Friday, December 2, 2016

Institutions Piling Into Illiquid Alternatives?

BusinessWire reports, World’s Largest Institutional Investors Expecting More Asset Allocation Changes over Next Two Years Than in the Past:
Institutional investors worldwide are expecting to make more asset allocation changes in the next one to two years than in 2012 and 2014, according to the new Fidelity Global Institutional Investor Survey. Now in its 14th year, the Fidelity Global Institutional Investor Survey is the world’s largest study of its kind examining the top-of-mind themes of institutional investors. Survey respondents included 933 institutions in 25 countries with $21 trillion in investable assets.

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

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

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

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

Primary concerns for institutional investors

Overall, the top concerns for institutional investors are a low-return environment (28 percent) and market volatility (27 percent), with the survey showing that institutions are expressing more worry about capital markets than in previous years. In 2010, 25 percent of survey respondents cited a low-return environment as a concern and 22 percent cited market volatility.
“As the geopolitical and market environments evolve, institutional investors are increasingly expressing concern about how market returns and volatility will impact their portfolios,” said Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation. “Expectations that strengthening economies would build enough momentum to support higher interest rates and diminished volatility have not borne out, particularly in emerging Asia and Europe.”

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

Continued confidence among institutional investors

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

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

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

Improving the Investment Decision-Making Process

There are a number of similarities in institutional investors’ decision-making process:
  • Nearly half (46 percent) of institutional investors in Europe and Asia have changed their investment approach in the last three years, although that number is smaller in the Americas (11 percent). Across the global institutional investors surveyed, the most common change was to add more inputs – both quantitative and qualitative – to the decision-making process.
  • A large number of institutional investors have to grapple with behavioral biases when helping their institutions make investment decisions. Around the world, institutional investors report that they consider a number of qualitative factors when they make investment recommendations. At least 85 percent of survey respondents say board member emotions (90 percent), board dynamics (94 percent), and press coverage (86 percent) have at least some impact on asset allocation decisions, with around one-third reporting that these factors have a significant impact.
“Institutional investors often assess quantitative factors such as performance when making investment recommendations, while also managing external dynamics such as the board, peers and industry news as their institutions move toward their decisions. Whether it’s qualitative or quantitative factors, institutional investors today face an information overload,” said Couto. “To keep up with the overwhelming amount of data, institutional investors should consider revisiting and evolving their investment process.

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

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

About the Survey

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

About Fidelity Institutional Asset Management℠

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

About Fidelity Investments

Fidelity’s mission is to inspire better futures and deliver better outcomes for the customers and businesses we serve. With assets under administration of $5.5 trillion, including managed assets of $2.1 trillion as of October 31, 2016, we focus on meeting the unique needs of a diverse set of customers: helping more than 25 million people invest their own life savings, nearly 20,000 businesses manage employee benefit programs, as well as providing nearly 10,000 advisory firms with investment and technology solutions to invest their own clients’ money. Privately held for 70 years, Fidelity employs 45,000 associates who are focused on the long-term success of our customers. For more information about Fidelity Investments, visit
Sam Forgione of Reuters also reports, Institutions aim to boost bets on hedge funds, private equity:
The majority of institutional investors worldwide are seeking to increase their investments in riskier alternatives that are not publicly traded such as hedge funds, real estate and private equity over the next one to two years to combat potential low returns and choppiness in public markets, a Fidelity survey showed on Thursday.

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

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

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

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

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

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

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

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

U.S. public pension plans, on average, had about 12.1 percent of their assets in real estate, private equity and hedge funds combined as of Sept. 30, according to Wilshire Trust Universe Comparison Service data.
And Jonathan Ratner of the National Post reports, Low returns, high volatility top institutional investors’ list of concerns:
Low returns and market volatility topped the list of concerns in Fidelity Investments’ annual survey of more than 900 institutional investors with US$21 trillion of investable assets.

