Pension360

Brazilian President Michel Temer details of his controversial pension overhaul plan earlier this week, and now further details are coming out about the expected savings the proposal would bring.

The overhaul would raise retirement ages and increase contribution required from workers — in effect, a significant cut in benefits for the country’s workers.

But the plan will bring billions in savings for the country over the next decade, to the tune of $200 billion.

From Reuters:

Brazil’s government expects to reduce expenditures by about 687 billion reais ($200 billion) between 2018 and 2027 with proposed changes to its costly pension system, the government’s pension secretary said on Tuesday.

The proposal to overhaul Brazil’s pension system, seen by investors as the most important of President Michel Temer’s agenda to shore up the country’s public finances, would automatically adjust up the minimum age of retirement as the population’s life expectancy grows, pension secretary Marcelo Caetano said.

Other changes would include removing tax exemptions on revenues from exports and demand rural workers to start contributing to the pensions system, Caetano told journalists.

The controversial pension reform plan at the heart of Temer’s austerity drive aims to shore up an economy mired in its worst recession on record by bringing under control a widening budget deficit. Temer unveiled the reform on Monday by saying it was necessary to avoid a collapse in the pension system.

 

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.

The California Supreme Court last week agreed to hear an appeal of a groundbreaking ruling that allows cuts in the pensions earned by current state and local government workers, including judges.

When judges have an obvious conflict of interest and excuse themselves from ruling on a case, the legal term is “recuse.”

But the seven Supreme Court justices seem unlikely to recuse themselves from a possible landmark ruling on this Marin County pension case, mainly because there is no clear alternative.

There is at least one well-publicized example of how judges ruling on their own pensions creates the appearance of self-serving, if not what President-elect Trump called a “rigged” system.

As Orange County unsuccessfully tried to overturn a retroactive pension increase for deputy sheriffs, an attorney arguing the case for the deputies in 2011 reminded the judges they were ruling on their own pensions.

“Miriam A. Vogel, a retired Court of Appeal justice, clearly told her former colleagues that the court’s decision would affect every pension in the state of California: ‘(I)t would affect yours, it would affect mine,’” former Orange County Supervisor John Moorlach (now a state senator) wrote in the Orange County Register.

“Then she took a couple of questions and sat down. She gave no legal citations, no elaborate arguments. Nothing,” Moorlach wrote.

The Arizona supreme court had an obvious way to avoid ruling on their own pensions earlier this month. Two appeals court judges sued to overturn reform legislation in 2011 that increased their pension contributions from 7 percent of pay to 13 percent.

Four Supreme Court justices appointed before 2011 recused themselves, leaving the decision to a panel of one Supreme Court justice and four lower-court judges who took office after 2011 and were not affected by the reform.

The panel overturned the reform on a 3-to-2 vote, costing the Arizona Public Safety Personnel Retirement System an estimated $220 million in back payments and adding $1.3 billion to the pension debt or “unfunded liability.”

The majority ruled that the pension promised at hire becomes a contract that can’t be cut, the Associated Press reported. The minority, including Justice Clint Bolick, said freezing contributions could jeopardize the pension plan.

Arizona switched new judges and elected officials to 401(k)-style plans in 2013, limiting pensions from the system to police, firefighters and correctional officers. A pension reform approved by voters earlier this year is projected to save $475 million.

In Rhode Island last year, an embattled judge who refused to recuse herself approved a settlement of union suits against major cost-cutting reforms after accepting a state motion to have a jury hear the cases.

A nationally known lawyer, David Boies, and others urged Superior Court Judge Sarah Taft-Carter to recuse herself because the ruling could affect her pension in addition to the pensions of her son, mother and uncle.

“If my financial interest should require disqualification, then all other state judges would be similarly required to recuse themselves,” Taft-Carter told the New York Times. “Plaintiffs brought this case the way they did to try to avoid federal jurisdiction,” Boies said.

The settlement retained 92 percent of the $4 billion savings expected from reforms that increase the retirement age, shift workers to a federal-style hybrid plan combining smaller pensions with a 401(k)-style plan, and suspend cost-of-living adjustments, the Providence Journal reported.

The Journal said giving the cases to a jury would make it more difficult for unions to prove that pensions are implied contracts. The leader of the reforms, Treasurer Gina Raimondo, who became governor, argued that pensions created by statute can be amended like statutes.

In California, some union suits challenging cost-cutting reforms in retiree health care have been filed in federal court, where judges have no state conflict. Pension suits are rarely if ever filed in federal court.

Landmark guidelines issued in a retiree health care case five years ago seemed to show federal court deference to state law and may foreshadow how the state Supreme Court will view the new pension case.

An agreement negotiated with Orange County unions in 2008 separated active and retired worker health care premiums, ending a pool begun in 1985 that raised county costs but cut payments by retirees because their age-related coverage costs more.

When the cut was upheld by a district court and appealed by retirees, the federal 9th circuit court asked the state Supreme Court: “Whether, as a matter of California law, a California county and its employees can form an implied contract that confers vested rights to health benefits on retired county employees.”

The state Supreme Court unanimously said in 2011 that a contract with vested rights “can be implied under certain circumstances from a county ordinance or resolution” if an intent to do so can be shown by evidence.

A federal district court, following the new state guidelines, again ruled that Orange County can end the retiree health care pool. The federal 9th circuit panel upheld the ruling in 2014.

The Marin County appellate court ruling in August gave new hope to cost-cutting pension reformers, and alarmed pension advocates, by breaking with what has become known as the “California rule”:

Pensions offered at hire become vested rights, protected by contract law, that can only be cut if offset by a comparable new benefit, which erases employer savings and limits most reforms to new hires without vested rights.

The rigid contract rule created by California judges in previous rulings (not by legislation, as reformers like to point out) has only been adopted by a dozen states. There is no similar rule for the remaining private-sector pensions regulated by a 1974 federal law.

With a section on the “emergence of the unfunded pension liability crisis,” the unanimous ruling by a three-member appellate panel in the Marin County case is aimed at allowing flexible cuts in growing pension costs that are taking funding from basic government services.

The bipartisan Little Hoover Commission and other reformers argue that allowing cuts in the pensions earned by current workers in the future, while protecting pensions already earned, is urgently needed to cut budget-devouring costs and make pensions affordable in the future.

Observing the California rule, Gov. Brown’s modest pension reform only applies to new hires, taking decades to yield significant savings. The reforms cover CalPERS, CalSTRS and county systems, but not UC and the half dozen troubled big-city pension systems.

The reform also exempts new judges from some of the cost-cutting provisions, lower pensions and a cap on total pension amounts. Judges often seem to be treated like a special case by the Legislature and the California Public Employees Retirement System.

Among CalPERS plans only judges have the most generous pension formula because they tend to enter the system at a later age and retire late. And only judges are eligible for retiree health care that pays 100 percent of the premium after 10 years of service, not 20 years like most state workers.

In addition, the main judges plan was 100 percent funded last year, far above 68 percent for the average CalPERS plan this year.

Judges hired before Nov. 9, 1994, are still in the only CalPERS pay-as-you-go plan with no investment fund. An annual CalPERS letter urging “prefunding” of the old plan said long-term costs would be cut and retirees assured of a pension check, if legislative funding is delayed.

Lawmakers and judges can clash. A superior court judge awarded judges back pay with 10 percent interest of about $5,000 per judge and a pension increase, ruling that a five-year salary freeze did not keep pace with increases in state worker pay as required by law.

Brown pushed legislation this year to end the link with state worker pay, Courthouse News Service reported, which would force judges to “beg” lawmakers for pay raises. Compromise legislation kept a modified state worker link, but sharply cut the back pay interest to about 0.5 percent of pay.

The Marin County case accepted by the Supreme Court last week is a union challenge to “anti-spiking” provisions in Brown’s reform legislation that prevent pensions from being boosted by stand-by duty, in-kind health care and other things.

The Supreme Court said it will delay action on the Marin case until an appellate court rules on similar union challenges to Brown’s “anti-spiking” reform in a consolidation of cases from Alameda, Contra Costa and Merced counties.

A majority of 401k sponsors, big and small, are concerned about being sued, according to new research from Cerulli Associates.

Most of the lawsuits have so far targeted massive plans, but even small plans are feeling the heat. And it’s having an effect on investment strategy, as many plans consider a more passive approach amid scrutiny of fees.

From 401kSpecialist:

More than half of 401k plan sponsors express concern over potential lawsuits, new research from Cerulli Associates finds.

