Wednesday, May 31, 2017

Big Departures at Dutch Pension Giants?

Elizabeth Pfeuti of Financial News reports, Dutch pension fund giant loses CEO:
One of the largest pension funds in Europe is to lose its chief executive, in the latest high-profile resignation to hit the sector.

Else Bos, who has led PGGM since 2012, is to quit the organisation in November. PGGM invests €205.8bn for various pension funds, including the €188bn PFZW scheme for medical workers.

PFZW is the second-biggest pension scheme in both the Netherlands and Europe.

Earlier this month, APG, Europe's largest pension fund, announced that Eduard van Gelderen, its chief executive, will leave the organisation in August. Van Gelderen is to take a senior investment role at the University of California's $100bn investment fund.

In a statement published by PGGM, Bos said: “I have very much enjoyed working at PGGM over the past 15 years. An organisation of committed professionals with a green heart who are devoted to creating a valuable future for participants and members. I am proud of what we have achieved together.”

Bos joined PGGM in 2002 and by 2004 was promoted to the executive board as chief executive officer for investments. She featured on FN's list of 100 influential people in finance in 2013.

Her new employer will be announced in due course, PGGM said.

Edwin Velzel, chairman of PGGM’s supervisory board, said of Bos: “Her ability to give such committed leadership to the prudent management and sustainable investment of the pensions of 2.9m participants has been a remarkable achievement.”

PGGM said it will begin looking for a successor in due course.
Nick Reeve of Investment & Pensions Europe also reports, PGGM chief executive Else Bos resigns:
Else Bos, chief executive officer of Dutch pension manager PGGM, is to exit the company on 1 November.

Bos will “take on a new position elsewhere”, PGGM said in a statement.

She has been CEO since 2012, having taken on the role from Martin van Rijn, who is now the Netherlands’ secretary of state for health, welfare, and sport.

During her period in charge of PGGM, Bos has overseen an expansion of its fiduciary offering as well as a major restructuring of its wider business in 2014. Aimed at reducing operational costs by up to €50m, the restructuring project included cutting 200 jobs.

In 2015, the group shut down its hedge fund programme following the decision of its main client, the healthcare fund PFZW, to divest completely from its allocation to hedge funds.

Bos first joined PGGM – the Netherlands’ second largest pension manager – in 2002. She was appointed CEO for investments in 2004, and chief of institutional business in 2010. She has also worked for ABN Amro and NIB Capital Management.

Edwin Velzel, the new chairman of PGGM’s supervisory board, said: “With conviction and vision, Else Bos has made an important contribution to the development of PGGM over the past few years.

“Her ability to give such committed leadership to the prudent management and result-driven and sustainable investment of the pensions of 2.9m participants has been a remarkable achievement. We are very grateful for everything Else has accomplished for PGGM and we wish her success in her future career.”

Bos described PGGM as “an organisation of committed professionals with a green heart who are devoted to creating a valuable future for participants and members”.

PGGM runs €206bn in assets for Dutch pension funds including PFZW and the doctors’ scheme SPH.

Earlier this month Eduard van Gelderen, CEO of APG Asset Management, the largest pension manager in the Netherlands, announced his departure from the group to join the University of California’s investment team.
Indeed, a couple of weeks ago, Nick Reeve reported, APG CEO van Gelderen to exit in August:
APG chief executive Eduard van Gelderen is to leave the Dutch asset manager in August to join the University of California’s investment team.

Van Gelderen joined APG Asset Management – which is responsible for running €451bn of assets for pension fund clients – in 2010, initially as chief investment officer. He became CEO in 2014, succeeding Angelien Kemna.

He will leave APG on 1 August, according to a press release from the Dutch group.

Gerard van Olphen, CEO of APG Group, said: “With the departure of Eduard, we will lose a top investor and an excellent colleague. Under his management, APG AM has produced €100bn in returns for our pension funds and their participants. We understand the attractive challenges of this new role in the US and we wish him good luck.”

Bart Le Blanc, who chairs the APG Group’s supervisory board, added that the “international cooperation projects and internal innovation programs” van Gelderen had introduced would “serve APG for a long time”.

Before joining APG, van Gelderen was deputy CIO at ING Investments, and has also been head of investments at Lombard Odier.

He is to join a star-studded investment team overseeing $107bn (€96bn) in pension and endowment assets at the University of California’s Office of the Chief Investment Officer. Led by CIO Jagdeep Singh Bachher, the team also includes former US public pension chiefs and a former US treasury adviser.

According to a memo published by the university yesterday, van Gelderen will be a senior managing director reporting to Bachher. He will be “product manager” for the university’s $56bn pension fund, and have oversight responsibilities for the team’s public equities investments – at $52bn, the largest allocation to one asset class.

The memo also highlighted van Gelderen’s experience in real assets, an area the university wants to expand, and praised his contacts across Europe as a “key factor” in diversifying the portfolio geographically.

Van Gelderen will remain at APG until 1 August to help the board “safeguard a careful and thorough transition”, the asset manager said.
These are two big departures at two giant Dutch pensions. Else Bos and Eduard van Gelderen are both highly respected CEOs who have left their mark at their respective pension funds.

It's interesting to note van Gelderen will join Jagdeep Singh Bachler at the University of California. Bachler was the former CIO at AIMCo when Leo de Bever was the CEO of that fund. Leo has acted as an advisor to APG in the past.

I can assure you van Gelderen will be paid a lot more to go work at the University of California’s Office of the Chief Investment Officer. Talented individuals with his experience and connections are in high demand.

As for Else Bos, I am sure she too has tremendous experience and great credentials, so it wouldn't surprise me if she was recruited to work somewhere where she will also receive a higher compensation package.

Dutch pensions are among the best in the world but their compensation isn't the best (it's decent but far from being highly competitive), which leaves these organizations exposed when other organizations try to recruit their top talent.

I don't have much to add because I haven't been tracking Dutch pensions in the last few years (see this older comment). If you have anything to add, feel free to reach out to me at LKolivakis@gmail.com.

Below, an old PBS report on why The Netherlands seems to have its pension problem solved. Ninety percent of Dutch workers get pensions, and retirees can expect roughly 70% of their working income paid to them for the rest of their lives.

It's far from perfect but there's no question the Dutch pension system is solid and way ahead of that in most other countries. We can all learn a lot from the Dutch when it comes to retiring in dignity and security.

Update: Leo de Bever, the former CEO of AIMCo, shared this me after reading this comment:
I know and respect both Eduard and Else.

Running a large fund in a heavily regulated environment can take you far away from making innovative long-term investments.

The Dutch central bank, the pension regulator, has some very restrictive ideas on what is prudent.

In the Netherlands and elsewhere, governance and risk management are becoming code words for not taking much risk. That gets tiresome after a while.

A lot of these decisions depend on non-financial factors. Doing the desirable as well as the profitable motivated me, and many pension managers I know, like Eduard and Else.

You have to have spring in your step when you go to work or it is not worth doing.

Or as a Dutch proverb says: a change of diet improves appetite.
Indeed, a change of diet improves appetite. I thank Leo for sharing his wise insights with my readers.

Tuesday, May 30, 2017

The $400 Trillion Pension Time Bomb?

Szu PingChan of The Telegraph reports, Pensions are sitting on a global time bomb, warns WEF:
The world’s biggest economies are sitting on a $70 trillion (£54 trillion) pensions time bomb that will balloon to more than $400 trillion within four decades unless policymakers take urgent action, the World Economic Forum has warned.

Analysis by the WEF showed the six countries with biggest pensions – the US, UK, Japan, Netherlands, Canada and Australia – as well as China and India – the two most populous countries in the world – faced a retirement savings gap of $428 trillion in 2050, up from $67 trillion in 2015 (click on image).


