General secretary of the International Trade Union Confederation, Sharan Burrow, spoke to the Lowy Institute for International Policy in Sydney, Australia on Thursday August 1 about the need for an effective G20 in a precarious world.

Ladies and Gentlemen,

The global economy is no more stable today than it was six years ago, and the scourge of unemployment and inequality is driving economic instability and social despair.

In 2010 global growth stood at 5 per cent and it was described as the “green shoots” of recovery, but in hindsight it was the highlight of concerted action. The International Monetary Fund just last month again revised down global growth projections to a mere 3.1 per cent.  With the eurozone in continued recession and slow growth in the US, the drag on the BRICS countries is the latest casualty. With projected growth for Brazil at 2.5 per cent and with another percentage point off China’s growth, there is an urgent need for leadership. No nation is an island in today’s globalised economy.

Muddled multilateralism

We are, at best, facing an era of prolonged stagnation. Added to this, the increasing failure of multilateralism must be a call to action for G20 leaders. From the IMF to the United Nations, the failure to understand that the global economic crisis, caused by greed and inequality, required a social response of equal or greater urgency to that of bailing out the financial sector has generated a tidal wave of mistrust in institutions.

For the state of the world for working people and their families is very bleak. Unemployment is again rising above 200 million and youth unemployment is a problem in every nation. For crisis countries and developing nations facing continuing unemployment with youth unemployment levels of 30 to 60 per cent societal tensions are in ferment.

The International Labour Organisation (ILO) estimates a need to create 600 million new jobs in the next 10 years. Without a determined approach to rebuilding economies with sustainable jobs and social protection at the core of a coordinated global effort, we are facing an economic and social time bomb.

The International Trade Union Confederation (ITUC) presented an economic and social outlook based on the ITUC’s 2013 Global Poll, inclusive of China and India, and covering more than half of the worlds’ population to the G20 labour and finance ministers joint meeting in Moscow last week. It paints a frightening picture.

More than half of the world population say their incomes have fallen behind the cost of living in the last two years.

Almost two out of three people rate the current economic situation in their country as bad.

Global citizens feel abandoned by their governments because they are seen as failing to tackle unemployment and prioritise business interests over the interests of working families.

80 per cent of all respondents say their government has failed to effectively tackle unemployment in their country. Even significant numbers of people in the BRICS countries and in Germany say their governments have failed to tackle unemployment. Only 13 per cent of voters believe their government is focused on the interests of working families.

Over half the world’s population don’t feel they have legal protection for job security.  66 per cent don’t feel they have legal protection for fair wages. In Spain, China and Japan the majority of people think they do not have protection for reasonable working hours.

Of critical concern is that only 13 per cent of people feel that their governments are acting in the interest of people and even more worrying almost 30 per cent of people say their governments are not acting in the interests of either people or business. When you consider this with the 2012 findings of the ITUC Global Poll that only 13 per cent of people believe that they have any influence over the economic decisions of their governments, and marry such with increasing social unrest, then the disenchantment and – worse – the disengagement is undermining confidence in democracy. The loss of trust is serious and must be addressed.

Green jobs and government leadership

Our message for the G20 is obvious. We need a plan – we need hope. This requires jobs jobs and jobs: jobs, decent wages and social protection.

Tragically, the demand for jobs, while recognised in communiques has gone unheeded in terms of coordinated action. Despite the anger and frustration we feel concerning the perpetrators of the crisis and equally failed austerity policies the reality is we need to rebuild our economies with jobs – income-led growth in a cleaner and greener future – if we are to secure an inclusive and sustainable global economy.

In this regard the Business 20 (B20) and the Labour 20 (L20) are united in our call for investment in infrastructure, particularly enabling green economy infrastructure.

The L20 has called for a coordinated target of €1 trillion – less than half of the money given to bail out the banks. And, unlike the banks, we do not demand that all this money comes from government, but we do need government leadership.

Indeed we have called repeatedly for a new investment model. With $25 trillion of workers’ capital invested in the global economy, we want our money out of the speculative economy and into patient capital. It is time to push the reset button on our pension funds and draw a line between investment and speculation.

Shifting focus and failure

Let me return to further demands for the Russian G20 and the Australian presidency, but first consider the history of both hope and despair that characterises the G20 leaders meetings.

We have been at all of these meetings and met with the majority of presidents or prime ministers as well as the heads of international agencies.

In 2008, the Washington meeting was an anxious dance of possibility dogged by the dominant but waning presence of George Bush. However the tactical cry from Dominique Strauss-Kahn was heard and a commitment to coordinated stimulus was born.

London drove new levels of ambition. Gordon Brown was a G20 activist and had the support of the majority of leaders, including Australia’s Prime Minister Kevin Rudd. The original Sherpa’s text was cautious, but the leaders themselves were not and the outcome was optimistic.