[…]

Survey data shows that smaller 401k plan sponsors are also taking notice of this increasingly litigious environment, as reflected by the nearly one-quarter of small plan sponsors (less than $100 million in 401k assets) who describe themselves as “very concerned” about potential litigation.

In particular, fee-related lawsuits have been a pervasive theme in the 401k plan market in 2016, further underscoring the 401k industry’s intense focus on reducing plan-related expenses. A significant consequence of this focus on fees is an increased interest in passive investing.

Plan sponsor survey results show that the top two reasons for which 401k plan sponsors choose to offer passive (indexed) options on the plan menu are because of “an advisor or consultant recommendation” or because they “believe cost is the most important factor.”

Several defined contribution investment only (DCIO) asset managers tell Cerulli that the demand for passive products is driven, primarily, by the desire to reduce overall plan costs.

“As advisors become increasingly fee conscious, some view passive options as a way to drive down overall plan expenses, which in turn demonstrates their value to the plan,” Jessica Sclafani, associate director at Cerulli, said in a statement.

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

Randy Diamond of Pensions & Investments reports, CalPERS balancing risks in review of lower return target:

The stakes are high as the CalPERS board debates whether to significantly decrease the nation’s largest public pension fund’s assumed rate of return, a move that could hamstring the budgets of contributing municipalities as well as prompt other public funds across the country to follow suit.

But if the retirement system doesn’t act, pushing to achieve an unrealistically high return could threaten the viability of the $299.5 billion fund itself, its top investment officer and consultants say.

“Being aggressive, having a reasonable amount of volatility and (being) wrong could lead to an unrecoverable loss,” Andrew Junkin, president of Wilshire Consulting, the system’s general investment consultant, told the board at a November meeting. CalPERS’ current portfolio is pegged to a 7.5% return and a 13% volatility rate.

The chief investment officer of the California Public Employees’ Retirement System and its investment consultants now say that assumed annualized rate of return is unlikely to be achieved over the next decade, given updated capital market assumptions that show a slow-growing economy and continued low interest rates.

Still, cities, towns and school districts that are part of the Sacramento-based system say they can’t afford increased contributions they would be forced to pay to provide pension benefits if the return rate is lowered.

A decision could come in February.

Unlike other public plans that have leaned toward modest rate of return reductions, a key CalPERS committee is expected to be presented with a plan in December that’s considerably more aggressive.

That was set in motion Nov. 15 at a committee meeting when Mr. Junkin and CalPERS CIO Theodore Eliopoulos said 6% is a more realistic return over the next decade.

At that meeting, it also was disclosed that CalPERS investment staff was reducing the fund’s allocation to equities in an effort to reduce risk.

Only a year earlier, CalPERS investment staff and consultants had agreed that CalPERS was on the right track with its 7.5% figure. So confident were they that they urged the board to approve a risk mitigation plan that did lower the rate of return, but over a 20-year period, and only when returns were in excess of the 7.5% assumption.

Two years of subpar results — a 0.6% return for the fiscal year ended June 30 and a 2.4% return in fiscal 2015 — reduced views of what CalPERS can earn over the next decade. Mr. Junkin said at the November meeting that Wilshire was predicting an annual return of 6.21% for the next decade, down from its estimates of 7.1% a year earlier.

Indeed, Mr. Junkin and Mr. Eliopoulos said the system’s very survival could be at stake if board members don’t lower the rate of return. “Being conservative leads to higher contributions, but you still have a sustainable benefit to CalPERS members,” Mr. Junkin said.

The opinions were seconded by the system’s other major consultant, Pension Consulting Alliance, which also lowered its return forecast.

Shifting the burden

But a CalPERS return reduction would just move the burden to other government units. Groups representing municipal governments in California warn that some cities could be forced to make layoffs and major cuts in city services as well as face the risk of bankruptcy if they have to absorb the decline through higher contributions to CalPERS.

“This is big for us,” Dane Hutchings, a lobbyist with the League of California Cities, said in an interview. “We’ve got cities out there with half their general fund obligated to pension liabilities. How do you run a city with half a budget?”

CalPERS documents show that some governmental units could see their contributions more than double if the rate of return was lowered to 6%. Mr. Hutchings said bankruptcies might occur if cities had a major hike without it being phased in over a period of years. CalPERS’ annual report in September on funding levels and risks also warned of potential bankruptcies by governmental units if the rate of return was decreased.

If the CalPERS board approves a rate of return decrease in February, school districts and the state would see rate increases for their employees in July 2017. Cities and other governmental units would see rate increases beginning in July 2018.

Any significant return reduction by CalPERS, which covers more than 1.5 million workers and retirees in 2,000 governmental units, would cause ripples both in and outside the state. That’s because making such a major rate cut in the assumed rate of return is rare.

Mr. Eliopoulos and the consultants are scheduled to make a specific recommendation on the return rate at a Dec. 20 meeting. But they were clear earlier this month that they feel the system won’t be able to earn much more than an annualized 6% over the next decade.

Gradual reductions

Thomas Aaron, a Chicago-based vice president and senior analyst at Moody’s Investors Services, said in an interview that many public plans have lowered their return assumption because of lower capital market assumptions and efforts to reduce risk. But Mr. Aaron said the reductions have happened “very gradually, it tends to be in increments of 25 or 50 basis points.”

Statistics from the National Association of State Retirement Administrators show that 43 of 137 public plans have lowered their return assumption since June 30, 2014. But NASRA statistics show only nine plans out of 127 are below 7% and none has gone below 6.5%.

“CalPERS is the largest pension system in the country; definitely if CalPERS were to make a significant reduction, other plans would take notice,” said Mr. Aaron.

Mr. Aaron said it would be hard to predict whether other public plans would follow. While there has been a general trend toward reduced return assumptions given capital market forecasts, some plans are sticking to higher assumptions because they believe in more optimistic longer-term investment return forecasts.

Compounding the problem is that CalPERS is 68% funded and cash-flow negative, meaning each year CalPERS is paying out more in benefits than it receives in contributions, Mr. Junkin said. CalPERS statistics show that the retirement system received $14 billion in contributions in the fiscal year ended June 30 but paid out $19 billion in benefits. To fill that $5 billion gap, the system was forced to sell investments.

CalPERS has an unfunded liability of $111 billion and critics have said unrealistic investment assumptions and inadequate contributions from employers and employees have led to the large gap.

Previously, CalPERS officials had said that any return assumption change would not occur until an asset allocation review was complete in February 2018. But Mr. Eliopoulos on Nov. 15 urged the board to act sooner, saying the U.S. could be in a recession by that date.

Richard Costigan, chairman of CalPERS finance and administration committee, said in an interview that he expects a recommendation and vote by the full board meeting in February, adding there is no requirement to wait until 2018 to consider the matter.

Some board members at the Nov. 15 meeting said CalPERS was moving too fast to implement a new assumption. “I’m a little confused at the panic and expediency that you guys are selling us right now,” said board member Theresa Taylor. “I think that we need to step back and breathe.”

But other board members suggested CalPERS needs to take immediate action even if it is uncomfortable.

Already adjusting

In a sense the system already has. Even without a formal return reduction, members of the investment staff have embarked on their own plan to reduce overall portfolio risk by reducing equity exposure, a policy supported by the board.

Mr. Eliopoulos said Nov. 15 that a pitfall of CalPERS’ current rate of return is the need to invest heavily in equities, taking more risk than might be prudent. He also said the system was reviewing its equity allocation.

The system’s latest investment report, issued Aug. 31, shows equity investments made up 51.1% or $155.4 billion of the system’s assets, down from 52.7% or $160 billion as of July 30 and down from 54.1% in July 2015.

CalPERS took $3.8 billion of the $4.6 billion in equity reduction and increased its cash position and other assets in its liquidity asset class. Liquidity assets grew to $9.6 billion as of Aug. 31 from $5.8 billion at the end of July.

But an even bigger cut in the equity portfolio occurred after the September investment committee meeting, when board members meeting in closed session reduced the allocation even more, sources said. It is unclear how big that cut was, but allocation guidelines allow equity to be cut to 44% of the total portfolio.

Board member J.J. Jelincic at the Nov. 15 meeting disclosed the new asset allocation was made at the September meeting closed session. But Mr. Jelincic said based on revisions the board approved in the system’s asset allocation, he felt the most CalPERS could earn was 6.25% a year because it was not taking enough risk.

Mr. Jelincic did not disclose the new asset allocation but said in an interview: “We are taking too little risk and walking away from the upside by not investing more in equities.”

