Thursday, October 31, 2013

Jim Leech on The Third Rail

Katia Dmitrieva of Bloomberg reports, Canada Pensions Need Reform, Ontario Teachers’ Leech Says:
Canada's politicians and business leaders need to reform the pension system or the country could be staring into the “abyss” as a wave of workers retire, the country’s third-largest pension fund manager said.

“The worst case scenario is that we just keep digging ourselves into a bigger hole and when we hit that final crisis the pain will be significantly greater because you’ve got a shorter time frame to do it,” James Leech, chief executive officer of Ontario Teachers’ Pension Plan, said yesterday in Toronto.

Leech, 66, co-authored “The Third Rail: Confronting our Pension Failures”, in which he highlights problems facing the country: Canadians aren’t saving enough for retirement, they’re living longer, and generating lower investment returns.

Leech cited Nortel Networks Corp. and the city of Detroit as examples of what can go wrong when a crisis hits and pensions aren’t prepared.

Nortel, once North America’s largest telephone-equipment maker, filed for bankruptcy in January 2009, leaving an underfunded pension plan. Detroit filed the biggest U.S. municipal bankruptcy with about $18 billion in debt, and said it didn’t have enough to pay its retirees, bondholders, and employees.

“The guarantee’s only as good as the solvency of the guarantor, and in some cases that can be threatened,” Leech said.
Third Rail

The ratio of elderly to working-age citizens will probably rise 16 percent over the next two decades, Canada’s finance ministry said in a 2012 report.

Even without a financial downturn or company default, pension issues should be addressed now before it’s too late, Leech said. The government needs to work with companies and pensions to stem the decline of defined benefit plans such as the Ontario Teachers’ fund; enhance the Canada Pension Plan, and make it mandatory for the self-employed to invest for retirement, he said.

“Pensions are the third rail, the electrified rail on the subway system,” said Leech, who joined the fund in 2001 and became CEO in December 2007. “You touch it, you get killed. It’s so much easier for all leaders -- business, labor, political to say ’I’m going to let another generation worry about that and I’m just going to kick the can down the way.’”

Leech faces his own retirement soon, leaving the C$129.5 billion ($123 billion) Toronto-based fund on Jan. 1. Ron Mock, currently senior vice president of fixed income and alternative investments, will succeed him.

Ontario Teachers’ earned 13 percent on investments in 2012, according to its annual report. That beat the 9.4 percent median return of Canadian pension funds, according to a Jan. 29 report by Royal Bank of Canada’s RBC Investor Services unit.

Ontario Teachers’ fund had 97 percent of assets needed to meet liabilities as of Jan. 1, 2013. It’s been facing funding shortfalls since 2003 as future pension costs increase faster than plan assets due to low interest rates and increasing life expectancy, according to the annual report.
Martin Regg Cohn of the Toronto Star also reports, Our pension peril is the third rail of politics:
The Third Rail, a new book on our pension peril, takes its title from the electrical rail that powers subways: Touch it, and you’re electrocuted.

That’s why most politicians keep their distance from pensions: They’re terrified of being zapped.

Undaunted, Finance Minister Charles Sousa points cheerily to an advance copy sitting in his sixth-floor office. He’s reading and heeding it, but disregarding the danger.

Sousa, it seems, isn’t afraid of being singed. On Friday, Ontario’s treasurer will convene his provincial counterparts in Toronto to sell them on long overdue reforms to the Canada Pension Plan, setting the stage for a premiers’ summit next month and a December showdown with federal Finance Minister Jim Flaherty.

Advance copies have gone out to most of the politicians around the table. The wise ones will read the Third Rail — and get a grip on it.

Co-authored by Jim Leech, one of Canada’s renowned pension wizards, the book is essential reading for decision-makers. And an indispensable primer for voters — the people who ultimately call the shots, and who will pay the price if the pension peril is put off for another day.

As head of the Ontario Teachers’ Pension Plan, Leech has street cred: His massive, $130-billion fund has achieved consistently high returns (13 per cent in 2012), at low risk, for an aging cohort of teachers (300,000 members).

When Leech talks, politicians listen. When he writes a book, it’s worth buying.

Written in accessible language (co-authored by Report On Business reporter Jacquie McNish), it outlines the demographic and fiscal pressures that pension founders didn’t foresee, and that fund managers closed their eyes to.

Retirees are living far longer than ever envisioned, and fewer workers are entering the labour force to backstop any pension losses (inter-generational diversification). Many teachers now spend more years collecting pensions than they do paying for them. The math no longer adds up, if it ever did.

Record high investment returns have petered out, replaced by low interest rates that are wreaking havoc. Employers have been forced to top up their pension funds at a time when cash is scarce, prompting most private firms to phase out traditional retirement plans for new employees.

“Pension plans were never designed to withstand these threats,” the book argues.

In the postwar boom, nearly half of all Canadian workers belonged to pension plans. Now, only 39 per cent get workplace pensions. In the private sector, a mere 12 per cent of employees belong to so-called “defined benefit” pensions that promise to pay a fixed amount upon retirement.

“Our business, labour and political leaders are preoccupied with laying blame or denying the enormity of the looming crisis,” the book says. “Politicians, loath to go near the third rail, reassure us our pension fears are overstated.”

Against that depressing backdrop of overstretched workplace pensions, the Canada Pension Plan is the underpowered pillar of our retirement system. Founded in 1966, the CPP now pays out an unrealistic maximum of $12,000 a year.

Leech warns that the CPP “will be of marginal assistance to middle-income earners.” He supports a proposal that would see someone earning $50,000 a year increase his CPP contributions from $2,300 to $2,930 annually — retirement payouts to $17,500 a year. A worker earning $100,000 a year would contribute even more to get an enhanced pension of $30,000 a year.

“Our problem is not a shortage of ideas but rather a lack of courage and political will,” Leech writes. “To date, the federal government has ignored any proposal to expand CPP.

In an interview, Leech expressed skepticism about an Ontario Pension Plan (OPP) that the province is considering to supplement the CPP if talks fail.

“It would be more expensive, because you have to start building the infrastructure to manage that fund,” he said. “It’s so much easier, it makes so much more sense to go the CPP route.”

Did he give that advice to Sousa when he last met Ontario’s treasurer? “My answer to him was that it (an OPP) was feasible, but clearly a second choice.”

As for Flaherty, with whom he talks regularly, Leech can’t explain the federal government’s timidity. But he is optimistic that the provincial finance ministers, who are closer to the ground, will lose their fear of the third rail after reading his book.

“I hope some of them will buy it and read it before Friday.”

There’s still time.
I too hope our political leaders who received a copy of The Third Rail will read it carefully ahead of their meeting on Friday. Jim Leech sent me an advanced copy earlier this week and I devoured it.

Yesterday afternoon, I had a chance to speak with Jim to discuss the book and his thoughts on what needs to be done to improve our retirement system (I thank Deborah Allen, Director, Communications and Media Relations at Teachers for setting up this conference call).

I started by praising Jim and his co-author, Jacquie McNish, for writing a book that reads more like a novel. I was afraid it was going to be another dreadfully boring book on pensions. Far from it, the book is short, concise and very well written. It focuses on three case studies -- New Brunswick, Rhode Island and the Netherlands -- before offering solutions to bolster Canada's pension system. 

What I like about the book is that each chapter gives you a brief historical background and then discusses the pension challenges each place faced and the key players who had the courage to confront those challenges and bring about much needed reforms. The book is grossly engaging. There were parts where I was so engrossed, I just couldn't believe what I was reading on how perilously close New Brunswick and Rhode Island were to pension Armageddon.

Jim told me he wanted to make sure the book was accessible to the lay person and made it a point not to write a boring book on pensions. "I'm giving a copy of this book to my kids for Christmas and they are my toughest critics." He added: "There is only one chart in the book" (on page 150).

I began by asking him why he wrote the book. He told me he was increasingly frustrated with the debate on pensions. "The focus needs to be on solving retirement security because Canadians aren't saving enough. I kept talking about it and one day Deborah Allen came to my office and asked me 'why don't you write a book?', so I did." 

We then talked about solutions to the looming crisis. The key for Jim is to implement New Brunswick's shared risk pension model which was enshrined in legislation in July 2012 and draws from the Netherland's pension system. "This way, employees, employers and pensioners all have a say on pensions and they share the risk of their pension plan." Indeed, New Brunswick has become a pension trailblazer and risk sharing must be part of the solution going forward.