This is based on the Organisation for Economic Co-operation and Development’s (OECD’s) recommendation that savers should aim for a retirement income of 70pc of earnings when they stop working.

The gap is expected to grow to the equivalent of $300,000 per person by 2050, adjusted for wage inflation, which is larger than the size of the global economy.

In the UK, the current shortfall of $8 trillion is forecast to rise by an average of 4pc per year to $33 trillion in 2050.

A study by the OECD in 2015 found that savers in the UK could on average expect the state to fund 38pc of their working-age income when they retired, lower than any other major advanced economy.

Across the 35 major economies in the OECD, the average was 63pc.

But while the think tank has praised the UK Government’s shake-up of the pensions system, which is now linked to life expectancy, it described the notion that it had found a “beautiful balance between affordability and sustainability [as] some sort of Panglossian fantasy”.

Many are not saving enough into private pension schemes, it warned.

The WEF said a five-point plan was needed to ensure those born today can retire and still receive a comfortable income.

Ageing populations

The WEF noted that life expectancy has been increasing “rapidly” since the middle of the last century, rising on average by one year, every five years.

This means babies born today can expect to live for more than 100 years. According to the forum, the number of people aged over 65 will increase from 600 million today to 2.1 billion in 2050 (click on image).


As population growth slows, this will mean the number of workers paying for the pensions of those in retirement will fall from eight workers today to four per retiree in 2050, putting pressure on the public purse.

All this will be against a backdrop of slower growth, lower interest rates and weaker returns on investments.

The WEF said: “Over the past 10 years, long-term investment returns have been significantly lower than historic averages.

Equities have performed between 3pc and 5pc below historic averages and bond returns have typically been around 1pc and 3pc lower.

Low rates have grown future liabilities, and at the same time investment returns have been lower than expected and unable to make up the growing pension shortfall.

Taken together, these factors have put increased strain on pension funds as well as on long-term investors that have commitments to fund and meet the benefits promised to current and future retirees.”

Saving for the future

The WEF believes working for longer is inevitable. George Osborne, the former chancellor, linked the state pension age to life expectancy in the previous parliament.

As a result, the Office for Budget Responsibility (OBR), the government’s fiscal watchdog, forecasts that workers will have to retire at 69 by 2055.

Under current plans in the UK, the state pension age will rise to 66 by 2020 for both men and women.

The OBR’s latest long-term projections suggest this move is necessary for state pensions to remain sustainable.

Official projections show 26.2pc of the UK population will be aged over 65 in 2066, compared with 18pc last year and 12pc in 1961.

The WEF believes workers need to save between 10pc and 15pc of their annual salary to support a reasonable level of income in retirement.

It warned that many workers faced a shock in later life, with current savings rates “not aligned with individuals’ expectations for retirement income – putting at risk the credibility of the whole pension system".

This means babies born today can expect to live for more than 100 years. According to the forum, the number of people aged over 65 will increase from 600 million today to 2.1 billion in 2050.
Sam Meredith of CNBC also reports, Pensions time-bomb for world's biggest economies could explode to $400 trillion, says WEF:
Future generations are on course to become enveloped in the biggest pension crisis in history, according to the World Economic Forum (WEF), unless policymakers from the world's leading economies take urgent action.

The Geneva-based organization predicted the challenges of an ageing population could result in the world's largest economies being forced to tackle a pension time-bomb.

Analysis from WEF showed six countries with the biggest pensions, including the U.S., Canada, U.K., Netherlands, Japan and Australia, as well as the two most densely populated countries in the world – China and India – would face a retirement savings gap in excess of $400 trillion in 2050, up from around $70 trillion in 2015.

'Financial equivalent of climate change'

"The anticipated increase in longevity and resulting ageing populations is the financial equivalent of climate change," Michael Drexler, head of financial and infrastructure systems at WEF, said in the report published on Friday.

The body that organizes the annual gathering of the global elite in Davos said with babies being born today having a life expectancy of more than 100, the costs of providing financial security to people in retirement could skyrocket to unprecedented levels.

According to the WEF's forward looking estimates, the retirement savings gap from all eight countries is set to inflate by 5 percent every year over the next four decades. This translates to an extra $28 billion of deficit every 24 hours.

"We must address it now or accept that its adverse consequences will haunt future generations, putting an impossible strain on our children and grandchildren," Drexler added.

The report based its pensions saving gap projections on the amount of money required in order to allow people to retire with a relatively unaffected standard of living. The Organization of Economic Co-operation and Development (OECD) recommend a target of 70 percent of one's pre-retirement income. The OECD argues this should give people enough financial security post-retirement as people generally save less and pay less tax when they stop working.

The WEF proposed a five-point checklist that policymakers should adopt to help curtail the impact of a pension crisis for future generations.

The high priority actions included reviewing the national retirement age, embracing technology assistance where needed, supporting financial literacy efforts for vulnerable people, providing clear communication to all and standardizing pension data to give citizens a full picture on their respective financial positions as they get older.

"While the challenge can seem overwhelming it is important to continuously evolve the systems in place to start to put positive changes in motion," the report said, before adding, "If we continuously review, assess and take small steps over time we will more likely be able to meet the needs of today's retirees and afford the promises we are making to today's workers."
You can read the World Economic Forum (WEF) report, We’ll Live to 100 – How Can We Afford It? by clicking here. The WEF put out a brief comment, 5 things you need to know about the global pension crisis:
At what age are you planning to retire? Do you have enough saved up to do so?

Two simple questions, but the answers are not so simple.

Depending on where you live, you could have a pension waiting for you – either from the government, or your job, or your personal savings.

But is it enough?

A new report from the World Economic Forum, We’ll Live to 100 – How Can We Afford It? takes a closer look at the global pension crisis. Here are five key findings.

1. We are living much longer than what pension systems were designed for

The chart below illustrates the retirement ages for the six countries with the largest pension systems.

Retirement age for most of these countries is 65 (with Japan the exception, at age 60).

The bottom bar represents the number of years of payments expected using life expectancy in 1960. This ranged from five to eight years of payments on average.

Looking at life expectancy in 2015, we can see that pensioners are now living eight to 11 years longer – and in the case of Japan, a whopping 16 years longer.

That means that pension systems are now having to pay benefits for two to three times longer than what they were designed for.

The top bar represents the expected increase in life expectancy by 2050 (click on image).


2. We currently have a pension gap between what is needed for retirement and what is saved

It is difficult to define what is considered adequate income for retirement.

One common assumption is that we will need less money in retirement than we do while we are working (during wealth accumulation).

There are three main sources of income during retirement: government sponsored pensions, work or occupational pension plans, and personal savings.

Because we are living so much longer these days, there is a gap between what we need during retirement and what we have available, even among countries with developed pension systems.

Add the two most populous countries (China and India), and one can see why this is truly a global pension crisis (click on image).


 3. The problem is worse for women

As if the wage gap wasn't enough of a problem, women have it worse with the pension gap as well.

Globally, retirement balances for women are typically 30-40% lower than that of men.

Lower wages account for some of this imbalance, but coupled with longer life expectancies for women, these smaller balances then need to be stretched over a longer period of time as well (click on image).


4. The gap is growing at an alarming rate

This problem is getting worse.

In the chart below, we have illustrated both the gap in 2015 as well as the gap by 2050.

For all countries, this is being driven by continued increases in life expectancy.

For some countries, there is also a demographic challenge of an ageing population with fewer workers to support them.