So, CalPERS is getting real on future returns? It’s about time. I’ve long argued that US public pensions are delusional when it comes to their investment return assumptions and that if they used the discount rates most Canadian public pensions use, they’d be insolvent.

And J.J. Jelincic is right, taking too little risk in public equities is walking away from upside but he’s not being completely honest because when a mature pension plan with negative cash flows the size of CalPERS is underfunded, taking more risk in public equities can also spell doom because it introduces a lot more volatility in the asset mix (ie. downside risk).

When it comes to pensions, it’s not just about taking more risk, it’s about taking smarter risks, it’s about delivering high risk-adjusted returns over the long run to minimize the volatility in contribution risk.

Sure, CalPERS can allocate 60% of its portfolio to MSCI global stocks and hope for the best but can it then live through the volatility or worse still, a prolonged recession and bear market?

This too has huge implications because pension plans are path dependent which means the starting point matters and if the plan is underfunded or severely underfunded, taking more risk can put it in a deeper hole, one that it might never get out of.

Yeah but Trump won the election, he’s going to spend on infrastructure, build a wall on the Mexican border and have Mexico pay for it, renegotiate NAFTA and all other trade agreements, cut corporate taxes, and “make America great again”. Bond yields and stocks have surged, lowering pension deficits, it’s all good news, so why lower return assumptions now?

Because my dear readers, Trump won’t trump the bond market, there are huge risks in the global economy, especially emerging markets, and that’s one reason why the US dollar keeps surging higher, which introduces other risks to US multinationals and corporate earnings.

I’ve been warning my readers to take Denmark’s dire pension warning seriously and that the global pension crisis is far from over. It’s actually gaining steam because the risks of deflation are not fading over the long run, they are still lurking in the background.

What else? Investment returns alone will not be enough to cover future liabilities. The best plans in the world, like Ontario Teachers and HOOPP, understood this years ago which is why they introduced a shared-risk model to partially or fully adjust inflation protection whenever their plans experience a deficit and will only restore it once fully funded status is achieved again.

In Canada, the governance is right, which means you don’t have anywhere near the government interference in public pensions as you do south of the border. Canadian pensions have been moving away from public markets increasingly investing directly in private markets like infrastructure, real estate and private equity. In order to do this, they got the governance right and compensate their pension fund managers properly.

Now, as the article above states, if CalPERS decides to lower its return assumptions, it’s a huge deal and it will have ripple effects in the US pension industry and California’s state and local governments.

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 onto 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.

Brazilian President Michel Temer on Monday will reveal details of his plan to overhaul the country’s retirement benefits system, according to Reuters.

The plan, which is likely to be controversial among citizens and lawmakers, calls for raising the retirement age, higher contributions from workers, and lower benefits.

From Reuters:

The pension reform, which had been promised by Temer since he became president in May, faces fierce opposition from powerful labor and civil servant unions that threaten to organize street demonstrations to block the changes.

Despite such threats, the government plans to send the reform plan on Tuesday to Congress where is expected to face a heated debate that could last several months.

“It will face a lot of resistance, but I believe Congress is well aware of the fiscal dilemma and social security is at the heart of the problem,” said deputy Reinhold Stephanes, a former pensions minister who may have the task of reporting to the lower house on the reform plan.

“We have to be in line with the pension standards of the rest of the world by having a minimum age of retirement of 65 years of age,” he told Reuters.

Expenditures from social security make up about 40 percent of the government’s primary spending, or spending before debt payments. It is considered the main threat to the country’s finances in the future.

 

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

BusinessWire reports, World’s Largest Institutional Investors Expecting More Asset Allocation Changes over Next Two Years Than in the Past:

Institutional investors worldwide are expecting to make more asset allocation changes in the next one to two years than in 2012 and 2014, according to the new Fidelity Global Institutional Investor Survey. Now in its 14th year, the Fidelity Global Institutional Investor Survey is the world’s largest study of its kind examining the top-of-mind themes of institutional investors. Survey respondents included 933 institutions in 25 countries with $21 trillion in investable assets.

The anticipated shifts are most remarkable with alternative investments, domestic fixed income, and cash. Globally, 72 percent of institutional investors say they will increase their allocation of illiquid alternatives in 2017 and 2018, with significant numbers as well for domestic fixed income (64 percent), cash (55 percent), and liquid alternatives (42 percent).

However, institutional investors in some regions are bucking the trend seen in other parts of the world. Many institutional investors in the U.S. are, on a relative basis, adopting a wait-and-see approach. For example, compared to 2012, the percentage of U.S. institutional investors expecting to move away from domestic equity has fallen significantly from 51 to 28 percent, while the number of respondents who expect to increase their allocation to the same asset class has only risen from 8 to 11 percent.

“With 2017 just around the corner, the asset allocation outlook for global institutional investors appears to be driven largely by the local economic realities and political uncertainties in which they’re operating,” said Scott E. Couto, president, Fidelity Institutional Asset Management. “The U.S. is likely to see its first rate hike in 12 months, which helps to explain why many in the country are hitting the pause button when it comes to changing their asset allocation.

“Institutions are increasingly managing their portfolios in a more dynamic manner, which means they are making more investment decisions today than they have in the past. In addition, the expectations of lower return and higher market volatility are driving more institutions into less commonly used assets, such as illiquid investments,” continued Couto. “For these reasons, organizations may find value in reexamining their investment decision-making process as there may be opportunities to bring more structure and accommodate the increased number of decisions, freeing up time for other areas of portfolio management and governance.”

Primary concerns for institutional investors

Overall, the top concerns for institutional investors are a low-return environment (28 percent) and market volatility (27 percent), with the survey showing that institutions are expressing more worry about capital markets than in previous years. In 2010, 25 percent of survey respondents cited a low-return environment as a concern and 22 percent cited market volatility.

“As the geopolitical and market environments evolve, institutional investors are increasingly expressing concern about how market returns and volatility will impact their portfolios,” said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation. “Expectations that strengthening economies would build enough momentum to support higher interest rates and diminished volatility have not borne out, particularly in emerging Asia and Europe.”

Investment concerns also vary according to the institution type. Globally, sovereign wealth funds (46 percent), public sector pensions (31 percent), insurance companies (25 percent), and endowments and foundations (22 percent) are most worried about market volatility. However, a low-return environment is the top concern for private sector pensions (38 percent). (click on image)

Continued confidence among institutional investors

Despite their concerns, nearly all institutional investors surveyed (96 percent) believe that they can still generate alpha over their benchmarks to meet their growth objectives. The majority (56 percent) of survey respondents say growth, including capital and funded status growth, remain their primary investment objective, similar to 52 percent in 2014.

On average, institutional investors are targeting to achieve approximately a 6 percent required return. On top of that, they are confident of generating 2 percent alpha every year, with roughly half of their excess return over the next three years coming from shorter-term decisions such as individual manager outperformance and tactical asset allocation.

“Despite uncertainty in a number of markets around the world, institutional investors remain confident in their ability to generate investment returns, with a majority believing they enjoy a competitive advantage because of confidence in their staff or access to better managers,” added Young. “More importantly, these institutional investors understand that taking on more risk, including moving away from public markets, is just one of many ways that can help them achieve their return objectives. In taking this approach, we expect many institutions will benefit in evaluating not only what investments are made, but also how the investment decisions are implemented.”

Improving the Investment Decision-Making Process

There are a number of similarities in institutional investors’ decision-making process:

• Nearly half (46 percent) of institutional investors in Europe and Asia have changed their investment approach in the last three years, although that number is smaller in the Americas (11 percent). Across the global institutional investors surveyed, the most common change was to add more inputs – both quantitative and qualitative – to the decision-making process.
• A large number of institutional investors have to grapple with behavioral biases when helping their institutions make investment decisions. Around the world, institutional investors report that they consider a number of qualitative factors when they make investment recommendations. At least 85 percent of survey respondents say board member emotions (90 percent), board dynamics (94 percent), and press coverage (86 percent) have at least some impact on asset allocation decisions, with around one-third reporting that these factors have a significant impact.

“Institutional investors often assess quantitative factors such as performance when making investment recommendations, while also managing external dynamics such as the board, peers and industry news as their institutions move toward their decisions. Whether it’s qualitative or quantitative factors, institutional investors today face an information overload,” said Couto. “To keep up with the overwhelming amount of data, institutional investors should consider revisiting and evolving their investment process.

“A more disciplined investment process may help them achieve more efficient, effective and repeatable portfolio outcomes, particularly in a low-return environment characterized by more expected asset allocation changes and a greater global interest in alternative asset classes,” added Couto.

