Pension360

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

The Public Service Alliance of Canada (PSAC) put out a press release, Liberal bill an attack on pensions:

The Liberal government is following the Conservatives’ lead by introducing legislation that will allow employers to reduce pension benefits.

Bill C-27, An Act to amend the Pension Benefits Standards Act, had its first reading in the House of Commons last week.

A target benefit pension plan is a big gamble

This bill will allow employers to shift from good, defined benefit plans that provide secure and predictable pension benefits, into the much less secure form of target benefits.

Unlike a defined benefit plan, where the employer and employees contribute and retirees know how much they can expect when they retire, the amount you receive under a target benefit pension plan is just that, a target. Meaning, the plan aims to give you a certain pension benefit, but there’s no guarantee.

The other big difference is that target pension benefit plans shift the financial risk from the employer to employees and pensioners.

PSAC will oppose this bill

Bill C-27 opens the door to eliminating or reducing defined benefit pension plans. PSAC has opposed target benefit pension plans since the previous Conservative government introduced consultations.

We will continue to resist any move in this direction, and continue to push for retirement security for all Canadians.

A PSAC union member brought this to my attention, providing me with some context:

Bill C-27 was introduced in the Parliament of Canada on October 19th, 2016 and will allow for the conversion of defined benefit pension plans to less secure “target benefit” pension plans. Quite remarkably this legislation has thus far been flying under the mainstream media radar.

In the opinion of the PSAC, Bill C-27 will eventually lead to the demise of “defined benefit” pension plans in the federal jurisdiction and is a component of the Morneau agenda to dismantle the Public Service Superannuation Act.

To say the least, I was shocked when I read this and replied: “Wow, interesting, I thought only the Harper government would try to pull off such sneaky, underhanded things. Hello Trudeau Liberals!” (at least Harper wore his colors on his sleeve when it came to pensions and his government did introduce cuts to MP pensions).

It never ceases to amaze me how politicians can act like slimy weasels regardless of their political affiliation. If Bill C-27 passes to amend the Pension Benefits Standards Act, it will significantly undermine public pensions of PSAC’s members and they are absolutely right to vigorously oppose it.

Who cares if the pensions of civil servants are reduced or shifted to target benefit plans? I care and let me state this, this bill is a farce, a complete and utter disgrace and totally incompatible with the recent policy shift to enhance the Canada Pension Plan (CPP) for all Canadians.

Think about it, on the one hand the Trudeau Liberals worked hard to pass legislation to bolster the Canada Pension Plan and on the other, they are introducing an amendment to the Pension Benefits Standards Act which will open the door to eliminating or reducing defined-benefit plans at the public sector.

The irony is that PSAC’s members helped the Trudeau Liberals sweep into power and this is how they are being treated? With friends like that, who needs enemies?

More importantly, there is no need to amend the Pension Benefits Standards Act to introduce target pension benefit plans because these pensions are safe and secure and managed properly at arms-length from the federal government at PSP Investments.

[Note: I can just imagine what the folks at PSP think of Bill C-27, something like “what the hell is the federal government trying to do here?!?”].

And let me repeat something, just like variable benefit plans which I covered in my last comment, target date benefit plans offer some interesting ways to help people invest properly for retirement, but they too suffer from the same deficiencies of defined-contribution plans because they invest solely in public markets and offer no guarantees whatsoever.

In fact, John Authers of the Financial Times wrote an article on this in the summer, Target-dated funds are welcome but no panacea for pension holes:

Much is riding on target-dated funds. As this week’s FT series on pensions should make clear, defined benefit pensions face serious deficits — but the same mathematics of disappointing returns and ever greater expense for buying an income also applies to defined contribution plans.

DC plans have been poorly designed. For years, 401(k) sponsors were lulled by the equity bull market into allowing members to choose their own asset allocations, and switch between funds and asset classes at will. This was a recipe for disaster, as members tended to sell at the bottom and buy at the top. The strong returns of the 1990s convinced many that they could get away with saving far less than they needed.

The industry and regulators have been alive to the problem, and their response is sensible. Now they offer a default option of a fund that aims to ensure a decent payout by a “target date” — the intended retirement date. These funds automatically adjust their asset allocation between stocks and bonds as the retirement date approaches, which in general means starting with mostly stocks and shifting to bonds as retirement approaches. This (good) idea mimics the best features of a DB plan.

Such funds are undeniably an improvement on the “supermarket” model of the 1990s. Savers avoid the pitfalls of taking too much or too little risk, and regular rebalancing helps them sell at the top and buy at the bottom.

But TDFs have problems, which are growing increasingly apparent. First, are their costs under control? Second, do they have their asset allocation right? And third, can we benchmark their performance?

On costs, the news is good. US regulations require 401(k) sponsors to look at costs, and the response has been to drive down fees. According to Morningstar’s Jeff Holt, TDFs’ average asset-weighted expense ratio stood at 1.03 per cent in 2009, and by last year had dropped to 0.73 per cent — a 30 basis point fall, which in a low return environment could make a very big difference when compounded.

But if TDFs are coming under pressure to limit costs, the pressure over asset allocation is taking them in every direction. They are designed as mutual funds, so they still do not hold the kind of illiquid assets that the best DB funds can fund, such as infrastructure. That is a problem.

So is the entire balance between stocks and bonds. The notion from the DB world was to reach 100 per cent bonds by the retirement date, when the fund could be used to buy an annuity. With low bond yields making annuities expensive, and life expectancy far longer than it used to be, this no longer makes much sense. A 65-year-old, with a decent chance of making it to 90, should not be 100 per cent invested in bonds.

But high equity allocations tend to emphasise that the TDFs expose savers to greater risk than a DB plan. According to Morningstar the average drawdown for 2010 TDFs during the crisis year of 2008 was 36 per cent — a potentially disastrous loss of capital for people about to retire. As stocks rapidly recovered, and as those retiring in 2010 would have been unwise to sell all their stocks, this should not be a problem — but it plainly hit confidence.

The early stages are also a problem. Our 20s and 30s are a time of great expense. Should young investors really be defaulted into heavy equity holdings when the risks that they lose their job are still high, and when they face possible big drains on their income, such as a baby, or downpayments on a first house?

So the “glide path” of shifting from equity to bonds is controversial. And there is no standard practice on it. According to Mr Holt, TDFs’ holdings of bonds at the target date for retirement vary from 10 to 70 per cent.

What about benchmarking? Such differences make it impossible. Asset allocation differences swamp other factors, and are driven by different assumptions about risk.

Establish bands for asset allocation at each age, but allow them to vary according to valuation. Funds designed for retirement should never take the risk of being out of the market altogether. But if, as now, bonds and US equities look overpriced while emerging market equities look cheap, an approach that took US equities’ weighting to the bottom of its band, while putting the maximum permissible into emerging markets, would probably work out well.

There is not, as yet, an incentive to do that, and there needs to be. TDFs, or something like them, should be at the heart of future pension provision. It is good that their costs are under control, but there are ways to make them far more effective: by allowing more asset classes, accepting that people at retirement should still have substantial holdings in equities, and encouraging TDFs to allocate more to asset classes that are cheap.

I agree with Authers, there are ways to make target-dated funds more effective and folks like Ron Surz, President of Target Date Solutions are at the forefront of such initiatives.

But no matter how effective they get, target-dated pensions or variable benefit plans will never match the effectiveness of an Ontario Teachers, HOOPP, Caisse, CPPIB, PSP Investments and other large, well-governed Canadian defined-benefit pensions which reduce costs, address longevity risk (so members never outlive their savings) and invest across public and private markets all over the world, mostly directly and through top funds.

