle correctly points to governance separating asset management from political interference. Canada's large public pensions have independent and qualified boards which oversee qualified and highly paid investment professionals.

It's true, Canada's large pensions do invest in-house, cutting fees, but they do not exclusively invest in-house. They still need relationships with top private equity funds in order to co-invest with them and lower overall fees while they scale into private equity.

Some like Ontario Teachers' and CPPIB have a significant hedge fund portfolio which they have nurtured over many years. There too, they invest with external managers and pay for alpha they cannot reproduce internally.

But it is true that Canada's large pensions are investing directly in infrastructure, the most important long-term asset class along with real estate, and they're doing a lot more private equity co-investments to scale into that asset and lower overall fees.

And to co-invest properly in private equity, you need to hire top talent and pay these people properly so they can quickly analyze co-investment opportunities as they arise.

So, I would say Canada's large pensions are for the most part taking more long-term illiquidity risk investing in private equity, real estate and infrastructure but the approach they take in private equity (doing more co-investments, a form of direct investing) and investing directly in infrastructure, explains a lot in terms of their investment success.

Also, one of the largest Canadian pensions, the Caisse, is doing a major multibillion greenfield infrastructure project, the REM, which will allow it to really cut costs and maximize the value of this project over the long run.

What else? The other part of the equation is liability management.

First, Canada's large public pensions use a low discount rate, much lower than their US counterparts which use discount rates based on rosy investment assumptions and a 20-year smoothed inflation number.

Lower discount rate means higher contributions from all stakeholders and it forces Canada's large pensions to really maximize risk-adjusted returns at a portfolio level.

But the biggest reason behind the fully funded and over-funded status (ie. surplus) of large and small pensions like Ontario Teachers', HOOPP, and CAAT Pension Plan is they have adopted a shared risk model, typically in the form of conditional inflation protection.

[Note: OPTrust and OMERS have guaranteed inflation protection and the former is fully funded while the latter is close to it but is now looking at adopting conditional inflation protection.]

What this means is when the plans run into problems, which they all do, they have the ability to fully or partially remove inflation protection on the benefits the plan's retired members receive for a period of time until the plan's fully funded status is restored (see clip below).

This is a critical element for the long-term sustainability of these plans and one that is making OTPP young again.

So, when you read about the success of Canada's large pensions, don't just think of how they approach investments, but also how they manage their liabilities.

Large US public pensions are starting to adopt elements of the Canadian model but the biggest impediment remains governance, separating public pensions from government interference.

Still, CalPERS, CalSTRS and Texas Teachers' are trying to adopt some of these elements, much to the benefit of their members and other stakeholders.

I also read somewhere that Texas Teachers' is lowering its discount rate to 7.25%, another step in the right direction.

Lastly, it's official, the Public Sector Pension Investment Board (PSP Investments) today announced the appointment of Eduard van Gelderen to the position of Senior Vice President and Chief Investment Officer:
Mr. van Gelderen will lead PSP’s Total Fund Strategy Group, overseeing multi-asset class investment strategies and total fund allocations and exposures in terms of asset classes, geographies and sectors. The responsible investment, government relations and public policy functions will also report to him. Mr. van Gelderen will report to the President and CEO and his appointment is effective immediately.

“Eduard has the precise combination of strong global expertise and leadership skills we were seeking for the Chief Investment Officer position,” said Neil Cunningham, President and CEO of PSP Investments. “He is an accomplished, multi-asset class investment leader with highly relevant C-level investment expertise in large scale, pension investment managers. With his proven ability to think both as an investor and as a strategist, I’m confident he has the edge required to take our Total Fund operations to the next level.”

“The Canadian model is a leader amongst global pension markets,” added Mr. Van Gelderen. “PSP Investments has earned its place as one of Canada’s top four pension investment managers, with a clear and focused strategy backed by a strong Board. I am excited to join PSP Investments at a time of accelerated evolution for the organization.”

About Eduard van Gelderen

Prior to joining PSP Investments, Eduard van Gelderen was Senior Managing Director at the Office of the Chief Investment Officer of the University of California. As a member of the executive team, his primary responsibilities included overseeing the University’s retirement plan, heading up equity and real assets activities, and handling strategic partnerships in Europe. He also served as CEO of the Dutch financial service provider APG Asset Management and Deputy CIO of ING Investment Management.

He holds a master’s degree in Quantitative Finance from Erasmus University Rotterdam and a post-graduate degree in Asset Liability Management from Maastricht University in Limburg. He is currently a PhD candidate at the International School of Management in Paris. Eduard is a certified Financial Risk Manager and a Chartered Financial Analyst and has served on several investment advisory boards.
You can read more about PSP's new CIO here.

If you want to understand why Canada's large pensions are in such good shape, it's because they know how to properly manage assets and liabilities, and have the right governance to attract and retain world-class investment managers like Eduard van Gelderen.

Below, Ron Mock, Ontario Teachers' Pension CEO, speaks to CNBC's David Faber about the organziation's investing strategies (May 1st, 2018). Listen carefully to Ron, he explains very clearly why they're not cutting out the middlemen as they still rely on solid partnerships all over the world to deliver stellar risk-adjusted returns.

