Have We Entered the Twilight Zone?

On January 25, 2006, Phillip Bowring wrote this op-ed piece in the NYT on pension liabilities:

A remarkable if obscure event last week highlighted the potentially colossal impact on the global economy of the collision of two forces: the pension needs of aging populations throughout the developed world and the collapse of long-term interest rates. Pensions do not feature in the long list of subjects to be discussed at the World Economic Forum in Davos this week, but they ought to.

The event last week was the fall in the rate of return of 50-year inflation-indexed British government bonds to under 0.4 percent. That is far worse than anything even Japanese savers have experienced - the inflation adjusted on yen bonds was never below 1 percent.

The British bond bubble is exceptional and caused in part by regulations that force pension fund trustees to seek safety more than yield. But it is also part of a global phenomenon. For example, yields on 20-year U.S. Treasury inflation-protected bonds are 1.9 percent and those on French, Canadian and other equivalents are lower. Conventional bond yields are close to record lows almost everywhere, including emerging and higher risk markets such as Russia and Argentina.

So why should this be a problem? Are not low interest rates good for economies, stimulating consumption and encouraging investment? Unfortunately, not always - particularly when pension schemes in many companies and countries are already inadequate to meet future obligations.

In the case of Britain, the fall in long-term rates over the past year has added $30 billion to the existing pension fund deficits. In the United States, many funds already had overly optimistic of rates of return on funds. For the time being, a pick-up in some equity markets may be delaying a day of reckoning. But funds assuming an annual return of 8 percent to 9 percent, when 10-year treasuries yield half that and corporate dividend yields are under 2 percent, will face a crisis if yields do not rise.

Low long-term interest rates are having or will have very serious negative consequences that outweigh temporary apparent benefits:

The more aware corporations become of the further growth in their unfunded pension liabilities, the less willing will they be to invest surplus cash in new ventures. It will go to shore up the funds. In the United States, the weak corporate investment response to very healthy profits suggests this is happening already.

As in Japan, low interest rates have minimal impact on willingness to consume. Instead they make it seemingly painless for the government to borrow heavily for investment in schemes and bridges to nowhere.

Low long-term interest rates encourage asset bubbles of all sorts. The world may not be in an equity bubble but many parts of it have been enjoying property bubbles - and now the bond bubble. That gives central banks, fearful of bubbles bursting, reason to delay return to more normal rates.

Low rates of return from bond and equity markets encourage a shift into nonconventional assets such as hedge funds and private equity. These promise higher returns but their lack of transparency and high leverage promise more train wrecks ahead.

Annuity yields are so low that pensioners will be forced to rely on the state for welfare.

It has become fashionable in the West to see "excess Asian savings" as the main cause of low bond yields. Yes, there is scope for China, South Korea, Japan and parts of Southeast Asia to spend more and save less. There is a trend in that direction already - and, in time, oil exporters now accumulating vast surpluses will also spend more of their new wealth.

None of this can adequately explain, however, why real interest rates in the United States can be at record lows while household saving is nonexistent and the government deficit enormous.Or why British rates are so low despite record levels of household debt and a rising government deficit.

A more plausible explanation is the extraordinarily rapid pace of money supply growth almost everywhere - in Europe, Australia and even Japan as well as in the lead money printer, the United States. Rapid expansion of reserve currencies has quickly been followed by monetary surges in Asia and Latin America.

Of course there are other influences. In the information technology era, growth may be less capital-intensive than during the era of steel. And global demographic change is adding to savings and reducing growth in demand for new houses and factories.

But the major central bankers and finance ministers should stop either blaming the Asiansor just musing over the causes of low rates. Individually and severally, they are supposed to be in control of money creation, credit growth and the supply of long-term public debt.

The problems of aging and pensions were already challenging enough. Current attempts to buy short-term expansion with artificially low interest rates can only make the long-term problems greater than ever.

Keep in mind that was written back in 2006, before the financial crisis hit. What has happened since then? Unfortunately, not much has changed:

• There are fewer hedge funds but they control more assets. The same goes for the big banks where assets are concentrated in the hands of a few.
• On Tuesday, Dominique Strauss-Kahn, the managing director of the IMF said international drive to impose new regulations in the wake of the financial crisis is fading and global cooperation is diminishing.
• Wall Street's bonus bonanza continues. The FT reports that top 400 executives of Credit Suisse will share a jackpot of more than SFr3bn when a special bonus scheme that reached maturity on Wednesday pays out next month.
• Judging from the meeting organized by the Institutional Limited Partners Association on Tuesday, in New York, the LPs want to elevate the dialogue with GPs -- to the industry level. But it is just a dialogue. Partly because there is less capital to go around for new funds against the backdrop of a vastly different environment, the give and take between GPs and LPs has become much more complex. Nonetheless, in the current tug of war, very few GPs have shown willingness to compromise on terms - of the 100 or so organizations that have endorsed the ILPA principles, only a few private equity firms have signed on.
• Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said the Fed is right to pledge to keep rates at record lows for an "extended period." But he — as Federal Reserve Chairman Ben Bernanke did last week — said that doesn't mean a specific time period or number of meetings.
• Investors should acclimate themselves to years of lower-than-normal returns in both stocks and bonds, Pimco's Bill Gross told CNBC.

On the last two points, the Economist had an interesting discussion on the Dangerous curve:

What is going on in government-bond markets? Longer-dated bond yields have risen in recent weeks and the gap between long- and short-term rates (known as the “yield curve”) is much higher than normal. Potential explanations range from the benign (the economy is returning to normal) to the apocalyptic (investors have lost their appetite for government debt).

An upward-sloping yield curve, in which long-term interest rates are above short-term rates, is normal. You would expect creditors to demand a higher return for tying up their money for extended periods. An “inverted” curve, with short rates above long ones, is usually seen as a herald of recession, as it turned out to be before the credit crunch.

So what does a very steep yield curve tell us? One possibility is that the economy is heading for a vigorous recovery. For one thing, long rates are a forecast of future short rates. So the markets are essentially predicting that the Federal Reserve will eventually increase rates because the economy has been restored to health. In addition a steep yield curve creates profitable opportunities for banks, which can borrow short-term at a low rate and lend to companies at a higher one. The Fed engineered a steep yield curve in the early 1990s to boost bank profits after the savings-and-loan crisis.

This time, however, a steep yield curve is hardly stimulating bank lending. Bank credit has contracted over the past 12 months. Big companies are turning away from the banks to the bond market as a result: high-yield bond issuance in March broke the previous monthly record. Smaller companies have found it more difficult to borrow money.

A rise in long-term bond yields could indicate a belief that inflation is set to soar. But inflation expectations, derived from the gap between yields on index-linked and conventional bonds, hardly suggest fears of a Zimbabwe-style debasement. American inflation is expected to average just 2.4% between now and 2028.

There are other possibilities. One current technical oddity in the markets is the “negative swap spread”. In the interest-rate swap market borrowers exchange fixed-rate streams of payments for floating ones (or vice versa). The floating rate is often based on LIBOR, the rate at which banks borrow from one another. The fixed-rate element normally carries a higher yield than that of Treasury bonds with the same maturity. After all, the other counterparty in the swap will usually be a bank, which is less creditworthy than the American government. But on March 30th the fixed-rate element of a ten-year swap was paying 3.82%, while the equivalent Treasury bond was yielding 3.87%. Does that really mean the market considers banks a better credit risk than the Treasury? Given the continued use by banks of government-support schemes of various kinds, that seems ridiculous.

A more likely explanation is the sheer volume of bonds being issued. These bond issuers would rather swap their fixed-rate obligations for floating-rate ones. So they have to pay a floating rate and receive a fixed one. The result is an imbalance of supply and demand: those people willing to pay the fixed-rate part of the swap can get away with a lower yield than the American government.

