Author: Leo Kolivakis

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.

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

Mohamed El-Erian wrote a comment for Bloomberg, The Titanic Risks of the Retirement System:

Imagine an entire enterprise set on course for disaster, driven by the owner’s arrogant pursuit of profit. The members of the management team, from the CEO on down, know better but fail to resist or are ignored. The clients remain totally unaware of the risks until far too late, with catastrophic results — particularly for the poorest among them.

This is the story line of the excellent “Titanic,” a musical now playing at the Charing Cross Theatre in London. As I took in this powerful portrayal of the human failures that brought down a ship thought to be unsinkable, it occurred to me that if we’re not careful, the tragic story could also end up describing the fate of the global retirement system.

With interest rates extremely low and the prices of stocks and bonds at historic highs, finding safe investments that can help guarantee a comfortable retirement has become increasingly difficult. This has put the managers of pension funds and other institutions that invest on behalf of future retirees in a difficult position, driving them to take ever greater risks in hopes of meeting their performance objectives — targets that are unlikely to be met absent a major revamp of economic policies and corporate prospects. As a result, individuals are increasingly being exposed to the threat of losses that cannot be recouped quickly.

The degree of long-term financial security that can be assured depends on three elements: future returns, correlations among different asset classes and volatility. The outlook for all three is becoming more uncertain.

What returns can investors realistically expect? With the combination of central bank activism and less robust economic prospects pushing bond yields into negative territory (most recently in the U.K.), fixed income markets no longer generate any meaningful returns — unless one takes on a lot more default risk by accumulating junk debt issued by corporations and emerging-market governments. In the stock market, high-quality dividend-yielding shares have reached unnerving valuations, leaving more volatile and risky options.

More sophisticated investors may be able to access investment vehicles that traffic in less crowded areas — but selecting the right manager is not easy, especially in a “zero sum” world in which one manager’s positive “alpha” is another’s losses.

In principle, the right mix of investments can provide greater return for the same risk. But this works only if the investments don’t move in sync — and correlations among asset classes have lately become unstable and less predictable. Sophisticated long-term investors realize that portfolio diversification, while still necessary, is no longer sufficient for proper risk mitigation. Yet the next operational step is not easy, and it typically involves giving up some potential return.

Then there’s volatility, which increases the chances that an investment will fall in value precisely when a future retiree needs the money. In recent years, central banks have largely been willing and able to repress financial volatility. Now, though, this is changing. Some, such as the Bank of Japan, appear less able while others, such as the Federal Reserve, somewhat less willing.

The repercussions for investment managers depend on where they stand. Those who oversee severely underfunded corporate or public defined-benefit pension plans are in a particularly tough bind: They must achieve high returns to meet their targets, so they face the greatest pressure to take on risks that could be catastrophic if companies and the economy don’t perform well enough to justify existing asset prices. Even better-funded pension plans that have matched their assets to their liabilities will be challenged to maintain historical returns if they take on new entrants.

To avoid disaster, policy makers and investment managers should consider three fixes. First, be a lot more realistic about the returns that can be achieved within traditional risk tolerance parameters. Second, put in place policies to boost savings and income, so people — particularly the most vulnerable — will have more money available to put aside for retirement. Third, be transparent with retirees about the risks that are being taken on their behalf, also offering less risky options with explicitly lower expected returns.

Absent urgent change, the retirement system could end up following the example of the Titanic. Like the ship’s passengers, many individuals would face the risk of devastating consequences. And like the second- and third-class passengers who had a hard time getting on lifeboats, the middle- and low-income segments of the population would be most at risk.

I’m glad Mohamed El-Erian finally decided to get on board and start writing about the pension Titanic which is one financial crisis away from sinking deep into the abyss.

El-Erian follows his former Pimco colleague Bill Gross who recently admonished US public pensions for not facing reality and letting go of their assumed rate of return which can never be achieved without taking undue and dangerous risks.

My former colleague from my days at BCA Research, Gerard MacDonell, had this to say on El-Erian’s titanic piece:

Deep thinker and clearly global guy Mohamed El-Erian probably needs to decide on the sense in which he wants to use the word titanic. Is it a large thing or an overrated thing?

He wrote this and Bloomberg published it:

This is the story line of the excellent “Titanic,” a musical now playing at the Charing Cross Theatre in London. As I took in this powerful portrayal of the human failures that brought down a ship thought to be unsinkable, it occurred to me that if we’re not careful, the tragic story could also end up describing the fate of the global retirement system.

The issue El-Erian chooses to use as a segue into his London theatre preferences and his favorite theme that uncertainty could rise is actually an important one. It would be great to see some reporting on it.

Financial market returns are going to be much lower than pension plans assume. This is an issue for companies offering defined benefit plans, as well as their beneficiaries. And even for defined contribution plans or just 401ks, beneficiaries broadly defined are probably in for a rude awakening.

It is darkly funny that this issue receives such little attention compared to the endless moaning, whining and gnashing of teeth around DA NATIONAL DEBT!!!!

At some risk of being self-referential too, I think this issue of pressure on pensions fits into the point that equities can be BOTH not significantly overvalued AND likely to generate very subpar returns. In slight contrast, bonds may be overvalued, but are now almost certain to deliver low returns, by definition if held to maturity.

Gerard is bright guy but when it comes to pensions, he should refer his readers to my blog because he never worked at one, nor does he really understand the bigger picture.

And what’s the bigger picture I’m referring to? Well, I went over it a week ago when I discussed Chicago’s pitchforks and torches:

There’s an even bigger problem which I want policymakers to wrap their heads around: chronic public pension deficits are deflationary.

Let me repeat that: Chronic and out of control public pension deficits are DEFLATIONARY. Why? Because it forces governments to introduce more property taxes or utility rate increases (another tax) to address them, leaving less money in the hands of consumers to spend on goods and services.

The other problem with raising taxes and utility bills is they are regressive, hurting the poor and working poor a lot more than Chicago’s ultra rich.

Now I’m going to have some idiotic hedge fund manager tell me “The answer is to cut defined-benefit pensions and replace them with cheaper defined-contribution plans.” NO!!! That is a dumb solution because the brutal truth on DC plans is they are failing millions of Americans, exposing them to pension poverty which is even MORE DEFLATIONARY!!

I want all of you to pay attention to what is going on in Chicago because it’s a cancer which will spread throughout parts the United States where chronic pension deficits are threatening municipalities, cities and states. And this slow motion train wreck will have drastic economic consequences for the entire country.

You will recall that chronic pension deficits are part of the six structural factors I continuously refer to when making my case for global deflation. In fact, I referred to these six factors recently in my comment on the bond market’s ominous warning:

[…] I remain highly skeptical that anything policymakers do now will be enough to resurrect global inflation. Readers of my blog know that rising inequality is just one of six structural themes as to why I’m worried of a global deflationary tsunami:

• The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full-time jobs with good wages and benefits are being replaced with part-time jobs with low wages and no benefits.
• Demographics: The aging of the population isn’t pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
• The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It’s not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I’m such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
• Rising inequality: Rising inequality is threatening the global recovery. As Warren Buffett once noted, the marginal utility of an extra billion to the ultra wealthy isn’t as useful as it can be to millions of others struggling under crushing poverty. But while Buffett and Gates talk up “The Giving Pledge”, the truth is philanthropy won’t make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption.
• High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
• Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary (think Amazon, Uber, etc.).

Why am I bringing this up? Because the stock market is acting as if reflationary policies will succeed while the bond market is preparing for a protracted deflationary episode.

And while some think negative yields outside the US are “distorting” the US bond market, I would be very careful here because the fact remains Asia and Europe remain mired in deflation which can easily spread to the United States via lower import prices. So maybe the bond market has it right.

This brings me to an important point, Gerard is right when he says that “bonds are now almost certain to deliver low returns, by definition, if held to maturity,” but he’s missing a crucial point, one that I keep hammering, in a deflationary environment, bonds are the ultimate diversifier.

Put simply, this means despite the fact that ultra low or negative yields are here to stay, you still need bonds in your portfolio to buffer the financial shocks or even the volatile markets that are the product of record low bond yields and everyone chasing yield by taking more risk.

Gerard is right that too many people are focused on the national debt without realizing how the United States of pension poverty is on the road to more debt if it doesn’t fix its retirement system and make it more like the one we have in Canada where our politicians just agreed to enhance the CPP which was the smartest move in terms of bolstering our retirement system.

This brings me to El-Erian’s solution to the pension crisis:

To avoid disaster, policy makers and investment managers should consider three fixes. First, be a lot more realistic about the returns that can be achieved within traditional risk tolerance parameters. Second, put in place policies to boost savings and income, so people — particularly the most vulnerable — will have more money available to put aside for retirement. Third, be transparent with retirees about the risks that are being taken on their behalf, also offering less risky options with explicitly lower expected returns.

Sure, delusional US public pensions need more realistic return targets, after all there’s no big illusion in the bond market, it’s sending a clear message to everyone to prepare for lower returns ahead.

But 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.

El-Erian is right, the US needs to put in place a system that promotes savings but saving for what, a 401(k) nightmare or something much better like an enhanced Social Security modeled after what the Canada Pension Plan Investment Board is doing?

All these Wall Street types peddling their retirement solution are only looking to gouge consumers with more fees and paltry returns. America definitely needs a revolutionary retirement plan, just not the one Tony James and Teresa Ghilarducci are pushing for.

Also, El-Erian is right, pensions need to be transparent about the risks they’re taking on behalf of retirees but they also need to be transparent about the lack of proper governance at US pensions and the need to implement a risk-sharing model to avoid a Chicago-style solution to the looming pension disaster which is coming to many American cities and states.

Last but not least, policymakers and public pensions have to be transparent and expose the brutal truth on defined-contribution plans as well as explain the benefits of large, well governed defined-benefit plans.

Of course, Bill Gross, Mohamed El-Erian, Gerard MacDonell and many others don’t discuss all this because they aren’t as well informed on all these issues to the extent that I am. I’m not deriding them, just stating a fact, when it comes to the pension Titanic sinking, there’s only one lone wolf who’s been warning all of you about the problem since June 2008 when he first started a blog called Pension Pulse.

With deflation on our doorstep, all of a sudden these experts are warning us of a looming retirement disaster. Where were they over the last decade, sipping the Kool-Aid?

Speaking of sipping the Kool-Aid, J.P. Morgan Asset Management, overseeing $1.7 trillion, says U.S. inflation is picking up. “U.S. inflation has actually come back,” Benjamin Mandel, a strategist for the company in New York, said Thursday on Bloomberg Television. “This idea that U.S. inflation is low and is always going to be low is an anachronism.”

My advice to all pensions is forget what Wall Street is selling you and prepare for the deflation tsunami ahead. The pension Titanic is sinking and you need to prepare for a long bout of low returns, low growth, low inflation and possibly even deflation ahead.

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

Benefits Canada reports, Ontario Teachers’ acquires U.S. oil and gas assets:

The Ontario Teachers’ Pension Plan – along with RedBird Capital Partners and Aethon Energy Management – will acquire J-W Energy’s assets in north Louisiana and northeast Texas.

Redbird, a North American-based principal investment firm, and Aethon, a Dallas-based onshore oil and gas investor, have partnered with the pension plan to purchase oil and gas upstream and midstream assets. Additional assets obtained in the partnership will be combined with the J-W assets to form a joint group, Aethon United.

“We are looking forward to partnering with Aethon, a proven firm with an exceptional track record and strong alignment with Ontario Teachers’, as well as expanding our strategic relationship with RedBird,” said Jane Rowe, senior vice-president of private capital at Ontario Teachers’. “These assets are a strong fit with our private equity energy portfolio and represent a compelling investment opportunity with an established base of long-life proven reserves and attractive growth opportunities.”

The Texas and Louisiana properties comprise approximately 84,000 acres and 380 miles of gathering and processing infrastructure which, added to Aethon United’s existing assets, results in a 350,000 net acres, the other portion of which is made up from previous deals with Encana, Noble Energy and SM Energy.

Ontario Teachers’ put out a press release on this deal:

Ontario Teachers’ Pension Plan (“Ontario Teachers'”) RedBird Capital Partners (“RedBird”), and Aethon Energy Management (“Aethon”) today announced the acquisition of J-W Energy’s (“J-W”) oil & gas upstream and midstream assets located in northeast Texas and north Louisiana. Additionally, Haynesville and Rockies assets acquired in partnership by Aethon and Redbird are being consolidated with the J-W assets, forming a joint partnership (“Aethon United”).

Located in north Louisiana and northeast Texas, the J-W Energy assets comprise approximately 84,000 net acres and 380 miles of associated gathering and processing infrastructure. The collective reserve base of the J-W assets combines low risk, long life, and highly predictable production with attractive development opportunities.

With this acquisition, Aethon United now operates in excess of 350,000 net acres and 166 MMcfe/d of production. In addition to the J-W Energy assets, Aethon United operates approximately 91,000 net acres in the Haynesville previously acquired from SM Energy and Noble Energy, as well as approximately 181,000 net acres in the Wind River Basin of Wyoming previously acquired from Encana.

Albert Huddleston, Founder & Managing Partner of Aethon, commented, “We are excited to partner with Ontario Teachers’ and continue our long-standing partnership with RedBird to acquire J-W Energy’s high quality, low risk, unconventional assets, which continues to expand our acreage in the Arkansas-Louisiana-Texas area. The J-W Energy assets help to diversify and expand our existing portfolio, and highlights Aethon’s ability to identify attractive E&P assets, offering strong risk-adjusted returns in the current market environment and in the future. We are grateful for the confidence shown in the Aethon Energy team for the series of investments in partnership with us by noted investors Ontario Teachers’ and RedBird, which ratifies our 26 year track record.”

“We are looking forward to partnering with Aethon, a proven firm with an exceptional track record and strong alignment with Ontario Teachers’, as well as expanding our strategic relationship with RedBird” said Jane Rowe, Senior Vice President of Private Capital. “These assets are a strong fit with our private equity energy portfolio and represent a compelling investment opportunity with an established base of long-life proven reserves and attractive growth opportunities.”

“Aethon has been a tremendous partner with RedBird in the build-up of our collective energy investments, and we’re excited to expand this partnership with our friends at Ontario Teachers’ with whom we have a very strong strategic relationship,” said Hunter Carpenter, Partner at RedBird Capital. “This partnership is an example of RedBird’s unique ability to identify proven owners and entrepreneurs like Aethon Energy who are frequently unavailable to traditional institutional capital. Aethon Energy represents a rare combination of investing and operating expertise providing superior historical performance and operating skill.”

About Aethon Energy Management

Aethon Energy Management LLC is a Dallas-based private investment firm that has managed and operated over $1.6 billion of assets, and is focused on direct investments in North American onshore oil & gas. Since its inception in 1990, Aethon has maintained a focus on acquiring under-appreciated assets where opportunities exist to add value through lower-risk development, operational enhancements and Aethon’s proprietary technical knowledge. Aethon’s 26-year track record spans multiple energy cycles and has consistently provided compelling asymmetric returns for its institutional and high net worth investors through disciplined buying and value creation. For more information, go to www.AethonEnergy.com.

About Ontario Teachers’

The Ontario Teachers’ Pension Plan (Ontario Teachers’) is Canada’s largest single-profession pension plan, with $171.4 billion in net assets at December 31, 2015. It holds a diverse global portfolio of assets, 80% of which is managed in-house, and has earned an annualized rate of return of 10.3% since the plan’s founding in 1990. Ontario Teachers’ is an independent organization headquartered in Toronto. Its Asia-Pacific region office is located in Hong Kong and its Europe, Middle East & Africa region office is in London. The defined-benefit plan, which is fully funded, invests and administers the pensions of the province of Ontario’s 316,000 active and retired teachers. For more information, visit www.Otpp.com and follow us on Twitter @OtppInfo.

About RedBird Capital Partners

RedBird Capital Partners is a North America based principal investment firm focused on providing flexible, long-term capital to help entrepreneurs grow their businesses. Based in New York and Dallas, RedBird seeks investment opportunities in growth-oriented private companies in which its capital, investor network and strategic relationships can help prospective business owners achieve their corporate objectives. RedBird’s private equity platform connects patient capital with business founders and entrepreneurs to help them outperform operationally, financially and strategically. For more information, go to www.RedBirdCap.com.

