Pension360

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

Reuters reports, Chicago mayor’s big plan to save its pension fund:

Mayor Rahm Emanuel unveiled a plan on Wednesday that he called “an honest approach” to save the city’s biggest retirement system from insolvency with a water and sewer tax to be phased in over five years starting in 2017.

The municipal retirement system, which covers about 71,000 current and former city workers, is projected to run out of money within 10 years as it sinks under an unfunded liability of $18.6 billion.

The new tax would generate $56 million in its first year and increase to $239 million annually by 2020, the mayor’s office said.

“Today, one of the big question marks that hung around the city because of past decisions — or past decisions that were not made — we have addressed,” Emanuel told an investor conference in Chicago.

“Every one of the city’s pensions has a dedicated revenue stream … to keep the promise not only to the employees, but to the city’s future and do it in a way that does not undermine the economic well-being of the city,” he said.

The plan would require approval by Chicago’s city council, which Emanuel said he intends to seek in September. Chicago then needs the Illinois legislature to approve a five-year phase-in of the city’s contribution to the pension system to attain a 90 percent funding level by 2057.

The tax comes on top of an increase in water and sewer rates between 2012 and 2015 to generate money to repair and replace aging infrastructure. Revenue rose from $644.1 million in 2011 to $1.125 billion in 2015.

The rescue plan for the municipal system follows previous action by the city to boost funding for police and fire pensions through a phased-in $543 million property tax increase, and its laborers’ system through a hike in a telephone surcharge.

Chicago’s big pension burden was a driving factor in the downgrade of the city’s credit rating last year to the “junk” level of ‘Ba1′ by Moody’s Investors Service. Standard & Poor’s warned in June it may cut the city’s ‘BBB-plus’ rating in the absence of a comprehensive pension fix.

The task of fixing the city’s pensions became harder after the Illinois Supreme Court in March threw out a 2014 state law that reduced benefits and increased city and worker contributions to the municipal and laborers’ funds.

Hal Dardick, Bill Ruthhart, and John Byrne of the Chicago Tribune also report, Emanuel proposes water, sewer tax to shore up ailing pension fund:

Mayor Rahm Emanuel on Wednesday called for a new tax on city water and sewer bills to stabilize the city’s largest pension fund, a move he portrayed as his latest tough decision to secure Chicago’s financial future.

Emanuel’s plan, which would increase the average water and sewer bill by 30 percent over the next four years, was quickly met with resistance from some aldermen who argued the city would be better off adding business taxes or even raising property taxes again to come up with the hundreds of millions of dollars a year needed to keep the city’s municipal workers’ pension fund from going bust.

Still, Emanuel projected confidence his plan ultimately would win approval in the City Council, which rarely rebuffs the mayor’s proposals and has yet to independently provide its own solution to solidify any of the city’s four major pension systems that have been woefully underfunded for more than a decade.

In a speech to about 200 financial investors Wednesday, Emanuel unveiled his water and sewer tax plan while making the case to Wall Street that his administration has done the hard work to brighten Chicago’s dark financial picture.

For the first time since he took office in 2011, Emanuel said, there are concrete plans to properly fund the retirements of the city’s police officers, firefighters, laborers and municipal workers. He told the Chicago Investors Conference that the city’s budget deficit is at a 10-year low. And he sought to make the case it all had been done without disturbing a business climate that has appealed to major corporations and startups.

“The city of Chicago met our challenges head on, dealt with them systematically, did it in a way that’s complementary to our overall economic strategy to contribute to the well-being and the overall growth strategy that is laid out for the city of Chicago,” Emanuel said from the Symphony Center’s ornate stage. “We addressed the past, but did it in a way that did not shortchange the future of the city of Chicago.”

But even as the mayor seemingly claimed victory on fixing Chicago’s financial woes, challenges remain.

Debt rating agencies have repeatedly lowered the city’s credit rating in recent years, with one placing it at junk status. The picture at Chicago Public Schools is even worse, with all three major rating agencies terming the district’s bonds junk while the Emanuel-appointed Board of Education plans to raise property taxes by $250 million next year to help pay for teacher pensions.

And several aldermen expressed opposition to Emanuel’s new utility tax, including Ald. Roderick Sawyer, chairman of the City Council’s Black Caucus. Sawyer, 6th, predicted Emanuel would have a hard time building enough council support for the water and sewer tax after asking aldermen to pass a record property tax increase to fund police and fire pensions last year.

“We understand that the can had been kicked down for many, many years, and now it’s incumbent upon us to find solutions,” Sawyer said. “This is a tough one, though. This is an additional tax that ramps up to many, many dollars a month.”

‘Pitchforks and torches’

Under Emanuel’s proposal, the new utility tax would be phased in over the next four years, with the average homeowner’s water and sewer bills increasing by $53 next year, or $8.86 on the bills sent out every two months. By the end of the four-year phase-in, that same homeowner would pay an additional $226 per year in water and sewer taxes, or $37.65 on each bill.

After four years, the proposal would amount to a 30 percent tax on water and sewer bills, or $2.51 for every 1,000 gallons of water used, the Emanuel administration said. The average annual water and sewer bill, based on 90,000 gallons of water, currently is about $684. The bills also would rise each year at the rate of inflation.

Once fully phased in, the new tax would produce an estimated $239 million a year to help reduce the $18.6 billion the city owes the municipal workers’ fund, which represents nearly all city workers except police officers, firefighters or employees who do manual labor.

Emanuel’s goal is to restore the municipal workers’ account to 90 percent funding over the next 40 years. The mayor and aldermen already have raised taxes to do the same for the city’s three other major pension funds for police, firefighters and laborers. Emanuel said he will seek a City Council vote on the water and sewer tax in September.

“I don’t take this lightly, but we are fixing the problem that has penalized the city’s potential to grow economically, and there’s a finality to it,” Emanuel said in an interview late Wednesday. “All four pensions have a revenue source.”

The taxes will be tacked on to bills that went up when, shortly after taking office in 2011, Emanuel set in motion a series of water and sewer fee increases that more than doubled those bills to upgrade water and sewer systems.