We then talked about enhancing the Canada Pension Plan. He supports a proposal that would see someone earning $50,000 a year increase his CPP contributions from $2,300 to $2,930 annually — retirement payouts to $17,500 a year. A worker earning $100,000 a year would contribute even more to get an enhanced pension of $30,000 a year.

Interestingly, for higher income brackets, he sees a role for a defined-contribution type plan which pools money and lowers fees. This is where I sort of disagreed with him. I told him that defined-benefit plans are way better than defined-contribution plans and didn't understand why CPP enhancement should be limited to a certain income bracket, even if these are the people most vulnerable to pension poverty.

He explained to me that the cost of phasing in an increase in CPP contributions for people earning more than $100,000 would be very high and it would probably not make sense to include higher income brackets. I found that argument weak and told him I know a lot of doctors, lawyers and other high income professionals who would gladly pay more in CPP contributions to bolster their retirement security.

But we both agreed that Ontario shouldn't go it alone on a supplementary pension and that the benefits of defined-benefit pensions are grossly underestimated and under appreciated. Teachers and other leading Canadian pension plans sponsored a recent study on the benefits of DB plans, showing how they reduce the annual payout of GIS by approximately $2-3 billion a year and contribute $14 - $16 billion annually to government coffers across Canada through income, sales and property taxes.

Jim told me that OAS and GIS will triple in the next 15 years. "These subsidies cost a dollar for every dollar people receive whereas pension contribution cost employees and employers 15 cents each, with the bulk of the assets being made up by investment gains." 

Interestingly, Jim also discussed the size of CPPIB, saying that it would make sense to have the money managed by a few large public funds than one single entity. Mark Wiseman would disagree with him but I also think it makes sense to cap these large funds at a certain level similarly to what they do in Sweden. Why? Because no matter how good their governance is, economies of scale will kick in and impact their returns.

We can discuss the appropriate cutoff point but in an ideal world, we wouldn't have an OTPP, HOOPP, OMERS, or CPPIB, just large public funds managing pension assets of all Canadians. And in my ideal world, companies wouldn't be in the pension business at all. Let them pay their share of CPP contributions but the money would be managed by well-governed public pension funds that operate at arms-length from the government.

I asked Jim what were some of the more memorable things he remembers from writing this book. He told me when he landed in Rhode Island and was met by husky customs officer with a gun who stared him down and asked him why he was visiting. He told her he was there to meet the state Treasurer. Jim told me she said: "You're here to meet Gina? She's the greatest." (I got a much deeper appreciation for Gina Raimondo reading this book, something you won't get reading the smut Matt Taibbi and Ted Seidle put out in their rants. Read this excerpt from the book published in the Globe and Mail, How the Rhode Island treasurer slayed her state pension dragon).

He also remembers walking into the state capitol building in Rhode Island and thinking how it was once a hustling place. "It"s a beautiful building but you can tell the effects of the fiscal crisis really had a negative impact. The building isn't as busy or well kept."

And that is another point that comes across this book. Pension deficits matter because when the shit hits the fan, and taxpayers can't contribute anymore, you will see drastic cuts in public services and then eventually cuts in benefits. At times, I found myself in complete disbelief reading some passages of this book, thinking to myself the pension shenanigans in New Brunswick and especially in Rhode Island make Greece look good (and trust me, that is very bad!).

Finally, I asked Jim what is his main concern going forward. He told me "inertia" and "politicians kicking the can down the road because they are petrified of the third rail." I asked him what about all those people who think we don't have a pension crisis and that rising interest rates and rising asset values will solve our pension crisis?

Here is where Jim Leech didn't mince his words. "They are all dreaming. That might be the case if people weren't living longer and investment gains were just as good as they were in the past but that certainly isn't the case now. I was in Chicago a few weeks ago and asked a group of senior investment managers how many of them really think they can attain an 8% rate of return on investments after fees on a sustained period. Not one of them raised their hand. Had to go all the way down to 6% before one person raised their hand."

He added: "These things are path dependent, meaning if funds experience losses at the beginning, it will be that much more difficult going forward to cover their deficit." I completely agree and think many people are underestimating the scale of the problem and the reforms that are needed to sustain the long-term viability of these pension plans.

Importantly, rising interest rates and asset values will help but not solve the looming pension crisis. And if for any reason, we get a Japan-style protracted period of low rates and low investment gains, watch out, things will get much much worse and some pension plans already at risk will find themselves insolvent, forcing politicians to make some very difficult decisions.

The main message of this book is that RRSPs aren't cutting it and while pensions are definitely worth saving, there is no free lunch. All stakeholders have to concede something if they want to maintain the long-term viability of pension plans. I highly recommend you take the time to read The Third Rail and try to understand why this pension crisis isn't going away anytime soon and why we need to implement reforms now to bolster our retirement system.

Below, Jim Leech, chief executive officer of Ontario Teachers' Pension Plan and co-author of "The Third Rail: Confronting Our Pension Failures," speaks about the book, the reluctance of government, business and labor leaders to deal with overhauling the pension system, and reasons why the Canadian government needs to work with companies and pensions to stem the decline of defined benefit plans.

You can also listen to this radio interview on the CBC's The Current where Anna Maria Tremonti talks to Jim Leech and his co-author, Jacquie McNish on their book. Great interview, well worth listening to. Also read Jacquie McNish's article in the globe and mail, The problem with pensions: symptoms and cures and Keith Ambachtsheer's review of the book here.

Jim Leech will soon retire from Ontario Teachers' Pension Plan and will become the next chancellor of Queen’s University. I thank him for taking the time to speak with me and Deborah Allen for setting up the interview. Remember, read the book, it's very well written and you will gain a deeper appreciation for why pensions matter and why we need to confront our pension failures now before it's too late.

Wednesday, October 30, 2013

Norway's Big Reversal Bet?

Mikael Holter of Bloomberg reports, Norway’s Sovereign Wealth Fund Shuns Stocks on Reversal Bet (h/t, Abnormal Returns):
Norway’s sovereign wealth fund, the world’s largest, warned that stock-market gains may reverse as Europe’s biggest equity investor said it won’t use new inflows to buy more shares.

“Our share in the stock market has been stable or falling even though markets are rising, and that means in practice that we’re not using inflows to buy stocks,” Yngve Slyngstad, chief executive officer of Norges Bank Investment Management, said at a press conference today in Oslo. The fund is preparing for a “correction” in stock prices, he said.

The warning follows a surge in stock values that added 7.6 percent to the fund’s equity portfolio last quarter. The $810 billion Government Pension Fund Global, the official name, returned 5 percent in the third quarter, representing a 228 billion kroner ($39 billion) gain, it said today. Bond investments climbed 0.3 percent and real estate holdings returned 4.1 percent, it said.

The fund has no immediate pension obligations and uses its long-term outlook to buy assets when others have to sell. After losing a record 633 billion kroner following the 2008 collapse of Lehman Brothers Holdings Inc. and ensuing global market slump, the fund raised its equity holdings by about 136 billion kroner in early 2009. In the second half of 2011, the fund bought more than 150 billion kroner in stocks as part of a strategy to invest in depressed assets.
Positive Signs

“In general, we see market corrections more as opportunities than as threats, so it’s not something that worries us,” Slyngstad said today in an interview. “If they come, that’s just a positive sign for us as an investor.”

Stocks rallied in the third quarter as the U.S. Federal Reserve unexpectedly refrained from ending its $85 billion-a-month quantitative easing program in September. Growth forecasts for China, the world’s second-biggest economy, also improved, propelling equities globally. The MSCI World Index of stocks gained 7.7 percent in the quarter, paring some gains late last month during the U.S. government shutdown.

The advance has pushed valuations for European shares to the most expensive level since the end of 2009. The Stoxx Europe 600 Index trades at 20.8 times reported operating profit, double the level from September 2011, according to data compiled by Bloomberg.
Holding Cash

Norway’s wealth fund, which gets its guidelines from the government, held 63.6 percent in stocks at the end of September, up from 63.4 percent in the second quarter. Bond holdings slid to 35.5 percent from 35.7 percent while real estate accounted for 0.9 percent. The fund is mandated to hold 60 percent in stocks, 35 percent in bonds and is building up to 5 percent in real estate, while allowing for fluctuations. It mostly follows global indexes and has some leeway to stray from those benchmarks.