For economies that are still developing, the increase in the gap is also being driven by rising wage growth as these countries continue to industrialize. By 2050, the total gap is a predicted to be a staggering sum of $400 trillion – roughly five times the size of the global economy today (click on image).


5. We need to act now

This is a difficult problem for policy-makers to address.

Politically, it is easy to ignore the future. But, as we have shown, this will lead to us paying a massive economic price.

We have proposed a series of measures for policy-makers to look at today (click on image):

I'm glad the World Economic Forum is finally paying attention to the global pension crisis, almost ten years after I began this blog. Welcome to the club!

So what are my thoughts on this report? There is definitely an alarmist tone to it which is meant to "shock and awe" policymakers and citizens reading it, and while I agree with the thrust of its arguments, I disagree with some points:
  • Longevity risk: No doubt about it, we are projected to live longer and this will put pressure on pensions as they need more money to pay future liabilities over a longer period. A sensible proposal is to raise the retirement age gradually to 70 years old over the next decade (easier for some jobs, not for others). In the case of Japan, I was shocked to read Japanese can retire at 60 and yet their pensioners are living a whopping 16 years longer. Do the math, this isn't sustainable, placing huge pressure on Japan's pension system.
  • The pension gap: The report says it is difficult to define what is considered adequate income for retirement but goes on to ascribe an arbitrary figure of 70% pre-retirement income. Can I be honest with you? Very few people will retire with a 70% pre-retirement income. I can assure you most people will retire with little to no savings and end up relying on some measly government pension which is why I've been very vocal on enhancing the Canada Pension Plan (the study found Canadians are among those most at risk) and enhancing US Social Security, provided they get the governance right (like we did in Canada with CPPIB managing assets of the CPP). But the fundamental issue behind the rising pension gap is lower wages, an ongoing global jobs crisis, and rising inequality, ensuring that most people cannot save enough for retirement. By the time people are done paying the mortgage, food and other needed expenses, they cannot afford to save five percent, let alone 15 percent of their income. And even when they do manage to save, they're left at the mercy of "the market", meaning if they're lucky, saved enough and don't retire before a major bear market, they might be able to squeeze enough out of their savings to retire in dignity and security. This is yet another reason why I'm a big proponent of enhancing the CPP, because unlike a defined-contribution plan which is just brutal during market downturns, a large, well-governed defined-benefit plan will pool longevity and investment risk and invest across public and private market assets. Moreover, there are plenty of other benefits to large well-governed DB plans that help improve the economy over the long run.
  • Pension crisis isn't gender neutral: No doubt, unless you are a female teacher or nurse working in Ontario where you're a member of two of the best defined-benefit plans in the world (OTPP and HOOPP), you're definitely not in better shape than your male counterparts when it comes to retirement because you are earning less and living longer. Women need to think about their retirement a lot more carefully than men, which is another reason why I'm for enhancing the CPP and US Social Security (provided they get the governance right).
  • On the $400 trillion projected gap: Here is where I want to tone things down because as I stated above this figure is based on an arbitrary 70% pre-retirement income figure which to be quite truthful, isn't needed. The older people get, the less they spend, so I don't know where they get this 70% pre-retirement income figure. Still, the pension gap is growing as people live longer and save less. I would have liked to have seen a range of figures starting from 40% pre-retirement income to 70% to see just how much this gap will grow in the coming decades.
  • On the five recommendations: I agree with the WEF recommendations but I find them timid. As I stated above, we need to bolster large, well-governed defined benefit plans that lower costs, pool investment and longevity risk, and invest across public and private markets all over the world either directly or through top funds. We also need to introduce proper risk-sharing into these plans to make them sustainable over the long run. 
On that last point, go back to read my previous comment on the pension prescription and those of you who can, forward it and this comment to the World Economic Forum.

In short here are my recommendations:
  1. Enhance large, well-governed defined-benefit plans, preferably ones that invest on behalf of all citizens (ie. state pension plans) and back them up by the full faith and credit of the state.
  2. Get the governance right like we did in Canada so you can hire experienced professionals that invest directly across global public and private markets and co-invest with top partners.
  3.  Get the risk-sharing right because from time to time pensions will experience shortfalls and you need to have a relief valve to restore fully funded status. In a low inflation world, I recommend pension plans introduce Conditional Inflation Protection. 
Those are my thoughts on the $400 trillion pension time bomb. If you have anything to add, feel free to contact me at LKolivakis@gmail.com.

One last thing which is worth noting here. When I discuss global deflation, one of the six structural factors I allude to is the global pension crisis. It's highly deflationary and exacerbates global wealth inequality which is itself deflationary. 

Policymakers really need to think about pensions a lot more carefully. As I stated in my previous comment on the pension prescription, everyone needs to play a role in solving a looming crisis that is only going to get worse. There are no easy solutions but in my mind, we absolutely need to bolster defined-benefit plans (and avoid defined-contribution plans) and make sure we get the governance and risk-sharing right.

And to do this, everyone needs to be committed to the best interests of the plan, including unions with unreasonable demands, governments who shirk their responsibilities in topping up pensions, public pensions with unrealistic return targets, and large alternative investment managers charging insanely high fees for mediocre returns in a low growth, deflationary world.

Below, discussing the geopolitical and economic effects on global markets with Michael Gapen, Barclays chief US economist and managing director, and Kevin Caron, Washington Crossing Advisors senior portfolio manager.

Geopolitical risks are the least of my concerns over the long term. Read this comment carefully and send it to your kids and friends. The global pension crisis should be one of our main concerns but in an age of Twitter, Facebook, Snapchat and Instagram, we are continuously distracted and ignoring the forest for the trees. The pension storm cometh, be prepared or risk a miserable retirement.

Second, Japan and Germany may be sitting on a ticking demographic time bomb where aging populations begin to drag down economic growth. Good thing they’re also prime candidates for robot revolutions. Bloomberg reports on how robots may help defuse this time bomb.

Lastly, one of my blog readers sent me Erik Townsend's interview with Professor Russell Napier on MacroVoices where they discuss the US dollar, the secular bond bull market, and the pension crisis (minute 28). Take the time to listen to this podcast, it's excellent.



Friday, May 26, 2017

The Pension Prescription?

A month ago, Adam Ashton of the Sacramento Bee reported, Unions kill bill to cut cost-of-living increases for CalPERS pensions:
Public employee unions presented a united front on Monday against a bill by Sen. John Moorlach that aimed to close California’s pension funding gap by eliminating cost-of-living increases and asking local governments to chip in a greater share of their revenue toward retirements.

Moorlach, R-Costa Mesa, shaped his Senate Bill 32 using the language of climate change laws the Legislature adopted to set goals for the reduction of greenhouse gasses. Last year’s SB 32, for instance, sought to cut greenhouse gas emissions to 40 percent below 1990 levels between now and 2030.

Moorlach’s pension bill similarly would demand that CalPERS and CalSTRS reduce their unfunded liability to 1980 levels by 2030. Today, both pension systems have about 64 percent of the assets they’d need to pay all of the benefits they owe.

Read more here: http://www.sacbee.com/news/politics-government/the-state-worker/article146516764.html#storylink=cpy

“The unfunded liabilities are killing us. The math is brutal,” said Dan Pellissier, president of an advocacy group called California Pension Reform.

Moorlach’s bill would have temporarily banned cost-of-living increases that pensioners receive, required local governments to increase their pension contribution rates by 10 percent and compelled public employers to offer 401(k) style defined contribution plans to supplement pensions.

The bill failed by a 3-2 vote in the Senate’s Public Employment and Retirement Committee after a parade of union representatives voiced opposition to it.

“This is really an attack on women,” said Jennifer Baker, a lobbyist for the California Teachers Association. She noted that some 72 percent of the state’s retired teachers are women.

