Author: Leo Kolivakis

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

Aliya Ram of the Financial Times reports, Calstrs to pull $20bn from external fund managers:

The California State Teachers’ Retirement System plans to pull $20bn from its external fund managers. The third-largest US pension scheme is blaming the withdrawal on high fees and disappointing returns across the investment industry.

Sacramento-based Calstrs, which oversees $193bn of assets, currently allocates half of its assets to external fund companies.

Jack Ehnes, the chief executive of Calstrs, told FTfm the scheme will reduce the level of money run by external companies to 40 per cent because it “costs pennies” to run the money internally versus paying fees to external investment managers.

“The best way to get better returns is not finding better managers,” he said. “For every $10 we pay an outside manager, we would pay $1 inside. That is a pretty daunting ratio.”

According to its latest annual report, the pension scheme’s largest external mandates are with Generation Investment Management, the London-based company that was co-founded by Al Gore, the former US vice-president, New York-based Lazard Asset Management and CBRE Global Investors, the property investment specialist.

As pension deficits grow due to rising life expectancy and poor returns, other schemes have also pulled mandates from external fund companies that are already under pressure from market volatility and the popularity of cheaper, passive portfolios.

Alaska Permanent Fund, which manages $55bn, said last week it will retrieve up to half its assets from external managers, while ATP, Denmark’s largest pension provider, and AP2, the Swedish pension scheme, both dropped mandates from external managers earlier this year.

Calstrs has already shifted $13bn of its assets in-house over the past year, according to Mr Ehnes. The number of investment staff employed by the pension fund has risen 15 per cent, to 155, over the past two years to deal with the increase in capital managed internally.

Calstrs’ latest annual report showed it paid $155.7m in investment fees in the year to the end of June 2015, nearly a 10th less than it paid in fees the previous year.

The fee intake of investment managers Morgan Stanley, T Rowe Price and Aberdeen Asset Management fell significantly, by 61 per cent, 24 per cent and 15 per cent respectively.

Mr Ehnes said the proportion of assets managed in-house at Calstrs could increase beyond 60 per cent as its expertise develops.

Glad to read that CalSTRS finally woke up and discovered the secret sauce of the Ontario Teachers’ Pension Plan (OTPP), the Healthcare of Ontario Pension Plan (HOOPP) and the rest of Canada’s Top Ten pensions which manage most their assets internally.

Of course, CalSTRS still has to work on improving its governance structure to get politics out of its investment decisions and hopefully they’re starting to pay their investment staff properly as they cut external mandates and bring assets internally (maybe not Canadian compensation standards but much better as responsibilities shift to internal management).

Why did CalSTRS decide to cut a big chunk of its external fund managers? There are a lot of reasons. First, the performance at CalSTRS during fiscal 2015-16 was far from great, likely prompting a lively internal discussion where they asked themselves the following question: “Why are we paying external fund managers excessive fees if they keep delivering mediocre returns?”

By the way, it’s not just CalSTRS asking this question. CalPERS nuked its hedge fund program exactly two years ago and its senior officers have gotten grilled on private equity fund fees (so have the ones  at CalSTRS and rightfully so as private equity’s misalignment of interests is the worst kept industry secret).

Even Ontario Teachers’ which is by far one of the biggest and best investors in external hedge funds, cut allocations to some computer-run hedge funds that weren’t delivering the goods.

And many other pensions and endowments are asking tough questions on their external managers and whether they are worth the fees. On Monday, Simone Foxman and John Gittelsohn of Bloomberg reported, Hedge Funds Cost N.Y. Pension Plan $3.8 Billion, Report Says:

The New York state comptroller’s decision to stick with hedge funds despite their poor returns has cost the Common Retirement Fund $3.8 billion in fees and underperformance, according to a critical report by the Department of Financial Services.

The state comptroller, who invests $181 billion for two systems covering local employees, police and fire personnel, “has over relied on so-called ‘active’ management by outside hedge fund managers,” the department said Monday in the 20-page report. “For years the State Comptroller has been frozen in place, letting outside managers rake in millions of dollars in fees regardless of hedge fund performance.”

Spokeswoman Jennifer Freeman defended the office of comptroller Thomas DiNapoli, accusing the department of harboring political motives.

“It’s disappointing and shocking that a regulator would issue such an uninformed and unprofessional report,” Freeman said in a statement. “Unfortunately, the Department of Financial Services seems more interested in playing political games, so remains unaware of actions taken by what is one of the best managed and best funded public pension funds in the country.”

Hedge funds, which charge some of the highest fees in the money-management business, have faced mounting criticism from clients over steep costs and performance that mostly hasn’t kept pace with stock markets since the financial crisis. The California Public Employees’ Retirement System, the largest U.S. pension plan, voted to divest of hedge funds in 2014 because they were too complicated and expensive. On Friday, the investment committee for the Kentucky Retirement Systems voted to exit its $1.5 billion in hedge fund holdings over three years.

Opening Round

The DFS report appears to be the opening round in an broader investigation into the management of New York’s retirement system, the third largest state fund at the end of 2015. Led by Superintendent Maria Vullo, the department said it was considering potential regulations on fees and profit-sharing “as well as pre-approval of contracts that provide for fees or profit sharing in excess of a certain rate.”

The topic is of interest to Governor Andrew Cuomo, who oversaw a three-year investigation of the comptroller’s office when he was New York Attorney General. By the end of that probe, former Comptroller Alan Hevesi pleaded guilty to one felony count stemming from a pay-to-play kickback scheme.

Categorized under New York system’s “absolute return strategy,” hedge fund investments lost 4.8 percent in the fiscal year that ended March 31, according to the system’s annual report. The average hedge fund lost 3.8 percent in the same period, according to data compiled by Hedge Fund Research Inc. New York’s hedge fund investments have returned an average of 3.2 percent each year over the past 10 years, compared with 5.7 percent for the total fund.

The DFS’s report said the state had paid almost $1.1 billion in fees to its absolute return managers, a category that includes hedge funds, since 2009. Had the system allocated that money to global equities managers instead, their performance would have netted the fund $2.7 billion more in gains.

Doubling Down

In the face of three years of “massive hedge fund underperformance,” the report added, the comptroller continued the gamble by almost doubling — increasing by 86 percent — the assets poured into the managers between 2009 and 2011.

Freeman said DiNapoli and Chief Investment Officer Vicki Fuller have taken “aggressive steps” to reduce hedge fund investments and limit fees, and that the system hasn’t put money into a hedge fund in well over a year.

The report also criticized the lack of transparency related to the system’s private equity investments, saying the comptroller hadn’t taken sufficient action to make sure funds were disclosing all their fees and expenses.

The pension system “has only recently discovered what should have been clear long ago — that making a commitment to alternative investments places a much greater monitoring burden on the investor,” the report said. “Taking on asset allocations that are complex to monitor and oversee and only belatedly understanding the challenges reflects poor planning.”

I don’t know what all the fuss is about but I actually read the full DFS report and completely disagree with that spokeswoman who defended the office of comptroller Thomas DiNapoli, claiming the report is “uninformed and unprofessional” and politically motivated.

In fact, kudos to New York State and Governor Andrew Cuomo and the Department of Financial Services for having the chutzpah and foresight to issue this report and spell out in clear terms the actual and opportunity cost of investing in hedge funds and private equity funds as well as other issues investing in these funds.

Moreover, I recommend all US, Canadian and European public pensions follow New York State’s lead and commission similar reports from independent and qualified professionals who can perform a serious and in-depth operational, investment and risk management audit of their public plans.

New York’s Common Retirement Fund should follow CalPERS, CalSTRS and others and nuke their hedge fund program and even cut a lot of their private equity funds which are delivering equally mediocre returns and charging it a bundle in fees ($1.1 billion in fees pays a lot of excellent salaries to bring assets internally provided they get the governance and compensation right).

Importantly, in a deflationary, ZIRP and NIRP world where ultra low or negative rates are here to stay, it’s simply indefensible to pay external managers huge fees for mediocre or even solid returns.

Yes, let me repeat that so the Ray Dalios, Ken Griffins, David Teppers of this world can understand in plain English: no matter how much alpha you are reportedly delivering, it’s simply ludicrous and indefensible to justify 2 & 20 (or even 1 & 10 in some cases) to your big pension and sovereign wealth fund clients.

I don’t care if it’s mathematical geniuses like Jim Simons and the folks at Renaissance Technologies or up and coming hedge fund gurus trying to one up Soros, the glory days of charging customers 2 & 20 or more on multibillions are over and they’re never coming back.

What about Steve Cohen, the perfect hedge fund predator? Will he be able to charge clients 5 & 50 for his new fund like he used to in the good old days at SAC Capital? No, there’s not a chance in hell he will be charging large institutional global clients anywhere close to that amount, provided of course that he first manages to lure them back to invest with him (a lot of big institutions are going to be reluctant or pass given his sketchy background but plenty of others won’t care as long as his new fund keeps delivering outsize returns of SAC and his family office).

And it’s not just hedge funds that need to cut fees. These are treacherous times for private equity funds and they need to cut fees too and reexamine their alignment of interests and whether they’re truly in the best interests of their large institutional clients and their members.

The same goes for long-only active management where there’s been a crisis going on for years. Why do institutional and retail investors keep forking over fees to sub-beta performers who obviously can’t pick stocks properly? It’s the very definition of insanity.

This is all part of the malaise of modern pensions and in a deflationary world where fees and costs add up fast, many other US public pensions will follow CalPERS, CalSTRS, and others who cut or are cutting allocations to external managers charging them hefty fees for mediocre returns or risk being the next Rhode Island meeting Warren Buffet.

Is this the beginning of something far more widespread, a mass exodus out of external managers? I don’t know but clearly there are some big pensions and sovereign wealth funds that are tired of paying hefty fees to external managers for lousy absolute and risk-adjusted returns.

The diversification argument can only take them so far, at one point funds need to deliver the goods or they will face the wrath of angry investors who will move assets internally and never look back.

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

Mary Williams Walsh of the New York Times reports, $1.6 Million Bill Tests Tiny Town and ‘Bulletproof’ Public Pensions:

Until the certified letters from Sacramento started coming last month, Loyalton, Calif., was just another hole in the wall — a fading town of just over 700 that had not made much news since the gold rush of 1849. Its lifeblood, a sawmill, closed in 2001, wiping out jobs, paychecks and just about any reason an outsider might have had for giving Loyalton a second glance.

“It’s a walking ghost town,” said Don Russell, editor of the 163-year-old Mountain Messenger, a local newspaper that refuses, fittingly, to publish on the web.

But then came those letters, thrusting Loyalton onto center stage of America’s public pension drama. The California Public Employees’ Retirement System, or Calpers, said Loyalton had 30 days to hand over $1.6 million, more than its entire annual budget, to fund the pensions of its four retirees. Otherwise, Loyalton stood to become the first place in California — perhaps in the nation — where a powerful state retirement system cut retirees’ pensions because their town was a deadbeat.

“I worked all those years, and they did this to me,” said Patsy Jardin, 71, who kept the town’s books for 29 years, then retired in 2004 on an annual pension of about $48,000. Now, because of Loyalton’s troubles, Calpers could cut it to about $19,000.

“I couldn’t live on it — no way,” she said. “I can’t go back to work. I’m 71 years old. Who’s going to hire me?”