“If we’re not buying equities these days, we’re buying bonds or just hold this as cash,” Slyngstad said. “We would of course like to invest more of it in the real estate market but that takes longer. As long as there are strong markets we don’t see any urge to increase our equity holdings.”

The investor, which posted its second-best year in 2012, is also undergoing a shift in strategy to capture more global growth. That’s involved moving investments away from Europe as emerging markets in Asia and South American make up a bigger share of the world economy. The fund has weighted its bond portfolio according to gross domestic product, after shifting away from a market weighting to avoid nations with growing debt burdens.
Largest Holdings

Its largest stock holding at the end of the quarter was Nestle SA (NESN), at a value of 38.5 billion kroner. The biggest bond holding was in U.S. Treasuries, at a value of 344 billion kroner, followed by Japanese and German government bonds.

“We consider U.S. Treasuries one of the safest investments you can do, and these last few weeks have not changed that view in any way,” Slyngstad said in the interview, referring to the first partial government shutdown in 17 years.

Mexico rose to fifth place in the fund’s bond holdings, while Brazil and South Korea joined the top 10, at the expense of France and Canada.

The fund will take “the time needed” to increase real estate investments to reach the target of 5 percent of total holdings, making bigger investments increasingly on its own rather than in partnerships, Slyngstad said. An initial ambition to reach the target in five years from its first real estate investment in 2010 may not be realized, he said.
Splitting Fund

Norway generates money for the fund from taxes on oil and gas, ownership of petroleum fields and dividends from its 67 percent stake in Statoil ASA, the country’s largest energy company. Norway is western Europe’s largest oil and gas producer. The fund, which had an average holding of 1.2 percent of the world’s listed companies at the end of 2012, invests abroad to avoid stoking domestic inflation.

Prime Minister Erna Solberg, whose government took power this month, said before the election she would consider splitting the fund into smaller units.

The government deposited 58 billion kroner of petroleum revenue into the fund in the quarter. The return beat the benchmark set by the Finance Ministry by 0.1 percentage point.

The investor got its first capital infusion in 1996 and has been taking on more risk as it expands globally. It first added stocks in 1998, emerging markets in 2000 and real estate in 2011 to boost returns and safeguard wealth.
I don't write enough about Norway's Government Pension Fund Global (GPFG). I should because Norway has done a superb job creating a sovereign wealth fund, intelligently investing their oil and gas proceeds for future generations. Unbelievably, Norway didn't even make Mercer's list of the world's best pension spots (I know it's a sovereign wealth fund, not a pension fund, but this country should have made top spot). Instead, the authors of that report praised Australia and its pension lessons from Down Under

And unlike other sovereign wealth funds, Norway's fund is extremely transparent. In fact, I used GPFG's governance framework as one of a few leading examples in a report I wrote back in 2007 for the Treasury Board of Canada on improving the governance of the federal public service pension plan. My report is still collecting dust somewhere in Ottawa but my contacts at the Office of the Auditor General of Canada tell me they are hard at work auditing the governance of that plan and I look forward to reading their latest report when it's publicly available.

Back to Norway's big reversal bet. GPFG is the world's biggest stock investor and soaring stock markets have helped bolster its performance in 2013:
The return on the GPFG during the first half of the year was 5.5 per cent, as measured in the currency basket of the Fund. When measured in Norwegian kroner, the return on the Fund was 15.9 per cent. The difference between the return in Norwegian kroner and in the currency basket of the Fund was caused by depreciation of the Norwegian krone relative to the currency basket of the Fund over this period. However, the return in international currency is the relevant measure with regard to developments in the international purchasing power of the Fund.
The return on the equity portfolio was 9.2 per cent, the return on the fixed-income portfolio was -0.4 per cent, and the return on the real estate portfolio was 3.6 per cent, as measured in the currency basket of the Fund (click on image below):


All in all, Norges Bank achieved a return in the first half of 2013 that exceeded the return on the benchmark index by 0.65 percentage point. Excess returns were generated in both equity management and fixed-income management (click on image below).

The average annual net real rate of return since yearend 1997, i.e. the return net of asset management costs and inflation, is calculated to be 3.2 per cent, as measured in the currency basket of the Fund. When measured from 1 January 1997 to the first half 2013, inclusive, the average annual net real return is calculated to be 3.4 per cent. The graph below shows the accumulated return on the equity and fixed income benchmark indices since 1998 (click on image).
As you can see, GPFG has performed well over the last ten years (gross return of 5.95%) and keeps its costs low (annual management cost is a mere 6 basis points). But the Fund is exposed to the whims of global stock markets and as shown in the chart above, it too got clobbered during the tech meltdown of 2001 and the global financial crisis of 2008.

The Fund's third quarter results are now available. You can read the quarterly report and see the highlights below:
  • Equity investments returned 7.6 per cent, while fixed-income investments returned 0.3 per cent. 
  • The return on equity and fixed-income investments was 0.1 percentage point higher than the return on the fund’s benchmark.  
  • Investments in real estate returned 4.1 per cent. 
  • The fund had a market value of 4,714 billion kroner at the end of the quarter and was invested 63.6 per cent in equities, 35.5 per cent in fixed income and 0.9 per cent in real estate.
And now that the Fund has recovered nicely from the crisis, it's looking to lower its risk in public equities and diversify its holdings. Like every other institutional investor in the world, GPFG sees multiple expansion getting out of whack as the Fed and other central banks pump enormous amount of liquidity into the global financial system, and it's exercising caution and looking to diversify its holdings as global stock markets soar.

One area of interest is real estate. Richard Milne of the Financial Times reports, Norway’s oil fund to ramp up property holdings:
The world’s largest sovereign wealth fund is aiming to ramp up hugely its property investments as it seeks to increase its holdings of real assets.

Norway’s $810bn oil fund is permitted to hold up to 5 per cent of its assets in property but its rapidly increasing size means that, despite amassing $7bn in real estate investments since 2010, this only amounts to 0.9 per cent of the fund.

Yngve Slyngstad, the fund’s chief executive, underlined how its property organisation had increased from 3 to 50 workers in the past three years.

He said it was “feasible but not likely” that the fund could reach its 5 per cent target by 2015, which would imply about $40bn of investments in the next two years.

“We have now built up a real estate team of a significant size that will be able to handle more transactions,” he told the Financial Times. “Whether we are going to do them or not that depends on the market and the opportunities.”

The oil fund has proceeded cautiously in property, investing with partners around the world.

But Mr Slyngstad opened the door to the fund investing on its own. “That may be a natural extension of the way we invest,” he added.

The fund has made its first property investments in the US in recent months, including paying $684m last month for a 45 per cent stake in the Times Square Tower in New York.

Mr Slyngstad’s comments on increasing its property investments came as the oil fund said it had made a return of 5 per cent in the third quarter, aided by the strong performance of equity markets.

Its equity investments returned 7.6 per cent while bonds earned only 0.3 per cent in the quarter.

At the end of September, it had a record 63.6 per cent of its holdings in equities and 35.5 per cent in bonds, the lowest to date.

Mr Slyngstad told a press conference that the fund was using most of its inflows from Norway’s petroleum reserves to buy bonds, adding that it was braced for a “correction” in stock prices.

The fund reduced its holdings in US and French debt during the third quarter.

But Mr Slyngstad said that the recent shutdown of the US government and flirtation with default had not changed the oil fund’s views of Treasuries being one of the safest investments in the world.

Norway’s new government, which came to power this month, has plans to change the oil fund’s mandate.

It announced in the coalition agreement vague plans for the fund to invest in emerging markets and possibly infrastructure.

Mr Slyngstad said the fund would wait to hear from the ministry of finance but also added: “We think it’s natural over a longer time that this fund invests in more asset classes and more in so-called real assets, of which infrastructure is one.

“Whether this is happening soon or in the long-distant future, we don’t know.”
I would caution Mr Slyngstad and his team at GPFF to take a measured approach when investing in illiquid investments, which is what they're doing. Admittedly, these are long-term investments which will help smooth the Fund's returns but record low interest rates are fueling a bubble in real estate, infrastructure and private equity.

Some pretty smart people are worried that pensions are taking on too much illiquidity risk at the wrong time and I agree. Think many pensions are ill-prepared for a rough landing, foolishly praying for an alternatives miracle. They better pray the Fed and other central banks avert a prolonged deflationary cycle because if they don't, the next financial crisis will decimate many pension plans.