All this to say that PSAC is right to vigorously oppose Bill C-27, it’s a total assault on their defined-benefit pensions, and if passed, this amendment will undermine their pensions, the ability of the civil service to attract qualified people to work for the federal and other governments, and the Canadian economy.

In short, it’s dumb pension policy and if Trudeau thinks he had a tough time in the boxing ring, let him try to pull this off, it will basically spell the end of his political career (this and the asinine housing market policies won’t help the Liberals’ good fortunes).

Stay tuned, more to come on this topic from other pension experts. I will update this comment as experts send in their views and if anyone has anything to add, feel free to reach me at LKolivakis@gmail.com.

Update: Jim Leech, the former president and CEO of the Ontario Teachers’ Pension Plan and co-author of The Third Rail, shared this with me (added emphasis is mine):

I think everyone is missing the point of this bill.

Until now, federal pension legislation has only recognized plans as either DC or DB – there was no provision for a hybrid/risk shared plan.

That is one reason contributing to the switch all the way from DB to DC at many companies – if the DB plan was not sustainable, the only alternative was to move all the way to DC – a middle ground was not available even if the parties wanted a middle ground.

As I understand it, this bill simply allows transition to a risk shared model as an alternative to closing the DB and going all the way to DC.

Greater legislative flexibility is a positive step.

While I agree with Jim, some form of a shared risk model like the one New Brunswick implemented makes perfect sense for all public pension plans, especially if they are grossly underfunded, I’m not convinced the federal government needs to introduce hybrid plans at this stage and share PSAC’s concern that this amendment opens the door to cutting DB pensions altogether.

Also, Bernard Dussault, Canada’s former Chief Actuary, shared these insights with me (added emphasis is mine):

There are two big fairness-related points with this legislation, namely:

• not only does it allow the reduction of future accruing pension benefits of both active and retired (deferred and pensioned) members, a vital right so far covered under federal and provincial (except NB since 2014) pension legislation;
• but it also allows the concerned sponsoring employers to shift to active and retired members the liability pertaining to any current (as at effective date of the tabled C-27 legislation) deficit under any concerned existing DB plan.

As shown in the two attachments hereto, I have been promoting over the past few years that the shortcomings of DB plans can be easily overcome in a manner that would make DB plans much more simple, effective and fair than TB plans. Points not to be missed.

One of the attachments Bernard shared with me, Improving Defined Benefit (DB) plans within the Canadian Pension Landscape, is available here. I thank Bernard and Jim for sharing these insights.

Startup hedge fund Mill Hill Capital was seeded this month by Protege Partners, according to the firm.

Mill Hill was founded in 2015 by investment management vet David Meneret, who previously worked at Macquarie in various roles since 2008, including head of securitized debt and financials trading.

The size of Protege’s investment is unknown. In the recent past, the firm has seeded managers with dollar amounts between $50 million and $125 million.

More info on Mill Hill, from Reuters:

As a trained engineer with degrees from Columbia and the Ecole Centrale Paris, Meneret has spent the last year readying the new fund’s launch with the help of former colleagues from global investment banking group Macquarie. Mill Hill now employs six people and will be largely numbers oriented, relying heavily on data and building models to make all types of trading decisions, Meneret told Reuters.

Meneret’s team includes former Macquarie colleagues Gaurav Singhal, Hongwei Cheng and Robert Perdock. They have experience running a so-called market-neutral relative value credit hedge fund that seeks to exploit differences in the price or rate of similar securities, after having worked at the Macquarie Credit Nexus Fund. David Modiano joined Mill Hill as head of business development and investor relations early this year.

FinAlternatives has some insight on Mill Hill’s strategy:

The new manager’s strategy will be focused on market-neutral relative value trading in U.S. credit, seeking opportunities across CLOs, corporate financials, corporate transportation, aircraft ABS, esoteric ABS, non-agency mortgage-backed securities, and credit indices, according to the company.

Mill Hill will reportedly utilize a combination of asset-level fundamental analysis and market-implied data-driven proprietary cash flow models to identifying long/short opportunities across asset classes, as well as a systematic approach to risk and portfolio management.

Mill Hill plans to start trading in November.

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

Lee Barney of Plan Sponsor reports, A Pension Plan That Makes No Promises (h/t, Suzanne Bishopric):

Variable benefit plans are a type of defined benefit (DB) plan that have been around for decades, according to Matt Klein, a principal and leader of the actuarial services practice at employee benefits consulting firm Findley Davies in Cleveland.

However, few sponsors and retirement plan advisers know about them, he says, estimating that there are fewer than 100 of these types of plans in the United States. Nonetheless, he believes that sponsors and retirement plan advisers might be interested in them since they shift the investment risk off of the sponsor’s shoulders onto the participant’s—while moving the longevity risk over to the sponsor.

Employers continue to shut down their pension plans, redeploying their employees into defined contribution (DC) plans, Klein notes. But unless participants are automatically enrolled into their DC plan at meaningful deferral rates into an appropriate qualified default investment alternative (QDIA), most DC participants fail to make appropriate investment and deferral decisions, he says. The DC system fails to properly prepare most people for retirement, he maintains.

A variable benefit plan is a type of pension plan that, unlike a traditional DB plan that promises a set return every year, fluctuates with the market, he explains. Hence the name variable benefit.

“Sponsors interested in a comprehensive benefits package that will be able to provide employees with a comfortable retirement might want to consider a variable benefits plan, which eliminates the traditional risks associated with defined benefit plans and provides a stable cost and contribution policy that fits better with companies’ goals and objective in the 21st century,” Klein says.

NEXT: Comparison to traditional DB plans

In a traditional DB plan, the employer takes on the investment risk, he explains. But when a pension plan faces a market correction, such as the 2008 financial crises, assets decrease significantly while participants’ promised benefits remain intact, requiring the sponsor to make additional contributions to fund the plan at the precise time when they are typically facing a recession, Klein notes.

Like a traditional DB plans, a variable benefit plan uses an accrual rate whereby the sponsor contributes a percentage of each participant’s salary to the plan each year and ensures that the assets are professionally managed. Unlike a traditional DB plan, however, a variable benefit plan establishes a hurdle rate, which is the percentage return goal for each year, Klein says. If the returns are actually higher than the hurdle rate, the sponsor can increase the participants’ benefits—but if it is lower, they can reduce the benefits, Klein says.

“You would invest the assets in a variable benefit plan very differently than a traditional DB plan,” he adds. “A lot of traditional DB plans are doing some sort of asset/liability matching or glide path strategy, matching bonds to expected cash flows coming out of the plan. With a variable benefit plan, you don’t have the downside risk keeping employers up at night. One way to approach investing in a variable benefit plan is to treat it like an endowment while still being cognizant of the downside risk.”

NEXT: Advantages for participants and sponsors

From the participants’ perspective, the key advantage of a variable benefit plan is that, like a traditional DB plan, when they retire, they receive an annuity that pays them a set monthly income, as opposed to a lump sum they would receive from a DC plan or even a cash balance plan, Klein notes.

He believes that because DC plans are so prevalent today, sponsors and participants are now accustomed to variable returns—and the fact that their balances could decrease—and that they might be more receptive to variable benefit plans.

“Part of my passion here is to try and educate employers and advisers that these plans do exist,” he says. “They meet all of the legal hurdles and requirements of the IRS, DOL and ERISA. They are a win/win for both plan sponsors and plan participants while splitting the investment and longevity risks between the employer and the participant.”