You will recall that famous quote from Gordon Brown, echoed by others that “Never again will the financial sector be in control of the real economy”. The ambition was there: financial regulation, jobs, the green economy and the inclusion of the ILO and the OECD in addition to the IMF. London indeed set a tone of optimism for global leadership.

Pittsburgh was equally ambitious with Obama’s commitment to jobs – “Quality jobs will be at the heart of the recovery” was his rallying call. He had sponsored the first G20 labour ministers meeting, with both business and labour gaining consultative status, and heeded their advice. There was renewed optimism. Indeed it was the labour ministers who called for joint action with finance ministers, but we would have to wait until Russia for that.

But just six months later in Toronto, key leaders had gone or were distracted and the policy of austerity was born. It was Angela Merkel supported by the OECD, in the absence of Gordon Brown, Lula and Kevin Rudd, who, at our entreaty ensured a commitment to quality jobs.

In Seoul the talk was of growth but not of jobs. It was a strange meeting with the president of Korea, when we needed to provide an historical analysis of the previous 15 years of increasingly jobless growth, to convince him that you could not assume growth equalled jobs and decent work.

It was in fact Australia’s Prime Minister Julia Gillard who brought us the marked-up copy of the communique where she had, with others, negotiated commitments to quality jobs.

But the evidence was already in: from London and Pittsburgh to Toronto and Seoul, or between 2010 and 2011, the almost religious fervour of coordinated global action had been replaced by the failed economic policies of the previous decades of IMF conditionality. Consequently we saw divisions emerge in the G20 as America and China both declined to follow Europe’s path.

Australia continued its path with the common sense to set fiscal consolidation targets to be reached over time and successfully rowed through the worst of the crisis with targeted investment, jobs and income policies, and only marginal slowdown in demand from China.

Nevertheless, unemployment was deepening. Dominique Strauss-Kahn could see the risks and in 2011 after serious consultations with union leaders in January of that year, we put aside differences and in April at the Brookings institute in Washington jointly called for coordinated action on employment. Sadly, a wasted effort.

The frontlines of failed “structural reforms”

Hence, with serious union opposition to austerity emerging in Europe, it was indeed with some trepidation that I led the first labour meeting with President Sarkozy late in 2011 at the start of the French G20 presidency.

To our great surprise, he was increasingly concerned about the social risks and pledged to support employment, labour rights, social protection and coherence. It was in this framework that unions and employer organisations constructed the platform for global social dialogue with an L20-B20 agreement based on these fundamentals. It remains a joint commitment to a floor of principles for the social dimension of the global economy on which we have since negotiated additional specific demands.

On the surface, the Cannes Declaration looked like coordinated action was back with a commitment to employment, decent work and social-protection floors but the tragedy of Greece dominated the agenda. A nation with an economy of just 0.2 per cent of the global economy was a trigger for the disasters to come. Instead of containment, the orthodoxy of IMF and EU conditionality simply embedded contagion and the social and economic crisis we see in Southern Europe today. Rather than recovery in crisis countries, the evidence is a slump in GDP, unemployment at crisis levels, a lost generation of young people, social unrest and higher debt to GDP ratios. The old IMF was reborn, the ILO-IMF commitments of Oslo were abandoned and new partners, the European Commission and the European Central Bank, emerged in the now-infamous “troika”.

With no effective financial regulation in sight, the unregulated ratings agencies, acting in concert with the vigilantes in the bond markets, set themselves up as arbiters of nations’ fortunes and governments and, at the behest of international institutions, went to war on their people. Wages and jobs slashed, collective bargaining and minimum wages attacked along with key social protection measures – a luxury that apparently could no longer be afforded from taxpayers’ own money.

The cowboys in the financial sector who caused the crisis got off scot-free, no one went to jail for perpetration of fraud relating to toxic products, banks were bailed out with taxpayer funds, and working people and their families found themselves in the frontlines of failed “structural reforms”.

The victory of economic dictatorship

This is the backdrop to the Los Cabos summit under the Mexican presidency of the G20. Again we were surprised by the commitment of President Calderon to investment in jobs, in the green economy, social protection and inequality.

The L20-B20 agreement called for three practical initiatives: investment in jobs in infrastructure and the green economy, inclusion of young people through scaling up apprenticeships and extending the model to female-dominated sectors and measures to reduce the informal economy – now at 40 per cent of global output and withering both sustainable business and decent work.

Meeting with some 14 leaders in Los Cabos and presenting, with business, to a leaders’ breakfast gave us a sense of shared frustration, but the tensions among leaders was also becoming more evident, with the US and Europe taking different economic pathways and the BRICS countries seeking coordination among themselves in an attempt to stave off contagion for their own economies.

Our assessment is stark. International institutions have failed: austerity and conditionality have created impoverished nations with increases in both unemployment and inequality and an open attack on workers’ rights. Institutions appear to have conveniently forgotten they failed to prevent a financial sector crisis, which became a debt crisis, at their insistence to use taxpayer dollars only to then demand that the successful social contract emerging from the Great Depression and World War II be torn up with no negotiation and no eye to the resulting social or economic impact. Economic crisis has, at the hands of these institutions, bred economic dictatorship with no respect for rights and no signs of recovery.

