Category: Home

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

A key committee last week approved a drop in the often-criticized CalPERS investment earnings forecast, gradually raising record rates already being paid by state and local governments. The change was then approved, as expected, by the full board.

The earnings forecast will drop from 7.5 percent to 7 percent, giving the nation’s largest public pension fund one of the most conservative forecasts, possibly setting a nationwide trend in the view of some.

But the painful and costly drop in the forecast used to “discount” or offset future pension obligations is still well above the 6.2 percent earnings forecast expected by CalPERS consultants during the next decade, which drove the action to drop the forecast.

Acting this month, rather than in February as some expected, seemed to reflect a general agreement and sense of urgency among employers and employees. As of last June, the CalPERS funding level fell to 68 percent of the projected assets needed to pay future pensions.

“It’s a little bit of pain for everyone,” said CalPERS President Rob Feckner, noting that five groups had come together on the action: labor, employers, the Brown administration, CalPERS staff, and the CalPERS board.

The committee approved a plan that would lower the earnings forecast or discount rate over three years, beginning with the state next year. Schools were split from the state and would begin in 2018 along with local governments.

The rate increase from a lower discount rate is phased in over five years. Some employee rates will go up, particularly for those hired after a pension reform in 2013 requiring them to pay half the “normal” cost, excluding debt from previous years.

When fully phased in the lower discount rate will cost the state an additional $2 billion, Eric Stern of Brown’s Finance department told the committee, half from the general fund that contributes $5.4 billion to CalPERS this year and the other half from special funds.

The rate increase comes in the middle of the usual four-year cycle for setting a discount rate. Wilshire and other consultants think that for several reasons global economic conditions have deteriorated since the current discount rate was reaffirmed at 7.5 percent two years ago.

Another sign of how seriously CalPERS regards the market change was the announcement Monday that, in a closed September session, the asset allocation of the $303 billion portfolio had been changed to reduce growth investments and the risk of losses.

Global equity investments were reduced from 51 percent to 46 percent of the portfolio, private equity dropped from 10 percent to 8 percent. Inflation assets increased from 6 to 9 percent, cash from 1 percent to 4 percent, and real estate from 12 to 13 percent.

Ted Eliopoulos, CalPERS chief investment officer, said the announcement was delayed to allow time for CalPERS to make some of the fund transfers. CalPERS investment changes often are not announced until later to avoid moving the markets.

At the Finance committee yesterday, board member J.J. Jelincic said the new asset allocation dropped the earnings forecast to 6.25 percent. His motion to drop the discount rate to 6.25 percent died without a second.

Staff told the committee that Jelincic’s assumption that the new allocation is expected to yield 6.25 percent is correct for the next decade. But the 7 percent discount rate is supported by the long-term yield over three decades.

At the Investment committee on Monday, Jelincic said CalPERS members need to know what’s being done with their money. His request for the public release of part of the transcript of the closed session, along with the agenda item, was referred to legal counsel.

Part of the urgency for action is that the underfunded California Public Employees Retirement System is unusually vulnerable to a major investment loss, unlike 2007 when it went into the deep recession and stock market crash with a funding level of 101 percent.

Two years ago, when the current 7.5 percent discount rate was reaffirmed, the funding level was estimated to be 77 percent, up from a low of 61 percent in 2009 after the CalPERS investment fund dropped from about $260 billion to $160 billion.

But since 2014, the economic outlook has declined and CalPERS investment earnings were well below the 7.5 percent target (0.6 percent last fiscal year and 2.4 percent the previous year), dropping the funding level to 68 percent as of June 30 this year.

“In all the data that (staff and consultants) have presented to us and that I’ve read, you drop to a level of 50 percent and it’s a point of no return as we know a pension system today,” board member Henry Jones said. “You may return, but it won’t be the same.”

Some think raising rates and the discount rate high enough to project 100 percent funding would become impractical. CalPERS is a mature system with the number of retirees soon expected to outnumber active workers.

Investment funds must be sold to pay pensions now, about $5 billion this year to add to $14 billion from employer-employee contributions to pay $19 billion for the pensions of the retirees. Reducing this growing “negative cash flow” is one of the reasons for raising rates.

Critics contend that an overly optimistic discount rate hides massive national state and local government pension debt. They argue that a risk-free discount rate should be used to aid “intergenerational equity” and reduce debt passed to future generations.

But the cost of using a risk-free rate to discount risk-free pension debt, following a basic finance principle, also would be massive. The yield on a 20-year Treasury bond early this month was about 3 percent.

Since the recession, CalPERS employer rates have increased roughly 50 percent. The discount rate was dropped from 7.75 to 7.5 percent in 2012. An actuarial method that no longer annually refinances debt was adopted in 2013.

The rate increase from a longer average life expectancy for retirees adopted in 2014 is still being phased in over a five-year period.

Some board members, perhaps referring to advance coverage of their meeting in the national media, said that a widely watched lowering of the discount rate by CalPERS would set a good example for other public pension funds.

“The recommendation before us gives us a chance to be a leader in the nation in responsible pension funding, and I think from a reputational perspective that is something it’s time for this system to take the lead on,” said board member Richard Gilliahan, Brown’s Human Resources director.

Board members also expect criticism that the discount rate was not dropped far enough. But state Controller Betty Yee and other board members said they will continue to work on the issue during the process leading to the scheduled rate review in 2018.

“This is all about the long-term sustainability of the fund,” said Richard Costigan, the Finance committee chair. “We are going to continue to have a robust discussion. This is just the start.”