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

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

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

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

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

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

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

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

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

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

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

He noted that with the Federal Reserve expected to produce its first rate hike in 12 months, it’s understandable why many U.S. investors are hitting the pause button when it comes to asset allocation changes.
On Thursday, I had a chance to speak to Derek Young, vice chairman of Fidelity Institutional Asset Management and president of Fidelity Global Asset Allocation. I want to first thank him for taking the time to go over this survey with me and thank Nicole Goodnow for contacting me to arrange this discussion.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In terms of illiquid alternatives, we both agreed illiquidity doesn't mean there are less risks. That is a total fallacy. I told him there are four key reasons why Canada's large pensions are increasing their allocations to private market investments:
  1. They have a very long investment horizon and can afford to take on illiquidity risk.
  2. They believe there are inefficiencies in private markets and that is where the bulk of alpha lies.
  3. They can scale into big real estate and infrastructure investments a lot easier than scaling into many hedge funds or even private equity funds.
  4. Stale pricing means that private markets do  not move in unison with public markets, so it helps boost their compensation which is based on four-year rolling returns (privates dampen volatility of overall returns during bear markets).
Sure, private markets are good for beneficiaries of the plan, especially if done properly, but they are also good for the executive compensation of senior Canadian pension fund managers. They aren't making the compensation of elite hedge fund portfolio managers but they're not too far off.

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

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

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

Below, Ian Lyngen, BMO Capital Markets head of US rates, discusses the outlook for the US bond market with Bloomberg's Vonnie Quinn and David Gura on "Bloomberg Markets."

Thursday, December 1, 2016

Addressing The UK's Pension Crisis?

The Mail Online reports, Pension funding deficits 'nearly a third of UK GDP':
Britain's mammoth funding gap for gold-plated company pensions stands at nearly a third of the country's economic output despite a £50 billion boost in November.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In her comment to the Guardian, pension expert Ros Altmann writes, There are fairer ways to set the pension age – but politicians are ducking them:
Younger generations are being told to prepare to wait even longer for their pensions, with former minister Steve Webb suggesting that the retirement age for a state pension will rise to 70.

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

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

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

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

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

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

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

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

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

Raising the state pension age is rather a crude measure for managing old-age support in the 21st century.
In her insightful comment, Ros Altmann shows why raising the pension age, while politically expedient, can be detrimental and devastating to certain socioeconomic cohorts, including people suffering from an illness and many women relying on their state pension to survive in their golden years.

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

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

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

For UK pensions that didn't hedge currency risk -- and I'm not sure on the figures but the majority don't hedge currency risk -- they took a huge hit on their foreign bond, stock, real estate and other assets just on the devaluation of the British pound. So if interest rates didn't rise and instead declined, those pension deficits would have been far, far worse.

And it's not just currency risk plaguing UK pensions. Cambridge Associates has come out with a new study which states many pension funds will struggle to close their funding gap unless they reduce their on public equities and other liquid assets:
Pension funds are too focused on holding liquid assets to the detriment of the long-term health of their investment portfolio, according to research by Cambridge Associates, the global provider of investment services. If they considered switching from liquid public equities to illiquid private investments, they could improve their chances of closing the funding gap and reduce the likelihood to requiring additional capital injections to honour their commitments to pension fund members.

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

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

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

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

A New Solution: The "Barbell Approach"

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

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

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

The Challenges of the Barbell Approach

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

The other requirement is astute manager selection. "Finding high quality managers is not easy," said Mr Koriath. "At Cambridge Associates, we track more than 20,000 funds across all private investments and in any given year we only see about 200 that merit our clients' capital." But the benefits of getting it right in private investments are substantial. Over a 10-year time frame, the annual difference between the top and bottom quartile managers of public equities is about 2 per cent. By contrast, for private equity and venture capital managers, the annual difference is as large as 12-18 per cent.
Obviously Cambridge Associates is talking up its business, after all, it is in the business of building customized portfolios for clients looking to allocate in alternative investments like private equity, real estate and hedge funds.

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

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

Lastly, one group that's not suffering from pension poverty in the UK is company directors. Carolyn Cohn of Reuters reports, Majority of UK pension funds say executive pay too high-survey:
Eighty-seven percent of UK pension funds say executives at UK listed companies are paid too much, a survey by the Pensions and Lifetime Savings Association said on Thursday, as Britain proposes changes to the way companies are run.