J-W Energy Company also put out a press release on this deal:

J-W Energy Company is pleased to announce the closing on July 1, 2016 of the sale of substantially all of the oil and gas assets owned by J-W Operating Company and substantially all of the midstream assets owned by J-W Midstream Company to affiliates of Aethon United LP. The assets included in the transaction are located mainly in the North Louisiana and North Texas areas and are comprised of approximately 95,000 net acres and 380 miles of associated gathering and processing infrastructure. The sale is an exit from the upstream and midstream business by J-W Energy Company, which will continue to own the largest privately-held compression fleet in the U.S. through its wholly-owned subsidiary, J-W Power Company. Over the past ten years, J-W Energy has exited from its drilling, valve manufacturing, gas measurement and wireline businesses as well, as part of a planned reallocation of company resources.

“This exit from the upstream and midstream businesses will allow J-W Energy Company to focus on our compression business, which has been less capital intensive than the upstream and midstream businesses. Despite this sale marking the end of J-W Energy’s long and successful history in the upstream and midstream businesses, we are confident that the dedicated employees of J-W Operating and J-W Midstream will be instrumental in the future success of this endeavor,” said David A. Miller, President of J-W Energy Company.

Wells Fargo Securities, LLC served as the exclusive financial advisor to J-W Energy on the transaction.

You can also read more about J-W Midstream Company here:

J-W Midstream Company is a natural gas gathering and processing company that has been active in the gathering, dehydration, treating, processing and transmission of natural gas for over thirty years. With that experience, we understand the producer’s need for high quality, cost-effective, completely reliable services.

From engineering and construction to contract gathering and processing, J-W Midstream Company is committed to providing a continuously uninterrupted flow of gas to our customers and real value to their bottom lines.

J-W Midstream Company operates more than 400 miles of natural gas pipeline systems in Louisiana and Texas, as well as processing facilities that range from small refrigeration and J-T skids to 25 MMSCFD cryogenic units.

Through an affiliate company, J-W Midstream Company can supply outsourced gas sales and other gas management functions.

So, what is this deal all about and why is Ontario Teachers’ partnering up with Aethon Energy and RedBird Capital to buy J-W Energy Company’s upstream and midstream businesses?

This is how private equity works. J-W Energy is a private company which is an industry leader in the leasing, sales and servicing of natural gas compression equipment, in both standard and custom packages. It has been leasing compressor and compressor/maintenance packages for more than 40 years.

The company was looking to exit its upstream and midstream businesses to focus on its core business which is the compression business. Once this opportunity presented itself, Aethon, RedBird and Ontario Teachers’ pounced to act quickly and acquire these assets.

This was a co-investment where Teachers’ invested a substantial amount alongside its partners and didn’t pay any fees. Along with Atheon and RedBird, Teachers’ will look to develop J-W Energy’s upstream and midstream businesses and because it’s a pension with a very long investment horizon, it doesn’t have the pressure that a traditional private equity fund has to unlock value of these business units during three or four years.

In other words, the deal is a win for J-W Energy Company and if Teachers’ and its partners succeed in improving the operations of the upstream and midstream businesses over the next five to ten years, it will be a win for them, the employees of these businesses and of course, Teachers’ contributors and beneficiaries.

Why invest in energy now? Last December, I wrote a comment on why Canada’s pensions are betting on energy and in November of last year, I met up with AIMCo’s president Kevin Uebelein here in Montreal on the day they announced a major transaction buying a $200M stake in TransAlata’s renewable energy business.

When it comes to energy, focus on what Jane Rowe said in the press release: “These assets are a strong fit with our private equity energy portfolio and represent a compelling investment opportunity with an established base of long-life proven reserves and attractive growth opportunities.”

When you are a pension the size of an Ontario Teachers’ you will seek attractive opportunities in down-beaten sectors across public and private markets and use your long investment horizon to realize big gains. This is a competitive advantage all of Canada’s large pensions have over traditional private equity funds, namely, they have very deep pockets and a much longer investment horizon to ride out short-term cyclical swings.

Teachers’ isn’t the only large Canadian pension looking to capitalize on energy opportunities. Lincoln Brown of Oilprice.com reports, Two Pension Fund Groups Bid for TransCanada’s $2B Mexican Pipeline:

A TransCanada Mexican pipeline is drawing significant interest from pension funds. Canada Pension Plan Investment Board, Public Sector Pension Investment Board and Borealis Infrastructure Corp. have created a consortium in order to purchase up to 49.9 percent of the business, which has been estimated to be worth some US$2 billion.

Caisse de Depot et Placement du Quebec’s new Mexican joint venture, CKD Infraestructura Mexico SA, are also interested in purchasing stakes, along with three other unnamed businesses.

That information comes from a source with knowledge of the situation who spoke to Bloomberg but asked not to be identified. TransCanada spokesman Mark Cooper has confirmed the company is seeking investors but would not comment beyond that. The Calgary-based company is trying to sell its minority stake in the pipeline, along with power plants in the northeastern United States to generate cash to buy Columbia pipeline Group Inc. That deal is estimated at US$10.2 billion.

Mexico is increasingly drawing the attention of investors. The country recently began a US$411 billion plan for its infrastructure, focusing on transportation and energy. Canada Pension and the Ontario Teacher’s Pension Plan already made an investment last month in a toll road operator in Mexico.

In June, the company announced it would build and operate a US$2.1 billion natural gas pipeline in Mexico. The company said it would parent with Sempra Energy’s IEnova unit, with TransCanada owning a 60 percent stake in the venture. The effort will be backed by Mexico’s state-owned power company and is expected to be in service by 2018. TransCanada recently made news in the United States when it announced a lawsuit against the state because of the suspension of the controversial Keystone XL pipeline project.

Lastly, Benefits Canada recently reports, Ontario Teachers’, PSP increase stakes in sustainable investment firm:

The Ontario Teachers’ Pension Plan and the Public Section Pension Investment Board will buy out Banco Santander’s interest in Cubico Sustainable Investments. The three firms launched the London-based renewable energy and water infrastructure company in May 2015.

After the acquisition, PSP Investments and Ontario Teachers’ will each own 50 per cent of Cubico’s shares.

Cubico’s initial portfolio included 18 water, wind and solar infrastructure assets with a net capacity of 1.2 gigawatts. The company has since acquired four new assets, bringing its net capacity to 1.62 gigawatts. Cubico’s 22 assets are in Brazil, Italy, Ireland, Mexico, Portugal, Spain, United Kingdom and Uruguay.

“Our increased participation in Cubico is aligned with PSP Investments’ long-term investment approach and strategy to leverage industry-specific platforms and develop strong partnerships with liked-minded investors and skilled operators,” Guthrie Stewart, senior vice-president and global head of private investments at PSP Investments, said in a release.

“Cubico’s flexible investment and acquisition approach fits well with Ontario Teachers’ approach to private investments,” Andrew Claerhout, senior vice-president of infrastructure at Ontario Teachers’ said in the release.

As you can see, Canada’s large public pensions have been busy hunting for traditional and alternative energy deals all around the world. They’re using their internal expertise and their expert network of partners to capitalize on opportunities as they arise, and that is why they are way ahead of their global counterparts when it comes to opportunistic, long-term investing.

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

Darrell Preston of Bloomberg reports, Bill Gross’s Admonishment Supported By Illinois Pension Fund:

Illinois’s largest public pension agrees with Bill Gross’s admonishment that it’s time to face up to the reality of lower returns and reduce assumptions about what funds can make off stocks and bonds.

Fund managers that have been counting on returns of 7 percent to 8 percent may need to adjust that to around 4 percent, Gross, who runs the $1.5 billion Janus Global Unconstrained Bond Fund, said during an Aug. 5 interview on Bloomberg TV. Public pensions, including the California Public Employees’ Retirement System, the largest in the U.S., are reporting gains of less than 1 percent for the fiscal year ended June 30.

Illinois’s largest state pension, the $43.8 billion Teachers’ Retirement System, plans to take another look at how much it assumes it will make in the coming year as part of an asset allocation study, said Richard Ingram, executive director. Currently it assumes 7.5 percent, lowered from 8 percent in June 2014. Plans for the study were in place before Gross made his remarks.

“Anybody that doesn’t consider revisiting what their assumed rate of return is would be ignoring reality,” Ingram, whose pension is 41.5 percent funded, said in a phone interview. The fund has yet to report its June 30 return.

Lowering how much pensions assume they can earn from investment of assets could put many in the difficult position of having to cut benefits or ask for increased contributions from workers and state and local governments that sponsor them or risk seeing the amount of assets needed to pay future benefits shrink. The $3.55 trillion of assets now held by public pensions is about two-thirds the amount needed to pay retirees, according to Federal Reserve data.

Since the financial crisis, the interest rates earned on bonds have remained low as stock prices have brought strong returns some years and more modest returns in other years. Calpers earned 0.6 percent in the fiscal year ended June 30, with an average gain of 5.1 percent over 10 years.

Illinois is struggling with $111 billion of pension debt, and more than half of that, or about $62 billion, is for the Teachers’ Retirement System. The partisan gridlock that spurred the longest budget impasse in state history only exacerbated the problem. Governor Bruce Rauner and lawmakers have made no progress in finding a fix for the rising liabilities that helped sink Illinois’s credit rating to the lowest of all 50 states.

Lagging Returns

Others also have reported meager returns recently, including a 0.19 percent gain for New York state’s $178.1 billion retirement system and a 1.5 percent increase in New York City’s five pension funds with $163 billion of assets, the smallest gain since 2012.

Government-retirement systems have lagged return targets after U.S. stocks declined last year and bond yields hold near record lows, leaving little to be made from fixed-income investments. Large plans have an average of 46 percent of their money in equities, with 23 percent in bonds and 31 percent in other assets such as private equity, Moody’s Investors Service said in a July 26 report, citing its review of fund disclosures.

“If investment returns suffer, you have to look at reality until we return to a more normal investment environment,” said Chris Mier, a municipal strategist with Loop Capital Markets in Chicago. “Some pensions don’t like changing those assumptions because then their liabilities increase.”

Pensions’ push into stocks and other high-risk investments have exacerbated pressures on the funds because of the “significant volatility and risk of market value loss” at a time when governments have little ability to boost contributions if returns fall short, Moody’s said in its report.

Dialing Back

Public pensions over 30-year-or-so horizons traditionally could hit targets for returns of 7 percent to 8 percent. But that was in an era before the Fed began holding down interest rates to stimulate the economy and returns in the stock market were not high enough to offset lower fixed-income investments.

Public pensions have been reducing assumed rates of returns, cutting from a median of 8 percent six years ago to 7.5 percent currently, said Keith Brainard, who tracks pensions for the National Association of State Retirement Administrators. Now “more than a handful” are below 7 percent, he said.

“We’ve seen a pronounced decline in return assumptions,” said Brainard.

Public pensions have been hurt by the Fed’s zero-rate policy that Gross says has led to “erosion at the margins of business models” such as the ones used for funding public pensions, which depend on assumptions about returns over time horizons of 30 years or more.

“Pensions have to adjust,” said Gross. “They have to have more contributions and they have to reduce benefit payments.”

Bill Gross is right, low returns are taking a toll on US pensions, especially delusional public pensions that refuse to acknowledge that ultra low and even negative rates are here to stay, and that necessarily means they need to assume lower returns ahead, cut benefits and increase contributions.

Of course, astute readers of this blog know my thoughts, cutting benefits and increasing contributions is the easy part. So is hiking property taxes and utility rates to fund unfunded public pensions, just like Chicago just did. Sure, it takes political courage to admit your public pensions are effectively bankrupt and require drastic measures to get them back to an acceptable funded status, but that isn’t the hard part.

It’s much harder introducing real change to US public pensions, change that I discussed in the New York Times three years ago when I wrote about the need for independent, qualified investment boards and governance rules that mimic what Canada’s large public pensions have done.

Importantly, apart from years of mismanagement, the lack of proper governance is a huge factor as to why so many US public pensions are in such dire straits yet very few politicians are discussing this topic openly and in a constructive manner.

And instead of cutting their assumed rate of return, what are US public pensions doing? What else, they’re taking more risks in alternative investments like private equity and hedge funds.

Unfortunately, that hasn’t panned out too well (shocking!). Private equity’s diminishing returns and hard times in Hedge Fundistan are hitting public pensions very hard.

In fact, Charles Stein of Bloomberg reports, Hedge Funds Make Last Place at $61 Billion Massachusetts Pension:

Public pension funds have soured on hedge funds.

The New Jersey Investment Council last week voted to cut its target allocation to hedge fund managers by 52 percent, following similar moves by pensions in California and New York. The institutions are disappointed by the combination of high fees and modest returns the hedge funds have delivered.

The chart below explains some of that unhappiness. In the 10-years ended June 30, the $60.6 billion Massachusetts public fund realized a 3.2 percent average annual return, net of fees, from the hedge funds in which it invests. That was the worst performance of seven asset classes the fund holds, according to data released last week for the Pension Reserves Investment Trust Fund. Private equity, with a 14.4 percent annual gain, was the top performer. The fund overall returned 5.7 percent a year.

It’s not that Massachusetts picked especially bad managers. Its hedge fund returns are roughly in line with industry averages. The fund weighted composite index created by Hedge Fund Research Inc. gained 3.6 percent a year over the same stretch.

Unlike some of its peers, Massachusetts hasn’t reduced its roughly 10 percent allocation to hedge funds. Rather, the pension in 2015 began making investments in the asset class through managed accounts rather than co-mingled accounts. The strategy has resulted in fee discounts of 40 to 50 percent, said Eric Nierenberg, who runs hedge funds for Massachusetts’ pension.

“We are hedge fund skeptics,” he said in an e-mailed statement. The investments made through the new structure have performed “considerably better” than the pension’s legacy holdings, Nierenberg said.

[Note: If you are looking for a managed account platform for hedge funds, talk to the folks at Innocap here in Montreal. Ontario Teachers’ Pension Plan uses their platform for its external hedge funds and they know what they’re doing monitoring operational and investment risks on Teachers’ behalf.]

I guarantee you over the next ten years, returns on all these asset classes will be considerably lower, especially private equity. And the most important asset class for all pensions in ten years will likely be infrastructure, but even there, returns will come down as more and more pensions chase stable yield.

The crucial point I want to drive home is this:  Yields are coming down hard across the investment spectrum and all pensions need to adjust to the new reality. Low returns are taking a toll on all pensions, especially US public pensions, but it’s record low and negative yields that are really hurting them. There is no big illusion in the bond market; it’s sending an ominous warning to all investors, prepare for lower returns ahead.

On that note, back to trading my biotech shares because when they start running, they run fast and hard and I need to capitalize on these rallies (click on image):

Sometimes I wonder how are hedge funds commanding 2 & 20 for mediocre returns when I can’t get more large pensions to subscribe or donate to my blog? Oh well, go figure.

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

Rory Carroll and Edward Krudy of Reuters report, Low investment returns taking a toll on U.S. pension funds:

For the second straight year, U.S. public pension funds have fallen well short of their investment targets, swelling their vast unfunded liabilities and placing a greater burden on municipalities to offset the underperformance through increased contributions, estimates show.

The funds, which guarantee retirement benefits for millions of public workers, logged total returns of around 1 percent for the fiscal year ending June 30, while private pension funds earned more than triple that, according to preliminary estimates from consulting firms Wilshire Consulting and Milliman, respectively. Those figures could change as complete data for the period becomes available.

That is a poor showing relative to the 7 percent or more that pension funds seek to earn annually.

The shortfalls could add fuel to the growing debate about the long-term viability of public pensions – which financier Warren Buffett once referred to as a “gigantic financial tapeworm.”

The funds have suffered from years of underfunding exacerbated by states lowering their contributions when the funds were performing well, political resistance to increasing taxpayer contributions, overly optimistic return assumptions and retirees living much longer than they used to.

The 100 largest U.S. public pension funds were just 75 percent funded, according to a 2015 study conducted by Milliman.