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

Gillian Tan of Bloomberg View reports, Pension Funds Should Look North For Inspiration:

When it comes to at least one type of investing, U.S. pension funds should take a (maple) leaf out of their Canadian counterparts’ playbook.

Despite being among the largest private equity investors, U.S. pension funds such as the California Public Employees’ Retirement System and the California State Teachers’ Retirement System have been slow to transition from a hands-off approach to one that involves actively participating in select deals, a feature known in the industry as direct investing.

A More Direct Approach

The benefits of direct investing are lower (or sometimes no) fees and the potential to enhance returns, and that makes it an attractive proposition. But so far, U.S. pension funds have been pretty content as passive investors for the most part, writing checks in exchange for indirect ownership of a roster of companies but without outsize exposure to any (click on image).

State of the States

State pension funds are comfortable writing checks to private equity firms but could bolster their returns by investing directly in some of those firms’ deals (click on image).

Not so Canadian funds. A quick glance at the list of the private equity investors — commonly referred to as limited partners — that have been either participating in deals alongside funds managed by firms such as KKR & Co. or doing deals on their own since 2006 shows that these funds have had a resounding head start over those in the U.S.

Notably Absent

Large U.S. pension funds are nowhere to be seen among private equity fund investors that participate directly in deals, a strategy used to amplify their returns (click on image).

Canadian funds’ willingness to pursue direct investing is driven in part by tax considerations: they can avoid most U.S. levies thanks to a tax treaty between the two North American nations, while they are exempt from taxes in their own homeland. But U.S. pensions would still benefit from better returns, so it’s curious that they haven’t been more active in this area.

There’s plenty of opportunity for direct investing. Private equity firms are generally willing to let their most sophisticated investors bet on specific deals in order to solidify the relationship (which can hasten the raising of future funds). It also gives them access to additional capital.

Rattling the Can

Private equity firms recognize that offering fund investors the right to participate directly in their deals bolsters their general fundraising efforts (click on image),

The latter point has been a crucial ingredient that has enabled larger transactions and filled the gap caused by the death of the so-called “club” deals (those involving a team of private equity firms) since the crisis.

Seal the Deal

U.S. private equity deals which are partly funded by direct investments from so-called limited partners reached their highest combined total since 2007 (click on image).

There are some added complications. Because some of the deals involve heated auction processes, limited partners must do their own diligence and deliver a verdict fairly quickly. That could prove tricky for U.S. pension funds, which would need to hire a handful of qualified executives and may find it tough to match the compensation offered elsewhere in the industry. Still, the potential for greater investment gains may make it worth the effort — even for funds like Calpers that are reportedly considering lowering their overall return targets.

With 2017 around the corner, one of the resolutions of chief investment officers at U.S. pension funds should be to evolve their approach to private equity investing. They’ve got retired teachers, public servants and other beneficiaries to think about.

This article basically talks about how Canada’s large pensions leverage off their relationships with private equity general partners to co-invest alongside them on bigger deals.

It even cites one recent example in the footnotes where the  Caisse de dépôt et placement du Québec, or CDPQ, in September announced a $500 million investment in Sedgwick Claims Management Services Inc., joining existing shareholders KKR and Stone Point Capital LLC.

Let me cut to the chase and explain all this. An equity co-investment (or co-investment) is a minority investment, made directly into an operating company, alongside a financial sponsor or other private equity investor, in a leveraged buyout, recapitalization or growth capital transaction.

Unlike infrastructure where they invest almost exclusively directly, in private equity, Canada’s top pensions invest in funds and co-invest alongside them to lower fees (typically pay no fees on large co-investments which they get access to once invested in funds where they do pay fees). In order to do this properly, they need to hire qualified people who can analyze a co-investment quickly and have minimum turnaround time.

Unlike US pensions, Canada’s large pensions are able to attract, hire and retain very qualified candidates for positions that require a special skill set because they got the governance and compensation right. This is why they engage in a lot more co-investments than US pension funds which focus exclusively on fund investments, paying comparatively more in fees.

[Note: You can read an older (November 2015) Prequin Special Report on the Outlook For Private Equity Co-Investments here.]

On top of this, some of Canada’s large pensions are increasingly going direct in private equity, foregoing any fees whatsoever to PE funds. The article above talks about Ontario Teachers. In a recent comment of mine looking at whether size matters for PE fund performance, I brought up what OMERS is doing:

In Canada, there is a big push by pensions to go direct in private equity, foregoing funds altogether. Dasha Afanasieva of Reuters reports, Canada’s OMERS private equity arm makes first European sale:

Ontario’s municipal workers pension fund has sold a majority stake in marine-services company V.Group to buyout firm Advent International in the first sale by the Canadian fund’s private equity arm in Europe.

Pension funds and other institutional investors are a growing force in direct private investment as they seek to bypass investing in traditional buyout funds and boost returns against a backdrop of low global interest rates.

As part of the shift to more direct investment, the Ontario Municipal Employees Retirement System (OMERS) set up a private equity team (OPE) and now has about $10-billion invested.

It started a London operation in 2009 and two years later it bought V.Group, which manages more than 1,000 vessels and employs more than 3,000 people, from Exponent Private Equity for an enterprise value of $520-million (U.S.).

Mark Redman, global head of private equity at OMERS Private Markets, said the V.Group sale was its fourth successful exit worldwide this year and vindicated the fund’s strategy. He said no more private equity sales were in the works for now.

