A Caisse of Outrageous Compensation?

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

This is a bilingual comment so bear with me. La Presse Canadienne recently reported on the compensation of the Caisse’s senior managers, Combien ont gagné les patrons de la Caisse de dépôt et placement du Québec en 2016?:

Les six principaux dirigeants de la Caisse de dépôt et placement du Québec (CDPQ) se sont partagé près de 11 millions $ en rémunération totale l’an dernier, indique le rapport annuel de l’institution dévoilé mardi.

C’est un peu plus que les quelque 10,7 millions $ en salaires qui avaient été octroyés en 2015.

Son président et chef de la direction, Michael Sabia, a touché un total de 2,82 millions $, en hausse de 8,5 pour cent. Ce montant tient compte du versement d’une rémunération incitative différée de 1,12 million $. En 2013, M. Sabia avait choisi de différer 900 000 $, une somme qui a évolué en fonction de la performance de la Caisse sur trois ans, ce qui lui a permis de réaliser un rendement de 221 723 $.

L’an dernier, M. Sabia a décidé de différer 1,74 million $.

Celui qui était jusqu’à tout récemment premier vice-président et chef des placements, Roland Lescure, arrive au deuxième rang au chapitre du salaire global, avec 2,62 millions $, en hausse de 20 pour cent.

M. Lescure, qui a quitté ses fonctions au début du mois pour se joindre à la campagne du candidat à la présidentielle française Emmanuel Macron, a touché une somme différée de 987 739 $.

En 2016, la Caisse a affiché un rendement de 7,6 pour cent, soit 18,4 milliards $, dépassant son indice de référence fixé à 5,8 pour cent. Sur cinq ans, il s’agissait toutefois de la moins bonne performance annuelle du bas de laine des Québécois.

Sur cinq ans, le rendement de la CDPQ a été de 10,2 pour cent, soit 1,1 point de pourcentage de plus que son indice de référence.

Au total, les employés de l’investisseur institutionnel ont touché des primes de 59 millions $, en hausse de 21 pour cent par rapport à l’an dernier. La Caisse justifie cette progression par son rendement sur cinq ans ainsi qu’une “valeur ajoutée” de 12,3 milliards $ générée l’an dernier.

L’ensemble des employés ont choisi de différer jusqu’en 2019 une somme de 32 millions $.

Below, I translate the key takeaways:

  • According to the latest annual report which came out last Tuesday, the top six directors at the Caisse were compensated a total of $11 million in 2016, a bit more than the $10.7 million they received in total compensation in 2015.
  • Michael Sabia, the President and CEO, received a total of $2.82 million in 2016, up 8.5 per cent from the previous year. This amount includes the payment of a deferred incentive fee of $1.12 million. In 2013, Mr. Sabia chose to defer $900,000, a sum that evolved based on the Caisse’s performance over three years, resulting in a return of $221,723. Last year, Mr. Sabia decided to defer $1.74 million.
  • Roland Lescure who up until recently was the CIO of the Caisse, came in second in the overall compensation at $2.62 million, up 20 per cent from the previous year. Mr. Lescure, who left office earlier last month to join the campaign of French presidential candidate Emmanuel Macron, received a deferred sum of $987,739.
  • In 2016, the Caisse posted a return of 7.6 per cent, or $ 18.4 billion, exceeding its benchmark of 5.8 per cent. Over five years, however, it was the worst annual performance of the Fund. Over five years, the Caisse’s performance was 10.2 per cent, 1.1 percentage points more than its benchmark.
  • In total, the Caisse’s employees received $59 million in compensation in 2016, up 21 per cent from the previous year. The Caisse justifies this increase by its five-year return and a “value added” of $12.3 billion generated last year. All employees chose to defer a total of $32 million in compensation until 2019.

Now, let’s go over the main tables going over compensation, starting with table 41 on page 103 of the Caisse’s 2016 Annual Report (click on image):

In order to understand these figures, it’s important to carefully read the Report of the Human Resources Committee which begins on page 93 of the Annual Report. La Caisse’s employees receive total compensation based on four components:

  1. Base salary
  2. Incentive compensation
  3. Pension plan
  4. Benefits

I’d like to highlight passages from pages 97 and 98 of the Annual Report (click on image):


Below, I embed an extract from page 100 of the Caisse’s 2016 Annual Report discussing Michael Sabia’s compensation (click on image):

And below is figure 36 which goes over the performance components of the President and CEO’s total compensation (click on image):

Also worth mentioning some added information provided on Michael Sabia’s compensation:

  • The compensation and other employment conditions of the President and Chief Executive Officer are based on parameters set by the government after consultation with the Board of Directors.
  • In accordance with his request, Mr. Sabia has received no salary increase since he was appointed in 2009. In 2016, Mr. Sabia’s base salary remained unchanged at $500,000.
  • In 2016, Mr. Sabia received his deferred incentive compensation amount for 2013. The amount of this deferred incentive compensation totalled $1,121,723 and included the return credited since 2013.
  • When he was appointed in 2009, Mr. Sabia waived membership in any pension plan. He also waived any severance pay, regardless of the cause. Even so, given that membership in the basic pension plan is mandatory under the provisions of the Pension Plan of Management Personnel (under Retraite Québec rules), Mr. Sabia is obliged to be a member despite his waiver. In 2016, contributions to the mandatory basic plan represented an annual cost to la Caisse of $20,779.

What else is important to note in terms of compensation at the Caisse? As mentioned on page 99 of the Annual Report, under the incentive compensation program, executives must defer a minimum of 55% of their calculated incentive compensation into a co-investment account. Deferred incentive compensation for 2016 is presented in Table 42 below (click on image):

Tables 43 and 44 below provide the pension summary and severance for the president and five most highly compensated executives at the Caisse (click on images):


Table 45 below provides details of the reference markets used to reference the compensation of the president and five most highly executives of the Caisse (click on image):

Make sure you read the footnotes to these tables to understand how compensation is determined.

The reference markets used for the CEO and executive VPs and non-investment positions used for referencing compensation are provided in tables 37, 38, 39 and 40 below (click on images):



As you can see, I provided you with a thorough discussion on how exactly compensation is determined at the Caisse. The key points are that the incentive plan is based on five-year returns and a significant portion of incentive compensation for senior executives and for employees is deferred (at the end of each three-year period, the deferred amount, plus or minus the average return credited for the period, will be paid to each participant as a deferred incentive payment with restrictions).

[Note: Read my comment going over the Caisse’s 2016 results.]

Obviously, any layperson, teacher or public sector employee looking at these figures and reading articles in the Journal de Montréal will think the Caisse’s top executives are extremely well compensated.

And no doubt, they are, and total compensation has increased over the last few years but it’s based on long-term performance and added-value over a benchmark (over the last five years) and is in line with what the Caisse’s peer group doles out to its senior executives and investment professionals.

It’s been a while since I last went into a full discussion on compensation at Canada’s large public pension funds. Over two years ago, I discussed a list of the highest paid pension fund CEOs  but I need to do a more thorough job of going over compensation to explain in great detail how it’s determined and why it’s important in terms of attracting and retaining top talent to do a job that is arguably far more important and difficult than most people realize.

Michael Sabia is paid very well but he’s the President and CEO of the second largest pension fund in Canada, he and his senior executives have delivered on long-term performance targets and his job is arguably a lot more difficult than that of his peers because there is a political dimension to it which quite frankly is daunting at times (for example, he recently appeared in front of Quebec’s National Assembly to defend the Caisse’s investments in companies that are registered offshore, which by the way most funds that pensions invest in are registered in!).

As for the rest of the Caisse’s top executives, they too are paid well but in line with their peer group (and even below) and it’s important to understand they have huge responsibilities and very difficult objectives to achieve.

Lastly, one person who is missing from this list is Daniel Fournier, the Chairman and CEO of the Caisse’s real estate subsidiary, Ivanhoé Cambridge (click on image):

Mr. Fournier is also a member of the Board of Otéra Capital, a CDPQ’s subsidiary specialized in commercial real estate financing and for which he is responsible. He reports to his own board, not Michael Sabia.

There are no public reports going over compensation at Ivanhoé Cambridge but given that real estate is the most important asset class at the Caisse, and that long-term performance has been stellar in this asset class, I wouldn’t be surprised if Daniel Fournier gets paid even more than Michael Sabia (just a guess here but he has huge responsibilities).

Anyway, these are my comments on compensation at the Caisse. Just like in other large shops, the top executives make the most because they have the most responsibility.

This comment is to provide many of you with more details on how compensation is determined at Canada’s second largest pension fund and if you go over the annual reports of other large Canadian pensions, you will find a similar thorough discussion on compensation.

One thing I would like these big public pensions to provide is information on the median compensation of top executives relative to median compensation of the rest of the employees at these funds and how this ratio has varied over time.

Once again, if you have anything to add, feel free to email me at LKolivakis@gmail.com.

CalPERS, CalSTRS Dislike Divestment As Dakota Access Pipeline Reignites Debate

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

A bill that began life as a requirement that CalPERS and CalSTRS divest holdings in Dakota Access Pipeline firms emerged from a legislative committee last week reborn — a requirement that the pension funds only report on their “engagement” with the firms.