Public pensions are supposed to be bulletproof, because cities — unlike companies — seldom go bankrupt, and states never do. Of all the states, experts say, California has the most protective pension laws and legal precedents. Once public workers join Calpers, state courts have ruled, their employers must fund their pensions for the rest of their careers, even if the cost was severely underestimated at the outset — something that has happened in California and elsewhere.

Across the country, many benefits were granted at the height of the 1990s bull market on the faulty assumption that investments would keep climbing and cover most of the cost. And that flawed premise is now hitting home in places like Loyalton.

There and elsewhere, local taxpayers are paying more and more, and some elected officials say they want to get off the escalator. But Calpers is strict, telling its 3,007 participating governments and agencies how much they must contribute each year and going after them if they fail to do so. Even municipal bankruptcy is not an excuse.

The showdown in Loyalton is raising the possibility that California’s pension promise is not absolute. There may be government backstops for bank failures, insurance collapses and pensions owed to workers by bankrupt airlines and steel mills — but not, apparently, for the retirees of a shrinking town.

“The State of California is not responsible for a public agency’s unfunded liabilities,” said Wayne Davis, Calpers’s chief of public affairs. Nor is Calpers willing to play Robin Hood, taking a little more from wealthy communities like Palo Alto or Malibu to help luckless Loyalton. And if it gave a break to one, other struggling communities would surely ask for the same thing, setting up a domino effect.

Some see a test case taking shape for Loyalton and for other cities with dwindling means. “Nobody has forced this issue yet,” said Josh McGee, vice president for public accountability for the Laura and John Arnold Foundation, which focuses in part on sustainable public finance, and a senior fellow of the Manhattan Institute.

When Stockton, Calif., was in bankruptcy, for instance, the presiding judge, Christopher M. Klein, said the city had the right to break with Calpers — but it could not switch to a cheaper pension plan without first abrogating its labor contracts, which would not be easy. Stockton chose to stay with Calpers and keep its existing pension plans, cutting other obligations and pushing through the biggest sales tax increase allowed by law.

Loyalton — which sits in a rural area of Northern California near the Nevada border, less than an hour’s drive from Reno — severed ties with Calpers three years ago. It has no labor contracts to break. Though the town is not bankrupt, its finances are in disarray: It recovered more than $400,000 after a municipal employee caught embezzling was fired. But a recent audit found yet another shortfall of more than $80,000.

“If a city doesn’t have the funds to pay, it’s just completely unclear how the legal plumbing would work,” Mr. McGee said. “I don’t know what would happen if the retirees sued.”

The retirees say they are open to filing a suit but cannot afford to hire lawyers for a titanic legal clash with Calpers.

“Nobody does squat for you with Calpers,” said John Cussins, Loyalton’s retired maintenance foreman, who now serves on the City Council. “I contacted every agency possible. To me, it’s just unbelievable that there isn’t some kind of help out there with the legal side of things. It leaves us at the mercy of the city and Calpers.”

Mr. Cussins said he had a severe stroke last year and was recently told he had Parkinson’s disease. He needs continuing care and said he might not be able to afford his health insurance if his pension were cut. Every time the pension issue comes up at City Council meetings, he is told to leave because, as a retiree, he is deemed to have a conflict of interest.

“I’d like to see somebody go to jail for this,” he said.

Calpers has total assets of $290 billion, so an unpaid bill of $1.6 million would hardly be a deathblow. But if Calpers gave one struggling city a free ride, others might try the same thing, causing political problems. Palo Alto may have lots of money, but its taxpayers still do not want to pay retirees who once plowed the snow or picked up the trash in far-off Loyalton.

“I think this is all about precedent setting,” Mr. McGee said.

In September, Calpers sent “final demand” letters to Loyalton and two other entities, the Niland Sanitary District and the California Fairs Financing Authority. The Niland Sanitary District has struggled with bill collections, and the fairs financing authority was disbanded several years ago when the state cut its funding. Both entities stopped sending their required contributions to Calpers in 2013 but have continued to allow Calpers to administer their pension plans.

In Loyalton, the City Council voted in 2012 to drop out of Calpers, hoping to save the $30,000 a year or more that the town had previously sent in, said Pat Whitley, a former mayor and a City Council member. (She is not one of the four Loyalton retirees but earned a Calpers pension through previous work on the Sierra County Board of Supervisors.)

“All our audits said that our benefits were going to break the city,” Ms. Whitley said. “That’s exactly why we decided to withdraw. We decided it would be a perfect time to get out, because everybody was retired.”

Loyalton did not plan to offer pensions to new workers, she said. And it had been paying its required yearly contributions to Calpers, so officials thought its pension plan must be close to fully funded.

But Calpers calculates the cost of pensions differently when a local government wants to leave the system — a practice that has caught many by surprise. If a city stays, Calpers assumes that the pensions won’t cost very much, which keeps annual contributions low — but also passes hidden costs into the future, critics say. If a city wants to leave, Calpers calculates a cost that doesn’t rely on any new money and requires the city to pay the whole amount on its way out the door.

That is why Calpers sent Loyalton the bill for $1.6 million.

“I never dreamed it was going to be that, ever. Ever!” Ms. Whitley said. “It defies logic, really.”

Loyalton’s expenditures for all of 2012 were only $1.2 million, and much of that money came from outside sources, like the federal and county governments. Local tax collections yielded just $163,000 that year, according to a public finance website maintained by the Stanford Institute for Economic Policy Research.

Ms. Whitley said Calpers had snared Loyalton in a Catch-22. The agency would not tell the town the cost of terminating its contract until the contract was ended, she said. But once that was done, it was too late to go back.

“We were very confused about why we owe $1.6 million, and why didn’t they tell us that before we signed all the papers,” she said.

Mr. Davis, the Calpers spokesman, said that since 2011, Calpers had been giving its member municipalities a “hypothetical termination liability” in their annual actuarial reports, so there was little excuse for not knowing.

Ms. Whitley disagreed. “It’s just too confusing,” she said. “I looked at what’s been happening with all the other entities, and I saw that eventually it’s got to collapse. It’s almost like a Ponzi scheme.”

The bill was due immediately, but Loyalton did not pay it. It has been accruing 7.5 percent annual interest ever since.

Meanwhile, Calpers has continued to pay Loyalton’s four retirees their pensions. But at a Calpers board meeting in September, some trustees said it was time to find Loyalton in default and cut the pensions. The board is expected to make a final decision at its next meeting, in November.

In Loyalton, Mr. Cussins, the retiree and City Council member, said he was so frustrated about being barred from the council’s pension discussions that he and another former town worker drove to Sacramento to attend Calpers’s last board meeting.

The trustees were cordial, he said, but they held out little hope.

“We had a bunch of them come and shake our hands,” he said. “I said, ‘We need some guidance.’ They told us the city could apply to get back into Calpers next spring. But they made it very clear that they will not allow the city to get back into Calpers until that $1.6 million is paid.”

First, let me thank Ray Dragunas for bringing this article to my attention on LinkedIn. Second, while many of you would dismiss this as an inconsequential “small town USA” case of a few retirees who will end up seeing their pensions slashed by CalPERS, you are gravely mistaken.

As Mary Williams Walsh astutely remarks in her article, Loyalton has been thrust onto center stage of America’s public pension drama and this showdown is raising the possibility that California’s pension promise is not absolute. This is particularly worrisome given California’s pension gap is widening and could bring about major changes to public sector pensions there.

And while Loyalton lacks the resources to fight CalPERS, if other cases develop where public sector retirees get screwed on their promised pensions, don’t be surprised if we get massive class action lawsuits (think Erin Brockovich) against retirement systems all over the United States.

I’m not kidding, California has the most protective pension laws and legal precedents, but this case clearly demonstrates public pensions are not bulletproof.

Of course, none of this surprises me. I started this blog back in June 2008 right in the midst of the financial crisis and foresaw the sinking of the pension Titanic in the United States and elsewhere.

These poor residents of Loyalton California just got a little taste of what happened to Greek pensioners when Greece narrowly escaped a total collapse but in return had to implement draconian austerity measures which included slashing public and private sector pensions.

However, the United States isn’t Greece, it’s the richest, most powerful nation on earth which prints the world’s reserve currency, so it’s hard to envision a massive and widespread public pension crisis where millions of public sector retirees see their pensions slashed.

But never say never. Politics drives a lot of these changes in policy, and it’s not always in the best interests of the country. You have former Fed chairman Alan Greenspan banging the table on entitlement spending run amok, but he and others fail to realize the dangers of rising inequality, which the pension crisis will only exacerbate, and its detrimental effects on aggregate demand.

Nobody really cares if Loyalton retirees see their public pensions slashed, but they should because if  slashing public pensions becomes far more widespread, it will add fuel to America’s ongoing retirement crisis and impact aggregate demand and growth for a long time.

This is why in my recent comment on the malaise of modern pensions, I discussed intellectual influences that shaped my thoughts on pensions and why we need to rethink their important role for the overall economy:

Quite simply, in a ZIRP & NIRP world where ultra low rates and the new negative normal are here to stay, the pension Titanic will keep sinking but some pensions, defined-contribution (DC) plans in particular, will sink much further and leave millions struggling with pension poverty while others, like large well-governed defined-benefit (DB) plans, will offer workers the ability to retire in dignity and security.

So, when I expose the brutal truth on defined-contribution plans and explain why Canadians are getting a great bang for their CPP buck, somewhere behind that message lies the influence of Chuck Taylor and a more just society.

Enhancing the Canada Pension Plan makes great sense for all Canadians and I’m sure Quebec will follow suit.

As far as the United States, it too needs to rethink its solution to its retirement crisis and I’m not talking about the revolutionary retirement plan being peddled right now. Private pensions have crumbled and public pensions are crumbling, and the situation is going to get a lot worse over the next ten years.

The next US president needs to set up a task force to carefully evaluate the pros and cons of enhancing Social Security for all Americans based on the model of the Canada Pension Plan Investment Board, but to do this properly, they first need to get the governance right.

Public pensions are not bulletproof but nor are they the problem. If stakeholders get the governance and investment assumptions right, introduce risk-sharing, then public pensions are part of the solution and will allow millions of people to retire in dignity and security which will benefit the economy over the long run.

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

Kate McCann and Katie Morley of the Telegraph report, Government’s ‘draconian’ pension reforms have backfired, experts warn, as OBR says changes will cost billions:

George Osborne’s pension reforms will backfire and end up costing the taxpayer billions of pounds more every year as people stop saving for their retirement, the official Treasury watchdog has warned.

The Office for Budget Responsibility said new saving schemes and the removal of tax relief on pensions for higher earners – billed as a move to save money – will ultimately end up costing the Exchequer £5 billion a year.

The watchdog warned that higher earners will move their money to tax efficient investments and may even drive up property prices as a result of the ill-thought through policy.

The Government controversially cut the amount people can save in a pension to £1m through their lifetime. The annual allowance was also cut to £40,000 – despite cuts in interest rates and stock market returns which combined to decimate the value of life savings.

The move was condemned by business groups and pension experts at the time who said it would deter millions of people from saving.

Theresa May is now under pressure to reverse the policy in the forthcoming Autumn Statement after the OBR warned it would also undermine public finances in the future.