Austerity is not working

Despite promises, the new IMF is the old IMF. Even its own research shows that austerity is not working. The announcement by Olivier Blanchard in the annual meeting in Tokyo last year admitted they had miscalculated the multipliers and that the negative impact of measures in Europe was more severe than expected.

In April, as backdrop to the IMF and World Bank meetings, the very premise of research by Reinhart and Rogoff, which underpinned the dominant policies, was challenged by Thomas Herndon, Michael Ash and Robert Pollin of the University of Massachusetts. They say they found some simple miscalculations or data exclusions that sharply altered the ultimate results. According to their rerunning of the figures, “The average real GDP growth rate for countries carrying a public debt-to-GDP ratio of over 90 per cent is actually 2.2 per cent, not –0.1 per cent”. In other words, heavy debts were not associated with the malaise that professors Reinhart and Rogoff – and much of the world’s economic elite – thought that they were.

And Laurence Ball, Davide Furceri, Daniel Leigh and Prakash Loungani in June 2013 examined the distributional effects of fiscal consolidation for a sample of 17 OECD countries over the period 1978 to 2009. The findings? “Fiscal consolidation has typically had significant distributional effects by raising inequality, decreasing wage-income shares and increasing long-term unemployment.”

Thus while we all agree fiscal consolidation over time is prudent management, the social and economic destruction wrought by pro-cyclical austerity lacks even a credible academic base.

Regulation gone awry

In addition, the financial sector has escaped vital reforms to date.

Four years after the commitment by the G20 leaders in London to re-regulate global finance, The Financial Stability Board (FSB) and its members – G20 finance ministries and central banks, the European Commission and several international organisations such as the Bank for International Settlements (BIS), the IMF, the OECD and the World Bank – have collectively failed to meet deadlines.

All standardised over-the-counter (OTC) derivative contracts – which are traded at 10 times world GDP – were to be traded on exchanges or electronic trading platforms by the end of 2012. Deadline missed.

OTC trading is still not regulated and not supervised as agreed, yet trading is at a record high and still largely disconnected from the value of the underlying assets. According to the BIS, the global value of all OTC derivatives market was at US$630 trillion at the end of December 2012 – the same level as 2007!

The US and the European Commission has some commitment to a coordinated set of reforms across the Atlantic but only a small step, and one that comes very late.

Government leaders also committed to increase both quality and quantity of capital held by banks as collateral to their assets and lending. Yet the new framework, Basel III, has been criticised by many – including the OECD – for being too complex and too reliant on self-reporting and self-assessment by bankers themselves. The phase-in of Basel III spans almost a decade to full implementation by 2019 and yet several G20 countries are already behind schedule.

Work is only just beginning on “shadow banking” – the opaque world of collateral default obligations and overnight “repo” lending market.

And no real recognition of the distortionary costs of high frequency trading equals no action.

Above all, separating the “too-big-to-fail” banks was a public rallying call. It was agreed that there were systemic risks to the entire financial sector. The G20 has an official list of 29 banks considered to be globally systematically important. But “ending TBTF” consolidation is unlikely to be fulfilled any time soon. Their market power has increased post-crisis. In all major OECD economies, assets held by the largest banks as a share of GDP rose significantly in the run-up to the crisis and have continued to do so post-crisis. In the US, JP Morgan Chase, Bank of America, Wells Fargo and Citigroup issue half of all mortgages and two–thirds of all credit cards. They held over a third of all bank deposits in the United States in 2009. It is a similar picture for European TBTF groups. And as self-interested institutions, they are spending enormous sums to lobby against reforms.

There have been similar concentration trends in the derivatives markets. In 1998, the derivatives forward-rate market was dominated by some 30 banks of equal size. In 2010, the market was dominated by 15.

G20 countries also committed to implement legislation on “resolution frameworks” by the end of 2012 to allow government to take pre-emptive action before a bank collapses and so avoid costly bailing out. Deadline missed; with the FSB acknowledging that “significant work remains”.

The US Dodd-Franck Act and the UK Vickers Commission have directed reforms but they are limited and not likely to be accepted globally.

A few countries have moved on taxation, with bank levies now relatively common across Europe, but the under-taxation of the financial sector is still a reality today. It is also because of the under-taxation of the financial sector that the labour movement strongly supports the creation of financial transaction taxation of global scale. Financial transaction taxes (FTTs) exist already in a number of countries. In January 2013 the EU finance ministers gave the green light to 11 member states representing two-thirds of EU GDP to establish a common FTT. Yet the European FTT has been and continues to be strongly opposed by banking and asset management groups.

The Australian G20 opportunities

On a more positive note, there is some renewed interest for long-term investment at the G20 level and in other international forums. The G20 should adopt “High Level Principles of Long-Term Investment Financing by Institutional Investors” when it meets in September 2013. This new agenda on long-term investment is much needed. It will help institutional and workers’ pension funds move away from short-term investment, and increase exposure to long-term projects financing infrastructure, job creation and helping meet climate-change challenges.