“I am delighted that we have demonstrated ultimate proof of concept with this exit and am confident the global team shall continue to generate the long-term, stable returns necessary to meet the OMERS pension promise,” he said.

OMERS, which has about $80-billion (Canadian) of assets under management, still allocates some $2-billion Canadian dollars through private equity funds, but OPE expects this to decline further as it focuses more on direct investments.

OPE declined to disclose how much Advent paid for 51 per cent of V.Group. OPE will remain a minority investor.

OPE targets investments in companies with enterprise values of $200-million to $1.5-billion with a geographical focus is on Canada, the United States and Europe, with a particular emphasis on Britain.

As pension funds increasingly focus on direct private investments, traditional private equity houses are in turn setting up funds which hold onto companies for longer and target potentially lower returns.

Bankers say this broad trend in the private equity industry has led to higher valuations as the fundraising pool has grown bigger than ever.

Advent has a $13-billion (U.S.) fund for equity investments outside Latin America of between $100-million and $1-billion.

The sale announced on Monday followed bolt on acquisitions of Bibby Ship Management and Selandia Ship Management Group by V.Group.

Goldman Sachs acted as financial advisers to the shipping services company; Weil acted as legal counsel and EY as financial diligence advisers.

Now, a couple of comments. While I welcome OPE’s success in going direct, OMERS still needs to invest in private equity funds. And some of Canada’s largest pensions, like CPPIB, will never go direct in private equity because they don’t feel like they can compete with top funds in this space (they will invest and co-invest with top PE funds but never go purely direct on their own).

[Note: It might help if OPE reports the IRR of their direct operations, net of all expenses relative to the IRR of their fund investments, net of all fees so their stakeholders can understand the pros and cons of going direct in private equity. Here you need to look at a long period.]

There is a lot of misinformation when it comes to Canadian pensions ‘going direct’ in private equity. Yes, they have a much longer investment horizon than traditional funds which is a competitive advantage, but PE funds are adapting and going longer too and in the end, it will be very hard, if not impossible, for any Canadian pension to compete with top PE funds.

I am not saying there aren’t qualified people doing wonderful work investing directly in PE at Canada’s large pensions, but the fact is it will be hard for them to match the performance of top PE funds, even after fees and expenses are taken into account.

Who knows, maybe OPE will prove me wrong, but this is a tough environment for private equity and I’m not sure going direct in this asset class is a wise long-term strategy (unlike infrastructure, where most of Canada’s large pensions are investing directly).

When it comes to private equity, Mark Wiseman once uttered this to me in a private meeting: “Unlike infrastructure where we invest directly, in private equity it will always be a mixture of fund investments and co-investments.” When I asked him why, he bluntly stated: “Because I can’t afford to hire David Bonderman. If I could afford to, I would, but I can’t.”

Keep in mind these are treacherous times for private equity and investors are increasingly scrutinizing any misalignment of interests, but when it comes to the king deal makers, there is no way Canada’s top ten pensions are going to compete with the Blackstones, Carlyles and KKRs of this world who will get the first phone call when a nice juicy private deal becomes available.

Again, this is not to say that Canada’s large pensions don’t have experienced and very qualified private equity professionals working for them but let’s be honest, Jane Rowe of Ontario Teachers won’t get a call before Steve Schwarzman of Blackstone on a major deal (it just won’t happen).

Still, despite this, Canada’s large pensions are engaging in more direct private equity deals, sourcing them on their own, and using their competitive advantages (like much longer investment horizon) to make money on these direct deals. They don’t always turn out right but when they do, they give even the big PE funds a run for their money.

And yes, US pensions need to do a lot more co-investments to lower fees but to do this properly, they need to hire qualified PE professionals and their compensation system doesn’t allow them to do so.

After twice vetoing similar measures, New Jersey Gov. Chris Christie last Thursday signed a bill that will require the state to make quarterly pension contributions, as opposed to one annual lump-sum payment.

The bill cleared both state legislative chambers unanimously in November.

However, there’s skepticism around the new law because it still doesn’t require the state to make full payments — and New Jersey has historically shorted its contributions or skipped them entirely.

More from NJ.com:

The new law will require governor to make pension payments on a quarterly basis by Sept. 30, Dec. 31, March 31 and June 30 of each year, instead of at the end of the fiscal year in June. In exchange, the pension fund would reimburse state treasury for any losses incurred if the state has to borrow money to make a payment.

State lawmakers voted overwhelmingly last month to approve the measure. It cleared the state Senate by a 35-0 vote and the state Assembly 72-0.

[…]

Hetty Rosenstein, state director Communications Workers of America, praised the bill, but stressed she’s focused on demanding the state make full payments.

“CWA supports quarterly pension payments,” she said. “However, unless the full amount due to the plan is appropriated, quarterly payments are meaningless. History shows we simply cannot rely on the word of the governor or Legislature when it comes to the pension.”

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

Heather Gillers of the Wall Street Journal reports, America’s Largest Pension Fund: A 7.5% Annual Return Is No Longer Realistic:

Top officers of the largest U.S. pension fund want to lower their investment targets, a move that would trigger more pain for cash-strapped cities across California and set an increasingly cautious tone for those who manage retirement assets around the country.

Chief Investment Officer Ted Eliopoulos and two other executives with the California Public Employees’ Retirement System plan to propose next Tuesday that their board abandon a long-held goal of 7.5% annually, according to system spokesman Brad Pacheco. Reductions to 7.25% and 7% have been studied, according to new documents posted Tuesday.