Also, see how a small adjustment to inflation protection is crucial to the sustainability of the Ontario Teachers' Pension Plan and making it young again.

Canada's large public pensions are in good shape because they know how to properly manage assets and liabilities and that is the recipe for long-term pension success.

Thursday, July 26, 2018

Did Markets Just Get Facebooked?

Jeff Cox of CNBC reports, Facebook's tumble threatens to take a big bite out of the Trump rally:
Facebook's sudden and stunning vulnerability threatens to undercut the foundation of the stock market rally since Donald Trump was elected president.

The social media giant has been the cornerstone of the FAANG trade — Facebook, Amazon, Apple, Netflix and Google parent Alphabet. Just by itself, Facebook has gained more than 80 percent since Trump's November 2016 victory. The S&P 500 more broadly is up some 35 percent during the time period.

But a disappointing earnings report Wednesday, particularly regarding its growth forecast, had investors fleeing the company Thursday and pulling down tech stocks in general. Other market indexes were not impacted as strongly.

Facebook was off more than 18 percent Thursday morning, costing the company more than $120 billion of its market cap. The loss by the social media giant pulled down the technology sector broadly, with the Nasdaq index losing more than 1 percent.

Of the other FAANG components, Apple shares were slightly positive while Amazon fell 2.2 percent and both Netflix and Alphabet also were negative.

Since the election, information technology stocks on the S&P 500 have gained 63.8 percent, easily the best among all sectors in the index, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

As those gains have occurred, the FAANG stocks have assumed outsize positions in many broad-market index funds.

For instance, the top four holdings in the $266 billion SPDR S&P 500 Trust ETF are Apple, Microsoft, Amazon and Facebook. Together, the four companies comprise more than 10 percent of the index's weighting.

"This is just another example of a classic, late-cycle development often found in tired bull markets – the hot money chase indeed," Larry McDonald, author of the Bear Traps Report newsletter, said in a recent post. "As more and more capital flows into passive index funds, more and more FAANG shares MUST be owned. Returns appear far better than the rest of the market's offerings, so even more capital flows in – it's a toxic, self-fulfilling cycle – when broken the declines will be HISTORIC."

McDonald said he expects the FAANG stocks to be targeted by the government, which will have to fund new tax revenue to pay for underfunded entitlement programs.

The good news is that the rest of the market was generally undisturbed for now. In fact, the Dow industrials, of which Facebook is not a member, surged some 150 points early on, boosting the blue chips by more than 0.5 percent. Even the S&P 500, which does have Facebook exposure, was off only fractionally.
At this writing, the Dow is up 120 points, S&P is flattish and the Nasdaq is down 1% mostly owing to the bloodbath in Facebook, down almost 20% today.

So, let me begin with Facebook (FB) by looking at the one-year daily chart and five-year weekly chart (click on images):

As you can see, momentum chasers got massacred buying the "Facebook breakout" above the 50-day moving average prior to earnings thinking it's headed higher. They got destroyed.

And there could be more downside ahead. The 52-week low is $148 a share so we might revisit it and if things really get bad in markets, don't be surprised if Facebook's share price tests its 200-week moving average ($127) or goes even lower.

Importantly, this isn't another 'buy the dip' scenario like in March when Zuckerberg was summoned to testify on Capitol Hill, the guidance was poor, user numbers are declining and increased security costs will shrink margins.

That's my two cents but who knows what will happen as many big hedge funds will undoubtedly buy the dip again hoping shares will climb back up.

Unfortunately, hope isn't a good strategy for these markets. You really need to hedge your equity risk or you will face more Facebook-type haircuts.

The good news is Amazon (AMZN) is reporting after the bell today and barring any negative surprise, I expect decent numbers and the Nasdaq should be fine tomorrow (if Amazon disappoints, watch out, it will get ugly out there).

I also expect strong US GDP figures Friday morning as administration officials have been talking it up (they know it's a great report), so that too will help ease the Facebook fallout.

But markets are weakening, the global economy is slowing and so is the US economy where the housing market is showing signs of cracking as international buyers are dropping out.

And while everyone is fixated on Facebook, I'm fixated on emerging market stocks (EEM) and bonds (EMB) as well as the US dollar (UUP) which is still at a 52-week high (click on images):

So far, the carnage has somewhat eased in emerging markets but it remains to be seen if this is a temporary reprieve as one bond-market veteran is bracing for more defaults.

Keep your eyes peeled on these charts because if we do get a crisis in emerging markets, it will spill over and clobber risk assets all over the world.

This week, I read a special report written by Tony Boeckh, Editor-in-Chief at Alpine Macro. Tony has over 50 years of experience analyzing the economy and markets and he wrote a great report which you should all read (contact info@alpinemacro.com to obtain it).

Tony examined liquidity conditions which are showing modest weakening now so he thinks it's premature to get overly bearish. His main concern is that the Fed will pay too much attention to low unemployment, GDP growth (coincident indicators) and rising inflation (lagging indicator) and tighten too much.

