Pension360

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Mary Childs and John Authers of the Financial Times report, Canada quietly treads radical path on pensions:

Half a decade ago, the top brass of New York City’s comptroller’s office hopped on a plane to learn from a Canadian pension plan. Then-mayor Michael Bloomberg and comptroller John Liu sent their deputies to study the model of their northern neighbours in an effort to develop a reform plan for the city’s five separate pensions.

When it comes to investing retirees’ funds, the Canadian model means building strong in-house teams and empowering them to make unorthodox decisions.

As a result, the Ontario Teachers’ Pension Plan (OTPP) and the Caisse de dépôt et placement du Québec, which manages the savings of the province’s public sector workers, as well as a handful of other Canadian public pension funds, now own an eclectic mix of assets.

That includes half of luxury retailer Neiman Marcus and a chunk of Stuyvesant Town in New York City; luxury retirement homes and dental service providers; toll roads in Chicago and airports in London as well as lotteries in Massachusetts and the UK.

This is a radical departure from the bonds and equities that still dominate US public pension portfolios. The Canadian plans hold over a fifth of their funds in real assets, such as infrastructure, and OTPP also uses leverage by borrowing sums from the money markets worth about 28 per cent of its entire portfolio. By contrast, the New York City Employee Retirement System has about 17 per cent invested in alternatives to stocks and bonds.

So far, the Canadian model is proving more successful. OTPP has made 8.2 per cent per year, net of fees, over the past decade. Nycers has generated 6.9 per cent a year over the same period — and this was before fees which in last fiscal year came to $183m paid to investment managers, per FT calculations based on accounts (click on image).

With the record low level of bond yields in developed economies making life harder for pension funds, the Canadian example is drawing more attention.

We noticed “a handful of pension funds who always beat us, in up as well as in down markets”, explains John Liu, who oversaw New York’s pension funds between 2010 and 2013. The one that stood out “consistently and by the greatest margin” was OTPP. “We didn’t think it was just dumb luck. They had managed to modernise their decision-making process by doing three things: by streamlining, by professionalising, and by depoliticising.”

The plan to emulate Canadian success in New York included creating a single board to manage the combined $120bn held in the five separate plans’ funds in a move that would give the city more heft as an investor as well as reduce costs.

While the ambition ran into political roadblocks, some major global pension funds are following suit, including Norway’s oil fund, the Danish pension group ATP, New Zealand’s superannuation system and Singapore’s sovereign wealth fund GIC. Even programmes within Texas and New Mexico are creeping in this direction.

It is not simply their asset mix that is helping the Canadian public retirement funds. Experts says governance is also critical. “They have been able to separate the management decisions of investing these plans make from political considerations,” said Dana Muir, a professor at the University of Michigan’s graduate business programme. “That would be difficult to accomplish in the US system.”

That, in turn, has given the funds greater ability to experiment in the search for returns.

“Because we know we have to innovate, we also have to have a little bit of tolerance for failure,” says Ron Mock, chief executive of OTTP. “Our very first private equity deal did not go very well, but yet we still had the support of the board, and management had the tenacity to learn and build.”

Another critical difference is “you actually capture enough of the knowledge and skills that you need to execute a long-horizon investment internally”, says Keith Ambachtsheer of the University of Toronto, a leading world authority on pensions. “To do that you have to have pay scales that allow you to attract those kind of people. The Americans don’t have that. Instead, they have to try to incentivise the Blackstones of the world to do it for them. That’s second best.”

The Canadian plans insist they do not want to add risk, but instead use their longer time horizon as an advantage over other investors, even if that means sacrificing the liquidity — or ability to sell easily — some of the assets they invest in.

Most are pushing further into real estate and infrastructure, and are seeking to develop expertise in operating the infrastructure assets, whether airports, renewable energy or roads.

“Being involved in the operation of assets is a source of additional value creation,” says Michael Sabia, chief executive officer of the Caisse de dépôt et placement du Québec. Citing the fund’s plan to construct and operate Montreal’s rapid-transit system as a proof of concept, he adds that “our intention is to export that approach to other countries and in particular into the US”.

Everyone is facing the challenge of low returns on traditional assets, says Lim Chow Kiat, GIC’s chief investment officer “A lot of funds have to pivot into private markets.” The change will prove “quite challenging” for many.

Five years on, New York City has consolidated investment meetings for the five plans — down from 54 gatherings per year to six — but it has yet to fully grasp the nettle. “We are the financial capital of the world, and we have a clunker of pension plan,” says Sal Albanese, a former member of the New York City Council.

Mr. Albanese is absolutely right, New York City is the financial capital of the world but they haven’t been able to adopt the Canadian model and the compensation they provide to their public pension fund managers is lousy, especially by NYC standards.

I’ve discussed all this three years ago in a comment, NYC Pension Chief Faces Huge Hurdles. Larry Schloss moved on to become president of Angelo Gordon & Co., a well-known alternatives shop where I’m sure he was compensated extremely well (according to his LinkedIn profile, he no longer works there).

There is nothing radical in this article for someone like me who has been covering Canada’s pension trendsetters for a long time. I don’t want to overtout the Canadian pension model but the truth is Canada’s large well-governed DB pensions are able to do things others can only dream of precisely because they got the governance right and are able to pay their senior pension fund managers big bucks to manage assets internally across global public and private markets.

And some of Canada’s highly leveraged pensions — in particular, HOOPP and OTPP — are able to intelligently use derivatives and other forms of leverage to juice up their returns even more than their large Canadian peers that are not allowed to leverage up their balance sheet.

As far as infrastructure, it’s a very hot asset class right now and I believe it will become the most important asset class in a world of low or negative interest rates. And Michael Sabia is right, those that have operational experience in infrastructure will have an enormous competitive advantage relative their peers and they will generate additional value creation along the way.

The Caisse is way ahead of everyone on this front, hiring many infrastructure experts with actual operational experience. This is why I praised Macky Tall and his team at CDPQ Infra in my comment on Canada’s pensions bankrolling infrastructure. By gathering an experienced team with operational experience, they are able to invest in greenfield infrastructure projects, allowing them to control these investments every step of the way.

Of course to do this, you need to hire the right people and pay them properly. In the US, public pensions can’t hire experienced people so they farm assets out to private funds that rake them on fees.

As I wrote in my last comment on the big bad Caisse:

[…] over the long run, nothing beats a large well governed defined-benefit plan which can invest directly across public and private markets all over the world and choose the top funds in public and private markets where it can’t invest directly. Canada’s Top Ten pensions have the size and expertise to do this efficiently which is why it’s very hard to top their long-term performance.

By the way, my last comment on the Caisse generated quite a few reactions. One Montreal hedge fund manager emailed me: ” Ton commentaire sur la Caisse m’a complètement déprimé!!!! Il ne reste plus qu’a me jeter en bas du pont Jacques-Cartier…ou attendre le nouveau Pont Champlain.” (“Your comment on the Caisse totally depressed me. Only thing left to do is jump off the Jacques-Cartier bridge or wait to jump off the new Champlain bridge”).

But another senior former senior pension fund manager who worked with me at the Caisse sent me this after reading my comment:

This was one of your best articles, certainly of recent months, if not years.

Can I address a couple of points you make.

Firstly, “Why are you bothering me with this?” Because you are one of the few places people can find a voice and be heard. You have a reputation for speaking truth to power, and that is important. If not you, who?

Secondly, I agree what you say about better management of all the defined benefit schemes and I think all pension funds should be thinking hard about their future structures.

I would, however, argue that Quebec needs an alternative to the Caisse; Ontario has Teachers, OMERS, HOOPP, etc and I believe that something similar would be good for Quebec over all. As the current fiasco at the McInnis cement project shows, the Caisse hasn’t learned from their previous mistakes.

You are 100% right that the finance industry in Quebec needs to adapt to a changing world, just as we ourselves have demanded that the companies we invest in adapt to NAFTA, China, or the latest technology. It’s painful, but history shows us that you adapt or die, and too many industries here have failed to adapt. Objecting to change because the current insiders don’t benefit

What Quebec needs to do is to sit down and think about what it wants from its finance industry, and to look at it as a whole – quite literally from the hundreds of students in Finance we graduate every year from our universities, to the layers that get laid off every time the next chief at the Caisse decides to make his mark, and especially the AMF.

I am blown away by the talented students I get to teach, and it hurts me that the only career advice I can give them is to head west. Why are we spending all that money subsidizing their education if we then put up insurmountable barriers to them getting jobs. It is reminiscent of our provincial politicians blowing hot air as they tell us how modern a Quebec is, how techno-savvy we are, even as they try and ban Uber.

The Caisse is the way it is because Quebec wanted bragging rights for the biggest pension fund in Canada. Well that era is past, CPPIB has that sown up forever. At the same time, we as Quebecers suffered because the concentration of risk meant that all the really bad mistakes hit us all. Clearly, what is good for the Caisse isn’t necessarily good for Quebec, and not all major decisions about Quebec’s financing should be routed through there either.

And Quebec needs to understand that the AMF is part of the problem not part of the solution; as Françoise Bertrand’s article in the Globe and Mail showed, the great and the good here are woefully out of touch.

Why does this justify a “QMERS”?

The Caisse, like CPPIB, needs big deals to have an impact on their returns. They have moved beyond economies of scale to the onset of dysfunctionality. A new company would rapidly gain the economies of scale that the municipal pension funds so badly need, but still be able to function profitably in the lower tiers of the market. As part of the set up, it could be included in their mandate that they have to invest say 1% of assets in Canadian Emerging Managers (if the Caisse were sensible they would follow suit but ask the new firm to run that for them), whilst the AMF could be brought in to see how it might stop discouraging start ups and favouring the BIG players.

But who could bring such a vision to life? Who understands the needs for scale, yet appreciates the benefits of a truly modern dynamic start up industry? Needs to be someone who knows the industry, but isn’t beholden to it. Someone who is used to going toe to toe with the big boys, but has a reputation for independent thinking. It’s on the tip of my tongue….

Yeah, thanks mate but I’m not really interested in such a position. However, if the board of directors at Finance Montréal wants you and me to come in to give them an earful of suggestions, I’ll let you know (don’t hold your breath).