Tom McPhail, head of pension policy at Hargreaves Lansdown, said: “The Government urgently needs to rethink its savings policies.

“In the short term fiscal changes such as the lifetime allowance cap at £1m will save it money, however in the longer term the package of various measures such as the pension freedoms, the increased Isa limits and the secondary annuity market will result in a worsening of public finances.

“Investors will simply substitute more tax advantaged products such as the Isa for the pensions where they fact the lifetime allowance cap.” The OBR’s analysis looked at a series of cuts to tax breaks on pensions savings for high earners since 2010, together with the impact of George Osborne’s new pension freedoms.

The Government has reduced the annual pension allowance, the amount people can put into their retirement pots before they have to pay tax, from £255,000 in 2010 to £40,000.

It has also cut the lifetime allowance from £1.8million to £1million today.

Over a million middle to high earners including teachers, doctors, lawyers and managers will have their retirement savings restricted as a result of the lower pensions lifetime allowance.

While the reforms will benefit the economy in the medium term because of increased tax, in the longer term there will be a cost to the taxpayer as people choose to invest their savings in alternative schemes, the report found.

The OBR said that by 2035 the Government’s policies will cost it £5billion a year in lost tax revenue.

It states: “In recent years, the Government has made a number of significant changes to the tax treatment of private pensions and savings and introduced a variety of government top-ups on specific savings products.

“In doing so, it has generally shifted incentives in a way that makes pensions saving less attractive – particularly for higher earners – and non-pension savings more attractive – often in ways that can most readily be taken up by the same higher earners.”

Under the Coalition Government Mr Osborne also increased the amount people can save in Isas, which led to more people using them to save. The value of adult ISAs had risen from £287billion in 2006 to £518billion.

As a result, wealthy savers are expected to max out newly increased £20,000 a year Isa limits instead of saving into pensions where the tax benefits are starting to look far less attractive.

However the report warns that: “If interest rates were to increase towards historically normal levels, the amount of tax forgone on interest income would increase”, adding to the long-term cost of the policies.

The watchdog warned that the Government’s assault on pension savings means house prices could rise because more people are investing in housing as a result.

It said: “Measures that change the relative incentive to save, whether in savings or pensions, will also affect the attractiveness of other investments such as housing.

“A number of the measures we cover in this paper could affect the housing market, mostly by increasing demand for housing and putting upward pressure on house prices.”

Jim Pickard and Josephine Cumbo of the Financial Times also report, UK budget watchdog warns of Osborne’s £5bn pensions gap:

George Osborne’s various pension reforms in his time as chancellor will blow a £5bn-a-year hole in the public finances in the long term by discouraging saving for retirement, the Budget watchdog has found.

Analysis by the Office for Budget Responsibility, published on Tuesday, found that the reforms had made pensions less attractive compared with other forms of savings, especially for those on high incomes.

The OBR examined multiple changes to the tax treatment of pensions and savings as well as the freedoms given to people to gain access to their retirement funds.

Mr Osborne, who was removed from the Treasury by Theresa May when she formed her post-Brexit vote government, scrapped the requirement for those with private pensions to buy an annuity on reaching retirement and allowed pensioners to sell their existing annuities on a secondary market.

He also oversaw restrictions to the annual pensions allowance and lifetime allowance which lowered annual tax free pensions contributions to £40,000 and lifetime contributions to £1m.

At the same time he lifted the individual savings account limit and introduced several new types of ISA, including the Lifetime ISA, seen as a rival to the traditional pension.

Although the reforms provided a small benefit in the medium term — until about 2021 — over the longer period there would be a significant cost, potentially adding a sum equivalent to 3.7 per cent of gross domestic product to public sector net debt over a 50-year period, according to the OBR.

“In recent years, the government has made a number of significant changes to the tax treatment of private pensions and savings and introduced a variety of government top-ups on specific savings products,” it said.

“In doing so, it has generally shifted incentives in a way that makes pensions saving less attractive — particularly for higher earners — and non-pension savings more attractive — often in ways that can most readily be taken up by the same higher earners.”

Forecasts by the OBR are taken seriously because it is Whitehall’s official spending watchdog. Its report found that “the small net gain to the public finances from these measures over the medium-term forecast horizon becomes a small net cost in the long term”.

The benefit from the reforms would peak at £2.3bn in 2018-19 before turning negative from 2021-22, rising in cash terms to reach £5bn by 2034-35.

Steve Webb, director of policy at Royal London investments group and a former pensions minister, said the report showed the consequences of the Treasury’s “attraction to ISAs and dislike of pension tax relief”.

“Although the overall cost of savings incentives has increased slightly over the long term, the balance has shifted markedly, with pension savers seeing cuts in support and greater incentives for short-term savings,” Mr Webb said.

“For a society with a major shortfall in long-term savings this seems a very odd rebalancing. What the Treasury has given in savings incentives via ISAs and related products it has largely taken away in cuts to pension tax relief, making pensions less attractive.”

The report acknowledged that the “relatively slow pace” at which the changes would affect the public finances would allow future governments to adjust policy if necessary.

Ros Altmann, who was pension minister until this summer, also criticised the changes: “We shouldn’t be spending extra taxpayers money subsidising people to have tax-free pension pots from the age of 60, which will be the case with the Lifetime ISA.”

You can read the report covering private pensions and savings from the UK Office for Budget Responsibility here. The report states the following:

The tax system affects the post-tax returns an individual can expect from investing in different financial assets. The Government is therefore able to influence individuals’ incentives – and so behaviour – by changing the tax treatment of private pensions and savings products. In recent years, the Government has made a number of changes in this area and introduced a variety of government top-ups on specific savings products. This has generally shifted incentives in a way that makes pensions saving less attractive – particularly for higher earners – and non-pension savings more attractive – often in ways that can most readily be taken up by the same higher earners.

I will be brief in my remarks and state any policy that incentivizes people to save less for pensions and more for non-pension savings is absolutely foolish for a lot of reasons, not just lost tax revenue.

When I look around the world at the global pension crunch, and read about these draconian pension reforms in the United Kingdom, it confirms my long-held belief that Canadians are extremely lucky to have the Canada Pension Plan (long live the CPP!) managed by the highly qualified professionals at the Canada Pension Plan Investment Board.

I really hope Quebec follows the rest of Canada and enhances the QPP and I am eagerly awaiting to hear the comments from CPPIB’s new (British) CEO, Mark Machin, when he testifies at Parliament at the beginning of November. I’m quite certain he will reiterate why Canadians are getting a great bang for the CPP buck.

As far as George Osborne’s draconian, shortsighted and foolish pension reforms, I hope Theresa May swiftly reverses them in the forthcoming Autumn Statement.

The last thing the UK needs is to penalize pension savings and inflate a property bubble. According to UBS, London is second only to Vancouver in a league table of world cities with property markets most at risk of a bubble.

Adding fuel to the property bubble, post-Brexit, the British pound is getting clobbered, making all UK assets (stocks, bonds, real estate and infrastructure) that much cheaper for foreigners.

Interestingly, after the recent flash crash in the Sterling, a buddy of mine who trades currencies sent me this (added emphasis is mine):

GBP is trading like an EM currency without central bank smoothing

The low print was 1.1378 but not many banks are recognizing that, most say its 1.1480 regardless the move highlights the algo (machine) trading problem… with banks not willing to take on risk you will get these moves.

It also counters the argument that hedge fund traders (algos) make/ provide liquidity and narrow spreads..something I have been arguing against all along. They front run the flow and force the price to gap until the true liquidity is found and since we have a scenario where the real liquidity providers are not providing liquidity any more (as a result of reduced risk implemented by regulators) you will get these moves. The banks don’t honor s/l orders anymore, they will fill you at the next best price (yeah sure, once they take their mandatory spread which is guaranteed profit at no risk).

You essentially have very little recourse (they will say we don’t want to lose you as a client so we will do our best (our best for themselves, not the client) and since almost all banks are acting the same way, where can you go… they say it’s not them it’s the regulators.

I can only imagine how many UK and other large global macro hedge funds are getting crushed taking big positions either way in the pound. Currencies remain the Wild West of investing, and my friend offers a brief glimpse as to why in his comment above.

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

Paul Delean of the Montreal Gazette reports, Quebec is still holding out on pension reform:

Possible changes to the Quebec Pension Plan and the merits of a trust fund for a relative on welfare were among the topics raised in the latest batch of reader letters. Here’s what they wanted to know.

Q: “The other provinces and the federal government appear to have come to an agreement on changes to the Canada Pension Plan (CPP). Where does this leave Quebec?”

A: Not budging from its holdout position, at least for now. Quebec Finance Minister Carlos Leitāo told the Montreal Gazette that Quebec isn’t obliged to adopt the reforms, since it runs its own retirement plan (Quebec Pension Plan), and the same issues that kept Quebec from signing on to the federal proposals last summer haven’t gone away.

Leitāo said Quebec has a lot of low-income workers who would find themselves paying more in contributions from their weekly paycheques, only to have the extra pension cash in retirement cut into the guaranteed income supplement available to low-income earners. “They’re worse off with this type of change,” he said.

Quebecers already pay slightly higher dues for the Quebec Pension Plan than other Canadians do for CPP (5.325 per cent of pensionable earnings up to $54,900, compared to 4.95 per cent for CPP) and payroll taxes for Quebec businesses (which include the employer’s matching QPP contribution) are higher than elsewhere.

The new CPP deal, going ahead after British Columbia approved it this month, will be phased in between 2019 and 2025. It will raise the CPP contribution rates of workers and employers and the amount of employment income on which those contributions are charged. In exchange, workers will get significantly higher benefits — as much as 50 per cent more, Ottawa says — from CPP in retirement. Someone with $50,000 in constant earnings throughout their working life would receive $16,000 annually from CPP instead of $12,000 now, the government said.

Ottawa said it’s cushioning the blow on low-income earners by enhancing its working income tax benefit and making the extra CPP dues tax-deductible. Leitāo said Quebec isn’t standing pat, just taking the time to study the issue further over the next year to make sure it implements reforms appropriate “for Quebec reality.” Since the federal changes aren’t coming until 2019, “we have time,” he said.

Quebec Finance Minister Carlos Leitāo raises excellent points on how a change in rising premiums would impact Quebec’s low-income workers. These are well-known issues not just in Quebec but in the rest of Canada where enhancing the CPP could leave low-income workers worse off.

But Leitāo isn’t slamming the door shut on enhancing the Quebec Pension Plan (QPP) and if you ask my opinion, Quebec being Quebec, will take it’s time to study this proposal but in the end it will have no choice but to adopt the exact same policy as the rest of Canada.

Why will Quebec follow other provinces and enhance its retirement system? Because if Quebec doesn’t adopt some sort of enhanced QPP, it will risk being left behind the rest of Canada in terms of long-term economic growth (policymakers need to understand the benefits of DB plans for the overall economy).

And as a friend of mine pointed out, in a competitive labor market, people will move where they can retire in dignity and security with more money, so it’s difficult to envisage Quebec being the sole holdout in terms of enhancing its pension system.

In my last comment, I went over the malaise of modern pensions, discussing the intellectual underpinnings of my position on enhancing the CPP for all Canadians.