Surprisingly, he isn't as worried about the flattening yield curve as many others including me are, stating the following:
In recent decades, the yield curve has inverted an average of 4-5 months before a market top and about 11 months before the start of a recession. However, these time lags are quite variable and the yield curve has given both false positives and false negatives when it comes to bear markets. The 1987 crash occurred when the curve was still quite steeply positive and the 1998 inversion was not followed by a serious bear market, nor by a recession in the U.S. Investors should be wary of putting too much faith in the yield curve and overreacting to its levelling slope. It is only one of many monetary indicators to follow.
Ed Yardeni, another veteran market analyst, had similar views on the yield curve not being bearish for stocks but François Trahan at Cornerstone Macro has done extensive research on the yield curve and it clearly points to a slowdown ahead and the continued dominance of Risk-Off markets.

This is why I keep warning my readers it's time to get defensive, not time to play momentum on your favorite tech stocks hoping for another tech mania.

The problem with technology (XLK) is it's overbought. Every major hedge fund and all index funds are loaded to the hilt on tech stocks which admittedly is also a response to a slowing economy and Risk-Off markets (click on image):

But tech stocks don't go up forever and when they get hit, they get whacked hard so investors need to reposition their portfolio accordingly to prepare for the coming slowdown.

In fact, Tony Boeckh concluded his special report by cautioning to avoid expensive stocks and I agree.

There are plenty of great tech stocks but they're all fully if not overvalued so one mistake, one slip, and investors risk facing a Facebook-type haircut.

And the problem with a lot of young traders on Wall Street these days is they've never lived through a really bad bear market, they don't know how to trade in such an environment, and to be frank, many of them are going to get their heads handed to them buying the big dips.

Then again, as I conclude this comment, Amazon just reported mixed results, beating on earnings but missing on revenues and the stock is up after the bell so it portends well for Friday. A great GDP report should also lift markets unless investors sell the news fearing the Fed will overreact.

Please note I am taking Friday off and will be back next week.

Below, Facebook's $100 billion-plus rout is the biggest loss in stock market history and Wall Street reacts.

More importantly, a 'storm is brewing’ in the US economy, says economist Diane Swonk and many investors are ill-prepared for the coming slowdown. Listen to her views, I'll be back next week.

Wednesday, July 25, 2018

CalSTRS Gains 9% in Fiscal 2017-18

Randy Diamond of Chief Investment Officer reports, CalSTRS Returns 9% for Fiscal Year:
The California State Teachers’ Retirement System (CalSTRS) saw a 9% net return in the fiscal year ending June 30, exceeding its assumed expected return of 7% by two percentage points, Chris Ailman, the system’s CIO, told the CalSTRS investment committee Friday.

The 9% return also beat the system’s custom benchmark of 8.6%.

The overall returns for the $223 billion retirement system, the second-largest in the US by assets under management, beat the nation’s largest retirement system, CalPERS, which announced last week fiscal year returns of 8.6% for the June 30 fiscal year.

“We will rank high compared to similar funds, but it is only one year,” Ailman said. “We need to repeat that performance year in and out, on average, over the next 30 years.”

Private equity was the best-producing asset class with returns of 13.8%, slightly under its custom benchmark of 14.7%.

This was followed by global public equities, which produced returns of 11.7% against a custom benchmark of 11.8%.

The third-best results among large assets classes was real estate, which saw results of 10.4%, above the custom benchmark of 7.1%.

Fixed income saw returns of 0.3%, above the returns of the custom benchmark of -0.2%.

CalSTRS’s new risk mitigation asset class saw returns of 1.8%, beating its custom benchmark of 1.7%. The pension system has put $20 billion into the new asset class designed to mitigate the risk of a market downturn.

Among smaller strategies, Innovative Strategies had the biggest results of 11.4% above the custom benchmark of 6.5%.

CalPERS’s Inflation Sensitive Strategy saw results of 8.5%, above the custom benchmark of 4.5%.

Over the three-year period ending June 30, CalSTRS saw returns of 7.8%, over the five-year returns of 9.1% and 10-year returns of 6.3%.

Ailman said the 10-year results were more challenged. Those results include the great financial crisis when CalSTRS lost around 25% of its portfolio.
CalSTRS's press release on FY 17-18 results is available here and below:
The California State Teachers’ Retirement System announced that the fund posted a 9.0 percent return (net of fees) for the 2017-18 fiscal year, exceeding the investment assumption of 7.0 percent for the second consecutive year and helping advance the fund towards full funding in the decades ahead. As of June 30, 2018, the total fund value was $223.8 billion.

“This year’s positive investment performance is yet another testament to the long-term sustainability of a well-run pension fund guided by a committed board of trustees and a staff of diverse and talented investment experts,” said Chief Executive Officer Jack Ehnes. “The fiscal year returns are only one part of CalSTRS’ pursuit of long-term value creation. The CalSTRS Funding Plan, passed into law in July 2014, is the overarching model of shared responsibility, working in tandem with the positive return performance generated by the investment portfolio.”

