Japan Pensions Bet on Hedge Funds

Chikafumi Hodo and Nishant Kumar of Reuters report, Japan pensions bet on hedge funds to boost returns:

Japan's corporate pension funds, hobbled by a sluggish domestic stock market, are raising their allocations to hedge funds as they scramble to boost returns for the country's ageing population.

The move is part of a broader trend in Asia where institutions are looking to raise exposure to hedge funds in search for absolute positive returns and as confidence in the asset class improves, lifting prospects for the $2 trillion (1.2 trillion pound) global hedge fund industry.

Nearly all of Japan's corporate pension funds, which collectively manage more than $900 billion, have lowered their guaranteed yield in the last decade from about 5.5 percent to below 3.5 percent on average, industry observers said.

"Considering that they have had a very hard time raising decent returns by directly investing in equities over the past years, pension funds are now very seriously considering taking more exposure in alternatives," Tamotsu Adachi, the co-head of private equity firm Carlyle's Japan unit, told the Reuters Rebuilding Japan Summit in Tokyo this week.

A survey of 31 Japanese corporate pension funds by U.S. fund manager Russell Investments showed pensions slashing investment in domestic equities to 14.6 percent of their assets on average as of end-March from 18.7 percent a year earlier.

By contrast, the 31 pension funds, which manage 7.54 trillion yen, said they had increased allocations to hedge funds and other alternative assets to 13.1 percent of their assets from 11.6 percent a year ago.

"In these conditions where Japanese pension funds are having trouble finding a return driver, they have to rely more on alternative assets, mainly hedge funds," said Mitsuhiro Arakawa, executive consultant at Russell Investments.

"They don't want to be in stocks after seeing them slump over the last 10 to 20 years. In fact, they may want to cut them at a quicker pace after the disaster in Japan," Arakawa said.

The blow of the March 11 earthquake and tsunami and ensuing nuclear crisis knocked the Japanese economy into recession and battered stocks. Japan's benchmark Nikkei average is still down about 7 percent since the earthquake.

Some corporate pensions are aiming to park as much as 40 percent of their assets in hedge funds, said Futoshi Ago, director at the prime brokerage arm of Bank of America Merrill Lynch in Tokyo.

Takahiro Mitani, president of the Government Pension Investment Fund, told the summit that while he had no plans to start investing in hedge funds immediately, the fund was evaluating the option. The GPIF, which holds about $1.4 trillion in assets, is known as a conservative fund that parks about two-thirds of its assets in Japanese government bonds.

GROWING TREND

The Nikkei stock average has lost about a third of its value in the last 10 years. By comparison, the Eurekahedge Hedge Fund Index has surged 160 percent, forcing institutions to rejig their asset allocations.

While Japanese corporate pension funds have kept their allocations to foreign stocks at around 20 percent of their assets in the past decade, they have cut their exposure to domestic shares by half. Investments in alternatives have risen to 13 percent from less than 3 percent.

Across Asia, institutions are preparing to invest more or are looking to start investing in hedge funds, after shying away from the asset class, as an uncertain economic outlook forces them to look at instruments that could benefit from falling markets.

South Korea's National Pension Service, the world's No. 4 pension fund with about $300 billion of assets, said earlier this month that it plans to raise its investment in alternatives to above 10 percent by 2016 from 5.8 percent in 2010 as a part of its move to diversify.

The industry has also received allocations from Chinese, Taiwanese and Malaysian institutions among others in Asia with more likely to join the fray.

"The market is far more ready now to make allocations to hedge funds. Clearly I think that the large institutions are setting the path for others to follow," said Max Gottschalk, co-founder of Gottex Fund Management, one of the world's biggest fund of hedge funds.

Only about 18 percent of global hedge fund assets are sourced from Asia, according to a Credit Suisse survey of 600 institutional investors representing $1.2 trillion of allocations to single-manager hedge funds.

"I think we are still in the early phase of adoption to alternatives in Asia and I think over the next 5-10 years Asia will become a far more prominent investor in this asset class," said Gottschalk who moved to Hong Kong earlier this year.