Quite simply, in a ZIRP & NIRP world where ultra low rates and the new negative normal are here to stay, the pension Titanic will keep sinking but some pensions, defined-contribution (DC) plans in particular, will sink much further and leave millions struggling with pension poverty while others, like large well-governed defined-benefit (DB) plans, will offer workers the ability to retire in dignity and security.

And as I keep emphasizing, regardless of your political and ideological views, good pension policy is good long-term economic policy, especially in societies with aging demographics where people can’t afford to retire in dignity and security.

You will hear all sorts of right-wing nonsense about entitlement spending run amok, impacting productivity and long-term growth (former Fed Chairman Alan Greenspan’s view), but the biggest problem impacting global aggregate demand and long-term economic growth is rising inequality exacerbated by the global pension crisis and other factors (like chronic unemployment and under-employment, high and unsustainable debt, disruptive shifts in technology, etc.).

And as I keep harping on my blog, Canadians are getting a great bang for their CPP buck just like Quebecers are getting a great bang for their QPP buck. Where they are not getting a good bang for their buck is in the mediocre returns of active managers investing solely in public markets and charging them outrageous fees for this gross underperformance, fees which eat up nearly a third (or more) of their retirement savings over time.

And the answer to this retirement crisis does not lie in more education and low-cost exchange traded funds (ETFs). Sure, everyone can learn and build on CPPIB’s success, but low cost ETFs are no panacea (especially not now) and definitely no substitute for a large, well-governed defined-benefit plan backed up by the full faith and credit of the provincial or federal governments.

There is a reason why the public sector unions of Quebec City approached the “big bad Caisse” to handle the retirement savings of their members, it’s in their best interests over the long run.

And my bet is when Quebec Finance Minister Carlos Leitāo comes back to discuss the results of their study, if it’s done properly, they will also follow other provinces and enhance the QPP for all Quebec’s workers and adjust it for low-income workers so as to not penalize them. Not to do so would be a grave and foolish long-term policy mistake.

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

Jennifer Schuessler of the New York Times reports, Canadian Philosopher Wins $1 Million Prize:

The Canadian philosopher Charles Taylor has been named the winner of the first Berggruen Prize, which is to be awarded annually for “a thinker whose ideas are of broad significance for shaping human self-understanding and the advancement of humanity.”

The prize, which carries a cash award of $1 million, will be given in a ceremony in New York City on Dec. 1. It is sponsored by the Berggruen Institute, a research organization based in Los Angeles and dedicated to improving governance and mutual understanding across different cultures, with particular emphasis on intellectual exchange between the West and Asia.

Mr. Taylor, 84, is widely regarded as one of the world’s leading philosophers, and a thinker whose ideas have been influential in the humanities, social sciences and public affairs. His many books include “Sources of the Self,” an exploration of how different ideas of selfhood helped define Western civilization, and “A Secular Age,” a study of the coexistence of religious and nonreligious people in an era dominated by secular ideas.

He was chosen for the prize by an independent nine-member jury, headed by the philosopher Kwame Anthony Appiah. The jury cited Mr. Taylor’s support for “political unity that respects cultural diversity,” and the influence of his work in “demonstrating that Western civilization is not simply unitary, but like all civilizations the product of diverse influences.”

Mr. Taylor’s previous honors include the 2015 John W. Kluge Prize for the Achievement in the Study of Humanity (shared with Jürgen Habermas), the 2007 Templeton Prize for achievement in the advancement in spiritual matters and the 2008 Kyoto Prize, regarded as Japan’s highest private honor. Both the Templeton and Kluge prizes also carry cash awards of more than $1 million.

It’s Canadian Thanksgiving, the US stock market is open (bond market is closed for Columbus Day) but I didn’t want to blog on markets. I beefed up my last comment on bracing for a violent shift in markets for you to read my thoughts on what is going on in the global economy and financial markets.

Instead, I want to take the time and reflect on what I am thankful for, my family, girlfriend, friends, all of whom I love deeply; my health which is remarkably stable after being diagnosed with multiple sclerosis (MS) back in June 1997; my neurologist, Dr. Yves Lapierre and the wonderful nurses and staff at the Montreal Neurological Institute (MNI); my contacts in the pension world and other experts who help me write insightful comments on pensions and investments; and last but not least, all of the institutional and retail investors who support my blog through their generous financial contributions via PayPal on the right-hand side.

But allow me to take a small detour to discuss with you my intellectual mentors, those who helped shape the way I view the world and why pensions are critically important to our society and economy. I was a late bloomer, intellectually speaking, and it wasn’t until I arrived at McGill University back in 1992 when I started really delving deeply into the history of economic, social and political thought where I learned from some great professors about the power of ideas and how to critically examine the world we live in.

At McGill, I was majoring in economics and minoring in mathematics and then went on to obtain a Masters in Economics where I submitted my thesis, a critical review of macroeconomic growth theory (see an older comment of mine on Galton’s Fallacy and the Myth of Decoupling which remains very pertinent today).

Even though I was proud of getting an “A” on my Masters thesis, which was literally smack in the middle of my diagnosis of MS and the toughest period of my life, I wasn’t an “A” student by any means. My academic GPA was 3.3 (B+) and I found all my courses at McGill very challenging.

It didn’t help that I was flirting with the idea of becoming a doctor like my father and took all these difficult pre-med courses (organic chemistry, biochemistry and physiology) as electives which was no picnic (I’m terrible at rogue memorization). Moreover, some of the upper level mathematics courses that I needed to complete my minor in mathematics were brutal (it was me and six foreign students who ate, spoke and breathed mathematics all day long, and I was petrified and very intimidated but managed to pass these courses with decent grades).

But my favorite courses by far were always courses which made me think and these included courses like underground economics by Tom Naylor, the combative economist and one of my mentors at McGill, comparative economic systems by Allen Fenichel, and history of economic thought by Robin Rowley who also taught us about the pros and  “con” in econometrics (he and Sir David Hendry, one of the world’s foremost experts of econometrics, were the only two who obtained a PhD in Econometrics with Distinction from LSE back in 1969).

While I enjoyed all these courses immensely, nothing compared to my electives in political theory. It was there where I was taught by some brilliant professors like the late Sam Noumoff, John Shingler, James Tully who now teaches at the University of Victoria, and of course, Charles (“Chuck”) Taylor. They taught us about the main ideas in political thought, from Aristotle, to Hobbes, Locke, Tocqueville, Machiavelli, Marx and many more great philosophers.

One of the things I still remember till this day is when at the end of the introduction to political theory course which they all taught together, they stood in front of a packed auditorium and asked the students to give their feedback. One student rose his hand and asked Chuck Taylor if he thought the course focused “too much on Aristotle.”

I swear to you, you could hear a pin drop as a deep hush fell over the auditorium as all the students eagerly anticipated professor Taylor’s response. He didn’t attack or denigrate the student in any way (he was too kind and classy to do this). Instead, he paused, reflected and then smacked his forehead and blurted: “Too much Aristotle, how is this even possible?!?“. He took an awkward moment and made us all laugh out loud, it was priceless and vintage Chuck Taylor.

[Note: My older sister shared another funny story from her days at McGill when Taylor saw her and a friend on campus and stopped them to ask: “You, you both take my course, can you direct me as to where it is?”].

In fact, those who know him best are in awe of his sheer brilliance (he could recite passages of major works off the top of his head) but also his humility, empathy and wonderful sense of humor. Charles Taylor is brilliant but he’s also extremely humble (part of his deep Catholic faith), socially engaged and represents the very best of McGill and what truly outstanding professors are all about.

After that initial course in political theory, I was hooked and started auditing some of his other courses in political theory, adding to my already charged academic curriculum. I was obsessed with reading all his books but two of them really struck a chord with me, CBC Massey lecture series, The Malaise of Modernity and his seminal book, Sources of the Self, which remains his Magnum Opus.

It was Charles Taylor who opened my eyes to liberalism and its critics where I delved into the works of Isaiah Berlin, Taylor’s thesis supervisor at Oxford University, as well as many other great political thinkers like John Rawls, Robert Nozick, Ronald Dworkin, Thomas Nagel, Michael Walzer, Richard Rorty, Alasdair MacIntyre, Michael Sandel, Will Kymlicka, Susan Moller Okin and Martha Nussbaum, another brilliant lady and prolific author.

[Note: During my long breaks, I used to go to the McGill bookstore on the corner of Metcalfe and  Sherbrooke and just hang around the second floor reading all their books, many of which I bought and still own.]

Why am I sharing all this with you? What do political philosophers and great thinkers have to do with pensions and investments? Well, quite a bit actually. When I discuss the benefits of defined-benefit pensions or enhancing the CPP for all Canadians, my thinking is deeply shaped by Taylor’s communitarianism (not to be confused with communism) and while it’s important to respect individual freedom and diversity, we also need to promote the collective good of our society.

Quite simply, in a ZIRP & NIRP world where ultra low rates and the new negative normal are here to stay, the pension Titanic will keep sinking, but some pensions, defined-contribution (DC) plans in particular, will sink much further and leave millions struggling with pension poverty while others, like large well-governed defined-benefit (DB) plans, will offer workers the ability to retire in dignity and security.

So, when I expose the brutal truth on defined-contribution plans and explain why Canadians are getting a great bang for their CPP buck, somewhere behind that message lies the influence of Chuck Taylor and a more just society.

And for that, I am very thankful I had the privilege to learn from this brilliant and generous man who in many ways reminds me of my father in terms of their deep faith, insatiable appetite to read about everything and generosity (they are also the same age).

I actually bought my father Taylor’s book, A Secular Age, and he enjoyed reading it but told me it is deeply rooted in Western thought where there is an equally important Eastern Orthodox thought of religion which is ignored (you need to read the works of my father’s friend, Christos Yannaras, a Greek theologian and leading intellectual to understand these nuances).

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

Josh Wingrove, Greg Quinn and Scott Deveau of Bloomberg report, Canada Pension chief to testify amid trillion-dollar boost:

The head of the Canada Pension Plan Investment Board will face lawmakers for the first time in 14 years as Prime Minister Justin Trudeau’s government finalizes a trillion-dollar cash expansion of one of the world’s largest public pension funds.

Mark Machin, who took over as president and CEO of the arm’s-length investment board in June, will speak to the House of Commons finance committee Nov. 1 at its request. His testimony comes as Trudeau prepares to amend the law governing both the Canada Pension Plan and CPPIB, which manages the $287-billion fund, to formalize a deal to expand benefits.

The new plan, rolled out from 2019 to 2025, will leave the fund on pace to reach $2 trillion by 2045 — doubling the value of the original program. Enacting legislation will be made public “shortly,” Finance Minister Bill Morneau said Tuesday after British Columbia signed on to the deal, clearing the way for the government to move forward.

Morneau has said he and his provincial counterparts are still finalizing pension expansion changes and will meet in December. A departmental official said CPP “policy actions” could still be forthcoming as part of a triennial review, while Morneau spokeswoman Annie Donolo ruled out “major changes.” All modifications must be approved by seven provinces representing two-thirds of Canada’s population.

“We need to make sure we get all the details right,” Morneau said Sept. 6. “We see the CPPIB vehicle as a respected and effective vehicle for managing Canada’s pension assets.”

Lower for longer

The Canada Pension Plan is the mandatory workplace retirement savings program for 19 million Canadians. Its expansion will substantially increase the investment board’s portfolio at a time when pension funds are coping with an era of low global interest rates that threaten returns.