In Britain a similar technical oddity has led to the 30-year swap spread being negative for a considerable period already. Demand from British pension funds, which use the swap market to hedge their long-term liabilities, has forced down fixed-swap rates. What is seen as an unusual situation in the American market may become the norm.

Technicalities aside, the most plausible explanation for the steep yield curve is the interaction of monetary and fiscal policy. On the monetary side the Fed is holding short rates at historically low levels in response to the severity of the crisis. On the fiscal side America’s budget deficit has soared to over 10% of GDP, leading to heavy debt issuance. Recent Treasury-bond auctions have seen fairly weak demand, forcing yields higher.

This still represents a challenge for markets. One reason why equities have rallied is that their potential returns have seemed attractive relative to government-bond yields. Now there will be more competition. And governments have been able to support their economies so generously because their financing costs have been so low. Higher yields will add to the pressure on them to tighten fiscal policy. A market and an economy too dependent on government support will have to learn to live without its crutch.

The problems of aging and pensions are only going to exacerbate fiscal woes, placing more upward pressure on bond yields as heavy debt issuance will continue to cover these costs.

Finally, there is a real risk that tightening fiscal policy at a time when private demand remains weak could send economies back into recession. Welcome to the twilight zone.

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Greek-Style Financial Crisis Hitting U.S. States?

Mary Williams Walsh of the NYT reports, State Debt Woes Grow Too Big to Camouflage:

California, New York and other states are showing many of the same signs of debt overload that recently took Greece to the brink — budgets that will not balance, accounting that masks debt, the use of derivatives to plug holes, and armies of retired public workers who are counting on benefits that are proving harder and harder to pay.

And states are responding in sometimes desperate ways, raising concerns that they, too, could face a debt crisis.

New Hampshire was recently ordered by its State Supreme Court to put back $110 million that it took from a medical malpractice insurance pool to balance its budget. Colorado tried, so far unsuccessfully, to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002. It wanted the money for its university system and seems likely to get a lesser amount, perhaps $200 million.

Connecticut has tried to issue its own accounting rules. Hawaii has inaugurated a four-day school week. California accelerated its corporate income tax this year, making companies pay 70 percent of their 2010 taxes by June 15. And many states have balanced their budgets with federal health care dollars that Congress has not yet appropriated.

Some economists fear the states have a potentially bigger problem than their recession-induced budget woes. If investors become reluctant to buy the states’ debt, the result could be a credit squeeze, not entirely different from the financial strains in Europe, where markets were reluctant to refinance billions in Greek debt.

“If we ran into a situation where one state got into trouble, they’d be bailed out six ways from Tuesday,” said Kenneth S. Rogoff, an economics professor at Harvard and a former research director of the International Monetary Fund. “But if we have a situation where there’s slow growth, and a bunch of cities and states are on the edge, like in Europe, we will have trouble.”

California’s stated debt — the value of all its bonds outstanding — looks manageable, at just 8 percent of its total economy. But California has big unstated debts, too. If the fair value of the shortfall in California’s big pension fund is counted, for instance, the state’s debt burden more than quadruples, to 37 percent of its economic output, according to one calculation.

The state’s economy will also be weighed down by the ballooning federal debt, though California does not have to worry about those payments as much as its taxpaying citizens and businesses do.

Unstated debts pose a bigger problem to states with smaller economies. If Rhode Island were a country, the fair value of its pension debt would push it outside the maximum permitted by the euro zone, which tries to limit government debt to 60 percent of gross domestic product, according to Andrew Biggs, an economist with the American Enterprise Institute who has been analyzing state debt. Alaska would not qualify either.

State officials say a Greece-style financial crisis is a complete nonissue for them, and the bond markets so far seem to agree. All 50 states have investment-grade credit ratings, with California the lowest, and even California is still considered “average,” according to Moody’s Investors Service. The last state that defaulted on its bonds, Arkansas, did so during the Great Depression.

Goldman Sachs, in a research report last week, acknowledged the pension issue but concluded the states were very unlikely to default on their debt and noted the states had 30 years to close pension shortfalls.

Even though about $5 billion of municipal bonds are in default today, the vast majority were issued by small local authorities in boom-and-bust locations like Florida, said Matt Fabian, managing director of Municipal Market Advisors, an independent consulting firm. The issuers raised money to pay for projects like sewer connections and new roads in subdivisions that collapsed in the subprime mortgage disaster.

The states, he said, are different. They learned a lesson from New York City, which got into trouble in the 1970s by financing its operations with short-term debt that had to be rolled over again and again. When investors suddenly lost confidence, New York was left empty-handed. To keep that from happening again, Mr. Fabian said, most states require short-term debt to be fully repaid the same year it is issued.

Some states have taken even more forceful measures to build creditor confidence. New York State has a trustee that intercepts tax revenues and makes some bond payments before the state can get to the money. California has a “continuous appropriation” for debt payments, so bondholders know they will get their interest even when the budget is hamstrung.

The states can also take refuge in America’s federalist system. Thus, if California were to get into hot water, it could seek assistance in Washington, and probably come away with some funds. Already, the federal government is spending hundreds of millions helping the states issue their bonds.

Professor Rogoff, who has spent most of his career studying global debt crises, has combed through several centuries’ worth of records with a fellow economist, Carmen M. Reinhart of the University of Maryland, looking for signs that a country was about to default.

One finding was that countries “can default on stunningly small amounts of debt,” he said, perhaps just one-fourth of what stopped Greece in its tracks. “The fact that the states’ debts aren’t as big as Greece’s doesn’t mean it can’t happen.”

Also, officials and their lenders often refused to admit they had a debt problem until too late.

“When an accident is waiting to happen, it eventually does,” the two economists wrote in their book, titled “This Time Is Different” — the words often on the lips of policy makers just before a debt bomb exploded. “But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite.”

In Greece, a newly elected prime minister may have struck the match last fall, when he announced that his predecessor had left a budget deficit three times as big as disclosed.

Greece’s creditors might have taken the news in stride, but in their weakened condition, they did not want to shoulder any more risk from Greece. They refused to refinance its maturing $54 billion euros ($72 billion) of debt this year unless it adopted painful austerity measures.

Could that happen here?

In January, incoming Gov. Chris Christie of New Jersey announced that his predecessor, Jon S. Corzine, had concealed a much bigger deficit than anyone knew. Mr. Corzine denied it.

So far, the bond markets have been unfazed.

Moody’s currently rates New Jersey’s debt “very strong,” though a notch below the median for states. Moody’s has also given the state a negative outlook, meaning its rating is likely to decline over the medium term. Merrill Lynch said on Monday that New Jersey’s debt should be downgraded to reflect the cost of paying its retiree pensions and health care.

In fact, New Jersey and other states have used a whole bagful of tricks and gimmicks to make their budgets look balanced and to push debts into the future.

One ploy reminiscent of Greece has been the use of derivatives. While Greece used a type of foreign-exchange trade to hide debt, the derivatives popular with states and cities have been interest-rate swaps, contracts to hedge against changing rates.

The states issued variable-rate bonds and used the swaps in an attempt to lock in the low rates associated with variable-rate debt. The swaps would indeed have saved money had interest rates gone up. But to get this protection, the states had to agree to pay extra if interest rates went down. And in the years since these swaps came into vogue, interest rates have mostly fallen.

Swaps were often pitched to governments with some form of upfront cash payment — perhaps an amount just big enough to close a budget deficit. That gave the illusion that the house was in order, but in fact, such deals just added hidden debt, which has to be paid back over the life of the swaps, often 30 years.

Some economists think the last straw for states and cities will be debt hidden in their pension obligations.

Pensions are debts, too, after all, paid over time just like bonds. But states do not disclose how much they owe retirees when they disclose their bonded debt, and state officials steadfastly oppose valuing their pensions at market rates.