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

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

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

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

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

The PLSA's members include more than 1,300 UK pensions schemes with 1 trillion pounds in assets.
What this article doesn't mention is that pension perks are increasingly a huge part of executive compensation in the UK, US and elsewhere. Corporate directors are padding the pensions of executives which are often based on their overall compensation, which is surging.

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

Below, a short Mirror clip on what is the new benefit cap and how it will affect UK citizens.

And former pensions minister Ros Altmann talked about changes to women's pension age - going upwards - to equalize with men back in February. Listen to her comments.

If you ask me, someone is getting the short end of the stick on these UK pension reforms and it isn't the corporate elites. I foresee a UK pension revolt in the not too distant future.

Wednesday, November 30, 2016

Liquidations Hurting Hedge Funds?

Amy White of Chief Investment Officer reports, How Liquidations Hurt Hedge Fund Returns (h/t, Ken Akoundi, Investor DNA):
It’s not just pension funds that have to worry about liability risks.

Hedge funds with high exposures to funding level risks “severely underperform” less exposed funds, according to research from the Copenhagen Business School.

“A good hedge fund follows alpha-generating strategies and simultaneously manages the funding risk that arises from the liability side of its balance sheet, that is, the risk of investor withdrawals and unexpected margin calls or increasing haircuts,” wrote PhD candidate Sven Klinger.

“If not managed properly,” he continued, “these funding risks can transform into severe losses because they can force a manager to unwind otherwise profitable positions at an unfavorable early point in time.”

At a time when many institutional investors are pulling out of hedge funds, proper management of liability risk is particularly essential—and failure to manage those risks can lead to a slippery slope, Klinger argued.

“If a fund generates higher losses than expected, investors get concerned about the possibility of unexpected future losses,” he wrote. “These concerns lead a fraction of the investors to withdraw their money from the fund, which, in turn, causes further losses for the bad fund.”

For the study, Klinger analyzed hedge fund returns between January 1994 and May 2015 using data from the TASS hedge fund database. He found that funds with low exposures to common funding shocks earned a monthly risk-adjusted return of 0.5%—while hedge funds taking higher liability risks earned zero risk-adjusted returns.

“Hedge funds that are exposed to more funding risk generate lower returns,” he wrote. “More precisely, hedge funds that generate lower returns when funding conditions deteriorate generate subsequent lower returns.”

These hedge funds also face larger withdrawals than hedge funds with lower exposure to liability risks, Klinger added—though they can temper risks by imposing strict redemption terms on investors.

“Higher risk should correspond to higher (expected) returns,” Klinger concluded. “Although this rule may hold for traded assets, it can be violated for hedge funds… a situation in which more risk-taking indicates less managerial skill.”

Read the full paper, “High Funding Risk, Low Return.”
There is nothing earth-shattering in these findings. Hedge funds have always been exposed to "redemption risk" which Klinger calls liability risk. The more concentrated a hedge fund is to any particular client, the higher the redemption risk, especially after a fund experiences significant losses.

A couple of months ago, I discussed why Ontario Teachers' cut allocations to computer-run hedge funds. A few hedge funds were forced to close shop after this move.

This is why most institutional investors cap their allocations to represent no more than 5% of the total assets under management and will typically never invest in any hedge fund where one client has more than  a 10% or 20% stake in the fund (I am giving you rough figures).

Obviously it varies and there are exceptions to this rule (like seeding a new fund) but why would anyone invest in a hedge fund knowing another big client can materially impact performance if they pull out? Also, from the hedge fund's standpoint, just like any business, it wants to properly diversify its client base so that it isn't exposed to liability risk if someone big pulls out.

But some hedge fund "superstars" have tight redemption clauses buying them time in case their performance gets hit. Case in point, Bill Ackman of Pershing Square.

Alexandra Stevenson and Matthew Goldstein of the New York Times recently reported, William Ackman’s 2016 Fortune: Down, but Far From Out:
William A. Ackman is a big-moneyed, swaggering hedge fund manager with a long list of accomplishments.

He played tennis against Andre Agassi and John McEnroe. He bought one of the most expensive apartments in Manhattan because he thought it would “be fun.” And three years ago, his hedge fund beat the competition to the pulp.