Ald. Ameya Pawar, 47th, called the new tax “the right thing to do,” noting that the alternative of not properly funding the pensions would be “catastrophic.”

But with homeowners already starting to feel the hit from last year’s property tax increase combined with a new round of assessments, Pawar acknowledged aldermen can expect complaints from constituents.

“People will be upset,” said Pawar, an Emanuel ally. “They’ve seen their water rates go up.”

Far Northwest Side Ald. Anthony Napolitano, 41st, said it’s going to be difficult for him to face constituents reeling from the huge property tax increases in bills they just received and tell them to brace themselves for another hit.

“Pitchforks and torches, probably,” he said when asked how residents would react. “It’s not going to be good. Because my reaction now, in my neighborhood, after these (property) tax bills came out is, ‘We’re leaving. We’re out.’

“I get that we’re in some tough times. And people get that we have to make some concessions, that we’re going to pay more in tax dollars. People get that,” Napolitano said. “But when it happens year after year after year, people are saying ‘Why am I staying here?'”

Northwest Side Ald. Milagros “Milly” Santiago, 31st, said the mayor should consider other revenue ideas brought forward in the past year by the council’s Progressive Caucus. Those have included a tax on financial transactions, a commuter tax, a graduated income tax, a “stormwater stress” tax on businesses with large parking lots and a move to return more money to the general fund from special taxing districts throughout the city.

“We’re here evaluating the whole thing and seeing if it’s legitimate for us to vote next month on this idea,” Santiago said as she left a briefing on the mayor’s plan at City Hall. “I don’t think it’s a good idea. We’re going to have to have a closer look at it and see if there’s other ways to do it. But it’s just not good news.”

Sawyer also advocated for Emanuel to consider some of the Progressive Caucus’ tax ideas, but many are long shots or would take time and approval elsewhere.

A financial transaction tax would require state and federal approval. A graduated income tax would require approval from a gridlocked Springfield. A commuter tax, which amounts to an income tax on suburban residents working in the city, would require state approval while critics argue it could cause a flight of businesses from the city or prevent new ones from moving in.

Only the stormwater tax on businesses and shifting more money from special taxing districts are within the City Council’s power alone.

“We did get a commitment that they’re going to look at all options this year. We’re going to hold them to that,” Sawyer said.

Aldermen did come up with additional ideas. Napolitano suggested allowing video gaming, which long has been banned in the city. Ald. Anthony Beale, 9th, called for charging tolls on expressways at the Chicago border.

Ald. Howard Brookins, 21st, urged a more traditional solution: another property tax increase. Brookins argued raising property taxes is more fair to lower-income residents and can be written off on federal tax returns. But he acknowledged another increase might not have enough support.

“This (the water and sewer tax), everyone is going to pay it equally; whether you live in a million-dollar home or a $50,000 home, we all have to use water, and it disproportionately affects the people of my community,” Brookins said. “We have to think long term and get away from the stereotypes about property taxes and start explaining to people why a property tax is fairer than the other taxes and fees that they are going to ultimately end up paying.”

Ald. Joe Moore, an Emanuel ally, said he’d be willing to entertain Brookins’ push for another property tax increase, but said “it’s kind of difficult to go to that well again” so soon. The water and sewer tax, he said, “might be the best of a bad set of options. … We have to do something.”

‘Once and for all’

While Emanuel’s utility tax would not require approval from state lawmakers, proposed changes he laid out Wednesday in how municipal workers contribute to their retirements would.

The mayor plans to ask the General Assembly and Republican Gov. Bruce Rauner to sign off on altering the municipal fund pension system to save about $2 billion over the next 40 years. The legislative changes to the pension fund would require newly hired employees, starting next year, to increase their retirement account contributions to 11.5 percent of their salary from 8.5 percent.

Employees who were hired from 2011 to 2016 and already receive lower retirement benefits would have the option of increasing their contributions to 11.5 percent. In exchange, they would be eligible to retire at age 65 instead of 67.

But employees hired before 2011 would see no changes, after the Illinois Supreme Court struck down Emanuel’s earlier attempt to reduce their benefits, citing a constitutional clause that states their benefits shall not be diminished or impaired. “You can’t touch existing employees, that’s walled off,” Emanuel told investors.

Emanuel and affected unions have an “agreement in principle” on identical changes to the much smaller city laborers fund, with additional city contributions coming from a $1.90-per-month-increase on landline and cellphones billed to city addresses that was approved by the City Council two years ago.

Last year, the mayor pushed through a $543 million property tax increase, phased in over four years, to come up with enough funding for police and fire pensions. No changes were made to the retirement age or contribution amounts for those two unions.

Emanuel stressed in his speech to investors that Chicago’s overall fiscal health is on the rebound.

“Chicago was in a pension penalty box. It had not addressed its problems,” Emanuel said. “Denial is not a long-term strategy, and for too long Chicago was operating where denial was the long-term strategy.”

Richard Ciccarone, president and CEO of the municipal bond analysis firm Merritt Research Services, attended the conference and said he thought the crowd was generally impressed with the mayor’s argument.

“He reinforced his strategy, which he said has been his since Day One, and that is that you can’t solve the fiscal problems without having economic growth. I think he made his case,” Ciccarone said. “I got the impression that they made headway with a lot of people here.”

In a question-and-answer session with the investors after Emanuel’s speech, the mayor was asked if he had enough votes from aldermen to pass the plan. “Yes,” Emanuel replied without hesitation.

The mayor continued to project that certainty in his interview with the Tribune, while also lavishing praise on the aldermen he must win over.

“The lion’s share of the aldermen did not create the problem, but the lion’s share of the aldermen in there have been part of the solution. I am confident they will take the necessary steps,” Emanuel said.

“They have never wavered, their knees have never buckled and they will answer the call of history to solve the problem once and for all.”

Back in May, I covered Chicago’s pension patch job and stated this:

When Greece was going through its crisis last year, my uncle from Crete would call me and blurt “it’s worse than Chicago here!”, referring to the old Al Capone days when Chicago was the Wild West. Little did he know that in many ways, Chicago is much worse than Greece because Greeks had no choice but to swallow their bitter medicine (and they’re still swallowing it).