The last time the California system lowered its investment expectation was in 2012, when the rate was dropped to 7.5% from 7.75%.

The new recommendation comes just 13 months after the fund known by its acronym Calpers agreed to a plan that would slowly scale back its target by as much as a quarter percentage point annually—and only in years of positive investment performance. Now Mr. Eliopoulos and other officials are concerned that plan may not be fast enough because of a mounting cash crunch and declining estimates of future earnings.

“There’s no doubt Calpers needs to start aligning its rate of return expectations with reality,” California Gov. Jerry Brown said in a statement provided to the Journal.

The accounting maneuver would have real-life consequences for taxpayers and cities. It would likely trigger a painful increase in yearly pension bills for the towns, counties and school districts that participate in California’s state pension plan. Any loss in expected investment earnings must be made up with significantly higher annual contributions from public employers as well as the state.

“Lowering the rate of return sooner is undoubtedly going to make it more difficult for cities that are teetering on the edge financially,” said Bruce Channing, chair of the city managers’ pensions committee for the California League of Cities.

Nearly three quarters of school districts said in a survey conducted by Calpers that the impact of dropping the rate would be “high” or “extremely high.”

A drop in Calpers’s rate of return assumptions could also put pressure on other funds to be more aggressive about their reductions and concede that investment gains alone won’t be enough to fund hundreds of billions in liabilities. Because of its size, Calpers typically acts as a bellwether for the rest of the pension world. It manages nearly $300 billion in assets for 1.8 million members.

Pensions have long been criticized for using unrealistic investment assumptions, which proved costly during the last financial crisis. More than two-thirds of state retirement systems have trimmed their assumptions since 2008, according to an analysis of plans by the National Association of State Retirement Administrators.

The Illinois Teachers Retirement System in August dropped its target rate to 7% from 7.5% in August, the third drop in four years, and the fund’s executive director has said the rate will likely be reduced further next year. The $184 billion New York State and Local Retirement System lowered its assumed rate from 7.5% to 7% in 2015.

Amit Sinha of The Thought Factory blog also wrote an opinion piece for MarketWatch, What Calpers decides about its investment-returns forecast matters for pension plans (and taxpayers) across the U.S.:

The investment team at Calpers has been signaling that the current assumption of 7.5% long-term investment returns may be too high, and it would probably peg it around 6% instead.

The 7.5% rate is hardly unusual among government pension funds. But as the $300 billion gorilla in the pension world, any change — likely to be discussed at its Dec. 19 board meeting — will be watched by other pension plans that could then have a harder time justifying their own targeted returns.

This chart of expected-return assumptions of some of the larger pension plans shows that while about 40% of the largest corporate plans assume returns 7% and below, only 9% of public pensions assume returns 7% and below (click on image).

There is an element of subjectivity in estimating future returns, and the decision comes loaded with behavioral and political implications. The number determines how well-funded a pension plan is, which in turn determines the amount a state or municipality needs to pay into their pension system. A higher number can make the pension plan appear healthier, requiring lower contributions today.

If the funded status appears artificially high, one risk is that officials can promise a level of benefits that they may be unable to maintain. In the future that can lead to higher taxes, fewer services and even a cut in actual pension benefits.

The flip side is that reducing the expected return to 6% may double the immediate contributions of some municipalities, according to Pension & Investments, adding to local budget stresses.

Look at what has been happening in Dallas over the past month. The troubled $2.1 billion Dallas Police and Fire System suspended lump-sum withdrawals and has asked the city for a one-time infusion of $1.1 billion, an amount roughly equal to Dallas’ entire general fund (but nowhere close to what the pension fund needs to be fully funded).

This case highlights two negative behavioral implications of using artificially high future investment assumptions to value pension benefits. First, the impression of being well funded can lead to making promises you cannot keep. In 1993 Dallas provided generous benefits without appropriately accounting for how it might be able to meet them. Second, expecting higher returns can drive money into riskier investments with the promise of higher returns. In the case of Dallas, the pension system invested in real-estate deals that didn’t deliver as expected.

My friend and author Ben Carlson has collated a few more examples of troubled pension plans here.

Widening out across the nation, the extent of underfunding is likely not $1 trillion across states — but $6 trillion.

Why is this?

The financially accurate approach to valuing future liabilities is using a discount rate that you are relatively certain of earning, such as a Treasury or high quality bond rate. Private pensions are required to account for their liabilities using high-quality bond rates. As the chart below shows, the rates that public pensions are required to use to account for their liabilities are significantly higher than the rates used by corporate pensions. This results in understating public pension liabilities, and creates an incentive to make expected returns as high as possible (click on image).

The investment consultant Callan Associates created this series of pie charts to highlight the increased complexity that pension plans need to take on in order to meet a 7.5% return assumption today. In January 1995, the 10-year Treasury yield was around 7.75%, allowing you to earn 7.5% returns over 10 years with relative certainty; currently it is just under 2.5%, thereby pushing investors into assets such as equities and alternatives that might provide higher returns, but come with greater risk. The S&P 500 for example, returned an annualized return of 10% since 1995, but came with higher volatility, including a 50% decline in value during the financial crisis (click on image).

Calpers has a relatively well-balanced asset allocation, as this table shows, and shooting for higher returns would mean increasing the risk profile of the fund, which may not be prudent (click on image).

Critics of moving to a more financially accurate method of pension accounting rightly point to the immediate pain that would cause. If municipalities in California have to double their contributions by reducing discount rates from 7.5% to 6%, then it would be a disaster for them if they used a discount rate similar to that of corporate pensions.