The revised AB 20 by Assemblyman Ash Kalra, D-San Jose, reflects a new emphasis on what the two big state pension funds say is often a less costly and more effective alternative to divestment: remaining a shareholder with a “seat at the table” to advocate change.

Since the sale of investments in firms doing business with apartheid South Africa in 1986, all CalPERS divestments have resulted in a total loss of $7.9 billion, including transaction costs and foregone investment returns, Wilshire consultants estimated earlier this year.

The two state pension funds, still struggling to recover from huge investment losses a decade ago, are taking a harder look at a small wave of divestment bills proposed by legislators on a wide range of political issues.

Both pension funds recently were about 64 percent funded, CalPERS as of last January and CalSTRS last June. Most of their employer contribution rates are doubling over a decade or less, squeezing local government and school budgets.

Experts predict that investment earnings, expected to pay nearly two-thirds of future pension costs, will weaken after a long bull market. Both pension funds recently dropped their investment earnings forecast from an annual average of 7.5 percent to 7 percent.

The small wave of divestment bills followed Gov. Brown’s signature two years ago on a bill by Senate President Pro Tempore Kevin de Leon, D-Los Angeles, requiring divestment, if fiduciarily responsible, of thermal coal companies not transitioning to clean energy.

Last year three bills that failed passage required pension fund divestment of any holdings in securitized home rental properties, banned additional investments in firms that further the boycott of Israel, and prohibited investments in Turkey government bonds.

This year, in addition to the pipeline, there are divestment bills on firms building a Mexican border wall and Turkey government bonds and a bill requiring the two pension funds to consider financial climate risk in the management of their funds.

Critics say divestment limits investment opportunity, decreases diversification, burdens staff, and may limit returns, increase risk, and result only in a turnover of shares with little or no effect on the target.

A union-sponsored constitutional amendment (Proposition 162 in 1992), a response to a legislative “raid” on pension funds, made paying benefits the top pension board priority, up from equal standing with minimizing employer contributions and reasonable administrative costs.

“A retirement board’s duty to its participants and their beneficiaries shall take precedence over any other duty,” said the amendment. Arguably, the two state pension boards could legally decline to divest, citing net losses and their fiduciary duty to pensioners.

“The Legislature may by statute continue to prohibit certain investments by a retirement board where it is in the public interest to do so, and provided that the prohibition satisfies the standards of fiduciary care and loyalty required of a retirement board pursuant to this section,” said the amendment.

A revised investment policy adopted by the CalPERS board last week in a second reading drew opposition during public comment from RL Miller, president of Climate Hawks Vote and the elected chair of the California Democratic Party’s environmental caucus.

Miller said the divestment policy can be summed up as “no divestment ever.” The policy said divestment “appears to almost invariably harm investment performance” and often is a mere transfer of ownership that only results in a loss of influence on the company.

“This Policy, therefore, generally prohibits Divesting in response to Divestment Initiatives, but permits CalPERS to use constructive engagement, where consistent with fiduciary duties, to help Divestment Initiatives achieve their goals,” the policy said.

Despite hearing in February from dozens urging Dakota pipeline divestment, Miller said, the only CalPERS response was a letter urging Energy Transfer Partners to reroute the pipeline, then 90 percent complete and only weeks away from moving oil through Sioux sacred land.

And despite a Democratic Party resolution in 2015 urging the California Public Employees Retirement System and the California State Teachers Retirement System to divest fossil fuel, she said, two of the largest CalPERS holdings are in Exxon and Chevron.

“You are deliberately choosing to shun the single most effective tool in an engaged shareholder’s tool box, divestment,” Miller said at a CalPERS investment committee meeting. (See CalPERS video, remarks begin at 1:14)

State Controller Betty Yee, who sits on the CalPERS and CalSTRS boards, told Miller she thinks the policy encourages engagement but is not an outright ban on divestment, which should be considered on a case-by-case basis.

“We are fiduciaries of this fund,” Yee said. “Our sole focus is how we are going to pay the benefits that our public-sector workers and educators have earned during their career, and it’s becoming a tougher business to be in as you heard this morning.”

People listen when CalPERS (investments valued at $317.5 billion last week) speaks, Yee said, but it lacks clout to make change on its own and does much engagement with other large investors. She said some work is not reported in documents that might reveal strategy.

“But understand, we are not letting up on this,” Yee said. “We also see the risk, the huge risk that climate is going to place on this fund relative to the ability of companies to continue to create long-term value.”

The CalSTRS board discussed divestment early this month while taking an “oppose unless amended” position on three bills. A forum to help legislators better understand work already being done was mentioned as a way to slow the introduction of divestment bills.

CalPERS did not take a position on the divestment bills. Kalra said he was influenced by the CalPERS and CalSTRS advocacy of engagement as he told the Assembly public pension committee his Dakota pipeline measure was no longer a divestment bill.

A bill requiring divestment of companies that build President Trump’s Mexican border wall was rescheduled for a hearing in the Assembly committee on May 3, an author of AB 946, Assemblywoman Lorena Gonzalez Fletcher, D-San Diego, said in a news release.

The committee approved a bill requiring divestment of Turkey bonds for failure to recognize the Aremenian genocide. The author, Adrin Nazarian, D-Van Nuys, said AB 1597 would only take effect if the federal government acts first.

Today, the Senate pension committee is scheduled to hear a bill requiring the two pension funds to consider climate risk in fund management and to make annual reports of climate risk in their investment portfolios, SB 560 by Sen. Ben Allen, D-Santa Monica.

CPPIB Preparing For Landing?

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

Benefits Canada reports, CPPIB to sell Irish aircraft leasing company:

The Canada Pension Plan Investment Board and its co-investors have announced the sale of Dublin-based aircraft leasing company AWAS to Dubai Aerospace Enterprise Ltd.

The CPPIB first invested in the company with European private equity firm Terra Firma in 2006.

“We are pleased with the outcome of this transaction,” said Ryan Selwood, managing director and head of direct private equity at CPPIB. “We continue to believe that the aircraft leasing industry is a highly attractive market for CPPIB over the long term and look forward to exploring future opportunities to invest in the sector at scale, subject to market conditions.”

AWAS leases airplanes to 87 airline customers in more than 45 countries and has assets totalling about $10 billion as of last November. The company owns 214 aircraft with an average age of 5.8 years, and has also ordered 23 new aircraft.

In March 2015, AWAS sold 84 aircraft to Macquarie Group Ltd. Since then, it has continued to grow its business and portfolio.

The deal is subject to regulatory approval and is expected to close in the third quarter of 2017.

The Telegraph also reports, Guy Hands’ Terra Firma sells aircraft leasing investment to Dubai-based rival:

Private equity baron Guy Hands has sold an aircraft leasing business his hedge fund Terra Firma has co-owned for more than a decade.

The fund, alongside co-investors and the Canada Pension Plan Investment Board (CPPIB), has sold the Dublin-based aircraft lessor Awas to Dubai Aerospace Enterprise, the largest aircraft lessor in the Middle East. The terms were not disclosed.

Awas was formed in 2006 when Terra Firma and CPPIB bought the underlying business and later snapped up rival Pegasus in 2007. It now boasts $7.5bn of owned aircraft assets that it leases out to 87 airlines in more than 45 countries. Besides the 214 aircraft it owns, Awas also has 23 new ones on order.

At acquisition in 2006, Awas owned 154 Airbus and Boeing aircraft, with long-term leases and what the investors saw as good rental income.

Terra Firma said its decision to invest in the company was based on its view the aviation sector would grow rapidly, with the world fleet expected to double by 2034, and steady demand from airlines for leased aircraft.

International Airlines Group said in its recent results in February it had 32 additional leased aircraft compared to the same period last year partially due to fleet renewal with 13 less owned aircraft.

But some airlines are eyeing greater levels of ownership, with easyJet stating in its full-year results in November last year the size of its leased fleet had decreased by 6.4pc to 64 while its owned fleet rose by more than 10pc to 180 thanks to its recent purchase of 20 A320 aircraft.

Mr Hands, chairman and chief investment officer of Terra Firma, said it was “the right time for Terra Firma to realise maximum value for our investors”.

“Under our ownership, we have transformed the company to better reflect the fast-changing market that it serves,” he said.

“This has been achieved through an active aircraft acquisition and disposal strategy to optimise the business’ portfolio and align with its diverse customer base.”

The sale of the business comes just over two years after the company sold 84 aircraft to Macquarie Group, a transaction that Terra Firma said was a significant stage in preparing the business for sale.

Dubai Aerospace Enterprise was founded in 2006 and counts airlines such as Emirates, EVA Airways, easyJet, Wizz and EgyptAir among its customers.

Ryan Selwood, managing director, head of direct private equity, at CPPIB, said in spite of the sale it would look for other opportunities in the aircraft leasing space in the future.

Goldman Sachs is acting as financial advisor and Milbank as legal advisor to the seller. The deal is subject to regulatory approval and is expected to close in Q3 2017.