As far as Norway is concerned, I like what they've done with their sovereign wealth fund and think they are on the right track. Mr Slyngstad is running a mammoth fund and they are doing a great job investing the proceeds of their oil-rich country. And while I realize that a correction in stocks is an opportunity for GPFG, I would love to talk to him about other investments to hedge downside risk, including tail risk strategies that are coming back to vogue as investors ponder volatility strategies (my email is LKolivakis@gmail.com).

Below, Yngve Slyngstad, head of Norway's oil fund, explains why the world's largest sovereign wealth fund could dramatically increase its property investments. He also discusses their views on Treasuries and the possibility of investing in infrastructure.

Tuesday, October 29, 2013

Are U.S. Pension Funds Going Canadian?

James Comtois of Pensions & Investments reports, MassPRIM taking closer look at cost structure:
The Massachusetts Pension Reserves Investment Management Board launched the first phase of a cost-saving and return-enhancing program that follows in the footsteps of public funds from other states that, in turn, are following in the footsteps of several Canadian plans.

Phase 1 initiatives of Project SAVE include renegotiating some public equity and hedge fund manager contracts to reduce fees for the $53.9 billion Boston-based fund; investing in hedge funds rather than hedge funds of funds and exploring more passive hedge fund strategies; looking at more private equity co-investing; establishing a cash overlay; and restructuring how the fund handles claims-filing procedures and recovery from class-action litigation proceeds.

“I noticed we spend a significant amount of time talking about returns, and although that's very important, we never took an in-depth look at our cost structure,” Michael Trotsky, MassPRIM's executive director and chief investment officer, said in a telephone interview. “Not all initiatives are just around cost savings; we're looking broadly at how we're running our business.”

Project SAVE, which stands for strategic analysis for value enhancement, was created by Mr. Trotsky earlier this year to find ways to reduce costs and potentially increase returns for MassPRIM. Some of these initiatives have been implemented; others are scheduled to go into effect in early 2014. MassPRIM expects these Phase 1 initiatives to either save the fund or provide return enhancements of $101.2 million per year.
Inspiration from SWIB

MassPRIM was inspired in part by a few other pension plans that have initiated similar programs. The $86.4 billion State of Wisconsin Investment Board, Madison, has been a big influence on the Massachusetts fund. For example, SWIB saves on fees by managing a substantial amount internally, whereas MassPRIM does no in-house management.

Wisconsin manages 56% of assets internally and is looking to increase that figure. Spokeswoman Vicki Hearing said SWIB manages 86% of U.S. equities, 52% of international equities and 50% of fixed income internally. It also manages nearly all of its Treasury inflation-protected securities investments in-house.

SWIB is also seeking to reduce expenses by direct investing or co-investing in private equity.

“SWIB seems to be a step or two ahead of everyone in this regard,” said Timothy Vaill, a member of MassPRIM's investment committee and the former chairman and CEO of Boston Private Financial Holdings Inc., who retired from the Boston-based bank holding company in 2010. “We visited them and had a good discussion with them.”

According to research from CEM Benchmarking, a Toronto-based benchmarking services firm that MassPRIM hired to study the fund's performance, many of MassPRIM's peers manage on average 24% of all assets internally.

SWIB wasn't the only asset owner that MassPRIM studied.

The $272.7 billion California Public Employees' Retirement System, Sacramento, manages 83% of its public equity portfolio internally and is looking to increase that percentage. The $47 billion Alaska Permanent Fund, Juneau, does co-investing and some direct investing in infrastructure and private equity, and plans to manage a portion of these public and private assets internally.

Mr. Vaill added that MassPRIM is also “watching the state of Oregon very closely,” as the Tigard-based Oregon Investment Council is proposing legislation that would grant it greater autonomy over running the $63 billion Oregon Public Employees Retirement Fund. MassPRIM also is looking at the $115.9 billion Teacher Retirement System of Texas, Austin, which is reducing expenses by co-investing with New York-based private equity firm KKR & Co. LP.

MassPRIM and other state funds actually are following in the footsteps of Canadian pension plans. Plans like the Toronto-based C$129.5 billion ($124 billion) Ontario Teachers' Pension Plan, Montreal-based C$185.9 billion Caisse de Depot et Placement du Quebec and Toronto-based C$60.8 billion Ontario Municipal Employees Retirement System have been able to make bold investments by managing assets internally through autonomous in-house teams and management subsidiaries such as the Quebec fund's Ivanhoe Cambridge and OMERS Capital Markets.

“We're looking at the Canadian funds as an example,” said Oregon Investment Council spokesman James Sinks regarding the proposed state legislation granting the Oregon fund greater operating independence.

Mr. Vaill also said MassPRIM executives spoke with some Canadian pension funds.
Maximizing legal claims

Where MassPRIM is branching out from its peers is through its litigation initiative. Through this aspect of Project SAVE, the fund developed a methodology with the help of its legal counsel to maximize claim recoveries and ensure that MassPRIM captures every available dollar in class action lawsuits.

Although MassPRIM officials are researching the advantages of making direct real estate investments and running some equity and fixed-income assets in-house, Mr. Trotsky noted that the rollout for these Phase 2 initiatives for Project SAVE “won't be for a while.”
The rollout won't be for a while but I commend Mr. Trotsky for taking the initiative to reduce expenses at MassPRIM by bringing more assets internally. Every U.S. state pension fund should be looking at ways to cut costs but to do this properly, they first need to adopt Canadian-style governance.

Interestingly, MassPRIM's private equity program was recently reported as being the best in the United States over the last ten and five years. They are among state pension funds that made a killing in private equity:
Private equity has been a winning bet for large public pensions, according to a new study.

Private equity delivered a 10 percent median annualized return to 146 public pension managing more than $1 billion over the last 10 years, according to a new report from industry trade association The Private Equity Growth Capital Council.

By comparison, the pensions earned a 6.5 percent annualized return on their total investments during the same period. Private equity also outperformed other investments, including stocks (5.8 percent); bonds (6.6 percent); and real estate (6.7 percent), according to the study.

Private equity is a bright spot in an otherwise troubled landscape for public pensions. Still hurt by the financial crisis, public plans are only 73 percent funded as of 2012, according to the Boston College Center for Retirement Research.

The Massachusetts Pension Reserves Investment Trust Fund earned the top rate of return from its PE portfolio with 15.4 percent annualized returns over 10 years.

Other top pension PE players over the same period were the Teacher Retirement System of Texas (15.5 percent); the Houston Firefighters' Relief and Retirement Fund (13.6 percent); the Minnesota State Board of Investment (14.4 percent); and the Iowa Public Employees' Retirement System (14.1 percent).

"We're delighted. It's a testament not only to the current staff, but to the legacy of those who launched and built a long-term track record second to none," said Michael Trotsky, executive director and chief investment officer for the Massachusetts pension.

"Private equity is an important asset class. It provides diversification and has been a leading contributor to our high returns since the mid-1980s."

Trotsky said the pension has about 10 percent of its money in PE—around the national average for large public retirement funds—and has no plans to change that. The state used 103 different PE firms as last year, including The Blackstone Group, Kohlberg Kravis Roberts and Bain Capital.


The PEGCC study also ranked pensions with the largest allocations to private equity.

The biggest is the California Public Employees'Retirement System, with $34.2 billion invested. Other huge allocators include the California State Teachers' Retirement System ($22.6 billion); the Washington State Department of Retirement Systems ($16.1 billion); the New York State and Local Retirement System ($14.9 billion); and the Oregon Public Employees Retirement System ($14.1 billion).

"Time and again private equity has proven that it's the single best asset class for public pensions, by delivering superior returns over long time horizons," Steve Judge, president and CEO of the PEGCC, said in a statement.

"Private equity continues to strengthen the retirement security of the millions of American police officers, firefighters, teachers and administrators who rely on hard-earned pension benefits. There is no doubt that private equity returns are essential to improving the pension funding equation."
I covered the PEGCC study in a recent comment on why pension funds love Wall Street and told my readers to take all these reports from consultants and industry trade groups touting alternatives with a grain of salt. Importantly, returns in private equity over the next ten years won't be anywhere close to what they were in the last ten years, especially now that fresh signs of a PE bubble are emerging.