Look, I agree with some of the things my friend mentions. The AMF (Quebec’s securities regulator) is part of the problem. Yes, following several highly publicized scandals, regulators need to be vigilant to make sure all funds are kosher but they’ve taken it to extremes to the point where only the big players can meet their increasingly taxing demands.

Second, maybe Quebec does need a new DB pension to handle all private pensions. The Caisse can still handle public sector pensions but we can introduce a new DB pension where large and small corporations are able to offer their employees an enhanced Quebec Pension Plan (enhanced QPP modeled after the enhanced CPP).

This new DB pension can hire experienced pension fund managers from CN, Air Canada and other Quebec pensions and investment outfits and it would be a great idea for a lot of reasons.

Where I disagree with my friend is that under Michael Sabia’s watch the Caisse has done a great job in tightening governance and oversight in all its investment and operational activities. Is it perfect? No but none of Canada’s Top Ten are perfect. If the next president of the Caisse can hold the same governance standards and even improve on them, I have no issue with the big bad Caisse gaining more power.

Alright, let me wrap it up. Those are my thoughts on Canada’s radical pensions. If you have anything to add, shoot me an email at LKolivakis@gmail.com and I’ll be glad to share your thoughts.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

This comment is bilingual, so please bear with me as I will explain it below. At the end of June, Patricia Cloutier and Valerie Gaudreau of Le Soleil reported, Tous les régimes de retraite de Québec passent à la Caisse de dépôt:

Dans l’espoir de faire des économies et d’améliorer leurs rendements, tous les régimes de retraite de la Ville de Québec seront dorénavant gérés par la Caisse de dépôt et placement du Québec (CDPQ).

Cet actif, qui s’élève à environ 2 milliards $, était auparavant géré par un comité composé de fonctionnaires de la Ville et de représentants syndicaux. La Caisse de dépôt, qui gère déjà le bas de laine des employés des Villes de Laval, Sherbrooke, Terrebonne et Magog, a ainsi ouvert la porte mardi à son plus gros déposant dans le secteur municipal. «On est très heureux de les accueillir. C’est une belle marque de confiance et de reconnaissance pour nous», soutient Maxime Chagnon, porte-parole de la CDPQ.

Dans la région de Québec, la CDPQ gère aussi les fonds des employés de l’Université Laval et d’une partie des employés de la commission scolaire de la Capitale.

En mêlée de presse, le maire de Québec, Régis Labeaume, a dit s’être entretenu avec le président et chef de la direction de la Caisse, Michael Sabia. «J’ai parlé à M. Sabia cette semaine, je lui ai dit qu’on lui envoyait 2 milliards $. J’ai dit qu’on voulait du bon rendement, il nous a promis tous les efforts. Je pense qu’on fait un bon coup. Ils sont très bien équipés», a-t-il commenté.

«On était dû pour changer et viser de plus gros rendements», a poursuivi M. Labeaume selon qui les syndicats ont aussi tout intérêt à percevoir de bons rendements depuis que la loi 15 oblige le partage à parts égales des déficits entre employés et employeurs. «Ils ont beaucoup plus d’intérêt maintenant pour le rendement car ils doivent payer 50 %», a-t-il dit.

Propos «indécents»

Jean Gagnon, président du Syndicat des cols blancs de la Ville de Québec, juge ces propos du maire «indécents». «Il faut être drôlement culotté pour s’approprier une démarche dont il était 100 % absent», soutient le syndicaliste. Selon lui, ce sont les syndicats qui ont tiré la sonnette d’alarme en ce qui a trait aux coûts élevés du régime. Un travail d’équipe de plusieurs mois s’est ensuite enclenché en collaboration avec la direction générale de la Ville.

Selon M. Gagnon, les employés municipaux sont eux-mêmes des contribuables et se sont intéressés depuis très longtemps au rendement des régimes de retraite. «Sauf qu’avant, je me faisais dire de me mêler de mes affaires!» lance-t-il, irrité.

La première solution envisagée par la Ville et les syndicats a été de créer un gros bureau de gestion des fonds à l’interne, avec une vingtaine d’employés, raconte M. Gagnon. Mais la structure aurait été lourde, et l’expertise, à développer. «Quand on a vu la proposition que la Caisse nous a faite, on ne pouvait avoir mieux», dit-il.

«La Caisse a eu un mauvais épisode en 2008, mais on sait qu’ils ont appris de leurs erreurs et ne referont pas ce genre de connerie-là», commente M. Gagnon, en parlant des pertes colossales enregistrées par la CDPQ il y a huit ans.

Alors qu’à l’heure actuelle, les frais de gestion des régimes de retraite des cadres, employés manuels, fonctionnaires, professionnels, pompiers et policiers sont de 0,29 %, ils pourraient maintenant descendre à 0,17 %, explique M. Gagnon.

Le représentant syndical évalue qu’entre les mains de la CDPQ, les rendements de ces régimes devraient augmenter, au minimum, de 1 %. Ce qui représente une économie de 22 millions $, tant pour les citoyens de Québec que pour les employés. «C’est une solution gagnant, gagnant», plaide-t-il.

Au 31 décembre 2015, les six régimes de retraite de la Ville de Québec comptaient plus de 9500 participants actifs, retraités et bénéficiaires.

Le chef de l’opposition à l’hôtel de ville, Paul Shoiry a aussi salué la décision mardi. «La Caisse de dépôt connaît des bons rendements depuis quelques années. Leur expertise est connue et je pense que financièrement, ça peut être une bonne chose. C’est probablement une très bonne décision», a dit l’élu de Démocratie Québec.

The article above was written at the end of June and basically discusses why the city of Quebec transferred $2 billion to the Caisse to manage its pension assets which were previously managed by a city pension plan. The Caisse didn’t solicit this business, it was approached to do this.

The main reason behind this move? Performance. The passage of Bill 15 in Quebec’s National Assembly forces public sector employees to share the risk of the pension plan, which means if a deficit occurs, they and the plan’s sponsor need to contribute more to shore it up (not sure if it’s Bill 15 but that is what the article states).

It is estimated that the plan’s performance will increase 1% which represents a savings of $22 million. In addition to this, there will be significant administrative savings, passing from 29 basis points to 17 basis points. The union representing Quebec City’s public sector employees pushed hard for this.

Now, the person who brought this to my attention shared this with me: “This is a terrible idea because it is setting a dangerous precedent as other cities and municipalities will follow and it will mean the end of many small equity and fixed income shops in Quebec that rely on these city and municipal pensions for mandates.”

He told me that Quebec’s financial community is dying and “nobody cares”. He said “Finance Montréal is doing a good job attracting back office jobs to Montreal and helping firms like Morgan Stanley and Societé Générale open up middle office jobs which helps many students in finance, but it’s not enough. There are no front office jobs being created here and that’s terrible.”

He said this will concentrate “more power in the hands of the Caisse and will jeopardize the emerging manager program which was set up to reinvigorate Montreal and Quebec’s financial community.”

He also told me that PSP’s CEO André Bourbonnais who sits on the board of Finance Montréal “went ballistic” when he found out that the Caisse will now be managing Quebec City’s pension assets because “he knows what it means for Quebec’s financial community.” [Note: This is all hearsay and the people that have met André  Bourbonnais tell me he’s a well-mannered person with a steady temperament.]

I listened patiently to his qualms and then asked him: “Why are you bothering me with this? I’m just a pension blogger trying to make a buck trading some biotech shares and here you are ranting and raving about the big bad Caisse taking over Quebec’s city and municipal pensions.”

Alright, so you all want to know my thoughts? I’ll share them with you and be very blunt so you are all crystal clear on them. I think it’s about time all of Quebec’s defined-benefit pensions be managed by the Caisse.

Why? Because over the long run, nothing beats a large well governed defined-benefit plan which can invest directly across public and private markets all over the world and choose the top funds in public and private markets where it can’t invest directly. Canada’s Top Ten pensions have the size and expertise to do this efficiently which is why it’s very hard to top their long-term performance.

And I’m not saying this to suck up to the Caisse or its senior managers. I couldn’t care less of what they think of me. I’m thinking of what is in the best interests of plan members and sponsors as well as Quebec taxpayers. And from my expert vantage point, there is no question whatsoever that they’re doing the right thing for their contributors, beneficiaries and the province’s taxpayers.

Will other unions in Quebec follow the decision of Quebec City’s public sector union and transfer their pension assets to the Caisse? I certainly hope so especially if it’s in their members’ best interests. I just finished a comment on the disaster at the Dallas Police and Fire Pension where I recommended almagamating all city and local pensions at the state level and improve their governance.

Will there be collateral damage because of decisions to transfer pension assets to the Caisse? Yes, no doubt about it. The person who shared this with be is right to lament that it will impact many Quebec based funds as well as consultants, actuarial shops and lawyers and accountants dealing with setting up new funds and managing their business. It will also impact brokers as they will receive less commissions.

Such is life, it is tough. When my buddy’s father closed up his children manufacturing shop in the nineties after Eaton’s closed stores and eventually went bankrupt, it meant he and others had to lay off many employees. He later admitted to me that he had too much concentration risk relying on Eaton’s.

The same goes for Quebec funds and consultants relying solely on Quebec’s small to mid size city and municipal pensions for all their business. If that is their business model, they’re going to close shop too.

The problem in Quebec is everyone knows each other and it’s a little fraternity. I call it “la petite mentalité québécoise” (the small Quebec mentality). It’s not just me. A French Canadian friend of mine once told me: “There are two type of Quebecers, those who think like Ginette Reno and those who think Celine Dion.”

I have no problem with Ginette Reno or Celine Dion, god bless both of these singers. But I understand what my friend was saying, either you’re going to think big time and act accordingly or close yourself off to what is familiar in your own surroundings. And if you’re going to do that, then you won’t enjoy big time success.

There are Quebec based private funds that think like Ginette Reno and others that think like Celine Dion. The latter are enjoying huge success while the former enjoy success but on a much smaller scale and their business model leaves them much more exposed to client concentration risk.

Again, such is life and it isn’t always fair. I know all about that on a personal and professional level, but I’m not going to shed a tear for Quebec based funds that close shop because of the right decision of Quebec City or other cities to transfer pension assets to the Caisse which will do a much better job, delivering better risk-ajusted results at a fraction of the cost.