The pension funds have been challenged by a multi-year environment of rock-bottom interest rates and mixed stock market performance.

Public pension funds likely did worse than private funds, because the public funds had more money in short-term bonds which, during the fiscal year, underperformed the long-term bonds that private pension funds favor, said Ned McGuire, vice president and member of the Pension Risk Solutions Group at Wilshire Consulting.

Complete data on the public funds isn’t available yet, but early reporters reveal significant underperformance.

The California Public Employees’ Retirement System (CalPers) and The California State Teachers’ Retirement System (CalStrs), the two largest public pension funds, returned 0.6 percent and 1.4 percent respectively, in the 12 months ending June 30. That is a huge miss compared with the 7.5 percent they need to reach fund their liabilities in the long run.

The New York State Common Retirement Fund, the nation’s third-largest public pension fund, earned just 0.19 percent return on investments, missing its 7 percent target.

The Wisconsin Retirement System, the ninth-largest U.S. public pension fund, had a return of 4.4 percent for its core fund in fiscal 2016, well below its assumed rate of return of 7.2 percent.

In response to missing its target, also known as its “discount rate,” CalPers on Monday said it was reviewing the changing demographics of its members, the economy and expectations for financial markets.

“We will conduct these reviews over the next year to determine if our discount rate should be changed sooner rather than later,” CalPers said in a statement.

Public funds had a return of just over 1 percent, while corporate funds had a return of 1.64 percent, according to a report released on Tuesday by Wilshire Trust Universe Comparison Service, a database service provided by Wilshire Analytics.

At the same time, the top 100 corporate funds returned 3.3 percent, according to Milliman. Becky Sielman, an actuary at Milliman, said the most recent underperformance is harder to handle because it continues a troubling trend for public and private funds.

“It’s easier to absorb one down year followed by a good year,” she said. “Likely what we have here for many plans is two down years in a row.”

There is a lot to cover here and while these reporters do a good job giving us a glimpse of what is going on at US public and private pensions, their analysis is incomplete (it’s not their fault, they report on headline figures). As such, let me dig deeper and take you through the key points below.

The first thing I would say is returns are coming down everywhere. Pension funds, mutual funds, insurance funds, hedge funds, private equity funds, and sovereign wealth funds. Why? Well, when interest rates around the world are at record lows or even negative territory, financial theory tells you that returns across the investment spectrum will necessarily come down.

You can’t manufacture returns that aren’t there; the market gives you what the market gives you and when rates are at record lows, you need to prepare for much lower returns ahead. This holds true for institutional and retail investors.

Interestingly, I posted an article on Twitter and LinkedIn yesterday on how a big Wall Street cash cow is slowly getting cooked. The article explains why many big banks are seeing fees from wealth and investment management divisions fall, putting a crimp in critical revenue at a time when Wall Street is having an increasingly tough time matching their return on equity targets.

In fact, Wall Street is now bracing for its worst two years since the financial crisis. With fees coming down, the big banks’ revenues are getting hit which is why they are in cost-cutting mode, preparing to navigate what will likely be a long deflationary slump. The only good news for Wall Street banks might be the $566 billion business of packaging commercial mortgages into securities (and even that isn’t good news if the CMBS market crashes).

But make no mistake, record low rates are hitting all financial companies (XLF), including life insurers like MetLife (MET) which plunged more than 8.5% Thursday after reporting earnings well below expectations and a $2 billion charge related to its planned spinoff of its US retail business.

On Friday morning, following the “blowout” US jobs report, yields backed up in the US bond market but nothing frightening. At this writing, the yield on the 10-year Treasury note backed up 6 basis points to 1.57% but the bond market isn’t worried of major gains ahead (quite the opposite).

In fact, while everyone is getting excited about the latest jobs report, I retweeted something from @GreekFire23 which should put a damper on expectations of a Fed rate hike any time soon (click on image):

Before you dismiss this, you should all take the time to also read Warren Mosler’s analysis on Trade, Jobs, SNB buying US stocks, German Factory Orders.

My take on the July US jobs report? It definitely surprised everyone to the upside but when you dig a little deeper, the employment picture is hardly as strong as the headline figure suggests.

Either way, I remain long the US dollar for the remainder of the year and as I wrote in my comment on “sell everything except gold” two days ago, I remain long the biotech sector (IBB and XBI) and short gold miners (GDX), oil (USO), metal & mining (XME), energy (XLE) and emerging market (EEM) shares. I also still consider US bonds (TLT) as the ultimate diversifier in a deflationary world.

Enough on my investment thoughts, let’s get back to analyzing the article above. Investment returns are coming down as rates hit record lows but that is only part of the picture.

Importantly, all pensions around the world are getting slammed by lower returns but more worryingly by higher future liabilities due to record low rates.

Remember what I keep harping on, pensions are all about managing assets AND liabilities. When risk assets (stocks, corporate bonds, etc.) get hit, of course pensions get hit but when rates are at record lows and keep declining, this is the real death knell for pensions.

This is why I keep warning you deflation will decimate all pensions. Why? Because deflation will hit assets and more importantly, liabilities very hard as it means ultra low and possibly negative rates are here to stay. [For all you finance geeks, the key thing to remember is the duration of pension liabilities is much bigger than the duration of pension assets so a drop in rates, especially from historic low levels, will disproportionately and negatively impact pension deficits as liabilities soar.]

This is the reason why UK pensions just got hammered following the Bank of England’s decision to cut rates. Lower rates mean pensions have to take more risk to meet their actuarial return target in order to make sure they have enough money to cover future liabilities.

But lower rates also mean public and private pensions need to get real about their investment assumptions going forward. When I went over whether CalPERS smeared lipstick on a pig, I didn’t blast them for their paltry returns but I did question why they’re still holding on to a ridiculously high 7.5% annualized investment projection to discount future liabilities. And CalPERS isn’t alone, most US public pensions are delusional when it comes to their investment projections. There’s definitely a big disconnect in the pension industry.

By contrast, US corporate plans use corporate bond yields to discount their future liabilities and most of them practice much tighter asset-liability matching than public pensions. This effectively means they carry more US bonds in their asset mix as they derisk their portfolios which explains why the top 100 corporate funds returned 3.3% as of the fiscal year ending in June when public pensions returned only 1% during the same time (domestic bonds outperformed global equities during this period).

But if you go look at the latest report on Milliman’s Pension Funding Index, you will see despite higher returns, corporate plans aren’t in much better shape when it comes to their funded status:

The funded status of the 100 largest corporate defined benefit pension plans dropped by $46 billion during June as measured by the Milliman 100 Pension Funding Index (PFI). The deficit rose to $447 billion at the end of June, primarily due to a decrease in the benchmark corporate bond interest rates used to value pension liabilities. As of June 30, the funded ratio decreased to 75.7%, down from 77.5% at the end of May.

The decision of the U.K. to separate themselves from the other 27 European Union countries will cause the most damage (compared to expectations) to the balance sheet of employers with a fiscal year that ends on June 30, 2016, and collateral damage to pension cost for fiscal years starting on July 1, 2016. The impact on pension cost could vary depending on the selection of a mark-to-market methodology or smoothing of gains and losses.

The projected benefit obligation (PBO), or pension liabilities, increased to $1.839 trillion at the end of June from $1.785 trillion at the end of May. The change resulted from a decrease of 23 basis points in the monthly discount rate to 3.45% for June, from 3.68% for May. The discount rate at the end of June is the lowest it has been in 2016 and is the second lowest in the 16-year history of the Milliman 100 PFI. Only the January 2015 discount rate of 3.41% was lower. We note that the funded status deficit in January 2015 was $427 billion. The highest funded status deficit in dollars was $480 billion in October 2012.

And again, US corporate plans use corporate bond yields to discount their future liabilities. If US public pensions adopted this approach, most of them would be insolvent. 

I leave you with something I wrote in my last comment on Chicago’s pension woes:

There’s an even bigger problem which I want policymakers to wrap their heads around: chronic public pension deficits are deflationary.

Let me repeat that: Chronic and out of control public pension deficits are DEFLATIONARY. Why? Because it forces governments to introduce more property taxes or utility rate increases (another tax) to address them, leaving less money in the hands of consumers to spend on goods and services.

The other problem with raising taxes and utility bills is they are regressive, hurting the poor and working poor a lot more than Chicago’s ultra rich.

Now I’m going to have some idiotic hedge fund manager tell me “The answer is to cut defined-benefit pensions and replace them with cheaper defined-contribution plans.” NO!!! That is a dumb solution because the brutal truth on DC plans is they are failing millions of Americans, exposing them to pension poverty which is even MORE DEFLATIONARY!!

I want all of you to pay attention to what is going on in Chicago because it’s a cancer which will spread throughout parts the United States where chronic pension deficits are threatening municipalities, cities and states. And this slow motion train wreck will have drastic economic consequences for the entire country.

I cannot over-emphasize how important it is to get pension policy right. Good pension policy based on facts, not myths, is good economic policy for the very long run.

The problem with US public pensions isn’t their nature (we under-appreciate the benefits of DB plans), it’s the ridiculous investment assumptions, poor governance and lack of risk-sharing that underlie them.

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

Reuters reports, Chicago mayor’s big plan to save its pension fund:

Mayor Rahm Emanuel unveiled a plan on Wednesday that he called “an honest approach” to save the city’s biggest retirement system from insolvency with a water and sewer tax to be phased in over five years starting in 2017.

The municipal retirement system, which covers about 71,000 current and former city workers, is projected to run out of money within 10 years as it sinks under an unfunded liability of $18.6 billion.

The new tax would generate $56 million in its first year and increase to $239 million annually by 2020, the mayor’s office said.

“Today, one of the big question marks that hung around the city because of past decisions — or past decisions that were not made — we have addressed,” Emanuel told an investor conference in Chicago.

“Every one of the city’s pensions has a dedicated revenue stream … to keep the promise not only to the employees, but to the city’s future and do it in a way that does not undermine the economic well-being of the city,” he said.

The plan would require approval by Chicago’s city council, which Emanuel said he intends to seek in September. Chicago then needs the Illinois legislature to approve a five-year phase-in of the city’s contribution to the pension system to attain a 90 percent funding level by 2057.

The tax comes on top of an increase in water and sewer rates between 2012 and 2015 to generate money to repair and replace aging infrastructure. Revenue rose from $644.1 million in 2011 to $1.125 billion in 2015.

The rescue plan for the municipal system follows previous action by the city to boost funding for police and fire pensions through a phased-in $543 million property tax increase, and its laborers’ system through a hike in a telephone surcharge.

Chicago’s big pension burden was a driving factor in the downgrade of the city’s credit rating last year to the “junk” level of ‘Ba1′ by Moody’s Investors Service. Standard & Poor’s warned in June it may cut the city’s ‘BBB-plus’ rating in the absence of a comprehensive pension fix.

The task of fixing the city’s pensions became harder after the Illinois Supreme Court in March threw out a 2014 state law that reduced benefits and increased city and worker contributions to the municipal and laborers’ funds.

Hal Dardick, Bill Ruthhart, and John Byrne of the Chicago Tribune also report, Emanuel proposes water, sewer tax to shore up ailing pension fund:

Mayor Rahm Emanuel on Wednesday called for a new tax on city water and sewer bills to stabilize the city’s largest pension fund, a move he portrayed as his latest tough decision to secure Chicago’s financial future.

Emanuel’s plan, which would increase the average water and sewer bill by 30 percent over the next four years, was quickly met with resistance from some aldermen who argued the city would be better off adding business taxes or even raising property taxes again to come up with the hundreds of millions of dollars a year needed to keep the city’s municipal workers’ pension fund from going bust.

Still, Emanuel projected confidence his plan ultimately would win approval in the City Council, which rarely rebuffs the mayor’s proposals and has yet to independently provide its own solution to solidify any of the city’s four major pension systems that have been woefully underfunded for more than a decade.

In a speech to about 200 financial investors Wednesday, Emanuel unveiled his water and sewer tax plan while making the case to Wall Street that his administration has done the hard work to brighten Chicago’s dark financial picture.

For the first time since he took office in 2011, Emanuel said, there are concrete plans to properly fund the retirements of the city’s police officers, firefighters, laborers and municipal workers. He told the Chicago Investors Conference that the city’s budget deficit is at a 10-year low. And he sought to make the case it all had been done without disturbing a business climate that has appealed to major corporations and startups.

“The city of Chicago met our challenges head on, dealt with them systematically, did it in a way that’s complementary to our overall economic strategy to contribute to the well-being and the overall growth strategy that is laid out for the city of Chicago,” Emanuel said from the Symphony Center’s ornate stage. “We addressed the past, but did it in a way that did not shortchange the future of the city of Chicago.”

But even as the mayor seemingly claimed victory on fixing Chicago’s financial woes, challenges remain.

Debt rating agencies have repeatedly lowered the city’s credit rating in recent years, with one placing it at junk status. The picture at Chicago Public Schools is even worse, with all three major rating agencies terming the district’s bonds junk while the Emanuel-appointed Board of Education plans to raise property taxes by $250 million next year to help pay for teacher pensions.

And several aldermen expressed opposition to Emanuel’s new utility tax, including Ald. Roderick Sawyer, chairman of the City Council’s Black Caucus. Sawyer, 6th, predicted Emanuel would have a hard time building enough council support for the water and sewer tax after asking aldermen to pass a record property tax increase to fund police and fire pensions last year.

“We understand that the can had been kicked down for many, many years, and now it’s incumbent upon us to find solutions,” Sawyer said. “This is a tough one, though. This is an additional tax that ramps up to many, many dollars a month.”

‘Pitchforks and torches’

Under Emanuel’s proposal, the new utility tax would be phased in over the next four years, with the average homeowner’s water and sewer bills increasing by $53 next year, or $8.86 on the bills sent out every two months. By the end of the four-year phase-in, that same homeowner would pay an additional $226 per year in water and sewer taxes, or $37.65 on each bill.

After four years, the proposal would amount to a 30 percent tax on water and sewer bills, or $2.51 for every 1,000 gallons of water used, the Emanuel administration said. The average annual water and sewer bill, based on 90,000 gallons of water, currently is about $684. The bills also would rise each year at the rate of inflation.

Once fully phased in, the new tax would produce an estimated $239 million a year to help reduce the $18.6 billion the city owes the municipal workers’ fund, which represents nearly all city workers except police officers, firefighters or employees who do manual labor.

Emanuel’s goal is to restore the municipal workers’ account to 90 percent funding over the next 40 years. The mayor and aldermen already have raised taxes to do the same for the city’s three other major pension funds for police, firefighters and laborers. Emanuel said he will seek a City Council vote on the water and sewer tax in September.

“I don’t take this lightly, but we are fixing the problem that has penalized the city’s potential to grow economically, and there’s a finality to it,” Emanuel said in an interview late Wednesday. “All four pensions have a revenue source.”

The taxes will be tacked on to bills that went up when, shortly after taking office in 2011, Emanuel set in motion a series of water and sewer fee increases that more than doubled those bills to upgrade water and sewer systems.

Ald. Ameya Pawar, 47th, called the new tax “the right thing to do,” noting that the alternative of not properly funding the pensions would be “catastrophic.”

But with homeowners already starting to feel the hit from last year’s property tax increase combined with a new round of assessments, Pawar acknowledged aldermen can expect complaints from constituents.

“People will be upset,” said Pawar, an Emanuel ally. “They’ve seen their water rates go up.”

Far Northwest Side Ald. Anthony Napolitano, 41st, said it’s going to be difficult for him to face constituents reeling from the huge property tax increases in bills they just received and tell them to brace themselves for another hit.

“Pitchforks and torches, probably,” he said when asked how residents would react. “It’s not going to be good. Because my reaction now, in my neighborhood, after these (property) tax bills came out is, ‘We’re leaving. We’re out.’

“I get that we’re in some tough times. And people get that we have to make some concessions, that we’re going to pay more in tax dollars. People get that,” Napolitano said. “But when it happens year after year after year, people are saying ‘Why am I staying here?'”