But what struck me from the article above is that MassPRIM has 10% of its assets (roughly $5 billion) invested in private equity using 103 different PE firms. I would love for someone to track the fees paid out to these private equity funds over the last ten years because I can tell you right away, they run in the hundreds of millions.

In the record low interest rate environment we're in right now, fees matter a lot. There is a reason why some large hedge funds are chopping fees in half and why many pension funds are increasingly looking to cut costs and bring assets in-house, following their Canadian counterparts which are dodging Wall Street everywhere they can. Costs matter a lot and it doesn't make sense to dole out huge fees, praying for an alternatives miracle, especially when you get mediocre performance in return.

And to be clear, large Canadian funds still rely heavily on private equity funds. They are not all flying solo but the trend is definitely to cut costs as much as possible and rely on external funds only when they have to because of the size of the deals or because they cannot replicate a strategy internally.

One thing all of Canada's top ten got right is governance and compensation. Senior public pension fund managers are compensated much better here than in the United States. Sure, their hefty payouts are scrutinized by the media but they are paid to deliver results over a rolling four-year period and that is why they get paid so well (we can argue whether they're overcompensated but that is market rate for experienced people in finance who deliver strong results).

I mention compensation because it's a huge problem in the United States. Ashby Monk wrote an article last June for Institutional Investor on why MassPRIM can't hold onto talent, explicitly focusing on low compensation. He rightly notes that MassPRIM has become a revolving door where people come to advance their career rather than the interests of the organization. That's what happens when you don't compensate pension fund managers properly for such important jobs (it took MassPRIM over a year to find someone to head their private equity).

Finally, there is another reason why Massachusetts has to look into cutting pension costs. According to the Massachusetts Taxpayer Foundation, the unfunded liabilities of the Massachusetts public pension system grew last year and reforms to ease the burdens had almost no effect:
State and municipal retirement funds in Massachusetts had $146 billion in unfunded liabilities at the end of 2012, the study by the Massachusetts Taxpayer Foundation said. With $63 billion on hand, that leaves a gap of $83 billion.

Reform measures to lower benefits owed new workers were passed by the state legislature in 2011 and took effect in April 2012. They included raising the retirement age from 55 to 60. The expected savings were projected to be $5 billion over 30 years. The study said the saving this year totaled $500,000 in the fund for state workers.

The amount of unfunded liabilities has grown the report notes. For instance, the state’s funding gap for teachers and state workers was $3.5 billion in 2000. In 2012, it reached $21.5 billion. Municipalities saw the gap grow from $13.5 billion in 2000 to $14.7 billion last year.

The failure of the funds to meet annual return on investment targets of 8 percent to 8.25 percent and delays of governmental payments to the system contributed to the growing amount of unfunded liabilities, the report said. In a move to restrict short-term contributions, payment schedules were extended from 2018 to 2040. Delaying the payments allowed governments to keep cash in the short-term, but dramatically raised long-term costs, the study said.

Other factors that contributed to the pension funds problems include early retirement incentives and enhanced benefits approved by the legislature.

Retiree health care benefits add an extra burden on municipalities and the state. The cost of paying for benefits already owed is pegged at $46 billion, the study said. It called the benefits “exceedingly generous,” in allowing retirees hired before April 2012 to retire at age 55 and making them eligible for full benefits with 10 years of service time.

Pension problems and how to address them have roiled governments from California to Rhode Island. In some states, constitutional guarantees are obstacles to making changes to promised retirement benefits. Unions often fight changes to benefits they say were fairly negotiated under collective bargaining rights.
I've already covered the pension rate-of-return fantasy and think it's high time U.S. public pension plans incorporate sensible reforms including reforms on governance so they can finally start paying pension fund managers appropriately.

Below, Stanford University Public Policy Lecturer David Crane discusses why state pensions are shifting investment strategies. He speaks with Trish Regan on Bloomberg Television's "Street Smart." Again, read my comment on why pension funds love Wall Street.

Monday, October 28, 2013

Will Catastrophe Bonds Wipe Out Pensions?

Sarah Jones and Margaret Collins of Bloomberg report, Pensions Muscle Into Reinsurance for Yield in Catastrophe Wagers:
The $30 trillion global pension fund industry is starting to muscle in on traditional reinsurers, financing protection against earthquakes and tornadoes as interest rates near record lows spur the search for yield.

A record $10 billion of institutional money flowed into insurance-linked investments in the 18 months through June, and for the first time is directly influencing pricing of some catastrophe risk coverage, according to Guy Carpenter, the reinsurance brokerage of Marsh & McLennan Cos. Catastrophe bonds can yield as much as 15 percent, LGT Capital Partners AG says.

Coverage provided by alternative capital, as pension and hedge-fund money is known in the insurance industry, reached $45 billion at the end of 2012, about 14 percent of the total global property catastrophe limit purchased, Guy Carpenter says. While welcomed by nations seeking to spread disaster burdens, pension investment is pushing down prices, even as reinsurers press for higher rates to compensate for more frequent extreme weather.

“This is the biggest change to the reinsurance sector’s capital structure in the last 20 years,” said David Flandro, global head of business intelligence at Guy Carpenter in New York. “Catastrophe reinsurance is relatively high-risk, high-return. Pension funds are looking for direct access. Most of the capital is here to stay.”

In a catastrophe bond, insurers pay buyers some of the premiums collected for protection against damage from natural disasters. In exchange for above-market yields, investors assume the risk of a disaster during the life of their bonds, with their principal used to cover damage caused if the catastrophe is severe enough. The first catastrophe bonds were issued after Hurricane Andrew in 1992.
‘Coming of Age’

New Zealand’s Superannuation Fund said in May it planned to more than double its holdings in catastrophe bonds and other insurance-linked assets, while firms such as PGGM NV in the Netherlands and Royal Bank of Scotland Group Plc’s employee-retirement fund have stepped up their reinsurance investments. Pension assets have reached $30 trillion globally this year, according to estimates from J.P. Morgan Asset Management.

“This is a coming-of-age moment,” said Michael Millette, global head of structured finance at Goldman Sachs Group Inc., which managed a catastrophe bond offering for the New York Metropolitan Transportation Authority after Superstorm Sandy in 2012. “Some of the largest asset-management complexes in the world are becoming more engaged in the space.”

Catastrophe bonds can become even more attractive in the wake of a disaster as capital is depleted and insurance prices rise, said Eveline Takken, head of insurance-linked securities, or ILS, at PGGM, which oversees about 140 billion euros ($193 billion) in retirement savings for Dutch pension funds.
Bond Returns

PGGM is continuing to set up new investments in catastrophe insurance, eight years after its first forays following Hurricane Katrina, she said by phone from Zeist, Netherlands.

The Swiss Re Cat Bond Total Return Index, which tracks dollar debt sold by insurers and reinsurers, shows catastrophe bonds have returned about 10 percent this year. U.S. 10-year Treasuries currently yield 2.5 percent. Takken and other fund managers interviewed declined to disclose their returns.

Pension funds like reinsurance because of its low correlation to equity and bond markets. They can invest directly in the securities or allocate funds to specialist asset managers, such as Secquaero Advisors Ltd. and Nephila Capital Ltd., firms that sold stakes to Schroders Plc (SDR) and KKR (KKR:US) & Co. respectively this year as interest in the asset class increased.

Falling Prices

More than 80 percent of catastrophe coverage is still provided by the Lloyd’s of London market and traditional reinsurers, of which Munich Re is the world’s largest. Munich Re said on Oct. 21 that rates in Germany need to rise following this year’s weather events, which included a “centennial” flood coming just 10 years after the last one.

Standard & Poor’s said in a presentation in London last month that the new capital threatened the industry’s earnings and is depressing pricing for property-catastrophe coverage.

“Pension fund money is what everyone is talking about,” said Maciej Wasilewicz, a London-based analyst at Morgan Stanley. “The funds involved have all done the due diligence, hired the right people and trained themselves up. They have the infrastructure to invest in this in the future.”

Wasilewicz said the inflows had begun to drive pricing most noticeably in U.S. hurricane and tornado coverage, which makes up more than 50 percent of total ILS issuance.
Canadian regulators last month urged the nation’s insurance companies to issue their first catastrophe bonds in the wake of flooding that inundated downtown Calgary, the nation’s most costly natural disaster.

‘Extremely Watchful’

According to Goldman Sachs, which estimates sales of catastrophe bonds to reach a record $8 billion this year, Canadian insurers had relied exclusively on reinsurance to help bear risks.