In Chicago, powerful public unions are going head to head with a powerful and unpopular mayor who got rebuffed by Illinois’s Supreme Court when he tried cutting pension benefits. Now, they are tinkering around the edges, increasing the contribution rate for new employees of the city’s smallest pension, which is not going to make a significant impact on what is truly ailing Chicago and Illinois’s public pensions.

All these measures are like putting a band-aid over a metastasized tumor. Creditors know exactly what I’m talking about which is why I’ll be shocked if they ease up on the city’s credit rating.

Importantly, when a public pension is 42% or 32% funded, it’s effectively broke and nothing they do can fix the problem unless they increase contributions and cut benefits for everyone, top up these pensions and introduce real governance and a risk-sharing model.

When people ask me what’s the number one problem with Chicago’s public pensions, I tell them straight out: “Governance, Governance and Governance”. This city has a long history of corrupt public union leaders and equally corrupt politicians who kept masking the pension crisis for as long as possible. And Chicago isn’t alone; there are plenty of other American cities in dire straits when it comes to public finances and public pensions.

But nobody dares discuss these problems in an open and honest way. Unions point the finger at politicians and politicians point the finger at unions and US taxpayers end up footing the public pension bill.

This is why when I read stupid articles in Canadian newspapers questioning the compensation and performance at Canada’s large public pensions, I ignore them because these foolish journalists haven’t done their research to understand why what we have here is infinitely better than what they have in the United States and elsewhere.

Why are we paying Canadian public pension fund managers big bucks? Because we got the governance right, paying public pension managers properly to bring assets internally, diversifying across public and private assets all around the world and only paying external funds when it can’t be replicated internally. This lowers the costs and improves the performance of our public pensions which is why none of Canada’s Top Ten pensions are chronically underfunded (a few are even over-funded and super-funded).

What else? Canada’s best public pensions — Ontario Teachers, HOOPP and even smaller ones like CAAT and OPTrust — have implemented a risk-sharing model that ensures pension contributors, beneficiaries and governments share the risk of the plan so as not to impose any additional tax burden on Canadian taxpayers if these plans ever become underfunded. This level of governance and risk-sharing simply doesn’t exist at any US public pension which is why many of them are chronically underfunded or on the verge of becoming chronically underfunded.

I have not changed my mind on Chicago’s pension patch job. It’s going from bad to worse and just like Greece, they’re implementing dumb taxes to try to shore up insolvent public pensions instead of addressing serious governance and structural flaws of these pensions.

But unlike Greece, Chicago and Illinois are part of the United States of America, the richest, most powerful country in the world, so they can continue kicking the can down the road, for now. Still, what message is Chicago sending to its own residents and to potential workers looking to move there?

I’ll tell you the message: apart from one of the worst crime rates in the nation, get ready for more property taxes and hikes in utility rates to conquer a public pension beast which has spiraled out of control.

And the sad reality is while these taxes might help at the margin, they’re not going to make a big difference unless they are accompanied by a change in governance, higher contributions and a cut in benefits (get rid of inflation protection for a decade!).

There’s an even bigger problem which I want policymakers to wrap their heads around: chronic public pension deficits are deflationary.

Let me repeat that: Chronic and out of control public pension deficits are DEFLATIONARY. Why? Because it forces governments to introduce more property taxes or utility rate increases (another tax) to address them, leaving less money in the hands of consumers to spend on goods and services.

The other problem with raising taxes and utility bills is they are regressive, hurting the poor and working poor a lot more than Chicago’s ultra rich.

Now I’m going to have some idiotic hedge fund manager tell me “The answer is to cut defined-benefit pensions and replace them with cheaper defined-contribution plans.” NO!!! That is a dumb solution because the brutal truth on DC plans is they are failing millions of Americans, exposing them to pension poverty which is even MORE DEFLATIONARY!!

I want all of you to pay attention to what is going on in Chicago because it’s a cancer which will spread throughout parts the United States where chronic pension deficits are threatening municipalities, cities and states. And this slow motion train wreck will have drastic economic consequences for the entire country.

On a personal note, it’s sad to see what is happening to this great American city. My father did his psychiatry residency in Chicago after leaving Greece over fifty years ago. His uncle had left Greece long before him and owned a great restaurant in Chicago for many years. He even had Al Capone as a silent partner (not by choice) and the restaurant was thriving during the city’s heydays (Capone would send two guys to pick up his share of the revenues every week and once in a while the guys would be replaced because they stole money and were probably left sleeping with the fish. Capone never bothered my great uncle).

Anyways, Chicago’s glory days are long gone. This city is headed the way of Detroit (some think it’s already there and even a lot worse). No matter what Mayor Rahm Emanuel does, there is no saving Chicago from its pension hellhole.

Though sources confirmed Rahm Emanuel’s proposal earlier this week, the Chicago mayor on Wednesday officially unveiled his proposal to raise utility taxes to generate revenue for pension contributions to the city’s largest funds.

The tax will hit water and sewer bills, and is expected to raise in the neighborhood of $230 million annually.

From NBC Chicago:

In a speech to investors Wednesday, Emanuel suggested applying a tax on the city water and sewer bills under a plan that would increase the utilities by close to 30 percent over the course of four years.

By the end of the four-year phase, the average homeowner would pay an additional $226 per year, the Tribune reports, or close to $38 on each bill.

Emanuel believes the new tax will help stabilize the city’s pension fund. With the new revenue source, the city could raise close to $239 million a year to help reduce the multi-billion dollar municipal workers fund that the city of Chicago owes.

The mayor says he will seek a City Council vote on the water and sewer tax in September.

The New Jersey Investment Council, the body that sets investment policy for the state’s pension systems, unanimously voted to cut its strategic allocation for hedge funds from 12.5% to 6%, as well as to prioritize low-fee managers.

Union officials had been putting pressure on the Council to make such a move; but ultimately, the Council decided it couldn’t stomach the fees it was paying for a hedge fund portfolio that returned -3 percent last fiscal year.