An additional reason an employer might consider a variable benefit plan is that, unlike traditional pension plans that are typically underfunded and that require DB plan sponsors to pay 3% of their underfunding each year to the Pension Benefit Guaranty Corporation (PBGC), variable benefit plans remain 100% or very close to 100% funded. The reason for this is that the benefits rise or decrease as the plan’s returns exceed, meet or fall below the hurdle rate, Klein says. Therefore, variable benefit plan sponsors do not have to pay the annual 3% to the PBGC, only the minimal per-head cost.

Findley Davies has created a white paper comparing the benefits of variable benefit, DB, DC and cash balance plans, titled, “The Future of Retirement Plans: Variable Benefit Plans.” The paper makes the case that variable benefit plans strike the right balance between investment, interest or inflation, and mortality risk. It is available here.

I went through the white paper, “The Future of Retirement Plans: Variable Benefit Plans,” and found it was well written.

The paper begins with the three most significant risks to any retirement plan (click on image):

Of these, the most significant risk is the direction of interest rates, especially when rates are at historic lows. The the lower they go, the higher the liabilities shoot up relative to assets.

Why? Because the duration of liabilities is much bigger than the duration of assets, so for any given decline in interest rates, the increase in liabilities will dwarf and increase in assets.

This is especially true in a low rate environment which is why I’ve always warned my readers a prolonged bout of deflation will decimate many pensions which are already in deeply underfunded territory.

So how does it work? There is an example given in the white paper (click on image):

 

And for the active participant using the same example (click on image):

What are my thoughts? Obviously variable benefit plans are better than defined-contribution plans because they offer a monthly income for life and from an employer’s perspective, they offer the added advantage they remain off the hook if the plan is underfunded as employees will bear cuts (or increases) to their benefits depending on where annual returns lie relative to the hurdle rate.

But let’s not kid ourselves, while variable benefit plans offer some benefits relative to DC plans, they are still far and away inferior to a large well-governed defined-benefit plan which has adopted a shared-risk model among its stakeholders (Ontario Teachers, HOOPP, OPTrust, CAAT for example).

Basically, without going into too much detail, variable pensions suffer from the same deficiencies as DC plans, namely, they only invest in public markets and are subject to the vagaries of the stock market. Only difference is if the plan has a bad year, benefits are automatically adjusted down, which is no skin off the employer’s back. There is zero risk-sharing going on here (employees assume all the risk in bad years).

Go back to read my last comment on Canada’s new masters of the universe where I stated the following:

The brutal truth on defined-contribution plans is they are leaving millions at risk of pension poverty which is why unlike the Andrew Coynes of this world, I kept harping on enhancing the CPP knowing full well Canadians are getting a great bang for their CPP buck.

And when I read about what is happening to Nortel’s pensioners, it infuriates me and reminds me that there is still a lot of work left to do in terms of pension policy in this country, like creating a new large, well-governed public pension here in Montreal in charge of managing the assets of all Canadian DB and DC corporate pensions (Montreal is home to the country’s best corporate DB pensions like CN’s Investment Division and Air Canada Pensions).

When it comes to pensions, nothing, and I mean nothing, compares to a large, well-governed DB pension which has adopted risk-sharing, typically in the form of adjusting inflation protection if the plan is underfunded, not cutting benefits every year depending on how stocks and bonds are doing.

And I would prefer if these were large well-governed public DB pensions like we have in Canada. Smaller DB pensions are struggling and I think it’s high time we consolidate a lot of local and city pensions into the big ones.

The new investment policy of China’s pension systems — which allows a portion of funds to be invested in public markets — could lead to mismanagement and corruption, wrote one of the country’s most influential newspapers this week.

Previously, pension money could only be invested in treasuries and similar low-yield instruments. But a new rule allows a portion of the money to be invested in the country’s stock market.

It’s a new frontier that opens up the opportunity for mismanagement in a country where graft is rampant, according to the newspaper.

From Reuters:

The influential state-run newspaper Global Times said late on Tuesday in its English-language edition that announcement from the Ministry of Human Resources and Social Security’s (MOHRSS) decision to proceed with the plan has triggered concerns over the management of the pension funds.

“Managing the pension could be a problem since the funds are currently in the hands of local governments,” Peng Xizhe, dean of the School of Social Development and Public Policy at Fudan University was quoted as saying.

Mismanagement of public funds is known to be rampant.

More than one million have been punished for corruption between 2013 and this September, as president Xi Jinping pushes ahead with a nation-wide anti-graft campaign, according to party statistics, though many only get administrative punishments.

 

Alaska Governor Bill Walker on Tuesday said he’d tabled a plan to issue $3.3 billion in pension obligation bonds.

The decision to scrap the plan comes as few members of the state Senate supported the idea. Credit rating agency S&P also told the state the bond issuance could lead to a credit downgrade.

More from Reuters:

“While we believe the financial benefits of issuing state pension obligation bonds significantly outweigh the financial risks, we recognize the need for legislative input,” Walker said in a statement.

Walker met with Senate Finance Committee members this week where they warned against proceeding with the sale out of concern about taking on more debt.

“Given their lack of support, I have decided not to proceed with the issuance at this time,” he said.

Credit ratings agency S&P Global Ratings had warned that Alaska could face a credit downgrade if it proceeded with the bond transaction.

“Not selling them now may delay the downward pressure on the rating, but absent fiscal reforms, many of the same fiscal pressures remain,” S&P’s Gabriel Petek told Reuters on Tuesday.

 

Institutional investors are becoming more interested in senior housing, especially as transparency grows around performance metrics, according to panelists at last month’s 2016 NIC Fall Conference.

One such panelist was a high-ranking official at one of the largest institutional investing bodies in the world: Canada’s $130 billion Public Sector Pension Investment Board (PSP Investments).

Transparency around performance metrics is key for institutional investors to truly dive in. Here’s what the PSP official had to say:

“The demographics are compelling,” said Neil Cunningham, senior vice president, global head of real estate investments, PSP Investments, a $130 billion fund that manages the pension assets of the Canadian armed services and public service employees. “We’ve made a tactical allocation to overweight U.S. seniors housing.”

[…]

Seniors housing has gained more acceptance among institutional investors, noted Cobb of Hamilton Lane, though she added that investors still need to be educated about the product. Cunningham believes that as transparency improves and the seniors housing market becomes better known, it will be a standard part of a portfolio because of the quickly aging population.

As an investor, Cunningham at PSP wants the operator to have at least a 20% investment in the property. With a stake in the project, the operator will have a solid knowledge of the market and submarkets, he said.

PSP is usually on the cutting edge of institutional investing trends. They are one of the world’s largest infrastructure investors, and along with other giants like CalPERS and the CPPIB, help pave the way for pension funds into new markets.

An Institutional Investor piece from April characterizes the activity of institutional investors so far:

Thus far, much of the institutional investment in senior housing has been through loans for independent and assisted-living facilities, far more than for those that require staffing of skilled workers, such as nurses, and also involve a higher level of operational risk. But experts say that even nursing facilities are increasingly attractive because of their higher returns, especially when compared with traditional multifamily properties. To help with the learning curve, the National Investment Center for Seniors Housing & Care in Annapolis, Maryland, which collects data about senior housing, has been hosting “new investor” events around the country.

[…]

“It used to be impossible for institutional investors to find quality real estate deals on the ground in markets they didn’t know, but now they can track algorithms, just like stock traders, to be able to pinpoint deals quickly,” says Picken. “They have access to much more opportunity that’s not just in their own backyard.”

Experts note that although it’s a complicated market, technology and the transparency that comes with it have created a welcoming environment for institutional investors to take advantage of the growing demand.