However, there is something flawed in this logic. Instead of acknowledging the problem and then finding a solution, the critics would rather pretend the problem doesn’t exist. It’s the difference between “you owe $6 trillion, let’s work out a way for you to pay it off over time” and “you only owe $1 trillion, no big deal”.

Unless the true extent of underfunding is brought to light, we may be providing beneficiaries with a false hope that their promised benefits are secure. If taxpayers reach the limit of what they are willing to contribute, and state and federal governments are unable or unwilling to step in, then a cut in benefits may end up on the cards.

Even if over the next few years we see stellar investment returns (and I hope we do!), this conversation needs to happen. Instead of increasing benefits or reducing contributions, excess investment returns should be used to fill the widening hole. And the first step toward that is recognizing the size of that hole.

What Calpers decides to do with its expected-return assumption is likely to be a political decision, driven by compromise. The hope is that it can open up a much-needed debate that leads taxpayers, beneficiaries, pension committees and governments down the path of better understanding who is going to bear the risk of things not going as planned.

But if we hide the numbers, it’s hard to make the right decisions.

Amit Sinha has worked in the investment industry for over 16 years and in his spare time writes about bringing financial concepts, technology, design and behavior together. You can follow him on his blog The Thought Factory.

I’ve already covered why CalPERS needs to get real on future returns, stating the following:

The main reason why US public pensions don’t like lowering their return assumptions is because it effectively means public sector workers and state and local governments will need to contribute more to shore up these pensions. And this isn’t always feasible, which means property taxes might need to rise too to shore up these public pensions.

This is why I keep stating the pension crisis is deflationary. The shift from defined-benefit to defined-contribution plans shifts the retirement risk entirely on to employees which will eventually succumb to pension poverty once they outlive their meager savings (forcing higher social welfare costs for governments) and public sector pension deficits will only be met by lowering return assumptions, hiking the contributions, cutting benefits or raising property taxes, all of which take money out of the system and impact aggregate demand in a negative way.

This is why it’s a huge deal if CalPERS goes ahead and lowers its investment return assumptions. The ripple effects will be felt throughout the economy especially if other US public pensions follow suit.

Unfortunately, CalPERS doesn’t have much of choice because if it doesn’t lower its return target and its pension deficit grows, it will be forced to take more drastic actions down the road. And it’s not about being conservative, it’s about being realistic and getting real on future returns, especially now that California’s pensions are underfunded to the tune of one trillion dollars or $93K per household.

It’s not just CalPERS. From Illinois to Kentucky, US public pensions need to get real on future return assumptions or pray for a miracle that will never happen.

And the Dow 20,000 won’t save them or other pensions which are chronically underfunded. This too is a pipe dream which ignores the simple fact that no matter how good investment teams are at US public pensions, investment gains alone will never be enough to shore up public pensions over the long run.

Why? Because pensions are all about managing assets and liabilities. Those liabilities are long-dated (go out 75+ years) so for any decline in interest rates, the increase in liabilities is disproportionately larger than the gain in assets (in finance parlance, the duration of liabilities is much larger than the duration of assets, so any decline in rates will impact liabilities negatively more than it impacts assets in a positive way).

Now, a lot of people are getting excited about rates going up at the same time as assets going up. After the Fed raised rates on Wednesday, I was shocked to see how many industry professionals were parading in front of CNBC cameras claiming that “inflation concerns are on the rise” and the “Fed will surprise markets by raising rates a lot more aggressively in 2017″.

Total nonsense! Keep dreaming! I stand by everything I wrote last Friday when I went over the unleashing of animal spirits and think a lot of people aren’t paying attention to the surging greenback making a 14-year high (and going higher) and how it will tighten US financial conditions, lower US inflation expectations (via lower import prices) and hurt the domestic economy and possibly spur another Asian financial crisis, starting in China.

I know, president-elect Donald Trump and his powerhouse administration will “make America great again” allowing US public pensions to get back to the good old days when they were using 8%+ investment return assumptions to discount their future liabilities.

Like I said, keep dreaming, these markets seem so easy when they quietly keep rising but that’s when you need to be paying the most attention because the trend is your friend until it isn’t and when things shift, they shift very abruptly, especially when expectations are priced for perfection in terms of fiscal and monetary policy.

All this to say that 7.5% annualized return over the next ten years is a big pipe dream and no matter how much US public pensions allocate to illiquid or liquid alternatives, they will never attain this bogey without taking huge risks which will likely set them back further in terms of funded status.

I am open to all criticisms, suggestions, counterpoints, but I pretty much stand by everything I’ve written above and think that the day of reckoning for many US public pensions is right around the corner. Better to be safe than sorry which is why CalPERS is right to lower its future return assumptions. Others will necessarily have to follow or risk a much worse outcome down the road.

Let me repeat, I don’t care if you’re CalPERS, CalSTRS, Ontario Teachers’, HOOPP or if you have George Soros, Ken Griffin, Jim Simons, Steve Schwarzman and Ray Dalio all sitting on your investment committee, investment gains alone are not going to shore up your pension when times are tough, especially if it’s already chronically underfunded.

At one point, pension plans need to adjust benefits too or shore up public pensions via more taxpayer dollars. That’s when the real fun begins.

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

Vipal Monga and Heather Gillers of the Wall Street Journal report, Dow 20000 Won’t Wipe Away Pension Problems:

The 2016 surge in stocks and bond yields is a rare positive for U.S. company and public pensions. But it doesn’t solve their problems.