Now the silver-haired billionaire is on the verge of notching another accomplishment, but it is a dubious one. He is on pace to record a hefty double-digit loss for investors in his firm, Pershing Square Capital Management, for the second year in a row.

It is a rare accomplishment in hedge funds, as investors like public pension funds have grown impatient with disappointing returns and more than a handful of well-known firms have been forced to shut down as a result.

Yet Mr. Ackman is not like most of his peers. He has brushed off questions about whether his investors were worried and frustrated with his steep losses, countering that over time his firm had “a good batting average.” Together with his analysts, he told clients last week that the companies in which he has made big bold bets remain “unique,” “successful,” “fantastic” and “terrific.”

“We all know someone like him,” said Doug Kass of Seabreeze Partners Management, a small hedge fund firm. “Ackman is the smartest guy in the room who tells you he is the smartest guy in the room.”

It has helped that Mr. Ackman has structured Pershing Square so that investors have to wait as long as two years to take their money out. While some big investors have withdrawn their money recently, others believe that his firm will turn the corner.

The question is how much latitude investors will give to a man who fancies himself the next Warren E. Buffett. Over the last two years, investors have either withdrawn or announced plans to redeem more than $1 billion from his hedge fund, including New Jersey’s state pension fund, the Public Employees Retirement Association of New Mexico and the Fire and Police Pension Association of Colorado.

There is one mistake Mr. Ackman has admitted to making: Valeant Pharmaceuticals International. The drug company has come under political attack for its pricing policy and has faced regulatory scrutiny over its accounting practices. In April, Mr. Ackman was called to Washington to testify at a Senate hearing, where he was questioned over his aggressive support of the company. A flustered Mr. Ackman was forced to concede, “I regret that we didn’t do more due diligence on pricing.”

His investors have regretted it, too. Shares of the troubled pharmaceutical company have plunged to about $18 a share from the average $190 a share he said his firm paid in 2015 to acquire a big stake. As shareholders began to question the company and the stock plummeted, he bought a bigger stake in a show of confidence. Mr. Ackman has secured two board seats to try to position a turnaround.

“I have an enormous stomach for volatility,” he told an audience last week at the DealBook conference sponsored by The New York Times.

Privately, Mr. Ackman has told some investors that in six months or so, Valeant’s situation should start to look better as it sells off divisions to pay down debt obligations.

But now Pershing Square Holdings, a publicly traded version of his private hedge fund, is on course for a second year of double-digit annual loss and is currently down 20.7 percent, after dropping 20.5 percent last year. The losses are somewhat smaller at the private portfolios in his hedge fund in part because differences in leverage can magnify losses.

“He’s 50 years old. He has no boundaries to his ambitions,” said Ruud Smets of Theta Capital Management, an investment firm in the Netherlands. “So he is someone who will make his way back and is realistic about the mistakes he’s made and what they should do better,” he said, referring to Pershing.

Making its way back to positive territory will be challenging for Pershing, however. Its position in Valeant has helped wipe out a nearly 40 percent gain that the firm had in 2014.

Pershing started 2015 with more money than it had ever managed — $18.5 billion — including money raised from the public listing in Amsterdam of Pershing Square Holdings. Today the firm’s assets are down to $11.6 billion, and two years of losing performances threatens to chip away at Mr. Ackman’s reputation as one of the more successful investors in the $3 trillion hedge fund industry.

But Mr. Ackman has a knack for turning things around. He had to wind down his first hedge fund firm, Gotham Partners, after an investment in a golf course went sour. With Pershing, a remarkable run of lucrative payoffs from investments in General Growth Properties, the Howard Hughes Corporation and Canadian Pacific made him a celebrity and helped him raise huge sums of money from big state pension plans and other institutional investors.

And he can change. While he has long been known for favoring liberal causes and contributing mainly to Democrats, Mr. Ackman spoke glowingly of Donald J. Trump last week at the DealBook conference after his election.

“I woke up bullish on Trump,” Mr. Ackman said, surprising some in the audience. He clarified later in an interview that he was referring to Mr. Trump’s approach to the economy, adding, “I don’t agree with his views on immigration, on deportation and certain other social issues.”