She continued, “This is not going to incentivize more people to want to become teachers.”

Baker’s argument resonated with Sen. Connie Leyva, D-Chino, whose mother receives a pension worth about $22,000 a year.

“I really worry that we are always trying to balance the pension funding problem on the backs of the lowest paid worker,” Leyva said.

“We just have to be very thoughtful and I’m afraid that for me this doesn’t get me where I need to be,” she said.
On Friday morning, I updated my last comment on how to steal millions from CalPERS to include this article and stated this:
I'm against Moorlach's 401(k) proposal, for good reasons, but go back to read my recent comment why Ontario is easing its funding rules and watch the clips at the end which show how Ontario Teachers' Pension Plan has partially or fully removed inflation protection (ie. cost-of-living-adjustments) to lower its pension deficit in the past (and it's not alone, HOOPP has done so too).

In my opinion, California's public-sector unions are not interested in sharing the risk of their plan, and this sets up a very dangerous showdown in the future when taxpayers refuse to bail these plans out. Some form of risk-sharing must take place in order to bring these plans back to fully funded status.

I also added a couple of clips from the Ontario Teachers' Pension Plan which explain how small adjustments to inflation protection were instrumental in tackling their pension deficit and restoring fully funded status to their plan.

I sent the article above to Jim Leech, the former CEO of Ontario Teachers' and co-author of The Third Rail: Confronting Our Pension Failures.

Jim was kind enough to share this with me:
A number of years ago I was asked by a troubled plan “How did we ever convince the Ontario Teachers’ unions to voluntarily introduce Conditional Inflation Protection”.

My response was/is: “You start 10 years earlier to educate the union leaders and members on the value of such changes. It takes time, trust and transparency.”

Of course, there is the added advantage that in a Jointly Sponsored Pension Plan, the unions/employees have a joint responsibility to ensure the Plan is sustainable – there is no “us and them”, there is only “us”.

But even in an employer sponsored plan, employee leadership needs to take some responsibility to ensure employees have a sustainable plan – a “guarantee” is only as secure as the “guarantor”.
I completely agree with Jim and when people ask me how Ontario Teachers', HOOPP and other Canadian plans were able to tackle their pension deficit and restore fully funded status, I say it's because of two critical factors:
  1. They got the governance right which means they operate at arms-length from the government. This allows them to get the compensation right so they can attract and retain qualified staff to manage a big chunk of the assets internally, significantly reducing operating costs, as well as invest and co-invest with external partners (to lower fees) where they see great investment opportunities which they can't invest in internally.
  2. They got the risk-sharing right which effectively means their sponsors share the risk equally if the plan experiences a deficit. Risk-sharing means both employees and employers share the risk of plan if it runs into trouble.
In particular, risk-sharing means either the contribution rate needs to increase, benefits need to be cut or both to restore the plan's funded status and make it sustainable for future generations.

In the past, OTPP and HOOPP made cuts to their benefits by making small adjustments to their inflation protection as a means to restore their plan's funded status. And when I say a small, I mean small, we are talking about a few dollars off the benefit payments to restore the plan's funded status.

Earlier this week, when I went over why Ontario is easing its pension funding rules, I mentioned this:
[...] as an aside, the key difference between Ontario Teachers' and HOOPP relative to OPTrust and OMERS is in the form of risk-sharing. The latter two plans guarantee inflation protection, which means no matter what, they never reduce benefits to their beneficiaries.

OTPP and HOOPP have both partially or fully cut inflation protection (otherwise known as cost-of-living adjustments or COLA) when their plans have experienced a deficit in the past. This has been a very useful mechanism to allow them to become fully funded again (watch this OTPP clip to understand why).

OPTrust and OMERS guarantee inflation protection so they have a harder job attaining an maintaining a fully funded status which in my view isn't right (their members need to share the risk of the plan more if they run into trouble).

Still, there's no denying that the problems at Ontario's DB plans aren't with OTPP, HOOPP, OPTrust, OMERS or even CAAT which is also fully funded and has a 50/50 shared risk model.

The problem lies with private-sector DB pensions that are either poorly managed or that don't have the flexibility to address their (going concern) pension deficits. And a lot of these pensions are going to get whacked hard in the near future as rates decline to a new secular low (as the US economy slows).
I still maintain that OPTrust and OMERS should follow OTPP and HOOPP an introduce conditional inflation protection but somehow they have managed to obtain fully funded status by guaranteeing full inflation protection (good on them but it makes their job more difficult in managing assets and liabilities and it makes more sense if they can partially adjust inflation protection when their plan runs into a deficit).

Still, despite these minor differences, it's clear that large Canadian public pensions are in much better shape than their US counterparts, many of which are chronically underfunded.

Earlier this week, I also discussed The Big Squeeze on US public pensions, going over a new report by the American Federation of Teachers which basically claims US public pensions are doling out huge fees to alternative investment managers and that is making their plans more underfunded.

I was careful when writing that comment, agreeing with some of the assertions from the report but I also stated the following:
The problem isn't paying fees when risk-adjusted performance is met. The problem is paying big fees for subpar or average returns in a low-return environment over a long period as your pension deficit gets worse.

Importantly, in a deflationary world, all those fees add up fast, impinging on the net performance of these external managers and this certainly doesn't help chronically underfunded pensions, many of which still cling to unrealistic return targets.

Very few public pensions were raising a big stink on fees when rates were much higher, performance was decent and their funded status was fully funded or close enough to fully funded status. A little inflation also helped justify these fees.

But in a low yield, low return deflationary world, costs matter a lot more and pensions are focusing on lowering operating costs across the board, including on the fees they pay to external managers.

Of course, we need to be realistic here. Some external managers have delivered great long-term results and therefore have a lot more clout than others. You're not going to go to Blackstone, Bridgewater, or any other brand name fund and dictate the terms of the deal. It's not going to happen because if they make one exception, they need to make it for all their investors which signed a most favored nation clause.

The other thing I'd like to bring to your attention is that a solid case can be made to increase the exposure to alternative, illiquid investments, especially if you can co-invest on bigger deals alongside your external partners to lower the overall fees.

This has been the driving force behind the success of Canada's large public pensions, otherwise known as the mighty PE investors. Where they can, Canadian pensions will invest directly and where they can't, they will invest with external partners and engage in co-investments to lower fees.

However, in order to do this, they implemented world class governance allowing them to operate at arms-length from the government. This allows them to compensate their pension managers properly in order to attract and retain talented individuals who are able to do direct deals independently or (as is more often the case) by co-investing alongside external partners.

More direct investments (either independently or through co-investments) allows Canada's large pensions to lower overall fees of their private equity program.

In the US, there is way too much political interference in public pensions and the results are they cannot pay their public pension fund managers properly to do what their Canadian counterparts do.

Then, one day, the American Federation of Teachers puts out a report highlighting The Big Squeeze, and all of a sudden teachers, police officers and other public-sector workers wake up to the reality that everyone is milking their public pension dry. And by the time they're done milking these pensions, there will be little left to pay the benefits that were promised to them.

I'm being very cynical but there is a lot of truth in the report the teachers put out. If their pensions are doling out huge fees to alternative investment managers, they have a right to know what they're getting in return for all those fees.

Having said this, I want to be balanced here because I maintain the view that good performance is worth paying for. Chronically underfunded US pensions with unrealistic return targets can't expect to make their target rate of return simply by investing in index funds. They need to invest in top-tier managers in the alternatives space to add value over and above their public market benchmarks.
There is a misconception that allocating to external private equity and hedge fund managers is a waste of time and money and that these pensions can improve their funded status by removing these funds from their asset mix (in most cases, their funded status will deteriorate if they remove these funds).

