The funding levels of US public pension funds, falling from 100 per cent in 2001 to 77 per cent now, is the result of bad governance, according to David Villa, chief investment officer of the $91 billion State of Wisconsin Investment Board (SWIB).

He says irrational governance and imprudent management has resulted in the funding crisis in the US.

He gives examples of bad governance including contribution holidays, unfunded benefit increases, unrealistic investment return targets (with a huge bias to be optimistic), uneconomic investment decisions, higher than normal expense ratios and under-compensated investment professionals.

Villa and Sorina Zahan, partner and chief investment officer of Core Capital Management, have been working together on a paper that looks at governance, market risk and system design. They presented the findings at the World Pension Forum Risk Summit, jointly convened by Conexus Financial, the publisher of conexust1f.flywheelstaging.com.

The study aims to develop a palatable mathematical framework to compare different structures to find their vulnerabilities. The modeling is based on option modeling.

Zahan says the study looked at market risk and the impact on different pension structures – defined contribution, defined benefit and a hybrid model – and how they behave when there is not an equilibrium return.

“We looked at the robustness of the structure and the variability of returns, and the net payoff to the employee and the sponsor.”

Not surprisingly the study found that defined contribution plans are very sensitive to market risk, but defined benefit funds were not.

“Convexity, or sensitivity to market risk, is a critical source of return that is often ignored,” she says.

The study found that the defined benefit structure is the most beneficial to the plan sponsor because it keeps the upside. However, that can only be realised when there is prudent investment and management.

“The impact of poor governance is greater on less robust, or more convex, structures. The trick is not to squander the cushion,” she says. “Nothing is wrong with the defined benefit structure, but with the way it is managed.”

The study argues that hybrid plans, which SWIB offers, can allocate both the upside and downside risks between the employee and the sponsor to achieve better alignment of interest.

Villa argues that the hybrid model means better governance because when the trustees come to the table, they’re more interested in getting it right.

 

Continued use of quantitative easing is sowing the seeds of financial instability, according to Sheila Bair, former chair of the Federal Deposit Insurance Corporation, who says that the 2008 crisis taught us a credit-driven economy is not sustainable.

Bair has been an outspoken critic of quantitative easing and says there has been too much reliance on the Federal Reserve Bank.

“The economic problems are structural, not cyclical, so they need to be solved through fiscal policy,” she says, recommending tax reform and the creation of an infrastructure bank.

She says quantitative easing, or cheap credit, is designed to get people spending again, but it penalises savers and creates pressure for the investment community to find yield.

“It encourages you to take risk,” she told the audience at the Conexus Financial/World Pension Forum Risk Summit.

Bair said she was worried about the assessment of risk in markets, and says that both the bond and stock markets are inflated.

In particular, she says investment in stock markets is driven by low yields in the bond market.

“I want to think that stock market growth is driven by fundamentals, but think it’s driven by low yield on bonds.”

Bair told the pension-fund audience that there was continued volatility to come, and that long-term structural reforms were needed.

“Monetary policy has been the only game in town. We have been in quantitative easing for too long, but the Fed will have to detach very slowly,” she says. “We need to get back to real economic growth, with real wage growth and the production of goods and services that people want to buy.”

The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress to maintain stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships.

Bair says she believes in a rules-based process to regulation and recommended that, as part of that,banks are required to have more capital on their balance sheets.

“They rely too much on short-term funding,” she says. “A well capitalised banking system is essential if we want to have a stable financial system.”

As investors of bank stocks, she recommends that pension funds look at whether they are getting good shareholder value. In particular, she says there is more value in the large financial conglomerates in pieces, rather than as large institutions.

“2008 could have been avoided,” she says. “There should have been more fundamental restructuring of the banks. The investing community needs to weigh into this.”

 

 

Moody’s recent downgrade of the City of Chicago was because of its pension liabilities, according to the city’s treasurer, Stephanie Neely, who says the current actions to fix the funding deficit problems are just “re-arranging the furniture”.