The person who shared this with me didn’t like my response. He lamented “the Caisse’s results especially in fixed income weren’t as strong as those of Ontario Teachers’,” to which I replied “And, who cares? The Caisse’s 2015 overall results were excellent even if Fixed Income underperformed its Ontario Teachers’ peers” (not to mention you need to be extremely careful when intepreting results from Canada’s highly leveraged pensions).

And in its recent semiannual update, the Caisse said over five years, the weighted average annual return on clients’ funds reached 9.2%, generating net investment results of $86.8 billion for this period. With respect to its benchmark portfolio, the Caisse produced $9.4 billion of value added. For the first six months of the year, the average return stood at 2.0%, generating $1.6 billion of value added. Net assets totalled $254.9 billion.

Now, I don’t know if André Bourbonnais who sits on the board of Finance Montréal “went ballistic” when he found out that the Caisse will be managing Quebec City’s pension assets. This might be all hearsay which is completely false.

But I will tell you what I think, there is no doubt in my mind that Quebec and Montreal’s finance cummunty is shrinking (this is happening everywhere) and there needs to be a lot more done to attract front office jobs to our beautiful city. And I think that both André Bourbonnais and Michael Sabia need to use their power to do a lot more to help this city’s financial community flourish once again.

How should they do this? That’s a tough question. Most Quebec hedge funds, just like most hedge funds, absolutely stink. Most have closed shop in the last few years (the only hedge fund I would invest in is my friend’s currency hedge fund and even he is battling for returns with one arm tied behind his back). The same goes for private equity funds, which are much fewer.

Maybe the focus should be more on opening up another long only shop like Hexavest or opening up a big global macro shop. Or maybe this city needs to make a huge pitch to the United Nations to bring its pension operations here. I argued for this in a recent post of mine.

I don’t know the answers but all I can tell you is the financial landscape is being irrevocably altered and it will impact pensions, hedge funds, private equity funds, mutual funds, banks, insurance companies, and many third party vendors and service providers.

The Illinois Teachers Retirement System could vote at this week’s board meeting to lower its assumed rate of return – an action that spurred a panicked memo from Gov. Rauner’s office.

The discount rate, currently at 7.5 percent, could stand to be lowered to a more realistic number. But Rauner’s office doesn’t want to deal with the higher contributions that would result from the decision.

From Reuters:

A Monday memo from a top Rauner aide said the Teachers’ Retirement System (TRS) board could decide at its meeting this week to lower the assumed investment return rate, a move that would automatically boost Illinois’ annual pension payment.

“If the (TRS) board were to approve a lower assumed rate of return taxpayers will be automatically and immediately on the hook for potentially hundreds of millions of dollars in higher taxes or reduced services,” Michael Mahoney, Rauner’s senior advisor for revenue and pensions, wrote to the governor’s chief of staff, Richard Goldberg.

When TRS lowered the investment return rate to 7.5 percent from 8 percent in 2014 the state’s pension payment increased by more than $200 million, according to the memo.

[…]

Mahoney cautioned that “unforeseen and unknown automatic cost increases would have a devastating impact” on Illinois’ ability to fund social services and education.

One of Rauner’s top Republican legislative allies, Senate Minority Leader Christine Radogno, urged the TRS board to delay a vote Friday to give the public time to weigh in on its possible actions.

“This issue is important enough at the very least to put the TRS board on notice we don’t want them taking any action that could cost taxpayers $200 to $300 million without appropriate scrutiny,” she said.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Brett Shipp of WFAA reports, Dallas police, fire pension board facing disaster:

The past month has been an emotional roller coaster for Dallas police and firemen. Thursday afternoon, the bad news continued.

The Dallas Police and Fire Pension System is a billion dollars in the red, and the plan to bail the system out is already being called “unacceptable” by some.

The bailout plan, unveiled Thursday, is a proposal that police and fire employees knew was coming. But the fact is, the Dallas Police and Fire Pension System is actually closer to $2 billion in the hole.

If things keep going the way they are going, the pension fund will be broke by 2030. That’s why consultants unveiled the bailout plan, which one police veteran called so drastic he believes it will be voted down by rank-and-file.

The plan calls for dramatic reductions in cost-of-living adjustments and deferred retirement option plans, also known as the drop program.

What’s more, the City of Dallas would immediately have to contribute $600 million into the fund just to keep it solvent.

“There is no choice. There have to be deep cuts,” said pension fund board member and Dallas City Council member Phillip Kingston. “We tried to make them the least painful as possible. There have to be deep cuts and there is no guarantee the city is going to love contributing the amount that being asked.”

The pension fund got into trouble after former administrators made millions of dollars in risky real estate investments. Some of those administrators and advisors are reportedly now under federal investigation.

The pension system is in such bad shape pension system officials says dramatic cuts must be made beginning this October.

Tristan Hallman of the Dallas Morning News also reports, Can Dallas Police and Fire Pension fund be saved? Officials propose changes to head off insolvency:

Jim Aulbaugh, a battalion chief for Dallas Fire-Rescue, is skeptical of any attempts to save his and his colleagues’ pensions.

“I don’t think it will make any difference,” said Aulbaugh, a 33-year veteran. “It’s a sinking ship that can’t be saved.”

But Dallas Police and Fire Pension Fund board members still believe they can salvage the system. And on Thursday, they unveiled a new plan built mostly on big cuts, new revenue and the hope that the city will pump new money into the fund.

Firefighters and cops, who are rallying for higher salaries at City Hall, understand that their retirements are in jeopardy. The pension system, set back by significantly overvalued real estate investments, is hurtling toward insolvency by 2030.

The fund has $3.27 billion in unfunded liabilities and less than $2.7 billion in assets — a funding ratio of 45 percent. Pensions are generally thought to be in danger if their funding ratio is less than 80 percent. The fund would need its members and the city to double their contributions to meet its requirements.

Texas Pension Review Board Chairman Josh McGee said the fund is “in a world of hurt” and is unaware of a state pension system in worse shape.

“It’s going to take shared sacrifice from all sides to actually fix the system,” he said. “That’s going to be difficult.”

The proposals represented pension system officials’ first concrete steps at comprehensive fixes.

Kelly Gottschalk, the system’s executive director, said the fund’s proposals would solve nearly two-thirds of the funding problem.

The most significant proposal is adding restrictions to the Deferred Retirement Option Program, better known as DROP. The program allows veteran officers and firefighters to “retire” in the eyes of the system, but continue working for their paychecks while their pension checks are sent to a separate investment fund. They pay a fee of 4 percent of their paychecks, less than the 8.5 percent contribution they’d make otherwise.

DROP gave recipients an 8 percent to 10 percent annual return even while the system earned significantly less. And actual retirees can keep their money in DROP indefinitely, accruing interest, and withdraw it whenever they want. That makes up $1 billion of the fund’s money.

The proposal won’t end that practice because the system needs the money. But it will tie it to Treasury bond yields.

That plan, if approved, will probably force cops and firefighters to either retire sooner or stay in the normal fund longer. Once in DROP, members could earn a 3 percent interest rate for seven years. Then, the money will earn nothing until they retire.

The plan will trim cost-of-living increases, base payments on a five-year highest-salary average rather than three years, and raise all members’ contributions to 9 percent. DROP recipients will have their contributions refunded when they withdraw.

Members must approve the plan. So officials also restored reduced benefits for officers hired in the last few years in return for the cuts.

Officials hope the city will join them in a request to increase the contributions on both sides. That means millions more taxpayer dollars would be sunk into the fund. The city currently contributes the maximum allowed percentage, which will amount to roughly $118 million this fiscal year.

Jim McDade, president of the Dallas Fire Fighters Association, said he hopes members and the city will do what it takes. Benefits are important, he said. Dallas cops and firefighters don’t pay into or receive Social Security.

“In the end, we have to save our pension,” he said.

Police Lt. Ernest Sherman, a 26-year veteran, said he doesn’t mind the proposed cuts.

“If the changes have to be made for the betterment of the pension, I’ll be fine,” he said.

But he said pension officials should have been more frank about the pension fund’s troubles. He said the hopefulness sounded like all the other proposed fixes he has heard over the years.

And he fears that all the changes may not be enough. Gottschalk worries that the proposals will cause a run on the system by DROP members like Aulbaugh, the battalion chief, who said he’s considering it.

Even if there is no run, the pension fund may even have a difficult time meeting its now-lower annual investment return target of 7.25 percent. And another economic downturn could hurt the system further.

“I don’t know how you save a system like that except with steep cuts and big increases in contributions,” said Steve Malanga, a senior fellow who studies pensions at the conservative research group Manhattan Institute. “Even so, the risk will remain very high for years to come.”

Zero Hedge provided more background and analysis in its comment, Dallas Cops’ Pension Fund Nears Insolvency In Wake Of Shady Real Estate Deals, FBI Raid (added emphasis is ZH):

The Dallas Police & Fire Pension (DPFP), which covers nearly 10,000 police and firefighters, is on the verge of collapse as its board and the City of Dallas struggle to pitch benefit cuts to save the plan from complete failure.  According the the National Real Estate Investor, DPFP was once applauded for it’s “diverse investment portfolio” but turns out it may have all been a fraud as the pension’s former real estate investment manager, CDK Realy Advisors, was raided by the FBI in April 2016 and the fund was subsequently forced to mark down their entire real estate book by 32%.  Guess it’s pretty easy to generate good returns if you manage a book of illiquid assets that can be marked at your “discretion”.

To provide a little background, per the Dallas Morning News, Richard Tettamant served as the DPFP’s administrator for a couple of decades right up until he was forced out in June 2014.  Starting in 2005, Tettamant oversaw a plan to “diversify” the pension into “hard assets” and away from the “risky” stock market…because there’s no risk if you don’t have to mark your book every day.  By the time the “diversification” was complete, Tettamant had invested half of the DPFP’s assets in, effectively, the housing bubble.  Investments included a $200mm luxury apartment building in Dallas, luxury Hawaiian homes, a tract of undeveloped land in the Arizona desert, Uruguayan timber, the American Idol production company and a resort in Napa. 