With this evident lack of progress, a global growth and unemployment crisis and increasing inequality, Russia has established significant priorities with job creation, labour activation and monitoring of progress. The innovation of a joint labour and finance ministers meeting demonstrated some commitment to coherence. The agenda is, again, not the issue. But with ambition constrained by an overriding priority to just manage the process, the jury is out on coherent commitment to coordinated action.

The Australian G20 must re-establish trust. Re-establishing trust requires a re-commitment to coordinated, concerted action with recognition that national policy is critical but not enough. It also requires inclusion of the representative voices of developing nations beyond individual invitations.

There are key areas of policy and governance where Australia’ experience demonstrates pathways for successful outcomes. These include: government action to prioritise jobs at the onset of the great recession; youth inclusion including the youth guarantee, apprenticeships, skills management and industry partnerships; productivity versus competitiveness; a demand floor with minimum wages and social protection; robust collective bargaining; climate justice; and just taxation measures.

The ITUC Global Poll 2013 tells us the worlds’ people support a five-point plan towards reducing uncertainty and inequality that is very much in line with these areas of focus – a plan offering hope for billions of workers:

1. Jobs: investment in infrastructure, new green technologies and industries. 92 per cent of people support investment in education, research and new technologies to create jobs, develop new industries and reduce unemployment. 88 per cent of respondents support investments in clean energy and environment related industries.

2. Fair wages: ensure reasonable wages through fair prices. Half the world’s population think prices of goods and services must reflect the cost of reasonable wages for the workers who help to provide these products.

3. Strong labour laws: including the right to strike supported by 99 per cent of people, a minimum wage, the right to collectively bargain and the right to join a union. More than 90% of people say workers across the world should receive reasonable wages and be able to work under decent working conditions.

4. A social protection floor: governments must step forward and protect the interests of workers and their families. 90 per cent and above support for active income measures which help to reduce inequality, such as decent unemployment benefits and pensions, affordable access to education, health and childcare.

5. Make large companies pay their taxes. Global citizens want tax evasion to end. They are also open to raising taxes for large companies with more than 80 per cent of people in support of measures to stop tax havens and increase taxes on big business.

However, an ongoing commitment to global coherence based on such priorities must be a certainty and result in coordinated action. The serious breakdown in trust of institutions requires coordinated action and with an often chaotic and increasingly ineffectual leadership of the UN, will the G20, step up?

If it is to do so, the ITUC believes there is an absolute need for international architecture to ensure the potential for an effective G20. Aside from the FSB, concerning financial regulation, there is no home for policy development, monitoring and support of commitments. We had great hope for the “mutual assessment process”, but it is a mere shadow of the original intent as nations watered down independent evaluation and failed to include employment and social protection as risk factors.

Will Australia put coordinated action and governance back on the table to ensure jobs, a new investment model, social protection, financial regulation, climate justice and rights? Or will the G20 simply result in more communiqués and greater loss of trust?

The ITUC, in cooperation with the ACTU here in Australia, as the L20 will continue to engage with both government and business, but a reinvestment by the leaders themselves must drive ambition and implementation to ensure hope.

The alternative is frightening.

The $46-billion Alaska Permanent Fund Corporation (APFC) will launch PCIO, a private equity version of its successful external chief-investment-officer partnerships, and is looking for partners now.

When the fund moved to a risk-based factor allocation a few years ago, it allocated mandates under its special opportunities bucket to five managers – PIMCO, GMO, Bridgewater, AQR and Goldman Sachs.

While the mandates had limits around volatility and tail risk, the idea was the mandates were a best-ideas approach giving managers freedom to invest. The Alaska Permanent Fund Corporation described them their “external CIOs”.

Now the fund will expand this idea to the private markets and is in conversation with Carlyle to be its first PCIO.

“The external CIO model has been good for us; we like it,” Mike Burns, executive director of APFC, says. “We really get a balance of approaches from the different managers and they haven’t performed at the same time or level. We are now looking at the same structure with private investments.”

Give us your best ideasMikeBurns04

Last month the board approved a commitment to Carlyle that is a specifically designed, custom program of private asset investment strategies.

The focus of that program is on global natural-resource investment strategies, including up to $375 million in primary investments to two or three of Carlyle’s private equity funds, with Carlyle International Energy Partners and NGP Natural Resources XI targeted for investment, and a yet-to-be-formed agribusiness or metals/mining fund may also receive an allocation. Also $375 million to pre-fund direct and other direct Carlyle investments, with a focus on the natural resource, metals and energy sectors.

“The Carlyle investment is step-one of a similar program to our external CIO program; the same structure with private investments,” Burns, pictured right, says.

“We are looking for managers to give us a broad multi-discipline platform. It’s pretty wide discretion with a private-equity focus. We want them to give us their best ideas. Carlyle matured quicker than the others.”