Joshua Rauh, an economist at Northwestern University, and Robert Novy-Marx of the University of Chicago, recently recalculated the value of the 50 states’ pension obligations the way the bond markets value debt. They put the number at $5.17 trillion.

After the $1.94 trillion set aside in state pension funds was subtracted, there was a gap of $3.23 trillion — more than three times the amount the states owe their bondholders.

“When you see that, you recognize that states are in trouble even more than we recognize,” Mr. Rauh said.

With bond payments and pension contributions consuming big chunks of state budgets, Mr. Rauh said, some states were already falling behind on unsecured debts, like bills from vendors. “Those are debts, too,” he said.

In Illinois, the state comptroller recently said the state was nearly $9 billion behind on its bills to vendors, which he called an “ongoing fiscal disaster.” On Monday, Fitch Ratings downgraded several categories of Illinois’s debt, citing the state’s accounts payable backlog. California had to pay its vendors with i.o.u.’s last year.

“These are the things that can precipitate a crisis,” Mr. Rauh said.

You better believe these are things that can precipitate a crisis. That's why the Federal Reserve will do whatever it takes to avoid debt deflation and try to reflate this problem away. If they can reflate assets, and let inflation expectations bring yields up, then the present value of future liabilities will come down, buying underfunded pension plans some more time.

But it won't be enough. As David Dodge stated, we need to have an "adult discussion" on pensions. You can't assume the problem away, and you can only buy so much time before you got to pay the piper.

Goldman Sachs is in the business of investment banking. They and others like JP Morgan are counterparties to these interest rate swaps that have caused debt to mushroom around the world. I find it ironic that Goldman issued a report acknowledging the pension issue and then concluded that states are very unlikely to default on their debt as they have 30 years to close pension shortfalls. If adopted, GASB's proposed changes to accounting rules on how pensions value their liabilities will add pressure to cover these shortfalls much sooner.

The pension issue won't go away. It might get better for one or two years, but if serious gaps are not addressed, and tough political decisions are not taken, it's only a matter of time before Greek-style debt woes hit the U.S. and other developed nations.

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Are Pension Liabilities Set to Explode?

Gina Chon of the WSJ reports, Gurus Urge Bigger Pension Cushion:

Government-pension problems, widely considered bad, may actually be even worse.

That is the assessment of some experts who maintain that the current rules of number crunching for state and local governments make retirement-benefit obligations seem lower than they really are.

Soon, their view may prevail. The accounting board for governments is likely to move toward changes that would increase the pension liability that local governments display on balance sheets by tens of billions of dollars.

If the modifications are approved, many already cash-strapped states and municipalities would likely have to increase the amount they are supposed to pay annually to their pension funds to help cover the shortfall.

The General Accounting Standards Board, or GASB, Norwalk, Conn., indicated the direction it was heading in board meetings in January and February.

Since then, public pension funds have been abuzz about the potential change. People familiar with the matter say it is likely those tentative decisions will be adopted. Initial recommendations will be out in June and a final decision is expected next year.

Even without GASB changes, underfunded pension systems already represent a financial problem for many states, thanks mostly to market declines, a lack of funding by governments and benefit increases.

According to a recent study by Wilshire Consulting, the average funding level of state public pension plans was at 65% in 2009, compared with 85% in 2008. Experts recommend that public pension funds maintain at least an 80% level of funding to be healthy.

The accounting changes generally focus on the entire amount of underfunding, rather than the status of a typically smaller annual contribution, and move away from using a fund's expected investment return to calculate pension liabilities.

Twenty-seven state treasurers and 61 representatives of pension systems wrote letters to GASB opposing any changes. The opponents include some of the largest pension funds in the country, including those in California, New York State and Texas.

"This volatility and uncertainty would promote not only inconsistency in the measurement and disclosure of pension information, but also would disrupt public sector budget processes," said the pension systems' letter on the possible changes.

Proponents of the modifications, which include some government bond buyers, civic groups and others who use the financial information presented by local governments, say the current standards mask problems facing pension systems, and therefore, the fiscal predicaments of local governments.

"The current pension deficit disclosure standards have been professionally gamed for a long time," said Diann Shipione, a former trustee of the pension fund for the city of San Diego who has long pushed for tougher standards in pension-fund accounting. "The GASB is now fighting to create the environment where greater clarity is the result."

One thing GASB is looking at is how pension liabilities should be calculated. Governments normally don't display their unfunded pension obligation as a liability on the balance sheet.

Instead, they list only the shortfall in the annual required pension contribution. As a result, states and municipalities that pay the annual contribution report zero pension liabilities. The total unfunded liability is reported in the notes section of the balance sheet.

Under tentative decisions by GASB's board, the displayed number would be changed to the total unfunded pension liability, typically larger than the annual obligation.

For example, New Jersey hasn't paid its annual contribution of $2.5 billion for the current fiscal year, but its underfunded pension liability currently stands at $46 billion.

Another issue: how to calculate the unfunded pension obligation. Currently, the total projected benefits obligation is lowered based on how much the fund is expected to reap in investments, commonly 8%.

Critics argue that rate, which for accounting purposes is known as the discount rate, is inappropriately high. GASB has looked at several alternatives that are currently lower than 8%.

The drop of one percentage point in the discount rate means a 10% to 20% increase in the total pension obligation, according to James Rizzo, senior consultant and actuary at Gabriel, Roeder, Smith & Co., a consulting firm for the public sector. For example, a pension system with a total liability of $100 billion would have an obligation of as much as $120 billion after a decline of one percentage point in the discount rate.

The displayed amount of the unfunded pension liability could be increased even further if GASB lowers the so-called amortization period for unfunded liabilities, or the number of years funds can stretch the liability over. The longer the period, the smaller it looks.

Currently the figure used is a maximum of 30 years. The GASB's tentative decision is that pension liabilities should be amortized over the remaining employment years of the worker, which can be closer to 15 to 20 years for some employees.

Changes to how pensions calculate their liabilities will hit every major public pension plan. Kris Hundley of the St-Petersburg Times recently reported on Florida's pension fund running a deficit for first time since 1997:

On March 1, the state agency that invests public pension money issued a news release bragging about a 16.3 percent rebound in its portfolio in the second half of 2009.

Two days later, the State Board of Administration sat down with its advisory council and revealed the rest of the story:

Even with those gains, Florida's public pension fund slipped into the red in 2009 for the first time in a dozen years. And the fund's shortfall is projected to be even bigger this year. That news has not been as widely publicized.

While past surpluses in the pension fund kept a lid on local contributions during boom times, now the bill is coming due. And plugging the multibillion-dollar deficit will require about a 40 percent hike in contributions from local governments stretched by declining revenues.

Though checks will still be in the mail for Florida's public retirees, by July the fund is expected to have just 87 cents for every dollar in pension promises made. Like a tiny leak, this unfunded liability can grow into a gusher if not addressed quickly. But none of the fixes will be too palatable with either the nearly 1 million public employees and retirees covered by the plan or taxpayers who foot the bill.

The options include:

• Raising more money from local governments.

• Trimming benefits for retirees.

• Making public employees, who now pay nothing toward their pensions, chip in.

Variations on these themes are already bubbling through the Legislature, with limited success. Under one proposal, the state's pension plan would be closed to new employees; another would make new hires pay 1 percent toward their pensions. A less-ambitious proposal by Republican Sen. Mike Bennett of Bradenton, which would affect benefits of employees with less than 10 years' service, was watered down in committee Tuesday. It's the first pension reform proposal to get a hearing this year.

Miami Republican Rep. Juan Zapata has put forth the most far-reaching changes, including limiting payouts to higher-paid "special-risk" employees like firefighters.

Zapata, who is not running for re-election, knows tinkering with benefits is unpopular.

"I took it upon myself to kind of take one for the team to, at the very least, have a conversation about it," he said. "Because nobody's talking about it, and it's an incumbent problem."

