Author: Leo Kolivakis

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

Mandi Woodruff of Yahoo Finance reports, State pension funds face $1 trillion funding gap:

More depressing news for workers who depend on a pension to fund their retirement: State-run pension funds faced a $968 billion shortfall in 2013, up $54 billion from the year prior, according to a new report by The Pew Charitable Trusts. When local pension fund shortfalls are factored in, the total pension funding gap surpasses $1 trillion.

“Policy makers are going to need to find a way to address [this funding gap] and it’s going to have to come down to some kind of plan to pay it down in an orderly fashion,” said David Draine, a senior researcher at Pew Charitable Trusts.

On average, state pension plans were only 74% funded. The implications for workers are huge. If states don’t find a way to fully fund pension plans, many workers who have dutifully paid into pension plans may not get back what they’ve put in and young workers may not get to participate at all.

Fewer than half of states were able to meet their required annual contributions to pension funds in 2013. New Jersey and Pennsylvania were the furthest behind— each was only able to make only half its annual funding contribution. As a result, more than one-third of their state pension funds were unfunded.

Overall funding rates were the worst in Illinois (with just 39% funded) and Kentucky (44%), where pension funding levels have declined for three years in a row. Just two states managed to finish the year with 100%-funded pensions: South Dakota and Wisconsin.

It should be noted that Pew’s report only looks at funding rates for 2013 and does not factor in the significant investment gains of 2014 (the S&P 500 index rose around 11% last year, according to data from FactSet). But even if it had, the budget shortfall would still likely exceed $900 billion, the report says.

They probably aren’t wrong on this point. In a recent analysis by Boston College’s Center for Retirement Research (CRR), researchers predicted that the pension funding rate would be 74% for 2014, the same rate as Pew’s report, which looked at 2013. If the market continues to improve, however, that funding level could reach 81% by the year 2018, CRR said.

To close the funding gap, like anyone who’s ever been overwhelmed by credit debt knows, states need to step up, Pew argues.

States have adopted pension funding standards that allow them to drag out their pension debts over a longer period of time (a maximum of 30 years) — similar to homeowners who want to stretch out their mortgage payments as long as possible. The result is smaller payments that are easier to swallow but don’t actually put a significant dent in the principal debt.

“This is similar to the negative amortization loans some homeowners used in the run-up to the financial crisis,” the Pew report says. “Initial payments on those loans failed to pay down any principal, and homeowners fell deeper into debt as a result.”

To see how your state ranked, check out the report here.

In June 2012, I wrote an extensive comment on the state of state pension funds. Back then, the funding gap for U.S. state public employee retirement benefits climbed by $120 billion to $1.38 trillion in fiscal 2010, which was understandable given the 2008 crisis hit pensions’ assets and liabilities as investments took a huge hit and bond yields tumbled to record lows.

Three years later we see that the situation hasn’t drastically improved even though U.S. stocks are soaring to record highs. What gives? A few things. First and foremost, states have failed to top up public pensions for years which is why the situation has consistently deteriorated.

Second, the main driver of pension funding gaps is interest rates and with rates still hovering around historic lows, it’s hard to see any significant improvement in state pension funding gaps. Worse, if another financial crisis hits markets, rates will go even lower and deflation will decimate all pensions.

Third, U.S. public pension funds are delusional, stubbornly clinging to their the pension rate-of-return fantasy which will force them to take greater risks in illiquid alternative investments to make their 7.5%-8% bogey. But illiquid alternatives are no panacea and I would heed the wise advice of Ron Mock, Ontario Teachers’ President and CEO, and start scaling back on them at this time.

Interestingly, over in the Netherlands, Dutch regulators just lowered the average return pension funds are allowed to assume over the long run, forcing them to hike premiums to build up capital due to persistent low interest rates. The Dutch take their pensions seriously which is why they monitor pension funding gaps very closely to make sure the assumptions being used reflect current market conditions.

But in the United States, regulators pretty much turn a blind eye to public pension funding gaps and the assumed rate-of-return used to discount future liabilities. Instead, state politicians enact stupid policies like shifting employees to defined-contribution plans, further exacerbating pension poverty, or they “extend and pretend” by emitting pension obligation bonds, something which can turn out to be the next bigger short.

Finally, in my opinion, the problem with U.S. public pensions is they lack the proper governance to bring assets internally to lower costs. I wrote about this in the New York Times, arguing that until U.S. policymakers get the governance right and introduce risk-sharing in their plans (just like the Dutch do), state pensions are doomed for failure. 

Photo by http://401kcalculator.org via Flickr CC License

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

Ashlea Ebeling of Forbes reports, Treasury Curtails Lump Sum Pension Payouts:

In a sudden move, the Treasury Department said it will stop allowing employers to offer certain workers the option to take out their pensions in a lump sum. Notice 2015-49, Use of Lump Sum Payments to Replace Lifetime Income Being Received By Retirees Under Defined Benefit Pension Plans, applies as of July 9, 2015.

“The drums were beating, but no one thought this would be manifested by the IRS issuing this deadline-driven edict,” says Nancy Gerrie, an employee benefits lawyer with McDermott Will & Emery.

The idea of a defined benefit pension plan is that you (and your spouse) get guaranteed payouts for life. As the plans have become a drag on corporate balance sheets, companies have been shedding pension liabilities by offering participants the option of taking a lump sum buyout (cash) or transferring their pension to an insurer who would continue the lifetime payments. While the lump sum may seem like a windfall, it often short changes the retiree.

The new rules will change the lump sum game of pension derisking going forward. The new rules close one door, prohibiting lump sum offers for people already in pay status—those receiving a stream of pension payments. If a plan has been around a long time, there will be a lot of people in pay status. There are some outs for employers already in the process of offering lump sums: if the board has met and made an irrevocable decision to do this, or if the employer has already sent communications to participants about an upcoming offer. But otherwise, if an employer hasn’t started the process, forget about it for those in pay status.

Employers will still continue derisking and offering lump sum payouts to participants who haven’t started receiving payments. Employees offered lump sums should consider 8 Questions To Ask Before Taking A Lump Sum Offer.

The first big companies to offer lump sum pension payouts to both participants with deferred benefits and those in pay status were Ford and General Motors, who got private letter rulings from the IRS okaying the move in 2012 (the rulings were on a technical issue, whether the move ran afoul of required minimum distribution rules). When that was cleared up, that prompted interest among other big employers, and the IRS issued four more private letter rulings okaying the move in 2014. “Now all of a sudden, boom! It’s not okay,” Gerrie says.

The Pension Rights Center, an employee advocacy group, welcomes the fact that the IRS told off employers. Many workers just don’t get it, but lump-sum buyouts can easily be outlived, and often result in a loss of retirement wealth. Surviving spouses and older participants in payout status are at particular high risk.

“Offering a lump-sum can be a form of corporate elder abuse,” says Norman Stein, senior policy advisor to the Pension Rights Center and a law professor at Drexel University in a policy paper here. Stein elaborates on the lower economic value of a lump sum for most employees, outlines retirement management, spousal protection and tax problems, and discusses election and consent issues for employees facing cognitive decline.

Is the new IRS rule a harbinger of tougher rules to come on lump-sum buyouts? “Some would love to say, ‘You can’t offer lump-sum cash-outs anymore,’ but I don’t think [regulators] would go that far,” Gerrie says.

Jerry Geisel of Business Insurance also reports, Pension advocate backs IRS rule banning annuity conversions to lump sums:

A new IRS and Treasury Department ban on employers offering pension plan participants currently receiving monthly annuity benefits the option to convert their benefit to a cash lump sum was needed to protect retirees, a consumer advocacy group says.

Federal regulators said last week that employers will not be “permitted to replace any joint and survivor, single life, or other annuity currently being paid with a lump sum payment or other accelerated form of distribution.” The ban generally went into effect July 9, though in certain situations, such as when an employer notified participants of the offer prior to July 9, the conversions still can place.

The Washington-based Pension Rights Center said it was “gratified” that regulators are ending the practice.

“The offer of a lump sum can create considerable confusion and anxiety for older Americans, who are often not in a position to appreciate the risks they face and the losses they might suffer,” Norman Stein a senior policy advisor at the Pension Rights Center and a professor at Drexel University School of Law in Philadelphia said Monday in a statement.

“Retirees who choose a lump sum have to invest the money at the same time they are drawing it down, which is even harder than investing money before retirement. They will have to pay new fees, which will reduce their account balance, and fluctuations in the markets can destroy their investment portfolio with no time to make up the losses,” he added.

Experts say to date, only a small percentage — less than 5% of employers, including Archer Daniels Midland Co., Ford Motor Co. and NCR Corp. — have given plan participants currently receiving benefits the option to convert their monthly annuity to a cash lump sum. Typically, such offers have been made to former employees who have earned an annuity but are too young to start receiving the benefit.

The key reason that such offers have not been extended to retirees collecting benefits is the fear of adverse selection in which retirees in poor health would be more likely you accept than those in good health, experts said.

Finally, Mekanie Waddell of ThinkAdvisor reports, IRS, Treasury Halt Lump-Sum Buyouts for Retirees Getting a Pension:

The Treasury Department and Internal Revenue Service amended Treasury regulations last week to stop companies from offering lump-sum buyouts to retirees who already receive a monthly pension.

The agencies’ new guidance will apply to plans going forward and not to employers that have amended their plans to make lump-sum buyout offers to retirees prior to July 9, 2015.

Norman Stein, senior policy advisor to the Pension Rights Center and a law professor at Drexel University, said that the Center is “gratified that Treasury has moved to stop these lump-sum buyouts, which are truly among the most cynical and dangerous pension abuses we’ve seen.”

The Pension Rights Center has criticized these so-called “de-risking” transactions, which it says “erase the federal private pension protections of [the Employee Retirement Income Security Act], turn guaranteed lifetime retirement income into a onetime chunk of money that can easily be outlived, and often result in a significant loss of retirement wealth for elderly Americans.”

Earlier this year Stein authored a policy paper on lump-sum buyouts and annuity transfers — another form of so-called “de-risking” activities. The paper asks whether pension plan de-risking is bad, whether it’s legal, and whether it can be stopped, slowed or moderated.

Stein notes that the offer of a lump sum can create considerable confusion and anxiety for older Americans, “who are often not in a position to appreciate the risks they face and the losses they might suffer.”

Retirees who choose a lump sum “have to invest the money at the same time they are drawing it down, which is even harder than investing money before retirement,” he said. “They will have to pay new fees, which will reduce their account balance, and fluctuations in the markets can destroy their investment portfolio with no time to make up the losses.”

Some retirees may also be exploited by unethical financial advisors who gain to profit from a lump sum’s resulting fees.

By taking a lump sum, retirees also lose any guaranteed benefit for their spouses, should they die first. In fact, “offering a lump sum can be a form of corporate elder abuse,” Stein said.

I applaud the IRS and Treasury for clamping down on lump-sum pension payouts. America’s pensions are in peril and the last thing it needs is more lump sum payouts which will exacerbate pension poverty.

While lump sum payouts sound attractive, the truth is they place enormous pressure on individuals to invest the money wisely and even if they do, they still run the risk they or their loved ones will outlive these savings. In other words, lump-sum pension payouts are no substitute for defined-benefit pensions which provide steady and secure payouts for life.

And while most companies have not offered lump sum pension payouts to their employees, the trend to de-risk pensions is clear, and it’s important that regulators nip this trend in the bud as soon as possible.

More importantly, it’s high time U.S. policymakers enhance Social Security for all Americans adopting the same approach and governance that has allowed the Canada Pension Plan Investment Board to prosper and successfully manage the pensions of millions of Canadians. Enhancing Social Security in the U.S. and enhancing the CPP in Canada is smart pension and economic policy.

Photo by TaxCredits.net

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

Last week, Bloomberg reported, China Plans to Allow Pension Fund to Invest in Stock Market:

China will allow its basic endowment pension fund to invest in stock markets, according to draft regulations posted on the Ministry of Finance’s website.

The fund also will be allowed to invest in domestic bonds, stock funds, private equities, stock-index futures and treasury futures, according to the draft. The proportion of investment in stocks, funds and stock-related pension products will be capped at 30 percent of the pension fund’s net value, according to the proposed rules posted Monday.

Chinese stocks entered a bear market Monday, as the exodus of over-leveraged investors overshadowed central bank efforts to revive confidence with an interest-rate cut over the weekend. Chinese regulators are expected to take additional steps to steady the market, including possibly suspending initial public offerings.

“The access of the pension fund as a long-term investor will remarkably increase liquidity supply and will benefit the sustainable, healthy development of the stock market,” Wen Bin, a researcher at China Minsheng Banking Corp. in Beijing, said by text message. “The Chinese market will be stabilized by the policy.”

Feedback on the draft rules can be given until July 13, according to the statement. The basic pension fund’s outstanding value was 3.59 trillion yuan ($578 billion) at the end of last year, the official Securities Times reported in May.

Shanghai Tumble

Short positions held by the basic endowment fund in stock-index futures and treasury-bond futures shouldn’t exceed the book value of the targeted stock indexes or treasury bonds, according to the draft rule. Money can also be used in equity investments for restructuring companies or in public listings of major state-owned companies, it said. The money can only be invested domestically.

The Shanghai Composite Index dropped 3.3 percent Monday to close at 4,053.03, taking the decline from its June 12 peak to more than 20 percent, entering bear-market territory. The gauge swung between a loss of 7.6 percent and a gain of 2.5 percent on Monday, its biggest intraday point move since 1992.

The recent selloff brings to an end China’s longest bull market, a rally that lured record numbers of individual investors and convinced traders to bet an unprecedented amount of borrowed money on further gains.

Saturday’s interest-rate cut, along with assurances from the securities regulator that risks from margin trading are controllable, failed to ease concerns that speculators are unwinding their positions.

Today, Ian Allison of the International Business Times reports, China’s government says ‘don’t panic’ amid $3tn bursting equities bubble:

With all eyes on Greece, people probably don’t want to know about a Chinese equity market rout to the tune of $3tn (£1.9tn, €2.7tn), prompting the communist government to throw in “everything but the kitchen sink” in response to this bursting bubble.

Chinese equities have shed 30% of their value since around the middle of June as an army of 90 million individual investors, which dominate the Chinese stock market, have sold shares as prices have fallen.

To combat this the Chinese government has been shovelling cash into blue chip stocks and telling people not to panic.

Meanwhile, since Monday 6 July volatility has been taken to new levels: the Shanghai Composite lost 5.1% before finishing 1.3% down and the Shenzhen was down 5.59%, taking it nearly 14% off early Monday’s high, while the Shanghai Comp is 8% off these highs.

Maybe the Chinese government still finds it difficult to accept the fact that financial markets cannot be driven by policies and stock returns cannot be dictated by an authority.

Some 760 companies have suspended trading in their shares, equivalent to a freeze of $1.4tn, or something like one fifth of China’s stock market value.

Economic consensus states China needs a thorough transformation of its economy away from a growth model that’s based on exports and investments and in many cases over-investment that creates bad debt, to one that’s driven by the consumer economy.

But pumping up the economy is unsustainable and could have the opposite effect of offloading losses onto household sector.

The Chinese growth story has been driven by margin lending, a means by which investors borrow money to invest using shares or managed funds as security. In times of high growth this technique can boost returns, but it can also magnify your losses.

Another risky factor in this equation is the country’s large shadow banking system of non-bank financial intermediaries, using all manner of securitised vehicles and asset-backed means of market making.

Meantime, the nations’ media has again tried to lend its support to calm nerves with the Securities Journal suggesting that the Chinese economy has the basis of a long-term bull market.

People’s Daily reported: “Confidence is more precious than gold. That’s what Chinese investors need at this moment; confidence, not panic.”

Analysts at Rabobank said: “Basically, China had hoped an equity bubble would rescue its property bubble while not worsening the debt picture: those hopes look forlorn, with serious consequences for all of us.

“Most worrying is that there isn’t really much China can do at this point: if a retailer’s share price means it needs double-digit retail sales growth for 20 years ahead to get the Price-to-Book value back to a reasonable range, what difference will 25bp, 50bp, 75bp, or even larger reductions in benchmark interest rates, or equivalent cuts in reserve ratios, make? (Though that is unlikely to stop China’s journey towards ZIRP and QE, as the US, Japan, and Europe have shown.)”