Board officials, excluding Machin, met informally with lawmakers earlier this year, according to finance committee chairman Wayne Easter. “We enthusiastically look forward to engaging with members of the House finance committee based on good dialogue held so far,” CPPIB spokesman Michel Leduc said.

Trudeau’s expansion will, in effect, create a two-stream plan managed by the investment board. Government officials refer colloquially to “CPP 1” and “CPP 2,” each distinct from an accounting perspective. The independent new program is considered to be fully funded and therefore will rely more heavily on future returns. Benefits for each generation will “depend on their own contributions and the associated investment returns,” finance department spokesman Jack Aubry said. That leaves fund directors under pressure to deliver.

‘Strong’ performance

The investment board’s track record is solid. It had a net return of 16 per cent on its investments for the calendar year in 2015, and a 7.5 per cent net return on an annualized basis for the past decade, according to a spokesman.

That compares to a 9.1 per cent net return in 2015 at Canada’s second-largest pension fund, Caisse de Depot et Placement du Quebec, according to its website. The Caisse returned about 5.96 per cent on an annualized basis over the past decade. Ontario Teachers’ Pension Plan had a 13 per cent net return in 2015 and an annualized return of 8.2 per cent over the past decade, according to its website.

CPPIB invests in private and public equities, fixed income products and real assets around the globe. Trudeau’s government isn’t considering “using other vehicles” to manage the new cash influx, Donolo said.

The Office of the Chief Actuary, in a report last month, found the fund’s investment income was nearly 250 per cent higher over the past three years than originally expected due to its “strong investment performance.” The investment board has been concentrated on diversifying across asset classes and geographies in an effort to reduce risk, in effect turning its eye away from Canada.

Political autonomy

The investment board is a world-renowned model, according to Michel St-Germain, a vice-chairman at the Association of Canadian Pension Management. “We have managed to create a governance structure that’s very autonomous, independent of political pressure. I’m quite confident that we will be able to maintain this,” he said. “Having said that there is a challenge. There will be a lot of money there.”

Machin, an Englishman who spent years in Asia for Goldman Sachs Group Inc., may shed light on how CPPIB will handle the cash influx. His appointment was announced in May along with the departure of former president and CEO Mark Wiseman to BlackRock Inc. At the urging of lawmakers, Machin’s hearing date was moved up to Nov. 1 from an initial date later in the month. It will be the first finance committee appearance by the head of the investment board since 2002.

“With the very rapid succession, I think it was important that parliamentarians and Canadians hear from the new CEO of the CPPIB,” Liberal lawmaker and committee member Steven MacKinnon said in an interview. “Ideally it would have been better to have had him earlier, but it’s now very timely with the announced expansion.”

I was busy with an emerging manager conference today but I wanted to quickly cover this story.

First, I think it is a great idea to invite Mark Machin, CPPIB’s new CEO,  to speak to parliamentarians and Canadians on what CPPIB does and why it is well equipped to handle the explosive growth that will come after the provincial and federal governments ratify the law to enhance the Canada  Pension Plan (CPP).

On Monday, I wrote a comment, “Long live the CPP!!” where I stated Canadians are very fortunate to have the Canada Pension Plan, its stewards, and the astounding and highly qualified professionals at the Office of the Chief Actuary, as well as the senior managers and board of directors running and overseeing the Canada Pension Plan Investment Board (CPPIB).

I also stated absent some new public defined-benefit plan which will manage and better protect existing corporate defined-benefit plans that are dwindling, the CPP is really all Canadians can rely on with certitude to retire in dignity and security.

Sadly, as I write this comment, another story appeared in the CBC today on a pension decision looming for thousands of former Nortel workers. Basically, a lot of nervous former Nortel employees are meeting across the country at gatherings meant to help them figure out what to do when the company’s pension plan finally winds down. Decisions have to be made by the end of the year.

The article quotes a 95 year old man, former Nortel executive Dave Stevenson, stating the following: “I thought the pension was good for life, like most pensions should be.”

Unfortunately, most private pensions are not good for life which is why I’ve been arguing all along to enhance the CPP and go even further to make sure we bolster existing private defined-benefit pensions or start offering them with new funds backstopped by the federal ad provincial governments.

Basically, my philosophy is private defined-benefit pensions are dying, being replaced by defined-contribution plans which are not real pensions for life, so we need to rethink this whole business of private companies managing pensions.

In an ideal world, working Canadians pension contributions would be matched by their employers but the retirement assets would be managed by the CPPIB or one or several other large, well-governed public pensions backstopped by the federal or provincial governments.

This way if when a company goes belly-up, like Nortel, the pensions are safe and not impacted in any meaningful way because the money is part of pooled assets of several thousand companies and every employee can be reassured they can still retire in dignity and security.

This is all very logical to me and I really hope Justin Trudeau who was my brother’s classmate in high school and Bill Morneau think long and hard about continuing to improve pension policy once they finish with enhancing the CPP. There is still a lot more work left to be done and as I keep harping on my blog, good pension policy is good economic policy.

On this note, I end with a news release from CARP, CPP Enhancement to Proceed, with BC Reconfirming Support:

Vancouver, BC: CARP members will be pleased to learn that the Province of British Columbia has confirmed their support of the agreement in principal to enhance the Canada Pension Plan, allowing all the provinces and the federal government to proceed with legislation enabling CPP enhancement.

Over the last week CARP members had engaged in an email writing campaign to BC Minister of Finance, Michael de Jong, asking him to support CPP enhancement without delay.

An agreement in principal was signed by the majority of provincial Ministers of Finance on June 20th, but in mid-July, Minister de Jong called for consultations with stakeholders in BC, before proceeding with ratification.

Today, the Government of British Columbia formalized their support of the agreement, citing strong support for CPP enhancement among the over 2000 comments received, with 65% supportive and 32% unsupportive. In contrast, over 90% of CARP members polled were supportive of CPP enhancement, even though they themselves would not benefit from the updated pension plan.

CARP COO & Vice President, Advocacy, Wanda Morris, who is currently in British Columbia meeting with volunteer Chapter leaders and government officials said, “Minister de Jong made the right decision to support CPP enhancement in June and we are glad that he has reiterated that support today, after hearing from British Columbians who are supportive of a strengthened national pension plan for Canadian workers.”

“Increases in CPP contributions from employees and employers are modest and affordable and will be phased in over a period of several years in the proposed plan, but the end result will be of significant benefit to future retirees and Canada will be a better country for it,” said Wade Poziomka, CARP Policy Director.

I agree with Wade Poziomka, the end result will be great for the entire country for years to come.

As far as Mark Machin testifying in Ottawa, all I can say is he is a very nice, smart and transparent leader and I’m sure he looks forward to answering all the questions parliamentarians want him to address.

One question I would ask him is do you think CPPIB can handle the growth which is a direct consequence of enhancing the CPP or should we create another CPPIB, say a CPPIB2 to handle the needs of CPP2?

Anyways, I am not worried about Mark Machin, he’s a consummate professional who will address all their questions in a very direct and open manner. There is a reason why China signed a deal to learn from CPPIB, it’s because its leaders want to emulate its success and that of other large, well-governed Canadian defined-benefit pensions.

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

Mary Childs of the Financial Times reports, Rhode Island cuts its hedge fund programme by two-thirds:

Rhode Island’s pension plan has decided to cut its investment in hedge funds by two-thirds, as retirement systems across the US re-evaluate their strategies for generating the returns they need to pay participants.

Over the next two years, the $7.7bn Employees Retirement System of Rhode Island will cut its allocation to hedge funds to 6.5 per cent from the 15 per cent it set in 2011 — joining a growing list of large investors who are dissatisfied by performance and pulling money from the sector.

“This wasn’t something we woke up one day and decided to do — it wasn’t something we did in response to headlines or political pressure,” said Seth Magaziner, general treasurer for the US state.

“We put a lot of work into this, a lot of modelling, a lot of testing and retesting of assumptions, and this was the result that the process led to,” he said: “We came to the conclusion that Rhode Island and many other states have been doing the process backward by starting with an assumed rate of return and trying to hit it.”

Instead, he said, Rhode Island set a risk tolerance “defined by real economic factors” such as the odds that certain costs may spike or that the fund would drop to less than 50 per cent funded. From there, it chose allocations designed to generate the most money possible at that risk level, and, working with the Pension Consulting Alliance, tested its conclusions against “thousands” of scenarios.

Many pension funds adopted alternative investment managers like hedge funds and private equity as high valuations across markets and low interest rates threatened returns from conventional long-only mutual funds. But hedge funds have struggled to generate returns in volatile markets, and their high fees have prompted some investors including the New Jersey and the New York City retirement systems to scrap or reduce their programmes.

Investors have already pulled more than $50bn from hedge funds this year, according to eVestment.

The total assets under management of the hedge fund industry exploded in size from $500bn at the turn of the millennium to almost $3tn by 2015. As assets have grown performance has suffered, with hedge funds as a whole failing to beat the S&P 500 over the past four years.

Rhode Island — which has less than 60 per cent of the assets it needs to pay its liabilities — is turning to passive trend-following strategies and private equity to help it claw back to a level where it can pay out its obligations. It is boosting its allocation to private equity from 7 to 12 per cent, over five years or more, to spread out exposure across different fund years and to avoid being forced to choose managers in a hurry, Mr Magaziner said.

Rhode Island will jettison its equity-focused hedge funds, but keep strategies categorised as “absolute return” with managers who have demonstrated that they are not correlated to the broader markets, and who will generate positive returns, he said.

“We’re going to stay passive when it comes to long public equity,” Mr Magaziner said. “We just didn’t have faith that active management could consistently achieve equity-like returns, so that’s that.”

Eight per cent of the plan has also been dedicated to a new strategy called “crisis offset” or “crisis protection” — long-duration Treasuries and passive momentum or trend-following strategies, assets that historically have made money in downturns.

“This is the part of our portfolio that we think is going to help us control against risk better than the bulk of our hedge funds have,” Mr Magaziner said. “If there really are strategies out there that will achieve positive performance at a time when everything else is dropping, that can be tremendously valuable.”

Things are not going well in Rhode Island. Edward Siedle recently wrote a comment for Forbes, Rhode Island Politicians’ Billion-Dollar Pension Hedge Fund Gamble Loses $500 Million:

Yesterday Rhode Island General Treasurer Seth Magaziner announced that the state pension would cut its $1 billion hedge fund investments– made under former Treasurer, now-governor Gina Raimondo– after losing big over the past five years. Neither Raimondo nor Magaziner ever heeded warnings that these high-cost, high-risk investments were inappropriate for the pension. A version of this article was published in GoLocal Prov yesterday.

***********

Do Rhode Island Governor Gina Raimondo and General Treasurer Seth Magaziner really believe they are smarter than Warren Buffett, considered to be one of the most successful investors in the world?

Of course not.

How could they?

The wreckage related to Raimondo’s failed stint as a small-time venture capitalist is finally out in the open for all Rhode Islanders to see.  The Point Judith II fund she pitched to the Employees Retirement System of Rhode Island (in which the pension risked $5 million) has returned a pathetic -1.1 percent over the past almost ten years—after paying her rich fees of 2.5 percent. If making money off your investors defines success, then Raimondo’s a superstar.