Guy Carpenter’s Flandro said the new money dominated discussions at the industry’s annual meeting in Monte Carlo last month, where reinsurers gathered with brokers and their clients to negotiate next year’s policies.

John Nelson, chairman of Lloyd’s, the world’s oldest insurance market, called on regulators in London last month to be “extremely watchful” of alternative capital, saying the new entrants could pose a threat by pricing risk too cheaply.

“Pension funds and other long-term investors are probably here to stay, so long as we can provide them with a decent return over the long term,” said Stephen Catlin, who founded Catlin Group Ltd. (CGL), a Lloyd’s insurer, almost 30 years ago.
Direct Investment

Pension funds’ impact on the reinsurance market has been felt even though most are allocating just 1 percent to 2 percent of their portfolio to the asset class, according to fund managers and analysts. Schroders, Europe’s largest independent money manager, started its first ILS fund this month after buying a 30 percent stake in Secquaero.

“It’s not a mainstream financial asset class,” said Daniel Ineichen, a former Secquaero partner who is lead manager of Schroders’s new ILS fund, which has raised $56 million. “It’s like a hybrid” between reinsurance and a traditional bond, he said.

KKR, the buyout firm run by Henry Kravis and George Roberts, agreed to buy 25 percent of Nephila in January. Greg Hagood, Nephila’s co-founder, said 75 percent of its $9 billion in assets comes from pension funds.

LGT Capital, a Swiss-based manager of about $121.5 billion in assets, bought Clariden Leu Ltd.’s ILS unit and its team of 10 specialists in 2012. Michael Stahel, a partner at LGT, which has about $2.5 billion in insurance-linked investments, said that almost all the capital raised this year was pension money.
Yield Gap

LGT says returns for a given catastrophe bond can vary from 2 percent to 15 percent, while some customized contracts between two parties can yield as much as 40 percent.

The New Zealand Superannuation Fund, which manages about $22.5 billion for the government, said in May that it plans to invest up to $275 million in reinsurance, its second mandate in the asset class since 2010. RBS (RBS)’s pension fund for employees boosted its holdings by more than 34 percent in the past year to 521 million pounds ($842 million), according to the Edinburgh-based bank’s 2013 annual report.

The Ontario Teachers’ Pension Plan, which manages C$129.5 billion ($124 billion), has been investing in catastrophe bonds since 2005, said Philippe Trahan, director of the firm’s ILS group, who declined to disclose its specific allocation.

As long as investors look for higher yield in a record low interest-rate environment, more opportunistic investors, including pension funds, will allocate to ILS, said PGGM’s Takken.

“In the end it’s all about convergence of price, and if it’s not attractive people will move away,” she said.
It doesn't surprise me that Ontario Teachers and PGGM are invested in catastrophe bonds. They typically are first-movers and then the rest of the pension herd follows suit.

Catastrophe bonds have been around for a long time. I remember doing research on them back in 2006 when I was working at PSP Investments in the asset mix group. It was still early days back then but the market has mushroomed since as yield-hungry pensions look for the next big thing uncorrelated to stocks, bonds, real estate and private equity.

According to the Wall Street Journal, investors seeking increasingly novel ways to boost returns amid low-yield environment are turning to catastrophe bonds:
Investors are buying bonds that bet against natural disasters such as earthquakes and storms at the fastest pace in six years, a sign that debtholders are seeking increasingly novel ways to boost returns amid the low-yield environment.

Sales of so-called catastrophe bonds—which unload insurance risk onto investors, and can be completely wiped out in the event of a natural disaster—have topped $6 billion this year and are set to be the highest since 2007, according to Artemis, a deal tracker.

That demand isn't showing any signs of slowing either: this week, a unit of French insurer AXA SA raised €350 million ($473.3 million) from selling catastrophe bonds that provide insurance cover against European windstorms, the largest ever such deal sold in euros.

The appeal for investors is threefold. First, catastrophe bonds offer chunky returns when compared with other fixed-income asset classes. Between the start of this year and the end of September, total returns on catastrophe bonds were almost 9.5%, according to a Swiss Re index. By contrast, investment-grade corporate bonds issued in euros had clocked up returns of about 1.3% over the same period, according to Markit.

Second, the bonds typically have floating-rate interest payments, meaning they offer some protection against rising benchmark interest rates. Third, unlike other bonds, their performance is largely independent of wider financial-market sentiment.

"A stock market crash isn't going to cause a U.S. hurricane," said Rishi Naik, head of insurance-linked securities trading at BNP Paribas.

For insurance companies, catastrophe bonds can also be more appealing than the traditional method of buying cover through a reinsurance provider. By selling bonds, insurers can lock in a fixed price over a set number of years, Mr. Naik said. Reinsurance contracts, by contrast, are typically renewed annually, so are vulnerable to price hikes.

Another advantage the bonds offer is that because the cash has already been raised from investors, insurance companies don't have to worry about the risk of a reinsurer failing to make good on its commitments after a catastrophic event, Mr. Naik said.

Calculating the likelihood of such events is the tricky bit. Investors largely rely on computer models to assess the probability of different catastrophes and therefore the chance a bond could default.

This week's deal from AXA, for example, provides the insurer protection against claims on windstorms that have a probability of occurring once every 100 years.

Bondholders can also use slightly more prosaic methods for predicting if a catastrophic event might occur, such as checking weather reports.

"We look at seasonal forecasts, forecasts for five days and short-term forecasts, so depending on how the forecast is we would use this information advantage and our experience to trade on it," said Niklaus Hilti, head of insurance-linked strategies for Credit Suisse's asset management business. "But obviously we can't do that with an earthquake."

Such default events are by their nature random, but they are also extremely rare. Since the catastrophe-bond market was founded in the late 1990s, only a handful of bonds have defaulted because of a natural disaster, according to Artemis. Those included bonds covering payouts on Hurricane Katrina and the 2011 Tohoku earthquake in Japan, which led to the Fukushima Daiichi Nuclear Power Plant meltdown.

That means investing in catastrophe bonds is all about timing, Mr. Hilti says.

"It's not a question of if the events will happen, it's a question of when," he said.

Mr. Hilti says his firm would consider all new issues, but the decision to buy will often depend on what type of insurance risk the bonds cover.

"We don't like taking such a huge concentration risk on U.S. hurricanes, which is about 70% of the market," he said.

To be sure, some market participants are concerned some new investors might not fully understand the risks of buying catastrophe bonds.

Swiss Re, a reinsurer, warned last month that this new cash is yet to be tested in the event investors suffer large losses from a natural disaster.

That is unlikely to stop the market from growing. The total amount of catastrophe bonds outstanding globally is currently just shy of $20 billion, Artemis data show. That figure could potentially quadruple over the next decade, reckons Paul Traynor, head of insurance at BNY Mellon.

Investors are likely to scoop the deals up too.

"We have a very strong view that the market is just about to take off," said Daniel Ineichen, a fund manager at Schroders, whose funds manage $300 million of insurance-linked assets.

"We've seen more investors get involved this year that hadn't participated before. On the supply side we've also seen new issuers this year, so both sides are developing and will likely continue to grow," he said.
I understand the appeal of investing in catastrophe bonds but like any new asset class, get very nervous when the pension herd moves into uncharted territory. Some know what they're doing but most are going to get burned investing in perilous paper and their collective action could increase systemic risk in the insurance industry:
Over $40 billion in cat bonds have been issued in the past decade, with $19 billion now outstanding (see chart below). This is a small fraction of the $300 billion in catastrophe-related payouts that insurers are theoretically on the hook for. But it is up from $4 billion a decade ago and the market could quadruple again in the next decade, thinks BNY Mellon, a financial group. Most cat bonds cover natural disasters in developed economies, particularly in America, where insurance is prevalent and losses from hurricanes, earthquakes and the like are well understood. But a broader range of risks, like Turkish earthquakes and Caribbean wind damage, are slowly coming to market.

Investor demand is strong. Pension funds and other institutional investors are on the hunt for assets generating decent yields, particularly if the returns are uncorrelated to stockmarkets. As recently as last year cat bonds paid up to 11 percentage points over Treasuries, for risks equivalent (at least according to the ratings agencies) to holding speculative-grade corporate debt. Large institutional investors buying cat bonds directly or via specialist funds now account for perhaps 80% of the market, says Bill Dubinsky of Willis, a broker.