Sure, in some cases, it makes sense to cut external managers, like when CalPERS nuked its external hedge funds (it never invested enough dedicated resources to that program and never took it seriously like OTPP and CPPIB do).

But cutting all allocations to private equity isn't wise, nor in the best interests of pension plan beneficiaries. These programs have added significant value-added to most US public pensions, net of all fees.

We can argue whether fees in alternative investments are still outrageously high -- and I believe they are and should be cut in half (1 and 10, not 2 and 20) for the big funds managing multi-billions -- but you would be hard-pressed to make a convincing case that public pensions can attain their required actuarial rate-of-return without allocating a percentage of their assets into alternatives, both liquid (hedge funds) and illiquid alternatives (private equity, real estate, infrastructure and private debt).

I also ended that comment by stating:
[...] it's very fashionable these days to blame everything on greedy bankers, hedge fund managers, and private equity managers, but from my vantage point, there is plenty of blame to go around when it comes to America's pension crisis. Unions, state and local governments and Wall Street all have unrealistic expectations on return targets, benefits, contribution rates, risk-sharing, and fees.

In the meantime, the pension storm cometh, and unless all these stakeholders come together to figure out a real long-term solution to this crisis, things will only get worse.
The biggest problem with pensions these days are stakeholders with inflexible views. Unions that don't want to share the risk of their plan, governments that shirk their responsibility in topping out these public pensions and making the required contributions, pension funds with poor governance and unrealistic investment targets, and powerful private equity and hedge funds that refuse to cut their fees in order to contribute to solving this crisis.

From a social and moral view, I truly believe that a case can be made to a group of elite private equity and hedge fund managers that they need to cut their fees in half and be part of the pension solution. In return, public pensions can perhaps allocate more assets to them over a longer period, provided alignment of interests and performance are maintained.

I don't know, I've been thinking long and hard of a pension prescription which will go a long way into solving a looming crisis that is only going to get worse. There are no easy solutions but in my mind, we absolutely need to bolster defined-benefit plans and avoid defined-contribution plans, and make sure we get the governance and risk-sharing right. And to do this, everyone needs to be committed to the best interests of the plan, including unions, governments and alternative investment managers.

If you have anything to add to this comment, feel free to reach out to me at LKolivakis@gmail.com an I'll be glad to post your thoughts.

Below, please take the time to once again watch a couple of clips from the Ontario Teachers' Pension Plan which explain how small adjustments to inflation protection were instrumental in tackling their pension deficit and restoring fully funded status to their plan.

The pension prescription isn't rocket science folks. If we want defined-benefit pensions to be sustainable over a long period, we need good governance and sponsors need to share the risk of their plan.


Thursday, May 25, 2017

How To Steal Millions From CalPERS?

Edward Siedle wrote a comment for Forbes, How To Steal A Lot of Money From CalPERS, The Nation's Largest Public Pension:
How hard would it be to steal millions from CalPERS, the nation’s largest public pension with $320 billion in assets? Easy-peasy.

Yesterday the Wall Street Journal reported a disturbing fact—a fact well known to pension insiders for years. That is, officials at CalPERS do not know the full extent of the fees the pension’s private equity managers take out of the pension.

At a 2015 meeting, the chief operating investment officer openly acknowledged that no one knew the performance fees paid.

Let’s clarify what’s going on here. Presumably the mega-pension knows, or can readily establish, all the fees—asset-based and performance—it pays its money managers pursuant to fee invoices. (A breakdown of other operational fees—which can be significant—can either be gleaned from investment fund financial statements or specifically requested from managers.)

What CalPERS doesn’t know is the performance and other fees its managers take directly from the funds they manage for CalPERS without asking, disclosing or invoicing.

At the same 2015 meeting, the chief operating investment officer admitted, “We can’t track it today.”

CalPERS claims to have turned to “big data” computer models—algorithms—to understand private equity costs. Supposedly, a software program developed by outside firms determined at the end of 2015 that the pension paid $3.4 billion in performance fees over the past quarter-century to private-equity firms. In 2016, that number was said to be $490 million. Don’t believe these figures for a second.

For those who are impressed by opaque algorithms no one understands and that lack effective feedback loops to highlight deficiencies and errors, I suggest reading Cathy O’Neil’s new book, Weapons of Math Destruction.

As an expert in ferreting-out hidden, excessive and illegal investment fees, I would never recommend any pension fiduciary (and certainly not a fiduciary overseeing hundreds of billions in government workers retirement savings) rely upon an ill-defined computer model to catch criminals.

So, to re-cap the problem facing CalPERS: Private equity managers are taking billions from the pension but the pension has no idea how much. How comforting is that to pension stakeholders? You’d think that California’s largest state employee union, SEIU Local 1000 and AFSCME would be concerned about protecting the retirement assets of their members that are participants in the state pension.

Of course, if CalPERS doesn’t know how much money these private equity managers are taking out of the pension, it cannot possibly know whether the amounts taken are legitimate or wrongful—i.e., theft.

In my opinion (and based upon my experience conducting over $1 trillion of pension investigations), it is almost certain some CalPERS private equity managers are, shall we say, misappropriating assets from the retirement system. Recent SEC staff findings confirm my views.

In 2014, SEC staff found that more than half of about 400 private-equity firms it examined had charged unjustified fees and expenses without notifying investors. To be sure, CalPERS conceivably could have adroitly avoided the hoards of private equity wrongdoers but, based upon my knowledge of longstanding CalPERS due diligence lapses and monitoring weaknesses, don’t count on it. As I wrote in 2011, CalPERS involvement in an investment scheme is no assurance of integrity or a “Good Housekeeping Seal of Approval.” 

CalPERS board member JJ Jelincic, who raised the issue of undisclosed fees in the 2015 board meeting mentioned earlier agrees. “We don’t know what fees our private equity managers are taking out of the pension and so we can’t possibly know whether all the fees are legitimate. When I’ve raised the issue, I’ve been told the managers are our “partners” in the funds and we should just trust them.”

I posed the following question to CalPERS today in an email: If CalPERS does not know precisely how much money private equity managers are receiving related to fund assets, how can stakeholders be assured that these managers are not wrongfully taking from the pension?

In response CalPERS said, “Our Private Equity fees are fully disclosed in our Comprehensive Annual Financial Report and in the Private Equity Annual Program Review.”

In my experience dealing with CalPERS, the board regularly claims certainty as to matters which it barely grasps. How long has CalPERS known about potential theft by its managers? At least four years.

On March 22, 2013, I sent a letter to the CalPERS board reciting my credentials (for those board members who did not already know me) and emphatically stating, “It is apparent to me, even from a distance that the fund continues to lack many of the safeguards I would recommend to improve management and performance.” I received no response to the letter.

A few months later, on May 13, 2013, I sent a second letter to board member Jelencic, as requested, providing further detail regarding issues which in my expert opinion should be investigated fully by the pension. Included in these issues were specifically “undisclosed fees related to investment providers/vendors,” and “private equity and hedge fund conflicts of interest, fee abuses and malfeasance.”

I am told that when Mr. Jelencic brought my second letter to the attention of the board at a closed meeting, the Board President responded, “How is this letter different from any of the thousands of others we receive? The suggestion to meet with me was rejected, I am told by Jelencic. CalPERS today stated, “We cannot comment on issues that are discussed in closed session.”

If it’s true that the CalPERS board regularly receives thousands of letters from forensic experts and other credible whistleblowers alleging potential wrongdoing regarding pension investments—allegations of wrongdoing which the board routinely ignores—that’s really scary. Unions protecting government workers should be alarmed that such warnings go unheeded and demand to see all such correspondence.