Despite huge exposure to bubbly 2005/2006 vintage real estate investments, DPFP assets “performed” remarkably well throughout the “great recession.”  But as it turns out, Tettamant’s “performance” was only as good as the illiquidity of his investments.  We guess returns are easier to come by when you invest your whole book in illiquid, private assets and have “discretion” over how they’re valued.

In 2015, after Tettamant’s ouster, $600mm of DPFP real estate assets were transferred to new managers away from the fund’s prior real estate manager, CDK Realty Advisors.  Turns out the new managers were not “comfortable” with CDK’s asset valuations and the mark downs started.  According to the Dallas Morning News, one such questionable real estate investment involved a piece of undeveloped land in the Arizona desert near Tucson which was purchased for $27mm in 2006 and subsequently sold in 2014 for $7.5mm.  Per the DPFP 2015 Annual Report:

In August 2014, the Board initiated a real estate portfolio reallocation process with goals of more broadly diversifying the investment manager base and adding third party fiduciary management of separate account and direct investment real estate assets where an investment manager was previously not in place. The reallocation process resulted in the transfer of approximately $600 million in DPFP real estate investments to four new investment managers during 2015. The newly appointed managers conducted detailed asset-level reviews of their takeover portfolios and reported their findings and strategic recommendations to the Board over the course of 2015 and into 2016. A significant portion of the real estate losses in 2015 were a direct result of the new managers’ evaluations of the assets.

Then the plot thickened when, in April 2016, according the Dallas Morning News, FBI raided the offices of the pension’s former investment manager, CDK Realty Advisors.  There has been little disclosure on the reason for the FBI raid but one could speculate that it might have something to do with all the markdowns the pension was forced to take in 2015 on its real estate book.  At it’s peak, CDK managed $750mm if assets for the DPFP.

With that background, it’s not that difficult to believe that DPFP’s actuary recently found the plan to be in serious trouble with a funding level of only 45.1%.  At that level the actuary figures DPFP will be completely insolvent within the next 15 years.  Plan actuaries estimate that in order to make the plan whole participants and/or the City of Dallas would need to contribute 73% of workers’ total comp for the next 40 years into the plan…seems reasonable.

According to an article published by Bloomberg, a subcommittee of the pension’s board recently submitted a proposal that would at least help prolong the life of the fund.  The subcommittee proposal calls for cost of living adjustments to be reduced from 4% to 2% while participants would be expected to increase their contributions to the plan.  Of course, taxpayers were asked to also provide “their fair share” equal to roughly $4mm in extra plan contributions per year, a request that would likely require the approval of the Texas legislature.  If approved, the proposal is anticipated to keep the plan solvent through 2046…at which point we assume they’ll go back to taxpayers for more money?

A quick look at the plan’s 2015 financial reports paints a pretty clear picture of the plan’s issues.

Starting on the asset side of the balance sheet, and per our discussion above, DPFP was forced to mark down it’s entire real estate book by 32% in 2015. Private Equity investments were also marked down over 20% (click on image).

This came as over 50% of the assets were diverted into illiquid real estate and private equity investments back in 2006 (click on image).

But asset devaluations aren’t the only problem plaguing the DPFP.  As we recently discussed at great length in a post entitled “Pension Duration Dilemma – Why Pension Funds Are Driving The Biggest Bond Bubble In History,” another issue is DPFP’s exposure to declining interest rates.  Per the table below, a 1% reduction in the rate used to discount future liabilities would result in the net funded position of the plan increasing by $1.7BN (click on image).

And of course the typical pension ponzi, whereby in order to stay afloat the plan is paying out $2.11 for every $1.00 it collects from members and the City of Dallas effectively borrowing from assets reserved to cover future liabilities (which are likely impaired) to cover current claims in full.  This “kick the can down the road” strategy typically ends badly for someone…like most public pension ponzis we suspect this one will be most detrimental to Dallas taxpayers. 

All of which leaves the DPFP massively underfunded…an “infinite” funding period seems like a really long time, right?

Since when did Zero Hedge become experts on pensions? Some of the stuff they write in their analysis is spot on but other stuff is totally laughable, like pensions causing the biggest bond bubble in history (Note to Zero Hedge: There’s no bond bubble, it’s called deflation stupid! And go back to school to understand the evolution asset-liability management and why in a deflationary environment, bonds are the ultimate diversifier).

Unlike Zero Hedge, I don’t take issue with the asset allocation of the Dallas Police and Fire Pension (DPFP) but rather in the shady, non-transparent way that they run their operations.

I can sum up the biggest problem at DPFP in three words: Governance, Governance and GOVERNANCE!!!!!!!!!!

I’m sick and tired of covering US public pensions with such awful governance and when disaster strikes, everyone blames public pensions and wants to dismantle them.

Folks, the pension Titanic is sinking, and what we’re seeing in Dallas, Chicago, Detroit, Tampa Bay, will be playing out in many US cities when the chicken comes home to roost.

When disaster struck Greece, and there was no money left to pay public pensions, they had to drastically cut benefits. Of course, this being Greece, it’s business as usual for Tsipras et al. as his government is increasing the civil service and turning a blind eye to undeclared income which now stands at 25% of GDP (I think it’s more like 50%).

In the United States, once public pensions go insolvent, sure, benefits will be cut and contributions will be increased but taxpayers will also be called upon to shore them up in the form of soaring property taxes and utility rates.

Instead of amalgamating city and municipal pensions at the state level and fixing the governance to manage more assets in-house, they’re introducing one Band-Aid solution after another.

As far as Dallas Police and Fire Pension, it’s a disaster and a real shame because not only is police morale low following the heinous shootings that rocked that city, now a lot of police officers and fire fighters are asking themselves whether they can count on their pension to be there when they retire.

I love Dallas. It’s a beautiful city. I visited it on a business trip back in 2004 when I was working at PSP Investments. I went with Asif Haque who now works at CAAT pension and Russell (Rusty) Olson, the former pension director of Kodak’s pension fund and author of Investing in Pension Funds and Endowments. We visited funds there and then drove to Houston which was nice but nowhere near as nice as Dallas (in my opinion).

Anyways, I don’t know how Dallas is now but it’s sad to see their police and fire pension on the verge of insolvency. In my opinion, this pension desperately needs the services of a Rusty Olson (don’t know if he’s still alive and kicking), a Ted Siedle (aka the pension proctologist) or even Harry Markopolos, the man who exposed the fraud at Madoff’s multi-billion hedge fund Ponzi and author of No One Would Listen (great book, a must read).

At the very least — and this is friendly, unsolicited advice — the DPFP should contact my friends at Phocion Investment Services and make sure their performance, risk and operations are being run properly and compliant with the highest standards.

In fact, if I was the sponsor or member of this pension plan, I would be demanding a comprehensive investment and operational risk audit of all activities at the Dallas Police and Fire Pension by an independent and qualified third party. And I’m not talking about the standard audit from a chartered accounting firm that basically signs off on activities.

[As an aside, back in 2004, I was elected to sit on the Board of the Hellenic Community of Montreal and the first thing I demanded was to hire a forensic accounting firm to go over all the books. I trusted nobody and refused to sign off on anything if the books weren’t properly audited by real experts who know how to uncover shady dealings. Things drastically improved since then, or so I hear.]

As far as investments go, one infrastructure expert shared this with me when it comes to the infrastructure investments at the Dallas Police and Fire Pension:

“[It’s] a true ‘mess’ in the US pension world. I met one of their investment team a couple years ago and learned that their infrastructure allocation was being used to fund extremely risky managed lanes toll roads in Dallas. Speaks to importance of picking the right advisors and investments when making an illiquid allocation”

When I pressed him on what exactly he meant by “extremely risky managed lanes toll roads in Dallas,” he elaborated and shared this with me:

As of 2015, their infrastructure investments were as per below (click on image).

Notwithstanding allocating all your infrastructure allocation investments to one manager (JPM is good but 1 – too much manager concentration, 2 – maritime and Asian infra are high risk strategies that should only form a small part of a diversified infra/real asset program), their co-investments in LBJ Express and North Tarrant are in managed lanes.

Managed lanes utilize variable tolling, to optimize traffic flow. They are constructed next to the free alternative and will change their tolls on a frequent basis based on prevailing traffic conditions on the free alternative. For example, if there is an accident or it is during rush hour, these lanes will increase their tolls as more drivers want to use them.

As anyone in infrastructure knows, forecasting traffic for regular toll roads or airports is much more of an art than a science so you could surmise just how extremely difficult it is to forecast and manage these types of managed lane investments. Definitely not for beginners or inexperienced US plans such as Dallas Police.

http://www.bloomberg.com/news/articles/2015-09-17/drivers-decry-rise-of-toll-lanes-as-texas-s-lbj-expressway-opens

Given what the article above mentions regarding Dallas’ real estate investments, I am not surprised. Scary to think about though and by the time it gets back to the Police, they are the losers and it is not fair. See the attachment on them selling their stakes in these investments, probably at the worst possible time.

If you would like to quote, please keep anonymous. When I read about this though it reinforces if US plans think they are going to make wise illiquid infrastructure investment decisions without someone experienced on their side or in house, they will prove disappointed. And the traditional GPs are definitely not fully on their side.

This person knows what he’s talking about and he’s right, the traditional GPs are definitely not on their side.

If you would like to contact me to discuss this comment, feel free to shoot me an email at LKolivakis@gmail.com and I’ll be happy to discuss my thoughts.

Lastly, you can read The Long-Term Financial Stability Sub-Committee’s presentation to the full Board at the August 11th Board Meeting by clicking here.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com.

The one thing some pension reformers say is needed to cut the cost of unaffordable public pensions: give current workers a less costly retirement benefit for work done in the future, while protecting pension amounts already earned.

It’s allowed in the remaining private-sector pensions. But California is one of about a dozen states that have what has become known as the “California rule,” which is based on a series of state court decisions, a key one in 1955.

The pension offered at hire becomes a “vested right,” protected by contract law, that cannot be cut, unless offset by a new benefit of comparable value. The pension can be increased, however, even retroactively for past work as happened for state workers under landmark legislation, SB 400 in 1999.