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

Theresa Tedesco and Barbara Shecter of the National Post report, Inside the risky strategy that made Canada’s biggest pension plans the new ‘masters of the universe’:

They are among the world’s most famous landlords with stakes in major airports in Europe, luxury retailers in New York and transportation hubs in South America. They rank as five of the top 30 global real estate investors, seven of the world’s biggest international infrastructure investors, and were at the table during six of the top 100 leveraged buyouts in corporate history. And they are Canadian.

The country’s eight largest public pension funds, which collectively manage net assets worth more than $1 trillion, have acquired so much heft in the past decade that they are being lauded in international financial circles as the new “masters of the universe.” Their clout has caught the attention of major Wall Street investment firms angling for their business, as well as institutional investors around the world that are emulating their investing model (click on image).

“Canada’s public-sector pension plans are high profile, widely admired and they’re certainly bigger than they used to be,” said Malcolm Hamilton, a pension expert and senior fellow at the C.D. Howe Institute in Toronto.

A veteran Bay Street denizen, who asked not to be named because his firm has business dealings with many of the funds, added: “Asset by asset, around the world by virtue of their investments through ownership or partnership, they are as much economic ambassadors for Canada as anybody.”

But the vaunted positions these pension-plan behemoths have on the world stage is attracting closer scrutiny — and some skepticism — from industry experts at home, including the Bank of Canada, because of the increased levels of risk they are taking and the potential “future vulnerability” many of them have assumed in the pursuit of growth.

“You’re seeing more and more pension funds taking on greater risk in the past 15 years,” said Peter Forsyth, a professor of computational finance specializing in risk at the University of Waterloo in Ontario.

The eight funds, which account for two-thirds of the country’s pension fund assets or 15 per cent of all assets in the Canadian financial system, are acting more like merchant banks in going after — and financing — blockbuster deals in increasingly riskier locations and asset types.

A major reason behind the pension plans’ thirst for less liquid assets, namely real estate, private equity and infrastructure — much of it in foreign places — is the low-interest-environment that has made traditional assets less desirable. Between 2007 and 2015, the big eight public pension funds’ collective allocation to these types of investments grew to 29 per cent from 21 per cent. And foreign assets jumped to account for 81.5 per cent of assets in 2015 from 25 per cent in 2007 (click on images below).

That strategy collides with their traditional image as conservative, risk-averse guardians of retirement nest eggs. Should investments go wrong, benefits would likely be slashed, contributions could be sharply increased and it is anyone’s guess who would be on the hook if there were major losses.

“On the world stage, they are the cream of the crop, but I think they are taking significant risks and they aren’t acknowledging it,” Hamilton said.

Perhaps more importantly, the pension sector in Canada lacks the same stringent cohesive regulatory oversight as banks and insurers, meaning there are less checks and balances governing a big chunk of everyone’s retirement plans. As a result, some industry participants are questioning whether public pension funds should be more closely examined.

“The pension funds are largely unregulated — what’s regulated is the payments to the beneficiaries. The investments of the pensions are not regulated,” said a veteran Bay Street risk expert who asked not to be named. “And so this is the conundrum they’re in as they move further afield … And it’s a big debate going on right now.”

With net assets ranging from $64 billion to $265 billion, the top eight pension funds — Canadian Pension Plan Investment Board (CPPIB), Caisse de depot et placement du Quebec, Ontario Teachers’ Pension Plan, British Columbia Investment Management Corp., Public Sector Pension Investment Board, Alberta Investment Management Corp., OMERS (Ontario Municipal Employees Retirement System and Healthcare of Ontario Pension Plan (HOOPP) — all rank among the 100 largest such funds in the world, and three are among the top 20, according to a study by the Boston Consulting Group released last February. Only the United States has more public pension funds on the global list.

The country’s giant public pension plans, flush with billions in retirement savings, began flexing their investment muscle on the heels of tougher banking laws following the financial crisis of 2008-2009.

Although Canada emerged as the darling in international financial circles for its resilience during the crisis and resulting recession — and the major banks basked in the glory — their global counterparts did not fare so well, which prompted policymakers to layer on additional regulation for all banks.

These new rules, many of which are contained in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, are supposed to protect the financial sector in times of stress by limiting risk-taking strategies. Canadian pension funds, unencumbered from those onerous banking rules, have been all too eager to rush in.

During the past 10 years, they have accumulated an eclectic mix of prime assets in unprecedented fashion. Among them: a 27-per-cent stake in the Port of Brisbane in Australia; interests in Porterbrook Rail, the second-largest owner and lessor of trains in the United Kingdom; luxury retailer Neiman Marcus Group in New York; Transelec, Chile’s largest electricity transmission company; Heathrow Airport; and Camelot Group, the U.K.’s national lottery operator.

In all, they’ve done 20 deals worth more than US$10 billion during that time, according to the Boston Consulting report.

It’s a deal binge that has created a “new world order” in which “Canada’s pension funds have barged Wall Street to stake a claim to be the new masters of the universe,” a British financial columnist noted last year.

Notably, the Canadian public pensions have invested in less conventional businesses and asset classes, where risks are generally higher than more conservative investments such as stocks and bonds. At the same time, there is potentially even more risk looming because the funds are pushing into asset classes and geographies where they have less experience.

For example, CPPIB in June 2015 paid $12 billion for General Electric Capital Corp.’s GE Antares Capital, a middle-market private-equity sponsor. The pension giant has also made a pair of recent investments in the insurance business.

Earlier this month, the Caisse announced plans to invest US$600 million to US$700 million over four years in stressed assets and specialized corporate credit in India. The Quebec-based pension group forged a long-term partnership with Edelweiss Asset Reconstruction Company, India’s leading specialist in stressed assets, which included taking a 20-per-cent equity stake in Edelweiss.

At the same time, the pension funds are increasingly barging in on the conventional bank business. The CPPIB, which invests on behalf of 19 million Canadians as the investment arm of the Canada Pension Plan, has started tapping public markets by issuing bonds to fund their large-scale deals rather than seek debt financing through the banks.

In June 2015, Canada’s largest public pension fund, with $287.3 billion in assets under management — and the eighth largest in the world — raised $1 billion by issuing five-year bonds. A follow-up offering of three-year notes raised an additional $1.25 billion.

“Pension funds used to stick with a balanced portfolio of public-traded debt and equities and a little real estate,” said Richard Nesbitt, chief executive of the Toronto-based Global Risk Institute in Financial Services. “The Canadian model of pension investment management invests into many more asset classes including infrastructure assets around the globe. Banks are still there providing support in the form of advice and corporate loans. But the banks tend to be more regionally focused whereas the pensions are definitely global.”

Meanwhile, Canada’s large pension funds are also borrowing more money to fund their investments. Since they have long time horizons relative to other investors — decades in some cases — they argue that gives them a competitive advantage in both the deal arena and the ability to tolerate more short-term volatility.

“The pressure has just been getting worse and worse, especially as interest rates continue to decline for public funds to get the returns they used to get,” said Hamilton, a 40-year veteran of the industry and former partner at Mercer (Canada).

Low interest rates have a double-whammy effect: they tend to boost the prices of assets and lower expected returns while at the same time reducing borrowing costs, making it cheaper to borrow money and increasing the incentive to use leverage.

But rather than cutting back their risk exposure, Hamilton said the funds, especially those pension plans that are maturing, are behaving the same way they did during the gravy days of high interest rates years 20 years ago. The reason they are behaving this way is because they can’t afford to suffer lower returns, he said, because either benefits would have to be cut or contributions to the plan raised to keep payouts the same.

“They are levering up and hoping for the best instead of making the tough choices,” Hamilton said. “There are alternatives, but they are not so pleasant.”