My advice to would-be criminals: If you want to steal millions, escape detection and prosecution, then set your sights on the mother of all pension honey-pots, CalPERS.
Ted Siedle, the pension proctologist, is at it again, and this time he's setting his sights on CalPERS, the largest and best-known US public pension.

I agree with Ted, it's unacceptable that any large public pension investing billions in private equity can't track all fees and other costs very closely (to the penny). This is a matter of basic accounting, no need for sophisticated algorithms to track these fees (that's ridiculous).

[Note: On calculating PE fees, one pension expert shared this with me: "If you put your mind to it, the base fees and performance fees are not so difficult to determine. The shadowy part is fees that get charged to the fund directly for various services."]

But it's important to note CalPERS does fully disclose its private equity fees in its Comprehensive Annual Financial Report and in the Private Equity Annual Program Review.” It has to by law or else its board and senior staff can be convicted of fraud and misappropriation of funds.

What about GPs? I doubt they're doing anything remotely shady in terms of fees. It's simply not worth it for them to risk their relationship with CalPERS or a SEC fine of millions of dollars.

I believe that Ted Siedle is trying to drum up business for himself. He wants to be able to conduct a comprehensive audit on CalPERS, above and beyond the standard financial statements. If so, he should be very upfront of his intentions when writing these articles.

Siedle isn't the only one criticizing CalPERS. In her latest comment, Yves Smith (aka Susan Webber of Aurora Advisors) also attacks CalPERS for keeping its board in the dark on how private equity "subscription line financing" gooses staff and GP pay and systemic risk:
It’s remarkable to see that some private equity general partners, who above all are experts at increasing their own net worths, are concerned about a gimmick that boosts reported private equity fund returns. By contrast, limited partners like CalPERS are in “Nothing to see here” mode on the increase risks and costs, which include being forced to liquidate investments at the worst possible time to pay down these extra private equity borrowings.

The gimmick is subscription lines of credit. They allow private equity fund managers to borrow at the level of the investment fund, in addition to the debt they heap onto the portfolio companies they buy. We had heard of them over two years ago, but didn’t write them up then because they weren’t being used all that much back then.
I will let you read the rest of Yves' comment here as it's long, self-indulgent, somewhat nauseating and very poorly researched and relies on outside experts who frankly don't have a clue of what they're talking about.

Yves does raise good points on transparency and the board's fiduciary duty, but there are some things she claims which are just ridiculous or plain wrong. For example, she ends her comment by stating (added emphasis is mine):
Can Costigan really be completely ignorant, say, the conflict of interest resulting from the consultants being hired by staff and therefore having incentives to keep them happy? Did he miss the entire financial crisis, in which ratings agencies gave overly rosy grades to subprime related credit vehicles because the structures were their clients? Or that ratings agencies are famously slow to issue downgrades because they want to stay on a good footing with their clients? Or that compensation consultants have managed to devise norms that result in ever-escalating pay irrespective of performance?

More specifically, Professor Ludovic Phallippou of Oxford, who specializes in private equity, has pointed out how consultants and academics had been comparing private returns to that of the S&P 500 from the mid 2000s to mid 2010. In the last two years, MSCI World has become the preferred point of reference. Why? Because the S&P 500 has been doing very well over the last three years, unlike the MSCI World index. And Sam Sutton, a private equity reporter at Buyouts Magazine, told me it was intriguing to see that CalPERS’ consultant CEM Benchmarking has wound up scoring every public pension fund client he’s written about as having above average performance, which would seem to be mathematically impossible until you allow for artful selection of peer groups.

As we reported in 2015, we caught CalPERS’ private equity consultant PCA trying to implement an absolute return for CalPERS and CalSTRS, which essentially meant ignoring the risks of private equity in looking at its returns. As we explained at the time on this site and at Bloomberg, this was not completely bogus analytically and intellectually, but would also throw the idea of risk measurement out the window. No finance academic would back this approach.

The only thing that stopped this scheme from being implemented on a stealth basis was an op ed in Sacramento Bee by private equity expert Eileen Appelbaum.

Costigan is either so clueless or so inattentive that he missed this sorry episode. There was no benefit whatsoever to retirees or system health to this proposed change. The benefits would accrue solely to staff, in terms of much more favorable bonus targets and greater ability to spin CalPERS performance as adequate. Mind you, there are other examples of staff playing fast and loose with numbers, like the one we wrote up yesterday, but this one was outrageous.

Moreover, Costigan admits staff has motive to seek more pay…they make less than their peers! And then he argues that because consultants back staff recommendations, that there is nothing to worry about.

Of course, since the board sat pat when CEO Anne Stausboll gave Chief Investment Officer Ted Eliopoulos a $135,000 gift via a bonus that violated his bonus formula by paying for non-performance, perhaps Costigan has a point. Senior staff gets paid for performance whether they deliver or not, so why would they need to play games?
So where did Yves go wrong in her flimsy and overly critical analysis? Well, just from the points I underlined, I can tell you she and the professor she cites are wrong.

The switch from using the S&P 500 to using MSCI World is a reflection of the global shift in the private equity portfolio, not because the latter is easier to beat.

Second, some consultants claim that having an absolute return benchmark is in line with meeting the actuarial target rate of return. In other words, there is a logic to using absolute return benchmarks in private markets but there are risks too.

What risks? In any given year, you can substantially underperform an absolute return benchmark if markets are getting clobbered and you need to value down your PE holdings (I've seen this plenty of times). Conversely, you can significantly outperform this benchmark when markets are soaring (seen this plenty of times too).

This is why many experts prefer a public market index and spread (to reflect illiquidity risk and leverage) when trying to benchmark private equity.

In the good old days when private equity funds were killing it in terms of performance, they would easily beat the S&P 500 + 300 basis points benchmark over a very long period.

But as more and more investors shift assets into private equity, the opportunity set is much smaller, so the spread has been reduced to 150 basis point or even less over the appropriate public market stock index.

Importantly, benchmarking private market assets isn't as easy as Yves and her professors think and I'm surprised they haven't taken the time to look at the value-added these programs have created at CalPERS and elsewhere over a 10 or 20-year period.

If you read Yves' comments, you will think that CalPERS board is totally incompetent and the senior executives are pulling wool over their eyes to "goose their pay."

This is total nonsense but I blame the governance structure at these large funds. Where is California's state Treasurer? Why isn't some auditor general performing a comprehensive risk, investment, operational, and performance due diligence of CalPERS and making the findings public?

Admittedly, such a comprehensive audit requires expertise and very few firms have the resources and knowledge to complete such a huge undertaking but as long as CalPERS stays quiet, people like Yves and Ted Siedle will be all over them, claiming incompetence, negligence, and even outright fraud.

[Note: CalPERS should hire my friends over at Phocion Investments, fly them over to Sacramento for three months and let them conduct an intense audit, especially performance audit. CalPERS will never do it but trust me, it will be the best bang for their buck ever as my friends have all worked at large pensions and they really know their stuff.]

But the problems at CalPERS keep mounting and it has become a PR nightmare. J.J Jelincic, an outspoken member of the CalPERS Board of Administration is not seeking re-election, setting up a wide-open race to succeed him:
Jelincic, an eight-year incumbent and CalPERS investment officer, told the pension fund in late March that he planned to run for another term.

But, he did not file paperwork to run by this week’s deadline. He posted a message on his website saying he would not be on the ballot.

Jelincic’s message further urged voters to press candidates for more information about CalPERS’ investment strategies. He did not return a phone call from The Bee by deadline.