The complete report with a wealth of charts is available on request. For additional materials on the survey, go to institutional.fidelity.com/globalsurvey.

About the Survey

Fidelity Institutional Asset ManagementSM conducted the Fidelity Global Institutional Investor Survey of institutional investors in the summer of 2016, including 933 investors in 25 countries (174 U.S. corporate pension plans, 77 U.S. government pension plans, 51 non-profits and other U.S. institutions, 101 Canadian, 20 other North American, 350 European, 150 Asian, and 10 African institutions including pensions, insurance companies and financial institutions). Assets under management represented by respondents totaled more than USD $21 trillion. The surveys were executed in association with Strategic Insight, Inc. in North America and the Financial Times in all other regions. CEOs, COOs, CFOs, and CIOs responded to an online questionnaire or telephone inquiry.

About Fidelity Institutional Asset Management℠

Fidelity Institutional Asset Management℠ (FIAM) is one of the largest organizations serving the U.S. institutional marketplace. It works with financial advisors and advisory firms, offering them resources to help investors plan and achieve their goals; it also works with institutions and consultants to meet their varying and custom investment needs. Fidelity Institutional Asset Management℠ provides actionable strategies, enabling its clients to stand out in the marketplace, and is a gateway to Fidelity’s original insight and diverse investment capabilities across equity, fixed income, high‐income and global asset allocation. Fidelity Institutional Asset Management is a division of Fidelity Investments.

About Fidelity Investments

Fidelity’s mission is to inspire better futures and deliver better outcomes for the customers and businesses we serve. With assets under administration of $5.5 trillion, including managed assets of $2.1 trillion as of October 31, 2016, we focus on meeting the unique needs of a diverse set of customers: helping more than 25 million people invest their own life savings, nearly 20,000 businesses manage employee benefit programs, as well as providing nearly 10,000 advisory firms with investment and technology solutions to invest their own clients’ money. Privately held for 70 years, Fidelity employs 45,000 associates who are focused on the long-term success of our customers. For more information about Fidelity Investments, visit https://www.fidelity.com/about.

Sam Forgione of Reuters also reports, Institutions aim to boost bets on hedge funds, private equity:

The majority of institutional investors worldwide are seeking to increase their investments in riskier alternatives that are not publicly traded such as hedge funds, real estate and private equity over the next one to two years to combat potential low returns and choppiness in public markets, a Fidelity survey showed on Thursday.

The Fidelity Global Institutional Investor Survey showed that 72 percent of institutional investors worldwide, from public pension funds to insurance companies and endowments, said they would increase their exposure to these so-called illiquid alternatives in 2017 and 2018.

The survey, which included 933 institutions in 25 countries overseeing a total of $21 trillion in assets, found that the institutions were most concerned with a low-return investing environment over the next one to two years, with 28 percent of respondents citing it as such. Market volatility was the second-biggest worry, with 27 percent of respondents citing it as their top concern.

Private sector pensions were most concerned about a low-return environment, with 38 percent of them identifying it as their top worry, while sovereign wealth funds were most nervous about volatility, with 46 percent identifying it as their top concern.

“With the concern about the low-return environment as well as market volatility, as a result we’re seeing more of an interest in alternatives, where there’s a perception of higher return opportunities,” said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation.

Investors seek alternatives, which may invest in assets such as timber or real estate or use tactics such as betting against securities, for “uncorrelated” returns that do not move in tandem with traditional stock and bond markets.

Young noted, however, that illiquid alternatives can also be volatile without it being obvious, since they lack daily pricing and as a result may give the perception of being less volatile.

“We would hope and would expect that institutional investors would appreciate the volatility that still exists within the underlying investments,” he said in reference to illiquid alternatives.

The survey, which was conducted over the summer, found that despite their concerns, 96 percent of the institutions believed they could achieve an 8 percent investment return on average in coming years.

U.S. public pension plans, on average, had about 12.1 percent of their assets in real estate, private equity and hedge funds combined as of Sept. 30, according to Wilshire Trust Universe Comparison Service data.

And Jonathan Ratner of the National Post reports, Low returns, high volatility top institutional investors’ list of concerns:

Low returns and market volatility topped the list of concerns in Fidelity Investments’ annual survey of more than 900 institutional investors with US$21 trillion of investable assets.

Thirty per cent of respondents cited the low-return environment as their primary worry, followed by volatility at 27 per cent.

“Expectations that strengthening economies would build enough momentum to support higher interest rates and diminished volatility have not borne out, particularly in emerging Asia and Europe,” said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation.

The Fidelity Global Institutional Survey, which is now in its 14th year and includes investors in 25 countries, also showed that institutions are growing more concerned about capital markets.

Despite these issues, 96 per cent of institutional investors surveyed believe they can beat their benchmarks.

The group is targeting an average return of approximately six per cent per year, in addition to two per cent alpha, and short-term decisions are being credited for those excess returns.

Institutional investors remain confident in their return prospects due to their access to superior money managers. They also have demonstrated a willingness to move away from public markets.

On a global basis, 72 per cent of institutional investors said they plan to increase their exposure to illiquid alternatives in 2017 and 2018.

Domestic fixed income (64 per cent), cash (55 per cent) and liquid alternatives (42 per cent) were the other areas where increased allocation is expected to occur.

However, institutional investors in the U.S. are bucking this trend, and seem to have adopted a “wait-and-see” approach.

The percentage of this group expecting to move away from domestic equity has fallen from 51 per cent in 2012, to 28 per cent this year. Meanwhile, the number of respondents who plan to increase their allocation to U.S. equities has risen to just 11 per cent from eight per cent in 2012.

“With 2017 just around the corner, the asset allocation outlook for global institutional investors appears to be driven largely by the local economic realities and political uncertainties in which they’re operating,” said Scott Couto, president of Fidelity Institutional Asset Management.

He noted that with the Federal Reserve expected to produce its first rate hike in 12 months, it’s understandable why many U.S. investors are hitting the pause button when it comes to asset allocation changes.

On Thursday, I had a chance to speak to Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation. I want to first thank him for taking the time to go over this survey with me and thank Nicole Goodnow for contacting me to arrange this discussion.

I can’t say I am shocked by the results of the survey. Since Fidelity did the last one two years ago, global interest rates plummeted to record lows, public markets have been a lot more volatile and return expectations have diminished considerably.

One thing that did surprise me from this survey is that the majority of institutions (96%) are confident they can beat their benchmark, “targeting an average return of approximately six per cent per year, in addition to two per cent alpha, and short-term decisions are being credited for those excess returns.”

I personally think this is wishful thinking on their part, especially if they start piling into illiquid alternatives at the worst possible time (see my write-up on Bob Princes’ visit to Montreal).

In our discussion, however, Derek Young told me institutions are confident that through strategic and tactical asset allocation decisions they can beat their benchmark and achieve that 8% bogey over the long run.

He mentioned that tactical asset allocation will require good governance and good manager selection. We both agreed that the performance dispersion between top and bottom quartile hedge funds is huge and that manager selection risk is high for liquid and illiquid alternatives.

Funding illiquid alternatives is increasingly coming from equity portfolios, except in the US where they have been piling into alternatives for such a long time that they probably want to pause and reflect on the success of these programs, especially considering the fees they are paying to external managers.

The move into bonds was interesting. Derek told me as rates go up, liabilities fall and if rates are going up because the economy is improving, this is also supportive of higher equity prices. He added that many institutions are waiting for the “right funding status” so they can derisk their plans and start immunizing their portfolios.

In my comment on trumping the bond market, I suggested taking advantage of the recent backup in yields to load up on US long bonds (TLT). I still maintain this recommendation and think anyone shorting bonds at these levels is out of their mind (click on chart):

Sure, rates can go higher and bond prices lower but these big selloffs in US long bonds are a huge buying opportunity and any institution waiting for the yield on the 10-year Treasury note to hit 3%+ to begin derisking and immunizing their portfolio might end up regretting it later on.

Our discussion on the specific concerns of various institutions was equally interesting. Derek told me many sovereign wealth funds need liquidity to fund projects. They are the “funding source for their economies” which is why volatile returns are their chief concern. (Oftentimes, they will go to Fidelity to redeem some money and tell them “we will come back to you later”).

So unlike pensions, SWFs don’t have a liability concern but they are concerned about volatile markets and being forced to sell assets at the wrong time (this surprised me).

Insurance companies are more concerned about hedging volatility risk to cover their annuity contracts. In 2008, when volatility surged, they found it extremely expensive to hedge these risks. Fidelity manages a volatility portfolio for their insurance clients to manage this risk on a cost effective basis.