CalSTRS’ returns reflect the following longer-term performance (click on image):

“This year we beat the 7.0 percent goal and exceeded our benchmark,” said Chief Investment Officer Christopher J. Ailman. “We will rank high compared to similar funds, but it is only one year. We need to repeat that performance year in and year out, on average, over the next 30 years. No small feat, but our award-winning staff and our complex portfolio are designed to do just that. This is a marathon, not a sprint to the finish line. And, as a large, mature pension system, we must continue to explore, innovate and collaborate to build an efficient, successful portfolio for the long term.”

The fiscal year saw strong double-digit returns in both the public and private equity markets with the S&P 500 returning over 14 percent. CalSTRS was positioned well to take advantage of this growth while maintaining a diversified portfolio to provide risk protection through the full allocation to the Risk Mitigating Strategies asset class which was fully implemented during the last 12 months. Given the focus on long-term funding to protect the funds’ value, these strategies are important to avoid losses experienced during market downturns such as the historic 2008 global financial crisis.

As of June 30, 2018, the CalSTRS investment portfolio holdings were 53.7 percent in U.S. and non-U.S. stocks, or Global Equity; 12.8 percent in Real Estate; 12.3 percent in Fixed Income; 8.9 percent in Risk Mitigating Strategies; 8.2 percent in Private Equity; 1.9 percent in Inflation Sensitive; 0.8 percent in Innovative Strategies and Strategic Overlay; and 1.4 percent in Cash.

About CalSTRS

The California State Teachers’ Retirement System, with a portfolio valued at $223.8 billion as of June 30, 2018, is the largest educator-only pension fund in the world. CalSTRS serves California’s more than 933,000 public school educators and their families from the state’s 1,700 school districts, county offices of education and community college districts. A hybrid retirement system, CalSTRS administers a combined traditional defined benefit, cash balance and voluntary defined contribution plan. CalSTRS also provides disability and survivor benefits. CalSTRS members retire on average after more than 25 years of service, with a median retirement age of 62.9, and a monthly pension of approximately $4,475, which is not eligible for Social Security participation. For more data, download the CalSTRS Fast Facts 2017 brochure.

See how CalSTRS demonstrates its strong commitment to long-term corporate sustainability principles in its annual Global Reporting Initiative sustainability report: Global Stewardship at Work.
Before I begin my comment, it's crucial you read and understand the details of the CalSTRS Funding Plan which explains in detail the rise in employee and employer contribution rates and other provisions to reduce the plan's deficit (click on image):

CalSTRS had a good fiscal year mostly owing to strong gains in private equity, domestic and global equities, real estate and inflation-sensitive assets.

CalSTRS's new risk mitigation asset class is described in detail here and here. It's a sizable $20 billion portfolio which invests in two absolute return strategies, global macros and commodity trading advisors (CTAs).

Why only these two hedge fund strategies? Because when markets turn south, these two strategies have historically offered investors "tail-risk protection". And more importantly, these two are the most liquid and scalable hedge fund strategies investors can invest in so it didn't take CalSTRS a long time to ramp up this portfolio.

Who are the managers in this portfolio? I don't have details, but my money is on brand name funds like Bridgewater and Winton Capital, basically top macro and CTA funds where CalSTRS can write a big check to gain access to these strategies quickly and efficiently.

[Note: My advice to CalSTRS is to use the same managed account platform Ontario Teachers', CPPIB, the Caisse, and other large pensions use to onboard and monitor all risks with their liquid hedge fund strategies, Inncocap, based here in Montreal and owned by the Caisse, BNP Paribas and management. The fees are very low, it's basically a service provider, not an advisor, which offers numerous advantages to its clients.]

What do I think of risk mitigation strategies? Well, given my outlook based on a flattening yield curve, I've already stated it's time to take a closer look at hedge funds.

And I mean ALL hedge funds, not just large global macros and CTAs which have had mixed results until this year where they seem to be staging a comeback (although I read CTAs are getting slammed this year).

My best advice to all large asset allocators is to roll up your sleeves, do your homework, and find the best long-only and absolute return managers all over the world and invest with them.

Easier said than done, I know, I worked with Mario Therrien at the Caisse back in 2002-2003 and was in charge of the directional hedge fund portfolio investing in top global macro, L/S Equity and CTA funds.

It was fun, I met some of the industry's best managers but I realized picking managers is a lot tougher than people think. Sure, you can use consultants but most of them are totally useless and will recommend the well-known brand names. At the end of the day, you really need to kick the tires, grill these managers who have huge egos, and make a decision as to whether or not they are worth an allocation and if so, how much.

Still, despite all that, I think it's very important to allocate to top absolute return managers and prepare for the eventual downturn. Don't focus on fees, focus on people, process, performance and persistence. That is my best advice.

If I were to recommend a hedge fund portfolio, I'd do exactly what we were doing at the Caisse back then, 50% multi-strategy and arbitrage strategies and 50% directional hedge funds (global macros, CTAs, L/S Equity and short-sellers).