“The benefits and contributions are the problem: we cannot invest our way out of this,” she says, adding that the new lowered rates of expected return won’t help in a significant way.

On average, the city’s five retirement plans are 40 per cent funded, with the Firemen’s Annuity Benefit Fund the worst off at 20 per cent funded.

The city’s pensions are guaranteed and to change the state constitution would be very difficult, she says, making changes to the situation unlikely.

Neely says the funds are liquidated every 10 to 12 months in order to pay benefits, which means the portfolios are unable to take advantage of private equity and other illiquid, long-term assets.

The city treasurer was speaking as part of a panel discussion at the World Pension Forum Risk Summit, jointly convened by Conexus Financial, the publisher of conexust1f.flywheelstaging.com.

Compared to Australia

Her session saw the comparison of the Chicago funds and their dire predicament to the Australian defined contribution system and specifically MTAA Super, the fund chaired by former Victorian Premier, John Brumby.

Brumby outlined to the largely US public-pension fund audience that the Australian superannuation guarantee system was possible because of agreement between unions, government and business about a long-term vision for Australia’s retirement, and a compulsory superannuation guarantee was legislated in 1992.

Because of the mandated contributions, the $6-billion MTAA Super, like many Australian funds, is able to take a long-term view of investments without having to worry too much about liquidity.

This allows the fund to invest in unlisted investments, and it currently has about 30 per cent in those investments.

Brumby says the big debate in Australia is the privatisation of infrastructure, with the infrastructure deficit estimated to be between $250 and $700 billion.

“If the states privatised rail, electricity and port assets to institutional investors, it would make privatisation process politically more palatable,” he says.

An indication of the demise of the system in Chicago is that the Labourers’ and Retirement Board Employees’ Annuity and Benefit Fund of Chicago was 130 per cent funded in 2000. This year it is 55 per cent funded.

It is estimated that given current contribution levels and market conditions, Chicago will drain pension assets in 12 years.

The Australian system, on the other hand, is estimated to grow from $1.7 trillion now to $7 trillion by 2020, due to the guaranteed nature of the system and mandated contributions, now at 9 per cent.

 

In his first major announcement as governor of the Bank of England, Canadian-born Mark Carney says ultra-low interest rates are here to stay. This couldn’t be worse news for pension funds, according to pension’s expert, Ros Altmann, but private-public collaboration on infrastructure could help ease the pain.

 

The prospect of another three years of ultra-low interest rates in the United Kingdom couldn’t be worse for pension schemes, argues Dr Ros Altmann, a pensions and economics policy expert and former investment banker who has advised governments, corporations, trustees and the pension industry.

Renowned particularly for her championing of savers short-changed by government policy, it’s no surprise she describes the first major announcement from Canadian Mark Carney, the new governor of the Bank of England, as promising three more years of misery.

Central to her argument against low interest rates is the “profound damage” pension funds are suffering from quantitative easing, QE, the government policy begun in 2009 designed to stimulate the economy by creating new money to buy government bonds.

“By buying so many gilts the government has forced long-term interest rates down and this is what pension funds use to value their liabilities. It is becoming more and more expensive to fund pension funds.”

Although the government argues asset price rises caused by QE will offset any increase in pension liabilities, Altmann doesn’t believe asset prices have risen in line. Estimates suggest that a 1 per cent point fall in gilt yields leads to approximately a 20 per cent  rise in pension liabilities, but only a 6-10 per cent rise in typical pension fund asset prices, she says.

Ballooning liabilities have caused many UK funds to try to adjust their investments to reduce risk by investing in bonds.

A strategy Altmann says “might prevent further sharp deteriorations but won’t overcome their deficits.” Adding: “Gilts are not a return generator” and “lock in” any deficit removing the potential of asset growth over time.

 

Infrastructure has the answer

 

One answer is for pension funds to invest more in infrastructure. The illiquidity premium will earn higher returns than gilts with the addition of a natural inflation hedge.