Burns says that the fund has had a long history with Carlyle which has created a “long memory bank” due to the ongoing relationship.

“Trust is more important than any strategy,” he says.

Burns says taking the advice of its consultant, Callan, adds a lot to the equation in this process.

The fund also recently awarded Blackstone two $500-million mandates; one to Blackstone Strategic Holdings Fund, a private equity fund with a strategy focused on investing in minority stakes of hedge fund general partnership interests; and an additional $500 million to a no-fee fund, in which Blackstone Alternative Asset Management will make investments in selected partnerships alongside Blackstone Strategic Capital Holdings.

“We feel one of our biggest assets is our ability to handle illiquidity and take a long-term view. We are a truly multi-generational fund and we want to play on our ability to make the most of the illiquidity premium.”

The new mandates will be funded over the next three years, most likely from equities mandates, but possibly from the existing external CIOs.

In addition to the special opportunities allocation of 20 per cent, the other risk-factor based allocations are cash and interest rates (6 per cent), company exposure (55 per cent) and real assets (19 per cent).

 

 

Financial repression will define the economic landscape for at least another decade, according to professor of financial economics at Tilburg University, Sylvester Eijffinger, which has serious implications for institutional investors.

Eijffinger, who also is also a visiting professor at Harvard, sits on the monetary experts panel of the European Union and is an adviser to the International Monetary Fund, says negative interest rates are the major issue of our time.

Negative real interest rates are here to stay, a realisation that has huge implications for investors.

“Governments have to de-leverage risk in times of low growth and they are not prepared to increase taxes; they have to do it with financial repression,” he says. “As an investor, be prepared. You have to realise that low interest rates are here to stay at the short-end and possibly at the long-end of the yield curve. This has huge implications for investments.”

By way of example, he says the European Central Bank’s policy rate stands at 0.5 per cent, while the eurozone’s annual inflation rate is 2.5 per cent. The Bank of England keeps its policy rate at only 0.5 per cent, despite an inflation rate that hovers above 2 per cent. And, in the United States, where inflation exceeds 2 per cent, the Federal Reserve’s benchmark federal funds rate remains at an historic low of 0 to 0.25 per cent.

This will be the financial and economic environment of the immediate future.

He says negative interest rates, which he describes as a kind of wealth tax, are necessary for governments to de-risk, but they come at the expense of savers.

“People who save should be aware that governments need to do this for at least a decade,” he says.

Eijffinger will give a keynote address at the Fiduciary Investors Symposium, an event that brings together institutional investors to examine the power and responsibility of fiduciary investment.

The event, which is convened by Conexus Financial, the publisher of conexust1f.flywheelstaging.com, will be held in Amsterdam from October 20 to 22, 2013. www.fiduciaryinvestor.com

Read an article by Eijffinger on the subject here.

 

 

 

Michael Trotsky, executive director and chief investment officer of the Massachusetts Pension Reserve Investment Management Board (PRIM), managers of Massachusetts $53.2-billion Pensions Reserves Investment Trust fund, PRIT, is planning a raft of cost-saving measures from co-investment to more passive strategies and much harder fee negotiation.

He’s mid-way through evaluating the fund’s many managers and strategies, determined to shave costs and improve returns.

The fund has just posted 12.7 per cent for the 12 months ending June 30, beating its 10.9-per-cent benchmark and adding $6.2 billion to its assets under management, but cutting costs is now a central theme.

“We spend of a lot of time evaluating performance and analysing our costs and fees. It’s prudent and it’s what Project SAVE is all about,” says Trotsky (pictured right), in reference to the cost saving initiative he launched earlier this year. Michael_Trotsky_-_July_11

Costs were an issue on which Trotsky grasped the nettle soon after his appointment in 2010 when, drawing on his hedge fund background, he restructured PRIM’s unwieldy hedge fund portfolio.

At the time the fund had five fund-of-funds managers, with $4 billion in 237 underlying hedge funds.

“The portfolio was struggling to beat its benchmark,” he recalls.

The fund now invests directly in 21 hedge funds and one fund of funds, managed by PAAMCO, specialising in emerging market hedge fund managers and amounting to 15 per cent of the portfolio.

It’s a process which Trotsky says has saved PRIM around $29 million in fees this financial year, and should be on course to save approximately $40 million per year once fully in place.

“Our hedge fund allocation is designed to reduce portfolio volatility with returns between equity and bonds. We are two years into our direct program and testimony to us doing a good job is the 3 per cent volatility for the allocation, compared to 12 per cent for the entire portfolio,” he says. For the fiscal year 2013 hedge funds returned 12.2 per cent.

Equities returns

Discussing the latest batch of returns from PRIM’s headquarters in the old quarter of Boston’s financial district, it’s equities that have been the star performer. The equity allocation, overweight accounting for 45 per cent of assets under management, posted returns of 18.4 per cent, beating a benchmark of 17.1 per cent. Now the plan is to pare back to target, says Trotsky.