Several thoughts came to me as I read this article. First, global assets into hedge funds are growing ever larger, meaning their influence in financial markets will become even more important. This is another source of liquidity and leverage, and keep in mind most hedge fund assets are in directional strategies: Long/Short Equity, global macro and commodity trading advisors (CTAs). This means you will see ever larger swings in risk assets on the way up and on the way down.

Second, with an aging population, Japan's corporate plans need to manage liquidity risk very carefully. This too means they will be biased towards directional absolute return strategies where liquidity and scalability are not as much of an issue as market neutral strategies. The problem is that there a lot of beta in these directional strategies and these corporate plans don't want to end up paying 2 & 20 in fees for beta.

Third, Asian institutions have an advantage of knowing who the good managers are in their own backyard but I would recommend they diversify into North American and European funds. They can go the fund of funds route, but they will end up paying an extra layer of fees, which might work fine until the next global crisis hits. These corporate plans need a strategy, and I would recommend managed account platforms (not just brand names) and direct investment into hedge funds. This is where funds like Ontario Teachers' are moving and for good reason, they and others got hammered with illiquid hedge funds putting up gates (and side pocket letters) during the 2008 crisis and are now managing liquidity risk much tighter.

Fourth, I worry that all these assets flowing into global hedge funds will dilute returns going forward and sow the seeds of the next crisis. It's not guaranteed but you have to pay attention to global trends in hedge funds because they're increasingly becoming the alternative investments of choice for global pension funds looking to juice their returns while they manage liquidity risk very closely.

Finally, there is an intelligent way and a dumb way to invest in hedge funds. I'd be glad to discuss some more ideas with these Japanese corporate pension plans and introduce them to some of Quebec's absolute return managers. In particular, one experienced manager who is setting up his relative value commodities trading fund with his partners, is a perfect fit for these plans. If you're interested in knowing more, please contact me at LKolivakis@gmail.com.

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What if 8% is Really 0%?

Mebane Faber of Cambria Investment Management sent me an excellent paper he authored, What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed:

It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return.

By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate.

In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison - the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.

So how does a pension manager get 8% in the current environment? Mr. Faber writes:

With government bonds yielding about 4% plan sponsors must invest in other outperforming assets to bring the cumulative return to 8%. The problem with allocating assets away from the risk-free rate is that they are, by definition, risky and uncertain. If a pension manager is employing the benchmark 60% stock/40% bond allocation, the 60% in equity or diversifying assets must return approximately 11% to achieve 8% total returns.

The second major problem outlined in this paper is that pension managers, in an attempt to deal with the realities of underfunding, may be tempted to chase higher performing and riskier asset classes, and may end up compounding the underfunding problem even more through exposure to these risky asset mixes.

Interestingly, according to Biggs, the targeted equity allocation does not correlate with projected return. Even worse, as shown in Exhibit 1 (above), funds using the highest return assumptions have the most underfunded pensions, a scenario that could be called, “fingers crossed and eyes closed”

Mr. Faber goes on to write:

The focus on illiquid assets (private equity, venture capital and timberland investments, for example) made the Endowment Model particularly attractive to funds that in theory have long time horizons, such as endowments and pensions.

Yet, as real money investors sought diversification through the same methodology, their portfolios were, in fact, becoming more correlated to each other while portfolio risks were becoming more concentrated and increasingly dependent upon illiquid equity-like investments.

Most real money funds were not prepared for the following stress scenario to their portfolio:

• US and Foreign Stocks declining over 50%
• Commodities declining 67%
• Real Estate (REITs) declining 68%
  

The figures above are the peak drawdowns from the bear markets of 2008-2009, and, importantly, they all occurred simultaneously. It is critical that pension funds – especially funds pursuing high equity allocations – consider all possible stresses to portfolio viability.

Mr. Faber then asks a simple question:

Are funds prepared for a lengthy bear market in equities like when stocks declined nearly 90% in the 1930’s? Are funds prepared for both raging inflation of the 1970’s and 1980’s and sustained deflation like Japan from 1990 to the present? It is our opinion that most funds do not consider these outcomes as they are seen as extraordinary and beyond the scope of either feasible response or possibility.