Creating a sovereign fund to mitigate the non-fundamental shocks is generally a good idea for emerging markets, but to assign a political task to these funds that they need to support the market index to a certain level simply won’t work.

Pumping investment into stocks of large state-owned enterprises which are large cap stocks means the index is supported to an extent, but most of the other stocks still fall harshly, many of them more than 10%.

Assistant professor of finance Lei Mao, of Warwick Business School, said: “I am surprised at the actions of the government; these actions are like casting political pressures to modify the trading behaviour of investors or to blatantly dictate how investors should trade, just to meet the political goals the government wants to achieve from the stock market.

“If the government aims to sustain a healthy market as a venue for financing, the rise of state-owned enterprise stocks are only aesthetically meaningful, since these enterprises never need any financing and they are not good investments anyway.

“When you create a sovereign fund and the purpose is to achieve political value from a rising market, then the allocation of funds will inevitably be distorted.”

Professor Lei pointed out that the Chinese government has restricted public funds from selling certain stocks – particularly, the pension funds are not allowed to sell any stock. This kind of direct ban destroys portfolio reallocation in the current market conditions, and the market is again distorted.

“These distortions, in today’s market, create a significant flow of funds to large state-owned companies – a ‘flight to state’. Plus they might create the reasons for another free-fall in the near future.

“Even an optimistic investor should not participate in the market for now. The government should learn, if not from the long histories of other markets, from their own mistakes,” he said.

Lesson from Japan

A look back at Japan’s dramatic economic slowdown in the 1990s suggests several lessons for China. Forecasters were extremely slow to recognise how much Japan’s growth potential had dropped and the collapse of asset prices had profound and long-lasting effects.

Global growth was not very badly affected in the following decade, with advanced economies performing quite well, but there were negative regional spillovers that contributed to the Asian crisis in 1997-98.

Trade exposures of the major advanced economies to China today are mostly quite moderate and similar to exposures to Japan in 1990, with the exception of Germany.

Analysts from Oxford Economics said: “Asian countries have intense trade links with China, greater than they had with Japan 25 years ago. The direct impact of a sharp Chinese slowdown would be centred in Asia, as was the case following Japan’s crash in the 1990s.”

I’ve repeatedly warned you, forget Greece, it’s the China bubble you should be worried about. Bloomberg reports that China is suspending initial public offerings, creating a market stabilization fund and telling investors not to panic in an effort to shore up its stock market, which has had the largest three-week drop since 1992.

So China’s policymakers are very worried and as Vanessa Desloires of the Sydney Morning Herald reports, their ‘kitchen sink’ approach to slow sharemarket plunge is not working:

In three weeks, the Shanghai Composite Index has wiped off more than $3 trillion, or a quarter of its value, ending a spectacular bull run which saw the benchmark index rise as much as 150 per cent in the 12 months to June.

So what exactly being done to try and prop up the country’s see-sawing sharemarket, are the measures working? Are there any proverbial rabbits left in the hat to pull out?

Here are the measures, dubbed by market commentators as the “kitchen sink” approach, Chinese authorities have lobbed at China’s crashing market over the past fortnight:

The first stage saw China’s central bank using methods more akin to the quantitive easing we’ve seen from western jurisdictions this could be called…

The Backroom Phase

June 25

The People’s Bank of China (PBoC) lowers its 7-day reverse repurchasing agreements lending rate, an indicator of interbank funding ability, by 3.35 per cent to 2.7 per cent. This makes it easier for banks to get their hands on capital to lend.

June 27

PBoC cuts interest rates for the fourth time this year. Borrowing and deposit rates cut by 25 basis points to 4.85 per cent and 2 per cent respectively. Banks have their reserve requirement ratio – the amount of capital they have to hold to sustain their loans – cut by 50 basis points. This is the first time since 2008 both rates have been cut simultaneously.

June 29

Chinese government allows its state-owned pension funds to invest in the share market for the first time, injecting up to 1 trillion yuan into the market.

June 30

Lowers its 7-day reverse repo rate again, from 2.7 per cent to 2.5 per cent. This injects 50 billion yuan ($A10 billion) into financial system through reverse repos.

However these measures failed to arrest the slide, prompting policy makers to turn their attentions to trying to cheer up investors, particularly retail investors, this could be seen as….

The Charm Offensive

July 1

No retail investor likes fees and to kick off July, the Shanghai and Shenzhen exchanges announce plans to lower transaction fees for share trading by 30 per cent by August.

July 2

The very next day, the China Securities Regulatory Commission (CSRC) loosens rules on margin financing, changing its strict stance on the practice of trading shares on borrowed money. Margin lending, again to retail investors, is widely believed to be behind the market’s bull run earlier up to June.

July 3

The CSRC said it was investigating irregularities between securities and futures trading across multiple markets. Reuters reports a source saying the Chinese Financial Futures Exchange has banned 19 accounts from short-selling for one month.

But the charm didn’t swing the market prompting remarkable direction intervention from the government perhaps describable as the…

Do As You’re Told Phase

July 4

Some 28 companies which had upcoming initial public offerings are made to postpone their floats, and the China Securities Regulatory Commission said there would be no IPOs in the near term. There have been more than 200 IPOs this year alone and were heavily oversubscribed. The 21 top Chinese brokerages also agree to plough 120 billion yuan in blue-chip exchange traded funds, billed as a sharemarket rescue fund. They will hold the stocks as long as the SCI remained below 4500 (in Tuesday morning trade the index was at 3745).

July 5

State-owned investment firm Central Huijin had bought exchange-traded funds and promised to buy more.

The regulator CSRC said the PBoC will inject 250 billion yuan into 11 financial institions to increase liquidity in a bid to stabilise the sharemarket which has tumbled into bear territory. The State Council announces the establishment of a 100 billion yuan national insurance investment fund.

Local media reports Chinese state pension fund, the National Social Security Fund ordered its managers “not to sell a single share”.

Communist party newspaper The People’s Daily warns people “not to lose their minds” and “bury themselves in horror and anxiety” as the measures will take time to produce positive results.

July 6

The China Financial Futures Exchange imposes a daily trading limit of CSI 500 index futures effective to 1200 lots for rise and fall, effective from Tuesday, state media outlet Xinhua reported.

July 7

Trading halted in 25 per cent of listed shares representing 700 mostly smaller stocks.

The market fell again on Tuesday morning, down 4 per cent at noon AEST.

So perhaps we can say the market has not obeyed the government’s edicts.

So what happens now?

While Xinhua reported that the weekend’s measures were responsible for Monday’s 2.41 per cent rise, ANZ senior economist Jo Masters said they were “short term fixes”.

“A modest lift in the Shanghai Composite… may be soothing some nerves, but at what cost?” Ms Masters wrote.

“There is still a deleveraging process to go through, which risks tightening market liquidity conditions,” she said.

“Fundamentally, the Chinese economy has found firmer footing over the past two months due to policy easings,” Raymond Ma, portfolio manager of Chinese equities said.

“Although investment demand and exports remained weak, green shoots are emerging in key areas such as property sales and consumption.

“As fundamentals are improving, I am seeing more value in oversold sectors such as Chinese insurance companies, brokers and selected information technology plays, which have declined for 20 per cent to 30 per cent over the past month or so,” he said.

IG markets strategist Evan Lucas said however the central bank and government’s attempts to stem the bleeding “appears to be futile”.

“The next steps would be increasing liquidity funds even further, with the PBoC backstopping and increasing pension funds exposure as well, some state-owned pension funds are already doing this by banning their advisors from selling,” Mr Lucas said.

“That would be the scorched earth scenario, it would mean the regulator becoming one of the largest shareholders,” he said.

He added that while he expected the plunge to slow, the ramp up in the preceding 12 months had been “just as biblical”.

My advice to China’s policymakers, stop tampering with the markets, you’re only going to turn a steep correction into a deep depression. Your pension fund can invest in Chinese equities but if they don’t have the right governance and are told when to buy and sell equities, they’re doomed to fail and they will lose a pile of dough which will create an even bigger problem down the road.

I’m far more worried about China now than anything else. If its stock market bubble bursts in a spectacular fashion, it will wreak havoc on China’s real economy and reinforce global deflation pressures.

In fact, China’s central bank has already admitted defeat in war on deflation. At a time of slowing economic growth and massive corporate debts, a deflationary spiral would be China’s worst nightmare. It  could potentially spell doom for developed economies as China’s deflation will reinforce the Euro deflation crisis and potentially create global deflation that eventually hits the United States.

The global reflationists remain unfettered.  They say get ready for global reflation. I think they’re way too optimistic and confusing short-term trends due to currency fluctuations, neglecting to understand that the long-term deflationary headwinds are picking up steam. There is a reason why 30-year U.S. bond yields are plunging and it’s not just Greece. China and global deflation are much more worrisome.

Photo credit: “Asia Globe NASA”. Licensed under Public domain via Wikimedia Commons

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

Alexandra Stevenson of the New York Times reports, Calpers’s Disclosure on Fees Brings Surprise, and Scrutiny:

Earlier this year, a senior executive of the California Public Employees’ Retirement System, the country’s biggest state pension fund, made a surprising statement: The fund did not know what it was paying some of its Wall Street managers.

Wylie A. Tollette, the chief operating investment officer, told an investment committee in April that the fees Calpers paid to private equity firms were “not explicitly disclosed or accounted for. We can’t track it today.”

It was an unusual disclosure. In the world of public pension funds, Calpers is a big fish. It manages $300 billion in retirement funds for 1.6 million teachers, firefighters, police officers and other state employees and is generally credited with being the most sophisticated investor in the pension world.

For J. J. Jelincic, a member of the Calpers board, the disclosure raised a red flag. “I am disturbed that we don’t disclose the carry,” Mr. Jelincic said, referring to carried interest, the industry term for private equity performance fees. “I am appalled and, actually, I’m not sure I believe the staff when they say they don’t know what the carry is,” he added.

It also caught the attention of Edward A. H. Siedle, a pension fraud investigator and a former lawyer at the Securities and Exchange Commission. Mr. Siedle, who has investigated public funds like those in North Carolina, Alabama and Rhode Island, and corporate retirement plans for Walmart, Caterpillar and Boeing, is seeking to investigate Calpers with the help of crowdfunding. He wants to determine, among other things, how much Calpers pays in private equity fees. He plans to pay for his project by raising $750,000 from the public through the online platform Kickstarter.

“The money manager knows to a penny what the fees are,” Mr. Siedle said. “The only explanation is that the pension fund has chosen not to ask the question because, from an accounting and legal perspective, those numbers have to be readily available. They are intentionally not asking because if the fees were publicly disclosed, the public would scream.”

Calpers paid $1.6 billion in fees to Wall Street in 2014, according to its annual report. The figure, however, does not include how much it paid in carried interest. Both Mr. Siedle and Mr. Jelincic say that figure could be as much as an additional $1 billion a year.

Private equity firms typically charge investors a management fee of 1 to 2 percent of assets and about 20 percent of any gains each year. But fees for transactions, costs for monitoring investments and legal fees are not readily disclosed. Those undisclosed fees result in a substantial weight on returns, according to a recent study by CEM Benchmarking.

Faced with ballooning deficits and lackluster performance, state pension funds nationwide are beginning to examine more closely how much they are paying Wall Street to manage their investments. Calpers for the first time this year will begin to make more payments to retirees than it receives from contributions and its investments. Pennsylvania is facing a $50 billion shortfall in its pension fund.

In New York City, the comptroller, Scott M. Stringer, commissioned a study of the city’s five pension funds that showed external managers fell more $2.5 billion short of benchmark returns over 10 years.

Mr. Siedle’s firm, Benchmark Financial Services, recently published a crowdfunded investigation into Rhode Island’s public employee pension fund. In an 81-page report, Mr. Siedle outlined how the pension fund had incurred $2 billion in preventable losses from investments in outside real estate, private equity and hedge funds. Seth Magaziner, Rhode Island’s treasurer, has disputed the report.

“Treasurer Magaziner strongly agrees with the need for greater transparency and lower fees by alternative investment managers doing business with public pension funds,” Shana Autiello, a spokeswoman for Mr. Magaziner, said.

In addition to wanting to examine the fees that Calpers pays, Mr. Siedle also wants to scrutinize the relationship its executives and placement agents — middlemen it hires to help it find money managers — have with Wall Street to determine whether any conflicts of interest exist. He plans to spend nine months sifting through Calpers’s public disclosures and will also comb through the private offering documents that external money managers give to consultants who advise Calpers.

Calpers said it was trying to address the lack of transparency around fees. In April, Mr. Tollette, the chief operating investment officer, told the investment committee that Calpers planned to require greater disclosure from the private equity firms it invests in, adding that this was an industrywide problem. Calpers is also working on a reporting program that would track data from each external firm with which it has investments.

“Calpers has long been a leader in advocating for fee economies and transparency, including in private equity,” Joe DeAnda, a spokesman for Calpers, said. “A necessary element in that effort is additional disclosure and reporting from the general partners managing the funds,” he added.

The public scrutiny comes as Calpers seeks to simplify what it has called a complex and expensive portfolio. This month, Ted Eliopoulos, the chief investment officer, said that over the next five years, Calpers would cut by more than half the 212 external money managers it invests with for private equity, real estate and global equity funds. It will reduce the number of private equity firms to 30 from 98, giving those firms $30 billion to manage. Calpers has put its money with some of the biggest private equity firms in the world, including TPG, Blackstone, Carlyle and Kohlberg Kravis Roberts.

Last year, as part of its move to slim down its external investments, Calpers decided to liquidate $4 billion of hedge fund investments.

The S.E.C. has started to look more closely at private equity firms to understand how they value their assets and charge fees. The agency, which has conducted examinations of private equity firms, found that more than 50 percent of the time there were violations of law or weaknesses in a firm’s controls.

Mr. DeAnda, the Calpers spokesman, said fund officials had been “actively engaging with some of our private equity partners to help improve the disclosure and data available and have been closely monitoring the regulatory announcements and attention around this subject.”

Mr. Siedle’s investigation will not be the first for Calpers. In 2009, it hired the law firm Steptoe & Johnson to look at its use of placement agents as part of a wider pay-to-play scandal across the industry. The investigation, which cost Calpers $11 million, uncovered evidence of bribery and corruption. The S.E.C. accused Federico R. Buenrostro Jr., the Calpers chief executive from 2002 and 2008, and Alfred J. R. Villalobos, a former board member turned placement agent, with fraud. The United States attorney in San Francisco charged the two men with criminal fraud. Mr. Buenrostro pleaded guilty last year to conspiracy to commit bribery and fraud. Mr. Villalobos, who pleaded not guilty, committed suicide this year. 

Seeking to put the controversy behind it, Calpers adopted new policies and disclosure requirements. It continues to use placement firms.

This article covers a lot of hot topics. First, let me disclose that I sent an email yesterday to Ted Eliopoulos, CalPERS’ CIO, and Réal Desrochers, the head of CalPERS’ private equity, to see their response to the article. My email went unanswered, which is odd since Réal knows me well.

Anyways, let me share with you my thoughts. It’s utterly unacceptable for any limited partner (pension fund, sovereign wealth fund, insurance company, endowment, etc) not to know the fees it’s doling out to private equity funds. In the case of CalPERS, the largest most followed public pension fund in the U.S., it’s worse as it should publicly disclose all fees being doled out to each of their GPs (private equity and other external funds).

I simply don’t buy the excuses being doled out by CalPERS’ senior staff and agree with J. J. Jelincic, one of their members cited in the article, there’s no way that CalPERS’ private equity staff don’t know what the carry is on each of their fund investments. I know Réal Desrochers well enough to know that he holds that information on his fingertips and can easily disclose it to any board member.

So why isn’t he doing so? I don’t know but if I was a CalPERS’ board member, I would demand the information or simply fire him for failing to disclose these fees and violating his fiduciary duties. It’s simply unacceptable for any public pension fund, especially CalPERS which prides itself on good governance, not to disclose all these fees as well as hidden fees and all relationships with third party placement agents.