“I originally ran for the CalPERS board because I thought the board was not doing its job and was too often being manipulated by staff. After eight years on the board, I can tell you it was even worse than I realized,” he wrote.

Three candidates have filed paperwork to run for Jelincic’s seat. They are State Personnel Board member Richard Costigan, state scientist David Miller, and Long Beach Unified School District member Felton Williams.

Costigan sits on the CalPERS board as an appointee from the State Personnel Board. He’s was a legislative affairs secretary and deputy chief of staff to Gov. Arnold Schwarzenegger.

He said he wanted to run for a four-year term on the CalPERS board because it would give him “more certainty” in his role on the board. His appointment from the Personnel Board must be approved every year.

Because Jelincic is not running for re-election, CalPERS is extending the candidate filing deadline for his seat. It is scheduled to close on May 30.

Michael Bilbrey, another incumbent, is seeking re-election. He’s facing challenges from Margaret Brown, the director of facilities at the Garden Grove Unified School District; Bruce Jennings, a retired legislative consultant in the Capitol; and Wisam Altowaiji, a retired city engineer for Redondo Beach.

CalPERS members will start receiving ballots for the election in September. Ballots will be counted in October.

The CalPERS board has 13 members. Some are elected by public employees and retirees, others are appointed by the governor and two are statewide elected officials.
I must say, I'm sorry to see J.J. Jelincic leave the Board as he has investment experience and asked a lot of important questions (which fell on deaf ears). More worrisome, he posted a very critical message on his website, basically saying the CalPERS Board is incompetent:
My term ends in January 2018. I have decided not to run for re-election.

I originally ran for the CalPERS Board because I thought the Board was not doing its job and was too often being manipulated by staff. After eight years on the Board, I can tell you it was even worse than I realized.

I have tried my best to improve the situation, and I think I have helped do that. But in the process, I have angered some senior management and fellow Board members who are invested in the status quo. It is clear to me that this Board has abdicated its responsibilities to challenge, monitor and supervise the staff.

The CalPERS Board is responsible for managing trust funds--other people’s money--but has allowed staff to fail to properly track costs. We have given staff permission to withhold information from the Board and allowed them to have exclusive control of the information given to the Board. The Board routinely rubber-stamps staff’s recommendations without examining alternatives or the implications of those decisions.

The Board recently changed asset allocations. Why? Secret! What factors were considered? Secret! What costs were evaluated? Secret! Was the impact on beneficiaries and employers considered? Secret!

Why should Board members know or care? Because they are fiduciaries who have an obligation to act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with these matters would use in the conduct of an enterprise of a like character and with like aims.” (from the California State Constitution) Would you hire someone to manage your money if they couldn’t tell you what they are doing or why? I invite you to ask any Board member to identify the investment strategy within any asset class.

A new election is coming up. Please look closely at the candidates. I encourage all of you to hold the Board to a higher standard. Demand real engagement. Demand real transparency. Demand real accountability.

I thank all of you for your support over the years.
After reading this, it raised my concerns the CalPERS Board isn't fulfilling its fiduciary duty. It also demonstrates why the governance at Canada's large public pensions is infinitely better than that of US public pensions. Board members at large Canadian public pensions are independent and highly qualified, they are nominated for a term and they are held accountable for these pensions.

I guarantee you that this nonsense would never fly at a board meeting at Canada's large pensions. How do I know? I've sat in on board meetings at PSP Investments when I worked there and every single board member asked good questions and was highly engaged in every aspect of that pension.

The same goes for other large Canadian pensions. The Board meetings at CalPERS are public (most, not all) and I'll give them that much, but sometimes I cringe listening to these board members and I was particularly appalled at how they treated J.J. Jelincic (see this article for more of a background).

Now, I don't know J.J. from a hole in the wall, have only exchanged one brief email with him, so I don't know everything that is going on with him and his interactions with other board members.

Dave Hart wrote a particularly nasty comment about him at the end of this article above:
It is not a sad day for Californians. J.J. went out of his way to create a wall between himself and the rest of the Board.  His comments referred to in the article are assertions that are impossible to verify and are very much "Trumpian": bombastic without any backup and do nobody any good. As a CalPERS employee, he was off work at full pay for the last 8 years and very much enjoyed being the bomb-thrower.  He failed to use his time in office to develop an articulate position of specifically what needed to be changed and made no attempt to find allies in or outside the CalPERS Board to make such changes. I wonder if his decision to not seek reelection coincides with his decision to retire from state service. In any case, his departure will not hurt CalPERS.  J.J. had the capacity to do a lot of good, but his ego took the front row. How do I know this?  I worked along side him as the chair of an allied bargaining unit for five years and got to know his good side as well as the not so good.  If the the BEE is going to print an article and repeat allegations they need to do more investigation to see if there is any there.
Obviously, J.J. has few friends on CalPERS's board and investment staff but I think he did his job as best as possible given the circumstances (when you're one against the rest of the board, you're basically a dead man walking).

Anyway, enough on that. In other interesting news, aiCIO reports that California Gov. Jerry Brown’s recently revised state budget proposes a $6 billion supplemental payment to CalPERS, which he says will save the state $11 billion over the next two decades:
The supplemental payment effectively doubles the state’s annual payment. It is intended to ease the effect of increasing pension contributions due to the state’s unfunded liabilities and the CalPERS Board’s recent decision to lower its assumed investment rate of return to 7% from 7.5%.

California currently has $282 billion in long‑term costs, debts, and liabilities; $279 billion are related to retirement costs of state and University of California employees, according to the revised budget.

“These retirement liabilities have grown by $51 billion in the last year alone due to poor investment returns, and the adoption of more realistic assumptions about future earnings,” said Brown in his budget.

As of June 30, 2016, CalPERS was only 65% funded, and reported unfunded liabilities of $59.5 billion. According to the revised budget, without the supplemental pension payment, the state’s contributions to CalPERS are on pace to nearly double by fiscal year 2023‑24. However, the additional $6 billion will reduce the unfunded liability, and help lower and stabilize the state’s annual contributions through 2037‑2038, assuming there are no changes to CalPERS’ actuarial assumptions.

According to the budget, contribution rates as a percent of payroll will be approximately 2.1 percentage points lower on average than the currently scheduled rates. For example, peak rates would drop from 38.4% to 35.7% for state miscellaneous (non‑safety) workers, and peak rates would drop from 69 percent to 63.9 percent for CHP officers.

The funding for the supplemental payment will be paid through a loan from the Surplus Money Investment Fund. Although the loan will incur interest costs of approximately $1 billion over the life of the loan, actuarial calculations indicate that the additional pension payment will lead to net savings of $11 billion over the next 20 years.

For 2017‑18, the state’s contribution to CalPERS is estimated at $5.8 billion ($3.4 billion General Fund). Without the supplemental payment, Brown says that the state’s contribution is estimated to reach $9.2 billion by 2023‑24, due to anticipated payroll growth, and the lower assumed rate of return. However, with the supplemental payment, the state’s 2023‑24 pension costs are projected to be $8.6 billion.
Lastly, Sen. John Moorlach wrote a comment that was republished on USA Today, Here's why Brown's plan to prepay CalPERS is smart:
Gov. Brown wants to prepay the California Public Employees Retirement System with $6 billion beyond what most had expected.

The source of the funds is the Surplus Money Investment Fund. Don’t ask me why a state with a $169 billion unrestricted net deficit has some $50 billion in a low interest bearing account with such an odd title. Perhaps the University of California Chancellor can explain how her system and the state can better pull these things off?

Also, don’t ask me why the timing is so odd. The Legislature just approved an annual $5.2 billion gas and auto tax increase, and now the governor has $6 billion for non-road repair expenditures?