The rise of cat bonds and other “insurance-linked securities” is starting to affect the price of insurance, particularly on the reinsurance side. The inflow of money from capital markets has helped push reinsurance premiums down by 15% this year, denting profits in the sector. Some weathered insurance executives are warning that naive investors are distorting prices, creating a frothy “shadow insurance” sector with systemic implications.

They are quietly hoping a well-timed calamity or two will lead to losses big enough for newbies to reconsider their approach. So far, however, the hurricane season in the Atlantic has been notable for its calm, delivering no August hurricanes for the first time since 2002, and only two in September. Even when catastrophes do occur, they do not necessarily wipe out cat-bond investors: only three of the roughly 200 bonds issued in the past 15 years have been triggered, says William Donnell at Swiss Re, a reinsurer.

Investors may lose interest if prices get too high. Yields on cat bonds have plunged to just six points over Treasuries in recent months, their lowest in a decade, amid an influx of new money and a dearth of catastrophes. “Pension funds are here to stay, but not at any cost,” says Luca Albertini of Leadenhall, an investor in the sector.

Many insurers and reinsurers say that the new investors are more a complement than a threat. Just as banks can profit either by lending money to a company or by arranging for it to tap capital markets, reinsurers can benefit from cat bonds. Some use capital markets to offset their own risk portfolio, leaving them more capacity to underwrite fresh risks. (There are equivalent products in the life-insurance business, paying out if fatalities spike because of a pandemic, for example.)

Cash pouring into insurance makes it cheaper—good news for those who need cover. The risk for insurers is that cat-bond investors keep swooping in just after a disaster, when firms usually put up prices; that would cut into the fat margins insurers have used to rebuild profitability. Britain’s financial regulator this week warned that the influx of new money into cat bonds could push insurers towards underwriting dicier business to keep profits up. Man-made disasters can be just as frightening as natural ones, after all.
Indeed, man-made disasters are just as frightening as natural ones and the influx of money into cat bonds could seed a new crisis which is why UK regulators are speaking out for the first time about risks to the insurance industry.

Once again, my biggest fear is that many pensions investing in catastrophe bonds are underestimating the risks and they will feel the pain once a natural disaster strikes. Just like in financial markets, natural disasters are becoming less rare than in the past (global warming is undoubtedly the main reason). Also, pensions pouring money into these cat bonds are creating problems for the insurance industry and drawing close scrutiny from regulators. This too is something worth considering before investing in these bonds.

(Read Matthew Klein's Bloombeg article, Is Your Pension Courting Catastrophe?)

Those of you who want to read more about catastrophe bonds can download an excellent primer from RMS by clicking here. You can also track the latest news on catastrophe bonds, insurance-linked securities, reinsurance and weather risk transfer on the Artemis website.

Below, Huffington Post's Rick Camilleri assembles a few industry experts to discuss why catastrophe bonds are gaining popularity. Good discussion, well worth listening to but some risks outlined above are not mentioned in this exchange.

Friday, October 25, 2013

On the Verge of Expanding the CPP?

Adrian Morrow and Bill Curry of the Globe and Mail report, Push to expand Canada Pension Plan gaining steam:
A provincial movement to expand the Canada Pension Plan is picking up speed, with civil servants drafting a concrete proposal for change and Ontario Premier Kathleen Wynne rallying support for the reform.

Ms. Wynne is kick-starting that push with a trip to Calgary to make her case to Alberta’s Alison Redford, whose province opposed a previous attempt to increase CPP benefits on the grounds that the tax hike to fund them would hurt businesses. The pair will hunker down for an hour Friday morning.

The push comes amid increasing concern many Canadians will be left high and dry when they retire. Earlier this week, the Bank of Canada put off hiking rates, stoking fear among pension funds that face shortfalls in their investments.

“It doesn’t matter where you are in the country, people are not saving enough. There is not enough being put aside for people’s retirement – whether you’re in a jurisdiction with full employment or not,” Ms. Wynne said in an interview at her Queen’s Park office. “I really want to understand Alison’s perspective on this and how she sees a solution.”

The Ontario Premier has reason to hope Alberta’s fears can be assuaged. Ms. Redford’s finance minister, Doug Horner, told The Globe and Mail his government will keep “an open mind” on the subject.

“What we want to ensure is that this doesn’t have a detrimental impact on jobs, on economies and on small and medium-sized businesses,” he said. “We have an open mind to the discussion, and we’ll look forward to having that national discussion.”

Ms. Wynne is also believed to have a good working relationship with Ms. Redford. A photo of the two of them high-fiving in the Queen’s Park library last winter hangs on the wall of the Ontario Premier’s office. Friday’s têtê-à-tête will take place at Ms. Redford’s favourite café, in the Prairie city’s trendy Sunnyside neighbourhood.

While Ms. Wynne is publicly pressing to gain other provinces’ backing, bureaucrats have been working behind the scenes on a white paper that would spell out exactly what CPP reform could look like. The policy is expected to be presented at a meeting of provincial finance ministers next week in Toronto. Prince Edward Island Finance Minister Wes Sheridan said the white paper will likely be largely based on measures he has been advocating. The PEI proposal would raise the current maximum insurable earnings cutoff from $51,000 to $102,000, meaning higher income earners would pay more in premiums but would also receive more in retirement.

“I’m feeling very confident that we can bring this to fruition,” he said.

Manitoba Premier Greg Selinger, who met with Ms. Wynne Thursday evening in Winnipeg, is also on board. “Manitoba has been working with Ontario and other provinces to lobby the federal government for a meaningful, phased-in and fully funded expansion of the CPP as a foundation piece of a plan to strengthening the retirement income system in Canada,” Mr. Selinger’s spokesman wrote in an e-mail.

CPP reform will also be on the agenda at a premiers’ meeting in Toronto in November. The push is building toward a sit-down between federal Finance Minister Jim Flaherty and his provincial counterparts in December, where the provinces can make their case directly to him. Ms. Wynne has already pressed him informally at a dinner hosted by Cardinal Thomas Collins last week.

Provincial finance officials are already preparing a backup plan that would create an Ontario-only pension plan if negotiations on an expanded CPP fail. But Ms. Wynne said she hoped not to exercise that option. “Our first choice is to bring in the federal government into this discussion with the provinces, and I don’t think that we have exhausted that outreach at this point,” she said.

The federal government remains non-committal toward a CPP increase, but has not ruled it out. The Minister of State for Finance, Kevin Sorenson, maintains in a statement that Ottawa will continue talking with the provinces, but also shares “the concerns of small business, employees, and some provinces of increasing costs during a fragile global recovery.”

Ottawa’s position has clearly shifted from three years ago, when Mr. Flaherty urged the provinces to support a “modest” CPP enhancement. When he was not able to secure the required level of support for a change, his focus shifted to promoting a proposal for voluntary Pooled Registered Pension Plans.
I've been calling for expanding the CPP for a long time and recently discussed a study sponsored by our leading pension plans highlighting the benefits of defined-benefit plans. There is a tremendous amount of misinformation and scaremongering when it comes to expanding the CPP and public pension coverage. Unfortunately, very few people are looking at the facts to gain a better understanding as to why expanding the CPP will significantly improve Canada's retirement system, lower long-term debt costs and improve productivity.

To be sure, there is no silver lining when it comes to pensions. People still need jobs, they still need to save enough for retirement, and their pensions still have to be managed by a well-governed pension fund.

In Canada, we are lucky to have the Canada Pension Plan Investment Board and other great public pension funds which form the top ten. They got the governance right, operating at arms-length from the government and compensating their pension fund managers properly. We should build on their success and propel our country to the world's best pension spot. Organizations like CARP are putting the pressure on provincial and federal ministers to reform the CPP but more needs to be done. We need a collective awakening akin the one we had when a publicly funded universal health insurance system was first introduced. 

Below, Tommy Douglas, the former CCF premier of Saskatchewan and father of medicare, explains his belief in the importance of government-funded health care. Our politicians have a historic opportunity to champion universal pension coverage by expanding the CPP. Let's hope they won't let Canadians down. 

Thursday, October 24, 2013

Pension Funds Love Wall Street?

David Crane wrote an op-ed for Bloomberg, Pension Funds Love Wall Street:
Public pension funds have been moving huge amounts of money into alternative investments managed by Wall Street.