On the topic of placement agents, the scandal that rocked CalPERS over two years ago should have been a wake-up call to ban them altogether. Instead, this arcane practice fraught with conflicts of interests continues at CalPERS and elsewhere where millions are squandered on middlemen.

The fact that Mr. Villabos committed suicide is tragic and shows you how ugly things get when big money meets big pensions. The potential for fraud and bribes is huge and I simply don’t trust placement agents or underpaid pension fund managers enough to take their word that everything is kosher. I’ve seen enough shady things from “CFAs” and even well-paid pension fund managers on the take to know that bribing pension fund managers although rare, can and does happen.

Ted Siedle, the pension proctologist, should shine a light on all these fees and third party relationships. When it comes to public pensions, my philosophy is simple, I want to know every detail in terms of performance and money and fees being doled out to all external managers and third party providers like placement agents, lawyers, accountants, software vendors, consultants, and brokers.

People think fraud and bribes at pension funds can only happen with external managers but that is nonsense. I’ve seen pension fund managers schmoozing with brokers, consultants and third party vendors, pushing commissions to their favorite brokers while ignoring others who don’t wine and dine them, sending a contract to their consultant buddies or buying expensive and useless risk, back and front software systems without a proper request for proposal (RFP) and proper bid process, scrutinized by internal and external auditors.

The same goes for law firms, accounting firms, actuarial firms and investment consultants. There needs to be a proper bidding process and the public should know which firms are selected every year and how much money is being doled out and on what basis.

What else? As I stated in my recent comment on private equity stealing from clients, limited partners should be made aware of any rebates private equity funds enjoy with third party providers and these rebates should be discounted from the fees they pay these funds.

Folks, we live in an era of deflation, pension poverty, underfunded pensions and increased regulatory scrutiny. The good old days of fast times in Pensionland are over. Board members and beneficiaries are increasingly asking for more transparency on fees and performance, and they’re holding pension fund managers accountable if they’re not meeting their fiduciary standards. And regulatory bodies are increasingly paying attention to public pensions too.

But let me not be overly critical of CalPERS staff in this post, after all Ted Eliopoulos and Réal Desrochers are not to blame for past investment mistakes that cost the giant fund billions and they’re moving to streamline investments and lower fees by chopping in half the number of external managers in illiquid alternatives and by nuking their hedge fund investments.

Finally, I highly recommend you read a RIABIZ article, CalPERS’s hatchet man, Ted Eliopoulos, goes on a manager firing spree, shaving hundreds of millions in management fees — but is it enough?.

This article provides a very decent overview of what Mr. Eliopoulos and his investment staff have managed to do in terms of cutting external manager relationships. It states that for its most recent fiscal year, the pension giant paid $1.6 billion in fees, with close to 90% of that money going to the real estate, private equity, and egregiously pricey hedge fund managers. But again that $1.6 billion in fees doesn’t include carried interest estimated at over $1 billion. A billion here, a billion there, pretty soon you’re talking about real money!

As far as their new investment approach to private equity, the article ends by stating this:

In its statement earlier this week, CalPERS said it expects to change its fundamental approach to private-equity investment. Going forward, CalPERS plans to invest via separately managed accounts with its external managers instead of investing in general funds. These external SMAs are often less expensive than traditional private-equity arrangements and offer more control and transparency for investors. Typically, however, they require larger sums of committed capital.

“I think this is all part of a much broader push for transparency, structure and as well pricing, in the investments space. The ‘black box’ hasn’t sold well since Madoff,” says Will Trout, a senior analyst with Houston-based Celent. See: Nine threats to the RIA business and how they can be avoided.

Such consolidation is good news for private-equity giants like The Blackstone Group LP, Carlyle Investment Management LLC, Apollo Global Management LLC and TPG, each of which already manages multiple billions for CalPERS and has capacity to take even more commitments.

In a sign of things to come, the Wall Street Journal recently reported CalPERS was handing another $500 million to Blackstone Group for a fund over which CalPERS will have some influence.

Yet CalPERS also made it clear that these Wall Street Goliaths won’t be the only winners of the consolidation push. Pensions & Investments reported last week that the fund is setting aside $7 billion to significantly increase allocations to managers in its development program who currently manage assets only in the tens of millions — an act that has the look of deconsolidation.

That $7 billion is a pittance compared to what Blackstone (BX), Carlyle (CG), Apollo (APO), KKR (KKR) and TPG are going to get but at least they thought of setting some money aside for emerging managers and smaller funds. Every pension fund should be doing this through specialized funds of funds that can identify and track top emerging managers and smaller funds that fall under the radar.

As far as separately managed accounts with its external managers, unlike Canadian funds, CalPERS and many U.S. pension funds don’t have the investment staff to co-invest alongside their private equity managers, so this approach allows them to provide a big chunk of money to fewer relationships, squeezing them hard on fees.

Still, don’t kid yourselves, private equity is only trying to emulate Warren Buffett because it sees the writing on the wall and wants to increase the size of assets under management so it can keep collecting management fees and carried interest on a larger asset base.

Photo by  rocor via Flickr CC License

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

Alistair Gray and Josephine Columbo of the Financial Times report, OECD warns over pension scheme solvency as low rates bite:

Retirement funds and life assurers are in danger of being unable to keep their promises to pensioners and policyholders because of rock-bottom interest rates, the Organisation for Economic Co-operation and Development has warned.

Ultraloose monetary policy poses “serious problems to the solvency” of pension schemes and insurers as they struggle to produce enough income to fund their obligations, the group of rich nations said on Wednesday.

The warning from the Paris-based body is among the starkest yet about how institutions from Germany to the US can generate sufficient returns to meet their obligations without taking on extra risks.

In its inaugural annual business and finance outlook, the OECD identified the impact of cheap money from central banks on insurers and pension schemes as one of the biggest challenges facing economic policy makers.

“The current low interest rate environment poses a significant risk for the long-term financial viability of pension funds and insurance companies,” said the report.

The OECD raised the prospect the funds could be forced to cut payouts to retirees, saying they may have to “renegotiate” their promises to remain sustainable.

The organisation joins a growing chorus of economists and regulators speaking out about problems caused by historically low interest rates, as central banks from the eurozone to China try to stimulate economic growth.

Its assessment comes just three months after a similar warning from the International Monetary Fund, which said the European life insurance sector was facing “severe challenges”.

The problem arises because such institutions have little choice but to allocate a big chunk of their investment portfolios to conservative, low-yielding assets, notably government and corporate bonds.

The nature of their commitments prevents them from investing in potentially higher-returning but more risky securities, such as equities. Yet the cautious investment strategy they pursue has become increasingly problematic as bond yields have tumbled.

The OECD said it was growing concerned that the funds were being tempted to turn to alternative assets, such as private equity.

Presenting the study in Paris on Wednesday, Angel Gurría, the OECD’s secretary-general, said: “Pension funds and life insurers are feeling the pressure to chase yield . . . and to pursue higher-risk investment strategies that could ultimately undermine their solvency.

“This not only poses financial sector risks but potentially jeopardises the secure retirement of our citizens.”

While the report itself acknowledged there was a lack of detailed data to provide evidence for such an asset allocation shift, it said figures available for the UK showed that pension funds “may already be engaging in a ‘search for yield’”.

In response to the report, the UK’s National Association of Pension Funds, which represents 1,300 workplace schemes, said the switch into new asset classes did not necessarily mean they were taking on extra risk.

“Some of the underlying assumptions of the report do not necessarily hold true on the ground with UK pension funds,” said Helen Forrest, defined benefits policy lead at the NAPF.

“It is not necessarily taking extra risk in the search for yield, but finding alternative ways of providing the inflation-proofing the funds require.”

You can view the OECD’s new annual Business and Finance Outlook by clicking here. To view it in PDF format register and view it by clicking here.

What are my thoughts on all this? The OECD is right, ultraloose monetary policy is wreaking havoc on global pensions and life insurers looking for yield, forcing them to search for higher yielding alternative assets, but in my humble opinion, this report is missing something.

Importantly, why are central banks pumping so much money into the global financial system and why are ultra low yields here to stay, forcing pensions and insurers to take risks in illiquid asset classes and hedge funds?

Regular readers of my blog already know my answer. I’ve been warning you to prepare for global deflation for a very long time. Never mind what the reflationistas tell you. Forget about billionaire hedge fund managers warning you of the bigger short.

I’m warning all of you, in a world of rising inequality, structurally high long-term unemployment, pension poverty, and aging demographics, global deflation is virtually assured and it will decimate pension plans struggling with chronic underfunding.

Of course, fears of deflation seem to be fading in Europe but it is still too early to claim bond markets are signalling a decisive shift to a less worryingly-low inflation environment. Mark my words, this is only a temporary reprieve due to the lower euro. Deal or no deal for Greece, the structural problems plaguing the eurozone remain unaddressed, and deflation will come back to haunt the continent.

And it’s the specter of deflation that still worries me, central bankers and most intelligent economists, bond managers and hedge fund managers warning the Fed not to make a monumental mistake and start hiking rates too fast and too aggressively.

My fear is that they will sign another bogus “extend and pretend” deal for Greece, that Europe will stabilize somewhat in the coming months and the Fed will interpret this as a green light to start hiking rates in September.

Such a move would be catastrophic for the bond market and other markets suffering from liquidity constraints. A shift in monetary policy without an appropriate and sustained shift in long-term inflation expectations can precipitate a liquidity time bomb, bringing about another more pronounced global financial crisis.

As far as the shift into alternative assets like private equity, go back to read Ron Mock’s warning on alternatives as well as my recent comment on private equity stealing from clients. Private equity is an important asset class for pensions, one that has a fairly long-term focus and is a good fit in terms of asset-liability management but ultra low rates have pushed deal pricing to nosebleed valuations, which is why some think it’s time to stick a fork in it.

There are other problems with private equity. Yves Smith of the Naked Capitalism blog published a comment, “A Bad Man’s Guide to Private Equity and Pensions”, discussing how the surge in dividend recapitalization is loading private companies up with debt and jeopardizing private pension plans.

I’ve covered why private equity is eying dividend recaps and think this is a similar trend to what is going on in public markets where ultra low rates are inflating the buyback bubble, allowing corporate CEOs to artificially inflate earnings-per-share so they justify their pay which is spinning out of control. Meanwhile, average wages for workers stagnate as corporate profits are being plowed back into buybacks instead of hiring people, increasing wages or investing in research and development.

So, ultraloose monetary policy is driving inequality as corporate CEOs jump on the buyback bandwagon. It’s also making the top private equity and hedge fund managers obscenely wealthy as global pensions search for yield and “scalable alpha”.

Of course, none of this is discussed in any OECD, IMF or central bank report. Finance capitalism has serious structural problems, and unless policymakers and global pensions start discussing how they’re fueling extraordinary inequality, this trend will continue, decimating the middle class in all developed countries.

Again, rising inequality, aging demographics, high structural long-term unemployment and the global pension crisis are why I remain convinced that we are heading for an unprecedented and prolonged period of global deflation. Anyone who thinks we are on a path to global recovery is absolutely fooling themselves. The China bubble will only exacerbate this global deflationary trend.

Remember, the titanic battle of deflation versus inflation should be central to your investment approach and how you address market volatility. If you think deflation is dead, you’re dead.

Photo by  Horia Varlan via Flickr CC License

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

John Mauldin revisited the topic of U.S. public pensions in his latest comment: Live and Let Die:

When you were young and your heart was an open book
You used to say live and let live…
But if this ever-changing world in which we’re living
Makes you give in and cry… Say live and let die.

– Paul McCartney, the Bond movie theme, performed by Wings

I am not sure if my heart was ever that much of an open book, but I like to think I’m still relatively young. Nevertheless, I must admit that sometimes I want to “give in and cry.” This is especially so when I look at our nation’s public pension funds.

It’s not as if no one saw the problem coming. Experts, including your humble analyst, have been harping on it for decades. Politicians at all levels of government knew very well that a train wreck was inevitable and still did nothing. In some places, like Illinois, the politicians actually did something worse than nothing: they bought votes with promises of future benefits. Even worse, many states had their pension funds sell bonds, thinking they would be able to profit on the difference. Then along came the Great Recession. Oops. Stellar timing.

Now the future is here. Where are the benefits?

In this week’s letter we’re going to return to the worsening problem of public pensions. I offer an analogy between what is happening in Greece today and what will soon happen in Illinois. There are no easy solutions when you kick the can down the road, as politicians are going to find out.

An Unexpected Decade

Ten years ago this week my topic was “Public Pensions, Public Disasters.” Here is how I started this letter on June 17, 2005:

This week we will look with fresh eyes at an old problem: US pension funds, both public and private, are underfunded; and the situation is getting worse. And the US taxpayer is going to get to fund the difference. The recent slew of data on pension funds suggests that little is being done to correct the huge and mounting problems I have written about for years. Even the recent market upturns of the past few years have not been as big a help as they should have been.

I doubt anyone would have noticed had I led with that same paragraph today. Every word is just as true now as it was then.

• Pensions are still underfunded.
• The situation is still generally getting worse (with some exceptions, thankfully).
• Taxpayers are still going to fund the difference.
• Recent market upturns have helped some, but not as much as you might think.

I’ve visited the topic of pensions repeatedly over the years. Some of my headlines are darkly amusing in hindsight:

How Not to Run a Pension (my personal favorite)

Unrealistic Expectations

Nothing But Bad Choices

Rich City, Poor City

Why have we not hit the wall yet? In that 2005 letter, I wrote this, referring to corporate pensions:

Let’s look at a typical 60% stock, 40% bond asset allocation mix. Let’s generously assume you can make 5% annualized on your 40% bond portfolio allocation in the next ten years. That means to get your 8% (assuming a lower average target) you must get 10% on your stock portfolio. Now, about 2% of that can come from dividends. That means the rest must come from capital appreciation.

Hello, Dow 22,000 in 2015. Care to make that bet with me? But pension plan managers are doing precisely that.

Here we are in 2015, and the Dow is at 18,115, not 22,000. The 10-year average annual total return (including dividends) in the SPDR Dow Jones Industrial Average ETF (DIA) was 7.99% as of 3/31/15. Stocks lagged about 2% per year behind what I thought pensions needed to see.

If stock performance didn’t bail out pensions, what about bonds? Was assuming a 5% annualized return back in 2005 a good move?

Actually, it was. The iShares Core US Aggregate Bond ETF (AGG) had a 4.77% 10-year average annual total return through 3/31/15. If you focused just on government bonds with the iShares 20+ Year Treasury Bond ETF (TLT), you had an average annual total return of 7.93%. However, you have to realize that the majority of those returns were capital gains and not actual interest income. Since rates really can’t drop all that much from here, and we are in a low-interest-rate environment for the foreseeable future, those types of returns are not going to happen in the next 10 years.

So, a balanced pension fund would have done better than expected in bonds, almost enough to offset the worse-than-expected return in stocks. That bought some time, assuming that the politicians provided the necessary contributions. As we will see, in many states they did not, so things have gotten decidedly worse even as the market has risen.

It is not the case that all pension funds stayed balanced for the whole decade. We had some severe bumps in 2008-2009. More than a few pension managers tweaked their strategies in response. Adding alternative investments to the mix has been a popular enhancement. The degree to which they enhanced your performance depends almost entirely on the alternative managers you picked. And if you were picking by means of hindsight, relying on past performance, you probably didn’t pick good managers for the recent environment.

So, to generalize, most pensions had “OK” investment returns in the last ten years but not enough to catch up without increasing contributions from governments, which in the main did not happen. However, those returns at least kept them on an even keel. Until the next recession, that is. But the modest performance managers eked out most certainly did not give legislators the luxury of promising even higher benefits to their retirees. But – you guessed it – many politicians made those promises anyway.

Spending Money You Don’t Have on Promises You Can’t Keep

Unless you are a national government and can print your own currency, and with enough effective means to discourage would-be foreclosure, you can run a spending deficit for only so long. Greece is presently learning this the hard way.

State and local governments in the United States must, by law (with the rare exception), somehow balance their budgets. So must their pension plans. As of ten years ago, they were generally succeeding. Here is Census Bureau data for FY 2002-2003 (click on image):

Source: https://www.census.gov/govs/retire/ret03t1.html

State and local pensions had total receipts of $147.7 billion that year and total payments of $134.8 billion. This is aggregate data, so any given plan might have done better or worse. Still, the overall picture doesn’t appear to be bad. Why was I so worried?