Last week, an appeals court issued a ruling in a Marin County case that is a “game changer” if upheld by the state Supreme Court, said a news release from former San Jose Mayor Chuck Reed, who wants to put a pension reform initiative on the 2018 ballot.

Justice James Richman of the First District Court of Appeal wrote that “while a public employee does have a ‘vested right’ to a pension, that right is only to a ‘reasonable’ pension — not an immutable entitlement to the most optimal formula of calculating the pension.

“And the Legislature may, prior to the employee’s retirement, alter the formula, thereby reducing the anticipated pension. So long as the Legislature’s modifications do not deprive the employee of a ‘reasonable’ pension, there is no constitutional violation.”

The ruling came in a suit by Marin County employee unions contending their vested rights were violated by a pension reform enacted in 2012 that prevents pension boosts from unused vacation and leave, bonuses, terminal pay and other things.

These “anti-spiking” provisions apply to current workers. The major part of the reform legislation, including lower pension formulas and a cap, only apply to new employees hired after Jan. 1, 2013, who have not yet attained vested rights.

The California Public Employees Retirement System expects the reform pushed through the Legislature by Gov. Brown to save $29 billion to $38 billion over 30 years, not a major impact on a current CalPERS shortfall or “unfunded liability” of $139 billion.

Similarly, legislation two years ago will increase the rate paid to school districts to the California State Teachers Retirement System from 8.25 percent of pay to 19.1 percent, while the rate paid by teachers increases from 8 percent of pay to 10.25 percent.

The limited teacher rate increase followed the California rule. The new benefit offsetting the 2.5 percent rate hike vests a routine annual 2 percent cost-of-living adjustment, which previously could have been suspended, though that rarely if ever happened.

While mayor of San Jose four years ago, Reed got approval from 69 percent of voters for a broad reform to cut retirement costs that were taking 20 percent of the city general fund. A superior court approved a number of the measure’s provisions.

But a plan to cut the cost of pensions current workers earn in the future by giving them an option (contribute up to an additional 16 percent of pay to continue the current pension or switch to a lower pension) was rejected by the court, citing the California rule.

In a settlement of union lawsuits, Reed’s successor locked in some retirement savings but dropped an appeal of the option. Reed, a lawyer, thinks the California rule is ill-founded and likely to be overturned if revisited by the state supreme court.

He has pointed to the work of a legal scholar, Amy Monahan, who argued that by imposing a restrictive rule without finding clear evidence of legislative intent to create a contract, California courts broke with traditional contract analysis and infringed on legislative power.

“California courts have held that even though the state can terminate a worker, lower her salary, or reduce her other benefits, the state cannot decrease the worker’s rate of pension accrual as long as she is employed,” Monahan wrote.

In the ruling last week, Justice Richman describes the setting for the reform legislation: soaring pension debt after the financial crisis in 2008-09 and a Little Hoover Commission report in 2011 urging cuts in pensions current workers earn in the future.

He cites several court rulings in the past that conclude cuts in pensions earned by current workers are allowed to give the pension system the flexibility needed to adjust to changing conditions and preserve “reasonable” pensions in the future.

Some of the court rulings cited allowed changes in retirement ages, reductions of maximum possible pensions, repeals of cost-of-living adjustments, changes in required service years, pensions reduced from two-thirds to one-half of salary, and a reasonable increase in pension contributions.

“Thus,” Richman wrote, “short of actual abolition, a radical reduction of benefits, or a fiscally unjustifiable increase in employee contributions, the guiding principle is still the one identified by Miller in 1977: ‘the governing body may make reasonable modifications and changes before the pension becomes payable and that until that time the employee does not have a right to any fixed or definite benefits but only to a substantial or reasonable pension.’”

Richman’s ruling makes several references to a unanimous state Supreme Court decision in 1977 in Miller v. State of California. He said the foundation of the unions’ constitutional appeal is a “onetime variation” in one word in another ruling.

“To be sustained as reasonable, alterations of employees’ pension rights must bear some material relation to the theory of a pension system and its successful operation, and changes in a pension plan which result in disadvantage to employees should be accompanied by comparable new advantages,” the state Supreme Court said in Allen v. City of Long Beach (1955).

Richman said a 1983 state Supreme Court decision (Allen v. Board of Administration) changed “should” have a comparable new advantage to “must,” citing two other State Supreme Court decisions that said “should” and an appeals court decision that said “must.”

In a decision a month later, he said, the Supreme Court used “should” while referring to a comparable new benefit and has continued to use “should” in all rulings since then.

“It thus appears unlikely that the Supreme Court’s use of ‘must’ in the 1983 Allen decision was intended to herald a fundamental doctrinal shift,” Richman said, citing two rulings that “should” is advisory or a recommendation not compulsory.

The 39-page decision written by Richman and concurred in by Justices J. Anthony Kline and Maria Miller makes other points in its rejection of a rigid view of the California rule and pension vested rights.

“The big question for pension reformers is whether or not the California Supreme Court will agree,” Reed said in a news release from the Retirement Security Initiative. “If it does, the legal door will be open for Californians to begin to take reasonable actions to save pension systems and local governments from fiscal disaster.”

There was no immediate word from the Marin Association of Public Employees and other county employee unions last week about whether the appeals court decision will be appealed to the Supreme Court.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Katia Dmitrieva of Bloomberg reports, Ontario Teachers’ Pension Plan seeking buyers for minority stake in $4-billion Vancouver real estate portfolio:

The Ontario Teachers’ Pension Plan is seeking buyers for a minority stake in its $4 billion real-estate portfolio in Vancouver, including office towers and shopping malls, according to people familiar with the matter.

Cadillac Fairview, the real-estate unit of Canada’s third-biggest pension fund, is looking to raise about $2 billion from the sale, according to the people, who asked not to be identified. Cadillac Fairview has hired CBRE Group Inc. and Royal Bank of Canada for the sale, the people said. Spokespeople for Cadillac Fairview, CBRE, and RBC didn’t immediately respond to requests for comment or declined to comment.

Cadillac Fairview is the latest pension group seeking to reduce its holdings in the Vancouver commercial market, where prices have reached record highs amid an influx of foreign cash even as new supply drives up vacancy rates. Ivanhoe Cambridge and the Healthcare of Ontario Pension Plan are seeking about $800 million for their office towers in Burnaby, British Columbia, just outside of Vancouver.

The Cadillac Fairview portfolio, which hasn’t yet started marketing, includes 14 properties in downtown Vancouver and Richmond, with some of Canada’s largest shopping centers, office towers, and historic buildings up for grabs. The assets include a portfolio of waterfront properties including Waterfront Centre, a 21-story tower on the harbor built in 1990; the 238,000-square-foot PricewaterhouseCoopers Place; and The Station, a historic property built in 1912 that serves as North America’s largest transport hub, currently pending approval for an added office tower.

Some of the country’s biggest retail assets are also in the mix, such as the Pacific Centre, a downtown retailer with 1.6 million square feet for which Cadillac Fairview submitted a proposal this year to expand. It’s the third-most profitable shopping mall in Canada, according to brokerage Avison Young, with $1,599 in sales per square foot. The center also contains eight office towers of two million square feet, including 701 West Georgia and the HSBC building.

Asset Gains

The net asset value of Cadillac Fairview’s real estate holdings increased 13 per cent to $24.9 billion in 2015 over the prior year amid high demand for assets in North America, according to the latest financial report from the Toronto-based pension fund. It also lists six of the Vancouver properties as worth at least $150 million.

Demand for Vancouver offices has sent prices of properties to record highs in recent transactions, including Anbang Insurance Group Co.’s purchase of the Bentall Centre. The vacancy rate in the city rose to a 12-year high of 10.4 per cent as of June 30 as tenants absorbed 1 million square feet of new space since the same time last year, according to Avison Young. Buildings downtown, where most of Cadillac Fairview’s properties are located, are faring better, with vacancy tightening to 7.8 per cent from 9.8 per cent at the end of 2015.

Additional space is set to flood the market, with six office towers under construction for delivery as soon as this year totaling about 802,700 square feet, and 10 buildings proposed for the city, including Cadillac Fairview’s Waterfront Tower, according to Avison Young’s mid-year 2016 report. Despite the vacancy, rental rates for the best quality assets in Vancouver are the highest in Canada and some U.S. cities such as Chicago and L.A. at about $30 a square foot, Avison Young said.

Earlier this month, Katia Dmitrieva and Nathalie Obiko Pearson of Bloomberg reported on how the Canadian housing boom was fueled by China’s billionaires:

The walls of Clarence Debelle’s Vancouver office on Canada’s west coast are lined with gifts from his real estate clients: jade and turtle dragon figurines; bottles of baijiu, a traditional Chinese alcohol; and enough special-edition Veuve Clicquot to fuel several high-end cocktail parties.

They are the product of Vancouver’s decade-long real estate frenzy. The city, with its stunning views of the mountains and yacht-dotted harbor, has long been one of the world’s most expensive places to live but price gains have reached a whole new level of intensity this year. Low interest rates, rising immigration, and a surge of foreign money—particularly from China—have all driven the increases.

Consider the latest milestones:

• The cost of a single-family home surged a record 39 percent to C$1.6 million ($1.2 million) in June from a year earlier.
• More than 90 percent of those homes are now worth more than C$1 million, up from 65 percent a year earlier, according to city assessment figures.
• Vancouver is now outpacing price gains in New York, San Francisco and London over the past decade.
• Foreigners pumped C$1 billion into the province’s real estate in a five-week period this summer, or about 8 percent of the province’s sales.

After copious warnings over the last six months, including from the Bank of Canada, that price gains are unsustainable, the provincial government of British Columbia moved last week. Foreign investors will have to pay an additional 15 percent in property-transfer tax as of Aug. 2 and city of Vancouver was given the authority to impose a new tax on empty homes.

As Canada waits to see what effect, if any, the moves may have, here are the stories from the city’s wild ride.

The great Canadian Vancouver real estate bubble, eh? Just keep buying Vancouver real estate and wait for all those Chinese billionaires and multimillionaires to buy your house at a hefty premium, especially if it has good Fen Shui.