From Bloomberg:

“It sends a message to the hedge fund community that the world has changed,” New Jersey council Chairman Tom Byrne said Wednesday in the meeting in Trenton. “Public funds aren’t going to just pay whatever fees they are charging.”

The pension’s investments in hedge funds, which typically charge a 2 percent management fee and 20 percent of profits, lost about 3 percent this year through May. The entire pension fund has gained 1.6 percent in 2016.

As part of the plan, the state is targeting to pay only a 1 percent management fee and 10 percent of profits.

The state’s investment division has made almost $1 billion in redemption requests from hedge funds this year, including Brevan Howard Asset Management and Farallon Capital Management. The plan calls for withdrawing an additional $300 million from hedge funds and reducing the number of firms it invests in to below 25 by the end of 2016, according to the documents.

New Jersey will eliminate its exposure to long-short equity and event-driven hedge funds next year, the plan says, and reduce its allocation to credit and distressed debt hedge funds to 1 percent from 3.75. Its target allocation to market-neutral and global macro funds will remain at 5 percent.

 

With another property tax increase as unpalatable as ever, Chicago Mayor Rahm Emanuel is considering levying a larger tax on utilities as a mechanism for raising funds to help stabilize the city’s underfunded pension systems, according to sources who talked to the Chicago Sun-Times.

Emanuel was coy on the subject when speaking this week, however.

From the Chicago Sun-Times:

Unwilling to hit property owners for the third time in one year, Mayor Rahm Emanuel plans to raise the city’s utility taxes to save the largest of Chicago’s four city employee pension funds, City Hall sources said Monday.

Chief Financial Officer Carole Brown acknowledged that the city needs “in the ballpark” of $250 million to $300 million in new annual revenue to shore up a Municipal Employees Pension fund with 71,000 members and $18.6 billion in unfunded liabilities.

After a luncheon address to the City Club of Chicago on Monday aimed at touting the progress made to right the financial ship, Budget Director Alex Holt refused to say where Emanuel would find the massive sum needed to save the Municipal Employees pension fund.

“Everything’s on the table and we’ll hopefully be in the position of announcing both the benefit reforms and the funding plan in the coming weeks,” Holt said.

“We’ve got to look at every possible source,” she said. “This is about solving a long-term problem and making sure that we’ve got funding sufficient to do that.”

Brown read from the same script. “Everything is on the table and we’ll be telling you our solution shortly,” she said. “We’re looking at every option. The mayor is committed to putting forth a solution for the Municipal Fund. Right now, we’re publicly considering everything.”

A Democratic Party official confirmed this week that the union representing teachers in New Jersey will not make any cash donations to the party until the Senate votes for a proposed constitutional amendment requiring the state to make full, quarterly payments to its public pension fund.

According to NJ.com:

County Democratic Party leaders won’t be able to count on New Jersey’s largest teachers union for political contributions this year because state lawmakers haven’t acted to put a constitutional amendment on state pension payments on the fall ballot.

Three county chairman told NJ Advance Media they received calls from a New Jersey Education Association lobbyist informing them the powerful union would be withholding campaign contributions until next spring out of frustration with stalled legislative action on the proposed public pension constitutional amendment.

[…]

The constitutional amendment would require the state increase payments into the government worker pension fund. It must be approved by the voters in a public referendum. But Senate President Stephen Sweeney (D-Gloucester) has so far declined to hold a vote on the referendum for a vote in the upper chamber until lawmakers resolve a transportation funding impasse.

The potentially steep price tag of a deal to fund the Transportation Trust Fund could jeopardize funding for the pension amendment, Sweeney has said. He was booed by public workers Monday when he adjourned a Senate session without holding a vote on the referendum.

The Assembly has already passed the measure.

 

Affluent retiree households — despite having similar median incomes as “traditional” retiree households — rely more on financial accounts for retirement income than sources like Social Security and pension benefits, according to a recent Vanguard study.

In an article on Benefits Pro, the specifics of the study were discussed:

The study divided households into two segments: the “traditional retirement” group, made up of households whose wealth holdings consist largely of guaranteed income sources like Social Security and pension income, and the “new retirement” group, which has predominant wealth holdings from financial accounts, including tax-deferred retirement accounts, a variety of taxable investment and insurance accounts, as well as bank checking and savings, money market, and similar accounts.

Among the study’s findings was where the two groups’ incomes originated. For both groups, the median total household income was about $69,500. The two groups of retirees, traditional and new retirement, showed very similar median incomes, the study said, and overall, a quarter of retirement income for wealthier households comes from financial account withdrawals.

But when it came to those financial account withdrawals, the new retirement group’s withdrawals made up an average of 39 percent of their retirement income; that’s more than twice as much as such withdrawals contributed to traditional retirement households.

In addition, withdrawals from retirement accounts are often made more to comply with required minimum distribution rules and their attendant tax penalties, and less because those households use the money.

In fact, nearly a third of such withdrawals are saved and reinvested in other accounts—while those households spend less than they withdraw.

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

Eleanor Warnock of the Wall Street Journal reports, Japan’s GPIF Pension Fund Suffers Worst Year Since 2008 Financial Crisis:

Japan’s $1.3 trillion public pension fund—the world’s largest of its kind—posted its worst performance since the 2008 global financial crisis in the fiscal year ended March on a fall in share prices world-wide and a strengthening yen.

The Government Pension Investment Fund recorded paper losses of ¥5.3 trillion ($51 billion), or a return of -3.81% on its investments, putting its total assets at ¥134.7 trillion at the end of March, the fund said Friday.

The GPIF’s results are seen as a gauge of broad market performance, as the fund owns nearly 1% of global equity markets and more than 7% of the Japanese stock market. Domestic and foreign equities comprised 44% of the portfolio at the end of March, below its 50% target weighting for the asset class, the fund said in a statement.

The GPIF isn’t the only major pension fund to struggle recently. The U.S.’s largest public pension fund, the California Public Employees’ Retirement System, or Calpers, said this month that it earned 0.6% on its investments for the fiscal year ended June 30, the second straight year the fund missed its 7.5% internal investment target. Norway’s Government Pension Fund Global had its worst performance since 2011.