Anshuman Daga of Reuters also reports, Dubai Aerospace to buy aircraft lessor AWAS, catapults to top tier:

Government-controlled Dubai Aerospace Enterprise Ltd (DAE) is acquiring Dublin-based AWAS, the world’s tenth biggest aircraft lessor, in a deal that will add over 200 planes to its fleet and more than double the size of its current business.

AWAS is the latest asset to be sold in the rapidly consolidating global aircraft leasing industry whose top 50 lessors had a fleet value of $256 billion last year, according to consultancy Flightglobal. The sector is seeing increased investment from players in emerging markets such as China, which were also in the running for AWAS, sources said.

Reuters had reported in December citing sources that AWAS had been put up for sale in an auction that could value the lessor at $7 billion, including debt.

DAE, controlled by the government of Dubai, signed a definitive agreement to buy AWAS from British financier Guy Hands’ private equity firm Terra Firma Capital Partners and Canadian Pension Plan Investment Board (CPPIB), the companies said on Monday. They did not disclose financial terms of the deal.

DAE, which calls itself the largest aircraft lessor in the Middle East with a portfolio of 112 planes, said the combined company will have an owned, managed and committed fleet of 394 planes with a total value of over $14 billion. It will have more than 110 airline customers spread across 55 countries.

“This acquisition of AWAS is strategically compelling and propels DAE into a top 10 aircraft leasing platform,” DAE Managing Director Khalifa H. AlDaboos said in a statement.

“Our leasing business has been growing at a rapid clip and this acquisition will more than double the current size of our business…”he said.

Paid for in U.S. dollars, aircraft are comparatively easy to re-lease to various airline operators across the world.

AWAS has a fleet of 263 owned, managed and committed narrow and wide-body aircraft, including a pipeline of 23 new aircraft on order to be delivered before the end of 2018.

DAE said its transaction will be financed by the group’s internal resources and committed debt financing. The deal is subject to regulatory approvals and is expected to be completed in the third quarter of this year.

The latest sale marks the exit of Terra Firma and CPPIB from AWAS, in which they first put in money in 2006. In 2015, Macquarie Group bought about 90 planes from AWAS for $4 billion.

DAE was advised by Freshfields Bruckhaus Deringer LLP and Morgan Stanley & Co. LLC. DAE was also advised by KPMG and Latham and Watkins LLP. Goldman Sachs is acting as financial adviser and Milbank as legal adviser to the seller.

You can read CPPIB’s press release on this deal here. What do I think of this deal? It’s a great deal for all parties involved.

Let me provide you with some background. Back in March 2011, CPPIB spent $266 million to help fund an expansion of AWAS:

The Canada Pension Plan Investment Board has pledged to spend $266 million to help fund expansion at Dublin-based aircraft leasing firm AWAS.

AWAS has a fleet of over 200 commercial aircraft on lease to more than 90 customers in approximately 45 countries. It employs roughly 120 people worldwide, and has 110 aircraft on order from Airbus and Boeing.

CPPIB’s investment adds to the $347 million US that CPPIB has already directly invested in the company.

The investment is part of $529 million US in total that AWAS secured to fund its expansion plans Thursday. The other major partner is Terra Firma — which pledged an additional $246 million US — but other investors are also putting up $17 million US.

CPPIB already owns 16 per cent of AWAS and the investment will increase its stake to 25 per cent. Terra’s stake will increase to 60 per cent, and other investors will own the remaining 15 per cent. CPP’s stake could increase beyond 25 per cent because it has committed a further $200 million US that AWAS could draw on at a later date.

The aircraft leasing firm’s plan to grow comes at an opportune time, CPPIB management said in a release.

“We are delighted to help fund AWAS’ acquisition strategy at what we feel is an attractive point in the aviation cycle to invest,” said Andre Bourbonnais, senior vice-president for private investments at CPPIB.

“We see this as another affirmation of the value of our proven platform, growth strategy,” AWAS president Ray Sisson said of the deal.

The CPPIB invests surplus money from employer and employee contributions that aren’t required to pay current retirement benefits. It had $140.1 billion in assets at the end of December.

As you can see, CPPIB can also thank André Bourbonnais (and Mark Wiseman) for this deal which netted it a very handsome return (AWAS was bought for roughly $4 billion and reportedly sold for over $7 billion).

Interestingly, Mr. Bourbonnais is now the CEO of PSP Investments which launched its own aviation leasing platform back in 2015 (SKY Leasing) with industry veteran Richard Wiley (Jim Pittman who is now the head of private equity at bcIMC worked on that deal).

What does Dubai Aerospace Enterprise (DAE) get from this deal? It’s catapulted to a top tier global  aircraft leaser and will enjoy rental income for many more years ahead but will likely ride out some turbulence in the short run depending on how bad the next global economic downturn is (you can read more on giants of aircraft leasing here).

If you look at the latest press releases from CPPIB, you’ll see it has been very busy lately with mega private deals which I would characterize as more defensive in nature (this after I recently stated CPPIB is sounding the alarm on markets).

For example, along with Blackstone, it recently acquired Ascend Learning from private equity funds advised by Providence Equity Partners and Ontario Teachers’ Pension Plan.Ascend is a leading provider of educational content, software and analytics solutions.

Today CPPIB announced that it and funds affiliated with Baring Private Equity Asia (BPEA) announced their intention to purchase all outstanding shares of, and to privatize, Nord Anglia Education, Inc. (Nord Anglia), the world’s leading premium schools organization, for a purchase price of USD 4.3 billion, including repayment of debt:

  • Nord Anglia operates 43 leading private schools globally in 15 countries in China, Europe, Middle East, North America and South East Asia
  • Funds affiliated with BPEA are the majority shareholders of Nord Anglia and BPEA controls 67% of Nord Anglia’s issued and outstanding share capital

The transaction is subject to shareholder approval and customary closing conditions.

Keep in mind, this mega deal comes after another deal announced in March when CPPIB and Singapore’s GIC bet big on US college housing.

Why invest billions in private schools and higher education? It makes perfect sense from a long-term perspective. It’s a play on global wealth inequality and how rich foreigners will spend a lot of money sending their kids to private schools and US colleges.

But it’s also a play on the need for students from all socioeconomic backgrounds to invest in higher education to compete in an increasingly more competitive workplace where certain skills are highly coveted (interestingly, the Fed’s Kashkari thinks spending on education, not infrastructure, is the key to US economic growth).

Lastly, please take the time to read this recent interview with John Graham, Managing Director, Head of Principal Credit Investments at CPPIB. Graham discusses CPPIB’s approach in private credit investments, including which segments are most attractive in this space and how CPPIB is dealing with increased competition from other institutions getting into private debt markets.

Are State Pensions Failing to Deliver?

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

Rupert Hargreaves of ValueWalk reports, State Pension Funds Take On More Risk, Higher Fees For Worse Returns:

State and locally run retirement systems are increasingly turning to alternative and complex investments to help boost returns but these decisions may not be the best for all stakeholders involved, that’s according to a new report from The Pew Charitable Trusts.

The report, which is the latest in a series of reports from Pew on the topic, uses data from the 73 largest state-sponsored pension funds, which collectively have assets under management of over $2.8 trillion (about 95 percent of all state pension fund investments).

The use of alternative investment by pension funds varies widely across the industry. The use of alternative investments for the 73 largest public funds analyzed by Pew within its report varies from 0 to over 50% of fund portfolios. There are also vast differences in returns and returns reporting.

State Pension Funds Take On More Risk, Higher Fees For Worse Returns

For the 41 largest state funds that can be clearly compared against target returns—those reporting performance after accounting for management fees and on a fiscal year basis— the average annual target return in 2015 was 7.7 %. Actual annualized returns over ten years, however, averaged 6.6 % and ranged from 4.7 % to 8.1 % a year. Only one of the 41 (and two of all 73 funds) exceeded their target return in 2015.

At the same time, the majority of funds report on the basis of a fiscal year ending June 30 and include 10-year performance returns minus the fees paid to investment managers, although 12 funds report on a different period and more than a third provide ten year returns only “gross of fees.”

States also vary in whether they include performance-based fees for certain investments, known as carried interest, for private equity. States that disclose the cost of carried interest report higher fees than states that do not.

Over the past three decades, public pension funds have increasingly relied on more complex investments to reduce volatility and improve returns. A difference of just one percentage point in annual returns on the $3.6 trillion managed by the US pension industry equates to a $36 billion impact on pension assets.

However, while asset managers have been diversifying into assets such as real estate, hedge funds, and infrastructure in an attempt to reduce volatility and improve returns, Pew’s research shows US public pension plans’ exposure to financial market uncertainty has increased dramatically over the past 25 years. Between 1992 and 2015 the expected equity risk premium for public funds increased from less than 1% to more than 4%, as bond yields declined in the assumed rates of return remained relatively stable. What’s more, research shows that the asset allocation required to yield target returns today has more than twice as volatile as the allocations used 20 years ago as measured by the standard deviation of returns.

Given the fact that the majority of pension funds target a long-term return rate of 7% to 8%, with three only falling outside the range and given the current depressed interest rates available on fixed income securities, is easy to see why funds are investing in more complex instruments in an attempt to improve returns.