Under Michael Sabia, the Caisse has tremendously cut its hedge fund allocations. It still invests in the space but Michael's focus is on infrastructure, real estate, private equity and private debt.

Nothing wrong with that, Michael thinks like a businessman and his focus is on the long run, but he has never experienced a nasty bear market while at the helm of the Caisse and my best advice to him is to start rethinking and repositioning the Caisse's external absolute return strategies portfolio and prepare for a protracted downturn.

Anyway, back to CalSTRS, it too is revamping its private equity portfolio. Arleen Jacobius of Pensions & Investments reports, CalSTRS posts 9% fiscal-year gain, working toward private equity portfolio changes:
CalSTRS posted a net return of 9% for the fiscal year ended June 30, outperforming its benchmark return of 8.6%, said Christopher Ailman, chief investment officer, at the pension plan's investment committee meeting on July 20.

The $223.8 billion pension plan outperformed its benchmark for the three-, five- and 10-year periods, earning a 7.8% annualized return for the three years, 9.1% for five years, 6.3% for 10 years and 6.5% for the 20 years ended June 30. By comparison, the benchmark returns were 7.7% for the three years, 9.3% for the five years, 7.15% for 10 years and 6.5% for the 20 years. CalSTRS earned a 13.4% net return for fiscal year 2017.

The asset class with the highest return for the fiscal year was private equity, earning 13.8%, although it underperformed its 14.7% benchmark return. The next highest returning asset class was global equities at 11.7%, slightly underperforming its 11.8% benchmark.

Innovative strategies earned 11.4%, outperforming its 6.5% benchmark; real estate returned 10.4%, vs. its 7.1% benchmark; inflation sensitive produced 8.5%, compared to its 4.5% benchmark; risk-mitigating strategies earned a 1.8% return vs. its 1.7% benchmark; and fixed income returned 0.3%, outperforming its -0.2% benchmark.

The risk-mitigating asset class was established in 2016 to protect against equity market downturns and includes long-duration U.S. Treasuries, trend following, global macro and systematic risk premiums.

CalSTRS' actual asset allocation as of April 30, the most recent data available, was 53.7% global equities, 12.3% real estate, 12.2% fixed income, 8.9% risk-mitigating strategies, 8% private equity, 2.9% cash and 1.9% inflation-sensitive.

Mr. Ailman also discussed the 10-year business plan, which he called a "road map" for the pension plan that could approach $400 billion in assets in 10 years. The business plan expects lower returns because assets are expensive these days, but also lower costs in the future, in part, as a result on CalSTRS' becoming less reliant on external managers, he said.

The California State Teachers' Retirement System, West Sacramento, is in the midst of studying how it can use a collaborative approach to investing including making direct investments either alone or together with other asset owners in each of its asset classes. Projected lower costs is consistent with the collaborative model, Mr. Ailman said.

Staff expects to return to the investment committee in September with a recommendation regarding the collaborative model and how pension officials can implement the approach.

Among the challenges reflected in the road map is hiring talent, Mr. Ailman noted. Hiring investment executives, motivating them and retaining them as they move up the ladder is part of what Mr. Ailman said he considers CalSTRS' succession planning. The 10-year plan across asset classes includes training junior staff for relationship transfer and succession planning.

Still, Mr. Ailman noted that "it is more and more a challenge to recruit."

In private equity, for example, CalSTRS has been looking to hire investment professionals with more transaction experience, said Margot Wirth, director of private equity, at the July 20 investment committee meeting. The private equity team has been "drifting toward" hiring more deal-focused professionals but that should accelerate as CalSTRS moves toward the collaborative model, she said.

Currently, 93% of CalSTRS' $18.2 billion private equity portfolio as of March 31 was invested with external managers, with the remaining 7% internally managed, Ms. Wirth said.

She said that it would "not be overly ambitious" to expect that 20% of the portfolio could be internally managed in co-investments in three years.

As part of its fiscal year 2019 business plan, CalSTRS' private equity team expects to work to establish joint ventures with other like-minded and complementary investors as well as to consider investing in money managers "when strategic for the program."

Also at the meeting, the investment committee got a first look at a revised private equity investment policy statement in which it would establish a subasset interim target allocation of 2% and a long-term target of 4% of the private equity portfolio for what it is now calling a multistrategy subasset class. (Interim targets are allocations expect to be achieved in 12 months to 36 months.) Last fiscal year, CalSTRS transferred the strategy it had then called tactical opportunities to the private equity portfolio from its innovations portfolio, where the strategy had been incubated. The new subasset class currently consists of 1.2% of the private equity portfolio but staff believes that some existing investments might logically reside in this subasset class, according to a staff report to the investment committee.

In addition to adding the new allocation, CalSTRS would increase its interim target to buyouts by 3 percentage points to 69% within the private equity portfolio, while retaining a 69% long-term target to buyouts, and trim the interim allocation to debt-related strategies by 5 percentage points to 10%. CalSTRS' long-term target allocation to debt-related strategies is dropping to 11% from 15%. The interim and long-term targets will not change for venture capital (10% and 7%, respectively,) longer-term strategies (2% and 5%) and special situations (7% and 4%).