Japan’s labor ministry has asked the GPIF to achieve a real investment return—accounting for a rise in wage increases—of 1.7% yearly. Though the fund’s performance for fiscal 2015 was well below that target, the fund’s average real annual performance of 2.60% over the past 15 years exceeded it.

However, because the GPIF manages reserves for Japan’s national pension plan, poor investment performance in the short term is judged harshly by the public and opposition political parties, many of whom are suspicious of financial markets. Even the timing of the announcement of the fund’s latest results had drawn criticism. Opposition politicians have pointed out that it was scheduled to come after national election earlier in the month. A loss reported before the vote could have hurt the ruling party’s showing, they said. The fund has said there was nothing political about the release date.

Domestic bonds were a bright spot in GPIF’s portfolio, even though the Bank of Japan has pursued a massive easing program in part to push Japanese investors away from domestic bonds and into higher-yielding assets. At the end of March, the fund had 37.55% of its portfolio in domestic debt—higher than the fund’s 35% asset-class allocation.

Domestic bonds returned 4.07% in the year ended in March as the BOJ’s asset purchases and the introduction of a negative interest-rate policy lifted bond prices.

Yuko Takeo and Shigeki Nozawa of Bloomberg also report, Japan Pension Whale’s $52 Billion Loss Tied to Passive Ways:

Friday was a big day for the world’s largest pension fund, which posted its worst annual loss since the financial crisis and disclosed individual equity holdings for the first time. The two may be connected.

The list of domestic shares owned by Japan’s $1.3 trillion Government Pension Investment Fund hews closely to the benchmark Topix index, which isn’t that surprising for a fund where almost 80 percent of investments are passive. But it means that in market downturns like in the past year, GPIF will struggle to increase assets.

The fund recorded a 5.3 trillion yen ($52 billion) loss for the 12 months ended March, the largest decline in seven years. Japan stock holdings tumbled 10.8 percent. For Sumitomo Mitsui Asset Management Co., GPIF should branch out from hugging indexes.

“There’s more they can do,” said Masahiro Ichikawa, a senior strategist at the Tokyo-based money manager. “They should be more active with their currency hedging and their investments. They should also look to increase exposure to alternatives.”

While criticism of GPIF’s passive approach to investing isn’t new, this is the first year the fund posted a loss since it doubled its allocation to stocks in 2014 and reduced its investments in domestic bonds, which were the only asset to return a profit in the year. The fund is taking flak on both sides, from those who want to turn back the clock to when it held more bonds to people who say it should become more of a stock picker.

The Topix index fell 0.1 percent at the close in Tokyo on Monday, as the yen traded at 102.43 per dollar following a 3.1 percent jump on Friday.

For a QuickTake on Japan’s pension fund, click here.

GPIF’s investment loss of 3.8 percent was the worst since a 7.6 percent slide in the 12 months ended March 2009. The fund lost 9.6 percent on foreign shares and 3.3 percent on overseas debt, while gaining 4.1 percent on Japanese bonds. GPIF said Toyota Motor Corp. and Mitsubishi UFJ Financial Group Inc., which have the largest weightings in the Topix, were the biggest Japan stock investments as of March 31, 2015.

GPIF’s Canadian pension peer, hailed as an example of how the Japanese fund should be run, posted a 3.4 percent return on investments for the fiscal year ended March, despite the global equity rout. The $212 billion Canada Pension Plan Investment Board had its biggest gains from private emerging market equities, real estate and infrastructure. South Korea’s national pension fund had a return rate of 2.4 percent this year as of April.

Home Bias

The Canadian retirement manager wrote in its 2016 annual report about how it had moved away from passively managing its portfolio to take advantage of its size, certainty of pension contributions and long-term investment horizon. The fund has just 19 percent of its holdings invested in Canada, whereas GPIF has 59 percent in Japanese securities.

“GPIF should invest more actively but from a long-term perspective,” said Tetsuo Seshimo, a portfolio manager at Saison Asset Management Co. in Tokyo. “That’s the only way they can improve their returns.”

GPIF President Norihiro Takahashi, speaking after the results announcement on Friday, said the fund planned to use its allowable deviation limits when allocating assets, in a sign he will be flexible in managing the portfolio.

In 2013, a panel handpicked by Prime Minister Shinzo Abe recommended ways to overhaul GPIF. While suggesting the fund move away from its concentrated investments in Japanese bonds, which it did the next year, the group led by Columbia University professor Takatoshi Ito said GPIF should consider increasing active management, moving some investments in-house, and tracking indexes other than the Topix as it includes stocks “lacking sufficient investment profitability.”

In-House Investments

GPIF took some suggestions on board, including adopting the JPX-Nikkei Index 400 as a new benchmark equity measure. Still, the fund’s overseers stopped short of letting the fund make in-house stock investments, a course that GPIF Chief Investment Officer Hiromichi Mizuno said would have helped cut costs and increase internal expertise.

GPIF also lost on overseas assets last fiscal year as the yen advanced 6.7 percent against the dollar, reducing the value of investments when repatriated. It wasn’t until December last year that reports said GPIF would start to hedge against currency fluctuations for a small part of its investments, a strategy called for almost a year earlier by one of its investment advisers.

“The results should lead to a debate on searching for new investments, whether it’s alternative assets, domestic small and mid-cap corporate debt, REITs or real estate,” said Akio Yoshino, chief economist at Amundi Japan Ltd. in Tokyo. “But the mainstream expectation is that GPIF probably won’t change its management direction.”

So Japan’s pension whale recorded a $52 billion loss (-3.81%) during its fiscal year ending at the end of March and “experts” are now giving them advice to be more active in alternatives and in hedging their foreign exchange risk.

I think a lot of people are making a big deal over nothing. A $52 billion loss is huge for North America’s large pension funds but it’s peanuts for the GPIF. Also, if the Caisse can come strong from a $40 billion train wreck in 2008, GPIF can easily come back from this loss in the future.

The loss GPIF recorded during its fiscal year can be explained by two factors:

1. A shift in its asset allocation away from domestic bonds to riskier domestic and foreign stocks.
2. A surging yen which negatively impacted its foreign stock and bond holdings.