As my mother would often remind me, appearances can be deceiving. I was worried because we knew the next tens of millions of Baby Boomers would soon start retiring, driving payment obligations sharply higher. Simply doing the math told us that even given the robust assumptions that pension funds were making, many pensions were going to be massively underfunded in the future. And if you made more realistic assumptions, there were numerous pension plans that were going to be in serious trouble.

Notice too that about half the total receipts came from earnings on investments instead of employee or government contributions. That’s important, as any portfolio manager knows, because you can’t spend an entire year’s earnings if you also need to accrue long-term capital gains. You have to reinvest. In fact, the bulk of planned payments in 30 years don’t come from current contributions but come instead from compounding returns on current portfolios. If you are using those current portfolios to pay benefits today, the money clearly will not be there. And every dollar you pay out today that should be used for investing means that eight dollars will not be there 30 years in the future. And that’s assuming you get the better-than-7% returns everyone is projecting they will make.

Now, let’s fast-forward ten years from 2003. The Census Bureau changed its data format, but I believe this is a comparable data set for 2013 (click on image).

Apparently, the Census Bureau also decided to pull investment earnings out of the contribution subtotal. Total 2013 contributions were $153.8 billion. Total payments were up to $260.8 billion in 2013, thanks to my fellow Baby Boomers. That would seem to leave a big deficit. It didn’t, because the plans also had $383 billion in investment earnings. About $107 billion of that went immediately to pay retirees.

Again, the problem with these numbers is that there is no guarantee investment earnings will be this high in any given year. That number could even be negative, as it has been at times in the past. Then what?

In 2013, CalPERS managed $230 billion. The fund calculates that it is underfunded by $80 billion. The management arrives at this number by assuming they will make 7.5% (which they only recently dropped from 7.75%). In 2009, they estimated that the fund was underfunded by only $49 billion. That means they missed their target by $30 billion in a roaring bull market.

In a December 2011 study, former Democratic assemblyman Joe Nation, a public finance expert at Stanford University, estimated that CalPERS’s long-term pension debt is a sizable $170 billion if CalPERS achieves an average annual investment return of 6.2 percent in years to come. If the return is just 4.5 percent annually – a rate close to what more conservative private pensions often shoot for – the fund’s long-term liability rises to a forbidding $290 billion. (Steven Malanga)

Last year I was in Norway. It has a sovereign fund that is larger than CalPERS but that benefits from some of the best management in the world. My talks with people involved in the fund and those who are very familiar with it suggest that they would be very happy to get 4% over the next 5–10 years. CalPERS ranks in the bottom 1% of all pension fund managers. Given all the resources they have, they are spectacularly bad at managing money. And when I say “they,” I mean the board of directors.

Malanga points out that CalPERS is a wholly owned subsidiary of the government-employee trade unions that control the board. He painstakingly chronicles the extent to which the unions dictate policy and investment decisions, leaving the professional management shackled.

And this is the issue. Nearly every public pension plan dramatically overstates its future potential income and returns, which makes the unfunded liabilities look better than they actually are. In coming weeks we’re going to be exploring in depth why the next decade is going to provide, on average, lower returns for pension funds and individual investors who are mired in traditional forms of investing.

In May, Moody’s downgraded Chicago bonds to junk status. One of their examiners pointedly asked, why is Chicago any different in Puerto Rico? Why indeed? My friend Mish Shedlock believes that Chicago is not alone in its misery. He thinks at least seven Illinois cities are in serious and immediate trouble. Detroit was not the last major city that will have to default on its obligations.

Sidebar: I know that many people invest in municipal bonds. Many of these, in fact most, are solid investments. Then there are some real dogs that are going to be extremely problematic. You need to look at, or have someone who is knowledgeable look at, bonds in your portfolios. I’m sure there are some properly run cities in Illinois, but I think I would throw the baby out with the bathwater there. There is no telling what politicians are going to require taxpayers in cities to do. It wouldn’t be the first time they took from the have-cities and give to the have-nots. Sadly, to my great chagrin and embarrassment, we did exactly that in Texas when we were forced to do so by judges.

State and local pensions, in aggregate, are running severely negative present cash flow. If we get a bad market year (and we will), they will have to dip into their principal, cut benefits, turn to taxpayers, or borrow cash. Local governments can also file bankruptcy; states can’t, except in theory. We may see that theory tested in the next 10 years.

None of those choices are good. If pensions have to sell into a falling market, cash flow will fall even more. Such a scenario probably means the economy is weak and tax revenues are falling. That makes raising taxes and issuing bonds problematic.

Cutting benefits might be the only choice. But guess what: in many states, cutting benefits to current retirees is unconstitutional. Let’s look at the dilemma this poses for one state.

Hello, Illinois, Anyone Home?

Courtesy of Bloomberg, here are the ten most underfunded state pension plans as of 2013, the latest available data. Notice how poorly – one could almost use the word disastrously – these bottom 10 states have performed in what has essentially been a bull market for the last five years. Their funding ratios have dropped anywhere from 15% to 25%. And that was in good times! (click on image)

Source: http://www.bloomberg.com/visual-data/best-and-worst//most-underfunded-pension-plans-states

Illinois has had the questionable honor of leading this list every year since 2008. For whatever reason, the state seems to be generous to its retired workers but reluctant to set aside enough money to actually pay for this generosity.

The situation is Illinois is unique enough to make Salman Khan use it as an example in his Khan Academy civics curriculum. I highly recommend watching his 7-minute presentation. He explains very clearly how Illinois arrived at this point.

Now, in their defense, the Illinois legislature tried to avoid the train wreck. In December 2013 they passed a package of reform measures after what sounds like an ugly fight.  Here is how the a described it at the time. (This attempt at reform bears review because what happened in Illinois may be coming to a state near you unless adequate action is taken immediately.)

The top leaders of both legislative houses, Democrats and Republicans, had cobbled together the bill and pushed strenuously for its passage, supported by the state Chamber of Commerce and the Illinois Farm Bureau. Union leaders and some Democratic lawmakers opposed it, just as strenuously, arguing that the bill fell too harshly on state workers who had paid into their pension plans over the years with the understanding that the benefits would be there when they retired. Some Republicans also opposed the bill, saying it did not trim enough to solve the state’s pension troubles.

“Today, we have won,” Gov. Pat Quinn, who made overhauling the pension system a focus of his administration, said in a statement after the vote. “This landmark legislation is a bipartisan solution that squarely addresses the most difficult fiscal issue Illinois has ever confronted.” He is expected to sign the legislation on Wednesday.

We Are One Illinois, a coalition of labor unions that opposed the bill, issued a very different assessment. “This is no victory for Illinois,” it said in a statement, “but a dark day for its citizens and public servants.”

The battle now turns to the courts, where union leaders have promised to take the legislation. Some opponents have asserted that it violates the State Constitution by illegally lowering pension benefits.

The plan’s architects said the measures would generate $90 billion to $100 billion in savings by curtailing cost-of-living increases for retirees, offering an optional 401(k) plan for those willing to leave the pension system, capping the salary level used to calculate pension benefits, and raising the retirement age for younger workers, in some cases by five years. In exchange, workers were to see their pension contributions drop by 1 percent. The measure also calls for the state to increase payments into the system by $60 billion to $70 billion.

As expected, the battle then moved into court. On May 8 of this year, the Illinois Supreme Court ruled unanimously that the changes violated the state constitution. That leaves Illinois back where it started.

In their written opinion, the seven justices showed zero sympathy for the state’s legislative branch. I thought this was outcome actually a bit refreshing. More from the NYT:

The court’s decision on Friday had long been predicted by legal experts here. In a 38-page written opinion, the justices sounded an unsympathetic note to suggestions that the state was forced to take drastic action when faced with what amounted to a financial emergency. The court noted that state lawmakers had, over decades, delayed or shorted what they should have contributed into the system, which covers state workers, teachers outside Chicago and others.

The General Assembly may find itself in crisis, but it is a crisis which other public pension systems managed to avoid,” Justice Karmeier wrote. He added later, “It is a crisis for which the General Assembly itself is largely responsible.”

Anyone who has raised teenagers will recognize this tone. Faced with the consequences of failing to plan ahead, they look to Mom and Dad for a bailout. The Illinois justices put the onus back where it should have been all along.

(I’ll quibble with Justice Karmeier on one point. In fact, many other public pension systems haven’t managed to avoid this problem. In many cases, politicians and other states have elected to do the same thing that Illinois did and have simply postponed the inevitable. Most of them will find themselves in the same sort of crisis at some point.)

Illinois must now go to Plan B, which is not going to be much easier. Governor Bruce Rauner wants to amend the state constitution to allow pension reforms. Passing such a bill will take a three-fifths majority of both the state house and senate, and then a minimum six-month wait before it can go to voters in the next general election. Then it has to get 60% in favor.

That process will almost certainly take years. In the meantime, the state has to keep paying benefits it can’t afford, which will force it to raise taxes and/or reduce other spending. Any of the choices will probably make the state less attractive to potential new residents and businesses, putting downward pressure on property values and tax revenue. There was an interesting chart in the Khan Academy presentation showing that pension benefits are now absorbing 50% of the Illinois budget for education, and the amount keeps rising every year. Either school taxes have to go up, or an already stressed system will become even more stressed. (On a side note, I have never understood why a seemingly sane man like Rahm Emanuel wanted to be mayor of Chicago. It’s like volunteering to be captain of the Titanic just as the ship scrapes into the iceberg.)

As I said, all the options are bad. Very bad. Be very careful before you throw stones at Illinois, however. Your state, county, or city may not be far behind. Especially if you are in California. And sadly, there are some parts of Texas that are going to be just as bad as Illinois within 10 years unless action is taken soon.

How Many Trillions Did He Say?

The problem will not solve itself. Something has to change. Let me note that some 12 years ago I was writing about how US pension funds were underfunded by $2 trillion. I was considered alarmist by many. It turns out that once again I was overly optimistic instead. Wharton Business School called the pension funding problem the “invisible crisis” in a recent report:

Wharton finance professor Robert Inman provided this cautionary perspective: … researchers who have studied this crisis have “corrected a fundamental flaw in the way that people were thinking about these unfunded liabilities.” The bottom line, Inman said, was that there were $3 trillion worth of unfunded pension liabilities at the state level, and $400 billion of unfunded liabilities at the large-city level. That turns out to be about $10,000 per American citizen. (emphasis mine)

When you throw in all counties and cities, it gets even worse! If you were to use what I think of as more realistic 10-year return numbers (which assume at least one recession) and a low-interest-rate environment for at least half that time, that number gets to be over $4 trillion!!!

Stop here a second. In the 2005 letter I quoted above, I pointed to research that the public pension shortfall could be $2 trillion in 10 years. I added exclamation points then, too, because the number was so alarming.

Here we are ten years later. After the rather impressive bull market that began in 2009, we now find that unfunded liabilities have doubled. Does anyone seriously think that the Dow is going to 50,000 by 2025? Or that long-term rates are going back to 5–6%? And even if both of those things were to happen, unfunded liabilities would still be significantly worse in 2025 than they are today.

But there are pockets of problems that simply cannot go without a solution until 2025. Inman noted, for example, that Chicago’s unfunded liabilities are 10 times its revenues. “Just assume that they’re going to have to pay 5% of that [number annually]. That means you’re looking at 50% of their cash that will have go to pensions.” Philadelphia, Boston, New York, Houston, and other major cities will face similar challenges. “What does it mean for cities to do this?” Inman asks. “If that number is 50%, then $1 has to get you back at least twice the benefits [you spend].” That’s a very high threshold for city services to have to meet.

It is obvious to me that there are no good solutions. Current taxpayers will wind up having to pay higher taxes and/or receive a lower level of services in return for their contributions. That means more potholes, fewer new roads, and less money for education and parks and all those things that make up a city. Or, as Inman noted, the “solution” can come in the form of lower property values. Higher taxes mean the value of your home declines relative to the cost of the taxes. That’s just a fact.

The ultimate losers will be the people who own those properties whose value declines. As Inman notes, there is no way that businesses and households “are going to move into a city unless they are absolutely certain that they will get dollars back for every dollar they spend.” Who wants to move into a city where 50% or more of your tax dollars are used to pay the pensions of people who were working and retiring well before you moved in?

Politics being what it is, the losing groups will be the most diffuse, unorganized ones: taxpayers and property owners. Until they revolt. There will be a backlash. You can only squeeze blood from a turnip for so long before the turnip gets annoyed.

Illinois residents are already getting squeezed. Their state taxes are high and going higher. Their home values may also be high; but, at the very least, growth in the value of those homes is going to slow down. Illinois homes may well lose value in the next few years, and possibly a lot of value.

Put yourself on the other side of the trade. Would you buy Illinois real estate right now? Not unless you can get it at a steep discount. If you’re a business owner, would you expand into Illinois, knowing you and your workers will payer higher taxes for reduced public services?

The answers are obvious, and not just for Illinois. What we see there will be only the dress rehearsal for similar problems in other states with underfunded pensions. They won’t all have the constitutional barrier that is gumming up the works in Illinois, but it won’t be fun anywhere.

For what it’s worth, the five states with the best 2013 pension funding ratios, according to Bloomberg, are Wisconsin, South Dakota, North Carolina, Washington, and Tennessee. Note that these are not all “red states.” Proper fiscal controls can happen under liberal politicians as well. In a previous letter I went through the data on underfunded cities. Many of those were, surprisingly, cities you would have thought of as conservative. Local politics being what it is, and given how surprisingly few people actually get involved in local politics, budget shenanigans can happen anywhere.

Why Illinois Is the Next Greece

Pension shortfalls are a thorny problem. I have great sympathy for people who devoted their careers to civil service and counted on a certain level of benefits. Depending on the city or state backing those benefits, many will not realize them in full. I have sympathy also for homeowners who aren’t going to see their investments pay off, and for average citizens who will have to suffer through traffic that is heavier and lines that are longer than they should be. We’re all going to feel this.

The one group I don’t sympathize with is the governors and legislators who approved pension deals they had to know were wildly unrealistic. Even worse are the consultants who told them the deals would work. A plague on both their houses. These politicians used public goods to buy votes and thought they could kick the can down the road forever. They were wrong.

Illinois is going to have a “come to Jesus moment” within the next few years. They will either have to amend their constitution to allow for reduced benefits, with all the weeping and wailing and gnashing of teeth that will accompany such a move, or the judges will force them to raise taxes or to reduce spending on other essential services, which will again be accompanied by weeping and wailing and gnashing of teeth by those being asked to pay ever-higher taxes for reduced services. You’re going to continue to see companies leave Illinois, when they can move across the state line and be more competitive.

The federal government will not come to the aid of Illinois. You will not be able to find a majority in the Senate willing to vote to bail out Illinois. That vote won’t fly back in their home states.

So why is Illinois like Greece? Because Germany and the rest of the “northern” countries have basically told Greece to get its budgetary act together and to do so on the backs of its own people. Tsipras is negotiating as hard as he can, but he simply has nothing to negotiate with. The Europeans are no longer scared that Greece might leave the EU. However, if Greece were to leave, it would owe some €95 billion against bank balances of what may now be less than €120 billion, as money flies out of the country.

Remember Cyprus? Its bank depositors were, in many cases, simply wiped out. 100%. Some banks were able to negotiate a $100,000 insured deposit, but not the largest banks, and only if they were allied with a non-Cypriot bank. Basically, that is what Draghi is going to tell the Bank of Greece: “If you default, we will take all the collateral, and that means the deposits, too.” That is precisely what they are allowed to do under the rules. And while the Eurozone is working towards implementing deposit insurance, those rules have not yet taken effect. I’ve seen estimates that Greek depositors could lose as much as €.95 on the euro.

That would of course mean a return of the drachma and immediate economic collapse, with even higher unemployment than the current 25%; and the government would almost immediately be thrown out. But of course, if Tsipras does what he will have to do, which is to accede to European (read German) demands, then there will almost immediately be a vote of no confidence, and he will not be reelected. Tsipras is a dead politician walking.