In November large corporate retirement plans gained back $116 billion needed to pay out future benefits largely because of dramatic market movements following Donald Trump’s Nov. 8 election win, according to consulting firm Mercer Investment Consulting LLC.

The S&P 500 soared and long-term interest rates rose, boosting asset values and lowering liabilities for pensions at 1,500 of the largest U.S. companies. The present-day value of future obligations owed by companies falls when interest rates rise.

Even with November’s gains, corporate pensions were left with a $414 billion funding deficit, $10 billion larger than it was at the end of last year, according to Mercer. Funding deficits occur when the value of assets in pension plans don’t equal the projected future payments to retirees.

“It’s been good, but not great,” said Michael Moran, pension strategist at Goldman Sachs Asset Management. “Things are better than where we were a month ago, but it’s still too early to declare victory.”

That tempered reaction indicates the magnitude of the funding gap faced by managers of retirement assets across the U.S. Pensions still haven’t recovered from the chronic deficits created by the financial crisis and perpetuated by low interest rates.

The largest corporate-pension funds lost more than $300 billion during the 2008 downturn, according to consulting firm Milliman Inc., and that loss wiped out the previous five years of gains.

Pension deficits are a big deal for companies, because firms must close funding gaps with cash they could use for other purposes. Companies such as General Motors Co., International Paper Co., and CSX Corp. have all borrowed money this year to pump funds into their pension plans.

Companies in the S&P 1500 have contributed $550 billion into their pension plans between 2008 and Nov. 30 of this year, according to Mercer. Even with those contributions, their funded status was 81.3% as of Nov. 30.

Although pension-funding levels fluctuate during the year, most companies lock in their pension obligations at the end of the year for accounting purposes. November’s run-up, if it continues into December, could help lessen the burden of what had earlier been shaping up to be a big drag on 2016 financial results.

Funding holes are a trickier problem for funds that manage the pension assets of public workers because market rallies don’t automatically help close the gap.

Public-pension liabilities have grown significantly over the past decade, with the 30 largest plans tracked by the Public Plans Database showing a net pension debt of $585 billion in 2014, compared with $186 billion in 2005.

Almost all public retirement systems engage in an accounting practice known as “smoothing” returns, meaning it takes time to fully recognize investment earnings that exceed expectations. That approach limits how much the funding status will improve this year even if strong stock markets help the plans earn a return above their targets.

“All we know is that interest rates have popped up a little bit and equity prices have run up over the last three weeks,” said Alan Perry, an actuary with Milliman. “How that’s going to filter into the ingredients that go into forecasting long-term returns, it’s too early to tell.”

The largest public pension in the U.S., California Public Employees’ Retirement System, is debating whether to lower its expected rate of return—currently 7.5%.

The fund, known by its acronym Calpers, absorbed substantial losses during the last recession and currently has just 68% of assets needed to pay for future obligations. It earned 0.6% on its investments in the fiscal year ended June 30, well short of its annual goal.

“It’s too early to tell whether this [recent improvement] is something that’s going to be sustained,” said California State Controller Betty T. Yee, who serves on Calpers’s board.

This is a good article which explains why big gains in the stock market and the backup in yields aren’t going to make a dent in America’s ongoing pension crisis.

First, let me split US private pensions apart from US public pensions. Unlike the latter, the former aren’t delusional when it comes to discounting their future liabilities. In particular, they don’t use rosy investment assumptions to discount future liabilities but actual AAA corporate bond yields which have declined a lot as government bond yields hit record lows.

Some think using market rates artificially inflates pension deficits at America’s corporate defined-benefit plans and there is some truth to this argument. But one thing is for sure, if reported corporate pension deficits are higher than they should be at private corporations, US public pension deficits are woefully under-reported using a silly and delusional approach which discounts future liabilities using a pension rate-of-return fantasy.

Now, it’s in US corporations’ best interests to over-report their pension deficits just like it’s in the best interests of US public plans to under-report them. How so? Aren’t pension deficits a noose around the neck of US corporations?

Yes, they are which is why they are trying to offload the risk onto employees and get rid of defined-benefit plans altogether for any new employees. What concerns me is that they are shifting everyone into defined-contribution plans which will only ensure more pension poverty down the road. That is the brutal truth on DC pensions, they aren’t real pensions employees can count on.

Interestingly, in an email exchange, Jim Leech, the former president of the Ontario Teachers’ Pension Plan, agreed with Bob Baldwin’s comments on Canada’s great pension debate and added this:

“My recollection is that the Tories were lobbied hard for this after New Brunswick succeeded in its reform and reluctantly introduced the TB concept. I say reluctantly because they were more interested in promoting their group DC plan – forget the name (it was PRPPs).

So drafting was in works by civil servants before Liberals won. The Canada Post labour strife put back on front burner as TB is most helpful answer there but unions are fighting tooth and nail. Liberals likely thought there would be no outcry as there was none when Tories announced originally.

Still amazed that GM/Unifor went straight to DC instead of adopting TB.”

What Jim is referring to is that sponsors are shifting employees into defined-contribution plans without first assessing the merits of target or variable-benefit plans.