Despite these concerns and anxieties, I like the proposal. It’s about time that the governor got serious about the state’s spiraling unfunded defined benefit liabilities, but, I would postulate that this proposal needs a little more sizzle to make it an even more interesting opportunity.

Let’s address the cash flow components of this idea. The state currently has funds that are earning less than 1 percent per year. Paying down a 7.5 percent loan would provide a bigger bang for the buck. The spread of more than 6.5 percent will provide significant savings to the state’s general fund.

It’s true that whatever is deposited into a defined benefit pension plan by a plan sponsor is irretrievable. That is, it’s not a loan to CalPERS, it’s a payment. Once it goes in, the state cannot ask for it back. But, this will be a prepayment. Consequently, should the state have a cash flow emergency, it could simply stop making the regularly scheduled payments into CalPERS and slowly accumulate back this advancement.

The upside? The state gets to pay down its liabilities sooner, which will have the potential of reducing the annual required contributions in future years. The state obtains the 6.5 percent spread in savings. CalPERS can allocate the funding to meet its own cash flow needs and reduce transaction costs by doing it in bulk. The state wins. The taxpayers will win. And CalPERS wins.

What could go wrong? Ask former New Jersey Gov. Christine Todd Whitman. In 1997, she issued $3.4 billion in pension obligation bonds. This is a risky technique that converts a soft debt to the pension system into a hard debt to bondholders.

The idea is similar to Brown’s proposal, in that the cost of the money is cheaper than the current 7.5 percent investment assumption rate of the plan. In the late 1990s, this may have been a brilliant move. But, when the “dot.com” boom turned to bust, pension plans lost a significant amount of plan funds invested in the internet-related industries.

The big risk the governor will have to face is the possibility that the investment markets may tank after making the contribution prepayment. Remember, if you lose 50 percent on your investments this year, you have to earn 100 percent next year just to break even on your principal.

It’s not a good idea to time the market. It’s better to dollar-cost average, which means investing the same amount at regular intervals over time.

We cannot see the future. It’s obvious that CalPERS cannot, based on its recent repositioning out of certain equity markets last September, which has cost it more than $900 million in lost appreciation.

Had Brown recommended this prepayment move last year, he would be a hero right now.

To make the proposal more interesting, Brown should ask the Board of CalPERS what type of incentive it will give the state for the prepayment. CalPERS will benefit from the large influx and should provide at least a 3.75 percent reduction on the actuarially calculated required contribution. This would provide a $225 million savings to the state, using the $6 billion figure, thus providing some sizzle.

Investing is not difficult, but it is also not for the faint of heart. You have to live with your decisions. Trust me, I managed a $7 billion portfolio and sat on the board of one of the nation’s largest public employee pension systems.

While serving as the Treasurer of Orange County, I assisted in constructing a prepayment vehicle for the pension system. Instead of 26 regular payments during the year on biweekly pay days, the county paid the full amount up front, less the negotiated incentive. The county borrowed the funds, at an interest rate lower than the investment assumption rate of the retirement system and has realized some $100 million in net present value savings over the last 11 years.

How did the county do with its investments over this time period, with the change in the regular payment intervals? It actually out-performed what would have occurred under the normal protocol.

We should always remember that past performance is not an assurance that future performance will be the same or better. But, prepaying CalPERS’s massive obligations is something that should be strongly encouraged. Pension plan debt is an expensive liability in the current low-interest rate environment. Consequently, public employee retirement stakeholders should enter into a good debate on this proposal.
Excellent comment and I agree with his views on the contribution prepayment but fear markets will tank in the near future and this will throw a wrench in this proposal.

Interestingly, Sen. Moorlach put forth a bill aimed to close California’s pension funding gap by eliminating cost-of-living increases but public sector unions united to kill that bill:
Moorlach, R-Costa Mesa, shaped his Senate Bill 32 using the language of climate change laws the Legislature adopted to set goals for the reduction of greenhouse gasses. Last year’s SB 32, for instance, sought to cut greenhouse gas emissions to 40 percent below 1990 levels between now and 2030.

Moorlach’s pension bill similarly would demand that CalPERS and CalSTRS reduce their unfunded liability to 1980 levels by 2030. Today, both pension systems have about 64 percent of the assets they’d need to pay all of the benefits they owe.

“The unfunded liabilities are killing us. The math is brutal,” said Dan Pellissier, president of an advocacy group called California Pension Reform.

Moorlach’s bill would have temporarily banned cost-of-living increases that pensioners receive, required local governments to increase their pension contribution rates by 10 percent and compelled public employers to offer 401(k) style defined contribution plans to supplement pensions.

The bill failed by a 3-2 vote in the Senate’s Public Employment and Retirement Committee after a parade of union representatives voiced opposition to it.

“This is really an attack on women,” said Jennifer Baker, a lobbyist for the California Teachers Association. She noted that some 72 percent of the state’s retired teachers are women.

She continued, “This is not going to incentivize more people to want to become teachers.”

Baker’s argument resonated with Sen. Connie Leyva, D-Chino, whose mother receives a pension worth about $22,000 a year.

“I really worry that we are always trying to balance the pension funding problem on the backs of the lowest paid worker,” Leyva said.

“We just have to be very thoughtful and I’m afraid that for me this doesn’t get me where I need to be,” she said.
I'm against Moorlach's 401(k) proposal, for good reasons, but go back to read my recent comment why Ontario is easing its funding rules and watch the clips at the end which show how Ontario Teachers' Pension Plan has partially or fully removed inflation protection (ie. cost-of-living-adjustments) to lower its pension deficit in the past (and it's not alone, HOOPP has done so too).

In my opinion, California's public-sector unions are not interested in sharing the risk of their plan, and this sets up a very dangerous showdown in the future when taxpayers refuse to bail these plans out. Some form of risk-sharing must take place in order to bring these plans back to fully funded status.

Below, once again, a couple of clips from the Ontario Teachers' Pension Plan which explain how small adjustments to inflation protection were instrumental in tackling their pension deficit and restoring fully funded status to their plan.

I also embedded Part 1 of CalPERS's recent Investment Committee. You can view all five parts here. As always, if you have anything to add, feel free to reach me at LKolivakis@gmail.com.

Update: After reading my comment, Alex Beath of CEM Benchmarking sent me this:
I wanted to reach out to you after reading the brief mention of our work at CEM today. I realize it’s a second hand mention and not your words, but I was hoping that you’d be able to issue a clarification. Many of our clients read your stuff, and I (clearly) wouldn’t want them to come away from it with the view that we are biased. We’re not.

The issue of course is the statement that:
"And Sam Sutton, a private equity reporter at Buyouts Magazine, told me it was intriguing to see that CalPERS’ consultant CEM Benchmarking has wound up scoring every public pension fund client he’s written about as having above average performance, which would seem to be mathematically impossible until you allow for artful selection of peer groups.”
The reason that Sam Sutton says this, presumably, is because the only funds that advertise their results are those that are “low cost”. In this I am unsurprised. Then again, if we were able to show that all our clients were low cost our business would no doubt do better, but like fools, we cling to models that show half of our clients as being high cost.

Anyway, to prove the point I’ll share with you the following, a comparison of Benchmark cost vs. Actual cost taken from the last time we choose to look at the comparison (2012). (I can send you a 2015 version tomorrow if you like; click on image)


(And for what it’s worth, I agree that funds need to do a better job capturing their Private Equity costs. Some do it well, some poorly. At CEM we currently support the use of the ILPA template for the simple reason that, after reviewing more than 200 LP financial statements, we found that it’s impossible to get (full) costs from them. The only way to get full costs from GPs is to ask.)
I thank Alex for sharing this with my readers.