Germany and its counterparts are using Greece as a moral object lesson for the rest of the periphery. You can bet that Portugal, Spain, and Italy (and France!) are watching and realizing they have to become far more serious in their reforms. Not that they are not already trying, but they are going to need to double down on reforms.

Illinois is going to provide the same object lesson to the rest of the 49 states. You can look at the table we highlighted earlier and see whether your state is headed in the wrong direction. Many states are in relatively good shape, and a few reforms can make them even better. There are some cities that are disaster zones, and they will be sad cases; but a serious majority can fix their problems if their politicians start to take action now. Pension reform will not be popular with the unions; but, as we can see from Illinois, even relatively modest changes were unpopular, and now the state is careening towards a civic financial collapse.

On the other hand, the Democratic leadership in Rhode Island actually pursued and got reform. Other states and cities are doing the same. If your state is in pursuing reform and using more realistic assumptions about future returns, then it is up to you to support such moves.

A lot of people will choose simply to move rather than stay and fight the good fight. Sad, but true. The data clearly shows that there is a general tendency to move from high-tax states to lower-tax states. While my former governor Rick Perry likes to take credit for all the jobs that have been created in Texas, the real growth factor was corporations fleeing high-tax states to come to Texas. It was the Texas state legislature that was the driver on low taxes. For sure, Perry was the evangelist and took advantage of their wisdom. But there are many other low-tax states, and nearly all of them are benefiting.

I enjoy reading Mauldin’s comments on U.S. public pensions as he raises important points on just how unsustainable the current course is and why U.S. public pension funds are delusional.

Nonetheless, he has the typical conservative spin on things which leads him to conveniently ignore the real origins of this looming crisis and how to properly address it.

Importantly, unlike Mauldin and others, I take a more balanced approach when discussing public pensions. Dismantling public pensions and replacing them with ineffective defined-contribution plans will only exacerbate America’s retirement nightmare.

American policymakers love treating public pensions as an evil. To be sure, just like in Greece, there are abuses that are a flagrant travesty, but the real reasons behind America’s public pension problem is lack of proper governance and state governments that have failed to top up their pensions over the years (so they can spend money elsewhere!). Also, Americans need to introduce shared-risk in their public pension plans once and for all, so that all the stakeholders feel the pain when the plans are underfunded.

And as I’ve repeatedly stated on this blog, the cure to the “public pension disease” is often worse than the disease. For example, very few policymakers and economists understand  the brutal truth on defined-contribution plans and how they exacerbate pension poverty. Even worse, politicians and economists just don’t understand the social and economic benefits of defined-benefit plans.

Below, another well-known blogger and economist, Mike “Mish” Shedlock was recently interviewed by Gordon T. Long as part of his ongoing series on the retirement crisis on the Financial Repression Authority website.

Take the time to listen to Mish as he echoes a lot of what John Mauldin discusses above. Unfortunately, just like John, he misses the bigger picture on why America needs to enhance defined-benefit plans and Social Security for all Americans. But first they need to get the governance and risk-sharing of these public pensions right!!!

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

Jon Henley of the Guardian also reports, ‘Making us poorer won’t save Greece': how pension crisis is hurting its people:

Five years ago, Sissy Vovou’s pension was €1,330 (£953) and landed in her back account 14 times a year: you used to get, she wistfully recalls, a full extra month at Christmas, plus a half each at Easter and for the summer.

Now it is a monthly €1,050 – and there are only 12 months in the Greek pensioner’s year. “In all,” she said, “I’ve lost 30% of my income. And I’m one of the lucky ones. I’m in the top fifth; 80% of Greek pensioners are worse off than me.”

Vovou, 65, who began work at 17 in the publishing industry and ended her career at the state broadcaster, ERT, is also lucky because her son, now 40, has a good job and a regular salary. She does not need to help him out.

Eleni Theodorakis, on the other hand, retired in 2008 from her job as an administrative assistant in a regional planning service, aged 55. “My pension is €942 euros a month – not too bad, really,” she said, almost shamefacedly, fishing the statement out of her handbag.

“Fortunately my son is all right, just about, though sometimes he gets paid late. And once or twice, not at all. But my daughter’s husband has been unemployed for four years now. They have a baby … I give them what I can. It isn’t easy. Thankfully, my sister has a big garden. We grow things.”

There are many like Theodorakis among Greece’s 2.65 million pensioners. According to a study last year by an employer’s association, pensions are now the main – and often only – source of income for just under 49% of Greek families, compared to 36% who rely mainly on salaries.

With a jobless rate of about 26% – youth unemployment is at 50% – and out-of-work benefits of €360 a month generally paid for no longer than a year, pensions have become “a vital part of the social security net for many, many people,” said Vovou. “Retired parents are having to help their adult children everywhere. And now they’re demanding we cut them even more? It’s just so very wrong.”

Pensions have become arguably the biggest hurdle in the tortuous, on-off negotiations between the leftwing government of the prime minister, Alexis Tsipras, and Greece’s creditors: its eurozone partners, the European Central Bank and the International Monetary Fund.

Before they will release €7.2bn in aid that Greece needs to pay public-sector salaries and pensions and repay €1.6bn in IMF loans, those lenders want further reforms to the pensions system, including penalties to put people off taking early retirement and more cuts to even the lowest pensions.

Tsipras is so far refusing to implement the measures, aimed at shaving the equivalent of 1% of GDP off the country’s pension bill, arguing they will do nothing to help Greece emerge from a slump that has seen the country’s economy shrink by 25%, and may only deepen its humanitarian crisis.

There is little doubt Greece’s pensions system needed reform. The EU’s most expensive, at about 17.5% of GDP, it was made up of more than 130 different pension funds and hid widespread abuse: a pension census ordered in 2012 as part of the country’s bailout conditions turned up more than 90,000 entirely bogus claimants – mostly the relatives of long-dead pensioners – and 350,000 more inconsistent claims.

Greece also had a remarkable 580 professions deemed hazardous or strenuous enough to qualify for early retirement: firemen and construction workers, certainly, but also hairdressers (because of the chemicals), wind instrument players (gastric reflux) and radio presenters (microbes in microphones).

But some reforms are under way: those 130 funds have shrunk to 13, the standard retirement age for men has been lifted to 67, and, above all, since 2010 public and private sector pensions have been severely pruned, on a scale ranging from a 15%-cut for the very lowest (under €500 a month) to as much as 44% for highest (more than €3,000).

Greek pensions are now, on the whole, far from exorbitant: social security ministry figures show the average main pension is €713 a month, and the average top-up pension – typically funded by an industry retirement scheme – €169 per month. Some 60% of pensioners get less than €800 gross a month, and 45% live on less than the monthly poverty limit of €665.

The problems the system faces now are closely related to the country’s particular plight – and Athens is not alone in arguing that further flat, across-the-board pension cuts of the kind envisaged by its creditors are unlikely to accomplish much beyond hurting pensioners even more.

The record-high unemployment rate, for example, means the pensions system is running a big deficit: contributions coming in are forecast, this year, to be roughly €2bn less than benefits going out.

That shortfall has widened further because of the large number of older Greek workers seeking early retirement: demand is up 14% in the private sector and 48% in the public sector since 2009.

With unemployment among the over-55s at about 20%, compared to just 6% five years ago, “I felt it was the wisest thing to do,” said Ioannis Konstatinidis, who retired four years early from a large, now privatised bank in 2012.

“People were losing their jobs, salaries were being cut, and there was so much uncertainty I just thought it was better to be sure of getting at least something.” Konstatinidis has ended up getting nearly 40% less than he had counted on, however. “Our retirement will not be quite as comfortable as we’d thought. But we’re luckier than lots of people.”

They are. Among the pension cuts being proposed is the abolition of the EKAS, a variable supplementary payment made to nearly 200,000 Greek pensioners to bring their monthly income up to €700 a month. (Other suggestions made by Greece’s creditors would hit people like that particularly hard: a hike in the tax on electricity, for example, from 13% to 23%).

Few Greeks think further pension cuts will achieve anything. They may also be illegal: the country’s highest court has already ruled that the private-sector pension cuts pushed through in 2012 were unlawful because they “deprived pensioners of the right to decent life”.

Unsurprisingly, the country’s pensioners’ unions have called for a major demonstration against further cuts on 23 June. “The government must absolutely not give in,” said Anastassios Georgiadis, of the retired postal workers’ association. “And Europe has to understand that it is not by making us even poorer that Greece will emerge from this crisis.”

I recently discussed the plight of Greek pensioners in my comment on a Greek suicide, referring to articles from CNBC and Bloomberg, but also referring to comments Greek finance minister Yanis Varoufakis made in Germany in his keynote speech:

I am often asked: “Be that as it may, why have you not concluded the negotiations with the institutions? Why are you not agreeing with them quickly? There are three reasons why.

First, the institutions are insisting on economically unsustainable macroeconomic numbers. Consider three such crucial numbers for the next seven years: The average growth rate, the average primary surplus and the average magnitude of fiscal measures (e.g. new taxes, benefit or pension reductions). The institutions propose to us actual numbers that are inconsistent with one another. They begin by assuming that Greece should achieve an average growth rate of about 3%. That’s fine and good. But then, in order to remain consistent with their ‘goal’ of showing that our debt can come down to 120% of our national income by 2022, they demand primary surpluses in excess of 3%, with large fiscal measures to achieve these primary surpluses. The trouble here, of course, is that if we were to agree to these numbers, and impose upon our weak economy these highly recessionary fiscal surpluses, we will never achieve the above 3% growth rate that they assume. The end result of agreeing with the institutions on their unsustainable fiscal numbers is that Greece will, yet again, fail miserably to achieve the promised growth targets, with appalling effects on our people and on our capacity to repay our debts. In other words, the past five years of spectacular failure will continue into the future. How can our new government consent to this?

Secondly, we may be an ideological government of the Radical Left but, unfortunately, it is the institutions that carry ideological fixations that make it impossible to reach an agreement. Take for example their insistence that Greece should be a labour protection-free zone. Two years ago, the troika and the government of the time disbanded all collective bargaining. Greek workers are left to their own devices to bargain with employers. Labour rights that took more than a century to win were swept away in a few hours. The result was not increased employment or a more efficient labour market. The result was a labour market in which more than one third of paid labour is undeclared, thus condemning pension funds and the government’s tax take to permanent crisis. Our government has tabled a highly sensible proposal: To take the matter to the International Labor Organization and to have them help us draft a modern, flexible, business-friendly piece of legislation that restores collective bargaining to its rightful place in a civilised society. The institutions rejected that proposal, branding our stance “backtracking from reforms”.

The third reason why we have not been able to agree with the institutions are the social unjust and unsustainable measures that they insist upon. For example, the lowest of pensions in Greece amount to 300 euros, of which more than 100 euros are made up by what is known as ‘solidarity pension’, or EKAS. The institutions insist that we eradicate EKAS while at the same time proposing that we push value added taxes on pharmaceuticals (that pensioners relay upon) from 6% to 12% and electricity from 13% to 23%. Put simply, no government that has a smidgeon of sensitivity toward the weakest of citizens can ever agree with such proposals.

The Bloomberg article also quoted Varoufakis as saying this:

“Of course this pension system is not sustainable,” Finance Minister Yanis Varoufakis said in Berlin on June 8. “Any butcher can take a cleaver and start chopping things down. We need surgery. We need to find ways of eliminating early retirements, of merging pension funds, of reducing their operating costs, of moving from an unsustainable to a sustainable system, rationally and gradually.”

In his comment on a new deal for Greece, Varoufakis stated this:

Additional wage cuts will not help export-oriented companies, which are mired in a credit crunch. And further cuts in pensions will not address the true causes of the pension system’s troubles (low employment and vast undeclared labor). Such measures will merely cause further damage to Greece’s already-stressed social fabric, rendering it incapable of providing the support that our reform agenda desperately needs.

I partially agree with Varoufakis but as I’ve previously stated, he conveniently ignores to mention the single biggest problem with Greek pensions, namely, the total lack of proper governance which introduces real transparency and accountability. Instead, the people running these pensions are political appointees or union hacks who are completely and utterly clueless on proper pension governance.

Pension governance, or lack of, is the true cancer of the Greek pension and economic system. If Greek pensions weren’t forced by law to buy Greek bonds, maybe they wouldn’t have taken a huge hit when Greece restructured its debt in 2012.

Instead, you have a bunch of clowns that are politically appointed by the ruling government du jour running a number of public pensions that should have been consolidated a long time ago. No Greek government has ever taken pension management seriously. If they did, they would scour the globe to hire the best and brightest Greek pension managers, pay them properly and protect them from political patronage.

Who are these people? There are plenty of extremely sharp Greeks in finance and some of them have experience running large pension funds. One example is Theodore Economou, someone I’ve profiled on my blog and think very highly of. There are many others working all over the world.

But before Greece starts hiring “the best and brightest,” it should change its laws, introduce real governance like nominating a qualified independent board of directors, making public pension funds more transparent and a lot more accountable.

Of course, no Greek government wants to do this because good governance is anathema to the Greek way of life where corruption and inefficiency run rampant.

Keep all this in mind as the endgame for Greece and Europe plays out once again. I still maintain Greece will get some form of debt relief, but I’m worried that the country I love so dearly has fallen so far behind that no matter what deal it gets, it’s doomed for decades of economic weakness.

Photo  jjMustang_79 via Flickr CC License

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

Gretchen Morgenson of the New York Times reports, When Private Equity Firms Give Retirees the Short End:

Who comes first, the investors or the person who manages their money?

That question is crucial for any investor. But it poses a special challenge for retired firefighters, police officers, teachers and other employees who may not know that their retirement money is being held in private equity funds.

These are opaque and costly investment vehicles that borrow money to buy companies and sell them, ideally, for a profit. The secrecy under which this $3.5 trillion industry operates has essentially required millions of people whose pensions are invested in these funds to simply trust that they are being treated fairly.

Yet the funds impose fees under terms that create conflicts of interest between investors and general partners who run private equity firms. A little-known practice involves discounts that the firms obtain from lawyers and auditors but do not always share fully with investors. A dive into regulatory filings over the last month revealed that 12 private equity firms said they had actual conflicts of interest in connection with such discounts, while 29 more described potential conflicts. Altogether, the 41 firms oversee almost $600 billion in client assets, documents show.

The disclosures appear in documents the firms filed with the Securities and Exchange Commission as registered investment advisers. For example, Carlyle Investment Management, the $113 billion firm led by David M. Rubenstein, states that in certain circumstances, lawyers, auditors and other vendors charge Carlyle rates that are better than those charged to its investors. As a result, Carlyle receives “more favorable rates or arrangements than those payable by advisory clients or such portfolio companies,” the filing said.

Carlyle declined to comment.

The implications of such arrangements seem troubling: Wealthy private equity funds receive discounts on legal, accounting and other outside work while pension fund investors, like retired bus drivers, librarians and teachers, pay full freight or, in some cases, a premium.

These discounts — and the potential and actual conflicts associated with them — have drawn scrutiny from the S.E.C. The Blackstone Group, the private equity giant run by Stephen A. Schwarzman, said in a filing last month that the S.E.C. was looking at the firm’s practices “relating to the application of disparate vendor discounts to Blackstone and to our funds.”

Although Blackstone said it had changed these practices in 2011, documents it filed in March as a registered investment adviser note that its funds or portfolio companies — both primarily owned by investors — may still pay more in service fees than Blackstone itself.

“Advisers and service providers, or their affiliates, often charge different rates or have different arrangements for specific types of services,” the filing states. “Therefore, based on the types of services used by the funds and portfolio companies as compared to Blackstone and its affiliates and the terms of such services, BMP L.L.C. or its affiliates may benefit to a greater degree from such vendor arrangements than the funds or such portfolio companies.”

A Blackstone spokesman declined to comment further on the filing.

The S.E.C. declined to comment about the private equity firms’ fee practices. But in a speech last month, Marc Wyatt, acting director of the S.E.C.’s office of compliance inspections and examinations, told a private equity industry group, “We can expect additional enforcement recommendations involving undisclosed and misallocated fees and expenses as well as conflicts of interest.”