I told Derek that they should do the same thing for pension plans, managing contribution volatility risk for plan sponsors. He told me Fidelity is already doing this for smaller plans (outsourced CIO) and for larger plans they are helping them with tactical asset allocation decisions, manager selection and other strategies to achieve their targets.

On the international differences, he told me UK investors are looking to allocate more to illiquid alternatives, something which I touched upon in my last comment on the UK’s pension crisis.

As far as Canadian pensions, he told me “they are very sophisticated” which is why I told him many of them are going direct when it comes to alternative investments and more liquid absolute return strategies.

In terms of illiquid alternatives, we both agreed illiquidity doesn’t mean there are less risks. That is a total fallacy. I told him there are four key reasons why Canada’s large pensions are increasing their allocations to private market investments:

1. They have a very long investment horizon and can afford to take on illiquidity risk.
2. They believe there are inefficiencies in private markets and that is where the bulk of alpha lies.
3. They can scale into big real estate and infrastructure investments a lot easier than scaling into many hedge funds or even private equity funds.
4. Stale pricing (assets are valued with a lag) means that private markets do not move in unison with public markets, so it helps boost their compensation which is based on four-year rolling returns (privates dampen volatility of overall returns during bear markets).

Sure, private markets are good for beneficiaries of the plan, especially if done properly, but they are also good for the executive compensation of senior Canadian pension fund managers. They aren’t making the compensation of elite hedge fund portfolio managers but they’re not too far off.

On that note, I thank Fidelity’s Derek Young and Nicole Goodnow and remind all of you to please subscribe and donate to this blog (pensionpulse.blogspot.ca) on the top right-hand side under my picture and show your appreciation of the work that goes into these blog comments.

I typically reserve Fridays for my market comments but there were so many things going on this week (OPEC, jobs report, etc.) that I need to go over my charts and research over the weekend.

One thing I can tell you is that US long bonds remain a big buy for me and I was watching the trading action on energy, metal and mining stocks all week and think a lot of irrational exuberance is going on there. There are great opportunities in this market on the long and short side, but will need to gather my thoughts and discuss this next week.

Illinois Gov. Bruce Rauner on Thursday vetoed a bill that would have provided a funding package of $215 million to the pension system of Chicago Public Schools [CPS].

The Senate promptly overrode the veto; however, the overriding process will likely stall in the House.

Rauner said he vetoed the bill because Democrats didn’t hold up their end of the bargain: state-wide pension reform.

From Crain’s:

“The agreement was clear: Republicans supported Senate Bill 2822 only on condition that Democrats re-engage in serious, good faith negotiations,” the governor said in his veto message. “Despite my repeated requests for daily negotiations and hope to reach a comprehensive agreement by next week, we are no closer to ending the (budget) impasse or enacting pension reform.”

Rauner’s reference was to a now two-year standoff between him and House Speaker Mike Madigan on whether to enact a “clean” budget bill with a needed tax hike, or to also pass some of the union-weakening, political reform that Rauner wants in his “Turnaround Illinois” agenda.

Though it was widely reported at the time that the CPS pension deal was linked to statewide pension changes, Senate President John Cullerton today denied that.

Details of the bill:

The measure, which would refinance pension systems covering laborers and white-collar workers by requiring taxpayers to put in more and newly hired workers to pay more, today zipped through the House by a veto-proof 91-16 margin and seems to be headed for routine final approval by the Senate.

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

The Mail Online reports, Pension funding deficits ‘nearly a third of UK GDP’:

Britain’s mammoth funding gap for gold-plated company pensions stands at nearly a third of the country’s economic output despite a £50 billion boost in November.

A report by PricewaterhouseCoopers shows the deficit for so-called defined benefit pensions – such as final salary schemes, which guarantee an income in retirement – narrowed by £50 billion to £580 billion last month.

This marks the third month in a row that the funding gap has improved after hitting a record high of £710 billion in August.

But the pensions black hole is still £110 billion higher than it was at the start of the year and is equivalent to almost a third of the UK’s entire gross domestic product (GDP).

PwC’s Skyval Index gives a snapshot of the health of the UK’s 6,000 defined benefit pension funds.

It reveals the battering that pension schemes have taken since the Brexit vote, with rock-bottom interest rates taking their toll after the Bank of England halved its base rate to 0.25% in August.

BT recently revealed its pension deficit surged to £9.5 billion at the end of September from £6.2 billion three months earlier.

Barclays has also seen its pension fund slip into the red by £1.1 billion from a surplus of £800 million last December, while Debenhams likewise suffered a reversal to a £4.1 million deficit in September against a surplus of £26.2 million in August last year.

Firms have blamed a sharp reduction in bond yields, which increases the pension liabilities, as a result of the Bank’s economy-boosting action after the EU referendum vote.

This peaked in August, when the pension deficit shot up by £100 billion, with bond yields since having recovered a little.

Businesses are now under pressure to pump cash into their company schemes to address the shortfalls, especially after BHS’s £571 million pension deficit contributed to its high profile collapse in April.

But Raj Mody, partner at PwC and global head of pensions, said companies should have realistic funding plans in place over longer timescales – up to 20 years rather than the nine or 10 year average.

He said: “Pension funding deficits are nearly a third of UK GDP. Trying to repair that in, say, 10 years could cause undue strain, akin to about 3% per year of potential GDP growth being redirected to put cash into pension funds.

“This would be like the UK economy running to stand still to remedy the pension deficit situation.”

When I warn my readers that the ongoing global pension crisis is deflationary, this is exactly what I am alluding to. Not only is the shift from DB to DC pensions going to cause widespread pension poverty as it shifts retirement risk entirely on to employees, but persistent and chronic public and private pension deficits are diverting resources away from growing and hiring people which effectively exacerbates chronic unemployment which is itself very deflationary (limits aggregate demand).

And while some think President-elect Trump and his new powerhouse economic cabinet members are going to trump the bond market and bond yields are going to rise sharply over the next four years, relieving pressure on pensions and savers, I remain highly skeptical that policymakers have conquered global deflation and would take Denmark’s dire pension warning very seriously.

How are British policymakers responding to their pension crisis? Last month, I discussed the UK’s draconian pension reforms, stating they would make the problem a lot bigger down the road.

This week, former pensions minister Steve Webb says the government is considering raising pension age sooner than previously planned, a proposal which has sparked outrage among citizens calling it a “huge tax increase”.

In her comment to the Guardian, pension expert Ros Altmann writes, There are fairer ways to set the pension age – but politicians are ducking them:

Younger generations are being told to prepare to wait even longer for their pensions, with former minister Steve Webb suggesting that the retirement age for a state pension will rise to 70.

I can understand why some policymakers seeking to cut the costs of state support for pensioners are attracted to the idea of continually raising pension ages, but I believe this is potentially damaging to certain social groups.

The justification for such an increase is based on forecasts of rising average life expectancy. But just using average life expectancy as a yardstick ignores significant differences in longevity across British society. For example, people living in less affluent areas, or who had lower paid or more physically demanding careers, or started work straight from school, have a higher probability of dying younger. Continually increasing state pension ages, and making such workers wait longer for pension payments to start, prolongs significant social disadvantage.

The state pension qualification criteria depend on national insurance contributions. Normally, workers and their employers make contributions that can amount to around 25% of their earnings. Even now, a significant minority of the population does not live to state pension age, or dies very soon thereafter, despite having paid significant sums into the system. By raising the state pension age, based on rising average life expectancy, this social inequality is compounded.

Increasing the state pension age is a blunt instrument. A stark cutoff fails to recognise the needs of millions of people who will be physically unable to keep working to the age of 70, because of particular circumstances in their working life, their current health, or environmental and social factors that negatively impact on specific regions of the country.

State pension unfairness is even greater, because those who are healthy and wealthy enough can already get much larger state pensions than others who cannot afford to wait. If you can delay starting your state pension until 70 – assuming you either have a good private income or are able to keep working – the new state pension will pay over £200 a week. But if you are very ill, caring for relatives, or for whatever reason cannot keep working up to state pension age (now 65 for men and between 63 and 64 for women) you get nothing at all.

In fact, just reforming state pensions is not the best way to cope with an ageing population. It is important to rethink retirement too. Those who can and want to work longer could boost their own lifetime incomes and future pensions, and also the spending power of the economy and national output, if more were done to facilitate and encourage later life working. Having more older workers in the economy, especially given the demographics of the western world, is a win-win for all of us. Even a few years of part-time work, before full-time retirement, can benefit individuals and the economy. But this should not be achieved by forcing everyone to wait longer for a state pension and ignoring the needs of those groups who cannot do so.