I’ve been short Canadian real estate for as long as I can remember, and have been dead wrong. I’ve also been short Canada for a long time and still think this country is going to experience some major economic upheaval in the next few years.

Canada’s banks are finally sounding the housing bubble alarm but it’s too late (they have good reason to be scared). This silliness will likely continue until you have some major macro event in China or Paul Singer’s dire warning of a major market breakdown because of the implosion of the global bond bubble comes true.

Since I’ve openly criticized Paul Singer’s views on bonds being “the bigger short”, I can’t see a major backup in yields as driving a housing crash in Canada or elsewhere. Instead, what worries me a lot more is the bond market’s ominous warning on global deflation and how that is going to impact residential and commercial real estate, especially if China experiences a severe economic dislocation.

Now think about it, why are several large Canadian pension funds looking to unload major commercial real estate in Vancouver? Quite simply, the upside is limited and the downside could be huge. That and the fact they’re looking to sell for nice gains and diversify their real estate holdings geographically away from Canada (incidentally, geographic diversification is the reason why foreign investors would consider buying Canadian real estate at the top of the market).

Some of Canada’s large pensions, like bcIMC, are way too exposed to Canadian real estate. The rationale was that liabilities are in Canadian dollars so why not focus solely on Canadian real estate, but this increased geographic risk. This is why bcIMC is now looking to increase its foreign real estate holdings (read more on this here).

Real estate is a long term investment. Pensions don’t buy real estate looking to unload it fast (even opportunistic real estate can take a few years to realize big gains) but rather keep these assets on their books for a long time to collect good yield (rents). Even if prices decline, a pension plan with a long investment horizon can wait out a cycle to see a recovery.

That is all fine and dandy but what if pensions buy at the top of a bubble and then there’s a protracted deflationary episode? What then? Vacancy rates will shoot up, prices will plummet and rents will get hit as unemployment soars and businesses go bankrupt. They then can be stuck with commercial real estate that experiences huge depreciation and depending on how bad the economic cycle is, it could take many years or even decades before these real estate assets recover even if money is cheap.

I mention this because a while back, I publicly disagreed with Garth Turner on his well-known Canadian real estate bubble blog, Greater Fool, telling him that he’s wrong to believe the Fed will raise rates because of higher inflation and that will be the transmission mechanism which will spell the death knell for Canada’s real estate bubble.

Instead, I explained that once global deflation becomes entrenched, companies’ earnings will get hit hard, unemployment will soar and many highly indebted Canadian families barely able to make their mortgage payments will be forced to sell their house even if rates stay at historic lows.

Admittedly, this is a disaster scenario, one that I hope doesn’t come true. What is more likely to happen is real estate prices will stay flat or marginally decline over the next few years, but that all depends on how bad the next global economic downturn will be. And some parts of Canada, like Vancouver and Toronto, will experience a more pronounced cyclical downturn than others (for obvious reasons).

Those are my thoughts on Canadian pensions unloading commercial real estate in Vancouver. As always, if you have any thoughts, shoot me an email at LKolivakis@gmail.com. And please remember to kindly subscribe or donate to this blog via PayPal at the top right-hand side to show your appreciation for the work that goes into these comments.

Update: It looks like the good times are over as Zero Hedge reports the average home price in Vancouver just plunged 20% in one month.

A friend of mine who up until recently lived in Vancouver sent me this after I sent him the Zero Hedge comment on Vancouver home prices plunging:

No surprise. Once government decides to get involved in letting the air out of bubble, things tend to spin out of control.

Maybe I was wrong, perhaps 15% is big enough to have the Chinese think twice about Vancouver.

If this is so, Vancouver and all of BC is about to experience a massive recession. Any growth in BC in the last five years came from residential construction. Every other sector (mining, forest products, tech) has done nothing. Tourism is still a bit of a bright star but there is only so much you can do with Whistler and the cruise boats.

Never occurred to me that the Chinese may consider Calgary as a destination.

My friend  told me the Chinese might view this new tax as prejudicial and it’s clearly impacting the market: “a lot of offers were pulled after the tax went into effect.”

Unlike me, he thinks that a macro event in China will only accelerate capital out of that country (says “capital controls in China are a joke”) and if the loonie keeps falling, Canada will remain a destination of choice.

He also told me that “commercial real estate isn’t very correlated to residential real estate in Vancouver because most Chinese are self-employed and work out of their home doing in import-export trading.”

That may be true but it’s hard to see how a recession won’t impact commercial real estate in Vancouver. Still, foreign investors are looking at diversifying their real estate holdings and they will buy some of the real estate Canadian pensions are unloading in that city.

The CalPERS board this week adopted a 5-year Environmental, Social and Governance (ESG) Strategic Plan, which includes points on private equity reporting, sustainable investment research and board diversity of companies in which CalPERS is a shareholder.

Read the document here.

On the private equity front, the plan aims to eventually have all of CalPERS’ PE managers complete the fee template designed last year by the Institutional Limited Partners Association (ILPA). It’s unclear whether all of the general partners will sign onto that initiative; anyhow, they have 20 years to make up their minds.

More on the 5-year plan, from PlanSponsor:

The plan identifies six strategic initiatives that will direct staff’s work. The initiatives are data and corporate reporting standards; UN PRI Montreal Pledge company engagement; diversity and inclusion; manager expectations; sustainable investment research; and private equity fee and profit sharing transparency. These initiatives are cross-cutting issues which will have impacts on risk and return. Each initiative has specific objectives, key performance indicators, and a timeline.

The comprehensive plan is a result of more than a year’s worth of review by staff and the CalPERS Investment Committee. During this time, staff presented a thorough review of each channel—environmental, social and governance. Staff also reported on how each channel could use the approach of integration, engagement, advocacy and partnerships to move the strategy forward.

[…]

The strategic plan serves as the framework by which CalPERS executes its shareowner proxy voting responsibilities; engages public companies to achieve long-term, sustainable risk-adjusted returns; and works with internal and external investment managers to ensure their practices align with CalPERS’ Investment Beliefs.

The key performance indicators will serve as benchmarks to measure the success of efforts for each initiative. Staff will report to the board the status of the key performance indicators on a quarterly basis.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Kambiz Foroohar of Bloomberg reports, UN’s $54 Billion Pension Fund in Power Struggle Over New Rules:

The United Nations needs some financial peacekeepers. A dispute over whether new regulations governing the $54 billion UN Joint Staff Pension Fund will result in higher fees paid to outside bankers or modernize oversight of the 67-year-old trust has divided fund CEO Sergio Arvizu and union leaders, sparking accusations of mismanagement.

Lost in the fight is the fund’s performance: the account returned 5 percent the past decade, according to a June 30 report by Northern Trust Corp. That 10-year performance compares with 5.1 percent for the California Public Employees’ Retirement System, the largest in the U.S., and the 5.7 percent median for U.S. public pensions, according to Keith Brainard, who tracks pensions for the National Association of State Retirement Administrators.

Yet internal rules approved this month that shift authority over issues such as staffing and budgeting from Secretary-General Ban Ki-moon’s office to Arvizu have fueled the spat. At stake is a fund with more than 126,000 participants which pays about 71,000 retirees in 190 countries. Those payments go out in 15 currencies, including dollars, euros, kroners and rupees.

“We have arguably one of the most complex pension plan designs,” said Arvizu, a 55-year-old former director of investments at Mexico’s social security institute, via e-mail.

Divided Leadership

Adding to the complexity is the pension’s structure. Arvizu oversees benefits and operations and reports directly to the UN General Assembly, the main body representing all 193 member countries. The investment division is headed by Carolyn Boykin, a former president of Bolton Partners Investment Consulting Group. Boykin reports to Ban.

The fund’s broad investments are typical for a pension: it holds 61.3 percent of assets in stocks and 29 percent in fixed income, according to an internal report. It also has 6.9 percent in categories such as real estate, timberland and infrastructure and 2.7 percent in alternative investments, including private equity, commodities and hedge funds.

Moreover, the UN pension is 91 percent funded, above the 73.7 percent median for state pensions, Brainard said. If a plan can meet its projected payments, “it’s in good shape,” he said.

With backing from the UN General Assembly, Arvizu in 2014 began campaigning for changes he said were needed to modernize pension management at an institution famous for its Cold War-era bureaucracy. His argument: running an investment fund can’t be judged the same way you measure success for a humanitarian mission.

The union pushed back, seeing in the proposals the potential for managers to direct more investments to external institutions, undermining UN oversight and undercutting returns.

“This is a plan to move the pension fund outside the UN financial regulations,’’ said Ian Richards, president of the Coordinating Committee for International Staff Unions and Associations of the UN system, which has more than 60,000 members. “We don’t feel this management should get flexibility over how to manage the fund without all the checks and balances.’’

‘Outsourcing to Wall Street’

Allegations of mismanagement and conflicts of interests followed. On its website, the main UN union urged its members to “protect our pension fund: stop its exit from the UN at a time of outsourcing to Wall Street.”

In a letter to members last year, Arvizu said he was facing a “malicious campaign with gross misrepresentations.” The allegations triggered an internal investigation by the UN’s anti-corruption watchdog, which cleared Arvizu.

Fund officials reject the idea that they are planning to outsource management.

“There are no plans to privatize the pension fund, it’s not even an issue,’’ Lee Woodyear, the spokesman for the fund, said in a phone interview. “There are a lot of checks and balances in place and the new rules solidify what’s already taking place in practice.’’

Yet Arvizu, who joined the UN fund in 2006, argues he does need flexibility to hire and promote employees with specialized experience.

“The expertise to carry out this work — including entitlements, risk management, plan design, asset liability management, and client services — are different from other parts of the United Nations system,” he said.

Measuring Risk

The UN also needed to adopt modern tools for measuring risk and ensuring transparency, he said. Asset liability management studies, which help managers assess risk and strategy, “were not done before in the fund,” Arvizu said via e-mail.

Relations between management and the unions soured further when benefits management software installed in 2015 had delays enrolling beneficiaries. Thousands of new retirees, some of whom had to wait six months before receiving payments, were enraged.

“No doubt more could have been done with 20/20 hindsight to ensure that no new retiree was delayed,’’ said Woodyear. “There were delays, and the fund was slow to communicate clearly on the delays.’’