In order to put some context to this, you all need to read a recent Bloomberg article by Tom Redmond on Japan’s Pension War.

I will leave it up to you to read that article but the key here is to understand the shift in GPIF’s asset allocation over the last two years (click on image):

As you can see, GPIF reduced its target weight in domestic bonds from 50% to 35% and increased its target weight in domestic and foreign stocks to 25% and slightly increased its weight in foreign bonds to 15%.

This shift in asset allocation was very sensible for the GPIF over a very long investment horizon because having 50% of its assets in Japanese bonds yielding negative interest rates isn’t going to help pay for future pension liabilities that are mounting as rates sink to record lows.

Ironically, negative rates are bad news for Japan’s biggest bank but they didn’t really hit GPIF’s domestic bond portfolio which returned 4.07% in the year ended in March as the BOJ’s asset purchases and the introduction of a negative interest-rate policy lifted bond prices.

Of course, on Friday, the Nikkei whipsawed after BOJ disappointment, the yen surged against dollar and Japanese government bonds (JGBs) sold off:

Japan shares whipsawed and the yen surged after the Bank of Japan threw markets a smaller-than-expected bone in a keenly watched decision on Friday.

While the BOJ eased its monetary policy further by increasing its purchases of exchange-traded funds (ETFs), it didn’t change interest rates or increase the monetary base, as analysts had widely expected.

The central bank said it would increase its ETF purchases so that their amount outstanding on its balance sheet would rise at an annual pace of 6 trillion yen ($56.7 billion), from 3.3 trillion yen previously.

“The message the BOJ is sending is not so much much ‘whatever it takes’ as ‘monetary policy’s pretty much played out’,” said Kit Juckes, global fixed income strategist at Societe Generale.

The Japanese yen surged against the dollar after the announcement, with the dollar-yen pair falling as low as 102.85, compared with around 103.75 immediately before the decision. The pair was already volatile before the announcement, touching a session high of 105.33.

At 2:31 p.m. HK/SIN, the dollar was fetching 103.52 yen.

The benchmark Nikkei 225 whipsawed after the decision, tumbling as much as 1.66 percent immediately after the announcement. It quickly retraced the fall, but then spent the remainder of the session volleying between gains and losses. At market close, the Nikkei finished up 92.43 points, or 0.56 percent, at 16,569.27.

In the bond market, Japanese government bonds (JGBs) sold off. The yield on the benchmark 10-year JGB jumped to negative 0.169, from an earlier low of negative 0.276. Yields move inversely to bond prices. Many analysts had expected the BOJ would increase its JGB purchases.

Sean Darby, chief global equity strategist at Jefferies, said in a note that the news on the ETF purchases “should boost sentiment on stocks,” but “overall monetary policy will only be marginally changed given that the BOJ’s balance sheet expansion has already decelerated.”

“The absence of any change on deposit rates will have disappointed those investors seeking a bolder move by the BOJ,” said Darby.

Other Asian markets were nearly flat or mostly lower. The ASX 200 in Australia saw a slight gain of 5.80 points, or 0.1 percent, to 5,562.35. In South Korea, the Kospi closed down 4.91 points, or 0.24 percent, at 2,016.19. Hong Kong’s Hang Seng index slipped 327.06 points, or 1.47 percent, to 21,847.28.

Chinese mainland markets were lower, with the Shanghai composite closing down 14.94 points, or 0.5 percent, at 2,979.37, while the Shenzhen composite was off by 9.44 points, or 0.48 percent, at 1,941.55.

So what is going on? Why did the Bank of Japan not do more to raise inflation expectations? The Japan Times reprinted an article from Reuters, BOJ eases further, signals policy review as inflation target eludes:

The Bank of Japan expanded stimulus Friday by doubling its purchases of exchange-traded funds, yielding to pressure from the government and financial markets for action but disappointing investors who had set their hearts on more audacious measures.

The central bank, however, said it will conduct a thorough assessment of the effects of its negative interest rate policy and massive asset-buying program in September, suggesting that a major overhaul of its stimulus program may be forthcoming.

BOJ Gov. Haruhiko Kuroda said the bank will conduct the review not because its policy tools have been exhausted, but to come up with better ways of achieving its 2 percent inflation target — keeping alive expectations for further monetary easing.

“I don’t think we’ve reached the limits both in terms of the possibility of more rate cuts and increased asset purchases,” Kuroda told reporters after the policy meeting.

“We will of course consider what to do in terms of monetary policy steps, based on the outcome of the assessment.”

Ahead of the meeting, speculation had mounted over the possibility it would take a so-called helicopter money approach that would entail more direct infusions of money into the economy.

Recently, the government downgraded its growth forecast for 2016 to 0.9 percent from 1.7 percent.

“With underlying inflation set to moderate further toward the end of the year, we think that the bank will still have to provide more easing before too long,” Marcel Thieliant of Capital Economics said in an analysis. “Overall, today’s decision was a clear disappointment,” he said.

The 7-2 central bank decision was to almost double its annual purchases of exchange traded funds to ¥6 trillion from the current ¥3.3 trillion. A fifth of that will be earmarked for companies that meet new benchmarks for investing in staffing and equipment, it said in a statement.

It also doubled the size of a U.S. dollar lending program to support Japanese companies’ operations overseas, to $24 billion.

The BOJ already is injecting about ¥80 trillion a year into the economy through asset purchases, mainly of Japanese government bonds.

The BOJ was under heavy pressure to act after earlier this week Prime Minister Shinzo Abe announced ¥28 trillion in spending initiatives to help support the sagging economic recovery led by his feeble Abenomics policies.

By coordinating its action with the big fiscal spending package, the BOJ likely aimed to maximize the effect of its measures on the world’s third-biggest economy, which is struggling to escape decades of deflation.

“The BOJ believes that (today’s) monetary policy measures and the government’s initiatives will produce synergy effects on the economy,” the central bank said in a statement announcing the policy decision.