He's absolutely right, the majority of pension funds are hoping -- nay, praying -- that we won't ever see another 2008 for another 100 years. The Fed is doing everything it can to reflate risks assets and introduce inflation into the global economic system. Pension funds are also pumping billions into risks assets, but as Leo de Bever said, this is sowing the seeds of the next financial crisis, and when the music stops, watch out below. Pensions will get decimated. That's why the Fed will keep pumping billions into the financial system. Let's pray it works or else the road to serfdom lies straight ahead. In fact, I think we're already there.

Below, Mebane Faber talks about the benefits of the ETF he manages, Cambria Global Tactical ETF (NYSE:GTAA). I thank him for sharing this paper with me.

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Honoring My Humble Father

Let me begin by wishing all the dads out there a very Happy Father's Day. It's another beautiful day in Montreal and I want to head out there and enjoy it, but first let me introduce you to the most important man in my life, my father, Dr. Thomas Kolivakis. That's him with his two grandchildren, Thomas and George. Another Thomas, their cousin, is in Crete with my sister and brother-in-law.

My father was born on December 22, 1931. As a child he lived through the second World War, an experience that had a profound effect on him. First, like many of his generation, he is deeply religious and has repeatedly told me that his most important relationship is the one with God. It has helped him persevere and deal with his personal challenges and it has given his life extraordinary meaning.

My father doesn't believe in what Marx described as using religion as the "opium for the masses." Instead, he prays, reflects and strives to be a better person by understanding the deeper meaning of the gospel. I often catch him reading the bible, and even though I'm not religious, I'll ask him what he's reading because I'm curious. He will explain it to me and relay it back to every day life.

The second thing that I noticed about my dad being brought up during the war is that he values education and hard work and doesn't believe in materialism and waste. If he sees me throwing away a piece of bread, he'll chastise me and tell me to freeze it instead. Drives me bananas sometimes but he's right, people are starving out there and we tend to take a lot of things for granted.

When it comes to his work, my father is incredibly devoted. He's almost 80 and has worked for over 40 years as a psychiatrist and still follows hundreds of patients very closely. My brother followed in his footsteps and I know part of me wanted to, but I got sidetracked and developed an addiction to macroeconomics and financial markets which I still have. Ironically, with his limited knowledge of financial markets, my father is much wiser than I am, stating flatly that the "stock market is all gambling," all part of what he calls "aero-capitalism" where individuals make a lot of money "selling nothing but hot air."

One of the things my dad keeps repeating to me is that "when it comes to money and sex, only too much is enough." He's seen a lot in his career and knows that money doesn't buy you happiness. He knows all about what Pete Peterson, another product of Greek immigrants, calls the meaning of enough. Having been diagnosed with MS at the age of 26, and recently turned 40, I know money isn't going to bring me happiness, but I still want to be rich because I'm still clinging to the silly notion that money buys you freedom (it can but it can also make you miserable).

Both my parents taught their three kids proper values in life and continued to do this even after a painful divorce when we were relatively young. They believe in education, hard work, and treating people with compassion and respect. My father sent us to French private schools and always told us that as long as we lived in Quebec, we should value the French language and culture.

But going to French private school also exposed me to money and other value systems. I remember back in high school, my well-to-do friends' parents were buying them cars, so I sat down with my father and asked him to buy me a car too. He listened to me patiently as I ranted on about how it's important to fit in, and asked my brother to join the conversation. I'll never forget what he told us: "I will never buy you a car. As long as you're doing well in school and complete a Master's at a minimum, I will pay for your food, clothes, vacations, give you some allowance, love you and support you. That's it. I learned how to drive at 29 at Soldier Field in Chicago when I was a resident and bought my own car. You will buy your own car when you can afford it."

I also remember when I first got to CEGEP (two year college mandatory in Quebec before university), I was enjoying my new found freedom. I had a hard time going from a strict French private school to college, so I abused my freedom and partied a lot. My grades suffered and my parents were not pleased. They decided not to send me to Greece that summer and I was fuming. I told them I would find work and leave on my own. My father told me to "do it."