“At 45 per cent our equity allocation is big against a target allocation of 43 per cent. It’s been based on the strong performance of equities; the normal rebalancing process will correct that overweight position.”

Of the sub allocations, domestic equity did best, returning 22.1 per cent.

Here a quarter of the portfolio is invested in enhanced index strategies benchmarked against the S&P 500 Index, with most of the remainder passively invested in a Russell 3000 Index fund.

Around 4 per cent of the domestic allocation is in an active mandate to small and mid-cap US corporates, the only “pocket” where Trotsky believes active management still pays in the domestic equity market.

Elsewhere in the equity allocation a developed-markets portfolio is split between a passive MSCI World Ex-US IMI Index fund and three active Europe, Australia and Far East mandates. An emerging markets allocation is split 50/50 between active and passive management.

More strong suits

Private equity and real estate, each accounting for 10 per cent of assets under management, were other strong suits, returning 14.1 per cent and 13.5 per cent respectively.

The private equity allocation, built up since the late 1980s and where PRIM considers itself “a pioneer”, includes over 100 managers and 200 different funds. Hamilton Lane has consulted since 2007 and the allocation aims to generate returns 3 per cent higher than US equities. It’s an area where Trotsky “does worry about the fees” but counters: “We have been doing private equity for a long time. The result is that we are in some of the best partnerships around the globe and have some very mature investments.”

The real estate allocation comprises core and none-core real estate strategies.

Core strategies include equity investment in both directly owned properties and real estate investment trust securities.

“We’ve had good performance from our direct ownership,” says Trotsky, adding that here investments are characterised by well-leased operating properties in the US that provide regular cash flows.

Non-core real estate includes more opportunistic investments such as properties that are not fully leased or require modest capital improvements.

Recently, in a bid to take advantage of low interest rates, the fund placed a moratorium on property-level debt in favour of portfolio-level leverage, issuing a $1-billion debt program in March 2013 through a combination of bank loans and private debt, but still maintaining a “relatively low” loan-to-value ratio of about 35 per cent.

“We were able to achieve an average duration of seven and a half years at 2.9 per cent; leveraged enhanced returns are a big kicker,” says Trotsky in reference to the cheap cost of borrowing and the enhanced return from investing the debt proceeds.

Positively, PRIM maintained its 6-per-cent expected five-to-seven-year return for real estate when it refreshed its asset-class return expectations earlier this year. Most other asset-class return expectations were cut, said Trotsky.

Other assets

Elsewhere value-added fixed income, comprising high yield bank loans, high yield bonds, emerging market debt and distressed debt, returned 7.6 per cent.

The worst performing asset class at PRIM was core fixed income, in which strategies include Barclays Capital Aggregate benchmarked active and passively managed portfolios, treasury inflation-protected securities and global active inflation-linked bonds.

The portfolio was down at minus 0.3 per cent although “still 88 basis points above benchmark”.

The fund is now mulling reform of its entire fixed income allocation ahead of an anticipated change in US interest rates.

“We saw the effects in May and June of interest rates going up,” says Trotsky. “The environment has changed with the economic recovery and interest rates will slowly begin to rise off of historical low levels. The consensus view is that the 30-year bull-run in fixed income will be reversed. We haven’t made any decisions yet but we are definitely thinking about it.”

The manager also has a 4-per-cent allocation to timberland in the US and Australia. It is the fund’s only natural resource play and Trotsky particularly likes the diversity it brings. “The thing about timberland is that if you don’t like the price today, you wait. It grows and you get more,” he enthuses. But PRIM’s robust results come against a backdrop of deficit and underfunding. As of January 2012 the fund was labouring under a $23.6-billion deficit, only 65 per cent funded. It is governed by a state legislature-set return of 8.25 per cent and, like other public schemes, has struggled to retain talent, fighting to fill its top posts because it can’t match salaries in the private sector. It limits Trotsky’s ability to develop an internal team, something he acknowledges “others are doing”. For now it’s business as usual. “Our performance over the benchmark is proof that our managers are earning their keep,” he says.

Getting Europe’s swelling institutional capital to support long-term projects that could benefit its uninspired economies was an idea that sent heads nodding around the continent as it suffered the brunt of the financial crisis. Get pension, insurance and foundation money into where it is most needed with the attraction of reliable long-term cash flows and you will get Europe moving again went the idea.

Despite some noble initiatives in the past couple of years, this grand vision remains just that. Governments appear enthusiastic, yet many investors feel more action is needed – coupled with a dose of empathy – to truly get long-term infrastructure investing going.

The respected EDHEC-Risk Institute in Paris recently summed up the feeling by stating that matching the supply of such investments with demand is “not self-evident.” It asked for “a policy and regulatory focus on the type of instruments that long-term investors need, rather than which sectors of the economy qualify as long-term investment.”