His flexibility when it comes to national politics is at odds with the reputation he has earned at times of being a stubborn investor and a firm believer in his own views — qualities his Wall Street critics contend have informed his firm’s money-losing investment in Valeant.

Some on Wall Street have quietly compared him to another hedge fund hotshot, John Paulson, who made nearly $15 billion for his investors by betting on the collapse of the housing market during the financial crisis, but has struggled at times since then. Mr. Paulson’s firm now manages about $12 billion in assets, down from $36 billion five years ago.

Mr. Paulson, who is also bullish on Mr. Trump and was an economic adviser to him during the campaign, is the second-biggest shareholder in Valeant after Mr. Ackman.

But while predicting Mr. Ackman’s downfall has become something of a sport for some of his enemies on Wall Street, the prediction has yet to come true.

Over all, Mr. Ackman’s hedge fund firm has had more success than failure. Since 2004, the firm has registered nine winning years and four losing years, including the partial results for 2016. In four of those years, one of the firm’s main funds showed an annual gain more than 30 percent.

He also scored a moral victory this year with his bet against shares of the food supplement company Herbalife. The Federal Trade Commission took the company to task over its marketing and sale practices. The agency’s order endorsed many of Mr. Ackman’s claims that Herbalife had taken advantage of consumers, but regulators stopped short of declaring the company an illegal pyramid scheme, as Mr. Ackman had hoped.

Four years ago, Mr. Ackman announced at a conference that he had wagered $1 billion that Herbalife would either collapse on its own or be forced to close by regulators. But so far neither has happened, and Herbalife shares trade above the price they were at when he first disclosed his bearish trade.

“You can either view it as he has the courage of his convictions or he is being foolish,” said Damien Park, managing partner at Hedge Fund Solutions, who specializes in analyzing activist investors.

Still, some investors have put new money into Pershing Square recently. In August, Privium Fund Management, in a note to clients, said it had reinvested in Mr. Ackman’s publicly traded fund.

“He didn’t become stupid overnight,” said Mark Baak, a director at Privium, an Amsterdam-based investment firm that manages about $1.4 billion. “His prevailing track record wasn’t luck. Even if he was overrated prior to Valeant, he is still a very good investor.”

Maybe next year will be different for Mr. Ackman, who recently took a large stake in the burrito chain Chipotle Mexican Grill.

If nothing else, he will be on the move. His firm plans to relocate from its perch in Midtown Manhattan overlooking Central Park to a new office on the Far West Side near the Hudson River. Mr. Ackman’s new hedge fund home will be in Manhattan’s so-called auto dealership row.

One of the selling points of the new office is a rooftop tennis court that Mr. Ackman asked for.
I went over how Valeant (VRX) cost the hedge fund industry billions in my recent comment going over top funds' Q3 activity, noting there are some elite hedge funds that have followed Ackman buying big stakes in this pharmaceutical.

But thus far, it hasn't paid off for any of them as the stock is down 8% at this writing on Wednesday mid-day and is hovering near its 52-week low (click on image):

Like I stated, there is no rush to buy Valeant shares and I sure hope for the sake of Bill Ackman's investors that he turns out to be right on this company because from my vantage point, it still looks like a dog's breakfast.

I also noted the following in that comment going over top funds' activity in Q3:
In their Bloomberg article, Hedge-Fund Love Affair Is Ending for U.S. Pensions, Endowments, John Gittelsohn and Janet Lorin note the following:

While the redemptions represent only about 1 percent of hedge funds’ total assets, the threat of withdrawals has given investors leverage on fees.

Firms from Brevan Howard to Caxton Associates and Tudor Investment Corp. have trimmed fees amid lackluster performance.

William Ackman’s Pershing Square Capital Management last month offered a new fee option that includes a performance hurdle: It keeps 30 percent of returns but only if it gains at least 5 percent, according to a person familiar with the matter.

The offer came after Pershing Square’s worst annual performance, a net loss of 20.5 percent in 2015. Pershing Square spokesman Fran McGill declined to comment.