The new private equity investment policy would reorganize its two main categories — traditional and opportunistic — by moving longer-term strategies (formerly "core private equity") and special mandates to opportunistic from traditional. The traditional category would then consist of buyouts, venture capital and debt-related investments. Opportunistic would consist of longer-term strategies, special mandates and the new multistrategy subasset class. The revised private equity investment policy would also allow staff to make co-investments alongside all of CalSTRS' general partners across asset classes, not only private equity general partners.

Staff is expected to bring the private equity investment policy statement back to the investment committee for adoption in September.

Mr. Ailman noted that longer-term strategies, which include investing in longer-dated funds that can last 20 years, is at the early stages with a lot of managers "stepping in" to the strategy. He added that private equity is undergoing "big changes." He mentioned that CalPERS is considering creating a separate entity to make direct private equity investments.

"I don't think you would … replicate that but good luck to them," Mr. Ailman said. "That's my pension plan."

Separately, Mr. Ailman said that he was starting a study of whether to keep investments in private prisons because they are posing an increased risk to CalSTRS' portfolio. The new risk factors are in respect to violations of human rights by private prisons that are now being used to house immigrants and children of immigrants who have separated from their parents. CalSTRS staff have already been speaking to company executives but this process increases resources to staff. CalSTRS has $120 million invested in three private prison companies: CoreCivic Inc., General Dynamics Corp. and GEO Group Inc.

Mr. Ailman noted the University of California Regents has already divested from private prison investments. The UC's investment office oversees the Berkeley-based university system's $66.7 billion pension fund and $11.9 billion endowment.

A spokeswoman for UC said that university sold some $25 million worth of indirect holdings in private prison companies in 2015. "As part of a comprehensive evaluation process for investments, UC assessed that these holdings were not a good long-term investment," she said in an email.

During public comment, a large number of CalSTRS' members asked the investment committee to divest from its private prison investments. Douglas Orr, a retired professor of economics and social sciences at City College of San Francisco, speaking on behalf of the American Federation of Teachers, suggested that CalSTRS collaborate with other asset owners to pressure private prison companies to discontinue its contracts to house immigrants and immigrant children with the federal government. California Federation of Teachers is also pressing the idea with CalSTRS and the $357.3 billion California Public Employees Retirement System, Sacramento, said Tristan Brown, legislative representative in the union's Sacramento office.

In other actions, CalSTRS' board on July 19 approved a compensation committee recommended setting the incentive criteria for a new position of director of investment strategy and risk. The new director would implement and monitor the overall investment portfolio's strategy and risk profile. During the board meeting, Mr. Ailman also noted as CalSTRS develops its collaborative model, the new director would make connections with other asset owners.
Anyone see CNN's recent documentary, American Jail? If you watch it, you'll understand how America's prison industrial complex works. It's all about profits, it's big business fraught with human rights abuses (the only place where forced slavery still exists in the US and it's legal). America loves its prisons but its prison system is a disaster on so many levels.

Anyway, CalSTRS is moving toward more long-term private equity and more direct investments in the form of co-investments following Canada's large pensions like Ontario Teachers', CPPIB, the Caisse and PSP Investments.

The benefit of this approach is you can maintain large allocations to private equity, lower overall fees and focus more on long-term investing.

The problem is in order to ramp up a co-investment program, CalSTRS needs to hire qualified people and pay them properly. This is the same problem CalPERS has as it gears up its direct program to co-invest and bring more assets internally.

How will CalSTRS go about this? Will it use BlackRock or someone else to ramp up co-investments? That all remains to be seen.

Lastly, I read a very silly comment on the naked capitalism blog on how CalSTRS is outperforming CalPERS. Please take these silly comments with a shaker of salt as CalSTRS takes more global equity risk than CalPERS, has a more concentrated PE portfolio, and you are not comparing two identical plans here with the same liabilities.

Also, both CalSTRS and CalPERS are underfunded, and funded status is the true measure of success, so who cares if one is outperforming the other? And while they both earned more than 8% last fiscal year, that's unlikely to go on for much longer.

The next 30 years will be a lot more challenging than the last 30 years. How do I know? Look at the starting point: historic low bond yields, all assets are way overvalued, demographic pressures will add more pressure on pensions, and America's public pension crisis will get worse.

Below, Part 1 and 2 of the CalSTRS's July Investment Committee meeting. All four parts and other meetings are available online here. Take the time to listen to CalSTRS's CIO Chris Ailman, he goes over a lot here.

Lastly, Ted Eliopoulos, CalPERS Chief Investment Officer, comments on the positive fiscal year returns and what it means as a long-term investor. For more information on CalPERS's fiscal 2017-18 results, click here and you will see a lot of similarities with CalSTRS's fiscal year results but there are important differences too as the two plans have a different asset allocation and different liabilities.