Forsyth said a main reason Canadian pension funds have avoided making tough choices is partly because of this country’s stellar record. Unlike the Netherlands, where the central bank forces public pension funds to cut benefits when there’s too much risk on the books, Canada has never really faced a systemic financial meltdown that would induce the government to enact such tough measures.

“There isn’t the same amount of pressure in Canada, because we didn’t have the financial blow-ups they had in other countries,” he said.

The Netherlands is one of only two countries whose pension system achieved the top grade in the prestigious annual Melbourne Mercer pension index in 2015 (the other is Denmark). Canada tied for fourth with Sweden, Finland, Switzerland, the U.K. and Chile, all of which are considered to have a “sound system” with room for improvement.

Nevertheless, Canada’s public pension system has pioneered new approaches to institutional investing and governance, and rates among the best in the world in terms of funding its public-sector pension liabilities.

The key characteristic of the Canadian model is cost savings. Canadian fund managers, unlike other public pension managers, prefer to actively manage their portfolios with teams — employing about 5,500 people (and about 11,000 when including those in the financial and real estate sectors) — an organizational style that allows them to direct about 80 per cent of their total assets in-house.

Cutting out the middleman creates considerable economies of scale by lowering average costs, especially through fees to expensive third parties such as Blackrock Inc. and KKR & Co. LP.

In private equity, for example, managers can charge a fee equal to two per cent of assets and 20 per cent of profits. Hiring internal staff and building up internal capabilities is far less expensive. So much so that the total management cost for most Canadian public funds is 0.3 per cent versus 0.4 per cent for a typical fund that relies on external managers.

[Note: I think this is a mistake, the total management cost for a typical fund that relies on external managers is much higher than 0.4%.]

The management style was pioneered by Claude Lamoureux, former head of Ontario Teachers’ Pension Plan, who was the first to adopt many of the core principles espoused by the late Peter Drucker in the early 1990s on creating better “value for money outcomes.” Now all large Canadians funds operate with these key principles.

“That’s the innovation. It’s a simple story of scale allowing you to disintermediate a distributor,” said a senior Canadian pension executive who asked not to be named.

The strategy may be simple, but it has had a significant impact on the bottom line. The cost savings have added up to hundreds of millions of dollars that have been invested rather than outsourced.

Since 2013, total assets under management for the top 10 major public pension funds have tripled, with investment returns driving 80 per cent of the increase.

Even so, the Bank of Canada issued a cautionary note about the challenges in its 2016 Financial System Review. In a recent study of the country’s large public pension funds, the central bank stated that “trends toward more illiquid assets, combined with the greater use of short-term leverage through repo and derivatives markets may, if not properly managed, lead to a future vulnerability that could be tested during periods of financial market stress.”

In its June 2016 paper, “Large Canadian Public Pension Funds: A Financial System Perspective,” the central bank noted the big eight funds have increased their use of leverage, but the amounts on the balance sheet are not considered high.

However, the BoC cautioned that although balance-sheet leverage — defined as the ratio of a fund’s gross assets to net asset value — varies greatly across the funds and appears “modest as a group,” it is still “not possible to precisely assess aggregate leverage using public sources” because it can take on many forms in addition to what is shown on the balance sheet.

“If not properly managed, these trends my lead in the future to a vulnerability that could create challenges on a severely stressed financial market,” the central bank paper warned.

Oversight for most public pension funds, not including the CPPIB, which is federally chartered, falls to the provinces and their regulators are non-arms’ length organizations created by, and report to, the provinces, which also directly and indirectly sponsor many of the same plans being supervised. In other words, pension regulators are not truly independent the way the Office of the Superintendent of Financial Institutions is to the financial sector.

“Can a regulator staffed by members of public-sector pension plans effectively regulate public-sector pension plans?” said C.D. Howe’s Hamilton. “In particular, can such a regulator protect the public interest if the public interest conflicts with the interests of the government and/or the interests of plan members? I think not.”

Furthermore, he said, most pension fund managers would characterize their behaviour as “prudent and creatively adapting to an unforgiving and challenging environment.”

Over at Ontario Teachers’, chief investment officer Bjarne Graven Larsen, welcomed the central bank’s scrutiny and acknowledged that risk is an integral part of any investment strategy. The trick as the pension plan evolves, he said, is to make sure there is adequate compensation for the amount of uncertainty.

“You have to have risk, that’s the way you can earn a return,” Graven Larsen said. Not every transaction will work out according to plan, of course, but he said the strategy is to ensure that losses will not be too great when assets or market conditions fail to meet expectations, even if that means taking a lower return at the outset.

Ontario Teachers’, the largest single-profession plan in Canada, recently moved its risk functions into an independent department and is also tweaking its portfolio construction in an attempt to account for the largest risks it takes and calibrate other positions to balance the potential downside.

“But you will, over time, be able to harness a risk premium and get the kind of return you need with diversified risk — that’s the approach, what we’ve been working on,” Graven Larsen said.

CPPIB, meanwhile, doesn’t have a designated chief risk officer, a key executive who plays a critical role balancing operations and risk. That absence sets it apart from other major government pension plans and other major Canadian financial institutions such as banks and insurers, according to Jason Mercer, a Moody’s analyst.

“A chief risk officer plays devil’s advocate to other members of management who take risks to achieve business objectives,” Mercer said. “The role provides comfort to the board of directors and other stakeholders that risks facing the organization are being overseen independently.”

For its part, CPPIB officials said they have created a framework that doesn’t rely on a single executive to monitor risk. Michel Leduc, head of global public affairs at CPPIB, said the pension organization has an enterprise risk management system that runs from the board of directors, through senior management, to professionals in each of the pension’s investment departments.

“This decentralized model ensures that individuals closest to the risks and best equipped to exercise judgment have local ownership over management of those risks,” Leduc said.

The risks some critics find worrisome, CPPIB officials see as a strength, courtesy of the funds’ unique characteristics, namely a steady and predictable flow of contributions — about $4 billion to $5 billion a year.

CPPIB in 2014 began shifting the investment portfolio to recognize that the fund could tolerate more risk while still carrying out the pension management’s mandate of maximizing returns without undue risk of loss.

The plan is to gradually move from a mix reflecting the “risk equivalent” of 70-per-cent equity and 30-per-cent fixed income to a risk equivalent of 85-per-cent equity and 15-per-cent fixed income by 2018.

With unprecedented amounts of money pouring into public pensions — fuelled by heightened assumptions from governments about what Canadians should expect to receive — the chorus for closer examination of the sector will likely reverberate.

After all, for all the bouquets tossed at them on the world stage, Canada’s public pension funds still have to prove whether their high-profile investments are worth the risk to those at home.

This article was written last Saturday. I stumbled across it yesterday when I read Andrew Coyne’s article on keeping tax dollars and public pension plans away from infrastructure spending.

I might address Coyne’s latest ignorant drivel in a follow-up comment (he keeps writing misleading and foolish articles on pensions), but for now I want to focus on the article above on Canada’s new masters of the universe.

First, let me commend Theresa Tedesco and Barbara Shecter for writing this article. Unlike Coyne, they actually took the time to research their material, talk to industry experts, including some that actually work at Canada’s large public pension funds (something Coyne never bothers doing).

Their article raises several interesting points, especially on governance lapses, which I will discuss below. But the article is far from perfect and the main problem is it leaves the impression that Canada’s large pension funds are taking increasingly dumb risks investing in illiquid asset classes all over the world.

I believe this was done purposely in keeping with the National Post’s blatantly right-wing tradition of fighting against anything that seems like big government intruding in the lives of Canadians. The problem is that the governance model at Canada’s large pensions was set up precisely to keep all levels of government at arms-length from the actual investment decisions, something which is mentioned casually in this article.