Northwest Side Ald. Milagros “Milly” Santiago, 31st, said the mayor should consider other revenue ideas brought forward in the past year by the council’s Progressive Caucus. Those have included a tax on financial transactions, a commuter tax, a graduated income tax, a “stormwater stress” tax on businesses with large parking lots and a move to return more money to the general fund from special taxing districts throughout the city.

“We’re here evaluating the whole thing and seeing if it’s legitimate for us to vote next month on this idea,” Santiago said as she left a briefing on the mayor’s plan at City Hall. “I don’t think it’s a good idea. We’re going to have to have a closer look at it and see if there’s other ways to do it. But it’s just not good news.”

Sawyer also advocated for Emanuel to consider some of the Progressive Caucus’ tax ideas, but many are long shots or would take time and approval elsewhere.

A financial transaction tax would require state and federal approval. A graduated income tax would require approval from a gridlocked Springfield. A commuter tax, which amounts to an income tax on suburban residents working in the city, would require state approval while critics argue it could cause a flight of businesses from the city or prevent new ones from moving in.

Only the stormwater tax on businesses and shifting more money from special taxing districts are within the City Council’s power alone.

“We did get a commitment that they’re going to look at all options this year. We’re going to hold them to that,” Sawyer said.

Aldermen did come up with additional ideas. Napolitano suggested allowing video gaming, which long has been banned in the city. Ald. Anthony Beale, 9th, called for charging tolls on expressways at the Chicago border.

Ald. Howard Brookins, 21st, urged a more traditional solution: another property tax increase. Brookins argued raising property taxes is more fair to lower-income residents and can be written off on federal tax returns. But he acknowledged another increase might not have enough support.

“This (the water and sewer tax), everyone is going to pay it equally; whether you live in a million-dollar home or a $50,000 home, we all have to use water, and it disproportionately affects the people of my community,” Brookins said. “We have to think long term and get away from the stereotypes about property taxes and start explaining to people why a property tax is fairer than the other taxes and fees that they are going to ultimately end up paying.”

Ald. Joe Moore, an Emanuel ally, said he’d be willing to entertain Brookins’ push for another property tax increase, but said “it’s kind of difficult to go to that well again” so soon. The water and sewer tax, he said, “might be the best of a bad set of options. … We have to do something.”

‘Once and for all’

While Emanuel’s utility tax would not require approval from state lawmakers, proposed changes he laid out Wednesday in how municipal workers contribute to their retirements would.

The mayor plans to ask the General Assembly and Republican Gov. Bruce Rauner to sign off on altering the municipal fund pension system to save about $2 billion over the next 40 years. The legislative changes to the pension fund would require newly hired employees, starting next year, to increase their retirement account contributions to 11.5 percent of their salary from 8.5 percent.

Employees who were hired from 2011 to 2016 and already receive lower retirement benefits would have the option of increasing their contributions to 11.5 percent. In exchange, they would be eligible to retire at age 65 instead of 67.

But employees hired before 2011 would see no changes, after the Illinois Supreme Court struck down Emanuel’s earlier attempt to reduce their benefits, citing a constitutional clause that states their benefits shall not be diminished or impaired. “You can’t touch existing employees, that’s walled off,” Emanuel told investors.

Emanuel and affected unions have an “agreement in principle” on identical changes to the much smaller city laborers fund, with additional city contributions coming from a $1.90-per-month-increase on landline and cellphones billed to city addresses that was approved by the City Council two years ago.

Last year, the mayor pushed through a $543 million property tax increase, phased in over four years, to come up with enough funding for police and fire pensions. No changes were made to the retirement age or contribution amounts for those two unions.

Emanuel stressed in his speech to investors that Chicago’s overall fiscal health is on the rebound.

“Chicago was in a pension penalty box. It had not addressed its problems,” Emanuel said. “Denial is not a long-term strategy, and for too long Chicago was operating where denial was the long-term strategy.”

Richard Ciccarone, president and CEO of the municipal bond analysis firm Merritt Research Services, attended the conference and said he thought the crowd was generally impressed with the mayor’s argument.

“He reinforced his strategy, which he said has been his since Day One, and that is that you can’t solve the fiscal problems without having economic growth. I think he made his case,” Ciccarone said. “I got the impression that they made headway with a lot of people here.”

In a question-and-answer session with the investors after Emanuel’s speech, the mayor was asked if he had enough votes from aldermen to pass the plan. “Yes,” Emanuel replied without hesitation.

The mayor continued to project that certainty in his interview with the Tribune, while also lavishing praise on the aldermen he must win over.

“The lion’s share of the aldermen did not create the problem, but the lion’s share of the aldermen in there have been part of the solution. I am confident they will take the necessary steps,” Emanuel said.

“They have never wavered, their knees have never buckled and they will answer the call of history to solve the problem once and for all.”

Back in May, I covered Chicago’s pension patch job and stated this:

When Greece was going through its crisis last year, my uncle from Crete would call me and blurt “it’s worse than Chicago here!”, referring to the old Al Capone days when Chicago was the Wild West. Little did he know that in many ways, Chicago is much worse than Greece because Greeks had no choice but to swallow their bitter medicine (and they’re still swallowing it).

In Chicago, powerful public unions are going head to head with a powerful and unpopular mayor who got rebuffed by Illinois’s Supreme Court when he tried cutting pension benefits. Now, they are tinkering around the edges, increasing the contribution rate for new employees of the city’s smallest pension, which is not going to make a significant impact on what is truly ailing Chicago and Illinois’s public pensions.

All these measures are like putting a band-aid over a metastasized tumor. Creditors know exactly what I’m talking about which is why I’ll be shocked if they ease up on the city’s credit rating.

Importantly, when a public pension is 42% or 32% funded, it’s effectively broke and nothing they do can fix the problem unless they increase contributions and cut benefits for everyone, top up these pensions and introduce real governance and a risk-sharing model.

When people ask me what’s the number one problem with Chicago’s public pensions, I tell them straight out: “Governance, Governance and Governance”. This city has a long history of corrupt public union leaders and equally corrupt politicians who kept masking the pension crisis for as long as possible. And Chicago isn’t alone; there are plenty of other American cities in dire straits when it comes to public finances and public pensions.

But nobody dares discuss these problems in an open and honest way. Unions point the finger at politicians and politicians point the finger at unions and US taxpayers end up footing the public pension bill.

This is why when I read stupid articles in Canadian newspapers questioning the compensation and performance at Canada’s large public pensions, I ignore them because these foolish journalists haven’t done their research to understand why what we have here is infinitely better than what they have in the United States and elsewhere.

Why are we paying Canadian public pension fund managers big bucks? Because we got the governance right, paying public pension managers properly to bring assets internally, diversifying across public and private assets all around the world and only paying external funds when it can’t be replicated internally. This lowers the costs and improves the performance of our public pensions which is why none of Canada’s Top Ten pensions are chronically underfunded (a few are even over-funded and super-funded).

What else? Canada’s best public pensions — Ontario Teachers, HOOPP and even smaller ones like CAAT and OPTrust — have implemented a risk-sharing model that ensures pension contributors, beneficiaries and governments share the risk of the plan so as not to impose any additional tax burden on Canadian taxpayers if these plans ever become underfunded. This level of governance and risk-sharing simply doesn’t exist at any US public pension which is why many of them are chronically underfunded or on the verge of becoming chronically underfunded.

I have not changed my mind on Chicago’s pension patch job. It’s going from bad to worse and just like Greece, they’re implementing dumb taxes to try to shore up insolvent public pensions instead of addressing serious governance and structural flaws of these pensions.

But unlike Greece, Chicago and Illinois are part of the United States of America, the richest, most powerful country in the world, so they can continue kicking the can down the road, for now. Still, what message is Chicago sending to its own residents and to potential workers looking to move there?

I’ll tell you the message: apart from one of the worst crime rates in the nation, get ready for more property taxes and hikes in utility rates to conquer a public pension beast which has spiraled out of control.

And the sad reality is while these taxes might help at the margin, they’re not going to make a big difference unless they are accompanied by a change in governance, higher contributions and a cut in benefits (get rid of inflation protection for a decade!).

There’s an even bigger problem which I want policymakers to wrap their heads around: chronic public pension deficits are deflationary.

Let me repeat that: Chronic and out of control public pension deficits are DEFLATIONARY. Why? Because it forces governments to introduce more property taxes or utility rate increases (another tax) to address them, leaving less money in the hands of consumers to spend on goods and services.

The other problem with raising taxes and utility bills is they are regressive, hurting the poor and working poor a lot more than Chicago’s ultra rich.

Now I’m going to have some idiotic hedge fund manager tell me “The answer is to cut defined-benefit pensions and replace them with cheaper defined-contribution plans.” NO!!! That is a dumb solution because the brutal truth on DC plans is they are failing millions of Americans, exposing them to pension poverty which is even MORE DEFLATIONARY!!

I want all of you to pay attention to what is going on in Chicago because it’s a cancer which will spread throughout parts the United States where chronic pension deficits are threatening municipalities, cities and states. And this slow motion train wreck will have drastic economic consequences for the entire country.

On a personal note, it’s sad to see what is happening to this great American city. My father did his psychiatry residency in Chicago after leaving Greece over fifty years ago. His uncle had left Greece long before him and owned a great restaurant in Chicago for many years. He even had Al Capone as a silent partner (not by choice) and the restaurant was thriving during the city’s heydays (Capone would send two guys to pick up his share of the revenues every week and once in a while the guys would be replaced because they stole money and were probably left sleeping with the fish. Capone never bothered my great uncle).

Anyways, Chicago’s glory days are long gone. This city is headed the way of Detroit (some think it’s already there and even a lot worse). No matter what Mayor Rahm Emanuel does, there is no saving Chicago from its pension hellhole.

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

Eleanor Warnock of the Wall Street Journal reports, Japan’s GPIF Pension Fund Suffers Worst Year Since 2008 Financial Crisis:

Japan’s $1.3 trillion public pension fund—the world’s largest of its kind—posted its worst performance since the 2008 global financial crisis in the fiscal year ended March on a fall in share prices world-wide and a strengthening yen.

The Government Pension Investment Fund recorded paper losses of ¥5.3 trillion ($51 billion), or a return of -3.81% on its investments, putting its total assets at ¥134.7 trillion at the end of March, the fund said Friday.

The GPIF’s results are seen as a gauge of broad market performance, as the fund owns nearly 1% of global equity markets and more than 7% of the Japanese stock market. Domestic and foreign equities comprised 44% of the portfolio at the end of March, below its 50% target weighting for the asset class, the fund said in a statement.

The GPIF isn’t the only major pension fund to struggle recently. The U.S.’s largest public pension fund, the California Public Employees’ Retirement System, or Calpers, said this month that it earned 0.6% on its investments for the fiscal year ended June 30, the second straight year the fund missed its 7.5% internal investment target. Norway’s Government Pension Fund Global had its worst performance since 2011.

Japan’s labor ministry has asked the GPIF to achieve a real investment return—accounting for a rise in wage increases—of 1.7% yearly. Though the fund’s performance for fiscal 2015 was well below that target, the fund’s average real annual performance of 2.60% over the past 15 years exceeded it.

However, because the GPIF manages reserves for Japan’s national pension plan, poor investment performance in the short term is judged harshly by the public and opposition political parties, many of whom are suspicious of financial markets. Even the timing of the announcement of the fund’s latest results had drawn criticism. Opposition politicians have pointed out that it was scheduled to come after national election earlier in the month. A loss reported before the vote could have hurt the ruling party’s showing, they said. The fund has said there was nothing political about the release date.

Domestic bonds were a bright spot in GPIF’s portfolio, even though the Bank of Japan has pursued a massive easing program in part to push Japanese investors away from domestic bonds and into higher-yielding assets. At the end of March, the fund had 37.55% of its portfolio in domestic debt—higher than the fund’s 35% asset-class allocation.

Domestic bonds returned 4.07% in the year ended in March as the BOJ’s asset purchases and the introduction of a negative interest-rate policy lifted bond prices.

Yuko Takeo and Shigeki Nozawa of Bloomberg also report, Japan Pension Whale’s $52 Billion Loss Tied to Passive Ways:

Friday was a big day for the world’s largest pension fund, which posted its worst annual loss since the financial crisis and disclosed individual equity holdings for the first time. The two may be connected.

The list of domestic shares owned by Japan’s $1.3 trillion Government Pension Investment Fund hews closely to the benchmark Topix index, which isn’t that surprising for a fund where almost 80 percent of investments are passive. But it means that in market downturns like in the past year, GPIF will struggle to increase assets.

The fund recorded a 5.3 trillion yen ($52 billion) loss for the 12 months ended March, the largest decline in seven years. Japan stock holdings tumbled 10.8 percent. For Sumitomo Mitsui Asset Management Co., GPIF should branch out from hugging indexes.

“There’s more they can do,” said Masahiro Ichikawa, a senior strategist at the Tokyo-based money manager. “They should be more active with their currency hedging and their investments. They should also look to increase exposure to alternatives.”

While criticism of GPIF’s passive approach to investing isn’t new, this is the first year the fund posted a loss since it doubled its allocation to stocks in 2014 and reduced its investments in domestic bonds, which were the only asset to return a profit in the year. The fund is taking flak on both sides, from those who want to turn back the clock to when it held more bonds to people who say it should become more of a stock picker.

The Topix index fell 0.1 percent at the close in Tokyo on Monday, as the yen traded at 102.43 per dollar following a 3.1 percent jump on Friday.

For a QuickTake on Japan’s pension fund, click here.

GPIF’s investment loss of 3.8 percent was the worst since a 7.6 percent slide in the 12 months ended March 2009. The fund lost 9.6 percent on foreign shares and 3.3 percent on overseas debt, while gaining 4.1 percent on Japanese bonds. GPIF said Toyota Motor Corp. and Mitsubishi UFJ Financial Group Inc., which have the largest weightings in the Topix, were the biggest Japan stock investments as of March 31, 2015.

GPIF’s Canadian pension peer, hailed as an example of how the Japanese fund should be run, posted a 3.4 percent return on investments for the fiscal year ended March, despite the global equity rout. The $212 billion Canada Pension Plan Investment Board had its biggest gains from private emerging market equities, real estate and infrastructure. South Korea’s national pension fund had a return rate of 2.4 percent this year as of April.

Home Bias

The Canadian retirement manager wrote in its 2016 annual report about how it had moved away from passively managing its portfolio to take advantage of its size, certainty of pension contributions and long-term investment horizon. The fund has just 19 percent of its holdings invested in Canada, whereas GPIF has 59 percent in Japanese securities.

“GPIF should invest more actively but from a long-term perspective,” said Tetsuo Seshimo, a portfolio manager at Saison Asset Management Co. in Tokyo. “That’s the only way they can improve their returns.”

GPIF President Norihiro Takahashi, speaking after the results announcement on Friday, said the fund planned to use its allowable deviation limits when allocating assets, in a sign he will be flexible in managing the portfolio.

In 2013, a panel handpicked by Prime Minister Shinzo Abe recommended ways to overhaul GPIF. While suggesting the fund move away from its concentrated investments in Japanese bonds, which it did the next year, the group led by Columbia University professor Takatoshi Ito said GPIF should consider increasing active management, moving some investments in-house, and tracking indexes other than the Topix as it includes stocks “lacking sufficient investment profitability.”

In-House Investments

GPIF took some suggestions on board, including adopting the JPX-Nikkei Index 400 as a new benchmark equity measure. Still, the fund’s overseers stopped short of letting the fund make in-house stock investments, a course that GPIF Chief Investment Officer Hiromichi Mizuno said would have helped cut costs and increase internal expertise.

GPIF also lost on overseas assets last fiscal year as the yen advanced 6.7 percent against the dollar, reducing the value of investments when repatriated. It wasn’t until December last year that reports said GPIF would start to hedge against currency fluctuations for a small part of its investments, a strategy called for almost a year earlier by one of its investment advisers.

“The results should lead to a debate on searching for new investments, whether it’s alternative assets, domestic small and mid-cap corporate debt, REITs or real estate,” said Akio Yoshino, chief economist at Amundi Japan Ltd. in Tokyo. “But the mainstream expectation is that GPIF probably won’t change its management direction.”