Magaziner, on the other hand, can boast a summer internship at Raimondo’s Point Judith Capital and two years as a portfolio associate, then research analyst at a small money management firm in Boston. Is this 31-year old qualified to manage $7.7 billion in state pension assets? Hardly.

Ignoring Warren Buffett and Other Questions

So why did Raimondo ignore Warren Buffett’s warning that public pensions should not gamble on hedge funds?

(As I advised Rhode Islanders approximately 4 years ago, Buffett made a million-dollar bet at the start of 2008 that a low-cost S&P 500 index fund would beat hedge funds over the next ten years. After eight years, as Buffett gloated at his company’s recent annual meeting in Omaha, the S&P 500 is crushing it. The fund Buffett picked, Vanguard 500 Index Fund Admiral Shares is up 65.67%; the high-cost, high-risk hedge funds are up, on average, a dismal 21.87%.

Also, when asked by a public pension trustee, Buffett advised that public pensions should avoid hedge funds and should prefer index funds.)

Worse still, why has Kid Magaziner stuck with Raimondo’s billion dollar-plus losing hedge fund bet and only yesterday announced plans to dump half the pension’s hedge fund investments for lower-cost, more traditional assets?

Why is it going to take Magaziner two years to exit hedge funds, even now?

The Answer to the Mystery

The answer to this longstanding mystery: Raimondo and Magaziner’s gambling state pension assets in hedge funds has never been about investing or prudent pension practices. It’s always been about politics.

These Rhode Island elected officials blatantly ignored credible warnings (by Buffett and, yes, me) and used $1 billion of public pension assets for their own political objectives. This week Magaziner even boasted that he gave my dire warnings about the dangers of high-cost, high-risk hedge funds “zero consideration.”

(Kid Magaziner should be sat down and told by a grown-up that when pension fiduciaries gamble and lose hundreds of millions of workers retirement savings, it’s probably not smart to admit having ignored the warnings of experts.)

Steering public monies to Wall Street has dramatically increased Rhode Island politicians’ campaign coffers to unprecedented levels. On the other hand, according to the General Treasurer’s office, the pension has lost 10 percent or approximately $100 million a year by investing in hedge funds. Over five years, that amounts to $500 million.

Any “savings” related to cutting workers’ 3 percent Cost of Living Adjustment (COLA) benefits over the past five years have been squandered. So much for Raimondo’s “pension reform” that was supposed to resolve the underfunding crisis. Further benefit cuts, or taxpayer infusions, will be required to restore funding.

The Bottomline

Workers’ benefits were slashed 3 percent to pay massive 4 percent fees to Wall Street hedge fund billionaires (who lost half a billion in workers’ retirement savings)—all in exchange for a measly few million dollars in political contributions. Talk about a deal with the devil. Was this foreseeable, and indeed foreseen, sleight of hand worth it?

Maybe to Raimondo and Magaziner the $500 million price paid by the pension to further their political ambitions is acceptable, but I doubt any state workers or taxpayers would agree.

That’s precisely the question the SEC, FBI (and, for that matter, Rhode Island’s sleepy Attorney General Peter Kilmartin) should be investigating.

Ted Siedle, the pension proctologist, is definitely not the type to tiptoe around issues. In this short comment, he rips into the former Treasurer of Rhode Island for using public money to invest in hedge funds in exchange for political contributions.

You’ll recall Gina Raimondo, the now governor of Rhode Island, was one of the heroes in Jim Leech and Jacquie McNish’s book, The Third Rail, for having the courage to implement tough pension reforms in that state.

Now we see Mrs. Raimondo may not be such a pension hero after all; she comes off as another cunning and opportunistic politician who went to bed with hedge fund sharks in order to advance her political career.

[Note: To be fair, if you read The Third Rail, you will see Raimondo implemented much needed and tough pension reforms but she’s obviously no angel and used her hedge fund contacts to get elected as governor.]

And who is this 31-year old Seth Magaziner, the current General Treasurer? At 31, he definitely doesn’t have the experience or qualifications to hold such a position. In fact, at 31, nobody should be in charge of $7.7 billion state pension fund, this is a complete travesty and farce.

Siedle is right, pensions and politics are not a good mixture, and he explains why. Hedge funds and private equity funds, many of which are underperforming and have a misalignment of interests with their limited partners, are effectively buying allocations and collecting fees no matter how well or poorly they perform.

But let me take a step back here because while I enjoy reading Ted Siedle’s hard hitting comments, he he too comes off sounding like a self-righteous and arrogant jerk who thinks he has a monopoly of wisdom when it comes to pensions and investments.

Well, he doesn’t, none of us do, and it’s high time I expose some of his blatant and biased nonsense against hedge funds. Yes, Warren Buffett is going to win that famous and silly $1 million bet against hedge funds which he made back in 2008 with Ted Siedes, co-founder of Protégé Partners.

So what? Who cares? I am sick and tired of reading about this epic and dumb bet Warren Buffett made against hedge funds right before markets tanked and came roaring back to make record highs. Buffett can thank Ben Bernanke, Janet Yellen, Mario Draghi, and Haruhiko Kuroda for unleashing a liquidity tsunami (in their misguided and feeble attempt to stop the coming deflationary tsunami) which helped thrust all risk assets much higher as everyone chases yield.

Comparing hedge funds to low cost exchange traded funds (ETFs) is just stupid, period. And by the way, most long only funds charging fees are going through their own epic crisis, and let’s not kid each other, this radical shift into exchange traded funds is one huge beta bubble which is making life miserable for all active managers.

In a recent comment of mine going over why  Ontario Teachers’ Pension Plan is cutting computer-run hedge funds, I stated the following:

[…] we can argue whether we are on the verge of a hedge fund renaissance or whether active managers could be ready to shine again but the point I’m making is most large pensions and sovereign wealth funds are more focused on directly or indirectly investing huge sums in illiquid alternatives and I don’t see this trend ending any time soon.

In fact, I see infrastructure gaining steam and fast becoming the most important asset class, taking over even real estate in the future (depending on how governments tackle their infrastructure needs and entice public pensions to invest).

I will end with a point Ron Mock made to me when I went over Teachers’ 2015 results. He stressed the importance of diversification and said that while privates kicked in last year, three years ago it was bonds and who knows what will kick in the future.

The point he was making is that a large, well-diversified pension needs to explore all sources of returns, including liquid and illiquid alternatives, as well as good old boring bonds.

And unlike other pensions, Ontario Teachers has developed a sophisticated external hedge fund program which it takes seriously as evidenced by the highly trained team there which covers external hedge funds.

Why does Ontario Teachers’ invest roughly $11 billion in external hedge funds through an overlay strategy? Are they dumb as nails? Haven’t they learned anything from Warren Buffett and Charlie Munger about how stupid investing in hedge funds truly is and what a waste of money it is?

I can guarantee you one thing, even though I don’t have the performance figures and fees paid to external hedge funds at Ontario Teachers’, there is no doubt in my mind (none whatsoever) that Ron Mock, Jonathan Hausman and the team covering external hedge funds there know a lot more about alpha managers than the Oracle of Omaha, Munger, Siedle and many other so-called experts of hedge funds who make blanket and often erroneous statements.

Trust me, I am no fan of hedge funds, think the bulk (90%++) of them stink, charging outrageous “alpha” fees for leveraged beta, or worse, sub-beta performance. Moreover, I agree with Steve Cohen and Julian Robertson, there is too much talent in the game, watering down overall returns, but there are also plenty of bozos and charlatans in the industry which have no business calling themselves hedge fund managers.

But all these self-righteous investment experts jumping on the bash the hedge funds bandwagon make me sick and if we get a prolonged deflationary cycle where markets head south of go sideways for a decade or longer, I’d love to see where they will be with their “keep buying low cost ETFs” advice (Buffett, Munger and Bogle will be long gone by then but Siedle and Seides will still be around).

I believe in the Ron Mock school of thought. When it comes to hedge funds and other assets, including boring old long bonds, always diversify as much as possible and pay for alpha that is truly worth paying for (ie. that you cannot replicate cheaply internally).

I will repeat what Ron told me a long time when we first met in 2002: “Beta is cheap. You can swap into any equity or bond index for a few basis points to get beta exposure. Real uncorrelated alpha is worth paying for but it’s very hard to find.”

Unlike other pensions, Ontario Teachers has developed a very sophisticated and elaborate program for investing in external hedge funds. Is it perfect? Are they hedge fund gods? Of course not, they experienced harsh lessons along the way but they were first movers in this area and always staffed this team with talented individuals who properly understand the risks of various hedge fund strategies.

In other words, they got the governance and compensation right and kept politics out of their investment decisions. That is why Ontario Teachers’ Pension Plan is fully funded and why Ontario’s teachers are in a great position when it comes to their retirement security.

I can’t say the same for Rhode Island’s public pension and many other US public pensions which are crumbling and facing disaster as the pension Titanic sinks. As long as they ignore the governance at their plans, they are doomed to fail and will keep succumbing to undue political interference which will only benefit a handful of hedge funds and private equity funds, not their members.

On Wednesday, I am off to cover the first ever emerging managers conference in Montreal which will feature emerging long only and hedge fund managers. I am looking forward to meeting managers I’ve already met in the past and new ones I have yet to meet. I will cover them on my blog.

I also wanted to cover parts of the AIMA Canada Investor Forum 2016 going on tomorrow and Thursday in Montreal but James Burron, AIMA Canada’s chief operating officer, told me that at the request of speakers, no press (I guess bloggers fall into this category) are allowed to cover this conference and only AIMA members can attend (I think this is silly and self-defeating but these are the rules they set).

Let me end by plugging Brian Cyr, Managing Director of bfinance Canada. I typically don’t plug investment consultants on my blog (quite the opposite, think most of them are useless), but over lunch yesterday, Brian explained the bfinance approach and how they get mandates from small to mid sized pensions for manager searches and I came away impressed with him and the approach.

Interestingly, unlike other consultants who put managers in a box, bfinance will take the time to understand its client’s needs, then go cast a wide net asking managers who can fulfill their search for a request for proposal. If the client chooses one of the managers, it’s the investment manager, not the client, that pays a fee to bfinance on assets obtained (a one time fee in the first year).

Amazingly, Brian told me that some clients think there is a conflict of interest in this model but they obviously don’t have a clue of what they’re talking about. The big conflicts of interest happen when consultants recommend funds they invest in or trade with or when they are used as “outsourced CIOs” to invest in funds they do business with.

No matter how big or small your organization is, I highly recommend you take the time to meet Brian Cyr and talk to him about their approach and what they can offer you in your search for traditional and alternative investment managers.

On that note, let me end by plugging yours truly. Please remember to support this blog (PensionPulse.blogspot.ca) via your PayPal contributions on the right hand side under my picture and show your appreciation for the work that goes into reading, researching and writing my comments.

Lastly and importantly, I am actively looking for a new gig, a job that compensates me properly for my knowledge, experience, qualifications and connections. For personal reasons, I am stuck here in Montreal, which is a beautiful city but not exactly a hotbed of financial activity. If you know of someone who is looking for someone with my background, please let me know (my email is LKolivakis@gmail.com).