Of course, TB plans are not DB plans and this is something that employees should be made aware of and something Bob Baldwin explained further when I asked him where he considers various plans (like OTPP, HOOPP, OMERS, etc.) fall in the spectrum:

“I would reserve the term Target Benefit for plans in which all accrued benefits (i.e. accrued benefits of active members, retirees and deferred vested benefits) are subject to adjustment based on the financial status of the plan. Aside from the New Brunswick’s shared risk plans, the best examples of this type of plan are the union initiated multi-employer plans. I would describe OTPP and HOOPP as plans that are largely but not purely DB. They are not purely DB because they have shifted some financial risk from the contribution rate to the benefits.

The fact that you asked the question is important to me. It speaks to the reality that pension design is more like a spectrum of choice rather than a binary choice between DB and DC or even a three way choice among DB, DC and TB. There are any number of ways that financial risk can be allocated. Unfortunately, when the reality that confronts us is a spectrum, the language we will choose to describe it will almost always be more categorical than the reality itself. That’s why in my earlier email urged paying more attention to how risk is allocated and less to the labels we use.”

I agree with Bob Baldwin and might add that even though OTPP and HOOPP are fully or even over-funded, not every public pension plan can do what they’re doing either because they don’t have the governance or because their investment policies don’t allow them to take the leverage that these two venerable Canadian pension plans take.

Also, while I like their use of adjusting inflation protection partially or fully to get their respective  plans back to fully-funded status, former actuary Malcolm Hamilton made a good point to me yesterday that in a low inflation world, adjusting for inflation protection becomes a lot harder and less effective (God forbid we go into deflation, then there will be no choice but to raise contributions, cut benefits or increase taxes).

As far as US public plans, they truly need a miracle. Every day I read articles about horror stories at Dallas, Chicago, San Diego, and elsewhere in the United States.

I highly recommend every state plan follows CalPERS and gets real on future returns but I recognize this will have ripple effects on the US economy and deter from growth over a long period.

The problem is ignoring the elephant in the room and waiting for disaster to strike (another financial crisis) will only make the problem that much worse in the future and really deter from US growth.

President-elect Trump is meeting with tech executives today. I think that is great as America needs to tackle its productivity problem, but something tells me he should also meet with leaders of US pension plans to discuss how pensions can make America great again.

One thing is for sure, Dow 20,000 or even 50,000 under Trump isn’t going to solve America’s pension ills or make a dent in America’s ongoing retirement crisis. And if we get another financial crisis, deflation, Dow 5,000 and zero or negative rates for a very long time, all pensions are screwed, especially US public pensions.

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

Richard Ferguson of the Australian reports, CPPIB acquires 50pc stake in AMP Capital-managed NZ portfolio:

North American investor Canada Pension Plan Investment Board has acquired a half-stake in an AMP Capital-managed portfolio of New Zealand properties for $NZ580 million ($557m).

CPPIB bought the 50 per cent interest in the New Zealand properties from another ­Canadian fund investor, PSP ­Investments, which will keep a half-stake in the suite of prime office and retail assets.

The portfolio of 13 buildings is worth $NZ1.1 billion in total and is located primarily in Wellington and Auckland.

Yesterday’s move was CPPIB’s first investment in New Zealand and saw the fund expand its $C38.4bn ($39bn) worth of global real estate investments.

CPPIB head of Asian real estate investments Jimmy Phua said the Canadian pension fund was attracted to New Zealand’s strong population growth and buoyant tourism sector.

“With this acquisition, we are able to gain a meaningful presence in the New Zealand commercial real estate market, partnering alongside PSP Investments, who is a like-minded, long-term partner,” he said.

CPPIB is partnered with AMP Capital in several Australian ventures and said the firm would continue to manage the New Zealand portfolio. “This is a rare opportunity to acquire a ­diversified portfolio that includes top-tier office and retail properties in New Zealand,” he said.

The AMP-managed property portfolio includes the Botany Town Centre and the Manukau Supa Centre in Auckland.

It also holds the 13-level St Pauls Square office building in Wellington, which is undergoing a $38 million refurbishment, ­before the New Zealand government moves in after signing a 15-year lease.

AMP Capital head of real estate investments Chris Judd said there had been talks about the expansion of the New Zealand property portfolio.

“Ultimately we will be looking at more acquisitions in the near future but right now I’m ­focused on investment performance,” he said.

CPPIB put out this press release going over the deal:

Canada Pension Plan Investment Board (CPPIB) announced today that it has signed an agreement to acquire a 50% interest in a diversified portfolio of prime office and retail properties in New Zealand from the Public Sector Pension Investment Board (PSP Investments). The 50% interest is valued at NZ$580 million (C$545 million) with an equity investment of NZ$230 million (C$216 million) subject to customary closing adjustments. PSP Investments will continue to hold the remaining 50% interest. The portfolio will continue to be managed by AMP Capital, an existing partner of CPPIB in Australia.‎

The portfolio comprises a mix of 13 well-located office properties and high-quality shopping centres totalling approximately 268,000 square metres (2.9 million square feet). Located primarily in Auckland and Wellington, the properties are situated within the central business districts and growing metropolitan markets.

“This is a rare opportunity to acquire a diversified portfolio that includes top-tier office and retail properties in New Zealand, a market with continuing population and tourism growth,” said ‎Jimmy Phua, Managing Director, Head of Real Estate Investments – Asia, CPPIB. “With this acquisition, we are able to gain a meaningful presence in the New Zealand commercial real estate market, partnering alongside PSP Investments, who is a like-minded, long-term partner and extending our relationship with AMP Capital.”

The transaction is expected to close following customary closing conditions and regulatory approvals.

At September 30, 2016, CPPIB’s investments in global real estate totalled C$38.4 billion.