Mark Gull, co-head of asset management at the United Kingdom’s £9-billion ($14-billion) Pension Insurance Corporation, says, “Ultimately, what I think is required is a major shift in the government’s understanding of investors’ requirements.” British policy makers might not take too kindly to that criticism, as they have arguably been the most active in Europe. The UK is targeting some $300 billion in primarily private infrastructure investment and has simultaneously supported the development of a national Pension Infrastructure Platform.

Nonetheless, “There is a disconnect between what the government is trying to do and what most investors are focused on,” says Duncan Hale, head of infrastructure research at Towers Watson in London. For now he thinks that is low-risk existing infrastructure with steady yields. Those are sensible investments no doubt, but not the kind of projects likely to rejuvenate a continent.

Mixed signs?

One of the oldest but most apt clichés in institutional investment is that the devil lies in the detail. That is where European authorities are currently failing, argue the critics. Regulatory frameworks can complicate long-term investments and there is little indication that governments are willing to provide the kind of financial support that would spur long-term funding of bold new projects from scratch.

The Solvency II framework will not apply to Europe’s pension funds, for the time being at least, but looks set to steer insurance capital clear of risky long-term projects. Philippe Herzog of civil society group, Confrontations Europe, says an “obsession” of European policy makers on stability after the financial crisis has only recently been matched with a desire to encourage growth.

Existing accounting regulations do little to entice investors into long-term infrastructure projects many argue. The $52-billion Universities Superannuation Scheme recently stated to a UK parliamentary committee that current mark-to-market accounting standards are “detrimental” to infrastructure investing. The fund wrote that “the introduction of IFRS mark-to-market accounting for pension funds has exposed funds to increased volatility and some difficulty in incorporating assessments that markets have overshot in either direction”.

Matching the buzz in the UK on infrastructure investing has been the interest from Danish investors in igniting a market in public-private partnerships (PPPs). The country’s large pension funds have joined forces to lobby the Copenhagen government to pledge its support for the deals. The roughly $600 billion in assets controlled by the county’s funds are projected to double the size of Denmark’s GDP in 20 years – a powerful statistical argument for unlocking infrastructure investment.

Public-private partnerships have been short on the ground so far though, with deals supporting schools and old-age homes marking a tentative start to pension funds’ exposure to the financing models. The partnerships are lacking altogether in so-called greenfield infrastructure, which involves the construction of new projects rather than developing or taking over existing works, known as brownfield.

Michael Nellemann Pedersen, investment director at $34-billion PKA says there is reluctance on the government’s part despite the best efforts of Danish pension funds. Pedersen feels the government has got its sums wrong in calculating that it would be cheaper to invest itself after borrowing from bond markets than support PPPs. While it may look that way at first, such assessments fail to account for the notoriously high long-term risk of major new projects that pension investors are willing to share, Pedersen argues.

Splitting risk is a difficult business that will be central to any publicly backed infrastructure efforts in Europe. Many argue that governments stepping in to shield investors from construction risk is a necessary step. Given the limited number of existing infrastructure projects, Hale is confident that increasing numbers of investors may take the initiative themselves to look up the risk spectrum and acquire greenfield risk.

“We can easily see some infrastructure projects where pension funds cover full risk, including construction risk, but we will need to be compensated in the return,” Pedersen says. He is hopeful that some big infrastructure PPPs can be launched in Denmark in the next year or two as a pilot project with more following. “We are still waiting for a breakthrough, but things take time and our government has to get used to the idea,” he adds.

The way ahead

Efforts such as the UK’s Pension Infrastructure Platform seem a bold attempt to kick start long-term infrastructure investing. The European Commission also has a role to play in coordinating governments’ efforts, but Herzog feels “it will be many years until a doctrine is clear as the problem is being addressed for the first time”. Highlights of activity at the European level include the European Investment Bank piloting a project bond scheme.

Pedersen is unsure of the need for any grand ideas in the Danish PPP space though, saying: “I think you should start on a minor scale and look to improve and evaluate.” In a similar vein, Hale urges patience, arguing that investors have only been looking at infrastructure for a few years so there is still a lot of learning going on in the asset class.

“Anything that can help articulate where the risk is divided will help” he says. Attention to development and planning-permission regimes could also play an important part in reducing construction risk, and efforts to prevent capital gains being accrued by PPP backers in the UK are another unhelpful element that could be tackled, Hale reckons.

Investors can lead

Aside from looking to leads from governments, investors can also play their part in making the infrastructure dream a reality. Hale calls for investors to avoid “shying away from construction risk”, as there have been many investments that have been rewarded handsomely for taking on this.

Nicolas J Firzli, head of the Paris-based World Pensions Council research group, points out that pension funds are being courted at a time that few are equipped for the complexities of direct long-term infrastructure investing. “We’re talking about a dozen North American pension funds, two or three from Australia and maybe five or six European pension funds,” he says.

Many European funds are therefore playing catch-up with their overseas peers. European investors were “easily outmaneuvered” by Canadian pension funds, according to Firzli, in a 2010 competition to acquire the UK’s only high-speed rail route linking London to the Channel Tunnel, known as High Speed 1.