“They had a terrible year and they have to be extremely worried about a loss of assets under management,” said Tom Byrne, chairman of the New Jersey State Investment Council, which had about $200 million with Pershing Square as of July 31. “You’re losing clients because your prices are too high? Lower your price. That’s capitalism.”
Let me put it bluntly, Bill Ackman's fortunes are riding on Valeant, it's that simple. Luckily for him, he's not the only one betting big on this company. Legendary investor Bill Miller appeared on CNBC three days ago to say battered Valeant stock worth double the current price.
If Ackman is offering a new fee option that includes a performance hurdle, it's definitely because he's worried about big redemptions coming in before Valeant shares turn around (if they turn around).

When I was investing in hedge funds, I invested in directional hedge funds that were typically very liquid and didn't put up gates. Nothing pissed me off more than hearing some hedge fund manager recite lame excuses to explain his pathetic performance (and poor risk management).

Having said this, sometimes there are good reasons behind a hedge fund's bad performance and the illiquidity of the strategy might warrant investors to be patient and take a wait and see approach.

When Ken Griffin's Citadel closed the gates of hedge hell after suffering losses of 35% in its two core funds - Kensington and Wellington - during global financial crisis, I went on record stating investors who were redeeming were making a huge mistake because they didn't understand what was going on and why some of the strategies were getting clobbered after credit markets seized up.

Another example closer to home is Crystalline Management run by Marc Amirault, one of the oldest and most respected hedge funds in Canada. Its core convertible arbitrage strategy got whacked hard in 2008 and came roaring back the following year. There wasn't a market for these convertible bonds in the midst of the crisis and the fund's long-term investors understood this and stuck with it during this difficult time.

[Note: I recently visited the offices of Crystalline Management  and they told me there is some capacity left (roughly $50 million) in their core strategy which is up double-digits this year.]

Anyways, all this to say that there are no hard rules as to when to redeem, especially if you don't understand the drivers of the underperformance.

One last thought came to my mind. I remember Leo de Bever telling me that AIMCo offered its balance sheet to some external hedge funds to mitigate against the effects of massive redemptions during the crisis so that "funds wouldn't be forced to sell positions at the worst time."

I am not sure if this was actually done or if they were toying with the idea but it obviously makes sense even if it's a risky strategy during the thick of things.

Below, CNBC’s Gemma Acton discusses how CTA Strategies weighed on hedge returns in October. And Andrew McCaffery, global head of alternatives at Aberdeen Asset Management, talks about how hedge funds will prove their worth during a volatile 2017.

That all remains to be seen. One institutional hedge fund investor shared this with me today: "I think as everybody else, we're permanently exploring creative ways to ensure better commercial alignment of interest and improve capital efficiency." Well put.

Tuesday, November 29, 2016

Canada's Great Pension Debate?

In a response to Bernard Dussault, Canada's former Chief Actuary, Bob Baldwin, a consultant and former board of director at PSP Investments, sent me his thoughts on Bill C-27, DB, DC and target benefit plans (added emphasis is mine):
Bernard Dussault has circulated an article and slide presentation in which he has provided a endorsement of DB workplace pension plans coupled with an expression of concern about certain design features of DB plans that he sees as discriminatory. I share his preference for DB. But, I think his account of DB is incomplete and avoids certain issues and problems in DB that DB plan members, people with DB governance responsibilities and DB advocates should be aware of.

In his article “How Well Does the Canadian Landscape Fare?” Bernard says: “… DB plans offer better retirement security because they attempt to provide a predetermined amount of lifetime annual retirement income at an unknown periodic price.” The unknown nature of the price is unavoidable given the factors that determine the price that have magnitudes that cannot be foreseen such as: future wages and salaries, investment returns and longevity.
In context, two attributes of DB in its pure form are important to note. First, all of the uncertainty will show up in variable contribution rates and none in variable benefits. Second, the plan sponsor or sponsors have an unlimited willingness and ability to contribute more to the plan if need be.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The future of pensions will require bolstering defined-benefit plans, better governance and a shared-risk model, which is why pensions like OTPP, HOOPP, OMERS, OPTrust, CAAT and other pensions will be able to deliver on their promise while others will struggle and will face hard choices.
This means while I firmly believe the brutal truth on defined-contribution plans is they aren't real pensions and will lead to widespread pension poverty because they shift retirement risk entirely on to employees and that the benefits of defined-benefit plans are grossly underestimated, I also firmly believe that some form of shared-risk must be implemented in order to keep DB plans solvent and sustainable over the long run.