The BOJ maintained its rosy inflation forecasts for fiscal 2017 and 2018 in a quarterly review of its projections. It also left intact the time frame for hitting its price growth target, but warned uncertainties could cause delays.

The BOJ justified Friday’s monetary easing as aimed at preventing external headwinds, such as weak emerging market demand.

The recent vote by Britain to leave the European Union has added to the uncertainties clouding the global outlook at a time when Japan’s recovery remains in question.

“There is considerable uncertainty over the outlook for prices against the background of uncertainties surrounding overseas economies and global financial markets,” the central bank said.

The central bank did not change the interest it charges on policy-rate balances it holds for commercial banks, which is now at a record low minus 0.1 percent.

Financial markets seemed underwhelmed by the central bank’s modest action.

The Nikkei 225 stock index had dropped nearly 2 percent on Friday but later regained some ground to end 0.56 percent higher.

Ahead of the BOJ decision, Japan reported further signs of weakness in its economy in June, with industrial output and consumer spending falling from the year before.

Core inflation, excluding volatile food prices, dropped 0.5 percent from 0.4 percent in May, while household spending fell 2.2 percent from a year earlier.

Unemployment had fallen to 3.1 percent in June from 3.2 percent for the past several months, but tightness in the job market has not spilled into significant increases in wages that might help spur more consumer demand and encourage businesses to invest in the sort of “virtuous cycle” Abe has been promising since he took office in late 2012 under Abenomics.

Still, while industrial output fell 1.9 percent from the year before, it rose 1.9 percent from the month before, with strong shipments related to home building and other construction.

My reading is that despite improving employment gains, Japan is still stuck in its deflation rut and policymakers are increasingly worried which is why they’re openly debating “radical policies” like helicopter money.

Importantly, by not acting forcibly, the BoJ basically intensified deflation in Japan because the yen surged higher which means import prices in Japan will fall further, putting more pressure the declining core CPI. It will also impact Japanese exporters like car and steel producers which isn’t good for employment.

Also, as I’ve warned of earlier this year, the surging yen can trigger a crisis, including another Asian financial crisis which will spread throughout the world and lead to more global deflation.

At this writing, the USD/ JPY cross is hovering around 102.4, which is above the 100 level, but if it falls below this level and continues to decline, watch out, things could get very messy very fast.

A surging yen below the key 100 level isn’t good news for risk assets as it will trigger massive unwind of the yen carry trade with big hedge funds and trading outfits use to leverage their positions in risk assets.

A full discussion of currency risks merits another comment. All I can say is that the GPIF’s results weren’t as terrible as they look given the big move in the yen and its new asset allocation.

As far as mimicking the Canada Pension Plan Investment Board (CPPIB) and the rest of Canada’s large pensions allocating a big chunk of their portfolio in alternatives like private equity, real estate and increasingly in infrastructure, that all sounds great but if they don’t have the right governance which allows them to manage these assets internally, then I wouldn’t recommend it.

Sure, GPIF is big enough to go to the big alternatives shops like Blackstone, Carlyle, KKR, etc. and squeeze them hard on fees but this isn’t the best long term approach for a mega fund of its size. before it heads into alternatives, it needs to get the governance right to attract and retain talented managers who will be able to do a lot of direct investments along with fund and co-investments.

There are a lot of moving parts now impacting the GPIF’s performance, least of which is the surging yen. A full discussion on currencies will have to take place in my follow-up comment as this one is already too long.

I’d be happy to talk to the people at the GPIF to discuss this post and put them in touch with some contacts of mine, including my buddy who trades currencies and can steer them in the right direction in terms of currency hedging policy (read my follow-up comment).

Japan’s $1.3 trillion Government Pension Investment Fund posted its worst return since 2009 in fiscal year 15-16, officials confirmed last week.

They also disclosed the fund’s equity holdings for the first time, and it revealed a largely passive investment strategy. Some observers wonder whether the fund could improve its long-term prospects by taking a more active approach.

From Bloomberg:

The list of domestic shares owned by Japan’s $1.3 trillion Government Pension Investment Fund hews closely to the benchmark Topix index, which isn’t that surprising for a fund where almost 80 percent of investments are passive. But it means that in market downturns like in the past year, GPIF will struggle to increase assets.

“There’s more they can do,” said Masahiro Ichikawa, a senior strategist at the Tokyo-based money manager. “They should be more active with their currency hedging and their investments. They should also look to increase exposure to alternatives.”

[…]

While criticism of GPIF’s passive approach to investing isn’t new, this is the first year the fund posted a loss since it doubled its allocation to stocks in 2014 and reduced its investments in domestic bonds, which were the only asset to return a profit in the year. The fund is taking flak on both sides, from those who want to turn back the clock to when it held more bonds to people who say it should become more of a stock picker.

“GPIF should invest more actively but from a long-term perspective,” said Tetsuo Seshimo, a portfolio manager at Saison Asset Management Co. in Tokyo. “That’s the only way they can improve their returns.”

GPIF President Norihiro Takahashi, speaking after the results announcement on Friday, said the fund planned to use its allowable deviation limits when allocating assets, in a sign he will be flexible in managing the portfolio.

GPIF is unlikely to make any major changes.

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.

Twice in recent decades CalPERS fell below 100 percent of the funding needed for promised pensions, and twice CalPERS climbed back. But since a $100 billion investment loss in 2008, the CalPERS funding level has not recovered.

Now with about 75 percent of the projected assets needed to pay future pensions, CalPERS has had low investment earnings during the last two fiscal years. Experts expect the trend to continue during the next decade.

“We have some challenges to confront in what is, both for ourselves and all institutional investors, moving into a much more challenging low-return environment,” Ted Eliopoulos, CalPERS chief investment officer, told reporters last month.

If the investment fund earnings that are expected to pay two-thirds of future pensions remain low, the annual payments to CalPERS from state and local governments may continue to grow.

So far, the CalPERS board has resisted Gov. Brown’s calls to raise rates even higher, citing the pressure on local government budgets of recent rate increases. The last one, covering longer lives expected for retirees, is still being phased in.

Many employer rates are already at an all-time high. For 80 miscellaneous plans, rates are over 30 percent of pay. For 135 police and firefighter plans, rates are over 40 percent of pay.