There is no provision, for example, for an ill-health early state pension, or for people to start state pensions sooner at a reduced rate. Politicians have entirely ducked this question but such a system would acknowledge the differences across society. There are, surely, more creative and equitable ways of managing state pension costs for an increasingly ageing population, using parameters other than just the starting age.

Indeed, raising state pension ages has already caused huge hardship to many women born in the 1950s. These women believed their state pension would start at 60, but many discovered only recently they will need to wait until 66. Many women have no other later life income, therefore they are totally dependent on their state pension.

Rather than just considering increasing the pension age, the government could consider having a range of ages, instead of one stark chronological cutoff. Allowing people an early-access pension, possibly reflecting a longer working life or poorer health, could alleviate some of the unfairness inherent in the current system. Increasing the number of years required to qualify for full pensions could also help.

Raising the state pension age is rather a crude measure for managing old-age support in the 21st century.

In her insightful comment, Ros Altmann shows why raising the pension age, while politically expedient, can be detrimental and devastating to certain socioeconomic cohorts, including people suffering from an illness and many women relying on their state pension to survive in their golden years.

There is a lot to think about in terms of pension policy not just in the UK, but here in Canada and across the world.

Also, remember how I keep telling you pension plans are about managing assets and liabilities. Clearly the backup in yields has helped many British and global pensions. Interest rates are the determining factor behind pension deficits. The lower yields go, the higher the pension deficits no matter how well assets perform because the duration of pension liabilities is a lot bigger than the duration of pension assets, so for any decrease or increase in the discount rate, pension liabilities will increase or decrease a lot faster than assets rise or decline.

In the UK, something happened earlier this year, a vote for Brexit which sent the British pound plummeting to multi decade lows relative to other currencies. Some think this is great for British exports and inflation expectations but I’m skeptical because a rise in exports and inflation expectations due to currency depreciation isn’t sustainable and it’s not the good type of inflation either (based on a rise in wages).

For UK pensions that fully hedged currency risk, they took a huge hit on their foreign bond, stock, real estate and other assets just on the devaluation of the British pound. So if interest rates didn’t rise and instead declined, those pension deficits would have been far, far worse for these pensions.

Conversely, for UK pensions that didn’t hedge currency risk, their foreign asset holdings rose as the pound took a beating. For these pensions, the gain in foreign assets would have dampened any losses on domestic assets and along with the rise in bond yields, helped their pension deficits.

And it’s not just currency risk plaguing UK pensions. Cambridge Associates has come out with a new study which states many pension funds will struggle to close their funding gap unless they reduce their on public equities and other liquid assets:

Pension funds are too focused on holding liquid assets to the detriment of the long-term health of their investment portfolio, according to research by Cambridge Associates, the global provider of investment services. If they considered switching from liquid public equities to illiquid private investments, they could improve their chances of closing the funding gap and reduce the likelihood to requiring additional capital injections to honour their commitments to pension fund members.

The average UK pension fund can have a staggering 90-95 per cent of their assets in liquid assets — those easily convertible into cash. This amount is far more than they need in order to be able to pay pension fund members. “Many schemes do not need to set aside more than 5-10 per cent of assets for benefit payments in any given year for the next 20 years,” according to Alex Koriath, head of Cambridge Associates’ European pensions practice. “By having such liquid portfolios, they are giving up return opportunities and face having to deal with the risk of a widening funding gap.”

Already, as of October 2016, the average UK pension scheme holds assets that cover just 77.5 per cent of their liabilities, according to data from the UK’s Pension Protection Fund. Even though the value of “growth” assets — such as equities — has soared over the past 5 years, this funding gap has continued to widen because the dramatic fall in interest rates has increased the value of liabilities at an even faster rate.

For a typical scheme, some 40 per cent of the liquid assets is invested in “liability-matching” assets such as gilts, while around 60 per cent is held in growth assets such as equities, credit and other such asset classes. Of the 60 per cent, some 5-10 per cent is invested in illiquid assets such as real estate, private equity, private credit, venture capital and other less liquid investments.

But this allocation may need to change because many pension funds are facing difficult choices. As their member population ages, trustees understandably want to “de-risk” by buying more liability-matching assets and selling more volatile assets such as equities. However, de-risking also means that fewer assets can earn the higher return that is needed to plug the large funding gap. Even a pension scheme that hedges just 40 per cent of its liabilities faces a more than one third chance of seeing its funding level fall by 10 per cent at least once during the next 20 years. “In other words,” said Mr Koriath, “the scheme could very well find itself needing a capital injection.”

A New Solution: The “Barbell Approach”

To close the funding gap, Cambridge Associates proposes considering a “barbell approach”. Here, trustees target substantially higher returns in a small part of the portfolio — say, 20 per cent — by focusing this portion on private investments. The rest of the portfolio — as much as 80 per cent — can then be focused on gilts and other liability-matching assets in order to reduce liability risk. Himanshu Chaturvedi, senior investment director at Cambridge Associates in London, said: “This approach to pension investing can deliver a hat-trick of benefits: plenty of liquidity, reduced volatility and appropriate rates of return to close the current funding gap.”

The 80 per cent allocation to liability-matching assets should address the volatility and liquidity issues facing pension funds. The increased hedging reduces the risk of a slump in funding levels, while the large allocation to liquid assets should provide ample liquidity to pay benefits without needing any liquidity from the growth assets. According to Cambridge Associates, a representative scheme that is mature and closed to future accrual (say 70 per cent funded on a buyout basis with liabilities split 75 per cent/25 per cent between deferred members and pensioners) only has to make annual benefit payments of between 3 per cent to 7 per cent of assets in any given year for the next 10 years. Meanwhile, the 20 percent allocation to private investments should help address the return requirements of pension funds, allowing them to target higher return opportunities in return for accepting illiquidity in this small part of the overall portfolio.

Mr Chaturvedi said: “In our view, even a growth portfolio purely focused on public equities, typically the highest expected return option available in public markets, will not close the funding gap fast enough for most schemes.” In the 10 years to September 2015, the MSCI World Index saw returns of 6.4 per cent. By contrast, the Cambridge Associates Private Equity and Venture Capital Index saw annualised returns of 13.4 per cent.

The Challenges of the Barbell Approach

In its analysis, Cambridge Associates found that there were two important requirements for successful implementation of the barbell approach. One is governance. As Mr Chaturvedi said: “A program of private investments takes years to put into place — perhaps two cycles of trustees. So it can’t be the passion of one group of trustees.”

The other requirement is astute manager selection. “Finding high quality managers is not easy,” said Mr Koriath. “At Cambridge Associates, we track more than 20,000 funds across all private investments and in any given year we only see about 200 that merit our clients’ capital.” But the benefits of getting it right in private investments are substantial. Over a 10-year time frame, the annual difference between the top and bottom quartile managers of public equities is about 2 per cent. By contrast, for private equity and venture capital managers, the annual difference is as large as 12-18 per cent.

Obviously Cambridge Associates is talking up its business, after all, it is in the business of building customized portfolios for clients looking to allocate in alternative investments like private equity, real estate and hedge funds.

But the recommendation for a “barbell approach” is sound and to be honest, even though most UK pensions are mature, I was surprised at how little illiquidity risk they are taking given they have a very long investment horizon and can afford to take on some illiquidity risk, especially since the average funded status of 77% is far from disastrous (I would be a lot more worried if Illinois Teachers’ Retirement System or some other severely underfunded pensions were trying to close their funded gap by increasing their allocation to illiquid alternatives).

And Mr Chaturvedi is right, allocating more to illiquid alternatives will not work unless these UK pensions get the governance right and choose their partners wisely.

Lastly, one group that’s not suffering from pension poverty in the UK is company directors. Carolyn Cohn of Reuters reports, Majority of UK pension funds say executive pay too high-survey:

Eighty-seven percent of UK pension funds say executives at UK listed companies are paid too much, a survey by the Pensions and Lifetime Savings Association said on Thursday, as Britain proposes changes to the way companies are run.

Britain began consultations on encouraging better corporate behaviour and curbing executive pay this week, part of Prime Minister Theresa May’s campaign to help those who voted for Brexit in protest at “out of touch” elites.

“It’s time companies got the message and started to reduce the size of the pay packages awarded to their top executives,” said Luke Hildyard, policy lead for stewardship and corporate governance at the PLSA.