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

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

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

Now, Bernard Dussault shared this with me this morning:
I sense that the description of my proposed financing policy for DB pension plans deserves to be further clarified as follows:

My proposed improved DB plan is essentially the same as Bill C-27's TB plan except that under my promoted improved DB:
  1. Deficits affect only active members' contributions (via 15-year amortization, i.e. through a generally small increase in the contribution rate), and not necessarily the sponsor's contributions, as opposed to both contributions and benefits of both active and retired members under Bill C-27.
  2. Not only are contribution holidays prohibited, but any surplus is amortized over 15 years through a generally small decrease in the members' and not necessarily sponsor's contribution rate.
Therefore, my view is that if my proposed financing policy were to apply to DB plans, TB plans would no longer be useful. They would just stand as a useless and overly complex pension mechanism.
But Bob Baldwin makes a great point at the end of his comment:
Rather than mandate the banning of contribution holidays, an approach that would create downside protection without building up excess surplus would be to mandate the adoption of funding policies that prohibit the use of surplus to reduce contributions or increase benefits until threshold levels of surplus have been achieved. The threshold levels should take account of the riskiness of the pension fund’s investments and the maturity of the plan. Funding policies of this general sort have begun to emerge in large Canadian plans and should be made to be common practice.
Funding policies need to be mandated to prohibit the use of surpluses to reduce contributions or increase benefits until certain threshold elements of pensions are achieved.

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

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

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

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

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

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

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

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

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

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

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

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

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

Below, something that works for Ontario Teachers, HOOPP and other pension plans that have experienced pension shortfalls in the past is to adjust inflation protection when their plan is in a deficit.

It's not rocket science folks, in order to get stable, predictable pension payments for life, you need good governance and members need to accept some form of a shared risk model to keep these pension plans sustainable and viable over the long run.

Monday, November 28, 2016

GPIF Riding The Trump Effect?

Anna Kitanaka and Shigeki Nozawa of Bloomberg report, World’s Biggest Pension Fund Finds New Best Friend in Trump:
One of the world’s most conservative investors has found an unlikely new ally in one of its most flamboyant politicians: Donald Trump.

The unconventional president-elect’s victory is helping Japan’s giant pension fund in two important ways. First, it’s sending stock markets surging, both at home and overseas, which is good news for the largely passive equity investor. Second, it’s spurred a tumble in the yen, which increases the value of the Japanese manager’s overseas investments. After the $1.2 trillion Government Pension Investment Fund reported its first gain in four quarters, analysts are betting the Trump factor means there’s more good news to come.

“The Trump market will be a tailwind for Abenomics in the near term,” said Kazuhiko Ogata, the Tokyo-based chief Japan economist at Credit Agricole SA. “GPIF will be the biggest beneficiary among Japanese investors.”

While most analysts were concerned a Trump victory would hurt equities and strengthen the yen, the opposite has been the case. Japan’s benchmark Topix index cruised into a bull market last week and is on course for its 12th day of gains. The 4.6 percent slump on Nov. 9 now seems a distant memory. The yen, meanwhile, is heading for its biggest monthly drop against the dollar since 2009.

GPIF posted a 2.4 trillion yen ($21 billion) investment gain in the three months ended Sept. 30, after more than 15 trillion yen in losses in the previous three quarters. Those losses wiped out all investment returns since the fund overhauled its strategy in 2014 by boosting shares and cutting debt. It held more than 40 percent of assets in stocks, and almost 80 percent of those investments were passive at the end of March.

Tokyo stocks are reaping double rewards from Trump, as the weaker yen boosts the earnings outlook for the nation’s exporters. The Topix is the fourth-best performer since Nov. 9 in local-currency terms among 94 primary equity indexes tracked by Bloomberg.