Tuesday, July 24, 2018

Behind the US Public Pension Crisis?

Elizabeth Bauer of Forbes reports, The Public Pension Crisis Is Not The Result Of Legislators' Failure To Fund:
Or, to be more, precise, it's not the primary cause.  Rather, a study by Wirepoints made available on their website yesterday points to a far more troubling cause:  the value of promised benefits has skyrocketed in the years since 2003, both in absolute terms and relative to measures such as those states' GDP growth.

Here is their headline, eye-popping chart:

What's going on?

In some cases, there is a simple answer:  as readers will recall from my prior article, the accounting rules for public pensions differ, depending on whether there's enough future projected assets, including future scheduled contributions, to cover promised pension benefits.  If there is, the plan discloses liabilities based on the expected future returns from those assets.  If not, then for the portion of the benefits which are not even hypothetically funded from planned future contributions, a municipal bond rate is used instead.  This can lead to swings in the liability, based solely on whether the legislature has a future contribution schedule in place -- when, of course, the real pension debt doesn't change whether you have a plan to fund it, any more than a hypothetical balloon mortgage isn't any more or less of a debt depending on how you plan to save up for it.

But this accounting rule is new, with the change being phased in starting in 2015.  Previously, plans could use this expected asset return even if the level of funding was only a trivial sum relative to the overall funding level.  As Bloomberg reported in 2017, Minnesota saw a dramatic increase in its liability, and a decrease in its funded status, as a result of the new accounting standard.

But much of the growth in benefit liability is, in fact, growth in benefits promised. As detailed at Crain's in 2015, the history of Illinois public pensions has been a litany of pension increases. In 1989, the state increased its cost-of-living adjustment from a non-compounded to a compounded basis.

As Crain's reports,
The bill's sponsors, including former Democratic Senate President Emil Jones, never said during floor debate how much that change might cost, once again leaving lawmakers in the dark about what they were voting on. It wound up passing by lopsided margins of 41-12 in the Senate and 108-4 in the House.
Subsequent legislation increased benefit formulas for "regular formula" state employees and teachers (1998), increased "alternative formula" benefit formulas for state employees and implemented earlier retirement ages for state employees (2001), and provided for early retirement benefit enhancements, described again by Crain's:
In 2002, as it became clear Democrats would retake state government, [former governor George] Ryan signed off on a lucrative exit strategy for thousands of state employees who got their starts under Republican administrations.

Ryan declined an interview request from Crain's. His plan, touted as a way to avoid nearly 7,000 layoffs, gave state workers and downstate and suburban teachers the option of speeding up their retirements by buying age and service credits needed to qualify for a pension.

Initial forecasts by the nonpartisan Illinois Pension Laws Commission estimated that 7,365 people would take advantage of the plan at a cost to the pension systems of $543 million over 10 years. . . .

The offer of full pension benefits to retirees as young as 50 proved so enticing that some state workers took out home-equity loans to generate enough money to gain eligibility. All told, 11,039 employees took the offer, a CGFA analysis in 2006 showed. That increased the liability to the state pension systems to $2.3 billion.
It's a pattern that is repeated over and over again: legislators using pension benefits as a form of "free money" to give away without the immediate and tangible financial consequences that would arise if they gave the affected employees pay raises.

Another state on this chart of most dramatic increases, New Hampshire, again, has a similar list of benefit increases over time, from multipliers and early retirement eligibility made more generous in 1974, to the use of asset gains in good years to fund cost of living adjustments, rather than reserve for lean years (1983), as well as expansions in medical subsidies, spouse's benefits, and a special program allowing for voluntary savings with generous interest crediting.

(Nevada appears to be something of an exception, since the benefits, while exceptionally generous, have been only modestly enhanced in recent years.  To what extent their growth in benefit liability is a long-term consequence of its earlier explosive population growth, from 800,000 in 1980 to 3 million now, requires some further math.)

Yes, reports on pension contribution holidays, or the "Edgar Ramp" detailed at Crain's, in which the former governor put together a funding plan which amounted to "let future generations pay" are enough to make your blood boil.  But this wouldn't have been avoided, only mitigated, if only shortsighted governors hadn't taken contribution holidays.  Even after reducing benefits for new employees in 2011, the cost of the annual new pension accrual for active employees amounts to 20% of pay in the Illinois Teachers' Retirement System, and 21% for the Illinois State Employees' Retirement System -- and, for the latter system, due to the generous early retirement provisions, the liability for retirees is double that of those still working.

How does your state rank? Take a look at the Wirepoints full 50-state listing to see.
I suggest you all read the study from Wirepoints which is available here.

There is no doubt that far too many states have overpromised, crippling their public pensions. You can click on the image below to see the worst offenders:

Not surprisingly, the public pension crisis is receiving a lot more attention because taxpayers are seeing their property taxes rising and wondering where all that money is going, and when they read to pay bloated public pensions, they understandably get very angry.

Who made these pension promises? Politicians buying union votes, that's who. The same thing happened in Greece where I can tell you of crazy, almost insanely crazy generous public pensions for decades until the debt crisis hit and the pension party came to an abrupt halt.