So Japan’s pension whale recorded a $52 billion loss (-3.81%) during its fiscal year ending at the end of March and “experts” are now giving them advice to be more active in alternatives and in hedging their foreign exchange risk.

I think a lot of people are making a big deal over nothing. A $52 billion loss is huge for North America’s large pension funds but it’s peanuts for the GPIF. Also, if the Caisse can come strong from a $40 billion train wreck in 2008, GPIF can easily come back from this loss in the future.

The loss GPIF recorded during its fiscal year can be explained by two factors:

1. A shift in its asset allocation away from domestic bonds to riskier domestic and foreign stocks.
2. A surging yen which negatively impacted its foreign stock and bond holdings.

In order to put some context to this, you all need to read a recent Bloomberg article by Tom Redmond on Japan’s Pension War.

I will leave it up to you to read that article but the key here is to understand the shift in GPIF’s asset allocation over the last two years (click on image):

As you can see, GPIF reduced its target weight in domestic bonds from 50% to 35% and increased its target weight in domestic and foreign stocks to 25% and slightly increased its weight in foreign bonds to 15%.

This shift in asset allocation was very sensible for the GPIF over a very long investment horizon because having 50% of its assets in Japanese bonds yielding negative interest rates isn’t going to help pay for future pension liabilities that are mounting as rates sink to record lows.

Ironically, negative rates are bad news for Japan’s biggest bank but they didn’t really hit GPIF’s domestic bond portfolio which returned 4.07% in the year ended in March as the BOJ’s asset purchases and the introduction of a negative interest-rate policy lifted bond prices.

Of course, on Friday, the Nikkei whipsawed after BOJ disappointment, the yen surged against dollar and Japanese government bonds (JGBs) sold off:

Japan shares whipsawed and the yen surged after the Bank of Japan threw markets a smaller-than-expected bone in a keenly watched decision on Friday.

While the BOJ eased its monetary policy further by increasing its purchases of exchange-traded funds (ETFs), it didn’t change interest rates or increase the monetary base, as analysts had widely expected.

The central bank said it would increase its ETF purchases so that their amount outstanding on its balance sheet would rise at an annual pace of 6 trillion yen ($56.7 billion), from 3.3 trillion yen previously.

“The message the BOJ is sending is not so much much ‘whatever it takes’ as ‘monetary policy’s pretty much played out’,” said Kit Juckes, global fixed income strategist at Societe Generale.

The Japanese yen surged against the dollar after the announcement, with the dollar-yen pair falling as low as 102.85, compared with around 103.75 immediately before the decision. The pair was already volatile before the announcement, touching a session high of 105.33.

At 2:31 p.m. HK/SIN, the dollar was fetching 103.52 yen.

The benchmark Nikkei 225 whipsawed after the decision, tumbling as much as 1.66 percent immediately after the announcement. It quickly retraced the fall, but then spent the remainder of the session volleying between gains and losses. At market close, the Nikkei finished up 92.43 points, or 0.56 percent, at 16,569.27.

In the bond market, Japanese government bonds (JGBs) sold off. The yield on the benchmark 10-year JGB jumped to negative 0.169, from an earlier low of negative 0.276. Yields move inversely to bond prices. Many analysts had expected the BOJ would increase its JGB purchases.

Sean Darby, chief global equity strategist at Jefferies, said in a note that the news on the ETF purchases “should boost sentiment on stocks,” but “overall monetary policy will only be marginally changed given that the BOJ’s balance sheet expansion has already decelerated.”

“The absence of any change on deposit rates will have disappointed those investors seeking a bolder move by the BOJ,” said Darby.

Other Asian markets were nearly flat or mostly lower. The ASX 200 in Australia saw a slight gain of 5.80 points, or 0.1 percent, to 5,562.35. In South Korea, the Kospi closed down 4.91 points, or 0.24 percent, at 2,016.19. Hong Kong’s Hang Seng index slipped 327.06 points, or 1.47 percent, to 21,847.28.

Chinese mainland markets were lower, with the Shanghai composite closing down 14.94 points, or 0.5 percent, at 2,979.37, while the Shenzhen composite was off by 9.44 points, or 0.48 percent, at 1,941.55.

So what is going on? Why did the Bank of Japan not do more to raise inflation expectations? The Japan Times reprinted an article from Reuters, BOJ eases further, signals policy review as inflation target eludes:

The Bank of Japan expanded stimulus Friday by doubling its purchases of exchange-traded funds, yielding to pressure from the government and financial markets for action but disappointing investors who had set their hearts on more audacious measures.

The central bank, however, said it will conduct a thorough assessment of the effects of its negative interest rate policy and massive asset-buying program in September, suggesting that a major overhaul of its stimulus program may be forthcoming.

BOJ Gov. Haruhiko Kuroda said the bank will conduct the review not because its policy tools have been exhausted, but to come up with better ways of achieving its 2 percent inflation target — keeping alive expectations for further monetary easing.

“I don’t think we’ve reached the limits both in terms of the possibility of more rate cuts and increased asset purchases,” Kuroda told reporters after the policy meeting.

“We will of course consider what to do in terms of monetary policy steps, based on the outcome of the assessment.”

Ahead of the meeting, speculation had mounted over the possibility it would take a so-called helicopter money approach that would entail more direct infusions of money into the economy.

Recently, the government downgraded its growth forecast for 2016 to 0.9 percent from 1.7 percent.

“With underlying inflation set to moderate further toward the end of the year, we think that the bank will still have to provide more easing before too long,” Marcel Thieliant of Capital Economics said in an analysis. “Overall, today’s decision was a clear disappointment,” he said.

The 7-2 central bank decision was to almost double its annual purchases of exchange traded funds to ¥6 trillion from the current ¥3.3 trillion. A fifth of that will be earmarked for companies that meet new benchmarks for investing in staffing and equipment, it said in a statement.

It also doubled the size of a U.S. dollar lending program to support Japanese companies’ operations overseas, to $24 billion.

The BOJ already is injecting about ¥80 trillion a year into the economy through asset purchases, mainly of Japanese government bonds.

The BOJ was under heavy pressure to act after earlier this week Prime Minister Shinzo Abe announced ¥28 trillion in spending initiatives to help support the sagging economic recovery led by his feeble Abenomics policies.

By coordinating its action with the big fiscal spending package, the BOJ likely aimed to maximize the effect of its measures on the world’s third-biggest economy, which is struggling to escape decades of deflation.

“The BOJ believes that (today’s) monetary policy measures and the government’s initiatives will produce synergy effects on the economy,” the central bank said in a statement announcing the policy decision.

The BOJ maintained its rosy inflation forecasts for fiscal 2017 and 2018 in a quarterly review of its projections. It also left intact the time frame for hitting its price growth target, but warned uncertainties could cause delays.

The BOJ justified Friday’s monetary easing as aimed at preventing external headwinds, such as weak emerging market demand.

The recent vote by Britain to leave the European Union has added to the uncertainties clouding the global outlook at a time when Japan’s recovery remains in question.

“There is considerable uncertainty over the outlook for prices against the background of uncertainties surrounding overseas economies and global financial markets,” the central bank said.

The central bank did not change the interest it charges on policy-rate balances it holds for commercial banks, which is now at a record low minus 0.1 percent.

Financial markets seemed underwhelmed by the central bank’s modest action.

The Nikkei 225 stock index had dropped nearly 2 percent on Friday but later regained some ground to end 0.56 percent higher.

Ahead of the BOJ decision, Japan reported further signs of weakness in its economy in June, with industrial output and consumer spending falling from the year before.

Core inflation, excluding volatile food prices, dropped 0.5 percent from 0.4 percent in May, while household spending fell 2.2 percent from a year earlier.

Unemployment had fallen to 3.1 percent in June from 3.2 percent for the past several months, but tightness in the job market has not spilled into significant increases in wages that might help spur more consumer demand and encourage businesses to invest in the sort of “virtuous cycle” Abe has been promising since he took office in late 2012 under Abenomics.

Still, while industrial output fell 1.9 percent from the year before, it rose 1.9 percent from the month before, with strong shipments related to home building and other construction.

My reading is that despite improving employment gains, Japan is still stuck in its deflation rut and policymakers are increasingly worried which is why they’re openly debating “radical policies” like helicopter money.

Importantly, by not acting forcibly, the BoJ basically intensified deflation in Japan because the yen surged higher which means import prices in Japan will fall further, putting more pressure the declining core CPI. It will also impact Japanese exporters like car and steel producers which isn’t good for employment.

Also, as I’ve warned of earlier this year, the surging yen can trigger a crisis, including another Asian financial crisis which will spread throughout the world and lead to more global deflation.

At this writing, the USD/ JPY cross is hovering around 102.4, which is above the 100 level, but if it falls below this level and continues to decline, watch out, things could get very messy very fast.

A surging yen below the key 100 level isn’t good news for risk assets as it will trigger massive unwind of the yen carry trade with big hedge funds and trading outfits use to leverage their positions in risk assets.

A full discussion of currency risks merits another comment. All I can say is that the GPIF’s results weren’t as terrible as they look given the big move in the yen and its new asset allocation.

As far as mimicking the Canada Pension Plan Investment Board (CPPIB) and the rest of Canada’s large pensions allocating a big chunk of their portfolio in alternatives like private equity, real estate and increasingly in infrastructure, that all sounds great but if they don’t have the right governance which allows them to manage these assets internally, then I wouldn’t recommend it.

Sure, GPIF is big enough to go to the big alternatives shops like Blackstone, Carlyle, KKR, etc. and squeeze them hard on fees but this isn’t the best long term approach for a mega fund of its size. before it heads into alternatives, it needs to get the governance right to attract and retain talented managers who will be able to do a lot of direct investments along with fund and co-investments.

There are a lot of moving parts now impacting the GPIF’s performance, least of which is the surging yen. A full discussion on currencies will have to take place in my follow-up comment as this one is already too long.

I’d be happy to talk to the people at the GPIF to discuss this post and put them in touch with some contacts of mine, including my buddy who trades currencies and can steer them in the right direction in terms of currency hedging policy (read my follow-up comment).

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

Andre Tartar and Jill Ward of Bloomberg report, Brexit’s Biggest Fans Face New 115 Billion-Pound Pension Hole:

Turning 65 in the U.K. used to mean mandatory retirement and a future of endless holiday. But in 2016 it has come to signify a very different cut-off: membership in the single most pro-Brexit age group in the June 23 European Union referendum.

About 60 percent of Britons 65 and older voted to leave the world’s largest trading bloc in the recent vote, the most of any age group, according to two separate exit polls. The glaring irony is that senior citizens are also the most reliant on pensions, which face a worsening funding gap since the Brexit vote.

The combined deficits of all U.K. defined-benefit pension schemes, normally employer-sponsored and promising a specified monthly payment or benefit upon retirement, rose from 820 billion pounds ($1.1 trillion) to 900 billion pounds overnight following the referendum, according to pensions consultancy Hymans Robertson. Since then, it has grown further to a record 935 billion pounds as of July 1.

A sharp drop in U.K. government bond yields to record lows, and a similar decline in corporate bond yields, is largely to blame for the uptick in defined-benefit pension liabilities. That’s because fixed income represented 47.5 percent of total 2014 assets for corporate pensions funds, of which about three-quarters were issued by the U.K. government and/or sterling-denominated, according to the 2015 Investment Association Annual Survey.

And the slump may not be over yet. While the Bank of England held off on cutting rates or increasing asset purchases at its July 14 meeting, early signals point to serious pain ahead for the U.K. economy. If additional quantitative easing is ultimately required to offset growing uncertainty, this would suggest “that bond yields are going to fall, which makes pensions a lot more expensive to provide,” former pensions minister Ros Altmann told Bloomberg. “Deficits would be larger if gilt yields fall further.”

Beyond gilt yields, Altmann said that anything that damages the economy is also bad news for pensions. The country’s gross domestic product is now expected to grow by 1.5 percent this year and just 0.6 percent in 2017, according to a Bloomberg survey of economists conducted July 15-20. That’s down from 1.8 percent and 2.1 percent, respectively, before the Brexit vote.

A weaker economy means companies will be less able to afford extra contributions precisely when pension schemes face a growing funding gap, possibly threatening future payouts to pensioners and creating a vicious feedback cycle. “If companies have got to put even more into their pension schemes than they have previously while their business is weakening, then clearly their business will be further weakened,” Altmann said.

Bad news, in other words, for Brexit’s biggest supporters.

Very bad news indeed but I guess British seniors weren’t thinking with their wallets as I thought they would when they decided to vote for Brexit.

Zlata Rodionova of the Independent also reports, Brexit supporters hit with record £935bn pension deficit because of the EU referendum:

The UK pension deficit hit a record level of £935 billion following UK’s vote to leave the EU, likely hitting pro-Brexit voters the hardest.

Support for the UK to leave the EU bloc grew with each age category, peaking at 60 per cent among those aged 65 and over, according to a survey of 12,356 referendum voters by Lord Ashcroft.

Ironically, the same voters are reliant on defined benefit pension to deliver their retirement income.

But UK’s pension deficit rose from £830 billion to £900 billion overnight following the EU referendum.

The vote then pushed the gap further to £935 billion as of July 1, according to Hymans Robertson, an independent pension’s consultancy, making it responsible for £115 billion of debt.

Gilt yields, the assets used to help value the cost of future payments, tumbled in the aftermath of the June 23 referendum, as investors bolted in favour of assets with a reputation for safety, putting more pressure on the pension industry.

Record lows in gilt yields in turn pushed the liabilities of UK pension schemes up to an all-time high £2.3 trillion on July 1.

“The gyrations in UK pension deficits are eye-watering. But one of the biggest factors that will determine whether or not pensions are paid to scheme members in full will be the health of the sponsoring company post Brexit,” Patrick Bloomfield, partner at Hymans Robertson, said.

Ros Altman, the former pensions minister, warned pensions could be under threat from the economic turmoil following UK’s vote to leave the EU.

“Good pensions depend on a good economy. Markets don’t like uncertainty, and we are clearly in unchartered territory,” Altmann said at an event in London.

“I hope we will get the political turmoil settled soon and do what we really need to be doing -which is making good policy for everyone in the country – who hopefully one day will be a pensioner if they aren’t one already,” she added.

As British businesses struggle to plan for an uncertain future in the aftermath of Britain’s decision to leave the EU, a worsening funding gap can reduce their scope to borrow money, curb their ability to invest and act as barrier to mergers and acquisitions.

High profile companies Tata Steel and BHS already showed evidence of the impact of pension deficits on investments and deal making this year.

The British Steel pension scheme, backed by Tata, has an estimated deficit of £700 million which has complicated the quest to find a new owner for Tata’s factories.

BHS’s pensions scheme had a £571 million hole when it collapsed. The risk of taking on the pensions burden is thought to be one of the reasons behind BHS’s failure to find backers or buyers for the business as a whole.

The fallout from Brexit on UK pensions is even more widespread than these articles suggest. Rob Langston of Raconteur reports, Brexit shock wave hits pension investors:

The full impact of Britain’s vote to leave the European Union has still to be felt, but uncertainty continues to affect pension investments as challenging times may lie ahead.

Pensions may not have been at the front of many people’s minds when entering the polling booths on June 23, but the Brexit referendum result is likely to have a lasting impact on pension schemes for years to come.

The immediate aftermath saw sterling plunge and markets fall, taking a toll on investors’ savings. But the longer-term effect may be just as significant.

While the impact of the EU referendum on markets may have trustees and pension scheme members seeking out the latest performance of their investments, there have been implications for the pension industry as a whole.

Ongoing annuity rates

For some scheme members close to retirement, the referendum result has had a major impact on their choices as annuity rates fell sharply post-Brexit.

“The cost of buying an annuity has got more expensive for DC [defined contribution] members close to retirement,” says Joanna Sharples, investment principal at consultancy Aon Hewitt. “Post-Brexit it will be really interesting to see how this translates across different annuity providers; however, quotes from one provider suggest that annuities are about 4 per cent more expensive, which is quite meaningful.”