State law requires government contributions be set at a rate that covers a year's benefits, but the state doesn't have to fully eliminate the long-term deficit. Last week, a House committee proposed taking this route, which still translates into a $460.8 million bump in local contributions.

But, barring a meteoric rise in investment returns, ignoring the pension deficit means watching it grow. To adequately address the gap, the fund's actuary said, governments will have to pony up even more money — more than doubling the contribution for some elected positions.

The House is proposing to postpone the full increase until after the fall elections.

• • •

While lawmakers tinker with the funding side of the equation, the SBA is exploring ways to increase investment returns on the $116 billion fund. The strategy? Put more money into higher-risk but potentially higher reward alternatives like hedge funds, private real estate and even timber land.

Dennis MacKee, SBA spokesman, denies that the move into riskier investments is anything new. "We started looking into hedge funds when we were well overfunded," he said.

And he says that by diversifying its portfolio, the SBA is actually decreasing risk.

But even if the SBA upped its risk profile considerably, the payoff is debatable. The board's consultants said earlier this month that by sticking with its current asset mix of mostly stocks and bonds, there's only about a 50-50 chance the fund is going to reach its assumed rate of return of 7.75 percent.

Jack up the risk? Probability of making that return ticks up slightly, to 55.4 percent.

"It's a joke," said Leo Kolivakis, a former senior investment analyst at two of Canada's largest pension funds and publisher of the blog, Pension Pulse. "They're deluding themselves if they think they can get that kind of return. And they're taking big risks with pensioners' money."

But the alternative is even less attractive. Lower the projected rate of return to a more conservative number and the state's pension gap grows, triggering even harsher demands on the funding side.

"Pension funds that are experiencing downturns are turning to a 'Hail Mary' pass to save them," said former SEC attorney and South Florida accountant Edward Siedle about the move to riskier investments. "But they'd better have a really good arm, because it's a stretch."

Nor are the SBA's trustees — Gov. Charlie Crist, Attorney General Bill McCollum and Chief Financial Officer Alex Sink — particularly eager to tackle the unfunded liability issue. As beneficiaries of the plan, they're not anxious to talk about paring back benefits. As politicians, all running for higher office, they see no upside in demanding more money from taxpayers or telling them they'll lose services because the dollars are going to government retirees. Voters will be mad enough to find out their library is closing. Tell them the money is going to the retired librarian and they'll be even madder.

Andrew Biggs, former principal deputy commissioner of the Social Security Administration, has strongly criticized public pensions for using what he calls "bogus accounting" and believes the unfunded liability in all states, including Florida, is worse than projected.

"There's no incentive for anybody to be honest about this stuff because the taxpayers are going to be upset," said Biggs, now resident scholar at American Enterprise Institute. "That produces lower contribution rates today but passes off the risk to future taxpayers."

• • •

When experts talk about the recently opened gash in Florida's pension fund, they quickly add this caveat: We're in a whole lot better shape than most states.

Florida was one of only four state pension funds to go into the current recession fully funded. And based on its performance in fiscal 2008 — before the market meltdown — Florida was touted as a nationwide model in a report on public pension funds by the Pew Center on the States.

Kil Huh, director of research at Pew, said it's not surprising that Florida's pension fund should slip into a deficit, given market conditions.

"You're going to see a drop in assets, as well as an increase in unfunded liabilities until the actuarially required contributions catch up," he said. "But that's provided states fully fund these things, which is a big 'if' in this fiscal environment."

States that procrastinate find the tab quickly snowballs. New Jersey was fully funded in 2002 when it began to shortchange its contributions. By 2008 the New Jersey plan was one of the worst in the nation, about 73 percent funded. Catching up now would cost an estimated $3 billion; the state's new governor has recommended simply skipping this year's payment.

Richard Keevey, a professor at Princeton University and consultant on a Pew pension report in 2007, has watched the New Jersey debacle unfold in his back yard.

"When economic times are bad, legislatures are torn by priorities and underfund the pension a little bit till things get better, but they never do," he said. "Florida shouldn't go down that path."

Eric Johnson, assistant county administrator in Hillsborough County, knows exactly what it would take for his municipality to fulfill its pension obligations to about 5,000 public employees this year: $44.5 million, an increase of 18 percent.

To meet that obligation during a year when tax revenues continue to plummet, Johnson said the county was considering cutting benefits or replacing workers with private contractors.

While he's relieved to hear the Legislature is proposing a somewhat smaller increase in contributions, Johnson is troubled by what that means long term. He worries that Hillsborough's triple A credit rating, which translates into lower borrowing costs, could be jeopardized by the move.

"If you have a pension plan, it ought to be fully funded," Johnson said. "Part of the creditworthiness of a government is based on its unfunded liabilities. And the challenge is, when you punt one time, how confident should anyone be that you won't punt a second time?''

If the new accounting standards are implemented, many states risk seeing their creditworthiness slip a few notches. As if that isn't bad enough, the WSJ also reported that federal criminal investigators are looking into possible wrongdoing involving investment transactions of public pension funds including Calpers, the nation's biggest public pension fund by assets.

Accounting woes and criminal investigations are going to rock US public pension funds. It's about time regulators start taking pensions seriously. My only concern is that it's too little, too late.

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David Dodge Calls for Pension Reform

Janet Taber of the Globe & Mail reports, David Dodge Calls For Pension Reform:

Former Bank of Canada Governor David Dodge is adding his voice to the debate over pension reform, calling today for a voluntary component to the Canada Pension Plan.

Speaking at the 'Canada 150: Rising to the Challenge' conference in Montreal this morning, Mr. Dodge also said there needs to be an “adult debate” over health care.

He painted a stark picture of choices and challenges facing Canadians today. Now the Chancellor of Queen's University, Mr. Dodge was the keynote speaker introducing the panel dealing with real life issue for Canadian Families.

Nortel workers and others workers who have lost pension savings as their companies went “bust” during the recession, Mr. Dodge said reforms will not likely help them.

But there is still time to help other workers.

“Much really can be done to improve the policy framework for these plans going forward,” he said, “possibly we could have a voluntary component for the Canada Pension Plan and the Quebec Pension Plan.”

Finance Minister Jim Flaherty announced this week that his government is launching cross-country consultations into pension reform.

Mr. Flaherty has said the government will be looking at four key areas, including adding a voluntary supplement to the CPP - which he admitted would be difficult to administer.

Some provinces are also looking at this, seeming to favour adding a voluntary layer of supplemental benefits to the CPP.

Michael Ignatieff’s Liberals, meanwhile, have called for something similar to what Mr. Dodge is saying - an opt-in plan to supplement the existing CPP.

The finance minister is guaranteeing that “all options” are on the table. Mr. Flaherty is hoping to find some sort of consensus between the federal and provincial governments in time for the ministers meeting in May.

This morning, Mr. Dodge said it was “absolutely essential” that reforms and changes take place.

“Let’s not kid ourselves, middle and upper middle Canadians now in their prime earning years are going to have to save more and expect to retire later in life than they hoped to do,” said Mr. Dodge.

On the health care issue, Mr. Dodge laid out several scenarios as to how Canadians can pay for escalating health care costs, including paying for it with dedicated health care taxes, reducing services and forcing individuals to pay or simply allowing longer wait times.

“These are stark and unpalatable choices,” he said. “There is no magic solution and we absolutely must have an adult debate about how we are going to deal with this.”

David Dodge is one of the sharpest economic minds in Canada. He knows we can't dodge the fiscal bullet. He sees the writing on the wall and he is calling for Canadians to save more, but the problem is that for most Canadians, there little room to save more, and anxiety abounds over pension woes.

Is there a way to improve the Canadian pension system? Of course there is, just like there is a way to drastically improve our health care system, but there needs to be a political will for change.