[Note to National Post reporters: Next time you want to write an in-depth article on Canada’s large pension funds, go out to talk to experts who work at these funds like Jim Keohane, Ron Mock and Mark Machin or people who retired from these funds like Claude Lamoureux, Jim Leech, Neil Petroff, Leo de Bever. You can also contact me at LKolivakis@gmail.com and I’ll be glad to assist you as to where you should focus your attention if you want to be constructively critical.]

In a nutshell, the article above leaves the (wrong) impression that Canada’s large pensions are not regulated or supervised properly, oversight is fast and loose, and they’re taking huge risks on their balance sheets to invest in assets all over the world, mostly in “risky” illiquid asset classes.

Why are they doing this? Because interest rates are at historic lows so investing in traditional stocks and bonds will make it impossible for them to attain their actuarial return target, forcing them to slash benefits and raise contributions, tough choices they prefer to avoid.

The problem with this article is it ignores the “raison d’être” for Canada’s large pensions and why they all adopted a governance model which allows them to attract and retain investment professionals to precisely take risks in global public and private markets others aren’t able to take in order to achieve superior returns over a very long period —  returns that far surpass Canadian balanced funds which invest 60/40 or 70/30 in a stock-bond portfolio.

The key point, something the article doesn’t emphasize, is Canada’s well-known balanced funds charge outrageous fees and deliver far inferior results relative to Canada’s large public pension funds over a long period precisely because they are only able to invest in public markets which offer lousy returns given interest rates are at historic lows. Even the alpha masters, who charge absurd fees, are not delivering the results of Canada’s large pensions over a long period.

And it’s not just fees, even if all Canadians did was invest directly in low-cost exchange-traded funds (ETFs) or through robo-advsiors, they still won’t be as well off in the long run compared to investing their retirement savings in one of Canada’s large, well-governed defined-benefit plans.

Why? Because Canada’s large defined-benefit pensions use their structural advantages to invest across public and private markets all over the world, and they’re global trendsetters in this regard.

[Note: This is why last week I argued that Norway’s pension behemoth should not crank up equity risk and is better off adopting the asset allocation that Canada’s large pensions have adopted, provided it gets the governance right.]

The brutal truth on defined-contribution plans is they are leaving millions at risk of pension poverty which is why unlike the Andrew Coynes of this world, I kept harping on enhancing the CPP knowing full well Canadians are getting a great bang for their CPP buck.

And when I read about what is happening to Nortel’s pensioners, it infuriates me and reminds me that there is still a lot of work left to do in terms of pension policy in this country, like creating a new large, well-governed public pension here in Montreal in charge of managing the assets of all Canadian DB and DC corporate pensions (Montreal is home to the country’s best corporate DB pensions like CN’s Investment Division and Air Canada Pensions).

Having said all this, I don’t want to leave the impression that everything at Canada’s large public pensions is just peachy and there is no room to improve their world-class governance.

In particular, I agree with some passages in the article above. Most of the financial industry is subject to extreme regulations, regulations which do not impact Canada’s large pensions in the same way.

This isn’t a bad thing. Some of them are using their AAA balance sheet to intelligently take on more leverage or emit their own bonds to fund big investments in private markets.

A lot of this is discussed in the report the Bank of Canada put out this summer on large Canadian public pension funds. And while the report highlights some concerns, it concludes by stating:

No pension fund can achieve a 4 per cent average real return in the long run without assuming a certain amount of properly calibrated and well-diversified risk. This group of large Canadian pension managers seem generally well equipped to understand and manage that risk. The ability of the Big Eight to withstand acute stress is important for the financial system, as well as for their beneficiaries. They can rely on both the structural advantages of a long-term investment horizon and stable contributions. Moreover, they have reinforced their risk-management functions since the height of the 2007–09 global financial crisis.

No doubt, they have reinforced their risk-management functions since the global financial crisis and some of the more mature and sophisticated funds are monitoring liquidity risks a lot more closely (OTPP for example), but all the risk management in the world won’t prevent a large drawdown if another global financial crisis erupts.

And it is important to understand there are big differences at the way Canada’s large pensions manage risk. As mentioned in the article, CPPIB doesn’t have a chief risk officer, instead they opted to take a more holistic view on risk and have ongoing discussions on risk between department heads (this wasn’t always the case as they used to have a chief risk officer).

Is that a good thing or bad thing? Do you want to have a Barbara Zvan in charge of overseeing risk at your pension fund or not? There is no right or wrong answer here as each organization is different and has a different risk profile. CPPIB is not a mature pension plan like OTPP which manages pensions and liabilities tightly, so it can focus more on taking long-term risks in private markets and less on tight risk management which it already does in a more holistic and individual investment way.

I personally prefer having a chief risk officer that reports directly to the Board, not the CEO, but I also recognize serious structural deficiencies at some of Canada’s large pensions where different department units work in a vacuum, don’t share information and don’t talk to each other (this is why I like CPPIB’s approach and think PSP Investments is also moving in the right direction with PSP One).

Are there risks investing in private markets? Of course there are, I talk about them all the time on my blog, like why these are treacherous times for private equity and why there are misalignment of interests in the industry. Moreover, there are big cracks in commercial real estate and ongoing concerns of pensions inflating an infrastructure bubble.

That is all a product of historic low interest rates forcing everyone to chase yield in unconventional places. We can have a constructive debate on pensions taking on more risk in private markets, but at the end of the day, if it is done properly, there is no question that everyone wins including Canada’s pension leaders which get compensated extremely well to deliver stellar long-term results but more importantly, pension beneficiaries who can rely on their pension no matter what happens in these crazy schizoid public markets.

But I am going to leave you with something to mull over, something the Bank of Canada’s report doesn’t discuss for obvious political reasons.

In 2007, I produced an in-depth report on the governance of the federal public service pension plan for the Treasury Board of Canada going over governance weaknesses in five key areas: legislative compliance, plan funding, asset management, benefits administration, and communication.

If I had to do it all over again, I would not have written that report (too many headaches for too little money!), but I learned a lot and the number one thing I learned is this: there is always room for improvement on pension governance.

In particular, as Canada’s large pensions engage in increasingly more sophisticated strategies across public and private markets, levering up their balance sheets or whatever else, we need to rethink whether there are structural deficiencies in the governance of these large pensions that need to be addressed.

For example, I’ve long argued that the Office of the Auditor General of Canada is grossly understaffed and lacking resources with specialized financial expertise to conduct a proper independent, comprehensive operational, investment and risk management audit of PSP Investments (or CPPIB) and think that maybe such audits should be conducted by the Office of the Superintendent of Financial Institutions or better yet, the Bank of Canada.

In fact, I think the Bank of Canada is best placed to be the central independent government organization to aggregate and interpret all risks taken by Canada’s large pensions (maybe if they did this in the past, we wouldn’t have had the ABCP train wreck at the Caisse).

Just some food for thought. One thing I can tell you is that we definitely need more thorough operational, investment and risk management audits covering all of Canada’s large pensions by independent and qualified experts and what is offered right now (by the auditor generals and other government departments) is woefully inadequate.

But let me repeat, while there is always scope for improving governance and oversight at Canada’s large pensions, there is no question they are doing a great job investing across public and private markets all around the world and their beneficiaries are very lucky to have qualified and experienced investment professionals managing their pensions at a fraction of the cost in would cost them to outsource these assets to external managers (the figures cited in the article above are off).