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

Last week, the Department of Finance Canada released a statement, Canadians Can Count on a Stronger, Financially Sustainable Canada Pension Plan:

Helping Canadians achieve a safe, secure and dignified retirement is a core element of the Government of Canada’s plan to help the middle class and those working hard to join it. The Canada Pension Plan (CPP) enhancement agreed to by Canada’s governments on June 20, 2016 will give Canadians a more generous public pension system, which will support the conditions for long-term economic growth in Canada.

Minister of Finance Bill Morneau today tabled in Parliament the 27th Actuarial Report on the Canada Pension Plan. The Report concludes that the existing CPP is on a sustainable financial footing at its current contribution rate of 9.9 per cent for at least the next 75 years. CPP legislation requires that an actuarial report be prepared every three years to support federal and provincial finance ministers in conducting financial state reviews of the CPP as joint stewards of the Plan.

The CPP enhancement will build on this strong record of financial management: The Chief Actuary will conduct an actuarial assessment of the enhancement once legislation implementing the enhancement is introduced in Parliament.

You can read the latest triennial actuarial report on the Canada Pension Plan here. Jean-Claude Ménard, Canada’s Chief Actuary, and his team did a wonderful job explaining the state of the CPP and why its on solid footing.

I agree with Bill Morneau, Canada’s Minister of Finance, who sums it up well in this statement:

“The CPP enhancement agreement that Canada’s governments reached in June means that Canadian retirees will enjoy a more secure retirement and a better quality of life. This Actuarial Report confirms that the agreement will build on a rock solid financial foundation. I would like to thank Chief Actuary Jean-Claude Ménard and his Office on behalf of Canadians for their hard work and dedication, and look forward to their continued efforts in helping to ensure that Canadians can count on a stronger CPP well into the future.”

Let me first publicly thank Michel Leduc, Senior Managing Director & Global Head of Public Affairs and Communications at CPPIB, for bringing this to my attention last week (click on image below to see him):

Unfortunately, I was busy last week covering why Ontario Teachers is cutting computer-run hedge funds, why these are treacherous times for private equity providing a follow-up guest comment from an insider who revealed the industry’s misalignment of interests, and ended the week discussing the ongoing saga at Deutsche Bank.

But I think it’s important Canadians step back and realize how fortunate we are to have the Canada Pension Plan, its stewards, and the astounding and highly qualified professionals at the Office of the Chief Actuary, as well as the senior managers and board of directors running and overseeing the Canada Pension Plan Investment Board (CPPIB).

Michel Leduc’s initial email to me started like this:

If you’re open to topics for your blog, the Chief Actuary of Canada’s report was tabled by the Minister of Finance yesterday – looking into the sustainability of the CPP. This only happens once every three years. It is a deep dive into the program. It is a big deal and no one really places enough attention to it, remarkably.

In any event, it is astounding to see that, since the last report (2012), investment income (CPPIB) is nearly 250% above what the Chief Actuary had projected three years ago. The report indicates that this allows a lower minimum contribution rate. For those detractors of active management – this slams the misguided view that it is mere experiment.

Michel followed up by providing me some key findings from the latest triennial actuarial report:

• Despite the projected substantial increase in benefits paid as a result of an aging population, the Plan is expected to be able to meet its obligations throughout the projection period.
• With the legislated contribution rate of 9.9%, contributions are projected to be more than sufficient to cover the expenditures over the period 2016 to 2020. Thereafter, a portion of investment income is required to make up the difference between contributions and expenditures.
• Total assets are expected to grow from $285 billion at the end of 2015 to $476 billion by the end of 2025.
• The average annual real rate of return on the Plan’s assets over the 75-year projection period 2016 to 2090 is expected to be 3.9%.
• The minimum contribution rate required to finance the Plan over the long term under this report is 9.79%, compared to 9.84% as determined for the 26th CPP Actuarial Report.
• Investment income was 248% higher than anticipated due to the strong investment performance over the period. As a result, the change in assets was $70 billion or 175% higher than expected over the period. The resulting assets as at 31 December 2015 are 33% higher than projected under the 26th CPP Actuarial Report.

A few key points I’d like to mention here:

• Strong investment performance obviously matters for any pension plan. The stronger the investment performance, the better the health of the plan as long as liabilities aren’t soaring faster than assets, and this this translates into less volatility for the contribution rate (ie., less contribution risk).
• Unlike HOOPP or OTPP, however, the Canada Pension Plan is not a fully-funded plan (it is partially funded) and assets are growing very fast, which effectively means the managers at CPPIB can use comparative advantages over most other pensions to take a really long view and invest in highly scalable investments across public and private markets.
• I think it’s critically important that Canadians realize these advantages and why it sets CPPIB apart not only from other (more mature) pensions but more importantly, from long only active managers, hedge funds, and even private equity funds, all of which are struggling to deliver the returns pensions need.
• In particular, the crisis in long only active management is a testament to why the CPPIB is so important to the long-term health of the Canada Pension Plan and more importantly, why large, well-governed defined-benefit plans are far superior to defined-contribution plans or registered retirement and savings plans.
• Not only this, the success of the Canada Pension Plan should make our policymakers rethink why we even allow private defined-benefit plans at all and why we don’t create a new large public defined-benefit plan that amalgamates the few corporate DB plans remaining in Canada to backstop them properly with the full faith and credit of the Canadian federal government.

In other words, I’m happy we finally enhanced the CPP but we need to do a lot more building on its success and that of other large Canadian defined-benefit plans.

I mention this because I read an article from Martin Regg Cohn of the Toronto Star, Death of private pensions puts more pressure on CPP:

It’s human nature to ignore pension tensions. Until the money runs out.

Full credit to our political leaders for coming together to expand the Canada Pension Plan this summer, recognizing that a looming retirement shortfall requires a long-term remedy.

Their historic CPP deal came just in time, for time is running out on conventional pensions in the private sector.

Long live the CPP. Private pensions are on life support, and fading fast.

If anyone still doubts the need for concerted action, or ignored the high stakes negotiations over the summer, here are two bracing wake-up calls from just the past week:

First, unionized autoworkers at GM made an unprecedented concession to relinquish full pensions (which pay a defined benefit upon retirement) for newly hired employees. The agreement, ratified by Unifor members over the weekend, marks the end of an era in retirement security.

Like virtually all other private-sector workers, new hires at car factories will be given a glorified RRSP savings account. These so-called “defined contribution” plans (I prefer not to call them pensions) get matching employer contributions but remain at the mercy of the stock market for decades to come, without the security of annuitized payments upon retirement.

It’s hard to fault Unifor for throwing in the towel after long insisting on pension parity among all workers. They were among the last major private-sector unionists to cling to full-fledged pensions that have been phased out across North America.

Why continue to burden your own employer with legacy pension costs that disadvantage them against competitors? For example, Air Canada has faced major pension liabilities in recent years, while upstart start-up airlines like Porter were free from such legacy costs and financial risks because their newly hired workers weren’t getting “defined benefit” (DB) plans backstopped by the company.

A second development last week tells the story of our pension peril from a different angle: While autoworkers were surrendering full pensions for new hires, steelworkers were fighting to rescue and reclaim their full defined benefit pensions.

But the way in which their pensions are being salvaged portends a losing battle. When U.S. Steel Canada filed for creditor protection, after taking over Stelco’s assets, it revealed a pension shortfall of more than $800 million. Upon insolvency, that liability would land in the lap of the province’s little-known Pension Benefits Guarantee Fund.

It has always been something of a Potemkin pension fund, with little to prop up its facade of protection. Like an undercapitalized bank, the pension fund could not withstand a run on its assets if too many private pensions failed — requiring replenishment by the provincial government and all other employers in the province.

That’s why Queen’s Park has long been loath to see a big bankruptcy deplete the fund. Behind the scenes, it recruited former TD Bank CEO Ed Clark to find a way to rehabilitate what remains of the old Stelco operations so that those pension liabilities could somehow be avoided.

After drawn-out court hearings and closed-door negotiations, a New York investment firm signed a deal last week with the provincial government to invest hundreds of millions of dollars to save 2,500 jobs — and prop up those pensions a little longer. The United Steelworkers union, which had been deeply skeptical of previous bidders, likes this proposal because it provides a pension infusion.

While that may sound like good news for pensioners and workers, it is surely just a stop-gap — neither a sure thing for the former Stelco workers, nor a safe bet for the taxpayers who could be on the line if it all unravels.

We don’t know how the story will end. The only certainty is continued uncertainty for private-sector pensions, no matter how much union muscle is brought to bear. Private DB pensions are dying, and our only recourse is a reliable, diversified public DB pension in the form of the CPP.

All the more reason to herald the CPP expansion agreed to this summer after nearly a decade of drawn-out negotiations and foot-dragging by the previous Conservative government in Ottawa. A strong push by Ontario’s Liberal premier, Kathleen Wynne, and national leadership by the new federal Liberal government, helped persuade other premiers to accept a pan-Canadian compromise.

Details of the CPP reform, announced this month, will take years to phase in. In truth, it is a relatively modest and staged increase after a half-century of virtual stasis since the plan’s creation.

It is a promising start. But decades from now, as more private sector plans die off and today’s young people grow older, Canadians will wake up to the need for a more robust round of CPP expansion to pick up the slack.

It’s only human.

Indeed, it’s only human and I’m glad that our policymakers finally decided to enhance the CPP but a lot more needs to be done.

In particular, the Department of Finance Canada should immediately study a proposal to create a new large, well-governed public pension which will absorb the few remaining Canadian private DB plans and staff this new organization properly using the existing pool of talented pension fund managers in Montreal.

I mention Montreal, not Toronto, because Montreal is where you will find the head offices of CN, Bell and Air Canada, all of which have talented pension fund managers managing legacy and active DB pensions. And this city desperately needs a new large public pension plan (Toronto has the bulk of them).

But absent this initiative, I agree with Cohn, “long live the CPP!!!”, it’s our only hope to bolster Canada’s retirement system and the economy over the long run.

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

Sebastien Canderle, author of The Debt Trap: How leverage impacts private-equity performance, sent me a guest comment (added emphasis is mine):

It usually takes a financial crisis of the magnitude witnessed in 2008 for glitches within an economic system to come to light.

It has been widely known and reported that private equity dealmakers could at times be ruthless when dealing with their portfolio companies’ management, employees and lenders. But at least these PE fund managers (general partners or GPs) were treating one party with all the respect it deserved. Their institutional investors (the limited partners or LPs) could feel appeased in the belief that the managers’ interests were aligned with their own. According to a report recently issued by research firm Preqin and entitled Investor Outlook: Alternative Assets, H2 2016, 63% of PE investors agree or strongly agree that LP and GP interests are properly aligned.

One of the most prevalent urban legends perpetuated by GPs and their PR machine is that their actions are vindicated by their sole concern to serve their investors’ interests. After all, given the 2% of annual management commissions limited partners pay to cover the GP executives’ salaries and bonuses, this argument of perfect alignment seems to make sense. But it is emphatically not the case.

Let’s review some of the many tricks that financial sponsors use to serve their own interests rather than (often to the detriment of) their LPs’. Note that the following is not meant to be an exhaustive list; just a few pointers that some LPs have come across in the past.

First, just to remind the reader, quick exits and dividend recapitalizations have one key advantage: they boost the internal rate of return (IRR), the key performance yardstick in private equity. You might think that it is a good thing for LPs, since it delivers strong performance. But actually, it is not always ideal. Upon receiving their money back, LPs then need to find a new home for the capital that has been returned to them earlier than expected.