Yet, the introduction of pension freedoms in April 2015 may have offered members a wider range of choices to mitigate the referendum result. Data from insurer and long-term investments industry body ABI suggests that annuity-buying activity has fallen away since the introduction of pension freedoms, with income drawdown products enjoying a corresponding rise in take-up.

Pension freedoms are likely to have a bearing on the type of investment decisions that are made in the post-referendum period, opening up opportunities to members they may not have enjoyed in previous years.

“Pensions freedoms have put existing default life cycles into question and there has been a sizeable shift from annuities to drawdown,” says Maya Bhandari, fund manager and director of the multi-asset allocation team at global asset manager Threadneedle Investments.

“We are now able to start on a blank sheet of paper and ask two crucial questions: what do people want and what do they need? Ultimately what people need is relatively simple tools and solutions that help them identify, manage or mitigate the three risks they face in retirement – financial market volatility, real returns and longevity.”

Brexit-proofing pensions

In light of the uncertainty brought about by Brexit, more scheme members might choose to take greater control over their pension savings. So-called Brexit-proofing pensions may appeal to many investors, although they will face a number of challenges.

“Pensions freedoms are still relatively new, which means people are currently faced with very mixed messages about how best to act in times of market uncertainty,” says Catherine McKenna, global head of pensions at law firm Squire Patton Boggs.

“We already know that one of the biggest trends of 2015 was the rise of the pensions scam and individuals should be careful to guard against Brexit uncertainty being used as a trigger to cash out their fund if this isn’t right for them.”

While the referendum decision and subsequent government shake-up may have ramifications for pension freedoms, any changes to existing pension legislation are unlikely to emerge in the immediate aftermath of the leave vote.

“In terms of legislation on pension freedoms, it is unlikely that the government will look to repeal what is already in place but, irrespective of Brexit, there may be further regulation to impose better value by reducing charges and product design for freedoms to develop,” says Ms McKenna.

Taking greater control of investment decisions in the current environment may pose a number of challenges, however, particularly with the increased level of volatility in markets seen in the wake of the result.

“From an investment perspective, Brexit has created much greater uncertainty and volatility in the markets, and made them more than usually reactive to political events,” says James Redgrave, European retirement director at asset management research and consultancy provider Strategic Insight.

“The FTSE 100 fell 500 points on June 24 – below 6,000 – and savers entitled to access their pots were advised to wait to take cash, if they could afford to do so.

“These markets have settled largely on the quick and orderly transition to a new government, after David Cameron’s resignation, and will have been buoyed by the Bank of England’s conclusion that an interest rate cut is not economically necessary.”

James Horniman, portfolio manager at investment manager James Hambro & Partners, says: “Investors have to position portfolios sensibly with insurance against all outcomes. Sterling is likely to come under continued pressure and there will almost certainly be volatility.

“As long as valuations are not unreasonable, it makes sense to weight any UK equity holdings towards businesses with strong US-dollar earnings rather than those reliant on raw materials from overseas – companies forced by adverse currency movements to pay extra for essential inputs from elsewhere in the world could see their profits really squeezed.”

The impact of home bias is likely to take a toll on some pension investments as fund managers have warned of being too exposed to the UK market. Under normal circumstances higher UK equities exposure may be expected, but the uncertainty introduced by the referendum result in local markets may harm returns.

Long term plans

Experts note that many trustees have already begun diversifying portfolios to mitigate geography and asset risk. The financial crisis remains a fresh memory for many trustees who will have taken a more robust approach to diversification in recent years.

“There’s been a general trend over the past decade of moving away from fund manager mandates that are very specific and narrow to wider mandates, such as global equities or multi-asset,” says Dan Mikulskis, head of defined benefit (DB) pensions at London-based investment consultancy Redington. “Trustees making fund manager changes will be more motivated to move to less constrained mandates.”

Yet, trustees and scheme members may need to get used to new market conditions and a longer-term, low-growth environment.

“Following Brexit, the conversations we’ve been having with investors are similar to those we’ve been having since the start of the year,” says Ana Harris, head of equity portfolio strategists for Europe, the Middle East and Africa at investment manager State Street Global Advisors.

“We haven’t seen a big shift in money or allocations, but there has been some realignment. What we are advising clients is not to be reactive to short-term volatility in the market and make sure plans for long-term investment are in place.”

“In the short term, it is likely there will be quite a lot of volatility in the market and members need to be aware of that,” says Aon Hewitt’s Ms Sharples. “One option is that everybody carries on as before with no change to strategy; however, the other option is trustees think about whether there are better ways of investing and opportunities to provide more diversification or add value.

“For people who are a bit further away from retirement, the key is what kind of returns can they expect going forward? Returns are likely to be lower than before because of pressure on the economy and lower growth expectations. To help offset this, members have the option of paying more in or retiring later, or a combination of both.”

With further details yet to emerge about what access the UK will have to EU markets and restrictions on free movement, the full impact of Brexit remains to be seen.

“Unfortunately, no one has a crystal ball. Even the best investment strategies may be adversely affected by current market volatility, but this is not to say members, trustees or fund managers should begin to panic,” says Ms McKenna of Squire Patton Boggs.

“There is little doubt that Britain leaving the EU will mean there are challenges ahead for investment funds; however, there are also opportunities for trustees to harness innovation and consider new investment portfolios.”

A greater focus on risk management has emerged as trustees attempt to mitigate some of the impact of June’s EU referendum result on pension schemes.

While attention may be focused on markets, pension scheme trustees will also have to consider a number of other risk management issues brought about by Brexit.

“I don’t think pensions should be focusing too much on whether sterling is going up or down, or whether one asset manager is performing,” says Dan Mikulskis, head of defined benefit pensions at investment consultancy Redington.

“Getting a risk management framework set up is sensible. With a simple framework to go by, there will be opportunities in a volatile market environment, but it’s always best left to the asset manager.”

Mr Mikulskis says regular reviewing of investment decisions and performance is likely to depend on the size of the scheme and the governance arrangements, adding that trustees may be put under pressure to communicate more frequently and effectively with scheme members.

Despite low interest rates, trustees should take care over possible liability hedging, while also recognising the challenges presented by a low-yield environment for bonds.

“We don’t think that just because rates are low they can’t fall further,” he says. “A lot of trustees that haven’t hedged will feel like they’ve missed the boat, but there are still risks on the down side.”

There sure are risks to the downside and trustees ignoring the bond market’s ominous warning are going to regret not hedging their liabilities because if you ask me, ultra low rates and the new negative normal are here to stay, especially if the deflation tsunami I’ve warned of hits us.

Brexit isn’t just hitting UK pensions, it’s also going to hit large Canadian pensions which invested billions in UK infrastructure and commercial real estate. They were right to worry about Brexit and if they didn’t hedge their currency risk, they will suffer material losses in the short-term.

However, Canada’s large pensions have a very long investment horizon, so over the long run these losses can become big gains especially if Britain figures out a way to continue trading with the EU after Brexit.

That all remains to be seen. In my opinion, Brexit was Europe’s Minsky moment and if they don’t wake up and fix serious structural deficiencies plaguing the EU, then the future looks bleak for this fragile union.

Brexit’s shock waves are also being felt in Japan where the yen keeps soaring, placing pressure on the Bank of Japan which is also grappling with expansionary fiscal policy. We’ll see what it decides on Friday but investors are bracing for another letdown.

In other related news, while Brexit’s biggest fans are in big trouble, Chris Havergal of the Times Higher Education reports, Bonuses up at USS as pension fund deficit grows by £1.8 billion:

Bonuses at the university sector’s main pension fund have soared, even though its deficit has grown by £1.8 billion.

The annual report of the Universities Superannuation Scheme says that the shortfall between its assets and the value of pensions due to members was estimated to be £10 billion at the end of March, compared with £8.2 billion last year and predating any negative effect of the Brexit vote on pensions schemes.

The health of the fund is due to be reassessed in 2017 and Bill Galvin, its chief executive, said that it was “too early” to say whether contributions from employers and employees would need to be increased.

Despite the expanding deficit, the annual report reveals that the value of bonuses paid to staff rocketed from £10.1 million to £18.2 million last year, with the vast bulk going to the scheme’s investment team.

This contributed to the number of USS employees earning more than £200,000 once salary and bonuses are combined increasing from 29 to 51 year-on-year.

Thirteen staff earned more than £500,000, up from three the year before. While the highest-paid employee in 2014-15 received between £900,000 and £950,000, last year one worker earned about £1.6 million, with another on about £1.4 million.

Mr Galvin told Times Higher Education that the increases reflected a decision to take investment activities in-house that were previously outsourced, and strong investment performance that meant that the deficit was £2.2 billion smaller than it would otherwise have been.

“Although bonuses to the investment teams have gone up, it reflects the fact they have contributed very substantially to keep the deficit from being in a worse position than it is,” Mr Galvin said. “We are delivering a very good value pension scheme, better than any other comparable schemes we have benchmarked.”

The report shows that Mr Galvin’s total remuneration, including pension contributions, increased by 12 per cent in 2015-16, from £432,000 to £484,000.

This comes after a summer of strike action by academics – many of whom will be USS members, particularly at pre-92 universities – over an offer of a 1.1 per cent pay rise for 2016-17.

The increased deficit means that the scheme’s pensions are now estimated to be only 83 per cent funded, compared with the 90 per cent figure predicted by the last revaluation in 2014.

Mr Galvin said that the assumptions made two years ago had been “reasonable”, but that asset values had not kept pace with declining interest rates.

The last revaluation led to the closure of the USS’ final salary pension scheme and an increase in contributions by employers and employees, but Mr Galvin said that a long-term assessment would be taken to determine if further changes were needed.

“Some of the things that will be relevant in the 2017 valuation have gone against [us] in terms of the assumptions we made at the last valuation,” Mr Galvin said. “That is a signal and we will consider what we should do about that…[but] it’s too early to say whether we do need to make any response or what that response might be.”

Mr Galvin added that, while an increase in liabilities since Brexit had been “broadly balanced” with an increase in the value of assets, it was “much too early” to determine the longer term impact of the UK leaving the European Union on the fund.

Looks like the Canadian pension compensation model has been adopted in the United Kingdom. That reminds me, I need to update the list of highest paid pension officers, but keep in mind Mr. Gavin is right, taking investment activities in-house saves the scheme money and it requires they pay competitive compensation to their senior investment officers.

Lastly, Elizabeth Pain of Science Magazine reports, Pan-European pension fund for scientists leaves the station:

Old age may not be something European scientists think about as they hop around the continent in search of exciting Ph.D. opportunities, broader postdoctoral experience, or attractive faculty positions. But once they approach retirement age, many realize that working in countries as diverse as Estonia, Spain, or Germany can be detrimental to one’s nest egg.

But now, there is a potential solution: a pan-European pension fund for researchers, called RESAVER, that was set up by a consortium of employers to stimulate researcher mobility. The fund was officially created on 14 July under Belgian law as a Brussels-based organization. Three founding members—the Central European University in Budapest; Elettra Sincrotrone Trieste in Basovizza, Italy; and the Central European Research Infrastructure Consortium headquartered in Trieste, Italy—will soon start making their first contributions. Researchers can also contribute part of their own salary to the fund.

“We have a solution” to preserve the pension benefits of mobile researchers, Paul Jankowitsch, who is the former chair of the RESAVER consortium and now oversees membership and promotion, said earlier this week here at the EuroScience Open Forum (ESOF). “The excuse [for institutions] to do nothing is gone.”

The European Commission has contributed €4 million to the set-up costs of RESAVER, as part of its funding program Horizon 2020. At least in principle, the fund is open to the entire European Economic Area, which includes all 28 E.U. member states except Croatia, as well as Norway, Lichtenstein, and Iceland.

Most European countries offer social security, and it’s usually possible to get access to benefits even if they’re accumulated in another country. But many universities and institutions also provide supplemental pension benefits that are not so easily transferred. Researchers who spend part of their career abroad—even if it’s just a few hundred kilometers from home—can find themselves paying into a variety of supplemental plans, often resulting in lower benefits than they would enjoy if they just stayed put. This puts a damper on scientists’ mobility.

The idea behind RESAVER is to create a common pension fund so that supplemental benefits will simply follow scientists whenever they change jobs or countries. Individual researchers can only join through their employers, which is why it’s essential for the scheme’s success that a large number of institutions around Europe join the initiative.

The big question is whether that will happen. In addition to the three early adopters, the RESAVER consortium, which was created in 2014, has some 20 members so far, together representing more than 200 institutions across Europe. That’s just a tiny fraction of Europe’s research landscape—and even most members of the consortium have not yet committed to joining the fund.

Take-up has been slow for a variety of reasons. According to Jankowitsch, the fund represents a long-term financial risk that many universities and research institutions are not accustomed to. Local factors further complicate matters. In France, many researchers have their pension fully covered by the state as civil servants. Although many institutions in Spain are part of the consortium, there are obstacles in Spanish law to joining a foreign pension fund. And in Germany, researchers at the Max Planck Institutes have little incentive to join because they already enjoy attractive pension packages.

Risk was also a concern for researchers in the audience at this week’s ESOF session. The RESAVER pension plan will be contribution- rather than benefit-based, meaning that researchers will know how much they put in but not how much they’ll get, as they would with many other pension plans in Europe. Although the fund has been conceived as a pan-European risk-pooling investment, Jankowitsch acknowledges that there will always be risks in the capital market.

Some attendees also wondered whether, with so few institutions participating, RESAVER could actually be a barrier to mobility, at least in the short term, by limiting researchers to those institutions. Young researchers worried about inequalities because Ph.D. candidates are employed in some places but are considered students in others, making them ineligible for participation. (The consortium is currently negotiating a private pension plan for researchers who don’t have an employment contract.)

The International Consortium of Research Staff Associations (ICoRSA) would like to see more transparency in the fund’s investment plan and more flexibility and guarantees for researchers, the organization says in a position statement sent to ScienceInsider today. But overall, “ICoRSA welcomes the initiative.”

Jankowitsch is optimistic: “We see a lot of questions, but not obstacles,” he said at ESOF. Institutes can benefit, because offering RESAVER to employees could give them a competitive hiring advantage, Jankowitsch said—but he encouraged researchers to urge their employers to join, if necessary. “If organizations are not joining, then this is not happening.”

This is an interesting idea but they should have modeled it after CERN’s pension plan which is a defined-benefit plan that thinks like a global macro fund. CERN’s former CIO, Theodore Economou is now CIO of Lombard Odier and he’s a great person to discuss this initiative with.

But before they launch RESAVER to bolster the pensions of European scientists, European policymakers and UK’s new leaders need to sit down and RESAVE the Euro.

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

Timothy W. Martin of the Wall Street Journal reports, Giant California Teachers Pension, Calstrs, Posts Worst Result Since 2008 Crisis:

The nation’s second-largest public pension posted its slimmest returns since the 2008-2009 financial crisis because of heavy losses in stocks.

The California State Teachers’ Retirement System, or Calstrs, earned 1.4% for the fiscal year ended June 30, according to a Tuesday news release. The result is the lowest since a 25% loss in fiscal 2009 and well below Calstrs’ long-term investment target of 7.5%. Calstrs oversees retirement benefits for 896,000 teachers.

The soft returns by Calstrs, which manages $189 billion, foreshadow tough times for other U.S. pension plans as they grapple with mounting retirement obligations and years of low interest rates. On Monday the largest U.S. pension, the California Public Employees’ Retirement System, said it earned 0.6% on its investments. Other large plans are posting returns in the low single-digits.

Calstrs did report big gains in real estate and fixed income. But its holdings of U.S. and global stocks—which represent more than half of its assets—declined by 2.3%.

The fund earned 2.9% on its private-equity investments, falling short of its internal benchmark by 1.7 percentage points. Real estate rose 11.1% but lagged behind the internal target.

Calstrs investment chief Christopher Ailman said the fund’s portfolio “is designed for the long haul and “we look at performance in terms of decades, not years.”

Over the past five years, Calstrs has posted returns of 7.7%. But the gain drops to 5.6% over 10 years and 7.1% over 20 years.