Indeed, Pew notes public pension funds more than doubled allocations to alternative investments between 2006 and 2014 with the average allocation rising from 11% of assets to 25% on assets. The higher expected return on these assets has allowed pension funds to keep return assumptions relatively constant.

But while managers have diversified in an attempt to improve returns, it seems exactly the opposite is happening. The shift to alternatives has coincided with a substantial increase in fees as well as uncertainty about future realized returns. State pension funds reported investment fees equal to approximately 0.34% of assets in 2014, up from an estimated 0.26% in 2006, which may seem like a small increase but in dollar terms, it equates to over $2 billion.

Pennsylvania’s state public pension funds are some of the highest fee payers in the industry with reported annual fees coming in at more than 0.8% of assets, or 0.9% when unreported carried interest for private equity is included. The dollar cost is $700 million per annum.

In total, the US state pension system paid $10 billion in fees during 2014 this figure includes unreported fees, such as unreported carried interest for private equity. Pew’s analysts estimate that these unreported fees could total over $4 billion annually on the $255 billion private equity assets held by state retirement systems.

Unfortunately, for all the additional risk being taken on, and fees being paid out, alternative investments and not helping state pension funds hit their return targets. 10-year total investment returns for the 41 funds Pew looked at reporting net of fees as of June 30, 2015, ranged from 4.7% to 8.1%, with an average yield of 6.6%. The average return target for these plans was 7.7%. Only one plan met or exceeded investment return targets over the ten-year period ending 2015.

You can click on the images below that accompanied this article:





Let me first thank Ken Akoundi of Investor DNA for bringing this report to my attention. For those of you who like keeping abreast on industry trends, I highly recommend you subscribe to Ken’s daily emails with links to investment and pension news. All you need to do is register here.

You can go over the overview of The Pew Charitable Trusts report here and read the entire report here.

Take the time to read this report, it’s excellent and very detailed in its analysis of state funds, highlighting key differences and interesting points on unreported fees and the success of shifting ever more assets into alternative investments like private equity, real estate and hedge funds.

A few things that struck me. First, it’s clear that state pensions are paying billions in hidden fees and something needs to change in terms of reporting these fees:

Comprehensive fee disclosure in annual financial reports is still uncommon, but a few other states have also adopted the practice. The South Carolina Retirement System (SCRS) collects detailed information on portfolio company fees, other fund-level fees, and accrued carried interest in addition to details provided by external managers’ standard invoices. Likewise, the Missouri State Employees’ Retirement System (MOSERS) is particularly thorough in collecting and reporting these fees, not only by asset class but also for each external manager. Both states reported performance fees of over 2 percent of private equity assets for fiscal 2014 in addition to about 1 percent in invoiced management fees.

If the relative size of traditionally unreported investment costs demonstrated by CalPERS, MOSERS, and the SCRS holds true for public pension plans generally, unreported fees could total over $4 billion annually on the $255 billion in private equity assets held by state retirement systems. That’s more than 40 percent over currently reported total investment expenses, which topped $10 billion in 2014. Policymakers, stakeholders, and the public need full disclosure on investment performance and fees to ensure that risks, returns, and costs are balanced to meet funds’ policy goals. Such assessments are unlikely when billions of dollars in fees are not reported.

I totally agree with that last part, we need a lot more fee transparency on all fees paid by asset class and each external manager. In fact, there should be a detailed breakdown of fees paid to brokers, advisors, lawyers, and pretty much all service providers at any public pension plan.

Moreover, it’s completely ridiculous that more than a third of state pensions only provide ten-year returns “gross of fees”. All public pensions should report all their returns net of all fees and costs because that represents the true cost of managing these assets.

Worse still, if you look at the state pensions that do report their ten-year returns gross of fees, you will see some well-known US pensions like CalSTRS and Mass PRIM (click on image):

It makes you wonder whether they have the appropriate systems to monitor all fees and costs or they are deliberately withholding this information because net of fees, the returns are a lot less over a ten-year period.

The Pew report also highlights mixed results among state pensions in terms of returns following a shift to alternative investment strategies:

Although no clear relationship exists between the use of alternatives and total fund performance, there are examples of top-performing funds with long-standing alternative investment programs. Conversely, funds with recent and rapid entries into alternative markets—including significant allocations to hedge funds—were among those with the weakest 10-year yields.

Among the funds with successful long-standing alternative investment programs, the report cites the Washington Department of Retirement Systems (WDRS):

For example, the Washington Department of Retirement Systems (WDRS) is among the highest-performing public funds and has had a private equities program since 1981, making it one of the earliest adopters of alternative investments. In 2014, the WDRS had 36.3 percent of total investments in alternative asset classes, including 22.3 percent in private equity, 12.4 percent in real estate, and 1.6 percent in other alternatives. Hedge funds were notably absent from the mix. The fund’s long-term experience with the complexities of alternatives is reflected in its performance metrics: The WDRS has one of the highest 10-year returns of plans examined here, at 7.6 percent in 2015, buoyed in large part by the performance of its private equity and real estate holdings.

Now, a few points here. Notice that almost all of the alternative investments at WDRS are in private equity (22.3%) and real estate (12.4%) and more importantly, they were early adopters of such investments and have relationships that go back decades? This means they really know their funds well and likely also do a lot of co-investments with their GPs (general partners or funds they invest in) to lower their overall fees.

Another success in shifting into alternatives was South Dakota’s Retirement System:

Similarly, the South Dakota Retirement System began its private equity and real estate programs in the mid-1990s and realized 10-year returns of over 8 percent in 2015. The fund held nearly 25 percent of assets in alternative investments in 2014, but lowered this to less than 20 percent in 2015, comparable to the 18.3 percent held in alternatives in 2006. The 2015 allocation includes over 10 percent in real estate, 8 percent in private equity, and 1 percent in hedge funds. The fund reports net since inception internal rates of return of 9 percent for private equity and 21.4 percent for real estate, in comparison to the S&P 500 index of 5.8 percent for the same period.

But most state plans have struggled shifting assets into alternatives:

Conversely, plans with more recent shifts into alternatives—especially those with significant investment in hedge funds—are among those that exhibit the lowest returns. For example, the three funds with the weakest 10-year performance among net fiscal year reporters—the Indiana Public Retirement System, the South Carolina Retirement System, and the Arizona Public Safety Personnel Retirement System—are also among the half dozen funds with the largest recent shifts to alternative investments. All three have increased their allocations to alternatives by more than 30 percentage points since 2006. Significantly, these funds also have hedge fund allocations above the median fund, and all three rank in the top quartile for reported fees.

For example, in contrast with the WDRS and South Dakota’s early diversification, South Carolina shifted into alternatives precipitously in 2007 when the state enacted legislation to establish a new retirement system investment commission and provide the needed statutory authority to invest in high-yield, diversified nontraditional assets. Within a year, over 31 percent of plan assets were invested in alternatives, and by 2014 those assets made up nearly 40 percent of the fund’s total.

As detailed in an independent audit, rapid diversification into alternative investments proved difficult for a newly founded, under-resourced investment commission: The South Carolina Retirement System’s 10-year return of only 5 percent in 2015 is among the lowest of the plans studied. Given the long-term, illiquid nature of these investments, correcting misjudgments or realigning investments made quickly during the commission’s first years may prove challenging.

Ah yes, I remember when South Carolina was going to throw in the towel on alts. Instead, it kept on going, praying for an alternatives miracle just like North Carolina.

But there are no miracles in alternative assets, just more complexity and higher fees and if not done properly, it’s a total disaster for the plan and its stakeholders.

The report also notes that many states have consistently achieved relatively high returns without a heavy reliance on alternatives:

The Oklahoma Teachers Retirement System (OTRS) stands out in terms of performance among state-sponsored pension funds. It ranked near the top percentile of all public funds in the United States with a 10-year return of 8.3 percent gross of fees in 2015. The OTRS holds 17 percent of its assets in alternatives—below the fund average of 25 percent—with the bulk of its investments in public equities (62 percent) and fixed income (20 percent). Diversifying within the equity portfolio, employing low-fee strategies, and cutting operating costs are explicitly part of the fund’s overall strategy.

The Oklahoma Public Employees Retirement System (OPERS) takes this approach even further, with 70.2 percent of its investments in equity and 29.5 percent in fixed income. The fund holds no alternative investments. OPERS’ investment philosophy is guided by the belief that a pension fund has the longest of investment horizons and, therefore, focuses on factors that affect long-term results. These factors include diversification within and across asset classes as the most effective tool for controlling risk, as well as the use of passive investment management. Still, the fund does employ active investment strategies in less efficient markets (click on image).


The report also highlighted the need for greater standardized reporting to increase transparency:

Public retirement systems’ financial reports are guided by GASB standards, in addition to those of the Government Finance Officers Association (GFOA) and the CFA Institute. Collectively, these guidelines are widely recognized as the minimum standards for responsible accounting and financial reporting practices. For example, both GASB and the CFA Institute require a minimum of 10 years of annual performance reporting; the CFA suggests that plans present more than 10 years of data. The GFOA recommends reporting annualized returns for the preceding 3- and 5-year periods as well.