There are a lot of ubber generous public pensions in the United States because of pension spiking, double-dipping and good old political favors where unions got what they wanted from politicians buying votes.

Add to this folly pension contribution holidays which I would make constitutionally illegal no matter what and you have the makings of a giant public pension crisis just waiting to blow up.

And don't kid yourselves, the pension crisis never really went away. It started after the dot-com blow-up in 2001, got much worse after the 2008 great recession and when the next crisis hits, it's going to expose a lot of chronically underfunded US public pensions for what they really are -- a time bomb waiting to explode or implode.

"But Leo, Google shares are soaring, Facebook shares are making a new 52-week high, the yield curve is steepening, financials like JP Morgan are rallying today, everything looks great."

Who cares? The big party is coming to an end, I warned all of you last week the yield curve is flattening for a reason, global PMIs are weakening, there is a day of reckoning coming and when it strikes, the fallout will last for years, bond yields will hit a new secular low, and many chronically underfunded US public pensions on life support will need a bailout or face collapse.

Luckily, the US can look at the Canadian model and adopt two important components which I discussed in my comment on Pennsylvania's pension furry:
It looks like all hell is breaking loose in Pennsylvania and I will be the first to admit that I was aware something was cooking here as I was approached months ago by a lady consulting the state treasurer telling me they're looking closely at fees being paid out to alternative investment managers at SERS and PSERS.

I put her in touch with a bunch of people I knew in Canada and never heard back from her. I also carefully explained the Canadian pension model to her so she understands that the success is built on two principles:

  1. World-class governance: Allows Canada's pensions to hire top talent across public and private markets and pay them properly. This is why over 70% of the assets are typically managed internally, lowering fees and costs, adding meaningful alpha over benchmark index returns over the long run.
  2. A shared-risk model: This means when pensions run into trouble and there is a deficit, the risk of the plan is shared which in turn means higher contributions, lower benefits or both. Pension plans in Canada with a shared-risk model have adopted conditional inflation protection to partially or fully remove cost-of-living-adjustments for a period until the plan's funded status is fully restored again.
I also explained to her that Canada's large pensions also pay big fees to private equity and real estate funds but they are doing more co-investments to lower overall fees (see my recent comment on PSP upping the dosage of private equity).

But to develop a solid, long-term co-investment program where pensions can invest alongside a GP on larger transactions where they pay no fees, they first have to invest in the traditional funds where they pay big fees and they need to hire qualified people to evaluate co-investment opportunities as they arise.

Still, if done properly, a good co-investment program allows pensions to scale into private equity and maintain target allocations without paying a bundle on fees.

I mention this because I guarantee you very few US public pensions have developed their co-investment program to rival that of Canada's large public pensions which is why they're paying insane fees to their private equity managers per dollars invested in their PE portfolio.
The two most important reasons as to why Canada's large pensions are fully funded are right there, world-class governance which separates governments from pensions allowing public pensions to manage more internally and adopting a shared risk model typically in the form of conditional inflation protection.

Pensions are all about managing assets and liabilities. You can have a "dream team" of investment managers managing assets but if your liabilities soar because rates are dropping and you're overpromising, your pension deficits will soar too.

US public pensions need to 1) get real on their return assumptions, 2) adopt world-class governance to attract top talent to their pensions and manage more internally and last but not least 3) adopt a shared risk model and replace guaranteed inflation protection with conditional inflation protection.

Let public sector unions scream and shout, it doesn't matter, confront them head-on and ask them to present a better solution to sustain their public pensions as more and more people retire with generous benefits.

By the way, politicians should take an ax to these generous benefits once and for all. This is just ridiculous, pensions aren't there to fully replace your average lifetime earnings or in some cases, make them even better in retirement.

On the one hand, public sector unions castigate America's CEOs for their lavish retirement packages and on the other, they defend gross abuses at their own public pensions allowing people to retire with eye-popping $100,000+++ pensions. Totally unacceptable.

That's why when I read a new Connecticut pension group is slated to meet for the first time today to tackle that state's ongoing pension crisis, I say don't bother, read this comment first and get ready to implement some very hard changes which will definitely piss off all your stakeholders.

There are no easy solution folks. The stock market won't save you, the Fed won't save you, Congress won't save you, pension obligation bonds won't save you, only common sense modifications and very hard choices will save your public pensions from ruin.

I know I sound like a broken record but I've been around ten years blogging on pensions so I think I know what I'm talking about. It doesn't matter if you ignore me because when the next crisis hits and stays with us, you're all pretty much screwed and will need to implement major changes to your public pensions.

Below, Thad Calabrese, NYU, and Kuyler Crocker, Tulare County Board of Supervisors, discuss why cities are investing in the market through the issuance of pension bonds.

I keep embedding this clip because I find it depressing that states and local governments are turning to pension obligation bonds to fund their pensions. That's only buying them time, it does nothing to solve the deep-seated structural problems plaguing US public pensions and will only make the situation worse when the next crisis hits.