Global Rally

But they’re not the only ones. More than $640 billion has been added to the value of global stocks since Nov. 10, when many markets around the world started to climb on bets Trump would unleash fiscal stimulus and spur inflation, which has boosted the dollar and weakened the yen. The S&P 500 Index closed Wednesday at a record high in New York.

Bonds have tumbled for the same reasons, with around $1.3 trillion wiped off the value of an index of global debt over the same period. Japan’s benchmark 10-year sovereign yield touched a nine-month high of 0.045 percent on Friday, surging from as low as minus 0.085 percent on Nov. 9.

GPIF’s return to profit is a welcome respite after critics at home lambasted it for taking on too much risk and putting the public’s retirement savings in jeopardy.

The fund’s purchases of stocks are a “gamble,” opposition lawmaker Yuichiro Tamaki said in an interview in September, after an almost 20 percent drop in Japan’s Topix index in the first half of the year was followed by a 7.3 percent one-day plunge after Britain’s shock vote to leave the European Union. Prime Minister Shinzo Abe said that month that short-term losses aren’t a problem for the country’s pension finances.

Feeling Vindicated

“I’d imagine GPIF is feeling pretty much vindicated,” said Andrew Clarke, Hong Kong-based director of trading at Mirabaud Asia Ltd. “It must be cautiously optimistic about Trump.”

Still, the market moves after Trump’s victory are preceding his policies, and some investors are questioning how long the benefits for Japan -- and GPIF -- can last. Trump already said he’ll withdraw the U.S. from the Trans-Pacific Partnership trade pact on his first day in office. The TPP is seen as a key policy for Abe’s government.

“It looks good for GPIF for now,” said Naoki Fujiwara, chief fund manager at Shinkin Asset Management Co. in Tokyo. But “whether the market can continue like this is debatable.”
In my opinion, it's as good as it gets for GPIF as global stocks surged, global bonds got hammered and the yen depreciated a lot versus the US dollar following Trump's victory.

I've already recommended selling the Trump rally. Who knows, it might go on till the Inauguration Day (January 20th) or even beyond, but the truth is there was a huge knee-jerk reaction mixed in with some irrational exuberance propelling global stocks and interest rates a lot higher following Trump's victory.

Last week, I explained why I don't see global deflation risks fading and told my readers to view the big backup in US bond yields as a big US bond buying opportunity. In short, nothing trumps the bond market, not even Trump himself.

All these people telling you global growth is back, inflation expectations will rise significantly, and the 30+ year bond bull market is dead are completely and utterly out to lunch in my opinion.

As far as Japan, no doubt it's enjoying the Trump effect but that will wear off fairly soon, especially if Trump's administration quits the TPP. And it remains to be seen whether Trump is bullish for emerging markets and China in particular, another big worry for Japan and Asia.

In short, while the Trump effect is great for Japan and Euroland in the short-run (currency depreciation alleviates deflationary pressures  in these regions), it's far from clear what policies President-elect Trump will implement once in power and how it will hurt the economies of these regions.

All this to say GPIF should hedge and take profits after recording huge gains following Trump's victory. Nothing lasts forever and when markets reverse, it could be very nasty for global stocks (but great for global bonds, especially US bonds).

One final note, I've been bullish on the US dollar since early August but think traders should start thinking about the Fed and Friday's job report. In particular, any weakness on the jobs front will send the greenback lower and even if the Fed does move ahead and hike rates once in December, you will see traders take profits on the US dollar.

If the US dollar continues to climb unabated, it will spell trouble for emerging markets and US corporate earnings and lower US inflation expectations (by lowering import prices).

Be very careful interpreting the rise in inflation expectations in countries like the UK where the British pound experienced a huge depreciation following the Brexit vote. These are cyclical, not structural factors, driving inflation expectations higher, so don't place too much weight on them.

And you should all keep in mind that Japan's aging demographics is a structural factor weighing down growth and capping inflation expectations. This is why Japan is at the center of the global pension storm and why it too will not escape Denmark's dire pension warning.

Below, Jonathan Pain, author of the Pain Report, says the dollar needed a technical correction before climbing further. And Marc Faber, The Gloom, Boom & Doom Reporter editor & publisher, weighs in on the Trump rally, and which areas he sees performing well under a Trump presidency.