However, funds apply these standards differently. And because the performance and costs of managing pension investments can significantly affect the long-term costs of providing retirement benefits to public workers, boosting transparency is essential.

In a recent brief on state pension investment reporting, Pew reviewed the disclosure practices of plans across the 50 states and highlighted the need for greater and more consistent transparency on alternative investments. State funds paid more than $10 billion in fees and investment expenses in 2014, their largest expenditure and one that has increased by about 30 percent over the past decade as allocation to alternatives has grown.

However, over one-third of the funds in the study report 10-year performance results before deducting the cost of investment management—referred to as “gross of fees reporting.”

But the biggest problem of all at most US state pensions is they’re delusional, stubbornly clinging on to their pension rate-of-return fantasy which will never materialize. They do this to keep contributions low to make their members and state governments happy but sooner or later, the chicken will come home to roost, and that’s when we all need to worry.

The other problem and I keep referring to this on my blog, is lack of proper governance, which effectively means there is way too much political interference at state pensions, making it extremely hard for them to attract and retain qualified candidates that can manage public, private and hedge fund assets internally, significantly lowering costs of running these state pensions (basically the much touted Canadian pension model).

There are powerful vested interests (ie. extremely wealthy, politically connected private equity and hedge fund managers) who want to maintain the status quo primarily because they are the main beneficiaries of this US pension model which increasingly relies on external managers to attain an unattainable bogey.

But after reading this report, you need to ask some hard questions as to whether this shift into alternatives, especially hedge funds, has benefitted US state pensions net of all the billions in fees being doled out.

“Ok Leo, but what’s the alternative? You yourself have pointed out there is a major beta bubble going on in markets and now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, what are these state pensions suppose to do?”

Good question. First, every investor needs a reality check and to prepare for lower returns ahead. Second, if deflation is coming, it will decimate all pensions, especially chronically underfunded pensions. They need to mitigate downside risks as much as possible and in a deflationary environment, the truth is only good old US long bonds (TLT) are the ultimate diversifier.

But bond yields are low and headed lower, which effectively means pensions need to diversify and take intelligent risks to make their required rate-of-return. Here is where it gets tricky. There are intelligent ways to take on more risk while reducing overall volatility of your funded status (think HOOPP, Ontario Teachers’ and other large Canadian public pensions) and dumb ways to increase your risk which will only make your general partners very wealthy but not benefit your plan’s funded status in a significant and positive way (think of most US state pensions).

My only gripe with The Pew Charitable Trusts report is it doesn’t focus on funded status to tie in all other information they present in the report. Pensions are all about managing assets and liabilities and it would have made the report a lot better if they focused first and foremost on funded status of each state pension, not just returns and fees.

Still, take the time to read the entire report and you have to only hope that one day Pew will do the same report for Canada’s large public pensions and compare the results to their US counterparts.

CalPERS Goes to Supreme Court to Argue Securities Suit Deadlines

It was the Supreme Court’s first full day with new Justice Neil Gorsuch, and the case they heard: California Public Employees’ Retirement System v. ANZ Securities.

CalPERS on Monday argued in favor of loosening the deadlines for investors to file securities lawsuits.

More from the National Law Review:

The case before the court, California Public Employees’ Retirement System v. ANZ Securities, dealt with a narrow issue of deadlines for initiating litigation. But it comes up when investors seek to opt out of settlements and sue issuers individually for false information in registrations.

The Securities Act of 1933 states that lawsuits cannot be filed more than three years after the securities offering. But citing a 1974 Supreme Court precedent American Pipe & Construction v. Utah, CalPERS claims that deadline can be tolled or delayed while class actions are under way.

“All manner of satellite litigation” could proliferate if statutory deadlines are interpreted too strictly, Tom Goldstein of Goldstein & Russell told the justices on behalf of the California pension fund, the largest in the nation. Because of the complexity of securities litigation, a three-year “statute of repose” limit advocated by defendants is too short, Goldstein argued, and would compel investor groups to file separate litigation early to protect their rights to opt out of class actions.

But Paul Clement of Kirkland & Ellis disputed Goldstein’s “parade of horribles,” noting that the three-year statute of repose has been in place for several years in the Second Circuit, without an avalanche of new litigation.

Justices Neil Gorsuch and Anthony Kennedy asked several pointed questions suggesting they weren’t very sympathetic towards CalPERS.

More background on the case, from the NLR:

The case before the court stems from the financial crisis of 2008. CalPERS sued the bankrupt Lehman Brothers and ANZ Securities, one of its underwriters, claiming false statements in registration documents. The pension fund had been part of a class action, but it opted out after a settlement was reached.

The timeline resulted in a conflict between statutory provisions that impose a deadline on when such lawsuits must be filed. The U.S. Court of Appeals for the Second Circuit ruled that the three-year deadline could not be put off. But the Second Circuit ruling also said the issue was “ripe for resolution by the Supreme Court” because of a circuit split over the issue.

Trump Signs Order Barring Cities From Requiring Small Businesses to Offer 401ks

President Trump last week signed a resolution that nixes a rule, implemented by Obama, that allowed cities to require small businesses without any retirement plan options to offer employees a 401k.

No city had yet created such a rule, but several major cities — including New York City and Seattle — were considering it.

From the Society for Human Resource Management:

Cities and counties will now be barred from requiring small businesses without 401(k)-type retirement plans to enroll workers into a government-run individual retirement account (IRA).

Meanwhile, a measure to block a requirement for similar small businesses to participate in auto-enroll IRAs run by the state still awaits a Senate vote.

On April 13, President Donald Trump signed Congressional Review Act (CRA) resolution H.J. Res 67, which blocks an Obama-administration Department of Labor rule to push local governments to create auto-IRAs. The House and Senate had voted in favor of the resolution to nix the rule by party-line votes in March.

No municipalities had launched their own IRAs for nongovernment workers, although New York City, Philadelphia and Seattle all have considered doing so under the Labor Department rule, the New York Times reported.

The House also passed a resolution, H.J. Res 66, to roll back a DOL rule allowing state governments to set up mandatory auto-IRA programs for small employers that don’t provide retirement plans for their employees. A Senate vote is expected when Congress returns later in April from its Easter recess, as May 9 is the deadline for passing a CRA resolution to block the rule.

Business groups support the rollback, but other groups and states strongly supported the rules.

CalPERS Weighs Private Equity Changes, Direct Investment

CalPERS is conducting an internal review on its private equity portfolio and considering changes to the program, according to the Wall Street Journal.

The pension fund is looking to cut costs — although it’s not necessarily looking to cut its private equity allocation — and it’s weighing a variety of options. From Reuters:

It is considering moves that would give it greater latitude in selecting and managing its private equity investments in an attempt to reduce costs, the Journal reported.

Some of the options under consideration include buying a private equity firm or creating a private equity fund outside of CalPERS, the Journal said, or it could also choose to act as sole investor in more customized accounts with outside managers.

CalPERS has even considered asking its staff members to make private equity investments directly, the Journal added.

CalPERS’ private equity portfolio has returned 12.3 percent annually for the last 20 years, but would have achieved much greater return had it not been for fees.

A Chilean Love Affair?

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

Benefits Canada reports, OMERS enters into infrastructure investment in Chile:

Borealis Infrastructure, the infrastructure investment manager of the Ontario Municipal Employees Retirement System, has signed an agreement to acquire a 34.6 per cent stake in a liquified natural gas company based in Chile.

The remaining stakeholders in GNL Quintero S.A. include Enagás, a large builder and operator of regasification plants and pipeline systems and Empresa Nacional del Petróleo, Chile’s state-owned energy company. As part of the transaction, OMERS has agreed to grant Enagás a 12-month call option for five per cent of its shares.

“Today marks not only our first direct infrastructure investment in Chile, but also signals our entrance into South America,” said Ralph Berg, executive vice-president and global head of infrastructure at OMERS Private Markets.

“GNLQ is a well-managed, world-class asset that aligns closely with our ongoing effort to diversify our global portfolio of core infrastructure holdings — and pay pensions to our members. We look forward to working constructively with our fellow GNLQ shareholders, GNLQ management and all local stakeholders in the years ahead.”

Located northwest of Santiago, Chile, GNLQ is a land-based terminal dedicated to the receiving, unloading, storage and regasification of up to 15 million cubic meters per day of liquefied natural gas. It’s focused on providing clean, efficient and safe energy to markets, which include residential and industrial users, power generators and the transportation sector.

Since it commenced operations, GNLQ has served nine gas-fired power plants, two refineries, 450 industries, more than 700,000 commercial and residential customers and 7,000 commercial vehicles. As well, the terminal has dispatched more than 40,000 liquefied natural gas tanker trucks to serve customers that aren’t connected to the pipeline grid, through satellite regasification units located up to 1,000 kilometres away from the facility.

You can read OMERS’s press release on this deal here, but it basically goes over the same things mentioned above.