John Gittelsohn of Bloomberg also reports, Calstrs Investments Gain 1.4% as Pension Fund Misses Goal:

The California State Teachers’ Retirement System, the second-largest U.S. public pension fund, earned 1.4 percent in the 12 months through June, missing its return target for the second straight year.

Calstrs seeks to earn 7.5 percent on average over time to avoid falling further behind in its obligations to 896,000 current and retired teachers and their families. The fund, which had $188.7 billion in assets as of June 30, averaged returns of 7.8 percent over the last three years, 7.7 percent over five years, 5.6 percent over 10 years and 7 percent over 20 years.

“The Calstrs portfolio is designed for the long haul,” Chief Investment Officer Christopher Ailman said Tuesday in a statement. “We look at performance in terms of decades, not years. The decade of the 2010s has so far been a good performer, averaging 10.3 percent net.”

U.S. pension funds have struggled to meet investing goals amid stock volatility, shrinking bond returns and slowing emerging-market growth at a time when retirees are living longer and health-care costs are rising. Long-term unfunded liabilities may ultimately need to be closed by higher employee withholding rates, reduced benefits or bigger taxpayer contributions.

The California Public Employees’ Retirement System, the nation’s largest pension fund with $302 billion in assets, earned 0.6 percent for the latest fiscal year, according to figures released Monday. Calpers trails its assumed annualized 7.5 percent rate of return for the past three-, five-, 10-, 15- and 20-year periods.

Calstrs and Calpers are bellwethers for public pension funds because of their size and investment approach. Both have pressured money managers to reduce fees while also using their influence as shareholders to lobby for environmental, social and corporate-governance reforms.

Calstrs returned 4.8 percent in the previous fiscal year after gaining 19 percent in 2014. Over the last decade, the teacher system’s returns ranged from a 23 percent gain in 2011 to a 25 percent loss in 2009.

Asset Allocation

The fund’s investments in stocks fell 2.3 percent last year, while fixed income and real estate both rose 11 percent and private equity increased 2.9 percent. As of June 30, Calstrs had about 55 percent of its assets in global stocks, 17 percent in fixed-income, 14 percent in real estate, 8.7 percent in private equity with the balance in cash and other financial instruments.

While Calstrs outperformed its benchmark index for equities by 0.2 percent last year, its returns trailed in every other category.

Since 2014, Calstrs’s unfunded liability has grown an estimated 27 percent to $69.2 billion while Calpers’s gap has increased 59 percent to $149 billion, according to Joe Nation, a professor of the practice of public policy at Stanford University. Both retirement systems’ assumptions of 7.5 percent returns are based on wishful thinking, he said.

“The assumption is we’re going to have a period like the 1990s again,” Nation said. “And there are very few people who believe that you’ll get the equity returns over the next five or 10 years that we saw in the 1990s.”

Of course, professor Nation is right, CalPERS, CalSTRS and pretty much all other delusional US public pensions clinging to some pension-rate-of-return fantasy are going to have to lower their investment assumptions going forward. The same goes for all pensions.

In fact, as I write my comment, Krishen Rangasamy, senior economist at the National Bank of Canada sent me his Hot Chart on US long-term inflation expectations (click on image):

While U.S. financial conditions and economic data have improved lately with consensus-topping June figures for employment, industrial output and retail spending, that’s not to say the Fed is ready to resume rate hikes. Brexit has raised downside risks to global economic growth and the FOMC will appreciate the potential spillover effects to the U.S. economy. But perhaps more concerning to the Fed is that its persistent failures to hit its inflation target ─ for four consecutive years now, the annual core PCE deflator has been stuck well below the Fed’s 2% target ─ is starting to disanchor inflation expectations.

As today’s Hot Charts show, both survey-based and market-based measures are showing sharp declines in inflation expectations. The University of Michigan survey even shows the lowest ever quarterly average for long-term inflation expectations. So, while markets are now pricing in a decent probability of a Fed interest rate hike later this year, we remain of the view that the FOMC should refrain from tightening monetary policy until at least 2017.

I agree, the Fed would be nuts to raise rates as long as global deflation remains the chief threat but some think it needs to raise rates a bit in case it needs to lower them again in the future (either way, I remain long the USD in the second half of the year).

The point I’m trying to make is with US inflation expectations falling and the 10-year Treasury note yield hovering around 1.58%, all pensions will be lucky to return 5% annualized over the next ten years, never mind 7.5%, that is a pipe dream unless of course they crank up the risk exposing their funds to significant downside risks.

Taking more risk when your unfunded liabilities are growing by 27 percent (CalSTRS) or 59 percent (CalPERS) is not a given because if markets crash, those unfunded liabilities will soar past the point of no return (think Illinois Teachers pensions).

Anyways, let’s get back to covering CalSTRS’s fiscal year results. CalSTRS put out a press release announcing its fiscal 2015-16 results:

The California State Teachers’ Retirement System remains on track for full funding by the year 2046 after announcing today that it ended the 2015-16 fiscal year on June 30, 2016 with a 1.4 percent net return. The three-year net return is 7.8 percent, and over five years, 7.7 percent net.

The overall health and stability of the fund depends on maintaining adequate contributions and achieving long-term investment goals. The CalSTRS funding plan, which was put in place in June 2014 with the passage of Assembly Bill 1469 (Bonta), remains on track to fully fund the system by 2046.

CalSTRS investment returns for the 2015-16 fiscal year came in at 1.4 percent net of fees. However, the three-and-five year performance for the defined benefit fund still surpass the 7.5 percent average return required to reach its funding goals over the next 30 years. Volatility in the equity markets and the recent June 23 U.K. referendum to exit the European Union, also known as Brexit, left CalSTRS’ $188.7 billion fund about where it started the fiscal year in July 2015.

“We expect the contribution rates enacted in AB 1469 and our long-term investment performance to keep us on course for full funding,” said CalSTRS Chief Executive Officer Jack Ehnes. “We review the fund’s progress every year through the valuation and make necessary adjustments along the way. Every five years we’ll report our progress to the Legislature, a transparency feature valuable for any such plan.”

The 2015-16 fiscal year’s investment portfolio performance marks the second consecutive year of returns below the actuarially assumed 7.5 percent. Nonetheless, CalSTRS reinforces that it is long-term performance which will make the most significant impact on the system’s funding, not short-term peaks and valleys.

CalSTRS continues to underscore and emphasize the long-term nature of pension funding as it pertains to investment performance and the need to look beyond the immediate impacts of any single year’s returns. And although meeting investment assumptions is very important to the overall funding picture, it is just one factor in keeping the plan on track. Factors such as member earnings and longevity also play important roles.

“Single-year performance and short-term shocks, such as Brexit, may catch headlines but the CalSTRS portfolio is designed for the long haul. We look at performance in terms of decades, not years,” said CalSTRS Chief Investment Officer Christopher J. Ailman. “The decade of the 2010s has so far been a good performer, averaging 10.3 percent net.”

CalSTRS’ net returns reflect the following longer-term performance:

• 7.8 percent over three years
• 7.7 percent over five years
• 5.6 percent over 10 years
• 7.1 percent over 20 years

Fiscal Year 2015–16 Returns (Net of Fees) and Performance by Asset Class (click on image):

As of June 30, 2016, the CalSTRS investment portfolio holdings were 54.8 percent in U.S. and non-U.S. stocks, or global equity; 16.9 percent in fixed income; 8.7 percent in private equity; 13.9 percent in real estate; 2.8 percent in inflation sensitive and absolute return assets; and 2.9 percent in cash.

About CalSTRS

The California State Teachers’ Retirement System, with a portfolio valued at $188.7 billion as of June 30, 2016, is the largest educator-only pension fund in the world. CalSTRS administers a hybrid retirement system, consisting of traditional defined benefit, cash balance and voluntary defined contribution plans. CalSTRS also provides disability and survivor benefits. CalSTRS serves California’s 896,000 public school educators and their families from the state’s 1,700 school districts, county offices of education and community college districts.

A few brief remarks on the results below:

• Just like CalPERS and other large public pensions with a large asset allocation to global equities, CalSTRS has a lot of beta in its portfolio. This means when global stocks take a beating or slump, their Fund will underperform pensions with less beta in their portfolio (like CPPIB, PSP, Ontario Teachers, etc.). Conversely, when global stocks soar, they will outperform these pensions. But when stocks get hit, all pensions suffer in terms of performance (some a lot more than others).
• Also similar to CalPERS, Private Equity had meager returns of 2.9%, underperforming its benchmark which returned 4.6%. CalPERS’s PE portfolio returned less (1.7%) but outperformed its benchmark by 253 basis points which signals “benchmark gaming” to me. You should all read Yves Smith’s comment, CalPERS Reported That It Made Less in Private Equity Than Its General Partners Did (Updated: As Did CalSTRS), to get more background and understand the key differences. One thing is for sure, my comment earlier in November 2015 on a bad omen for private equity was timely and warned all you the good days for PE are over.
• CalSTRS’s performance in Real Estate (11.1%) significantly outperformed that of CalPERS (7.1%) but it under-performed its benchmark which returned 12.6%. Note that CalPERS  realized losses on the final disposition of legacy assets in the Opportunistic program which explains this relative underperformance.
• More interesting, however, is how both CalPERS and CalSTRS use a real estate benchmark which reflects the opportunity cost, illiquidity and risk of the underlying investments. I’m mentioning this because private market assets at CalPERS and CalSTRS are valued as of the end of March, just like PSP and CPPIB. But you’ll recall I questioned the benchmark PSP uses to value its RE portfolio when I went over its fiscal 2016 results and this just makes my point. Again, this doesn’t take away from PSP’s outstanding results in Real Estate (14.4%) as they beat the RE benchmark CalPERS and CalSTRS use, just not by such a wide margin.
• Fixed Income returned less at CalSTRS (5.7%) than at CalPERS (9.3%) but it uses a custom benchmark which is different from that of the latter. Still, with 17% allocated to Fixed Income, bonds helped CalSTRS buffer the hit from global equities.
• Inflation Sensitive Assets returned 4.2% but CalSTRS doesn’t break it down to Infrastructure, Natural Resources, etc. so I can’t compare it to CalPERS’s results.
• Absolute Return returned a pitiful 0.2%, underperforming its benchmark by 100 basis points (that benchmark is low; should be T-bills + 500 or 300 basis points). Ed Mendell wrote a comment, As CalPERS Exits Hedge Funds, CalSTRS Adds More, explaining some of the differences in their approach on hedge funds. CalSTRS basically just started investing in large global macro and quant funds and squeezes them hard on fees. The party in Hedge Fundistan is definitely over and while many investors are running for the exits, most stay loyal to them, paying outrageous fees for mediocre returns.

These points pretty much cover my thoughts on CalSTRS’s fiscal 2015-16 results. As always, you need to dig beneath the surface to understand results especially when comparing them to other pension funds.

You can read more CalSTRS press releases here including one that covers research from University of California, Berkeley which shows that for the vast majority of teachers, the California State Teachers’ Retirement System Defined Benefit pension provides a higher, more secure retirement income compared to a 401(k)-style plan. (I don’t need convincing of that but they need to significantly improve the funded status to make these pensions sustainable over the long run).

Rob Kozlowski of Pensions & Investments reports, PSP Investments returns 1% for fiscal year:

Public Sector Pension Investment Board, Montreal, returned 1% in the fiscal year ended March 31, a news release said.

The C$116.8 billion ($89.5 billion) pension fund exceeded its policy benchmark return of 0.3%, and its best-performing asset class was real estate at 14.4%, followed by infrastructure at 12.7%.

Natural resources returned 6.9%; private equity, 2.4%; and public markets, -3.2%.

A final asset class, private debt, was first instituted in November and thus one-year returns are not yet available.

As of March 31, the actual allocation was 58.8% public markets, 17.4% real estate, 10.7% private equity, 7.4% infrastructure, 3.1% cash and cash equivalents, 2.1% natural resources and 0.5% private debt.

PSP Investments manages the pension assets of Canadian federal public service workers, Canadian Forces, Reserve Forces and the Royal Canadian Mounted Police.

Officials at the pension fund could not be immediately reached to provide further information.

I too reached out to PSP to arrange a conversation with André Bourbonnais, PSP’s President and CEO, but they told me he “wasn’t available”. Instead a very nice lady called Anne-Marie Durand, Senior Manager, External Communications, was polite enough to respond to my email and told me she’d be happy to answer my questions via email.

Note to PSP and all other pensions: I work very hard covering your fiscal year results. The least you can do is have the decency to provide me with a short phone conversation with the CEO or CIO of your organization. I have no time to waste emailing questions to your communications people who aren’t investment officers. Moreover, some of the material may be sensitive in nature and not suitable or appropriate for email correspondence.

Now that I got that out of the way, let me get to work because there is a lot to cover. Unfortunately, the journalists are asleep this week because apart from the one article I posted above, there isn’t any coverage on PSP’s fiscal year 2016 results by the major media outlets (by the way, you can now follow PSP Investments on Twitter here @InvestPSP).

PSP Investments did put out a press release which was published on Yahoo, PSP Investments’ net assets reach $116.8 billion (added emphasis is mine):

• One-year total portfolio return of 1% resulting in $0.9 billion of value added above the policy benchmark return
• Five-year annualized return of 8.9% resulting in $6.4 billion of value added above the policy benchmark return
• Ten-year annualized net return of 5.9% resulting in $7.2 billion of cumulative net investment gains over the return objective

MONTRÉAL, July 21, 2016 /CNW Telbec/ – The Public Sector Pension Investment Board (PSP Investments) announced today that its net assets under management reached $116.8 billion at the end of fiscal year 2016 (fiscal 2016), compared to $112 billion at the end of the previous fiscal year. The total portfolio generated a return of 1%, exceeding the policy benchmark return of 0.3%, and created $0.9 billion of value added.

Over the past five fiscal years, PSP Investments has recorded a compound annualized return of 8.9%, compared to 7.3% for the policy benchmark. It generated investment income of $37.3 billion, and $6.4 billion of value added above the benchmark. For the 10-year period ending March 31, 2016, PSP Investments recorded an annualized net return of 5.9%, and generated $7.2 billion of cumulative net investment gains over the return objective.

“In a year characterized by high volatility and negative returns in most markets and by significant changes internally, our team has been able to provide a positive performance, both in absolute terms and against our policy benchmark return,” said André Bourbonnais, President and Chief Executive Officer of PSP Investments. “Most of our private market asset classes, and more particularly real estate, recorded strong returns during the year and surpassed their respective benchmarks. However, public equity markets posted negative returns and private equity underperformed. Our overall performance suffered as a result. After five consecutive years of positive, often double-digit returns, PSP Investments continues to exceed our long-term real return objective of 4.1%, thereby contributing to the long-term sustainability of the public sector pension plans whose assets we invest in order to provide financial protection for those who dedicate their lives to public service,” Mr. Bourbonnais added.

Corporate highlights and strategic initiatives

“Fiscal 2016 was a year of significant change for PSP Investments. After assuming his position as President and CEO at the end of fiscal 2015, André Bourbonnais immediately undertook a broadly-based strategic review,” said Michael P. Mueller, Chair of the Board. “That review is having a transformational effect. It has resulted in a new direction and a shift in organizational responsibilities, as well as in investment, operational and compensation models. PSP Investments is becoming a more cohesive organization with an increased capacity to deliver on its mission and mandate.”

Among the strategic initiatives undertaken in fiscal 2016, the position of Chief Investment Officer was enhanced with responsibility for implementing a total portfolio approach and evolving the portfolio construction framework by pursuing cross-functional investments with an efficient mix of asset classes.

Private debt, which focuses on principal debt and credit investments in primary and secondary markets worldwide, was introduced as a new asset class in November 2015. It is a long-term asset class that offers attractive premiums on underlying illiquidity.

Although it remains committed to Canada, PSP Investments is expanding its global footprint. It opened an office in New York where the private debt market is centred. It is developing London as a European hub to pursue private investment and private debt opportunities.