‘Compliance Risks’

Yet disputes keep flaring up. In July, the fund’s Asset and Liabilities Monitoring committee warned the pension was “exposed to significant governance, investment, operational and compliance risks.’’

According to an analysis by the UN union, the fund faces “significant concentration risks’’ from its two biggest portfolios, North American Equity and Global Fixed Income, which combined account for $30.5 billion. Two senior investment officers run these funds and vacancies in risk management have not been filled.

That’s now underway, Boykin said, hinting at the fund’s broader concerns about bringing capable professionals into the global body.

“The hiring process at the UN is lengthy,” she said.

Union leaders say they’ll keep pressing for the backlog of beneficiary payments to be fixed and on management to scale back the scope of the new regulations. But like other battles at the UN, little can happen quickly: the next fund review won’t take place until July 2017.

The last time I covered the UN’s pension fund was last year when I discussed the United Nations of Hedge Funds. I see things are only getting worse at the United Nations Joint Staff Pension Fund (UNJSPF).

A person familiar with the UNJSPF’s operations and politics shared this with me:

[…] the real problem is investment underperformance, YTD 190 basis points BELOW the policy benchmark followed by dismal performance in 2015.  The story I was told was that the recent attacks on the CEO (who doesn’t manage the investment portfolio) were a diversionary tactic. The purpose was to distract the audience from the dismal investment returns since the current Representative of the Secretary-General (RSG), Carolyn Boykin arrived and put a stop to tactical asset allocation. The Chairman of the Investments Committee and the Director of Investments left shortly after Boykin’s arrival, as did the Chief Risk Officer. Very ugly.

In an odd governance structure, Ms. Boykin doesn’t report to the pension fund CEO Sergio Arvizu. She reports to UN Secretary-General Ban Ki-moon and there’s even a picture of her shaking hands with him on the top of the UNJSPF’s website (click on image):

Ah, the United Nations, a vast organization full of important diplomats debating the world’s entrenched problems. I have tremendous respect for the UN and even joined McGill’s model UN club during my undergrad years where along with other students, we got to visit Princeton, Harvard, Columbia, Yale and Univ of Pennsylvania to simulate UN committees and debate other university students on key global issues. We also visited the United Nations on a few occasions (only from the outside).

And we performed exceptionally well and won many model UN events. There were a lot of very talented students representing McGill University back then (much smarter than me), including Tim Wu who is now a professor of law at Columbia’s Law School. Tim is credited with popularizing the concept of network neutrality in his 2003 paper Network Neutrality, Broadband Discrimination (Tim is a genius, had a 4.0 GPA while studying biochemistry and biophysics at McGill and then went on to study law at Harvard. He was also one of the nicest guys I met at McGill).

Anyways, enough reminiscing on my model UN undergrad days, let’s get back to the real UN and its pension woes. My contact sent me a recent critical analysis of the pension fund’s management and performance done by the UN Staff Union which you can all read by clicking here (note its date, July 2016).

Now, if you take the time to read this report, you’ll see it’s pretty scathing. There are some concerns that I agree with — including the sections on performance, risk management, governance and the way tactical asset allocation decisions are taken — but there are parts where quite frankly, I thought it was a bit ridiculous and too harsh.

In particular, this part on Boykin taking part in the Closing Bell ceremonies at the NYSE sponsored by Blackrock, “one of the top ETF providers” (click on image):

So what? Blackrock does business with everybody which is why it’s the world’s largest asset manager and able to attract talented individuals like Mark Wiseman to its shop.

But my contact shared this background with me on this event:

The “Closing Bell” appearance was a very sore subject within the Investment Management Division, (IMD) because the staff who worked on the Low Carbon Index project, which was completed BEFORE Boykin arrived at the UN, were not invited to the event. Boykin wanted to take full credit.

Ok, so maybe Boykin might be a narcissistic power hungry leader (I don’t know the lady) who wants to be the center of the universe. She won’t be the first nor the last alpha type at the UN which is a notorious breeding ground for such personalities.

Unfortunately, there may be more to this story. According to the UN Pension blog, when Secretary-General Ban Ki-moon appointed Boykin to the UN Pension Fund as his Representative for Investments in September 2014, rumors swirled like snowflakes that the new RSG had a spotty record — something to do with the Maryland State Retirement and Pension System where she was Chief Investment Officer from 1999 to 2003 (read the background here).

I can’t comment on Ms. Boykin’s personal qualifications. I’m sure she’s qualified or else she wouldn’t have been selected for the job.

But I can comment on the performance and more importantly governance of the UN pension fund. The latest performance figures (as of July, gross of fees) are provided publicly by Northern Trust, the master record keeper (click on image):

As you can see, the YTD performance of the pension fund relative to its policy benchmark is weak (5.06% vs 6.96%) but I wouldn’t read too much into one year’s performance. It’s meaningless for pensions which have a very long investment horizon.

According to the Bloomberg article above, the account returned 5 percent over the past decade, which isn’t great but it’s in line with what other large US public pension funds delivered during that period (Canada’s large pensions vastly outperformed their US counterparts during the last decade).

More importantly, the article states the UN pension is 91 percent funded, above the 73.7 percent median for state pensions. It’s the funding status of the plan that ultimately counts and on this front, there are no alarm bells ringing.

Having said this, if the governance is all wrong, you can expect weak performance to persist and the funding status of the plan to deteriorate, especially if low and negative rates are here to stay. And don’t forget, the UN pension is a mature plan, meaning there is little room for error if its pension deficit grows.

And it’s the governance of the UN pension that really worries me. Just like many state pensions, it’s all wrong with far too much political interference.

[Update: Read the latest comment from the UN Pension Blog going over investment performance and the health of the fund. “Looking ahead, it is clear that the Fund is facing a number of challenges in terms of leadership, governance, investment performance and its ability to pay retirees.”]

The UN pension needs to adopt the same governance rules that has allowed Canada’s Top Ten pensions to thrive and become the envy of the world. It needs to adopt an independent, qualified investment board to oversee the pension and hire experienced pension fund managers to bring assets internally and save the pension a bundle on fees.

Before it does all this, the UN needs to perform a thorough operational, performance and risk management audit of its pension. And I mean thorough and not the politically sanitized version. Have it done by Ted Siedle, the pension proctologist, or better yet hire me and my friends over at Phocion Investment Services here in Montreal and we will provide you with a comprehensive and detailed audit report on the true health of the UN pension.

What else do I recommend? I highly recommend the United Nations transfers the operations of its pension to the beautiful city of Montreal. I know, such a self-serving recommendation, but before you dismiss it, think about these points:

• Montreal is home to ICAO
• The city has world class universities, a diverse population and many fluently bilingual and multi-lingual finance and economics students with MBAs, Master’s and PhDs.
• Two of the largest Canadian public pension funds, the Caisse and PSP, are here and there are great private sector pensions here too (CN, Air Canada, etc.). There are many experienced pension professionals who can manage assets internally at a fraction of the cost of what it costs the UN to farm assets to external managers, many of which are underperforming. Of course, this assumes the UN gets the governance right, allowing its pension fund to compensate ts staff properly.
• Moving to Montreal would not only cut costs, it would distance pension managers from the politics of the UN’s General Assembly.
• Rents are much cheaper in Montreal and it’s a short plane ride away from New York City with no time difference.

The UN should really consider the pros and cons of moving its pension management division to Montreal. I can put together a team of highly qualified investment managers with years of experience at a moment’s notice (not holding my breath but I’m dead serious on this recommendation of moving the UN’s pension operations to Montreal).

But before the UN even contemplates this suggestion, it has to first fix its pension governance so that potential candidates will want to come work at the UN pension fund.

Why not fix the governance and hire people from New York City where financial talent abounds? Yeah, it can do that but it will cost the UN a lot more money and I strongly doubt they will get a better long term performance.

Those are my thoughts on the UN pension. As always, if you have anything to add or just want to reach out to me, feel free to send me an email at LKolivakis@gmail.com.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Ed Bartholomew, a consultant on pension financial management, and Jeremy Gold, a Fellow of the Society of Actuaries, wrote a comment for MarketWatch, The $6 trillion public pension hole that we’re all going to have to pay for:

U.S. state and local employee pension plans are in trouble — and much of it is because of flaws in the actuarial science used to manage their finances. Making it worse, standard actuarial practice masks the true extent of the problem by ignoring the best financial science — which shows the plans are even more underfunded than taxpayers and plan beneficiaries have been told.

The bad news is we are facing a gap of $6 trillion in benefits already earned and not yet paid for, several times more than the official tally.

Pension actuaries estimate the cost, accumulating liabilities and required funding for pension plans based on longevity and numerous other factors that will affect benefit payments owed decades into the future. But today’s actuarial model for calculating what a pension plan owes its current and future pensioners is ignoring the long-term market risk of investments (such as stocks, junk bonds, hedge funds and private equity). Rather, it counts “expected” (hoped for) returns on risky assets before they are earned and before their risk has been borne. Since market risk has a price — one that investors must pay to avoid and are paid to accept — failure to include it means official public pension liabilities and costs are understated.

The current approach calculates liabilities by discounting pension funds cash flows using expected returns on risky plan assets. But Finance 101 says that liability discounting should be based on the riskiness of the liabilities, not on the riskiness of the assets.

With pension promises intended to be paid in full, the science calls for discounting at default-free rates, such as those offered by Treasurys. Here’s the problem: 10-year and 30-year Treasurys now yield 1.5% and 2.25%, respectively. Pension funds on average assume a 7.5% return on their investments — and that’s not just for stocks. To do that, they have to take on a lot more risk — and risk falling short.

Much debate focuses on whether 7.5% is too optimistic and should be replaced by a lower estimate of returns on risky assets, such as 6%. This amounts to arguing about how accurate is the measuring stick. But financial economists widely agree that the riskiness of most public pension plans liabilities requires a different measuring stick, and that is default-free rates.

Ignoring this risk leaves about half of the liabilities and costs unrecognized. At June 30, 2015, aggregate liabilities were officially recognized at more than $5 trillion, funded by assets valued at almost $4 trillion and leaving $1 trillion — or more than 20% — unfunded. These are debts that must be paid by future taxpayers, or pensioners lose out. Taking into account benefits paid, passage of time and newly earned benefits, we estimate June 30, 2016 liabilities at $5.5 trillion and assets roughly unchanged at that same $4 trillion, indicating a $1.5 trillion updated shortfall.