The number of shareholder revolts, defined as cases where more than 40 percent of shareholders voted against pay awards at FTSE 100 company annual meetings, rose to seven this year from two in 2015, the PLSA’s analysis found.

The PLSA said it will publish guidelines encouraging pension funds to take a tougher line on the re-election of company directors responsible for setting company pay.

The average pay of bosses in Britain’s FTSE 100 index rose more than 10 percent in 2015 to an average of 5.5 million pounds ($6.9 million), meaning CEOs now earn 140 times more than their employees on average, according to a survey by the High Pay Centre released in August.

The PLSA’s members include more than 1,300 UK pensions schemes with 1 trillion pounds in assets.

What this article doesn’t mention is that pension perks are increasingly a huge part of executive compensation in the UK, US and elsewhere. Corporate directors are padding the pensions of executives which are often based on their overall compensation, which is surging.

And remember what I keep warning of, rising inequality is deflationary, so keep your eye on this trend too as it limits aggregate demand.

Despite some very public griping and high-profile exits from and about hedge funds and private equity, institutional investors are still looking to increase their allocations to both investment vehicles in 2017 and 2018, according to a survey.

The Fidelity Global Institutional Investor Survey polled 933 institutional investors across the globe. In all, 72 percent of them said they’d be increasing their allocations to PE and hedge funds over the next two years.

Their pooled responses also show their confidence in meeting return targets, even if they’re also wary about the market climate.

More details from Reuters:

The survey, which was conducted over the summer, found that despite their concerns, 96 percent of the institutions believed they could achieve an 8 percent investment return on average in coming years.

[…]

institutions were most concerned with a low-return investing environment over the next one to two years, with 28 percent of respondents citing it as such. Market volatility was the second-biggest worry, with 27 percent of respondents citing it as their top concern.

Private sector pensions were most concerned about a low-return environment, with 38 percent of them identifying it as their top worry, while sovereign wealth funds were most nervous about volatility, with 46 percent identifying it as their top concern.

“With the concern about the low-return environment as well as market volatility, as a result we’re seeing more of an interest in alternatives, where there’s a perception of higher return opportunities,” said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation.

 

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

In a response to Bernard Dussault, Canada’s former Chief Actuary, Bob Baldwin, a consultant and former board of director at PSP Investments, sent me his thoughts on Bill C-27, DB, DC and target benefit plans (added emphasis is mine):

Bernard Dussault has circulated an article and slide presentation in which he has provided a endorsement of DB workplace pension plans coupled with an expression of concern about certain design features of DB plans that he sees as discriminatory. I share his preference for DB. But, I think his account of DB is incomplete and avoids certain issues and problems in DB that DB plan members, people with DB governance responsibilities and DB advocates should be aware of.

In his article “How Well Does the Canadian Landscape Fare?” Bernard says: “… DB plans offer better retirement security because they attempt to provide a predetermined amount of lifetime annual retirement income at an unknown periodic price.” The unknown nature of the price is unavoidable given the factors that determine the price that have magnitudes that cannot be foreseen such as: future wages and salaries, investment returns and longevity.

In context, two attributes of DB in its pure form are important to note. First, all of the uncertainty will show up in variable contribution rates and none in variable benefits. Second, the plan sponsor or sponsors have an unlimited willingness and ability to contribute more to the plan if need be.

The second of these attributes is, in principle, largely implausible. There simply are not sponsors who can and will contribute more without limit. Moreover, as I have noted in several publications, in practice when combined employer and employee contributions get up to the 15 to 20 per cent level, even jointly governed plans that were purely DB begin allocating some financial risk to benefits – usually by making indexation contingent on the funded status of the plan.

Moreover above some level, escalating pension contributions begin to depress pre-retirement living standards below post retirement levels. Even recognizing that the impact on living standards of a particular combination of benefit levels and contributions will vary from member to member in a DB plan (you can’t make it perfect for everyone), it is still desirable to try to avoid depressing pre-retirement living standard below the post-retirement level. The object of the workplace pension exercise is to facilitate the continuity of living standards and depressing pre-retirement living standards below the level of post-retirement living standards is not consistent with that objective. You can have too much pension!

The contributions that are relevant to the question whether contributions are depressing pre-retirement living standards to too low a level include both employer and employee contributions. This is because in most circumstances, the economic burden of employer contributions will fall on the employee plan members. This happens because rational employers will reduce their wage and salary offers to compensate for foreseeable pension contributions. There may be circumstances where an employer cannot shift the burden fully in the short term. But, in the normal case, the burden will be shifted. To the extent that required pension contributions are varying through time and being shifted back to the employee plan members, the net replacement rates generated by DB plans are clearly less predictable than the gross replacement rates.

Under the subheading “Strengths of DB plans”, Bernard’s slides include the following statement “investment and longevity risks are pooled, i.e. not borne exclusively by members, be it individually or collectively.” Having introduced the word “exclusively” the statement is probably correct. But, there are a variety of risks to plan members in DB plans. As was noted in the previous paragraph, there is a risk in ongoing DB plans that the pre-retirement living standards will be depressed below post-retirement levels. There is also a risk that a DB plans will get into serious financial difficulty and benefits will be reduced for future service and/or the plan will be converted to DC for future service. Both of these outcomes focus financial risks on young and future plan members as does escalating contributions. Finally, in the event of the bankruptcy of a plan sponsor, all members will face benefit reductions if the plan is not fully funded.

Bernard’s article and slides include reference to provisions in DB plans that he finds discriminatory. For me, the provisions on which he focuses raise a related issue.

The key factors that determine outcomes in all types of workplace pension plans are the same: rates of contributions, salary trajectories, returns on investment, longevity and so on. So what is it that allows a DB plan to provide a more predictable outcome? It is basically two distinct but related things: varying the contribution (saving) rate through time to meet a pre-determined income target; and, cross-subsidies within and between different cohorts of plan members.

In and of itself, the existence of cross-subsidies is not a bad thing. It is fundamental to all types of insurance and insurance is worth paying for. But, what DB plans could do much better than they do is to help plan members understand what the cross-subsidies are and how much they cost. This would allow plan members to decide what cross-subsidies are “worth it” and which ones are not worth it. My guess would be that within limits established by periods of guaranteed payments, members would accept cross-subsidies based on differential longevity in order to have a pension guaranteed for a lifetime. There may be less enthusiasm for a cross-subsidy from members whose salaries are flat as they approach retirement to those whose salaries escalate rapidly.

With respect to the plan features that Bernard has identified as discriminatory, my first and strongest inclination is to shine light on them so plan members have a chance to decide what is and is not acceptable.

The relatively predictable outcomes of DB plans in terms of the benefits they provide are clearly desirable. DC plans – especially those that involve individual investment decision-making and self-managed withdrawals – impose too much uncertainty on plan members with respect to the retirement incomes they will provide and demand excessive knowledge, skills and experience of plan members – not to mention time. As a renown professor of finance put it, a self-managed DC arrangement is like asking people to buy a “do it yourself” kit and perform surgery on themselves.

It is unfortunate however, that so much of the discourse about the design of pension plans is presented as a binary choice between DB and DC. There are several reasons why this is unfortunate.

First, the actual world of pension design is more like a spectrum than a binary choice. In Canada and across the globe, there are any number of pension plan designs that combine elements of DB and DC. Financial risks show up in both benefits and contributions.

Second, sometimes plans are managed in ways that are not entirely consistent with formal design features of plans. In the 1980s and 1990s when returns on financial assets were high and wage growth low, many DB plans ran up surpluses on a regular basis and these were often converted into benefit improvements. Many DB plans were managed as if they were collective DC plans (investment returns were determining benefits) with DB guarantees. The upside investment risk was not converted into variable contributions.

Third and finally, some plans that are labelled DB fall well short of addressing all of the financial contingencies that retirees will face. This is most strikingly true of DB plans that make no inflation adjustments. What is defined – in terms of living standards – only exists during the period immediately after retirement.

The difficulty in knowing exactly what we are referring to in using the DB and DC labels has not rendered the terms totally meaningless. As noted above, there are plans that are mainly DB but allocate some financial risk to the indexation of benefits. There are also a few grandfathered Canadian DC plans that include minimum benefit guarantees. The union created multi-employer plans have fixed rates of contribution like DC plans, pool many risks like a DB plan, but allow reductions in accrued benefits. The point is not to get stuck on the DB and DC labels but to understand how financial risks are being allocated.