That is a critical point that unfortunately doesn’t come out clearly in the article above which leaves the impression that all Canada’s large pensions are doing is taking undue risks all over the world. That is clearly not the case and it spreads a lot of misinformation on Canada’s large, well-governed defined-benefit pensions which quite frankly are the envy of the world and deservedly so.

The board of the Dallas Police and Fire Pension Fund — one of the most underfunded plans in the country — approved a plan on Friday that attempts to improve the plan’s funding by cutting benefits and increasing contributions from workers and the city.

As the dwindling funding status of the pension fund made headlines this year, there was a “run on the bank” that saw Dallas’ public safety workers — fearful that their pension benefits were in jeopardy — retire and lock in their pension.

The “run” only exacerbated the pension fund’s issues.

WFAA 8 describes the plan:

The plan would increase the contributions of police and firefighters who are not in DROP from 8.5 percent to 9 percent.

The contribution of active police officers and firefighters who are in DROP would rise from 4 percent to 9 percent.

The plan calls for ultimately increasing the contribution to 12 percent by 2018, but that requires legislative approval and the city making it legally obligated to provide funding to the plan.

The city has already agreed to increase its contribution from 27.5 percent to $28.8 percent – the highest percent allowed by state law.

It would also spread the pain to retirees. They would see their cost of living adjustments drop significantly drop.

Police and firefighters vote on the plan on Monday, and 65 percent of them need to approve the plan for it to move forward.

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

Richard Milne and Thomas Hale of the Financial Times report, Norway’s oil fund urged to invest billions more in equities (h/t, Denis Parisien):

Norway’s $880bn oil fund is being urged to invest billions of dollars more in equities and take on more risk in what would be a big shift in its asset allocation away from bonds.

The world’s largest sovereign wealth fund should invest 70 per cent of its assets in shares, up from today’s 60 per cent, at the expense of bonds, according to a government-commissioned report on Tuesday.

The move is highly significant for global markets as the oil fund owns on average 1.3 per cent of every single listed company in the world and 2.5 per cent in Europe.

The report is the latest salvo in a debate on how much risk the long-term investor should take and comes amid growing warnings of dwindling returns for government bonds in particular. The allocation to equities was increased from 40 per cent to 60 per cent in 2007.

“With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk,” Hilde Bjornland, an economics professor behind the recommendation, told the Financial Times.

The centre-right government will evaluate the recommendations before setting out its own position in the spring. Senior insiders said they expected the allocation change to go through as the report was co-authored by two former finance ministers.

Siv Jensen, the finance minister, told the Financial Times: “We are always thoroughly evaluating how we are running the fund … We know now that we have a very low interest rate regime globally. We have 40 per cent in bonds, and that will affect the return over time.”

Saker Nusseibeh, chief executive of Hermes Investment Management, a UK asset manager, said there was a broader trend of investors looking to increase their equity exposure. “This is about the realisation that you cannot make returns of the same amount that you used to make in the past,” he said.

He added: “If you are a sovereign wealth fund … you will question why you would have so much in fixed income at all.”

The latest survey of fund managers from Bank of America Merrill Lynch shows a rise in cash holdings, which in part reflects “scepticism or outright fear of bond markets”, according to Jared Woodard, an investment strategist at the bank.

In a sign of how the Norwegian debate might unfold, the chairman of the report, Knut Mork, voted against the other eight members and argued the allocation to equities should be cut to 50 per cent. This would give the government a more predictable income stream from the fund, he said.

The Norwegian government is permitted to take out up to 4 per cent of the value of the fund each year to use in the budget. But it is using only about 3 per cent this year.

The report estimated that the fund’s real rate of return was expected to be 2.3 per cent over the next 30 years. A majority of the commission suggested “one potential margin of safety” could be to restrict the government’s ability to take money out of the fund to the level of the expected real return.

Mikael Holter and Jonas Cho Walsgard of Bloomberg also report, Norway Sovereign Wealth Fund Urged to Add $87 Billion in Stocks:

Norway’s $874 billion wealth fund needs to add more stocks as record low interest rates and a weak global economy will otherwise lower returns to just above 2 percent a year over the next three decades, a government-appointed commission recommended.

The Finance Ministry should raise the fund’s stock mandate to 70 percent from 60 percent, the committee, comprised of academics, investors and two former finance ministers, urged on Tuesday. A decision on increasing its stock investments will be made by the ministry, which hasn’t always agreed with the conclusions of similar reviews on the fund’s holdings.

“A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value,” the group said. “The majority is of the view that the this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run.”

Norway is looking for ways to boost returns that have missed a real return goal of 4 percent as interest rates have plunged globally in the aftermath of the financial crisis. The government is this year withdrawing money from the fund for the first time to make up for lost oil income after crude prices collapsed over the past two years.

“The 60 percent equity share has over time been very good for us because it has given us considerable income from the fund,” Finance Minister Siv Jensen said in an interview after a press conference. “But we have also experienced that there can be swings from one year to another because the stock market moves over time.”

‘Considerably Less’

After getting its first capital infusion 20 years ago, the fund has steadily added risk, expanding into stocks in 1998, emerging markets in 2000 and real estate in 2011 to safeguard the wealth of western Europe’s largest oil exporter.

It’s currently mandated to hold 60 percent in stocks, 35 percent in bonds and 5 percent in real estate. After inflation and management costs, it has returned 3.43 percent over the past 10 years.

The committee said that the expected returns from the fund are now “considerably less” than 4 percent. With the current equity share, the commission predicts an annual real return of just 2.3 percent over the next 30 years.

Still, that didn’t stop the chairman of the commission, Knut Anton Mork, from disagreeing with the majority’s conclusion. The former chief economist at Svenska Handelsbanken in Oslo instead recommended cutting the stock holdings to 50 percent.

“The minority recognizes that the reduction in the oil and gas remaining in the ground over the last decade is an argument in favor of a higher equity share, but considers this less important than the predictability of budget contributions from the fund,” he said.

Lastly, Will Martin of the UK Business Insider reports, The world’s biggest sovereign wealth fund is about to start taking more risks:

Norway’s Global Government Pension Fund, the biggest sovereign wealth fund in the world by assets under management, could be about to start taking a lot more risks if it follows the advice of a government-commissioned report into the way it allocates its assets.

The new report, released on Tuesday, argues that the £716 billion ($880 billion) fund should increase its holdings of shares, and move around £71 billion ($87 billion) of its assets into riskier equity holdings.

This would mean that roughly 70% of the fund’s assets are held in stocks, up from just less than 60% right now. As a result, the fund’s government bond portfolio would shrink substantially.

“A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the Fund and a higher risk of a decline in its long-run value,” the report noted.

“The majority is of the view that this risk is acceptable, provided that there is political will and ability to adapt economic policy to the accompanying increase in risk, in both the short and long run.”

Previously, the fund held around 40% in equities before increasing its allocation to 60% in 2007, just before the global financial crisis hit.

Norway’s sovereign wealth fund is looking for new ways to make money given the rock-bottom yields most developed-market government debt has right now, and following the crash in oil that has seen prices for the world’s most important commodity crash from more than $100 per barrel to just more than $50 now, having briefly dropped below $30 early in the year.

The crash has impacted Norway’s economy so much that in 2016 — for the first time in nearly two decades — the fund is expected to  see net outflows, with the Bloomberg reporting February that the government will withdraw as much as 80 billion kroner (£7.99 billion; $9.8 billion) this year to support the economy.

Rock-bottom global bond yields are making things even more tricky, as interest rates close to zero all around the world continue to bite. The eurozone, Switzerland, Sweden, Denmark, and Japan all already have negative interest rates, and rates in most other developed markets are pretty close to zero. In the UK, the rate is 0.25%, while in the USA it is 0.5%.