Let me expound. What institutional investors like pension funds and university endowment departments aim to do when they commit capital to the PE sector is to yield a higher return on their money than if it was allocated to lower-risk securities. But another crucial decision criteria is to put money to work for several years (typically 6 to 10 years).

When I state ‘higher return’, there are two ways to look at it: either through the IRR or via a money multiple. The difference is that an IRR is expressed as a percentage whereas cash-on-cash return is shown as a multiple of the original investment. And the difference matters enormously.

If a GP exits after two years (via a quick flip), a 1.5-times return yields a 22.5% IRR. It is massively above the hurdle rate (usually 8%, although many larger GPs do not bother with offering any preferred return to their LPs, or they offer a lower rate). So this 22.5% yield would enable the GP to look forward to carried-interest distribution (assuming of course that the rest of the portfolio does not contain too many underperforming assets and that there is no clawback clause in the LP agreement).

But a similar 1.5-times return after six years only yields an internal rate of return of 7%, which is below the standard hurdle rate, so it will not give right to carry for the GP since it did not give LPs an adequate return for the risk they were exposed to. A six-year holding period represents a higher-risk investment for a GP. Yet, an LP would receive 1.5 times its original capital and would still be satisfied, especially if that capital had delivered lower returns in a low-coupon bond environment like the one witnessed since 2009.

Because GPs know that the time value of money affects the likelihood of their investment performance falling below the hurdle rate, they have every incentive to partially or fully realise (that is, exit) their investment as quickly as possible. Quick flips are therefore preferable to GPs, even if the LP wished to see its capital remain deployed in order to accrue further value. GPs do not care if LPs then struggle to find a new home for the capital returned too early. All a GP cares about is whether its strategy will deliver carried interest, which is why quick flips and dividend recaps are so prevalent. The time value of money explains why GPs do not always serve their LPs’ interests.

Conversely, at times GPs prefer to hold on to investee companies longer than warranted, even when they receive approaches from interested bidders. In some instances fund managers can make more money from the annual fees they charge their LPs than by selling an asset. Imagine that a portfolio company is given a value by third parties that would grant an IRR of less than 8%. It might be totally acceptable to the LP, but because it falls below the hurdle rate, it will not enable the financial sponsor to receive carry. However, if the latter retains the company in portfolio, it will continue to charge annual management fees (of 1% to 2%) on the LPs’ capital invested in that company. You understand now why some LBOs turn into long-term corporate zombies or end up spending a while in bankruptcy. As long as their financial sponsors retain ownership of the companies, they keep charging management commissions to their LPs, but as soon as control is transferred to the creditors, fees stop coming in because the investment is deemed ‘realised’.

This strategy, as old as the industry itself, was adopted by very many GPs in the years following the Credit Crunch; especially GPs who failed to raise a follow-on fund. These PE managers (themselves becoming zombie funds) simply decided to milk the assets the only way advantageous to them, even if it meant extending the life of the fund beyond the typical 10-year period. For the LPs, realising the portfolio would have been clearly preferable in order to reallocate the recovered capital to higher-yielding opportunities. But they had few means to force their fund managers to comply (since they had already refused in most cases to up their commitment in a subsequent vintage). For the GPs, charging these fees enabled the senior managers to make millions in annual bonuses for several more years without having to sell the assets.

There is more. Consider the following practice, which most GPs are guilty of. When a fund is relatively recent (say, less than five years old since its original closing), it contains a fair share of unrealised assets in its portfolio. By this I mean that a lot of acquired companies are still held in portfolio. The implication is that, when valuing the unrealised portion of the portfolio at the end of each quarter, the GP managers need to use estimates. There is a guideline issued by national trade associations to define these estimates, but there is quite a bit of wiggle room here. What prevents a GP from taking out ‘outliers’ that do not show a pretty enough comparable multiple? Many GPs tend to be quite carefree (who wouldn’t be when doing his/her own self-assessment?) by mostly using comparable multiples that grant a high valuation (and therefore a high unrealised IRR) to the portfolio.

Why do GPs bother acting that way? For several reasons, but here is the key one: imagine that the GP wants to raise a subsequent vintage to its current fund. Its existing LPs will certainly be more interested in taking part in the new vehicle if they see a high IRR (even if unrealised) as a likely outcome of the current fund. You might argue that LPs are not that gullible and will not commit further capital unless a significant portion of the portfolio has been exited and has shown good results. Yet in 2008 several funds were raised even though the 2005/06 vintages had not been fully utilised, let alone materially realised. We know what happened to these 2005/06 funds. Their performance was far from stellar.

Recent years have seen a vast number of GPs raise new vintages even though their previous funds had seen no or very few portfolio realisations. North American energy specialist investor Riverstone launched a fresh fundraise in 2014 only one year after closing its previous vehicle (Riverstone Global Energy and Power Fund V) and before having exited any investment from that vintage. Admittedly, the fundraising process lasted more than two years. This month, tech specialist Thoma Bravo closed its latest fundraise at $7.6 billion, exceeding its $7.2 billion hard cap even though it was set at practically twice the size of the $3.65 billion fund raised in 2014. British outfit Cinven raised its sixth vintage in the first half of 2016 – after just four months on the road – when it had only divested one company (out of 15 portfolio companies) from its fifth fund of 2013. Cinven VI was reportedly twice oversubscribed. French mid-market firm Astorg had exited none of the seven companies acquired out of its fund V (raised in 2011) before reaching the hard cap of its fund VI in June 2016. Similarly, Australian shop Quadrant raised its fifth fund in August 2016 (on its first close) only two years after raising the previous vehicle. Quadrant PE No4 had exited none of its five investments. All these GPs had to use interim IRRs in order to raise fresh vintages despite the lack of meaningful exit activity from their previous vehicles. Time will tell whether the reported unrealised IRRs were realistic, but LPs do not seem too bothered by the very high-risk profile of immature vintages.

There is another reason why, traditionally, GPs artificially inflated their unrealised IRRs. In the early days of the sector’s history, PE managers used to be able to raise funds without granting LPs any right to the aforementioned clawback. Clawbacks are ways for institutional investors to recoup previously distributed carry if the GP manager’s performance at the end of the life of the fund falls below the hurdle rate. Nowadays, the vast majority of PE funds’ agreements include a clawback clause, but years ago it wasn’t always so, which explains why GPs tended to ‘tweak’ IRR calculations to their advantage and distribute themselves carried interest on the basis of high unrealised returns. Why not do it if you can get away with it.

Anyone telling you that GPs only care about maximising returns is just a scandalmonger. In truth, GPs care even more about charging fees, primarily because two-thirds of GPs never even perform well enough to receive any carried interest. Thus, I cannot possibly draw a list of LP/GP interest misalignment without raising the issue that has made front-page news (at least in the specialised press) in the years following the financial crisis.

The debate that has been taking place around management and monitoring fees and the double-charging by GP managers is not new, but it looks like even the foremost LPs committing billions of dollars to the sector failed to keep track of how much they were being charged annually by their GPs. Perhaps this is why, according to the aforementioned Preqin report, two-thirds of investors consider that management fees remain the key area for improvement and more than half of respondents are asking for more transparency and for changes in the way performance fees are charged.

In 2015, high flyers KKR and Blackstone were fined by the Securities and Exchange Commission $30 million and $39 million respectively for, allegedly, failing to act in the interest of their LPs in relation to deal expenses and fee allocation. Similarly, following another S.E.C. investigation, in August of this year their peer Apollo was slapped with a $53 million fine for misleading investors on fees. The issue of fee transparency and conflicts of interest is unlikely to be restricted to the mega segment of the industry. So there might be more bad news to come if the regulators choose to pursue the matter further.

Again the foregoing list is not meant to be exhaustive, but it serves to demonstrate that the alignment of interests between private equity GPs and LPs is kind of a myth. It took a financial crisis to remind everyone of this evidence, though based on Preqin’s research, not all investors seem aware of it.

You will recall Sebastien Canderle has already written another guest comment on my blog, A Bad Omen For Private Equity?, which I published in November last year.

Sebastien was kind enough to forward me this comment after he read my last comment on why these are treacherous times for private equity. I sincerely thank him as he is a PE insider who worked for four different GPs during a 12-year stretch, including Candover and Carlyle in London.

In other words, he knows what he’s talking about and doesn’t mince his words. He raises several important issues in the comment above and while some cynics will dismiss him as wanting to sell his book, I would buy his book, read it carefully and take everything he writes above very seriously.

We talk a lot about risk management in public markets but what about risk management in private markets where too many LPs don’t devote enough resources to really take a deep dive and understand what exactly their private equity and real estate partners are doing, what risks they’re taking, and whether they really have the best interests of their investors at heart.

I used to invest in hedge funds at the Caisse and saw my fair share of operational screw-ups which could have cost us dearly. When I moved over to PSP, I worked on the business plan to introduce private equity as an asset class and met GPs and funds of private equity funds. I used my due diligence knowledge in hedge funds to create a due diligence questionnaire for private equity GPs. It’s obviously not the same thing but there are a lot of issues which they have in common and I really enjoyed meeting private equity GPs.

Unlike hedge fund managers — and I’ve met some of the very best of them — top private equity GPs are all very polished, and when they’re good, they can close a deal with any LP. I remember a presentation given by fund managers at Apax Partners at our offices at PSP in Montreal. When they were done, Derek Murphy, the former head of private equity at PSP looked at me and said: “Man, they’re good, they covered all the angles. You can tell they’ve done this plenty of times before.”

Interestingly, Derek Murphy is now the principal at Aquaforte Private Equity, a Montreal company he set up to help Limited Partners (LPs) establish “aligned, high-performing, private equity partnerships” with General Partners (GPs). You can read all about what they do here.

I don’t mind plugging Derek’s new firm. Someone told me he’s “too scared” to read my blog which made me chuckle but if you’re an LP looking to improve your alignment of interests with private equity GPs, you should definitely contact him here (rumor has it his boxes were packed the minute PSP announced André Bourbonnais was named the new CEO and he quit shortly after knowing their styles would clash).

Anyways, I really hope you enjoyed reading this comment even if it shines a critical light on deceptive practices private equity GPs routinely engage in. Trust me, there are plenty more but Sebastien’s comment above gives many of you who don’t have a clue about private equity how private equity’s alignment of interests with LPs are often totally screwed up.

Those of you who want to learn more on private equity can read Sebastien’s books here as well as the links on my blog on the right-hand side. I also recommend you read Guy Fraser-Sampson’s book, Private Equity as an Asset Class (first edition is available for free here), as well as other books like Private Equity: History, Governance, and Operations, Inside Private Equity, and one of my favorites, Thomas Meyer’s Beyond the J Curve: Managing a Portfolio of Venture Capital and Private Equity Funds. Lastly, Jason Scharfman has written a decent book, Private Equity Operational Due Diligence: Tools to Evaluate Liquidity, Valuation, and Documentation.

The problem these days is too many so-called experts are too busy to read and learn anything new. They think they know a lot but they’ve only scratched the surface. My philosophy is to never stop reading, learning and sharing. And if you have expert insiders like Sebastien Canderle offering you something worth publishing, you take it and run with it.

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