Canada’s large pensions have a long love affair with Chile. In fact, it was over ten years ago that a consortium led by Brookfield Asset Management, which included Canada Pension Plan Investment Board (CPPIB), British Columbia Investment Management Corporation (bcIMC) and another institutional investor, entered into a definitive agreement to acquire Transelec, the largest electricity transmission company in Chile, from Hydro-Quebec International Inc. for US$1.55 billion.

Ontario Teachers’ has major stakes in two Chilean water utilities and last year made a $1.35 billion bet on Latin American infrastructure in a partnership with CPPIB and Latin American infrastructure group IDEAL, an infrastructure development and operating company that is among the holdings of Mexican billionaire Carlos Slim.

That toll road deal was CPPIB’s first infrastructure investment in Mexico, but there are others in South America including two in Chile, and a gas pipeline in Peru.

Back in 2012, CPPIB committed $1.14 billion to acquire about half ownership in five major toll roads in Chile, part of its strategy of making long-term investments to support future benefit payments.

In early 2016, Alberta’s AIMCo sold its stake in a Chilean toll highway for about $1.5-billion to its partner. AIMCo bought a 50 per cent interest in Autopista Central de Chile in late 2010 for $878-million and made a great return on it.

So what is it about Chile that attracts so much attention from Canada’s large pensions? For this, let’s examine a recent article by Nathaniel Parish Flannery of Forbes, How Will Chile’s Economy Perform In 2017?:

Since the 1990s Chile has earned a reputation for being the best managed economy in Latin America. Policymakers built up strong institutions, developed new industries and helped foster more than two decades of impressive growth. Although copper mining is still the backbone of Chile’s economy companies such as FirstSolar and SunEdison have invested heavily in the country’s burgeoning solar energy sector.

Still despite its sizable upside, Chile is still defined by extraordinarily high levels of inequality and in recent years has been rocked by a number of massive and sometimes violent protests. Voters have grown disenchanted with current left-of-center president Michelle Bachelet (who also served a previous term as president from 2006 to 2010). Voters will elect Chile’s new president in November 2017. With Bachelet so unpopular right now the election will be worth watching. Voters could choose right-of-center billionaire businessman Sebastian Piñera who served as president from 2010 to 2014 and placed his assets  in a blind trust. (Forbes estimates Piñera’s assets are worth $2.7 billion. He is the wealthiest top-level politician in Latin America.)

With so much unrest bubbling under the surface of Chile’s well-polished veneer of stability and civility, voters could also turn to a candidate who is more independent from the political establishment. Already this year companies such as BHP Billiton have been affected by labor unrest and a longstanding conflict with the country’s Mapuche indigenous group continues to simmer. To get a sense of what people can expect from Chile’s economy in 2017, I reached out to Michael Baney, a Latin America expert and senior analyst at Allan & Associates, a boutique political risk consultancy.

Nathaniel Parish Flannery: What can we expect in terms of GDP growth in Chile this year? Some economists are estimating growth is going to be a bit slower than what we’ve seen over the last few years. Do you seen any causes for concern?

Michael Baney: A few days ago, Chile’s central bank revised its growth projection range down to 1% to 2%, largely based on concerns over the impact of a recent strike at Escondida, the world’s largest copper mine. Chile’s economy is heavily dependent production and export of the red metal: copper and copper products account for just under half of its exports, with China being by far its largest trading partner.

Even if growth in Chile reaches 2% this year, it would still be far more sluggish than what was seen during the height of the global commodities boom. Back in 2004, growth reached 7%, for example, and after it dipped during the financial crisis, it recovered to 5.8% in 2011 and 2012.

Such were the boom days for Chile and much of Latin America, a key source of raw materials. Those days are definitively over, however, and while 2% growth isn’t terrible for a country as wealthy as Chile, it will likely be some time before rates reach their former highs. One bright spot for Chile is that the copper glut appears to be coming to an end, which may attract further mining investment, although part of the reason for the recent increase in copper prices is concerns about labor unrest in Chile itself.

Parish Flannery: Chilean voters are going to head to the ballot box again. What’s at stake in the upcoming election? Do you think we are going to see a surprise ending?

Baney: The past year has been marked by major protests against the administration of President Michelle Bachelet, whose approval ratings have hovered around 25%. Bachelet can’t run again this year, and probably wouldn’t want to even if she could. While the country has yet to hold primary elections, leftist senator Alejandro Guillier and conservative former president Sebastián Piñera are shaping up to be the main two contenders for the presidency. Piñera has led in several polls, but after Brexit, the Colombian peace referendum, and the election of Donald Trump, I think we’ve all learned to be somewhat skeptical of political polling data.

One thing to watch is the congressional elections. Chile used to have a strange electoral system that had the effect of deadlocking the congress between the two main coalitions no matter who won the most votes. A constitutional reform made with the intent of finally completing Chile’s long transition to full democracy abolished that system, however, and this will be the first congressional election run without it.

Interestingly, the election comes at a time when party affiliation is at a low and general disgust with politics is at a high. While we may not see any surprises during this electoral cycle, the reform would make it easier for an anti-system populist from outside the two main coalitions to gain a foothold in congress, much like has been seen elsewhere in the world. It would be ironic if the reform meant to fully democratize Chile helped lead to the rise of a candidate with questionable respect for democratic institutions.

Parish Flannery: As we look ahead in 2017 are there any particular political risk flash-points that you think merit attention?

Baney: The past month has seen a major escalation of the conflict between the state and radical Mapuche groups. The Mapuche are an indigenous group in who live in the heart of southern Chile’s timber region, and some Mapuche organizations have hijacked logging trucks, burned millions of dollars’ worth of equipment and structures, and threatened to attack hydroelectric dams. A few weeks ago, one Mapuche group destroyed 19 parked trucks, a warehouse, and several pieces of industrial equipment owned by a logistics company in what was the most significant such attack the country has seen in decades. Chile has a reputation for being among the safest and most stable countries in Latin America, but it is far from being without risks.

Chile does have a great reputation but this article highlights the main risks of investing in infrastructure in Latin America or elsewhere, namely, political and regulatory risks.

We all remember the boom-bust story of Brazil. In 2013, I asked whether Eike Batista burned Ontario Teachers’ and a year later, I covered CPPIB’s risky bet on Brazil. Whether it’s Brazil, Mexico, Columbia, Chile, Peru or Argentina, investing in Latin America is risky business. You absolutely need the right partners to deal with thorny political and regulatory risks.

But there’s no denying that things are changing for the better in Latin America where growth projections and inflation expectations are relatively high compared to the G7 developed economies.

Still, there is cause for concern. Emerging markets in Latin America are inextricably linked to China and there are economic and demographic factors that can hamper future growth. In his new book, behind Upside: Profiting From the Profound Demographic Shifts Ahead, demographer Kenneth W. Gronbach outlines some of his concerns:

Gronbach also looks at trends shaping the rest of the planet. He offers a fascinating analysis on China, including the problem of a profound gender imbalance with far more men than women. He expresses concern over the impact of aging rates in Latin America. Access to information is a global shift —in the era of Big Data, we have more power than ever to read the numbers as we chart our future course. Gronbach is a well qualified, highly engaging guide.

I’ve covered Chile’s Pension Crunch when I went over the global pension crunch last year. These are serious structural issues that Chile and others need to address or else they will impact long-term growth.

What else concerns me? Samuel Gregg of the American Spectator reports the model in Chile is under siege:

Whenever anyone thinks of economic success stories, Latin America doesn’t exactly leap to mind. For the most part, modern Latin American economies have been characterized by corruption, cronyism, statism, populism, boom-bust cycles, failed reform efforts, and colossal meltdowns. There is, however, one major exception to that rule — Chile.

Beginning with General Pinochet’s military regime in 1973 and continuing after the 1990 transition to democracy, Chile’s economy underwent significant liberalization. Today, Chile is officially classified as a developed country. And the benefits have encompassed the less well-off. As the World Bank stated in 2016:

The percentage of the population considered poor (those who live on US$ 2.5 per day) declined from 7.7 percent in 2003 to 2.0 percent in 2014, and moderate poverty (US$ 4 per day) fell from 20.6 percent to 6.8 percent during the same period. Moreover, between 2003 and 2014, the average income of the poorest 40 percent of the population increased by 4.9 percent, a figure considerably above the average income growth of the population as a whole (3.3 percent).

Some nations would kill for these numbers. They are primarily the result of Chile embracing free trade, labor market deregulation, anti-inflationary policies, large-scale privatizations, and strong private property protections.

Undergirding this has been the long-term commitment by intellectuals, such as those associated with the think-tank Libertad y Desarrollo, to making tough-minded and in-depth arguments for market economies and their institutional prerequisites such as rule of law. Above all, many Chileans decided decades ago to stop blaming “the North” and mysterious “interests” “out there” for the country’s problems.

All these hard-won achievements, however, are now under threat. Since 2014, President Michelle Bachelet’s center-left administration has sought to undermine what Chileans call “the model.”

In the name of equality (by which they mean the equalization of starting points and results), Bachelet’s government is trying to turn Chile into a European social democracy. The fact that social democracies are faltering everywhere in Western Europe isn’t, apparently, a relevant consideration.