Firzli also cautions that whatever they do, governments might be best advised to tread carefully. “All our experiences tell us that governments and pension funds might not always have converging interests,” says Firzli. “The steering of private pension capital by public or semi-public entities, even indirectly and benevolently, isn’t necessarily a good idea.” However, some careful listening and patient fine-tuning might just pave the road to infrastructure riches in Europe.

Even using the assets of the pension plan was not enough of a leg-up to save the city of Detroit from bankruptcy. As the last words in the song Put your hands up for Detroit by Fedde Le Grand say, it is system shutdown. The fiscal demise of this city may be a lesson for other public funds about the unqualified need for a reality check. Now, (finally) it must be time to talk.

I’ve always been a fan of intervention. And sitting down with the stakeholders of US public pension funds is my idea of fun. Let’s talk. What are you afraid of? Why is there not a real conversation about the underfunding situation America’s public pension system is facing? What is stopping them from “manning up”, as we say in the West, to the unbelievable unreality that that pension fund world is living in?

Readjust your mindset

So what is the reality? For one, a return of 8 per cent a year for the next 30 years is not possible. Further as academic research, including the most recent paper by academics at Maastricht and Notre Dame, Pension fund asset allocation and liability discount rates: camouflage and reckless risk taking by US public plans? shows, linking liabilities to return expectations is not the optimal way to structure a fund. As a demonstration of that fact, defined benefit public and corporate funds in Europe and Canada do not have actuarial structures that dictate that connection, and neither do US corporate funds. US public pension funds are unique, in a bad way.

This structure also hides the fact that the underfunding situation is actually worse than it appears. One of the authors of this paper, Martijn Cremers, says that while the average funding level of US public pension funds is reported as 80 per cent, in reality it is much worse, with Pew Research Center estimating it is more like 57 per cent.

According to the paper, the fact that US public funds equate the liability discount rate to the expected rate of return results in the funds “camouflaging the degree of underfunding”.

“It makes liabilities very hard to measure. It is subjective and hard to argue about,” Cremers, who is professor of finance at Notre Dame, says. “Liabilities shouldn’t be hard to define or be so subjective.”

Invalidate complexity

Politics, finance and ethics. It’s a murky stomping ground, but the world of US public pension funds, more than ever is a political quagmire.

The complexity of the politics in these funds, and the power and financial validity it gives the state, unions and staff, means that the reality is being ignored.

Solving the underfunding issues in these funds will require political courage, starting with an honest assessment of the reality of the underfunding position. In simplistic terms, you can’t get from A to B if you don’t know that you’re at A.

To this point Cremers says US pension funds need to be as objective as possible about their liabilities, which would allow an equally objective assessment of the outcome and current promises.

It is then possible to do asset liability modelling and think about asset allocation with the right perspective.

“If a more realistic liability discount rate is used, then it is a more dire picture of funding status. But then we can talk about how to respond, and at least there is a conversation about where we are,” Cremers says.

“As a financial economist, I can say that you make better decisions if you are realistic about where you are.”

It’s old chat

But this is not a new conversation.

In 2009 a brief by Pew found that 30 US cities at the centre of the country’s most populous metropolitan areas faced more than $192 billion in unpaid commitments for pensions and other retiree benefits, primarily health care.

As part of its American Cities research, Pew says that “unfunded pension and retiree health care obligations pose a significant concern for city budgets. Although these unpaid bills are not due immediately, they limit policymakers’ ability to invest in other priorities because they place a claim on future revenue. Every dollar that goes to plug a hole in a city’s retirement funds is a dollar that cannot be spent on education, public safety, libraries, and other services.

It also becomes a vicious cycle of robbing Peter to pay Paul.

“The longer unfunded liabilities go un-addressed, the larger the bill facing future city budgets and taxpayers. To shore up retirement funds, local officials may have to cut services, reduce the workforce or raise taxes. Cities also can pay a price through higher borrowing costs because credit rating agencies incorporate unfunded retirement costs into their analyses,” the Pew report says.

No creative luxury

The Detroit story couldn’t have been summarised better.

The city has a liquidity crisis for some time. Without intervention the city would have run out of cash before the end of the 2013 fiscal year. Enter the pension fund. In order to get a positive cash flow of $4 million in fiscal year 2013, it deferred about $120 million of current and prior year pension contributions and other payments. But the pension fund is about $3.5 billion underfunded, and at this level of underfunding it is estimated the city would have to contribute approximately $200 million to $350 million annually to fully fund currently accrued, vested benefits.

Some perspectives on the city’s bankruptcy, such as that of a recent Atlantic Cities article reckon that all is not lost for Detroit. The argument is that the difference between fiscal and economic crisis is marked, and that Detroit’s bankruptcy signals a beginning.

This may be true for the music industry or entrepreneurs and investment capital, but retirement and the funding of it does not have the luxury of such creative ventures.