I don’t know much about New Zealand except that it’s a beautiful country and boasts the best rugby team in the world, the All Blacks.

From what I’ve read, New Zealand’s political stability is in stark contrast to Australia’s shakes and shifts and the country’s economy is being labeled “the miracle economy“.

Why did CPPIB buy this real estate portfolio? To diversify its real estate holdings in Asia and New Zealand, just like Australia, is a stable country with a strong economy which will benefit over the long term as Asian emerging markets grow.

It is also worth noting that the Kiwi-CAD cross rate is fairly stable and one Canadian dollar equals about 1.06 New Zealand dollars, so currency risk isn’t as big of a deal here (unless you get a Brexit type of event in New Zealand which seems highly unlikely).

Why is PSP selling part of its real estate holdings in New Zealand? Why not? It wants to lock in profits and focus its attention elsewhere. It’s not selling out, still has a big stake, and now has a great long-term investor alongside it to manage these assets.

Don’t forget, in Canada, it’s all a big giant pension club. Everyone knows each other. André Bourbonnais, PSP’s CEO, used to work at CPPIB and knows Mark Machin, CPPIB’s CEO, very well. Neil Cunningham, PSP’s Senior Vice President and Global Head of Real Estate Investments, knows Graeme Eadie, CPPIB’s Senior Managing Director & Global Head of Real Assets.

There is a lot of communication between the senior managers of Canada’s large pensions so if someone is looking to unload something or buy something, they will talk to each other first to see if they can strike a deal. It could be that CPPIB’s real estate partner in Australia, AMP Capital, approached them with this particular deal but I am certain there were high level discussions between senior representatives at these funds.

Anyway, that isn’t a bad thing, especially between PSP and CPPIB, two of the largest Canadian Crown corporations with very similar liquidity profiles and a lot of money to invest across public and private markets all around the world. In my opinion, they should be partnering up on more deals.

[Note: One area where they are not similar is in the way they benchmark their respective policy portfolios and in particular, the way they benchmark real estate assets. This is a deficiency on PSP’s part which I’ve discussed plenty of times on this blog, like when I covered PSP’s fiscal 2016 results. Neil Cunningham and his team are doing an outstanding job managing PSP’s real estate portfolio, but it sure helps that their benchmark doesn’t reflect the risks they take and is easy to beat.]

In other real estate news, Pooja Sarkar of India’s Economic Times reports, CPPIB to invest in India’s largest realty deal:

In the largest deal brewing up in the commercial real estate space in India, Canada Pension Plan Investment Board ( CPPIB) is leading the negotiation to acquire private equity firm Everstone Group’s industrial and logistics real estate development platform, IndoSpace, as part of private real estate investment (REIT), said two people familiar with the development.

The entire deal is pegged at Rs 15,000 crore making it the largest commercial real estate transaction in the country, they added.

“The deal has been structured in two parts, in the first phase, CPPIB will acquire the ready development space of nearly 10 million sft for nearly Rs 4000 crore,” said the first person mentioned above.

“Indospace is developing another 30 million sft across the country which will be developed and added to this portfolio and the payouts will be linked to that. Everstone will continue to manage these assets even after the full sale process,” the second person added.

IndoSpace is a joint venture between Everstone Group and US-based Realterm. Everstone is a private equity and real estate firm that focuses on India and South-East Asia, with over $3.3 billion of assets under management. Realterm is an industrial real estate firm that manages approximately $2.5 billion of assets across 300 operating and development properties in North America, Europe and India.

Sources add that Everstone has hired Citi bank to run the sale process.

Reits are entities that own rent-generating real estate assets and offer investors regular income streams and long-term capital appreciation.

With this sale, this would be the first successful Reit offering from the Indian subcontinent.

“The talks were on with three serious contender but final negotiations are underway with CPPIB and it would be the largest investment by Canadian pension fund in India to date,” the first person added.

CPPIB and Everstone both declined to comment for the story.

The deal is expected to be signed by January end with CPPIB head expected to visit India two weeks late and discuss the transaction, said another person involved in the matter.

This is a good deal as India is one of the emerging markets that many analysts feel has great prospects ahead even if there will be problems along the way, like its unprecedented assault on cash.

The point with all these private market deals is that CPPIB, PSP and other large Canadian pensions are setting up teams in these regions and finding the right partners to make these long-term strategic investments which will benefit their funds and their beneficiaries.

Below, Canada Pension Plan Investment Board Chief Executive Officer Mark Machin says he was among the minority of investors who accurately foresaw Donald Trump’s march to the White House:

In an interview on BNN, Machin said his doubts in the polls indicating a Hillary Clinton victory began growing in late 2015.

“I had personally predicted a Trump win for the past year; I thought the margin of error was very, very tight in the polls … and it could quite easily swing in Trump’s direction,” he said.

Machin said investors can easily assess scheduled political events like the U.S. election and the U.K. referendum, but are no better at accurately predicting the outcome than the polls.

“Markets are not great at judging the outcomes because market participants don’t really have any better insight than anybody else on what the politics and public opinion is going to be,” he said. “They’re also not that great at judging what the reaction will be after the event as well, and that was classically the case in … the U.S. election.”

Watch the entire interview below or click here if it doesn’t load below. He discusses CPPIB’s investments and how they are positioning their portfolio to achieve the long-term actuarial target rate-of-return. He also discusses why CPPIB’s governance is the key to its long-term success.

I met Mark Machin a few months ago when he was in Montreal and think he’s very nice, very smart and a very capable leader.