“Our strategic efforts reflect considered, deliberate choices, and were undertaken with a view to enhance the construction of our portfolio,” said André Bourbonnais. “The impact of these strategic changes will not be felt overnight, but they are consistent with our long-term perspective. Our vision is to be a leading global institutional investor that reliably delivers on its risk-return objective by focusing on a total fund perspective. We seek opportunities to invest innovatively at scale. Our investment approach is to leverage select business-to-business relationships and gain local market insights to identify deployment opportunities. The positive returns we generated in many asset classes during fiscal 2016 result from the ongoing implementation of this strategy.”

Portfolio highlights by asset class

PSP Investments’ net assets increased by $4.8 billion in fiscal 2016. Gains are attributable to net contributions of $4.0 billion and comprehensive income of $0.8 billion. Strong returns in Real Estate, Infrastructure and Natural Resources were partially offset by lower returns in Private Equity and negative returns in Public Markets.

Public Markets

• At March 31, 2016, Public Markets had net assets of $68.6 billion, compared to $76.3 billion at the end of fiscal 2015. In fiscal 2016, Public Markets recorded investment income of negative $2.5 billion, for an overall return of negative 3.2%, compared to a benchmark return of negative 2.3%. Most of Public Markets strategies performed above their respective benchmark, but the Value Opportunity Portfolio had a fairly significant negative impact on Public Markets’ performance. Over a five-year period, Public Markets has generated an annualized return of 7.9%, compared to a benchmark return of 7.5%.

Real Estate

• At March 31, 2016, Real Estate had net assets of $20.4 billion, an increase of $6.0 billion from the previous fiscal year. Direct ownership and co-investments accounted for 88% of Real Estate assets, an increase from 86% at the end of fiscal 2015.
• In fiscal 2016, Real Estate generated investment income of $2.3 billion, for a total return of 14.4%, compared to a benchmark of 5.1%. Over a five-year period, Real Estate investments produced an annualized return of 12.9%, compared to a benchmark return of 5.5%.
• In fiscal 2016, Real Estate deployed $3.5 billion in new investments broadly diversified across geographies and sectors, and had unfunded commitments of $1.5 billion for investments closed during the year.

Private Equity

• As at March 31, 2016, Private Equity had net assets of $12.5 billion, an increase of $2.4 billion from the previous fiscal year. Direct investments and co-investments accounted for 40% of the assets in the Private Equity portfolio, in line with fiscal 2015.
• In fiscal 2016, Private Equity generated investment income of $279 million, for a return of 2.4%, compared to a benchmark return of 8.9%. The portfolio generated distributions of more than $1.0 billion during the year, from realized capital gains, interest and dividends. Portfolio income was primarily generated by investments in funds, including targeted funds of funds portfolio, and by gains in certain direct holdings. However, overall portfolio performance was offset by positions primarily in the communications and energy sectors, which were impacted by macro-economic factors, resulting in lower valuation multiples for many investments. Over a five-year period, Private Equity investments generated an annualized return of 11.1%, compared to a benchmark return of 11.2%.
• In fiscal 2016, Private Equity committed a total of $2.7 billion to funds with existing and new partners, and completed new direct investments and co-investments of $1.2 billion, including the acquisition of AmWINS Group, a leader in the wholesale insurance industry in the United States, and of Homeplus, one of South Korea’s largest multi-channel retailers, in a deal led by fund partner MBK Partners.

Infrastructure

• As at March 31, 2016, Infrastructure had net assets of $8.7 billion, an increase of $1.6 billion from the previous fiscal year. Direct investments accounted for 86% of the assets in the Infrastructure portfolio, up slightly from 85% at the end of fiscal 2015.
• In fiscal 2016, the Infrastructure portfolio generated investment income of $940 million, for a return of 12.7%, compared to a benchmark return of 5.5%. The portfolio return was driven mainly by direct investments in the transportation and utilities sectors in Europe and emerging markets. Over a five-year period, Infrastructure investments generated an annualized return of 9.6%, compared to a benchmark return of 6.5%.
• In fiscal 2016, Infrastructure acquired a participation in Allegheny Hydro, LLC, and reinvested in Angel Trains Limited, Cubico Sustainable Investments Limited and AviAlliance GmbH. It also committed to an agreement to acquire a New England portfolio of hydroelectric assets from ENGIE Group for an enterprise value of US$1.2 billion.

Natural Resources

• As at March 31, 2016, Natural Resources had net assets of $2.5 billion, an increase of $1.0 billion from the previous fiscal year. Direct investments accounted for 96% of Natural Resources assets.
• In fiscal 2016, Natural Resources generated investment income of $150 million, for an overall return of 6.9%, compared to a benchmark return of 5.1%. Portfolio returns were primarily driven by investments in timber and agriculture, which generated a return of 20.5%. Valuation gains were materially offset by markdowns in oil and gas investments. Since its inception in June 2011, Natural Resources has generated an annualized return of 11.1%, compared to a benchmark return of 4.5%.
• In agriculture, Natural Resources continued to expand and add to the number of investment platforms in which it participates alongside high quality, like-minded operators in some of the world’s lowest cost regions, including Australasia, North America and South America.

Private Debt

• Private Debt was approved by the Board of Directors as an asset class in November 2015. It focuses on principal debt and credit investments, in primary and secondary markets worldwide. Private Debt’s priority is to provide credit capital to non-investment grade US and European corporate borrowers. It has a target allocation of 5% of PSP Investments’ assets under management. At March 31, 2016, Private Debt had funded net assets of $640 million across six direct investment transactions.
• In fiscal 2016, Private Debt generated net investment income of $1.4 million, resulting in a rate of return of 3.0%, compared to a benchmark return of negative 3.9%. Portfolio returns were driven by upfront fees, coupon interest, valuation adjustments and foreign exchange gains and losses. The return of the asset class was negatively impacted by the fluctuation in the Canadian dollar, resulting in significant foreign exchange losses for the year. The rate of return in local currency (US dollars) amounted to 9.1% for the year.
• In fiscal 2016, Private Debt committed to a total of US$2.3 billion, including a significant financing commitment alongside partner Apollo Global Management, LLC, to participate in the take private transaction of The ADT Corporation, a leading home and business security monitoring company.

For more information about PSP Investments’ fiscal year 2016 performance or to view PSP Investments’ 2016 Annual Report, visit investpsp.com.

About PSP Investments

The Public Sector Pension Investment Board (PSP Investments) is one of Canada’s largest pension investment managers with $116.8 billion of net assets under management as at March 31, 2016. It manages a diversified global portfolio composed of investments in public financial markets, private equity, real estate, infrastructure, natural resources and private debt. Established in 1999, PSP Investments manages net contributions to the pension funds of the federal Public Service, the Canadian Armed Forces, the Royal Canadian Mounted Police and the Reserve Force. Headquartered in Ottawa, PSP Investments has its principal business office in Montréal and offices in New York and London. For more information, visit investpsp.com or follow Twitter @InvestPSP.

Since when did PSP’s website become investpsp.com and not investpsp.ca? Both websites work but I guess given the “global focus” dot.com is more appropriate.

Anyways, let’s get on with analyzing PSP’s fiscal 2016 results but before we do, please take the time to read the Chair’s Report (page 12), the President’s Report (page 14) and the interview with PSP’s CIO, Daniel Garant, on “One PSP” on page 23 of  PSP’s 2016 Annual Report.

The complete 2016 Annual Report is available here and in my opinion, it’s excellent and well worth reading all of it which I did yesterday. But if you can’t read it all, at least read the passages I mentioned because it’s important to note, this isn’t Gordon Fyfe’s PSP, it’s clearly André Bourbonnais’s PSP, and there are important strategic and cultural shifts going on at this organization.

Of course, as you will read below, there are some benchmark legacies from the Gordon Fyfe/ André Collin/ Derek Murphy/ Bruno Guilmette days that still linger at PSP (the players change but gaming benchmarks goes on unabated, especially in Real Estate).

Actually, since I’m a stickler for benchmarks, let’s begin with PSP’s benchmarks which can be found on page 36 of the 2016 Annual Report (click on image):

As you can see, the benchmarks for Public Markets are pretty straightforward and widely recognized in the industry. However, when it comes to Private Markets, things become a lot less clear.

Private Equity has a benchmark which reflects the Private Equity Universe (plus the cost of capital), which is fine, but Real Estate, Infrastructure, and Natural Resources all have “custom benchmarks” which reflect their cost of capital, and this is far from fine.

Why are benchmarks critical? Because benchmarks are how you calculate the value-added of an investment portfolio which determines compensation of senior investment officers. And if the benchmarks don’t reflect the risks, opportunity cost and illiquidity of the underlying portfolio, pension fund managers can easily game their benchmark to their advantage.

Let me show you what I mean. Below, I embed the PSP’s portfolio and benchmark returns which can be found on page 37 of the 2016 Annual Report (click on image):

As you can see, PSP Investments reports portfolio returns vs benchmark returns for fiscal year 2016 and the annualized portfolio returns vs benchmark returns for the last five fiscal years.

This is great, every pension fund should report this along with a clear and in-depth discussion on the benchmarks they use to gauge value added in public and private markets.

Now, notice the huge outperformance of the Real Estate portfolio in fiscal 2016 (14.4% vs 5.1% benchmark return) and over the last five fiscal years (12.9% vs 5.5% benchmark return)?

The same goes for the Infrastructure portfolio. In fiscal 2016, it returned 12.7% vs 5.5% for its benchmark and over the last five fiscal years, it returned an annualized rate of 9.6% vs 6.5% for the benchmark (over a longer period, the benchmark for Infrastructure seems appropriate).

So what’s the problem? The problem is these two asset classes make up a quarter of PSP’s asset mix and when I see such outperformance over their respective benchmark over one or five fiscal years (especially in Real Estate), it immediately signals to me that the benchmark doesn’t reflect the risks of the underlying portfolio.

Not only this, PSP’s Real Estate has accounted for the bulk of the value-added since its inception (both in dollar and percentage terms), and this has helped senior officers at PSP collect multi millions in compensation.

Now, for comparison purposes, I looked again at my comment on CPPIB’s fiscal 2016 results. PSP and CPPIB are similar pension funds in many ways except the latter is much bigger. But they both have fiscal years that end on March 31st and their asset mix and liquidity profile are similar.

So why did CPPIB gain 3.4% in fiscal 2016 and PSP only 1%? A big factor behind this relative outperformance is that CPPIB doesn’t hedge currency risk whereas PSP is 50% hedged, so the former enjoyed currency gains across the public and private market investments (PSP is reviewing its currency hedging policy and will likely move to no hedging like CPPIB).

But it’s not just currency gains, CPPIB had a stellar year and really fired on all cylinders across all its investment portfolios. The overall results don’t reflect this but if you dig deeper and analyze the results properly, you will see this.

CPPIB’s Real Estate and Infrastructure portfolios also enjoyed great performances in fiscal 2016, returning 12.3% and 9.3% respectively (click on image):

Notice, however, that CPPIB doesn’t report the same way as PSP, namely, portfolio returns over one and five fiscal years relative to benchmark returns.

This is because CPPIB has one of the toughest Reference (benchmark) Portfolios in the industry (CPPIB provides an in-depth discussion on risk and how they benchmark investment activities and they do consider opportunity cost and illiquidity). It has an elaborate and detailed way to measure risk of each investment but I wish it did report the same way as PSP because then I can show you the outperformance (or value-added) over benchmark at CPPIB is considerably less over one and five fiscal years for Real Estate (Yes, PSP returned more in RE but a bigger reason is the benchmark used in RE is alot easier to beat at PSP).

I’ve discussed PSP’s private market benchmark issues before (see last year’s comment) and I want to make it clear, I have nothing against PSP’s Real Estate team. Neil Cunningham is a great guy and he and his team are delivering outstanding results but if I was sitting on the Board of PSP, they wouldn’t be getting away with this benchmark (Note: Even with a tougher benchmark, they would still outperform with these type of returns).

Anyways, all this discussion on benchmarks and outperformance leads me to compensation. I highly suggest you read the entire Compensation section which begins on page 72 of the 2016 Annual Report. Below, I embed the summary compensation table (along with footnotes) which can be found on page page 79 (click on image):

A few brief remarks on compensation

• The compensation is fair and in line with short-term and mostly long-term performance. Sure, the senior investment officers at PSP get paid extremely well, especially by Montreal standards, but given the size of the fund and the investment activities across public and private markets that require specialized skill sets and given what other large Canadian pensions pay their senior investment officers, it’s not outrageous.
• What I find outrageous are the lavish severance packages. When I read how much former officers Bruno Guilmette and John Valentini earned, I almost fell off my chair. The amount includes a severance package which is clearly outlined in the previous annual report but still, these are huge packages. At least Bruno was a senior investment officer (“alpha generator”) but John was an interim CEO for nine months before André Bourbonnais was appointed CEO so that factored into his compensation (no worries, he landed on his feet quickly at Fiera Capital).
• Noticeably absent from these former officers is Derek Murphy, PSP’s former head of Private Equity. He left the organization soon after Bourbonnais took over the helm (either he quit or settled but his name doesn’t appear in the table above). He is now running a PE firm in Montreal called Aquaforte which helps institutional investors get a better alignment of interest with general partners (GPs).

And the points below on the new incentive plan are taken from the 2016 Annual Report:

• It was agreed that the incentive compensation framework should be less formulaic and produce less volatility in year-to-year payouts while allowing management and the Board to differentiate rewards based on components which go beyond investment performance alone. An overriding goal was to shift investment performance measurement from purely relative,
  medium-term metrics to long-term absolute, total fund results. Another goal was to encourage more cooperation across the organization, again aligning individual success with the total fund, not just its component parts. This is a key element of One PSP. It was also decided that senior management should have a larger proportion of its compensation deferred and performance conditioned.
• The new incentive compensation plan will be driven  by two key elements: 1) an annual overall assessment of PSP Investment’s performance based on a mix  of relative (five-year) and absolute (seven-year) total fund investment performance, as well as five-year relative investment performance for individual asset classes, and the achievement of business units’ respective annual objectives derived from PSP Investments’ five-year business strategy, and 2) an annual assessment of personal objectives.

Lastly, let me end this comment with some positive feedback:

• First, as I stated, you should all take the time to read the entire 2016 Annual Report, especially the Chair and President’s report, as well as the interview with the CIO on “One PSP”. The Annual Report is excellent and provides a lot of details I cannot go over here.
• Second, there is no question that André Bourbonnais is trying to steer the ship toward a new and solid direction. He and his senior team have laid out a detailed strategic plan which includes cultivating One PSP, improving the brand locally and internationally, increasing the global footprint, creating scalable and efficient investment and operational activities, and developing their talent.
• Third, in my opinion, enhancing the role of the CIO with responsibility for implementing a total portfolio approach and evolving the portfolio construction framework by pursuing cross-functional investments with an efficient mix of asset classes is critical and very smart.
• Fourth, I was happy to see PSP is finally taking an initiative on diversity in the workplace, just like CPPIB is doing. I’m a big believer in diversity in the workplace at all levels of the organization and think that PSP, CPPIB and all of Canada’s Top Ten pensions have a lot of work to do on this front not just by promoting women and offering them equal pay but also by promoting visible minorities and incorporating other disadvantaged minorities like aboriginals and especially people with disabilities (Note to PSP: You should ask candidates to self-identify when they apply for jobs and have specific programs targeting minorities. All Canadian pension funds should follow the Royal Bank’s model and significantly improve on it).
• Fifth, the introduction of private debt as an asset class makes a lot of sense. You should all read a paper by professor Amin Rajan, The Rise of Private Debt as an Institutional Asset Class, to understand what private debt is all about and why PSP is perfectly placed to take advantage of this asset class.
• Sixth, I’m glad PSP is on Twitter and communicating a lot more about its investment activities (they should add a dedicated YouTube channel). You can find the latest articles on PSP here, including one that discusses the hire of Oliver Duff as managing director of principal debt and credit investments (Europe), to lead a European private debt push.

That is all from me, I am literally pooped and want to go out to enjoy the summer weather. Before I do, I want to wish you a great weekend and publicly thank the few who support this blog via your donations and subscriptions.

As for Mr. Bourbonnais and the rest of PSP, I wish you a lot of success and even though the new shift will have some bumps along the way, I’m confident the Fund and its beneficiaries and contributors will be better off in the long run.