As I learned during a recent visit to Chile, the word used to describe this dismantling project is retroexcavadora (literally, “backhoe”). It was first used by a left-wing senator, Jaime Quintana, in March 2014 to explain how the government would root out the Chilean model’s political and economic foundations.

In 2016, for example, Chile’s labor market laws were changed to make it harder for businesses to let employees go. The same legislation forbids companies from extending benefits to workers who don’t belong to unions. It also privileges unions as the main bargaining unit, regardless of whether individual workers actually want to belong to them. So much for the right of free association. Instead, it’s back to the redundant “capital-and-labor” logic of the 19th century.

Chile’s educational institutions are also under assault. This involves a concerted drive by Bachelet’s government to undercut a largely user-pays, demand-driven higher education system. The goal is to extend “free” higher education to ever-increasing numbers of students. How this “free” learning will be paid for is, at best, unclear.

Accompanying this measure are efforts to diminish parental choice, private schools, and Chile’s voucher system. Vouchers, it appears, have produced good outcomes for Chilean students across socioeconomic levels. They have also boosted private school attendance. By 2011, about 40 percent of Chilean students from the lower income bracket went to private schools.

Again, however, what matters to the Chilean left is the ideological priority of equalization and its distrust of non-public institutions. Free choice is out. Leveling down is in.

The Bachelet government’s number-one target, however, is Chile’s constitution. First approved via referendum in 1980 and considerably modified through referenda and legislation since then, the Chilean left has never accepted its legitimacy. That’s partly because the constitution was implemented under Pinochet. But it’s also because Chile’s constitution limits state power in ways which are anathema to the left.

Their long-term goal is a new constitution: one that waters-down the present constitution’s strong guarantees of private property and the commitment to the Catholic principle of subsidiarity, which pervades the text. Subsidiarity’s decentralizing implications are especially important, because they ensure that Chile’s constitution attaches a higher premium to limited government than your average Latin American country.

There’s considerable evidence that Bachelet’s government is trying to rig the consultative process for the drafting of a new constitution. Moreover, based upon what Bachelet ministers have said, their preferred arrangements would take Chile closer to the constitutions adopted by left-populist governments in countries like Ecuador and Bolivia in recent years. A quick glance at these documents soon indicates that they are the polar opposite of Chile’s present constitutional provisions — not least because they amount to institutionalized populism.

Retroexcavadora, however, is now encountering problems. Just five minutes of conversation with Chilean parents soon reveals just how they resent the government’s willingness to sacrifice educational choice and quality of education to the god of equality. Angry parents means angry — and motivated — voters.

Another difficulty is that President Bachelet herself is caught up in a series of corruption scandals involving family members. Although Bachelet was once very popular, her approval ratings presently linger in the mid-20 percentiles.

Nor is a perceptible decline in economic conditions helping Bachelet’s government. Chile’s unemployment rate, for instance, is now 6.4 percent. That’s up from 5.8 percent a year ago. In 2016, the Chilean economy expanded at the anemic European-like growth-rate of 1.6 percent, down from 2.3 percent in 2015. This year’s growth projections aren’t that great either.

The question of whether retroexcavadora succeeds, however, ultimately depends on presidential and legislative elections due at the end of 2017. The constitution bars Bachelet from seeking another consecutive term. But it does allow her predecessor, the conservative pro-market Sebastian Pinera, to run. And running he is.

It’s too early to predict the likely outcome. Yet one thing is certain. If Chilean voters decide they want to maintain the model, Chile will continue to show that Latin America nations aren’t doomed to become Argentina, let alone left-populist disasters like Venezuela. On the other hand, if Chileans effectively endorse retroexcavadora, Latin America risks losing the example that shows the entire continent the politics and rhetoric of envy need not be its future.

For 647 million Latin Americans, the stakes couldn’t be higher.

As you can read, the stakes are high for this year’s elections in Chile, and you can be sure Canada’s large pensions will be following political developments there very closely.

However, as I keep stressing on this blog, Canada’s large pensions have a very long investment horizon, if they’re making long-term infrastructure investments in Chile, Mexico and elsewhere in Latin America, it’s because they believe they can manage the political, regulatory and currency risks and come out ahead as these investments will offer them stable returns over the long run.

I’ll put it to you this way, Canada’s large pensions aren’t buying infrastructure stakes in airports, ports, toll roads or natural gas, electric transmission utilities to flip them a year later. Sure, if some entity offers them an attractive price, they will sell these assets on occasion, but they typically want to keep them on their books for a long time because it’s part of their strategy to meet long-dated liabilities with as much certainty as possible.

OPTrust Launches People for Pensions?

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

Jann Lee of Benefits Canada reports, OPTrust shines spotlight on DB model with new campaign:

The OPSEU Pension Trust has launched People for Pensions, an online campaign encouraging its plan members to become informed about defined benefit pension plans and how they support the economy.

People have shifted from having a mindset of pension envy to one where they yearn for financial security but don’t necessarily see the value of a defined benefit plan, says Hugh O’Reilly, president and chief executive officer at OPTrust. He notes the campaign is a chance for plan members to not only educate themselves about defined benefit plans but also share knowledge with colleagues, friends and family.

While most plan members value their plan, there’s still those who don’t understand the multiple benefits a defined benefit model brings and how it compares to other retirement savings vehicles, such as registered retirement savings plans and defined contribution plans, notes O’Reilly.

According to the People for Pensions website, OPTrust will communicate with members through the website, an email newsletter and social media channels, such as Facebook and Twitter. The campaign is also led by a representative from OPTrust who will make several workplace presentations across the province.

While the campaign isn’t necessarily targeted to younger employees, it’s designed to be modern and accessible, says O’Reilly. “It’s an opportunity to educated anyone who’s interested [in the issue]. Our whole organization is member-driven and they believe others should have what they have, a defined benefit plan.”

OPTrust put out a press release on its new “People for Pensions” program:

OPTrust launched the People for Pensions program last week to raise awareness about the overall value of defined benefit (DB) pension plans. Research has shown OPTrust members and retirees place a high value on their pensions and would like to know more about all the benefits of their pension plan.

The People for Pensions program shares information with members and encourages them to share it with their peers, friends and families. This information highlights the benefits of a defined benefit plan versus other kinds of retirement savings vehicles and how the defined benefit model supports the economy. In just three days, the community signed up more than 200 new members.

Members of a defined benefit pension plan can rely on a stable amount of pension income in retirement because payments are based on a formula using years of service, and are paid for life. Unlike retirement savings in a Defined Contribution plan that are directly impacted by ups and downs in the stock market, DB plans use a set formula to calculate pensions. DB plans make investment decisions over a long-term horizon and are structured to weather market volatility.

Any active member of the OPSEU Pension Plan can be a People for Pensions member. Retirees who are drawing a pension from the OPSEU plan and members who are entitled to a future pension can also become a member of the program. Interested people can sign up at www.peopleforpensions.com or call the community lead at 1-800-906-7738 ext 3052.

OPTrust will send information about the defined benefit pension model which program members can, in turn, discuss with their co-workers and others as they see fit. Some people may want to use the information in casual conversations while others may choose to share the information through their own social media channels.

“In addition to providing great service to our members, we are creating conversations that are intended to lead to better retirement incomes for all. Workplace pensions are an integral part of the retirement landscape in Canada but they must be nurtured and sustained,” said Hugh O’Reilly, President and CEO of OPTrust. “This is part of our work of being a Pension Citizen.”

About OPTrust

With net assets of $19 billion, OPTrust invests and manages one of Canada’s largest pension funds and administers the OPSEU Pension Plan, a defined benefit plan with almost 90,000 members and retirees. OPTrust was established to give plan members and the Government of Ontario an equal voice in the administration of the Plan and the investment of its assets through joint trusteeship. OPTrust is governed by a 10-member Board of Trustees, five of whom are appointed by OPSEU and five by the Government of Ontario.

It’s funny, this morning I was thinking how nice it would be to create an App on pensions so people can truly understand the differences between investing in a defined-contribution plan as opposed to a defined-benefit plan.

Part of good governance on pensions — and I know all about this topic, perhaps more than I’d like to know — is communication. It’s the responsibility of the board of directors and senior management to communicate effectively and on a regular basis the activities at their pension.

Here, OPTrust is taking it a step further, openly encouraging its members to educate themselves on the benefits of well-governed defined-benefit plans and to share information with other members.

Let’s face it, most members of any pension plan don’t really have a clue of what’s going on at their pension. They typically only inform themselves when something is drastically wrong, placing their pension benefits at risk.

I always tell my readers to think about pensions this way: pensions are all about managing assets and liabilities. You first need to understand the liabilities and the factors that impact them and then figure out a long-term strategy to meet these long-dated liabilities with as much certainty as possible.

Hugh O’Reilly, President and CEO of OPTrust, knows all this. He penned an op-ed comment with Jim Keohane, President and CEO of HOOPP, Looking for a better measure of a pension fund’s success, underscoring the need to place a pension’s funded status front and center when looking at its success.

This is why OPTrust is changing the conversation, focusing more on its funded status when delivering its annual results. Others like HOOPP, Ontario Teachers’ and OMERS are also emphasizing their funded status when discussing their annual results.