Low interest rates mean low yields on bonds, meaning that the fixed-income market is not one where there is much money to be made right now, and that has helped drive the recommendation to move more money into stocks.

“With a higher share of equities the expected return will increase as will the income to the government budget. Yes, it comes with higher risk but we think we are well equipped to handle this risk,” Hilde Bjornland, an economist who was part of the team that compiled the report, told the Financial Times.

Should the fund take up the report’s recommendations, it could have a substantial impact on European, and even global markets. The fund’s stock holdings are already so large that if averaged out, it would hold 2.5% of every single listed company in Europe. In the UK for example, the fund has invested almost £50 billion in stocks, spread across 457 different companies.

There are two huge global whales that everyone looks at, Japan’s Government Pension Investment Fund (GPIF) and Norway’s Government Pension Fund Global (GPFG). The latter was created for the following reason:

The Government Pension Fund Global is saving for future generations in Norway. One day the oil will run out, but the return on the fund will continue to benefit the Norwegian population.

As you can imagine, it’s a big deal for Norwegians and global markets what decisions are taken in regards to the Fund’s asset allocation and its investments which are managed by Norges Bank Investment Management.

I am very well aware of Norway’s Government Pension Fund Global because when I wrote my report on the governance of the federal public service pension plan for the Government of Canada (Treasury Board) back in 2007, I used the governance of Norway’s pension as an example on how to improve transparency and oversight.

What I like about Norway’s pension fund is that it’s clear about its investments, takes responsible investing very seriously and is extremely transparent, providing great insights in its reports, discussion notes, asset manager perspectives and of course, in its submissions to the Ministry of Finance.

For example, in its latest publicly available submission to the Ministry on October 14, there is an excellent discussion on how the Fund can properly benchmark unlisted real estate investments, going over three methods:

The first uses data from IPD for unlisted real estate investments, adjusted for autocorrelation. The return series from IPD can be broken down into the countries and sectors in which the fund is invested. The greatest challenge when using IPD data for calculating tracking error is that the time series are updated only quarterly or annually. The relative volatility of equities and bonds is currently calculated using weekly data, equally weighted, over a three-year period. Even an extension of the estimation period to ten years, for example, will yield relatively few observations if the calculations have to be performed on quarterly or annual data.

The second method uses data for shares in listed REITs, adjusted for leverage. The main benefit of using REITs over IPD data is the availability of observable daily prices. To be able to represent the fund’s unlisted real estate investments meaningfully, we need to select individual funds in the markets in which the fund is invested. Their leverage must also be adjusted to the same level as the “equivalent” investment in the fund. This selection process and adjustments to take account of differences in risk profile will to some extent need to be based on criteria that will be difficult for experts outside the bank to verify.

The third method is based on an external risk model developed by MSCI. The Bank has commissioned MSCI to compute a return series for an unlisted real estate portfolio that resembles the GPFG’s portfolio of unlisted real estate investments. An external risk model gives the Bank less insight into, and less control over, the parameters that influence the return series, but has the advantage of being calculated by an independent party.

I will let you read the entire submission to the Ministry of Finance as it is extremely interesting and well worth considering for large pensions that invest in global unlisted real estate and are not properly benchmarking these investments (and I include some of Canada’s large venerable pensions with “stellar governance” in this group).

Now, the latest submission recommending to increase the allocation of global public equities to 70% from 60% and reducing the allocation of global fixed income to 25% from 35% is not yet available on its website in the news section.

It will be posted on the website but I am not very interested in reading their arguments as I don’t agree with this recommendation at all and side with Knut Anton Mork who thinks the allocation should be cut to 50%.

But I also think the allocation to global fixed income should be cut by 10% so that the Fund can invest more in unlisted real estate and infrastructure all over the world (see below).

My reasoning is that over the short, intermediate and even long run, the return on stocks and bonds will be very low and very volatile so now is definitely not the time to crank up the risk in global equities.

Look, Norway’s pension fund can put out all the academic discussion notes it wants on the equity risk premium but when making big shifts in asset allocation, the folks at NBIM really need to think things through a lot more carefully because cranking up the allocation in stocks at this point exposes the Fund to a serious drawdown, one that might take years to recover from, especially if the world falls into a long deflationary cycle (my biggest fear).

Bill Gross rightly noted last month now is not the time to worry about return on capital but return of capital. In his latest comment, he notes that the doubling down strategy of central bankers significantly increases the risk in risk assets.

All this to say that I am surprised Norway’s mammoth pension fund is seriously considering increasing risk by increasing its allocation to global equities at this time.

True, global bonds have entered the Twilight Zone and there are cracks in the bond market, which is why delivering alpha gurus are pounding the table that bonds are dead meat, as are other bond bubble clowns.

But unless someone convinces me that the fading risks of global deflation are credible and sustainable, I still see bonds as the ultimate diversifier in a deflationary world.

One thing is for sure, Fed Chair Janet Yellen isn’t convinced that global deflation is dead which is why her speech last Friday on staying accommodative for longer, overshooting the Fed’s 2% inflation target, was a real game changer for me.

More worrisome, Yellen’s speech was a stark admission the Fed may be behind the deflation curve (or unable to mitigate the coming deflation tsunami) and investors may need to brace for a violent shift in markets, one which could spell doom for equities for a very long time.

And if that is the case, you have to wonder why in the world would Norway risk its savings from oil revenues and flush them down the global stock toilet?

I’m not being cynical doomsayer here, more of a realist. I’ve actually recommended selectively plunging into stocks right now, but that advice carries huge risks and it won’t help a mega fund like Norway’s GPFG.

Admittedly, it’s a mathematical certainty that global bonds are not going deliver great returns over the next ten years, but it might be a lot worse in global stocks, especially when you adjust returns for risk.

So what advice do I have for Norway’s GPFG? Take the time to read my conversation with HOOPP’s Jim Keohane where he admitted HOOPP will never invest in negative yielding bonds, preferring real estate instead.

I personally recommend GPFG follows Canada’s large pensions and ramp up its infrastructure investments which it just introduced into its asset allocation. Generally speaking, there is a growing appetite for infrastructure as large institutional investors are looking for scalable investments that can deliver steady cash flows over a long period.

[Note: Norway’s sovereign wealth fund has bemoaned the smaller scale of infrastructure projects in developing nations after a report to the government called for it be allowed to invest in the asset class, but in my opinion it should exclusively focus on developed nations initially.]

Still, I’m not going to lie to you, infrastructure investments are frothy and they carry their own set of unique risks (illiquidity, regulatory, political and currency risks like what happened to British infrastructure investments post Brexit).

But Norway’s pension has to stop being so excessively reliant on global public markets and start considering the benefits of global private markets. There is a reason why the Canada Pension Plan Investment Board and other large Canadian pensions are scouring the globe for opportunities across public and private markets, delivering excellent long-term results, and I think Norway’s GPFG and Japan’s GPIF need to follow suit, provided they get the governance right (not worried about Norway’s governance even if it’s not perfect, it is excellent).

To be sure, Norway’s GPFG is an excellent fund that is run very well but it’s essentially at the mercy of public markets and far more vulnerable to abrupt shifts in global stocks than large Canadian pensions.

No matter how much risk management it has implemented, at the end of the day, Norway’s GPFG is a giant beta fund and that means it will outperform Canada’s large pensions during bull markets but grossly underperform them during bear markets.

On that note, let me remind all of you once again that it takes a lot of time and effort to research and write these comments. Please kindly show your appreciation by donating or subscribing to PensionPulse on the right-hand side under my picture (you need to view web version on your cell to view the PayPal options on the right-hand side under my picture).