Below, you can watch Mr. Dodge speaking to reporters on health care reform. As he states, "you can't assume the problem away" on health care (and pensions). You're either going to pay for it with higher taxes and special levees or pay for it out-of-pocket which has distributional consequences. Mr. Dodge is clear, we need an "adult discussion" on these issues and we need to stop making promises which we can't deliver. I couldn't agree more.

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Private Equity's Unwelcome Intruder?

Hester Plumridge reports in the WSJ, Private Equity's Unwelcome Intruder:

The Ontario Teachers Pension Plan has just beaten European buyout firm CVC Capital Partners to the chase to buy U.K. lottery operator Camelot Group. While the £389 million ($576.4 million) deal may be relatively small, it could be the start of a wider trend. Pension funds such as Ontario Teachers are bypassing secondary funds to take charge of equity investments themselves. Their offers of longer-term ownership, and the potential for paying higher prices, could give them an edge with vendors.

Pension funds traditionally invest in companies via secondary vehicles: specialist-mutual, private-equity, sector or index funds. But Ontario Teachers, which manages $87.4 billion of funds, claims to be changing the industry model. Well over half of its $34.9 billion equity investments are made directly in companies. Benefits include eliminating hefty external manager fees, as well as retaining greater control over holdings.

Other funds are following suit. The California Public Employees' Retirement System, the largest U.S. pension fund by assets with $200 billion, will invest directly up to a third of the $1.3 billion earmarked for infrastructure investments this year.

In theory, pension funds have several advantages over private-equity managers. Pension-fund liabilities, and therefore their investment time frames, stretch to decades, rather than years as is the case with private equity. The promise of long-term ownership swung the Camelot deal for shareholders. Pension funds also may have a lower cost of capital than private equity, as they don't require a liquidity premium to reflect the cost of locking up money. That may enable them to outbid private equity or run investments with less aggressive capital structures. Escaping private equity's hefty fees also boosts returns.

Of course, direct investment requires in-house expertise that is both resource heavy and hard to build up, which is why so few pension funds are doing it. But Ontario Teachers notes that returns on its portfolio of in-house investments have exceeded those from external managers.

Private equity should keep its fingers crossed that the idea doesn't catch on.

I strongly doubt this idea will catch on because most pension funds do not have the in-house expertise to engage in direct investments. And I would caution readers that the big private equity funds still source the big deals, allowing pension funds to co-invest at lower fees (they still need in-house expertise to co-invest alongside PE funds).

The press release on Teachers' website offered a few more details on this deal:

The Ontario Teachers’ Pension Plan (Teachers’), the largest single-profession pension plan in Canada, announces that it has agreed to acquire Camelot Group plc, which has an exclusive licence to operate the UK National Lottery, for an estimated consideration of £389 million. Details of the transaction were not disclosed.

Teachers’ will acquire the shares from Camelot’s five shareholders: Cadbury Holdings Ltd., De La Rue Holdings plc, Fujitsu Services Ltd., Royal Mail Enterprises Ltd. and Thales Electronics plc. Completion of the transaction is conditional upon approval from Camelot’s regulator, the National Lottery Commission.

Wayne Kozun, Teachers’ Senior Vice President, Public Equities, said: “As a pioneer in direct investing, and with an excellent global investment track record, we look forward to partnering with management to realize the full potential of the Camelot business over the remaining licence term and into the future.” Mr. Kozun added that, as a pension plan, the fund has a long term time horizon, as it can be 70 years or more from the time a teacher‘s career begins until the last survivor pension payment is made. “We’re known as a patient investor,” he said.

The acquisition is made on Teachers’ behalf by its Long-Term Equities division, which is focused on direct investments that have steady cash flow and growth potential over a long-term horizon.

“We believe that Camelot is a world leading lottery operator and we are delighted to be involved with such a company which presents a unique, long term opportunity to earn attractive risk-adjusted returns,” said Lee Sienna, Vice President Long Term Equities. “As a significant shareholder or sole owner, Teachers’ Long Term Equities division works actively with the board and management of portfolio companies to develop strategies and policies that build businesses and create long-term value. Camelot is an excellent example of a first class business with long term potential and we look forward to making further investments to grow the company.“

Dianne Thompson, Chief Executive of Camelot Group plc, said: “We welcome Teachers’ commitment to The National Lottery’s ongoing success, and look forward to the opportunity of working with them to continue our progress in developing the business and delivering even more money for the Good Causes.”

Teachers’ already has a successful history of direct investments in UK companies, including Acorn Care and Education, Bristol International Airport, Birmingham Airport, Scotia Gas Networks, InterGen and Thomas More Square Estate, as well as substantial shareholdings in a variety of publicly listed companies. It has offices in Toronto, London and New York.

Of course, things don't always go Teachers' way. Earlier this week, Australia's Future Fund, the country's version of a sovereign wealth fund, said it wouldn't back Ontario Teachers' Pension Plan and Canada Pension Plan Investment Board in its attempt to buy control of toll road operator Transurban.

Both Teachers and CPPIB are heavily investing in private equity and infrastructure deals, which carry their own set of risks. While I welcome the shift towards direct investments, I also know that most of these deals are co-investments alongside big PE funds to bring down fees. It's no panacea and these investments still need to be properly benchmarked to reflect the risks the pension fund managers are taking.

***Feedback***

Here are some comments I received:

"The partners of Private equity firms usually are serial entrepreneurs who have their own substantial amounts of money in the fund AKA skin in the game and hard knocks experience. The EMPLOYEES at a pension fund have neither. I am not a big fan of private equity as the valuations are suspect. But if I had to chose one to manage my money I know which one I would pick because in private equity realm fees are usually a rounding error. They either win huge or go bust."

and this one:

"I think it is still way too early to pass judgment on these deal as only time will tell if pension fund are discipline enough to play this role- I hope they are but it is a tall order

I just hope it sends a signal to the GPs that possibly pension funds are dead serious about reviewing the economic arrangements of these business model with the 2 and 20 plus fee. Something is sure I believe that the Canadian pension funds are going to antagonize the community of GPs and may be this is a good thing

The board of these pension funds need to be ready to pay their deal makers just like the other side of the table and let these deal makers have real skin in the game and have downside risk as well as the compensation structure today is insane."

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A Greek Sigh of Relief?

Ambrose Evans-Pritchard reports in the Telegraph, Europe agrees IMF-EU rescue for Greece:

After weeks of discord, Europe's leaders have agreed to an emergency facility for Greece backed by the International Monetary Fund and bilateral loans from eurozone states.

The accord was vague on figures and aid can be invoked only as a "last resort" if Greece is shut out of the capital markets. Since Greece is already paying an untenable debt premium, the wording once again leaves it unclear what exactly has been settled.

Angela Merkel, the German Chancellor, and Jan Peter Balkenende, the Dutch premier, leaders of the two key creditor states, imposed their demand that the IMF must be central to any rescue.

While the Eurogroup is to play a "co-ordinating" role, Germany and Holland will retain a veto over use of the facility. Greece said it was "satisfied" by the terms.

The accord masks a bitter struggle between Germany and a French-led bloc over the future shape of Europe. For all the rhetoric, Berlin has refused to cross the Rubicon towards an EU fiscal union, shattering long-held assumptions about the inevitable march of the EU project. By bringing in the IMF, it ensures that each sovereign state remains responsible for its own debts.

A host of questions remain unanswered, not least whether the IMF's board will disburse funds without retaining control over austerity plans, or whether it will accept EU conditions at all. The IMF usually imposes devaluations and steers monetary policy. When public debt is already too high – as it may be in Greece at 125pc of GDP this year – the Fund can engineer a controlled default.

Jean-Claude Trichet, head of the European Central Bank, said it was a "very, very bad idea" to let the IMF into the eurozone, a foretaste of how hard it will be for the Fund to work with EU bodies.