According to a recent report by Cliffwater LLC, an adviser to institutional investors, from 2006 to 2012 state pension funds more than doubled their allocations to alternative investments, which include private equity, real estate, hedge funds and commodities. Totaling almost $600 billion, these nontraditional investments now constitute 24 percent of public pension fund assets. In contrast, the funds dropped their investments in stocks to 49 percent from 61 percent over the six-year period.

There’s a reason for that big move, as explained in a recent International Monetary Fund report. Over the last 10 years, the average U.S. public pension fund earned a return of 6.4 percent a year, very healthy but not enough to meet the 8 percent return guaranteed to government employees. In an effort to take pressure off the state budgets that must cover those deficiencies, the IMF reports that state pension funds have been shifting billions to alternative investments promising higher yields.

To the casual observer, public pensions and hedge funds might seem like strange bedfellows. Public pension funds like to portray themselves as battlers for the little guy; hedge funds levy sizable fees that often go into the pockets of rich people.
Cynical Ploy

Some commentators even depict pension fund participation in alternative funds as a cynical ploy by pension reformers to transfer wealth from retirees to billionaire fund managers. That was the myth promoted in an Oct. 12 op-ed article in the San Francisco Chronicle by self-proclaimed progressive writers Matt Taibbi of Rolling Stone and David Sirota.
But pension funds started shoveling money into alternative investment programs well before pension reform was even in the news. As one example, the California Public Employees’ Retirement System, the largest U.S. public pension fund and a vigorous opponent of pension reform, has more than doubled its targeted investment in private equity over the past 10 years. Its 2012 report lists almost $20 billion of investments in funds managed by Blackstone Group LP (BX), Apollo Global Management LLC (APO), the Carlyle Group LP (CG), KKR & Co. (KKR) and other well-known private equity companies. Calpers and other public-pension funds moved into alternatives for one reason: They are desperate to achieve higher yields to help close pension deficiencies. If they are successful, there will be greater security for retirees and less pressure to cut public services or to raise taxes.

Of course, the foray by Calpers into alternatives isn’t a panacea. Pension costs continue to rise in California. Calpers has announced an additional 50 percent increase in costs commencing in 2015, and the most recent performance of its alternatives has lagged that of its conventional assets. But the trajectory of California’s rising pension costs would have been even steeper had Calpers not increased its allocation to alternatives.

Sirota and Taibbi are right that the fees paid for alternative investment management are higher than those charged for managing conventional assets. But state pension funds are still welcoming alternative-fund managers with open arms because ultimately what counts most to them and their members are higher net yields after -- and regardless of -- fees. Would you prefer to earn (say) 10 percent after a 2 percent fee or (say) 7 percent after a 1 percent fee? In and of itself, fee size shouldn’t drive investment selection.
Higher Returns

Fortunately for those funds, the higher fees have paid off. According to Cliffwater, alternative investments played a role in the above-average performance of 19 of the 20 top-performing state pension funds over the last 10 years. Pension funds that allocated less to alternatives did worse.

Absurdly, Sirota and Taibbi also accuse alternative investment managers of favoring an end to defined-benefit pensions. The reality is exactly the opposite. Defined-benefit plans are a gravy train for private equity and hedge fund managers; 401(k) plans deploy much less capital into such nonconventional investments. Alternative investment managers would lose a fortune if pension money were shifted to 401(k) plans.

There’s no guarantee unconventional assets will outperform conventional assets, but for now state pension funds and defined-benefit pension defenders have good reason for their aggressive support of alternative investments. So-called progressives who prefer to portray Wall Street as sucking blood from working people and conspiring to end their pensions should acknowledge that truth.

(David Crane, a former financial-services executive, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011.)
This op-ed covers many points but ignores others. First, since 2006, state pension funds have significantly altered their asset allocation, getting out of stocks and bonds into alternative investments like private equity, real estate, infrastructure and hedge funds.

Crane rightly notes the main reason behind this shift is that U.S. state pension funds are not meeting their 8% bogey but he fails to mention the rate-of-return fantasy has forced these funds into taking on too much illiquidity risk at the wrong time.

Second, think highly of Cliffwater but take their report on state pension performance and trends with a grain of salt. There is no doubt some state funds have done better than others investing in alternatives. For example, Beth Healey of the Boston Globe reports the $53 billion Massachusetts state pension fund had the highest performance in private equity among large U.S. public pension funds over the last decade, delivering a 15.4% annualized return in private equity over the last ten years.

The figures are based on a recent report by the Private Equity Growth Capital Council, showing the Massachusetts state pension fund outperforming other large state funds over the last five and ten years. You can click on the image below to see the rankings of the top ten state pension funds by private equity returns.


You can see Texas Teachers actually performed just as well in private equity over the last ten years (15.5%) but hasn't fared as well over the last five years (6.3%). Interestingly, the average annualized return for private equity of these ten pension funds over the last five years is 7.8%, much lower than what it was over the last ten years (12.3% for nine funds where data is available) and only proves my point as more money comes into alternatives, returns will come down significantly.

I take all these reports by consultants recommending alternatives and industry trade groups representing alternative investment funds with a grain of salt. The bulk of U.S. state pension funds praying for an alternatives miracle, buying the hedge fund myth, are doling out huge fees and getting mediocre returns. Sure, Wall Street loves it but the approach and governance are all wrong. U.S. state pension funds can learn a lot from their Canadian counterparts, most of which are dodging Wall Street every chance they get.

Of course, it would be irresponsible of me to lump all alternative investment managers in one bucket, nor do I agree with Matt Taibbi that hedge funds are looting pension funds. Taibbi doesn't have a clue of what he's talking about when it comes to hedge funds or pension funds. He has a beef with Dan Loeb, one of the best hedge fund managers in the world, and doesn't understand that how good managers are bringing down the cost of state pension funds.

Taibbi appeals to the masses wrongly claiming there is a wealth transfer from pensions to "rich and evil" hedge fund managers. Great stuff for selling magazines but it's all sensational rubbish which ignores the hedge fund model with all its imperfections is a lot better than mutual funds charging fees for closet indexing. And despite the high fees, top alternative funds have helped state funds lower the cost of their pension plans.

This brings me to the last issue raised in Crane's op-ed, alternatives investment managers would lose a fortune if pension money were shifted to 401 (k) plans. In fact, Stephen Schwarzman, David Rubenstein, Henry Kravis, Ray Dalio, Dan Loeb, and many other financial elites benefiting from the shift into alternative assets should be pushing Washington hard to bolster defined-benefit plans and privatize Social Security (it's only a matter of time). They stand to lose the most from the demise of defined-benefit plans.

As always, welcome feedback from my readers on this subject and don't pretend to have a monopoly of wisdom when it comes to pensions or alternative investments. Feel free to email me if you have valuable insights you'd like to add to this comment (LKolivakis@gmail.com). I will edit it accordingly.

Chris Conradi, a retired actuary, shared this with me:
Although I did not work on the investment side, in my role as actuary for a number of public retirement systems, I occasionally was present at board meetings where proposed investments in hedge funds were discussed—either to invest initially or to increase the allocation. In these meetings, the rationale was almost always given as risk reduction, not increasing returns.
Hedge funds, it was argued, could dampen the impact of down markets, while giving up some of the return in a pure equity investment. Mathematically, they were treated as lower return and lower volatility than equities, and they were treated as poorly correlated with equities. If all this were true—and I am a skeptic—you can see why they might have a role, despite their high fees and poor liquidity.

The argument for private equity and venture capital, on the other hand, was to get exposure to these segments of the equity marketplace which were not as accessible as the S&P 500. There was a recognition (expectation) that these came with higher risk and higher returns. Getting into these spaces was treated as an extension of the movement from S&P 500 stocks to small cap.
I know all these arguments all too well unfortunately, there is a lot of hype in these investments and what they purport to offer in terms of downside protection and true diversification.

Below, Private Equity Growth Capital Council CEO Steve Judge discusses investing in private equity with Deirdre Bolton on Bloomberg Television's "Money Moves."

Again, take these performance reports touting alternatives with a grain of salt and remember the returns on all assets, including alternatives, are not going to be anywhere close to what they were in the last ten years. As pension and sovereign wealth money flows into these assets, returns will come down significantly. And if another crisis hits, alternative investments will get clobbered so choose your managers carefully and don't put all your eggs in the alternatives basket!