The basic strength of DB plans in providing a relatively predictable retirement income is not diminished by the issues raised above. But, it is clear that for the well being of plan members and sponsors, the basic strength of DB has to be reconciled with acceptable levels and degrees of volatility of contributions. It also has to be reconciled with reasonable degrees of cross-subsidization within and between cohorts of plan members. With regard to cross-subsidies between cohorts, a regime in which accrued benefits cannot be reduced places all financial risk on young and future plan members. Target benefit plans try to avoid this problem by spreading the risk sharing across all cohorts as in the union created multi-employer plans.

Bernard’s article and slides touch on a number of regulatory issues. The only one of these that I will comment on is the prohibition of contribution holidays. This suggestion is put forward along with the use of realistic assumptions that err on the safe side.

In an environment where investment returns are consistently greater than the discount rate (e.g. the 1980s and 1990s), the practical effect of banning contribution holidays will be to build up surpluses that will significantly exceed what is required to protect against downside risks that plans may face. Rather than mandate the banning of contribution holidays, an approach that would create downside protection without building up excess surplus would be to mandate the adoption of funding policies that prohibit the use of surplus to reduce contributions or increase benefits until threshold levels of surplus have been achieved. The threshold levels should take account of the riskiness of the pension fund’s investments and the maturity of the plan. Funding policies of this general sort have begun to emerge in large Canadian plans and should be made to be common practice.

First, let me thank Bob Baldwin for sharing his thoughts on DB and DC plans. Bob is an expert who understands the complexities and issues surrounding pension policy.

In his email response, Bob added this: “(in a previous email he stated) my views were quite different from Bernard’s. I am not sure whether I should have said “quite different” “somewhat different” “slightly different”. In any event, they are attached. You would be correct in inferring that they cause me to be more open to Bill C-27 than Bernard is.”

Go back to read my last comment on Bill C-27, Targeting Canada’s DB Plans, where I criticized the Trudeau Liberals for their “sleazy and underhanded” legislation which would significantly weaken DB plans across the country. Not only do I think it’s sleazy and underhanded, I also find such pension policy inconsistent (and hypocritical) following their push to enhance the CPP for all Canadians.

In that comment, I shared Bernard Dussault’s wise insights but I also stated the following:

Unlike Bernard Dussault and public sector unions, however, I don’t think DB plans can be bolstered just by prohibiting contribution holidays (something I agree with). I believe that some form of risk-sharing is essential if we are to safeguard DB plans and make sure they are sustainable over the long run. Target benefit plans are not the solution but neither is maintaining the farce that DB plans can exist with no shared-risk model.

[Note: To be fair, after reading my comment, Bernard sent me his proposed DB pension plan financing policy which “promotes true risk sharing at any level (ideally 50%/50%) between the plan sponsor and the plans members, in such a way that not only would both parties share the cost but also the 15-year amortization of surpluses and deficit.”]

I take Denmark’s dire pension warning very seriously and so should many policymakers and unions who think we can just continue with the status quo. We can’t, we need to adapt and be realistic about what defined-benefit pensions can and cannot offer in a world of low or negative rates.

On that note, let me once more end by sharing this nice clip from Ontario Teachers’ Pension Plan on how even minor adjustments to inflation protection can have a big impact on plan sustainability.

The future of pensions will require bolstering defined-benefit plans, better governance and a shared-risk model, which is why pensions like OTPP, HOOPP, OMERS, OPTrust, CAAT and other pensions will be able to deliver on their promise while others will struggle and will face hard choices.

This means while I firmly believe the brutal truth on defined-contribution plans is they aren’t real pensions and will lead to widespread pension poverty because they shift retirement risk entirely on to employees and that the benefits of defined-benefit plans are grossly underestimated, I also firmly believe that some form of shared-risk must be implemented in order to keep DB plans solvent and sustainable over the long run.

I mention this because public sector unions think I am pro-union and for everything they argue for in regards to pension policy. I am not for or against unions, I am pro private sector, as conservative as you get when it comes to my economic policies and fiercely independent in terms of politics (have voted between Conservatives and Liberals in the past and will never be a card carrying member of any party).

However, my diagnosis with multiple sclerosis at the age of 26 also shaped my thoughts on how society needs to take care of its weakest members, not with rhetoric but actual programs which fundamentally help people cope with poverty, disability and other challenges they confront in life.

All this to say, when it comes to pension policy, I am pro large, well-governed DB plans which are preferably backed by the full faith and credit of the federal government and think the risk of these plans needs to be shared equally by plan sponsors and beneficiaries.

Now, Bernard Dussault shared this with me this morning:

I sense that the description of my proposed financing policy for DB pension plans deserves to be further clarified as follows:

My proposed improved DB plan is essentially the same as Bill C-27’s TB plan except that under my promoted improved DB:

1. Deficits affect only active members’ contributions (via 15-year amortization, i.e. through a generally small increase in the contribution rate), and not necessarily the sponsor’s contributions, as opposed to both contributions and benefits of both active and retired members under Bill C-27.
2. Not only are contribution holidays prohibited, but any surplus is amortized over 15 years through a generally small decrease in the members’ and not necessarily sponsor’s contribution rate.

Therefore, my view is that if my proposed financing policy were to apply to DB plans, TB plans would no longer be useful. They would just stand as a useless and overly complex pension mechanism.

But Bob Baldwin makes a great point at the end of his comment:

Rather than mandate the banning of contribution holidays, an approach that would create downside protection without building up excess surplus would be to mandate the adoption of funding policies that prohibit the use of surplus to reduce contributions or increase benefits until threshold levels of surplus have been achieved. The threshold levels should take account of the riskiness of the pension fund’s investments and the maturity of the plan. Funding policies of this general sort have begun to emerge in large Canadian plans and should be made to be common practice.

Funding policies need to be mandated to prohibit the use of surpluses to reduce contributions or increase benefits until certain threshold elements of pensions are achieved.

Take the example of Ontario Teachers’ Pension Plan and the Healthcare of Ontario Pension Plan, two of the best pension plans in the world.

They both delivered outstanding investment results over the last ten and twenty years, allowing them to minimize contribution risk to their respective plans, but investment gains alone were not sufficient to get their plans back to fully-funded status when they experienced shortfalls.

This is a critical point I need to expand on. You can have Warren Buffet, George Soros, Ken Griffin, Steve Cohen, Jim Simons, Seth Klarman, David Bonderman, Steve Schwarzman, Jonathan Gray and the who’s who of the investment world all working together managing public pensions, delivering unbelievable risk-adjusted returns, and the truth is if interest rates keep tanking to record low or negative territory, liabilities will soar and they won’t produce enough returns to cover the shortfall.

Why? Because the duration of pension liabilities is a lot bigger than the duration of pension assets so for any given drop (or rise) in interest rates, pension liabilities will soar (or drop) a lot faster than assets rise or decline.

In short, interest rate moves are the primary determinant of pension deficits which is why smart pension plans like Ontario Teachers’ and HOOPP adjust inflation protection whenever their plans run into a deficit.

This effectively means they sit down like adults with their plan sponsors and make recommendations as to what to do when the plan is in a deficit and typically recommend to partially or fully remove inflation protection (indexation) until the plan is fully funded again.

Once the plan reaches full-funded status, they then sit down to discuss restoring inflation protection and if it reaches super funded status (ie. huge surpluses), they can even discuss cuts in the contribution rate or increases in benefits, but this only after the plan passes a certain level of surplus threshold.

In the world we live in, I always recommend saving more for a rainy day, so if I were advising any pension plan which has the enviable attribute of achieving a pension surplus, I’d say to keep a big portion of these funds in the fund and not use the entire surplus to lower the contribution rate or increase benefits (apart from fully restoring inflation protection).

I realize pension policy isn’t a sexy topic and most of my friends love it when I cover market related topics like Warren Buffet’s investments, Bob Prince’s visit to Montreal, Trumping the bond market or whether Trump is bullish for emerging markets.

But pensions are all about managing assets AND liabilities (not just assets) and the global pension storm is gaining steam, which is why I take Denmark’s dire pension warning very seriously and think we need to get pension policy right for the millions retiring and for the good of the global economy.

In Canada, we are blessed with smart people like Bernard Dussault and Bob Baldwin who understand the intricacies and complexities of public pension policy which is why I love sharing their insights with my readers as well as those of other experts.

It’s not just Canada’s pension debate, it’s a global pension debate and policymakers around the world better start thinking long and hard of what is in the best interests of their retired and active workers and for their respective economies over the long run.

As I keep harping on this blog, regardless of your political affiliation, good pension policy is good economic policy, so policymakers need to look at what works and what doesn’t when it comes to bolstering their retirement system over the long run.