Now let’s factor in both the cost of risk and low U.S. Treasury rates. We estimate the 2016 risk-adjusted liabilities nearly double to about $10 trillion, leaving unfunded liabilities of about $6 trillion, rather than $1.5 trillion.

Because today’s actuarial models assume expected returns and ignore the cost of risk, risk isn’t avoided; indeed it is sought! By investing in riskier assets, pension plans’ models then enable them to claim they are better funded and keep required contributions from rising further.

Risky assets (like stocks) are of course expected to return more than default-free bonds. If that weren’t true, no investor would hold risky assets. But expected to return more doesn’t mean will return more.

Risky assets might well earn less than default-free bonds, perhaps much less, even over the long term — that’s what makes them risky. And if that weren’t true, no investor would hold default-free bonds.

Compounding the problem, today’s aggregate annual contributions of $160 billion don’t even pay for newly earned benefits, adding more debt to be paid by future generations. State and local governments already face making bigger required contributions — even under the measurement approach that ignores risk — requiring higher taxes and crowding out other government spending. That is already happening in Chicago. In Detroit, Stockton, Calif., and Puerto Rico, bondholders haven’t been paid.

Some actuaries argue it’s time to change this approach. This was spelled out in a recent paper written by several members of a pension finance task force jointly created by two industry groups 14 years ago. We are two of those authors.

The leadership of the American Academy of Actuaries, which speaks for its 18,500 members on public policy matters, rejected the paper. It also persuaded the Society of Actuaries, the other industry group, not to publish it. On Aug. 1, the presidents of the two organizations issued a joint letter disbanding the task force and declaring that the authors couldn’t publish the paper anywhere.

This is more than just an internal dispute. Today’s public plan actuaries serve their clients, who want lower liabilities and costs, even at the expense of future taxpayers and other stakeholders.

Plans are in trouble. Every year they are in deeper trouble. Many taxpayers are aware that state and local government pension plans are underfunded. They generally aren’t aware just how dire the situation is.

Good numbers don’t assure success, but bad numbers lead to bad decisions and may invite disaster.

Ed Bartholomew is a former banker and now is a consultant on pension financial management. You can follow him on Twitter @e_bartholomew. Jeremy Gold is a Fellow of the Society of Actuaries (and recent vice president and board member) and a member of the American Academy of Actuaries (and former vice chairman of the Pension Practice Council. Follow him on Twitter @jeremygold.

Actuaries are typically known as very nice, extremely smart and sensible people but reading this article you get the sense the Society of Actuaries wants to cover up a $6 trillion pension hole.

Are these authors way off? Are they engaging in classic fear mongering to make the US pension deficit problem seem much bigger than it actually is?

Yes and no. Last Friday, I discussed why the pension Titanic is sinking, stating the following:

[…] while low returns are taking a toll on all pensions, especially US public pensions, the most pernicious factor driving pension deficits is record low or negative bond yields.

Importantly, at a time when pretty much all asset classes are fairly valued or over-valued, if another financial crisis hits and deflation sets in for a prolonged period, it will decimate all pensions.

To understand why, you need to understand what pensions are all about, namely, matching assets with liabilities. The liabilities most pensions have in their books go out 75+ years, while the investment life of most of the assets they invest in is much shorter (this is why pensions are increasingly focusing on infrastructure).

This means that a drop in rates will disproportionately impact pension deficits, especially when rates are at record lows because the duration of pension liabilities is much bigger than the duration of pension assets.

So even if stocks and corporate bonds are soaring, who cares, as long as rates keep declining, pension deficits will keep soaring. And if another financial crisis hits, watch out, both assets and liabilities will get hit, the perfect storm which will sink the pension Titanic.

Interestingly, very few people know this but pension deficits soared two years after the tech bubble crashed and in 2009 after the financial crisis hit even though stocks and corporate bonds (risk assets) came roaring back precisely because the Fed cut interest rates and kept them low to reflate risk assets.

The problem right now is interest rates are close to zero in the US and in many countries they are negative, so if another financial crisis hits, it will decimate all pensions, especially chronically underfunded public pensions like the ones in Chicago and the state of Illinois.

Pension deficits are path dependent, which in effect means the starting point matters a lot as do investment and other decisions along the way. If a pension plan is already underfunded below the 80% threshold (ie. assets cover 80% of liabilities) many consider to be manageable, then taking more investment risk at a time when assets are fairly valued or over-valued can lead to a real disaster, a point of no return where the only thing left is to ask taxpayers to bail them out or introduce cuts to benefits and increases to contributions.

The authors rightly note:

“Here’s the problem: 10-year and 30-year Treasurys now yield 1.5% and 2.25%, respectively. Pension funds on average assume a 7.5% return on their investments — and that’s not just for stocks. To do that, they have to take on a lot more risk — and risk falling short.”

Now, some economist will tell you, bond yields are “artificially low,” a product of what is going on outside the United States. I keep hearing such silly arguments and all I can tell you is there is no big illusion going on in the bond market, it’s definitely delivering an ominous warning to all investors to prepare for a long period of low and volatile returns.

Now, I don’t want to claim that Ed Bartholomew and Jeremy Gold are 100% right and all other actuaries are ignorant fools. We can certainly debate their figures as well as their use of current market rates to discount future liabilities. Some actuaries prefer a “smoothing of rates” to smooth out market fluctuations and avoid excessive volatility in the funding status.

But what if rates continue to go lower or even go negative in the United States? Two years ago, I warned of the possibility of deflation coming to America and even though it seemed highly unlikely back then, it certainly isn’t as far-fetched as you may think now. This is why I keep warning you of the deflation tsunami headed our way, it will wreak havoc across financial markets and cripple pension plans for years.

Ah, don’t worry, the Fed will raise rates, the global recovery is well underway, interests rates will normalize and all these pension deficits we are worried about today will magically disappear.

If you believe that, go out and buy yourself a Powerball ticket and try your luck there. I prefer to live in reality and from where I stand, things don’t look good for pensions, banks, insurance companies, retail investors and even elite hedge funds trying to outsmart markets.

And I’m concerned as to why the American Academy of Actuaries would cover up the findings of these authors and disband the task force, declaring that the authors couldn’t publish the paper anywhere. This isn’t the way scientists work. Let the authors publish their findings and if other actuaries take issue with their findings, let them publish counter arguments.

I’m not taking sides here. I think Bartholomew and Gold raise many excellent points but they are also grossly inflating the problem, providing detractors of public pensions with ammunition to attack them. Don’t get me wrong, there’s no doubt in my mind the pension Titanic is sinking but as is often the case, the solutions to this problem are worse than the disease.

On this note, let me unequivocally state my support for large, well-governed defined benefit plans like the ones we have here in Canada. Go read the Funding Q&A of the Ontario Teachers’ Pension Plan to gain an understanding of why I feel so strongly that the solution to pension deficits isn’t to switch people into defined-contribution plans, that will only exacerbate the long-term problem.

The brutal truth on defined-contribution plans is they leave too many workers and retirees exposed to the vagaries of markets. There is a misconception that switching people into DC plans saves taxpayers but it doesn’t because as more people succumb to pension poverty, it increases social welfare costs and the national debt.

The sooner policymakers understand the benefits of large, well governed defined-benefit plans, the better off the United States and other countries struggling with an aging demographics with little or no savings will be.

Update: Bernard Dussault, Canada’s former Chief Actuary, shared this with me after reading the article above:

Consistent with the attached actuarial financing policy that I am promoting for Defined Benefit (DB) plans, I almost completely disagree with the observations made in the MarketWatch article you cited in your comment.

Indeed, the valuation assumption in respect of the investment return (yield) on the pension fund should be as realistic as possible, i.e. based on actual past experience regarding the average return actually expected in the long term. Obviously, the riskier the assets, while the more volatile will be the yield, the higher it will be.

I am not in a position to assess whether the 7.5% assumed yield to which reference is made in the concerned article is realistic, but if it is, then it should be assumed. Besides, for indexed pensions, the main assumption to look after if the real rate (i.e. assumed nominal rate minus assumed inflation/indexation rate) of return as opposed to the nominal return.

While preparing the 16th actuarial report on the Canada Pension Plan in 1996 (http://www.osfi-bsif.gc.ca/Eng/Docs/cpp16.pdf), I concluded (please refer to section B on of pages 10 and 11 of that report) on the basis of statistics looking at several investment types from 1923 to 1995 that a diversified investment portfolio should not realistically be expected to produce a real of return of more than 4%.

One has to keep in mind that once the assumed realistic of return is determined for both liabilities and contribution rates purposes, the valuation actuary shall look at the other important, simple and not too numerous aspects of my attached proposed financing policy, in particular:

• the prohibition of contribution holidays;
• the amortization over 15 years of all emerging surpluses and deficits.

Bernard’s comments prompted this response from Ed Bartholomew on Twitter (click on image):

And that prompted this response from Bernard Dussault who doesn’t have a Twitter account:

Regarding your questions “who bears risk even for 4%? And are they getting paid to take that risk?” in respect of my proposed financing policy for DB plans. As you know, in most cases the plan sponsor is responsible for amortizing deficits under a DB pension plan. It could well fall partially or totally on the shoulders of plan members. In any event, this deficit-related risk is exhaustive and encompassing, i.e. I do not see the need to include a premium or investment risk within the valuation of liabilities. If both the normal contribution rate and liabilities are calculated on a realistic and long term basis (i.e. avoiding changing the long term term assumptions from one valuation date to another), deficits would normally in the medium and long term be essentially offset by surpluses, provided there are no changes in plan design, no contribution holidays and no avoidance of both surplus and deficit amortization. In that sense, either your second question is not relevant or I do not understand it. Any DB plan is normally sponsored freely by an employers, which involves a business risk for which he/she will be paid for to the extent of how good is that risk.

I thank Bernard for his valuable insights on this and other pension issues I’ve covered on my blog and thank Ed Batholomew and Jeremy Gold for sharing their views on this important issue.