“It is disappointing that there has not been more urgency in putting pension fund money to new infrastructure,” she says.

One way to encourage it would be for the government to underwrite future inflation linked income streams for large scale infrastructure projects.

“This would provide pension trustees with a realistic alternative to long-term inflation linked gilts,” she suggests. “The government should say that if a project doesn’t deliver whatever the benchmark is, we will make up the difference. It would have been far better for the economy than QE.”

Altmann would also like the government to help pension funds better hedge against people living older. It is why she argues for the government to issue a longevity bond.

Although pension funds can enter into longevity swaps Altmann argues that this can be a risky transaction for many funds because of counterparty risk.

“If the government was counterparty it would be a safer and better yardstick against which pension funds could measure longevity risk,” she says.

The coupon on the bond would be linked to rising life expectancy, so if life expectancy at the fund rose, so would income from the bond. Alternatively if life expectancy fell, income would too.

“Longevity bonds would pay an interest rate dependent on rises in life expectancy which would allow pension schemes and annuity providers to better match their liabilities.”

She argues that too many UK funds have assumed that stock market returns will keep pace with their liabilities, calling it “an assumption” among pension funds that equity returns would keep up with longevity and inflation.

“This is now not the case,” she says, and urges funds to diversify and for trustees to look for both long-term themes and opportunities outside the UK.

Investment strategies she admires include the Pension Protection Fund, the UK’s lifeboat fund, which she says has the right balance between hedging its liabilities and diversified growth with its portfolio split between a 70 per cent allocation to bonds and cash, 10 per cent in global equity and 20 per cent to alternatives.

She is gloomy about the ability of local authority schemes to make up their growing deficits, saying “at some point” central government will have to bail out local authority pension schemes because taxpayers can’t fund all the pensioners.

“Funds need to be careful about their liabilities. Asset returns are not the only thing they should worry about.”

 

For more of Altmann’s views visit her blog

 

 

 

 

The Norwegian government should establish a new fund, the Government Pension Fund – Growth, to invest in developing countries, resulting in the dual benefits of jobs creation and investment returns for the fund, recommends a report by Re-define, commissioned by Norwegian Church Aid.

The NCA, which is a member of the humanitarian alliance, Act Alliance, believes that the  $760 billion sovereign wealth fund’s unique long-horizon positions it for investment in developing countries, and could go some way to providing capital for job creation.

It argues that capital from the Norwegian Sovereign Wealth Fund could be channelled into low income and lower middle-income group of countries, benefiting the fund by securing its value for future generations, but also provide much-needed capital to developing countries to create jobs and infrastructure.

Currently the Government Pension Fund – Global, invests 94 per cent in developed markets, with a target of 10 per cent in emerging markets. At the end of March, 2013 the fund invested 62.4 per cent in shares, 36.7 per cent in fixed income and 0.9 per cent in real estate.

 

 

To access the report, authored by Re-define’s managing director, Sony Kapoor, click here

 

 

 

Spain is a country of high geographic diversity where barren plains meet lush mountains and quiet old villages dot the landscape between vibrant, majestic cities. Fittingly perhaps, the country’s largest occupational pension investor Fonditel shines out as a highly sophisticated investor among an underdeveloped pension landscape.

The €3.9-billion ($5.2-billion) fund – that mostly covers employees at Spanish telecoms giant Telefonica – is getting more sophisticated too, according to chief investment officer, Jaime Martinez Gomez.

An important part of the fund’s “significant evolution”, according to Martinez, has been defining its investment philosophy. This has led to the adoption of a dynamic risk model centered around a tool that informs the fund of its tactical risk position. A series of inputs make long-term assessments that aim to give the fund an asymmetric return profile.

The tool has consistently told Martinez since the start of 2012 that the fund should be in a risk-on mode. He explains that this has come because long-term price momentum is the most dominant of the tool’s inputs. The fund has accordingly taken a hefty overweight on its equity position – some 47 per cent compared to a strategic allocation of 35 per cent.

