Institutional investors need to be conscious of cyber threats, especially from the Chinese, who are interested in macroeconomic changes that may result in large amounts of money moving around, according to James Mulvenon, vice president of the defense group at the Center for Intelligence Research Analysis.

Mulvenon says the risks to companies of their intellectual capital being stolen is a real threat, and that the disappearance of companies such as Nortel and the recent Cisco Systems court battle were examples of the Chinese stealing data.

“We don’t know the scale of the problem, but we know it is getting worse because of us moving to the cloud and the general use of technology.”

According to Mulvenon the risk mitigation techniques should not be about keeping Chinese hackers out, but about managing them when they are in.

“I no longer spend money on defense networks to keep them out, but on monitoring networks on what is going on within the network.”

Mulvenon, a Mandarin speaker, says the Chinese are motivated to steal data in a bid to deepen their economy.

“For 25 years their economy has been shallow. We send them our components, they assemble them and then send them back. There are few global Chinese brands.”

In 2006 the Chinese government set out a plan to 2020 that had indigenous innovation at its core, and this included getting technology out of Western companies.

The good news is that most sophisticated companies in the US are running their own counter-intelligence operations with fake servers and information.

In addition, Mulvenon says he is not convinced that the Chinese would get “full utility from the information they are stealing in this cyber espionage”.

He advises institutional investors to look at their own organisations and those they invest in, and ask what is being done to protect data.

Mulvenon was a keynote speaker at the Risk Summit, convened by World Pension Forum and Conexus Financial, publisher of conexust1f.flywheelstaging.com.

Agency risk in public pension funds is a big problem waiting to surface, according to Britt Harris, chief investment officer of the Teachers Retirement System of Texas.

“In terms of beliefs, you have to decide whether the pension system is a profit centre for beneficiaries or a political system to influence outcomes,” he says.

“Also who’s money is it? The state contributes, but essentially it is a deferred tax, so in my case it is the teachers’ money and not the government’s.”

Harris says most of the world operates under professional management, but in the public sector, the board itself runs the system. “It is a formula for disaster.”

Before Harris started as chief investment officer, the fund had had seven people in the position in 10 years.

“You can’t expect to be great if you can’t attract and retain good people.”

Since he has been at the Teachers Retirement System, the board has been transformed.

“As an older CIO, I was able to say I wouldn’t work in that system or that most professional investors wouldn’t.”

Now the board sets the return expectations, the parameters and uses outside consultants to provide analysis of the team. The fund has been audited 30 times in the past three years, and Harris believes both the board and the chief investment officer are fiduciaries.

“It comes down to where the best decisions will be made and for investments, we believe that is with the staff.”

Harris was speaking in a session at the Risk Summit, convened by World Pension Forum and Conexus Financial, publisher of conexust1f.flywheelstaging.com, in which Hershel Harper, chief investment officer of the South Carolina Retirement System Investment Commission, says his fund still has a significant amount of start-up risk.

“In 2005 the investment commission started, but we have never been fully funded or fully staffed. This introduces operational risk and compliance risk.”

The panel, which also included managing director of Wilshire Associates Patrick Lighaam, vice president of strategy and asset allocation at CenturyLink Investment Management Mary Beth Gorrell and senior relationship manager at Bridgewater Associates Joel Whidden, was discussing portfolio risks.

According to Harris, Teachers Retirement System portfolio-risk management was more focused on bubbles than tail risk.

“We looked at tail risk but never did anything. We decided the amount of tail-risk hedging we could do relative to the whole portfolio wouldn’t make much of a difference,” he says. “Our ability to avoid a problem is low; what we do after the problem is our advantage. Before a bubble you need IQ and after the bubble you need courage.”

Harris says the fund tries to focus on where the fund’s competitive advantages are, and one of those is its long term nature.

The Teachers Retirement System has a duration of 24 years and pays out 3 per cent of the fund per year.

The concept of investment beliefs is the basis for strategic management and, while widely used in other parts of the world, is “innovative” from a US perspective, Allan Emkin, managing director of Pension Consulting Alliance, says.

In a session at the Risk Summit, convened by World Pension Forum and Conexus Financial, publisher of conexust1f.flywheelstaging.com, Emkin said he favoured the investment beliefs investigations being undertaken by some of his clients.

“In my 30-year career, people have implied investment beliefs but never explicitly had them. It provides a vehicle to provide a discussion in depth.”

Emkin is consultant to CalPERS, which is currently undertaking an investment beliefs process that has included discussions with staff, the board and consultants as well as an offsite workshop.

“The most important thing that has come out of the process, in my opinion, is it has dramatically improved dialogue between staff and the board about what is important for a large institutional portfolio,” he says.

Emkin said he was personally pleased that a number of the investment beliefs the board has adopted are not textbook – such as risk being multi-faceted and not fully captured by tracking error.

“I personally hate tracking error: it is a way to guarantee managers never get fired because they have a band within which to operate.”

 

For the story on the CalPERS investment beliefs workshop and a list of the draft investment beliefs, click here

 

 

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.