The euro fell below $1.33 against the dollar on Mr Trichet's comments. Investors have learned in any case to treat EU summit headlines with a pinch of salt. A string of rescues over the past six weeks proved little more than bluff.

The package is to be about €22bn (£20bn) with a "substantial " share from the IMF and a "majority" from Eurogroup states, at stiff interest rates. This barely tides Greece through to the end of the May. It cannot be triggered until Greece faces default. The ECB says this risks delaying until the fire is out of hand.

The concern in the markets is that Greece will need more support before long if austerity measures cause a deeper slump this year than the 0.8pc contraction forecast by Athens. Deutsche Bank expects the Greek economy to shrink 4pc this year. This would play havoc with public finances, perhaps tipping the country into a self-feeding slide.

"There are huge risks in this new adventure," said Jacques Cailloux, Europe economist at RBS. "We think the first stage will be cash on the table and that will be enough to calm things down until next year. This is a last chance for Greece. If it goes wrong there may have to be talk later of debt restructuring, since there will be extreme opposition from Germany for any more aid."

China is watching nervously, increasingly worried about the large chunk of its $2.4 trillion (£1.6 trillion) of foreign reserves held in eurozone bonds.

"Greece is only one case, but it's only a tip of the iceberg," said Zhu Min, the vice-governor of China's central bank. "The main concern today obviously is Spain and Italy."

Zhu Min said it is unlikely that Greece will default, but real concern is the deeper structural problem with the way the euro is run. "We don't see decisive action that tells the market, 'We can solve it, we can close it,' so the market is very volatile," he said. Beijing has repeatedly questioned the safety of dollar assets. This is the first time it has questioned the euro in such terms.

"China is really the big story of the day for Europe," said Simon Derrick, currency chief at the Bank of New York Mellon. "Nobody at China's central bank gives a speech like this without clearance from the highest level. They are saying, 'We have a lot of money invested in your debt and we think it is time for you to get your house in order'," he said.

Interestingly, this evening Bloomberg reports, Trichet Welcomes Greek Pact, Reversing Earlier IMF Criticism:

“It was a complex situation,” Trichet told reporters in Brussels late yesterday. “I am extraordinarily happy that the governments of the euro area found out a workable solution.” Earlier, he said that an IMF role in the funding of a rescue framework for Greece would be “very, very bad.”

I wonder if those comments from China were behind Trichet's change of attitude. Regardless, Europe's common currency woes have been exposed and while Greece can breathe a little easier, it's got to rein in public spending, and start thinking of a long-term plan to diversify its economy beyond tourism and shipping.

The announcement of aid came as Greece celebrated its Independence Day, scaled down amid the crisis. Below you can watch Greek Prime Minister George Papandreou, arriving at a summit in Europe, expressing thanks for the solidarity and support that Greece received during the financial crisis. I want to wish my fellow Greeks "Xpovia Polla!"

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Canada Launches Pension Consultations

CBC reports that Flaherty seeks views on pension reform:

Finance Minister Jim Flaherty wants to hear Canadians' views on whether the country's retirement income system needs to be improved, and, if so, how that should be done.

Flaherty announced plans Wednesday for a series of public town hall meetings, roundtables and online consultations over the next five weeks.

The town hall meetings will be held in Charlottetown, Quebec City and Richmond, B.C. Discussions with stakeholders, experts and government representatives will take place in St. John’s, Winnipeg and London, Ont.

The online consultation process runs until April 30. The government wants feedback in time for a meeting of federal and provincial finance ministers in May, which will tackle a number of reform options.

The government has faced mounting pressure to act quickly on the pension issue, but Flaherty said the retirement income system's challenges are complex so reforms shouldn't be rushed.

"Retirement savings issues are too important to Canadians for governments to meddle blindly or rashly," he said.

"Changes to the system could carry unanticipated consequences. There's simply too much at stake for ill-considered action."

But federal NDP Leader Jack Layton said it was "disappointing" that Flaherty was not taking any immediate action on pension reforms.

"It's simply further consultation and a very limited one at that," he said.

Layton noted that the House of Commons voted nine months ago to support a motion that would boost retirement benefits, and provide protection for workers whose pensions are at risk because their companies have gone bankrupt.

Even among those who favour a more cautious approach, Ottawa has faced pressure to move immediately to amend the Bankruptcy Act, to ensure that pension assets are protected against being lost when companies go bankrupt, as happened with the high-profile insolvencies of Nortel and Canwest in 2009.

"Yes, the government is working on that," Flaherty told Evan Solomon on the CBC's Power and Politics show on Wednesday. "But it's not a simple issue, because if you start giving preference in certain situations, you can discourage lending and might be deterring growth," he said.

Concerns growing

Concerns over the adequacy of the current pension system have been growing in recent years. About two-thirds of Canadians are not covered by company pension plans. Surveys also suggest that about a third of Canadian families have no retirement savings at all and many others worry that they're not saving enough.

Last week, an analysis by the C.D. Howe Institute said most Canadians underestimate the amount they need to save for retirement. Its study said people need to save between 10 and 21 per cent of their pre-tax income for 35 years to get a retirement income at age 65 that would provide 70 per cent of their pre-retirement income.

While the Canada Pension Plan is actuarially sound for the next 75 years, the program is designed to replace just 25 per cent of the average working wage. It pays maximum retirement benefits of $934 a month.

Some, like the NDP, have suggested that the CPP system be beefed up to provide benefits that would approximate 50 per cent of the average working wage. That would require higher mandatory contributions.

British Columbia and Alberta have been pressing for a system that would allow Canadians to voluntarily contribute more to the CPP. They've said they may set up their own voluntary pension supplement program if Ottawa doesn't lead the way.

Flaherty dismissed that possibility, saying both provinces have since released it would be unwise to go it alone on the issue.

"They were at one point but quite frankly they realized this is not simple," Flaherty said. "You don't do this on the back of an envelope, because if you make a mistake you're visiting that mistake for the next 30 or 40 years."

Others would like to see a greater role for the private sector to manage retirement savings for the large numbers of Canadians who have no company-sponsored pension plan. Even some with corporate pension plans are worried because the plans are severely underfunded after having taken a major hit during the 2008 market downturn. There have also been suggestions to boost the age at which people qualify for CPP or Old Age Security.

Many don't contribute to RRSPs

About 60 per cent of families have registered retirement savings plans, but figures show many don't contribute every year and the median value was only $25,000 as of 2006. About 6.2 million Canadians put money into an RRSP in 2008.

The view that Canada's retirement income system needs a complete overhaul is not unanimous. Some pension experts say only minor tweaks are needed and don't see an urgent problem.

Flaherty said Canada's existing retirement income system is considered to be one of the strongest in the world.

"We fully intend to ensure that it stays that way," he said. "But we look forward to listening to Canadians about possible improvements in the system."

Last year, Canadians were asked for reform ideas for federally regulated private pensions. Most company pensions, however, are provincially regulated.

The government said the round of consultations announced Wednesday is meant to address the broader issue of retirement income adequacy.

There are already views on how to bolster the Canadian pension system. Some feel that pension reform should enhance private options for saving while others feel that it's time we enhance public pensions.

You can watch a series of CTV interviews on this issue by clicking here. I would bring your attention to Susan Eng's interview on CTV as well as her interview on BNN. Susan is the VP Advocacy at CARP, a group for Canadians over the age of 50.

Finally, this morning I was invited to speak at the Standing Senate Committee on Banking, Trade and Commerce on April 22nd to share my thoughts on how we can bolster our pension system. I look forward to sharing my thoughts with this committee as a follow-up to my testimony at Parliament Hill last April.

I also invite all my readers to share their thoughts on this important matter. Individuals interested in participating in the online consultations are invited to do so through the following link to the Department of Finance website: www.fin.gc.ca/activty/consult/retirement-eng.asp.