Private equity firms oversee the assets of endowments, wealthy individuals and pension funds — which indirectly expose huge numbers of unsophisticated people to them. The firms typically charge the investors 1.5 to 2 percent of assets annually, as well as 20 percent of any gains their portfolio companies generate. The firms usually require that the investments remain in the funds for at least five years.

Returns from private equity funds, once strong investment alternatives, have on average trailed those of the broad stock indexes over the last five years.

As returns diminished, investors focused on the sizable private equity fees. In addition to hefty management fees, they include charges for services like advice on mergers and acquisitions for companies in fund portfolios. Many investors have demanded that the firms reimburse them for a portion of such charges.

Regulators have identified certain fees as problematic. One example is the so-called monitoring fee, which investors pay to private equity firms, ostensibly for overseeing portfolio companies in the funds.

Often, though, the firms charged investors for the monitoring of companies no longer in fund portfolios. After the S.E.C. highlighted this practice last year, some firms, like Blackstone, stopped doing it.

According to Preqin, a data research firm, public pension funds’ investments in private equity totaled $321 billion in 2015, up from $248 billion in 2011. Some big pensions are throttling back, though. On Monday, the $300 billion California Public Employees’ Retirement System announced that it was reducing its private equity managers to 30, from 98, in a move to pare portfolio costs.

Calpers’s decision follows a series of disclosures that have emerged since the Dodd-Frank law in 2010 required private equity firms with more than $150 million in assets under management to register as investment advisers and make public filings about their operations.

In these filings, private equity firms delineate possible or realized conflicts posed by variations in service fees charged by outside law firms and others.

Consider a filing by Apollo Global Management, the private equity behemoth overseen by Leon Black. It states that Apollo and its funds receive discounts on plain vanilla legal work such as employment contracts and regulatory filings. Apollo and its investors also receive discounts, its filings show, on charges known as broken-deal fees, which arise when a proposed acquisition or sale of a portfolio company is not completed.

No discounts are given on investment transactions, including those charged to investor-owned funds managed by Apollo, however. In fact, Apollo says that for these transactions, outside service providers often receive a premium beyond the level of customary rates.

“Legal services rendered for investment transactions,” the filing states, “are typically charged to the Apollo Private Equity Managers, their affiliates and clients on a ‘full freight’ basis or at a premium.” Because investment transactions typically occur in investor-owned funds, they end up paying the bulk of the premium prices.

Apollo’s spokesman, Charles V. Zehren, said in a statement: “Apollo has long been a leader in implementing best practices relating to fee arrangements with service providers. The fee and discount structures that we have negotiated for Apollo are made available to our fund clients and to all portfolio companies that wish to participate.”

But J. J. Jelincic, a member of the Calpers board, has criticized the Apollo arrangement: Making investors pay higher prices, he says, allows the firm to reduce its own costs.

“It puts the lie to the fact that we are partners with the private equity firms,” Mr. Jelincic said. “We are simply a source of income to the general partners; we are not partners.”

Private equity investors have not typically been informed of the vendor discount arrangements or of the total amount of money involved. Several members of Calpers’s board and staff learned of the Apollo practice only recently, Mr. Jelincic said. They received a presentation about it from Michael Flaherman, a former chairman of the investment committee of the Calpers board who is conducting research into private equity as a fellow at the Edmond J. Safra Center for Ethics at Harvard University.

Mr. Flaherman declined to comment on the discussions.

Joe DeAnda, a Calpers spokesman, said in a statement: “Calpers has long been a leader in advocating for fee economies and transparency, including in private equity. We have been actively engaging with some of our private equity partners to help improve the disclosure and data available, and have been closely monitoring the regulatory announcements and attention around this subject.”

First Reserve Management, a $17 billion private equity firm with offices in Houston, London and Greenwich, Conn., is another whose filings indicate that outside vendors provide it with discounts that may benefit the firm more than its investors.

A First Reserve document states that “advisers and service providers, or their affiliates, may charge different rates or have different arrangements for services provided to First Reserve and its affiliates as compared to services provided to the First Reserve Funds and their portfolio companies.” That could hurt investors.

The document says it could result “in more favorable rates or arrangements than those payable by the First Reserve Funds or such portfolio companies.”

First Reserve did not respond to an email seeking comment.

In their S.E.C. filings, 12 of 41 firms with actual or potential conflicts of interest framed their discount arrangements as actual ones. For example, Freeman Spogli & Company a $4 billion private equity fund, said, “There is often a conflict of interest between the firm, on the one hand, and the funds and portfolio companies, on the other hand.”

The five New York City pension funds overseen by Scott M. Stringer, the city comptroller, invest with Apollo, Blackstone, Carlyle, First Reserve and Freeman Spogli. Asked how he views the potential conflicts relating to vendor discounts, Mr. Stringer said: “The S.E.C. has raised serious concerns, and we support them taking a hard look at this issue. It’s clear that we still don’t have enough transparency from our private equity partners.”

So far, few pension funds or other investors have complained publicly about the discounts.

The South Carolina Retirement System Investment Commission, with $30 billion under management, uses private equity funds heavily and invests with Apollo. Asked about the firm’s practice of letting investors pay a premium for some outside work, Michael Hitchcock, the commission’s executive director, provided a statement.

“We will continue to work with our managers to reduce the overall fees we pay,” Mr. Hitchcock said, “and will place a particular emphasis on availing ourselves of the opportunity for fee savings due to our managers’ relationships with third-party service providers.”

In some respects, these issues are as old as Wall Street, where the interests of financiers and their clients have not always been aligned. A trenchant book on the topic first published in 1940 remains a classic. It is by Fred Schwed Jr. and carries the plaintive title “Where Are the Customers’ Yachts?”

Today, it may be time to ask: Where are the customers’ discounts?

Indeed, where are the customers’ discounts and yachts? I’ve been warning my readers for a long time, stick a fork in private equity, it’s done! I’m increasingly concerned about how the liquidity time bomb will impact the industry and agree with Ron Mock, president and CEO of the Ontario Teachers’ Pension Plan, things are getting very frothy in private equity and other alternatives where valuations are being bid up to nose-bleeding levels.

The article above highlights another problem the industry is confronting, namely, increased regulatory and investor scrutiny over the fees being charged and whether clients enjoy the rebates large private equity firms enjoy with third-party service providers like auditors and lawyers.

In her latest assault on the private equity industry, Yves Smith of the naked capitalism blog comments, Carlyle, Apollo, Blackstone Cheat Private Equity Investors with Legal Fee Ruse,rips into the practice and ask whether pension fund fiduciaries are doing their job:

It appears that this story got to Morgenson by virtue of a former CalPERS board member turned private equity researcher presenting evidence of this practice to some CalPERS board members, and potentially to other pension funds as well. Board member JJ Jelincic, who has almost become a regular here by virtue of taking the rare role at CalPERS of digging into questionable private equity practices, gave the only sensible reaction of any of the investors quoted in the Times story:

“It puts the lie to the fact that we are partners with the private equity firms,” Mr. Jelincic said. “We are simply a source of income to the general partners; we are not partners.

By contrast, consider the misdirection in the official CalPERS comment:

Joe DeAnda, a Calpers spokesman, said in a statement: “Calpers has long been a leader in advocating for fee economies and transparency, including in private equity. We have been actively engaging with some of our private equity partners to help improve the disclosure and data available, and have been closely monitoring the regulatory announcements and attention around this subject.”

First, DeAnda exhibits precisely the sort of cognitive capture that Jelincic highlighted, that of thinking that someone who sees (and treats) you as a meal ticket should be thought of as a partner. But confusing legal structures with the actual economic relationship is pervasive among investors. Second, the fee issue is not a transparency problem. It’s an abuse of fiduciary duty. And it’s not remedied by ex post facto disclosure in Dodd Frank mandated SEC filings after the investment was made (Form ADV).

The New York City Comptroller, Scott Stringer, gives an even more lame response:

Asked how he views the potential conflicts relating to vendor discounts, Mr. Stringer said: “The S.E.C. has raised serious concerns, and we support them taking a hard look at this issue. It’s clear that we still don’t have enough transparency from our private equity partners.”

“We support the SEC taking a hard look.” How about doing your job for city retirees and asking some questions yourself? Aren’t you the one ultimately responsible for the handling of these funds? Not only does he want the toothless SEC to do his work for him, but he makes it clear he’s not interested in rocking the boat. All he wants is a “hard look”. It looks like Stringer is an ambitious enough pol that he does not want to alienate future campaign donors. And again, we have the “transparency” dodge and the mischaracterization of firms as partners when they are actually taking advantage of his dereliction of duty.

Another ugly bit here is that the law firms are complicit in this behavior, and many of them work both sides of the street. For instance, we wrote early on about how Boston’s blue-chippiest firm, Ropes & Grey, using it to warn the candidate we hoped would win the New York City comptroller’s race, Eliot Spitzer, was not only working on every side imaginable of private equity transactions, but was also taking advantage of a loophole in standard conflicts of interest waivers for its partners to take an economic position in deals ahead of and in clear conflict with that of its longest-standing client, Harvard. We didn’t bother addressing this post to Stringer too because it was clear he was too unsophisticated and spineless to take on private equity kingpins. So why aren’t investors at a minimum also asking law firms that represent them, if they also represent private equity firms, what their discount and other billing practices are?

And as readers are seeing, Stringer, who oversees a pension system that is one of the largest private equity investors in the US, typifies the complacency that makes pension funds such easy prey for private equity firms. It’s time that fund beneficiaries, meaning retirees, as well as taxpayers who are ultimately on the hook, start raising hell with state and local politicians who have a role in pension fund supervision.

Yves, aka Susan Webber, raises good points but she’s on a crusade against the private equity industry and adds too much conspiratorial sauce to her comments. Also, she discloses at the end of her comment “We have made a private equity whistleblower filing to the SEC.”

In other words, she’s looking to profit off her “investigative work” which is fine but it makes her comments far less impartial than she claims them to be.

As far as CalPERS, it recently made a wise decision to chop external managers in half, keeping the allocations to private equity, real estate and other illiquid alternatives, but reducing the number of funds. This follows a move last September where it nuked its hedge fund program.

As part of this shakeup, CalPERS just announced it topped up the war chest of Blackstone Group ‘s Tactical Opportunities team with another $500 million, deepening its multibillion-dollar footprint with the New York firm:

The nation’s largest public pension fund has been laying the groundwork to pledge larger checks to a handful of firms while cutting its total number of managers. In concentrating large amounts of capital with a few managers, limited partners are funneling more money to the biggest alternatives firms equipped to invest across a range of strategies.

Calpers’s latest commitment to Blackstone will be managed in an account customized for the $300 billion-plus pension fund, giving it a bigger voice in shaping the portfolio. This will bring Calpers’s pledges to Blackstone’s Tactical Opportunities platform to about $1.4 billion since 2012, a pension fund spokesman said. Calpers disclosed the pledge this week in an investment report.

This latest mandate from Calpers is a coup for Blackstone as the buyout shop-turned-alternatives firm looks to lock in more captive capital. Calpers’s latest pledge gives the Tactical Opportunities group, which cycles between various strategies and styles, extra firepower to bid for fast-moving deals.

Since the late 1990s, Calpers had committed more than $3.5 billion to active Blackstone partnerships as of Sept. 30.

The Wall Street Journal reported earlier this week that Calpers plans to slash the number of firms that manage its money to reduce costs and ease staffing burdens , which would potentially free up more capital for its key relationships. A spokesman said the pension fund hasn’t officially embarked on the cuts yet.

Blackstone has been successful in winning hefty mandates from public investors because it has cultivated the image that it can deliver returns even as it gets bigger, challenging the notion that returns suffer as a firm’s asset base grows and it is pressured to put more dry powder to work. This has helped shape the view that private equity can be a scalable business, said an investment official at another public fund with a sizable Blackstone exposure.

For more on how and where institutional investors are investing their money, check out LBO Wire.

This too is a good move if CalPERS bargained hard on fees and decides to finally scrutinize all costs these large alternatives firms are charging it. I’ve covered Blackstone’s David Blitzer in a previous comment of mine on the alternatives blitz bonanza, and think very highly of him and his team.

(In a separate move, Blackstone, which is the biggest real estate private equity firm, hired Jonathan Pollack from Deutsche Bank AG to be chief investment officer of its property-debt unit, which oversees almost $10 billion of investor capital.)

Of course, one problem with CalPERS strategy is it will give private equity “kingpins” more money and more clout. Also, the bifurcation of the private equity and hedge fund industry worries me because it’s the largest funds that keep garnering all the assets, making them less prone to focus on performance.

This is why I applauded CPPIB’s recent deal with GE, because it gives them immediate exposure to the mid-market space and they won’t be paying any fees to any private equity fund. The deal has risks but over the very long run these risks will dissipate and it has better alignment of interest with all their stakeholders.

As always, feel free to reach out to me if you have any comments on this topic (LKolivakis@gmail.com). Private equity is an important asset class but we need to remove all the secrecy that surrounds fees and costs. Period.

Photo by  Timothy Sulllivan via Flickr CC License

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

David Berman and Bertrand Marotte of the Globe and Mail report, CPPIB lands $12-billion deal for GE lending arm:

The Canada Pension Plan Investment Board has struck a $12-billion (U.S.) deal to acquire General Electric Co.’s private-equity lending arm, expanding its corporate lending capacity among smaller companies, where the fund had long sought a foothold.

The acquisition of Antares Capital is CPPIB’s largest deal to date. It is being backed by $3.85-billion of the pension fund’s own money, with the balance of the purchase price provided by debt from a consortium of international banks.

The deal is expected to close in the third quarter.

“It is extremely complementary to our existing business and that is why we are so interested in it,” said CPPIB chief executive officer Mark Wiseman.

Chicago-based Antares has a leading 20-per-cent share of the $96-billion business of providing loans for private-equity-backed transactions across industries. It specializes in the mid-market, focusing on companies with annual revenue as high as $1-billion.

The loans are generally rated below investment grade, and are therefore higher yielding than top-rated corporate debt.

CPPIB has an existing business lending larger amounts of money directly to companies, but the pension fund had been keen to expand its range.

“We had been undergoing a strategy review of the middle market for a number of years,” said Mark Jenkins, global head of private investments at CPPIB.

“So as soon as it became apparent that Antares was going to be one of the companies that was going to be sold, we knew that this was a good opportunity for us.”

CPPIB began discussions with GE in late April, soon after the U.S. conglomerate announced plans to sell off pieces of GE Capital, its finance arm.

The deal gives CPPIB about $11-billion in existing loans, mostly with durations under five years. The deal also comes with the Antares origination business, which will remain as a standalone unit under its existing management and brand name.

“Essentially, if we just bought the loan book, we’d be buying a melting ice cube. As the loans ran off, that portfolio would just wind down,” Mr. Wiseman said.

“What we’ve done is, we’ve bought the origination business that will continually refresh and replenish the portfolio. So essentially we’ve bought an ice cube that will never melt.”

He said other pension funds were likely rival bidders for Antares, but that CPPIB would consider bringing in partners as the deal progresses over the coming months.

“It’s our nature to partner,” Mr. Wiseman said. “If you look globally at what we do, we like working in concert with others.”

The Canadian fund manager is set apart from typical asset managers because of its long-term investment horizon and stable assets. It has been expanding into the United States to take advantage of the country’s relatively strong economic recovery but also as a diversification strategy.

CPPIB has a mandate to generate average annual returns of 4 per cent, after accounting for inflation. This can be a struggle when government bonds, once the foundation of pension assets, are yielding well below that figure.

CPPIB is “really pushing the envelope here and being creative about what is going to work over the next 10, 20 years,” said Keith Ambachtsheer, director emeritus of the Rotman International Centre for Pension Management at the University of Toronto.

“There are risks in this business, especially if rates start surging higher, but I know they have qualified staff to handle the risks of each deal,” said Montreal-based pension and investment analyst Leo Kolivakis.

The $265-billion (Canadian) Canada Pension Plan fund has delivered an average annual return of 6.2 per cent, after inflation, over the past 10 years.

However, its foray into riskier assets appears to be paying off. The fund delivered a return of 18.3 per cent in its 2015 fiscal year ended March 31.