“Employers are reporting that these contribution levels are putting significant strain on their budgets and limiting their ability to provide services to the people in their jurisdictions,” the annual CalPERS funding and risk review said last November.

Low earnings also would undermine a new CalPERS “risk mitigation” strategy that over the decades could very gradually, without triggering a major rate increase, reduce the current earnings forecast, 7.5 percent a year, which critics say is too optimistic.

When earnings are 11.5 percent or higher, the strategy switches half of the money above 7.5 percent to investments with lower yields but less risk of loss. The CalPERS board rejected a Brown aide proposal for a five-year phase in of a 6.5 percent forecast.

After the CalPERS board adopted the risk mitigation strategy last November, Brown said in a news release: “This approach will expose the fund to an unacceptable level of risk in the coming years.”

Some CalPERS board members and union officials predicted CalPERS would once again recover when investments plunged from $260 billion in the fall of 2007 to $160 billion in March 2009, dropping the funding level from 101 percent to 61 percent.

But among the differences this time, in addition to the size of the loss, were low interest rates, stagnant or shrinking payrolls, a wave of Baby Boom retirements, and a maturing fund with negative cash flow requiring the sale of investments to pay pensions.

When the funding level remained low after a lengthy bull market in stocks, which are half of the CalPERS fund valued at $302 billion last week, board members began to mention a new threat.

The board has been told by experts that if the funding level drops low enough, perhaps around 40 to 50 percent, pushing rate increases and earnings forecasts high enough to get back to full funding becomes impractical.

The investment earnings CalPERS reported for the fiscal year ending June 30 were a scant 0.61 percent, lower than the 2.4 percent earned the previous year. The two lean years followed two good years of double-digit earnings, 17.7 and 12.5 percent.

Markets, like most things happening in the future, tend to be difficult to predict with certainty. In the famous quip of the distinguished economist Paul Samuelson: “Wall Street indexes predicted nine out of the last five recessions.”

The earnings forecast or “capital market assumptions” adopted by CalPERS two years ago was 7.1 percent during the next 10 years, Eliopoulos told reporters last month. Now Wilshire and other consultants have dropped their 10-year forecast to 6.64 percent.

“We quite clearly have a lower expected return expectation than we had just two years ago,” Eliopoulos said. “So that will be reflected in our next cycle, which again will look at a 10-year period.”

A routine CalPERS “asset liability management” process begins next year and will be completed in 2018. If the earnings forecast is lowered, CalPERS presumably faces difficult decisions about raising rates and adding higher-yielding but riskier investments.

“We are cognizant that this is a challenging environment for institutional investors and that we have to work collectively within CalPERS to address these challenges,” Eliopoulos said.

The CalPERS reply to earnings forecast critics has been that its long-term earnings average more than 7.5 percent. But after the two weak years, the three-year CalPERS earnings average is 6.86 percent and the 20-year average 7.03 percent.

In a new nationwide look at public pension funding, CalPERS is about average despite generous pensions it sponsored (SB 400 in 1999) and encouraged (AB 616 in 2001) and placing last five years ago in a Wilshire ranking of investment performance.

The average pension system was 74 percent funded last year with an earnings forecast of 7.6 percent, said a brief by Alicia Munnell and Jean-Pierre Aubrey of the Center for Retirement Research at Boston College using the Public Plans Database.

Why the earnings forecast is at the center of the debate over whether CalPERS and other public pension systems are “sustainable” or need major cost-cutting reform is shown by a chart in the brief.

Using a 7.6 percent earnings forecast to offset or “discount” future pension costs, the funds in the national database have 74 percent of the projected assets needed to pay future pensions and a debt or “unfunded liability” of $1.2 trillion.

But if the earnings forecast is dropped to 4 percent, near the risk-free bond rate some critics say should be used to discount guaranteed pensions, the funding level drops to 45 percent and the unfunded liability soars to $4.1 trillion.

The brief issued in June by Munnell and Aubrey uses italics to emphasize that financial economists argue that a risk-free rate should be used for reporting purposes, apparently implying not for setting employer rates and allocating investments.

“Moreover, even many who agree that the expected return may be appropriate for funding purposes are concerned about the level of assumed returns in the current financial market environment,” their brief added, echoing the remarks by Eliopoulos.

Since the CalPERS funding level last year reported in the database, 74.5 percent, is similar to the 74 percent national average, another chart in the brief shows two possible investment scenarios that might roughly apply to CalPERS, given investment differences.

If investment earnings are the “baseline” average of 7.6 percent, the funding level would by 77.6 percent in 2020. If earnings are the “alternative” average of 4.6 percent, the funding level would be 72.1 percent in 2020.

Japan’s Government Pension Investment Fund — the largest pension fund in the world with $1.3 trillion in assets — posted a return of -3.8 percent for its fiscal year 15-16, officials confirmed on Thursday.

The loss, which amounts to $51 billion, comes on the heels of a years-long portfolio overhaul which saw the fund skew its allocation towards equities and away from bonds.

More from Bloomberg:

The annual loss — GPIF’s first since doubling its allocation to stocks and paring domestic bond holdings in October 2014 — came during a volatile stint for markets. Japanese shares sank 13 percent in the year through March while the yen climbed 6.7 percent against the dollar, reducing returns from overseas investments. The only asset class to post a profit was local debt, which jumped in value as the Bank of Japan’s adoption of negative interest rates sent yields tumbling.

“The results are painful,” said Masahiro Ichikawa, a senior strategist at Sumitomo Mitsui Asset Management Co. in Tokyo. “Because it’s a pension fund, they need to have a long-term outlook, so I don’t think we can say yet that they took on too much risk. It was a harsh investment environment for most of us.”

In a press briefing in Tokyo after the results were announced, GPIF President Norihiro Takahashi said he will reflect on the performance, but that the current portfolio has enough flexibility to adapt to different market conditions and he wants to run the fund steadily. Yoshihide Suga, Japan’s chief government spokesman, said GPIF’s management shouldn’t be influenced by short-term moves and there is absolutely no issue with its financing.