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Horny For Hedge Funds?

They're back! Facing severe funding shortfalls, public pension funds are popping a few blue pills, horny as ever for hedge funds:

• Hedge fund firm RAB Capital confirmed clients are returning to its funds that were battered by the credit crisis, after it swung to a loss in 2009 and cut its dividend.
• Citigroup expects to double the size of its team that advises institutional and government fund clients on hedge fund investments, the bank's global prime finance head, Nick Roe, told Bloomberg in an interview.
• Standard Life Investments (SLI) will pay a "modest upfront" fee for a 75.1 percent stake in the fund of hedge funds firm, which runs more than $50 million in assets, a spokesman said.
• Investors are flocking to hedge funds that bet on mergers and acquisitions (M&A) in the hope that a revival in takeover activity will help deliver more of the bumper returns they enjoyed in last year's rally.

Investing in event-driven hedge funds makes sense since according to the OECD, global investment in mergers and acquisitions has shrunk to its lowest level year-on-year since the onset of the economic crisis in 2007 (just make sure you're paying for alpha, not disguised beta!).

And there's no doubt in my mind that faced with the prospect of stricter regulation and a huge shift in investor sentiment post financial crisis, hedge funds are coming of age.

But not everyone is horny for hedge funds. Opalesque reports that although public pension plans and their corporate counterparts were hit equally hard by the global market crisis, a new study from Greenwich Associates shows they are responding to historic funding shortfalls in dramatically different fashions:

With an eye toward constraints imposed by tougher accounting rules, companies that sponsor defined benefit pension plans are shedding risk from their investment portfolios and are apparently preparing for the inevitability of much higher cash contribution requirements.

Public pension funds, meanwhile, are shifting money into riskier asset classes in what is looking like a “swing-for-the-fences” attempt to close shortfalls with future investment returns that far outpace those of the broad market.

“Corporate funds have traditionally invested much larger portions of their assets in equities, while public funds took a more conservative stance with bigger allocations to fixed income,” explains Greenwich Associates consultant Dev Clifford. “As a result of their differing strategies in the wake of the crisis, public pension funds and corporate funds are approaching parity in their U.S. equity allocations, and public funds are making and planning meaningful investments in private equity, international stocks, hedge funds and real estate.”

The typical U.S. defined benefit pension plan saw the value of its assets fall by approximately 19% from 2008 to 2009 before the recovery that began in March-April last year, bringing the overall value of assets in the portfolios of U.S. defined benefit plans down to levels last seen four to five years ago. Although recovering markets reversed some of those declines, asset values have yet to return to those seen in 2007. At the same time, the value of pension liabilities soared due to persistently low interest rates and the demographics of an aging population.

The resulting damage to pension funding status was sudden and severe. Among public pension funds, the combination of growing liabilities and a drop in asset values to $2.7 trillion in 2009 from $3.2 trillion in 2008 depressed average solvency ratios to 83% from 86%. More than 30% of U.S. public funds now have solvency ratios of 79% or lower, and more than one in 10 public funds have a solvency ratio of 69% or lower. Average solvency ratios for state funds declined to 80% in 2009 from 84% in 2008 and average ratios for municipal funds dropped to 84% from 88%. Average funding ratios for the projected benefits obligation of U.S. corporate pension funds fell to 80% in 2009 from 101% in 2008. The proportion of U.S. corporate pensions funded at less than 85% rose from approximately 8% in 2008 to 57% in 2009 and the share funded...

So why are public pension funds increasing risk - allocating more to alternative investments like hedge funds, private equity, real estate and infrastructure - while corporate plans are dialing down risk?

In his Streetwise blog, Andrew Willis notes that funds that are making these shifts in asset allocation expect to be rewarded for their moves:

Public funds with assets of $500 million or less increased their stated expected outperformance to a staggering 180 basis points in 2009 from an already aggressive 135 basis points in 2008.

“These are very aggressive expectations,” says Greenwich Associates consultant Chris McNickle in a report. “Most investment managers struggle to generate the levels of outperformance expected by institutional investors; it would be rarer still for an entire portfolio to achieve that level of outperformance for any number of years.”

Another key reason as to why public pension funds are aggressively allocating to alternative investments is that it's much easier to game the benchmarks for hedge funds, private equity, real estate and infrastructure. Public pension fund managers know this, so they continue to shovel billions of dollars into private funds, looking to collect big bonuses at the end of their fiscal year - bonuses based on bogus benchmarks for alternative investments.

It's also nice to travel first class across the world, getting wined and dined at top restaurants by alternative investment managers looking for that big public pension fund cheque.

I can just imagine the next big hedge fund, private equity, real estate or infrastructure conference. All those beautiful young sales ladies peddling their funds to horned up public pension fund managers swinging their big pension penises, many of whom have no idea of what investment and operational risks lurk behind these funds.

But it's not their money they're investing, so what do they care if a fund implodes when the next crisis hits? Right now they're mesmerized by the allure of "absolute returns", completely impervious to the systemic risks they're creating by collectively chasing after these hot alternative investments. They should be careful or else they risk catching the next systemically transmitted disease.

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Pension Woes May Deepen Financial Crisis

Global pension tension is on the rise again:

• In Canada, the federal government will stop short of cutting existing pension benefits to public servants in enacting its austerity program, but Stockwell Day, the Treasury Board President, refused to say whether future entitlements would be spared the knife in an effort to rein in Ottawa's massive $53.8-billion deficit.
• In the private sector, more victims of a failed scheme watch payouts shrink. David Dodge, former governor of the Bank of Canada, says Canadians need to save far more if they want to retire comfortably - even those Canadians who think they have great company pension plans and solid RRSPs.
• In the UK, a report from Towers Watson said the cost of gold-plated pension promises made to public sector workers has soared to nearly £1,200billion, which is about 80% of the country's total economic output.
• In France, President Nicola Sarkozy must contend with a strike by transport workers angry over pension reforms.
• Even in Germany, Bundesbank President Axel Weber said pension entitlements will probably need to decline in future as Germany’s population shrinks. Towers Watson notes that German DAX firms paid 30% more into pensions in 2009.

But it's in the US where pension tension is really on the rise. Andrew Biggs of the American Enterprise Institute reports in the WSJ, Public Pension Deficits Are Worse Than You Think:

Pension plans for state government employees today report they are underfunded by $450 billion, according to a recent report from the Pew Charitable Trusts. But this vastly underestimates the true shortfall, because public pension accounting wrongly assumes that plans can earn high investment returns without risk. My research indicates that overall underfunding tops $3 trillion.

The problem is fundamental: According to accounting rules adopted by the states, a public sector pension plan may call itself "fully funded" even if there is a better-than-even chance it will be unable to meet its obligations. When that happens, the taxpayer is on the hook. Yet public pension plans ignore market risk even as they shift into risky foreign investments, hedge funds and private equity.

A simple example illustrates the flaw. Imagine that you borrowed $100, which you absolutely, positively must repay in 20 years. How much money would you need today to consider that debt "fully funded?"

Here are two correct answers, followed by an incorrect one. All three rely on "discounting," a method of calculating the sum of money needed today to fund a given liability in the future.

First, discount $100 at the 4.5% yield on safe, 20-year Treasury notes. This produces a present value of $41.46, which you invest in Treasury securities. Barring federal government bankruptcy, you can repay your debt with certainty.

Second, discount $100 at the expected return on stocks—say 8%. This produces a present value of $21.45, which you invest in equities. Next, purchase a "put option" giving you the right to sell your portfolio 20 years hence for no less than $100. This option would cost $20.08, for a total cost today of $41.53. Barring the collapse of the options exchange, you also can be certain of repaying your debt.