Barbara Shecter of the National Post also reports, CPPIB expands its debt business in $12B deal to buy Antares lending unit of GE Capital:

The Canada Pension Plan Investment Board has struck a $12-billion deal to acquire Antares Capital, the U.S. sponsor lending portfolio of GE Capital.

The Canadian pension investment giant will retain the management of Antares, and a staff of about 300, to continue generating loans.

CPPIB is better known for investments in real estate and infrastructure assets and sectors such as retail, but executives said Tuesday’s transaction is in the same category as CPPIB’s purchase last year of a reinsurance business, Wilton Re.

Both businesses were purchased with a portfolio of financial assets – reinsurance contracts in the case of Wilton Re, and loans in the case of the GE unit – and operational expertise to replenish those portfolios.

“This acquisition exemplifies our strategy to achieve scale in key sectors through platform investments,” said Mark Wiseman, the chief executive of CPPIB, adding that the acquisition will help diversify the fund’s investment portfolio.

Executives said the strategy makes sense for CPPIB, which invests the funds not needed by the Canada Pension Plan to pay current benefits and looks to generate returns over decades.

“The book of loans [in Antares] is like an ice cube in that the loans will run off over time because they will be repaid,” said Mark Jenkins, global head of private investments at CPPIB. “The platform that we’re acquiring alongside that asset allows us to continue to replenish that loan book such that we don’t have a shrinking ice cube in our hands.”

The Antares deal expands the Canadian pension organization’s presence in the private debt business by firmly establishing it in the mid-market. The acquisition will give CPPIB the expertise to make smaller loans in private equity transactions than it has traditionally done through its direct loan business, which targets positions between US$50 million and US$1 billion.

Jenkins said the Antares Capital and Wilton Re acquisitions aren’t as different from traditional CPPIB investments as they appear on the surface.

“This is no different (than) any other company we would buy… whether it be Neiman Marcus that’s a retailer or Informatica (Corp.), which we announced, which develops and sells software,” Jenkins said. “We’re effectively buying a business where the main widget that they make or, if you will, create is a loan that they have with a middle market private equity sponsor.”

Antares, which is based in Chicago, will continue to operate as a standalone business governed by its own board of directors.

The purchase gives the Canadian pension giant access to the management team including managing partners David Brackett and John Martin, as well as the employees responsible for generating loans across the United States through offices in Atlanta, Chicago, Los Angeles, New York, and San Francisco.

Over the past five years, Antares has provided more than $120 billion in financing.

The acquisition is intended to complement and expand CPPIB’s principal credit investments portfolio. Formed in 2009, the principal credit investments group has invested more than $17 billion in global credit markets.

Jenkins said CPPIB has been looking to enter the mid-market for a couple of years. Customers tend to form strong relationships with their lenders, which leads to less turnover than in large-cap space, he said. Returns tend to better as well, due to better terms and stronger covenants for lenders than in the large-cap space.

CPPIB’s experience in the lending business and long-term investing horizon probably helped edge out competitors for the GE Capital business, Jenkins said, though the field of credible bidders would arguably have been small, given the specialized niche and ongoing funding requirements.

“I would say it was a very narrow group of institutions that could credibly put a bid in because of the scale of the transaction and also the certainty of funding,” he said.

“I think we had additional credibility because we know the business.”

Euan Rocha of Reuters also reports, Canada’s CPPIB to buy GE private equity lending arm for $12 billion:

Canada Pension Plan Investment Board (CPPIB) said on Tuesday it has agreed to buy GE Capital’s private equity lending portfolio for $12 billion, in a deal that will greatly expand the largest Canadian pension fund’s lending business.

GE’s Antares unit is the leading lender to middle market private equity-backed transactions in the United States. In the past five years it has provided over $120 billion in financing.

“This provides us with a very unique opportunity to access the U.S. middle market space via a very attractive platform,” said Mark Jenkins, CPPIB’s global head of private investments.

GE’s retreat from lending and a broader move to reduce its exposure to its finance arm comes as U.S. regulators move to curb aggressive lending practices. GE announced plans in April to sell $200 billion worth of finance assets as it focuses on its industrial products business.

In a separate statement, GE said it plans to continue to run the Senior Secured Loan Program – a joint venture between affiliates of GE Capital and affiliates of Ares Capital; and its Middle Market Growth Program, a joint venture between affiliates of GE Capital and affiliates of Lone Star Funds; for a period of time to provide CPPIB the opportunity to work with both parties.

If CPPIB is unable to reach deals with both parties GE said it plans to wind down its investments in those two programs.

With this deal, GE said it has now finalized $55 billion worth of asset sales and it remains on track to complete roughly $100 billion worth of asset sales this year.

“This was the biggest thing we wanted to get done early and we did it in 60 days from a standing start,” said GE Capital’s head, Keith Sherin, adding he stood by GE’s rough target for agreements for $20 billion to $30 billion in finance asset sales by the end of the month.

GE and CPPIB expect the deal to close in the third quarter, pending regulatory approvals. JPMorgan Securities and Citigroup advised GE on this transaction, while Credit Suisse and Morgan Stanley acted as CPPIB’s advisors.

CPPIB has invested over $16 billion in leveraged loans, high yield bonds, and mezzanine financings since 2009. This deal solidifies its foray into the lending sphere as it looks for investment opportunities for its roughly C$264 billion ($213.37 billion) in assets under management.

In his article, Scott Deveau of Bloomberg notes, Canada Pension Makes Biggest Bet Yet With $12 Billion GE Unit:

Canada Pension Plan Investment Board’s largest acquisition to date, the $12-billion purchase of a lending business from General Electric Co., is unusual for another reason: the Canadian firm did it alone.

The portfolio of loans in GE Capital’s U.S. Sponsor Finance business, and its management team, justified the risk of doing the deal without any partners, said Mark Jenkins, Canada Pension’s global head of private investments.

“When you put the two entities together, that’s the value for us,” Jenkins said in an interview.

The $12-billion price tag, of which Canada Pension paid $3.85 billion in equity, was a premium on the roughly $10 billion in loans on the books in the unit, called Antares Capital. The unit has a book value of about $3 billion, people familiar with the matter said last month.

Jenkins said it was justified. Already a lender for large companies globally, Canada Pension has had a harder time cracking the market for lending to smaller U.S. companies, Jenkins said. Canada Pension has C$265 billion ($215 billion) in assets.

“The comparative advantage Antares has is that you have long-term relationships with the middle-market sponsors, and that’s important,” Jenkins said. The management team, which will remain in place, was also an important component in generating future business, he said.

Another piece of GE’s business — an $8-billion Senior Secured Loan Program GE co-manages with Ares Management — was not included in the sale. Canada Pension remains open to talks with Ares about that business, Jenkins said.

Alternative Lenders

A U.S. regulatory clampdown on leveraged loans made by big banks has created a growth opportunity for alternative lenders, like the leveraged loan business. The U.S. Federal Reserve has discouraged debt levels from crossing certain thresholds and narrowed the window in which the loans must be paid down.

The measures have limited the lending power of big banks, Bobby LeBlanc, senior managing partner at Onex Corp., Canada’s largest private equity firm said last week.

“There is some constraint, but there is also alternative lenders that have popped up that are not regulated,” he said at an investor day. “Capital that’s not regulated always finds a way to our door.”

Major Divestiture

The deal marks the first major divestiture since GE announced a goal April 10 of unloading about $200 billion of GE Capital assets. Chief Executive Officer Jeffrey Immelt is speeding the exit of the banking division that imperiled the Fairfield, Connecticut-based parent company during the financial crisis.

GE Capital plans to continue to operate the joint venture with Ares for a period of time prior to closing to provide the parties an opportunity to work to together on a go-forward basis, the company said in Tuesday’s release.

If a mutual agreement can’t be reached, GE said it will retain the business so that it can execute the orderly wind down of the program.

You can also read an excellent article from the Canadian Press published in the CBC which points out the following:

CPPIB has been attracted to the U.S. middle market — which would be served by commercial banks in most countries, including Canada — by the structure of the loans, the lower loss rates and a stable customer base, Jenkins said.

Part of the reason the business has been very resilient through the ups and downs of the economic cycle is the relatively short duration of the loan agreements.

“These loans, on average, will mature after four years or be refinanced. So you’re constantly replenishing that loan book at different times through the cycle and you can adjust pricing.”

The Toronto-based fund manager will spend $3.85 billion to buy 100 per cent ownership of Antares Capital from GE Capital. The rest of the $12-billion transaction is in the form of new debt from a syndicate of global banks that will be used to run the business, Jenkins said.

Jenkins wouldn’t reveal what rate of return CPPIB expects from the Antares investment but said it’s in line with the overall investment portfolio on a risk-adjusted basis.

GE strategy to sell

The CPP Investment Board oversees about $264.6 billion of assets on behalf of the Canada Pension Plan, which is funded by employee and employer contributions. The CPPIB invests surpluses that will eventually be used to supplement retirement payments for about 18 million contributors and beneficiaries.

General Electric said earlier this year it plans sell most of the assets of its GE Capital financial arm over the next 18 months, but planned to keep components that relate to its industrial businesses.

In its announcement from Fairfield, Conn., GE Capital said it will provide time for CPP Investment Board to work towards forging relationships with two partners of its U.S. Sponsor Finance business — which is primarily made up of Antares Capital.

Jenkins said CPPIB is willing to negotiate but the outcome won’t affect its purchase of Antares.

The deal is expected to close in the third quarter, subject to regulatory approvals.

Lastly, I highly recommend you take the time to read CPPIB’s press release on the deal:

Canada Pension Plan Investment Board (“CPPIB”) announced today that an affiliate of its wholly owned subsidiary, CPPIB Credit Investments Inc. (“CPPIB Credit Investments”), has signed an agreement with GE Capital to acquire 100% of the Company’s U.S. sponsor lending portfolio, Antares Capital (“Antares” or “the Company”), alongside Antares management for a total consideration of US$12 billion. The transaction is subject to customary regulatory approvals and closing conditions and is expected to close during the third quarter of 2015.

Based in Chicago, Illinois, Antares is the leading lender to middle market private equity sponsors in the U.S., offering a “one-stop” source for lending and other services to middle market private equity sponsors within a US$96 billion a year market. Over the past five years, Antares has provided more than US$120 billion in financing.

“This acquisition exemplifies our strategy to achieve scale in key sectors through platform investments. It secures a market-leading business that is exceptionally well positioned to deliver value-building investment flows,” said Mark Wiseman, President & CEO, CPPIB. “In doing so, we are advancing the prudent diversification of our investment portfolio, strengthening the Fund even further.”

Upon closing, Antares will operate as a standalone, independent business governed by its own board of directors. The Company will retain the brand most associated with its long and impressive track record in the U.S. middle market, Antares Capital, and the team responsible for its long-term success led by its Managing Partners, David Brackett and John Martin. The acquisition will expand and complement CPPIB’s existing Principal Credit Investments portfolio.

“We have been studying the attractive economics of the U.S. middle market lending sector for several years. Antares represents a rare opportunity to invest in the leading lender in this segment of the market and involving companies owned by private equity sponsors,” said Mark Jenkins, Senior Managing Director & Global Head of Private Investments, CPPIB. “With this single transaction, we immediately acquire turn-key scale and a long-term partnership with the best, most experienced management team in the market. This business is extremely complementary to our existing business, which is not focused on the middle market.”

Antares’ core business is diversified across multiple industries and sponsors, and the mid-market segment provides attractive supply/demand dynamics due to the changing landscape of lenders in this space. Antares will be a highly strategic, long-term platform investment for CPPIB Credit Investments.

“The management team has done an excellent job in growing and managing the business, and we look forward to working together with the entire Antares team to further grow the business over the long term,” said Mr. Jenkins. “In acquiring these highly prized assets, we are able to leverage our comparative advantages of a long investment horizon and a stable capital base. We view Antares as a long-term addition to our portfolio and we are confident that it will provide CPPIB access to these attractive assets for the long term.”

CPPIB Credit Investments will be partnering with Antares’ entire seasoned management team and its approximately 300 employees. Antares has successfully built long-term relationships with more than 300 middle market private equity sponsors over many years.

“We are excited to partner with CPPIB. We couldn’t imagine a better outcome to the sale process for our team or our customers,” said David Brackett, Managing Partner, Antares Capital. “CPPIB brings deep understanding and knowledge of our market and permanent capital, which will allow us to serve our customers in both good and challenging times. We also look forward to continuing to offer our clients our existing best-in-class financing products and anticipate broadening our capabilities.”

CPPIB Credit Investments’ desire and intention to invest follow-on growth funding at scale into the Antares platform and significant access to capital, should position Antares to grow and prosper for decades to come. CPPIB Credit Investments will stand ready to immediately invest follow-on capital into Antares post closing to support origination of unitranche loans for its clients at scale, as we believe this is a differentiated product that will support Antares’ market leading position.

“In partnering with CPPIB, Antares is ideally positioned to continue, and expand upon, its market leading support for our private equity sponsor client base,” said John Martin, Managing Partner, Antares Capital. “In CPPIB we will have a strategic owner who is committed to our business model, with unparalleled capital resources. Additionally, this partnership will allow Antares to better address the realities of today’s leveraged lending environment. Our team will invest side by side with CPPIB Credit Investments and is thrilled about having the opportunity to build our franchise in the years ahead.”

With investments and 36 professionals in the Americas, Europe and Asia, CPPIB’s Principal Credit Investments (PCI) group focuses on providing financing solutions both globally and across the capital structure. The group makes direct primary and secondary investments in leveraged loans, high yield bonds, mezzanine, intellectual property and other solutions. PCI participates in unique event-driven opportunities, such as acquisitions, refinancing, restructurings and recapitalizations, and targets positions between US$50 million to US$1 billion in any single credit. The team underwrites on a standalone basis or with select partners depending on the investment opportunity. Since its first investment in 2009, the group has invested over US$17 billion in the global credit markets.

Now, let me briefly provide you with my thoughts on this mega deal:

• CPPIB is over-exposed to large private equity funds where it pays hefty fees to invest with top global funds and co-invest along with them on bigger deals  (it pays no fees on co-investments but still needs to invest with big funds to gain access to the bigger deals).
• In order to diversify the private equity portfolio away from this large-cap space into mid-market space, it would have to find many mid-market funds, paying out even more fees, to properly diversify its private equity portfolio into the U.S. mid-market.
• When GE announced it was divesting from some of its financial business for regulatory reasons, a gift was presented to CPPIB and Mark Jenkins and his team pounced on the opportunity.
• By buying Antares Capital from GE Capital at a premium, it made GE very happy and CPPIB will gain exposure to the U.S. mid-market space on a massive scale, avoiding paying fees to mid-market private equity funds.
• More importantly, CPPIB is buying a well established lending business generating steady cash flows as the loans mature relatively quickly and will be able to leverage off the senior managers of Antares Capital to gain important insights on the U.S. economy, insights no other pension fund in the world will be privy to.
• Also, by buying the business directly, it will keep operations going and will benefit from the origination and underwriting activities of this business and be able to use the knowledge of these senior managers as a source for consulting them on other deals (it remains to be seen how they will compensate these senior managers but it’s fair to say they will be the highest paid employees at CPPIB).
• For its part, Antares gets a solid partner with a long investment horizon. No more worrying about quarterly earnings results or big downturns in the economy, this deal will allow them to focus on the long run and building up the capacity of their business to an unprecedented scale. There were big private equity funds bidding for this business too but they aren’t the right fit because their investment horizon is much shorter than that of CPPIB. Antares will also benefit from synergies with CPPIB and their huge network of expert partners and bankers.
• There was a premium paid but in my opinion, it was justified as the returns and knowledge transfer from this deal over the very long-run will more than offset this premium.
• With this deal, CPPIB will be placed in an enviable position, one that others can only dream of. However, I wouldn’t be surprised if other large Canadian pension funds are asked to join them on this deal. That all remains to be seen.

Having said this, I want to temper my enthusiasm a little because I’ve worked as a senior economist at the Business Development Bank of Canada (BDC), a Crown corporation that among its functions, primarily assists Canadian banks to provide loans to small and medium-sized businesses. The mid-market space is much riskier than the large-cap space because it’s more economically sensitive, which is why the returns are better (to compensate for the extra risk).