It’s important to remember that HOOPP, OMERS, OTPP and OPTrust are all pension plans which manage assets and liabilities. HOOPP and OTPP have adopted a shared-risk model which effectively means when their plan runs into a deficit, the risk is equally shared among the plan’s sponsor and its members. In the past, when OTPP and HOOPP were underfunded, they raised contributions or cut benefits (typically cut full inflation protection to offer partial indexation until their plan was fully funded again).

OPTrust and OMERS guarantee full indexation, which places an added burden on them to achieve fully funded status when their respective plan experiences a shortfall. They can raise contributions on active members but they try to avoid this as much as possible to maintain inter-generational equity.

In others words, there is no shared-risk model at OPTrust and OMERS, much to their detriment even if their retired members are happy knowing they don’t need to share the burden if their plan experiences a deficit.

What about AIMCo, bcIMC, CPPIB, PSP and the Caisse? They are large pension funds managing the assets of their plan members taking into consideration their liabilities which are determined by the plan’s actuaries. In other words, liabilities figure into their investment decisions but they manage assets only, not the liabilities.

It’s a bit confusing but one thing Canada’s large defined-benefit pensions all have in common is great governance separating government from their investment decisions allowing them to attract and retain very talented staff across public and private markets which in turn allows them to invest more of the assets directly, lowering overall cost of operations.

What else do Canada’s large, well-governed DB pensions have in common? They all believe in the benefits of DB pensions and are particularly aware of the brutal truth on DC plans.

I would go a step further. In my last comment I touched upon America’s growing retirement angst and someone sent me another great comment on financial insecurity gripping the nation.

Clearly the private sector solution is leaving far too many people behind. It’s not just that people are failing to save for retirement, the actual structure of their retirement leaves them far too vulnerable to the vagaries of markets.

Again, very briefly, the benefits of large public defined-benefit plans which are all ideally backed up by the full faith and credit of the federal government are:

  1. Companies can focus on their core business, not pensions.
  2. Pensions will be portable no matter where you work (private and public sector)
  3. DB pensions pool investment and longevity risk so members are not impacted by a bad bear market and will never outlive their savings
  4. Ability to invest directly in public and private markets, not only lowering costs, but also taking advantage of a pension’s long investment horizon.
  5. Ability to invest with the very best managers across public and private markets all over the world.
  6. Members can be assured they will get their pension promise fulfilled and plan their retirement with the peace of mind of knowing they won’t succumb to pension poverty.
  7. The direct and indirect benefits to the overall economy from these large DB pensions cannot be overlooked. They create good paying jobs and by fulfilling their plan’s mission, their members can spend accordingly during retirement, allowing governments to collect more income and sales taxes. In other words, good pension policy that bolsters DB plans makes good economic policy because it lowers social welfare costs, increases aggregate demand and government revenues.

All this to say I wish OPTrust lots of success with their new “People for Pensions” program and hope others follow suit. Get the word out, educate people on the benefits of DB pensions (one lonely blogger can’t do it all by himself).

CalPERS State Rate Doubles in Decade to $6 Billion

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

The annual cost of state worker pensions would increase to $6 billion in July in a recommendation from CalPERS actuaries, up $521 million from the current fiscal year and double the amount paid a decade ago.

School districts would pay $2 billion next year for the pensions of non-teaching employees, up $342 million from the current fiscal year and also double the amount paid a decade ago.

California Public Employees Retirement System rates, already at an all-time high, will continue to climb for at least another half dozen years as the last of four rate increses enacted since 2012 are phased in.

The nation’s largest public pension system is in a bind.

As rates go up, the investment earnings expected to pay nearly two-thirds of future pension costs are expected to go down. In February, CalPERS lowered its long-term annual earnings forecast from 7.5 to 7 percent.

The CalPERS investment fund was valued at $315.5 billion Monday. But like many pension systems, CalPERS has not recovered from huge investment losses during the financial crisis, when its fund plunged from $260 billion in 2007 to $160 billion in March 2009.

State worker pension funds had an average of 65 percent of the projected funds needed to pay future pensions last June, according to the new actuarial valuation expected to be approved by the CalPERS board next week.

The California Highway Patrol was the most troubled of the six state worker funds in the report, only 58.5 percent funded. Experts have told CalPERS that falling below 50 percent makes recovery very difficult, if not impractical.

A generous “3 at 50” pension formula negotiated by the Highway Patrol union and approved in landmark CalPERS-sponsored legislation, SB 400 in 1999, provides 3 percent of final pay for each year served at age 50, capped at 90 percent of pay.

The “3 at 50” formula was widely adopted by local police and firefighters. Critics say the high cost of pensions for crucial safety workers, who are a large part of local government budgets, is one of the reasons retirement costs are crowding out funding for basic services.

In 2007 the rate paid by the state for Highway Patrol pensions was 32.2 percent of pay. The Highway Patrol rate recommended for the new fiscal year beginning in July is 54.1 percent of pay. By 2023 the Highway Patrol rate is projected to be 69 percent of pay.

The miscellaneous rate for most state workers in 2007 was 16.6 percent of pay. The recommended miscellaneous rate for next fiscal year is 28.4 percent of pay, projected to increase to 38.4 percent of pay in 2023.

Highway Patrol members contribute 11.5 percent of pay to their pensions and do not receive Social Security. Miscellaneous members, who do receive Social Security in addition to their pensions, contribute 6 to 11 percent of pay, many of them at 8 percent.

A cost-cutting pension reform requires state workers hired after Jan. 1, 2013, to work two years longer to receive the same pension benefit as previously hired workers. Due to their union clout or other factors, state workers are exempt from a reform cost-sharing requirement.

The reform requires new hires in CSU, the California State Teachers Retirement System, 21 independent county systems, and CalPERS school plans to pay half the “normal” cost of their pensions, excluding the now large debt or “unfunded liability” from previous years.

As new hires fill positions, the reform is expected to curb growing pension costs, but significant results are likely years away (see Los Angeles Times/CalMatters analysis). Meanwhile, CalPERS state rates will continue to climb.

In 2007 the state paid CalPERS $2.7 billion, less than half the $6 billion recommended for the new fiscal year. School districts and other education employers paid CalPERS $920 million in 2007, less than half the $2 billion recommended for the new year.

School districts pay a higher rate for non-teaching employees in CalPERS than for teachers in CalSTRS. And unlike teachers, non-teaching school employees receive Social Security in addition to their pensions.

The CalPERS rate recommended for non-teaching school employees next fiscal year is 15.5 percent of pay. Last week the CalSTRS board approved a rate of 14.4 percent of pay for teachers in the new fiscal year.

Under a funding plan enacted by legislation three years ago, the CalSTRS rate for teachers will reach 19.1 percent of pay in 2020. The CalPERS non-teaching rate is projected to be 23.8 percent of pay in 2020 and 27.3 percent in 2023.

The pension rate hikes will take a big bite out of school district budgets. In 2013 the combined rate was 19.65 percent of pay (CalPERS 11.4, CalSTRS 8.25). In 2020 the combined rate is expected to be 42.9 percent of pay.

Teachers pay more toward their pensions than non-teaching school employees. Teachers hired before the reform contribute 10.25 percent of their pay to CalSTRS. Non-teaching school employees hired before the reform contribute 7 percent to CalPERS.

The CalPERS rate for new non-teaching school employees hired after the 2013 reform is recommended to increase to 6.5 percent of pay in the new fiscal year, up from 6 percent. The CalSTRS rate for new teachers, 9.2 percent of pay, is not expected to increase until 2018.

CalPERS rate increases began in 2012 when the earnings forecast used to discount future pension costs was dropped from 7.75 percent to 7.5 percent. An actuarial method that no longer annually refinances debt was adopted in 2013.

A rate increase for a longer retiree life expectancy adopted in 2014 is still being phased in. One of the reasons listed for the CalPERS school rate increase next fiscal year is “the second year of a 5-year phase in of 2014 change in assumptions.”

And one of the reasons for the CalPERS state worker rate increase is the first year of a three-year phase in of lowering the discount rate from 7.5 to 7 percent. The discount rate next fiscal year is 7.375 percent.

Yet another complication is a five-year phase in of the rate increase resulting from the lower discount rate. As a result, the new actuarial report can project annual rates through 2023.

New actuarial valuations recommending rate increases for the pension plans of 1,581 local governments are expected this fall. The cities, counties and special districts in CalPERS have a wide range of funding levels.

This week Marc Joffe of the California Policy Center issued an updated report saying local governments will pay about $5.3 billion to CalPERS in the new fiscal year. He projects the payments to CalPERS will rise to $9.8 billion in fiscal 2022-23, an increase of 84 percent.

“In Fiscal Year 2015-16, at least 26 California cities and counties devoted over 10 percent of their total revenue to pension contributions,” said Joffe’s report.

“San Rafael, San Jose and Santa Barbara County shouldered the highest pension burdens — exceeding 13 percent of revenue. Major local governments that have recently surpassed the 10 percent pension contribution of total revenue threshold include Contra Costa County, Berkeley and Newport Beach.”