As the fund does not want to fully incur the risks involved with blindly following its dynamic-risk management tool, it has also begun a “tactical hedging” process to cover its heavy equity exposure. “We believe it’s the right moment to hedge equities as low volatility has reduced the prices of hedges and performance has been good for the past 12 months,” says Martinez.

Despite Fonditel covering the potential downside, its 47-per-cent equity allocation marks a bold position in relation to other Spanish pension funds. They tend to follow the general continental European tradition of being bond-heavy investors. “We are more global in that sense than our peers, with the average equity allocation of Spanish funds being around 20 per cent,” says Martinez.

Fonditel invests to a steady strategic geographic spread, with 50 per cent of equity exposure in Europe, 30 per cent in the US and 20 per cent in emerging markets. It might decide to gain Japanese exposure at an upcoming strategic review, Martinez reveals, as well as possibly reducing an underweight on Spanish equities to reflect a brighter economic outlook for crisis-hit Spain.

Smart side of alternative scene

Fonditel’s 14 per cent strategic alternative allocation is also unusually high for a Spanish fund, says Martinez. With the financial crisis and the country’s real estate crash hitting the alternatives portfolio badly, he concedes, “This hasn’t served us too well over the last five years.”

The alternatives segment has been underweighted, too, in order to cater for a growing number of inactive or retired members who have worked for Telefonica since the fund was established 20 years ago. “Having a lot of members retired or close to retiring means we have to be more conservative with our illiquid investments,” Martinez explains.

The fund now has a 6.5 per cent private equity allocation, 3.5 per cent real estate investment and 1.5 per cent commodity exposure. Commodities were occupying as much 5 per cent of the portfolio as recently as 2011, but Fonditel has made a sharp switch out of cyclical commodities to retain just gold and agriculture investments, and has since reduced two-thirds of its gold exposure. “In our opinion, gold has lost part of its attraction in the past 12 months due to the probable end of quantitative easing in the United States,” he argues.

“In the next five years, we will probably further reduce our investments in very illiquid assets,” Martinez says. Instead of shunning alternatives as a consequence, Fonditel is reinvesting alternative-asset sales in a smart-beta portfolio. This should allow it to keep an exposure to alternative-risk premiums while enjoying greater liquidity.

“We have developed a model smart-beta portfolio that includes a number of strategies benefitting from different risk premiums and this will likely evolve further,” he explains.

The pain and gain in avoiding Spain

Keeping a substantial alternative exposure is a key focus, says Martinez, as Fonditel has a “low expected return” on its fixed-income portfolio, which is given a strategic weighting of 51 per cent of the fund.

Ironically, these expectations, Martinez says, would not be so dampened were it not for its activity during the eurozone crisis. “If you have all your investments in Spanish bonds, you will now have a nice expected return, but we decided not to focus on this risk,” he explains.

Fonditel has been underweighting its bond holdings significantly. “Fixed income is not going to be as good as it has been in the last two years, so we need to trust in the equity market to generate a real return,” says Martinez. It splits its fixed-income portfolio in two equal segments covering duration risk and credit risk. The first category includes core European government bonds and the second category mainly US and European corporate debt, along with emerging market sovereign bonds. Fonditel has added its remaining Spanish government paper, along with Italian and – intriguingly – French government debt in the latter category. Martinez sees “more credit risk than interest rate risk” in these investments.

Managing most of its assets passively in house, Fonditel uses futures and other traded derivatives to match indices.

The fund operates on a defined contribution basis and aims for returns of three percentage points above European inflation rates. Its risk-on position has delivered returns of between 9.9 and 14 per cent (for separate plans) in 2012 and up to 8 per cent to date in 2013. Most significantly for Martinez, he says confidentially that “the innovations we are making in our investment process are adding to our returns for the time being”.