Go back to read my comment on hedge funds preparing for war where I wrote:

[…] hedge funds and private equity funds are now lending to small businesses starving for credit. Having worked as a senior economist at the Business Development Bank of Canada (BDC), a Crown corporation that finances and consults small and medium-sized enterprises, I can only wish these private debt funds a lot of luck making money in this area.

True, U.S. job growth rebounded last month and the unemployment rate dropped to a near seven-year low of 5.4 percent, which bodes well for lending to small and medium-sized enterprises, but there’s still plenty of slack in the economy with the number of Americans not in the labor force rising to a record 93.2 million (most of those unemployed are women). Moreover, America’s risky recovery poses serious challenges to the economy and can come back to haunt these private debt lenders.

This is particularly true if a liquidity time bomb is triggered by the Fed and global deflation comes back to haunt us, spreading to America. At a recent AIMA luncheon I attended many participants dismissed this possibility stating we should prepare for global reflation. 

But I’m still very worried and agree with Michael Feroli of JPMorgan Economics, there is a new structural slowdown for the U.S. economy and America’s retirement nightmare will exacerbate this slowdown.

In a recent and excellent interview you should all read, David Brackett, CEO of Antares, stated that the interest rate environment is “favorable” adding this on how high interest rates would need to rise to impact mid-market lenders:

…because you are dealing with two components, leverage levels and interest rates, that are variable, it is tough to figure out where that would be. Leverage levels could likely expand from where they are today. If we look at our performance in the crisis, our losses were minimal and our private equity sponsors were really supportive. I think we’re in a very favorable interest rate environment. There would have to be a major movement in rates, which isn’t happening.

I hope he’s right and while some hedge fund gurus are warning of the bigger short, I’m far more worried about global deflation and a new structural slowdown in the U.S. and global economy.

One private equity expert shared this with me on this mega deal with GE:

Deal looks strategic, not something they will sell onwards to someone else in a few years, so that is probably why they have no partners. Seems like a good fit for CPPIB, and captures more economics around their broader belief in the private markets. That said, it does feel like a market/credit cycle top type of transaction.

He added this: “Most notable is CPPIB putting more profile to Mark Jenkins,” to which I replied: “Yup, they’re grooming him to be the next Mark Wiseman” (he has big shoes to fill there).

So take a good look at Mark Jenkins, CPPIB’s global head of private investments (a Goldman alumnus), because I guarantee you he’s next in line once Mark Wiseman decides to step down.

Finally, while this deal has risks and has a nice premium attached to it, I think the synergies between CPPIB and Antares will far outweigh all the risks and it was a great deal for all parties involved, including GE (a core holding of the Oracle of Omaha).

More importantly, from a policy perspective, this deal illustrates why the federal government should move quickly to make mandatory enhancement of the CPP our country’s new retirement policy. CPPIB delivered exceptional results in fiscal 2015 and will continue to do so over the very long run by investing in public and private markets through funds and direct investments which lower the costs to the fund.
Photo credit: “Canada blank map” by Lokal_Profil image cut to remove USA by Paul Robinson – Vector map BlankMap-USA-states-Canada-provinces.svg.Modified by Lokal_Profil. Licensed under CC BY-SA 2.5 via Wikimedia Commons

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, Calpers to Cut External Money Managers by Half:

The largest U.S. public pension fund intends to sever ties with roughly half of the firms handling its money, one of the most aggressive industry moves yet to reduce fees paid to Wall Street investment managers.

The California Public Employees’ Retirement System, or Calpers, will tell its investment board on June 15 of its plans to reduce the number of direct relationships it has with private-equity, real-estate and other external funds to about 100 from 212, said Chief Investment Officer Ted Eliopoulos. The action will be made public on Monday.

The dramatic move by the $305 billion Sacramento-based retirement system will create some big winners and losers in the investing world. The list of external money managers Calpers uses include some of the biggest names on Wall Street, including private-equity firms Carlyle Group LP, KKR & Co. and Blackstone Group LP.

The push by Calpers to downsize could have broader ramifications beyond its own portfolio. Calpers is considered an industry bellwether because of its size and history as an early adopter of alternatives to stocks and bonds, and the shift could prompt other U.S. pensions to scale back their ties to Wall Street.

“There really will be a significant amount of discussion at other pensions” about whether they should cut external managers in the wake of Calpers’s decision, said Allan Emkin, a managing director at Pension Consulting Alliance who has advised the fund since the 1980s.

The pullback would take place over the next five years and is expected to save Calpers hundreds of millions of dollars in management fees. It paid $1.6 billion to external managers last year.

The reduction in outside managers won’t fundamentally change Calpers’s investment strategy, or the percentage of assets managed in-house versus externally. The remaining 100 or so outside managers will simply get a bigger pool of funds varying from $350 million to more than $1 billion, Mr. Eliopoulos added.

The goal, Mr. Eliopoulos said, is “to gain the best deal on costs and fees that we can.”

The 50-year-old Mr. Eliopoulos became the pension fund’s top investment official last September after helping Calpers recover from severe losses sustained during the 2008 financial crisis as head of its real-estate portfolio. His first major move as chief was to shed a $4 billion investment in hedge funds, part of a movement to simplify the approach of a fund that in recent decades loaded up on assets such as real estate, private equity and commodities.

Fees paid to outside managers have ballooned over the past decade as many public retirement systems followed Calpers into hedge funds and private equity in an attempt to boost long-term returns and meet their mounting obligations to retirees. But now some pension officials are tiring of the high expenses often charged by outside managers as state and local governments struggle to make up for losses incurred during the financial crisis. Many U.S. pensions, including Calpers, still don’t have enough assets to cover their future costs despite a run-up in the stock market in recent years.

“Fees are becoming an increasingly scrutinized area at public pensions,” said Jean-Pierre Aubry, an assistant director at the Center for Retirement Research at Boston College.

In New York City, outside money-management expenses are under review after an April report from Comptroller Scott M. Stringer said external investment firms have cost the city’s local retirement systems billions in the past decade. A similar discussion is under way in New Jersey, where state pensions have paid out $1.5 billion in fees over the past five years, according to a recent report presented to the state Senate last Thursday.

In Pennsylvania, where the state is grappling with a $50 billion pension hole, Gov. Tom Wolf declared in a March budget address that “we are going to stop excessive fees to Wall Street managers.”

California’s proposed reduction in outside managers is part of a larger effort to reduce risk and complexity at a fund that manages investments and benefits for 1.7 million current and retired workers. Calpers posted a total return of 18.4% for its most recent fiscal year ended June 30, beating its benchmark, but it only has enough assets to cover 77% of its future retirement payouts.

As recently as 2007, Calpers had about 300 external managers—a remnant of its pioneering foray into alternative investments such as real estate, hedge funds and private equity. Over the past eight years, it reduced that number to 212, but it is still difficult for the pension fund to effectively monitor all of its investments, according to Mr. Eliopoulos.

There are so many outside managers currently that Calpers doesn’t have the ability to make sure all those funds share the same objectives as the large California pension fund and are performing well, according to Calpers Chief Operating Investment Officer Wylie Tollette.

“We need to do a better job of keeping track of how those managers evolve, what strategies they’re good at, what they may not be good at to ensure they’re effectively earning their place at the table every year,” said Mr. Tollette, who currently gives Calpers a “B-minus” at doing those tasks.

“For an organization like Calpers we need to be an A, if not an A-plus,” Mr. Tollette said.

As a measure of overall assets, Calpers currently pays about 0.34% toward management fees, Mr. Tollette said. In 2014, the $1.6 billion spent on those expenses included a one-time incentive payment of $400 million to real-estate funds.

Mr. Tollette said that by 2020 he would like to see the amount drop “below” 0.25% of total assets, excluding performance fees. External funds charge management fees, plus a share of the investing profits.

Calpers doesn’t expect to immediately terminate outside firms or liquidate holdings, according to Mr. Eliopoulos, who pushed for the hedge-fund decision as well as the move to whittle the number of external funds. The fund’s evaluation of external managers is expected to begin next month. Calpers will consider investing performance, the length of the relationship and strategy, among other factors, Mr. Eliopoulos said.

The biggest cuts are expected to occur in Calpers’s private-equity portfolio, where the number of private-equity managers will slim to about 30 from roughly 100. Real estate will go to 15 outside managers from 51. Fixed income and global equity, which is largely managed in-house, will drop to roughly 30 from nearly 60 now.

Only the group that invests in timber and infrastructure projects like roadways is expected to rise, from about six managers to 10. Some 15 slots will go to upstart firms that Calpers plans to identify over the next several years.

Mr. Eliopoulos said the staff discussed a reduction higher or lower than roughly 100 but decided to land on a whole number. “There’s no science to this. This is a judgment,” he said.

In September 2014, CalPERS dropped a hedge fund bomb, effectively nuking its allocation to external hedge funds. Now, the giant U.S. pension fund everyone loves to track has struck fear in PE firms, announcing a major reduction in the number of external money managers handling its private equity and real investments.

What do I think about this latest move? It’s about time! CalPERS’ private equity portfolio in particular was so messed up, giving money to pretty much anyone with a pulse, that it was delivering median returns and effectively became a benchmark for the private equity industry.

But when you’re investing in illiquid alternatives, paying top fees to overpaid and over-glorified private equity gurus, you don’t want benchmark/ median returns. You want top decile returns or don’t bother investing in this asset class (stick to indexing your portfolio to the S&P 500).

The guy in charge of CalPERS’ private equity portfolio, Réal Desrochers, knows this all too well. He’s been slowly revamping the portfolio over the last few years, mulling over its benchmark, and has a simple philosophy: give bigger allocations to fewer top managers and squeeze them hard on fees and performance.

That is one approach. In Canada, our large public pensions prefer doing a lot more direct deals and co-investments, paying no fees whatsoever. They still invest in top private equity funds to get co-investments, but the focus is more on direct deals. Of course, to do this, you need to get the governance right, pay your staff appropriately, and operate at arms-length from the government, something that U.S. public pension funds haven’t figured out yet.

And Canada’s large pensions aren’t shy to voice their concerns over the fees being doled out to private equity managers. In November 2014, the heads of private equity portfolios of Canadian and Dutch pension funds, as well as sovereign wealth funds, lambasted private equity fees:

Pension-fund managers from the Netherlands to Canada, searching for new ways to invest, lambasted private-equity executives at a conference in Paris this week for charging excessive fees.

Ruulke Bagijn, chief investment officer for private markets at Dutch pension manager PGGM, said a Dutch pension fund for nurses and social workers that she invests for paid more than €400 million (about $500 million) to private-equity firms in 2013. The amount accounted for half the fees paid by the PFZW pension fund, even though private-equity firms managed just 6% of its assets last year, she said.

“That is something we have to think about,” Ms. Bagijn said.

The world’s largest investors, including pension funds and sovereign-wealth funds, are seeking new ways to invest in private equity to avoid the supersize fees. Some investors are buying companies and assets directly. Others are making more of their own decisions about which funds to invest in, rather than giving money to fund-of-fund managers. Big investors are also demanding to invest alongside private-equity funds to avoid paying fees.

Jane Rowe, the head of private equity at Ontario Teachers’ Pension Plan, which manages 141 billion Canadian dollars (US$124.4 billion), is buying more companies directly rather than just through private-equity funds. The plan invests with private-equity firms including Silver Lake Partners LP and Permira LP, according to its annual report. Ms. Rowe told executives gathered in a hotel near Place Vendome in central Paris that she is motivated to make money to improve the retirement security of Canadian teachers rather than simply for herself and her partners.

“You’re not doing it to make the senior managing partner of a private-equity fund $200 million more this year,” she said, as she sat alongside Ms. Ruulke of the Netherlands and Derek Murphy of PSP Investments, which manages pensions for Canadian soldiers. “You’re making it for the teachers of Ontario. You know, Derek’s making it for the armed forces of Canada. Ruulke’s doing it for the social fabric of the Netherlands. These are very nice missions to have in life.”

The comments mark a strong public show of discontent and suggest efforts to tackle high fees paid to private equity are building.

Ms. Rowe was in part responding to private-equity executives such as Carlyle Group co-founder David Rubenstein, who warned that investors who do more acquisitions themselves rather than through private-equity funds will have to pay big salaries to hire and retain talented deal makers.

“Some public pension funds will just not pay, in the United States particularly, very high salaries and will not be able to hold on to people very long and get the most talented people,” Mr. Rubenstein said at the conference. “I don’t think there are that many people who will pay their employees at these sovereign-wealth funds and other pension funds the kind of compensation necessary to hold on to these people and get them.”

As an illustration of the challenge public institutions face in justifying high salaries, Harvard University finance Prof. Josh Lerner showed a photograph of a student protest against inequality. A Harvard student holds up a placard with the numbers “180-1,” which is the ratio between the highest and lowest paid staff at the university, he said. The “1” is a janitor and the “180” is an executive at Harvard Management Co., which invests the university’s endowment, Prof. Lerner said.

“This is saying that there’s too much pay inequality at Harvard,” he said. “Even at Harvard, they don’t really understand the principle of paying for performance.”

Mr. Rubenstein had a further warning for investors seeking to compete for deals with private-equity firms. “If you live by the sword, you die by the sword,” he said. If investors buy companies themselves rather than hire private-equity firms to do so, “you can’t blame somebody else if something goes wrong.”

That is a risk Peter Pereira Gray at the U.K.’s Wellcome Trust is increasingly prepared to take. The trust bought a student housing company and a large U.K. farm this year. “We need to do more ourselves,” he said. “That includes private direct assets.”

Mr. Rubenstein is right, very few places understand the principle of paying for performance. And in response to investors’ outcries on fees, private equity is trying to emulate Warren Buffett, but I’m afraid many investors will get cooked in this asset class and other illiquid alternatives in the next few years. They should all heed the warning of Ontario Teachers’ CEO, Ron Mock, who knows a thing or two about the liquidity time bomb and managing assets in volatile times.

Getting back to CalPERS, I think Ted Eliopoulos, its CIO, is doing a great job redirecting the assets of this giant supertanker, and I’m not just saying this because of his Greek heritage. He is listening to his senior managers, especially Real Desrochers, and taking some bold steps to solidify and streamline CalPERS’ investment approach.

But all isn’t perfect in this story. In her latest attack on CalPERS (see this previous post), Yves Smith (aka Susan Webber) of the naked capitalism blog put out another critical comment, CalPERS Admits It Has No Idea What it is Paying in Private Equity Carry Fees:

As we’ve mentioned, many of the fees and costs that private equity investors bear are hidden from them by virtue of being shifted to the portfolio companies. For instance, private equity firms charge what Oxford professor Ludovic Phalippou has called “money for nothing” or “monitoring fees”. Many also charge “transaction fees” on top of the large fees they pay to investment bankers for buying and selling companies. The reason that those charges are opaque to private equity limited partners is that they have no right to see the books and records of the investee companies.

But surely limited partners like private equity investor heavyweight CalPERS know what they are paying in contractually specified fees, namely the annual management fee and the so-called carried interest fee, which is a profit share (usually 20%) which usually kicks in after a hurdle rate has been met (historically, 8%), right?

Think again. Private equity firms simply remit whatever they realize upon the sale of a company, net all those lovely fees and expenses (which include hefty legal fees) and any carry fee they think they think they are entitled to take.

Put it this way: if you were selling your house, would you hire a firm to provide a turnkey service (spruce up the house, negotiate the sale with a buyer, and take care of all the closing costs) and not demand an accounting of the gross price and what was deducted to arrive at your net proceeds? Yet it’s standard practice all across the industry for private equity investors simply to receive distributions with no explanation at all.

See the discussion from the investment committee section of the CalPERS board meeting. The presentation on cost management starts at 1 hour 55 minutes, and the section on carried interest begins at 2 hours 6 minutes, and the CalPERS staff member making the presentation is Wylie Tollette, Chief Operating Investment Officer.

I’ll let you read the rest of Yves Smith’s critical comment here but clearly there is a need to reduce the number of external managers in private equity and improve the reporting of all fees in this portfolio.

As always, I welcome any feedback you have on this topic and remember, I’m not charging you 2&20 for my insights, which are devastatingly good and honest, so get to it and donate or subscribe using PayPal at the top right-hand side of this blog (that includes some people mentioned in this comment).

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