But here is a third answer: discount $100 at an 8% interest rate. Invest $21.45 in stocks. Declare yourself "fully funded." This doesn't work because there's a very good chance your risky assets won't appreciate in value enough to cover the debt. Yet this is how public sector pension accounting operates.

Vested pension benefits are constitutionally guaranteed in eight states and protected by law in two dozen more. And in most every state politics makes accrued benefits impossible to cut. Orange County, Calif., in the 1980s and New York City in the 1970s effectively made pension obligations senior to government debt by paying full retirement benefits even as they inflicted losses on bondholders.

Yet public pensions discount ironclad liabilities at the high rates of return they project for risky investment portfolios. Consider New York state's Employees Retirement System (ERS), which assumes an 8% return on its assets. Discounted at this interest rate, ERS's liabilities had a present value of $141 billion as of 2008. ERS assets at that time were $152 billion, making the program overfunded by 7%.

But New York's portfolio is hardly likely to produce a steady 8% each year. Since 1990 its returns have varied widely, ranging from 30.4% in 1998 to -26.4% in 2009. A "Monte Carlo" computer simulation (a standard technique for modeling financial risks) incorporating fluctuating asset returns shows that New York's ERS has only around a 45% probability of meeting its liabilities. Instead of an $11 billion surplus, the ERS is almost $100 billion shy of funding its benefits with certainty.

In a recent AEI working paper I've shown that the typical state employee public pension plan has only a 16% chance of solvency. More public pensions have a zero probability of solvency than have a probability in excess of 50%. When public pension assets fall short, taxpayers are legally obligated to make up the difference. The market value of this contingent liability exceeds $3 trillion.

Public pension plans are hiding behind unrealistically low deficit figures. This allows policy makers to dodge difficult choices today at the cost of a much heavier burden on taxpayers in the future.

There is no question in my mind that public pension funds are deluding themselves if they think they will make up the shortfall by investing more in hedge funds and private equity, or by leveraging up their bond portfolio.

In his state of the state speech earlier this year, Gov. Arnold Schwarzenegger said California is "about to get run over by a locomotive." Schwarzenegger was talking about the future costs of funding pensions for public employees. Currently, the tab is running at more than $3 billion a year at a time when California is trying to close a $20 billion deficit, fueling growing anxiety as the shortfall is plaguing pensions.

On Monday, New Jersey Gov. Chris Christie signed three bills designed to save taxpayers billions by making pensions and health benefits for government workers less generous. Still, the state pension plan is woefully underfunded and these measures are like band-aids on a metastasized tumor. Moreover, nothing was done to shore up the governance of the plan (don't forget that governance matters!).

Finally, Tamara Keith of NPR reports, Pension Woes May Deepen Financial Crisis For States:

There's a looming U.S. financial problem that's big, is getting larger and could threaten the solvency of some states. From Connecticut to California, pension funds for teachers, firefighters and other public employees are severely underfunded.

"Generally, they're in an abominable state," says Joshua Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University.

A recent report from the Pew Center on the States put the tab for unfunded pension liabilities at $452 billion. But Rauh and others say pension funds are using unrealistic assumptions about investment returns, meaning the pension funding hole is likely much deeper.

"Our calculation is that it's more like $3 trillion underfunded," Rauh says.

And the kicker is that taxpayers are on the hook.

Stuck With The Bill

"People say, 'Well that's ridiculous. We're just not going to pay it. Let [the pension funds] go broke,' " says Robert Gentzel, policy director for the Pennsylvania State Employees' Retirement System. "That's not what would happen. The taxpayers are ultimately going to have to pay the bill."

That's because public employee pension funds are backed by the full faith and credit of the government. Over the past several decades, many states and local governments made pension promises that will be expensive to keep. Now, they're struggling to fund their obligations.

Take Cranston, R.I.

"Right now, the unfunded liability is $240 million," Cranston Mayor Allan Fung told NPR's Jim Zarroli. That's more than double the city's annual budget.

Fung added, "It's a big obligation, and it's basically a ticking time bomb for the city of Cranston that we are trying to get a handle on."

Underfunding Becomes Next Generation's Problem

The Pew report found state pension obligations nationwide were 84 percent funded. That doesn't sound so bad, but that figure does not include the full impact of the 2008-2009 market collapse, which hit pension funds hard.

Disappointing returns isn't the only funding challenge pension funds face. Many local and state governments haven't been putting enough money into the funds. When budgets are tight, shorting pension funds is a lot more politically palatable than raising taxes or having to make painful cuts.

"Underfunding is very easy because all you're doing is making this the next generation's problem," says Rick Dreyfuss of the free market-oriented Commonwealth Foundation in Harrisburg, Pa. "The next generation doesn't understand the magnitude of this, and they're too young to vote, so there's not a lot of political opposition to that."

Dreyfuss says there's a high political rate of return for increasing benefits, and there's basically no political upside to actually paying for those benefits.

Playing Catch Up

This table shows how many years it would take for each state to make good on its pension promises if it spent all its tax revenue on pensions -- and nothing else.

State	Plans analyzed	Assets (in billions)	Years to catch up
Ohio	5	$115.6	8.7
Colorado	1	29.3	8.3
Rhode Island	1	6.0	7.7
Illinois	4	65.7	7.2
Alabama	3	22.3	6.4
Wisconsin	1	62.2	6.3
South Dakota	1	6.0	6.0
Missouri	3	27.0	5.8
Mississippi	3	15.1	5.7
Oregon	1	46.1	5.7
New Mexico	2	16.2	5.5
South Carolina	2	21.8	5.4
Kentucky	3	21.6	5.4
Oklahoma	4	12.0	5.2
New Jersey	4	60.5	5.0
Arizona	3	25.0	4.9
Connecticut	3	20.4	4.7
Texas	4	125.3	4.7
Georgia	2	53.7	4.6
New Hampshire	1	4.4	4.5
Maine	1	8.3	4.4
Nevada	1	17.8	4.2
Minnesota	4	36.2	4.2
California	3	330.0	4.2
Montana	2	5.9	4.1
Arkansas	3	8.1	4.1
Louisiana	2	17.7	4.0
Maryland	1	27.8	4.0
Hawaii	1	8.3	3.9
Pennsylvania	2	70.9	3.9
Iowa	1	18.1	3.7
Kansas	1	10.3	3.7
Wyoming	4	4.8	3.7
Alaska	2	11.7	3.7
Idaho	1	8.1	3.6
Utah	3	18.6	3.4
Indiana	2	15.5	3.4
Florida	1	97.2	3.3
Washington	7	44.3	3.2
Virginia	1	41.3	3.2
Michigan	4	43.4	3.1
Massachusetts	2	37.8	2.9
Tennessee	1	25.8	2.8
West Virginia	2	6.6	2.7
New York	3	189.8	2.6
North Carolina	2	59.1	2.6
Nebraska	2	5.4	2.1
North Dakota	2	2.9	2.1
Delaware	1	6.2	2.0
Vermont	3	2.4	1.7

Notes:

Pension assets are taken from Pensions and Investments for September 2008 and projected forward to December 2008 using asset allocation data and realized asset class investment returns. Tax revenue data used to calculate the years of tax revenue each state would need to devote to pension funding to catch up on its pension promises is based on 2007 data from the U.S. Census Bureau Census of Governments. Pension assets and liabilities are aggregated to the state level.

Source: Analysis of data by Robert Novy-Marx and Joshua D. Rauh from "The Liabilities and Risks of State-Sponsored Pension Plans" (PDF), Journal Of Economic Perspectives, Fall 2009

Please listen to this NPR interview and keep in mind that while one battle was won on health care, another one rages in pensions.

Last year, I stated that the pension crisis will define President Obama's legacy. I still stand by that statement and worry that unless a comprehensive approach is taken, including meaningful financial reforms, pension costs will balloon out of control, leaving taxpayers on the hook and possibly deepening the financial crisis. I fear it's already too late.

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