So I did it, found any job I could. I worked in a smoked meat factory in the east end. Never ate smoked meat ever again. I worked at a Jewish cemetery digging graves with a shovel and wheelbarrow. That was the hardest job I ever did. Didn't last long there too. Finally, I found a job cleaning tennis courts near my house which paid me well. It was fun, got to tan, and made enough money to head off to Greece and party with my buddies on the islands. Best years of our lives! But the lesson my parents taught me was that I was fortunate enough to go to school and should take it a lot more seriously. I never took the value of an education for granted ever again.

Last summer, my sister told me that when she had her boy, she realized just how much we owe everything to our parents. We do owe everything to our parents and I don't tell them often enough how much I love and cherish them.

The Quebec Association of Psychiatrists recently awarded a lifetime achievement award to my father for clinical work. He's an extremely humble man and wasn't comfortable making a speech. I was in Toronto that day helping a Montreal commodities manager seed his fund, but my brother, sister-in-law, and two of his three grandchildren were in attendance.

Words cannot express how proud I am of my father and how much I love him. He has put up with my insufferable character which has gotten worse ever since and I was diagnosed with MS, especially in recent years. I have been through a lot, and he has stuck by my side every step of the way. He's still there for me, patiently listening to all my problems, consoling me when things aren't going my way with uncanny compassion, and praising me when he's proud of me. I'm learning to listen more to him, going to the gym, and will take the necessary steps to be a better person, a lot more like him.

That's why today I want to honor the most important man in my life, my father. Thank you for being the greatest father and grandfather in the world. If at the age of 80, I can look back at my life and be half the man you are, I will be proud of myself. I leave my readers with the one video I absolutely love watching on this special day. Happy Father's Day!

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Notes From Montreal Pension Conference

Spent the last couple of days at a pension conference here in Montreal, Sommet Avantages & Retraite. There were numerous excellent presentations covering all sorts of pension issues. Here are some brief bullet notes:

• Bernard Morency, Executive Vice-President, Depositors and Strategic Initiatives at the Caisse de dépôt et placement du Québec, kick-started the conference with an excellent presentation on the future of pension plans. Mr. Morency made a forceful argument that if defined-benefit plans are going to survive, then all stakeholders will need to make concessions. During the question period, I asked him if he sees a role for the private sector and he said "yes because if we leave pensions all up to the government, chances are they will understate the true cost."
• I assisted most of the investment workshops. Ron Chesire of Triasima spoke on integrating lessons on behavioral finance in risk management.
  
• Bernard Augustin of Addenda Capital focused on liability-driven investments (LDI) arguing that the low interest rate environment requires a better understanding of how to separate out the alphas and betas in a portfolio.
• There was an excellent presentation by Emmanuel Matte of Standard Life on how to properly assess a fund's risk across all investment portfolios. Importantly, instead of dollar allocations, risk budgeting should be implemented based on economic scenarios. Mr. matte demonstrated that this approach adds significantly to returns while minimizing downside risk.
  
• Rene Martel of PIMCO gave a good technical overview of LDI, explaining bond leverage using repos and total return swaps into various equity indexes.
  
• My former boss at PSP, Pierre Malo, now at Perseus Capital, explained how to manage the hidden bomb of currency risk. I have already referred to this topic on my blog. And I thank Pierre for inviting me to this conference as his guest.
  
• Finally, the most fascinating and inspiring presentation came from Martin Lafontaine of GSK who worked at Project Hope in Munsieville, South Africa. Martin discussed the five factors of success and how they united rival factions in Munsieville to hold World Cup mock games for the children of Munsieville. You can follow Martin's blog but please donate generously to Project Hope.

That's all from me. Not much in a blogging mood lately as the weather is spectacular and I plan on enjoying my weekend. Wish you all a great weekend and wish all dads a Happy Father's Day. Below, a video from Project Hope on Munsieville International Children's Cup.

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Beware Contagion From Greeks Baring Rifts?

Richard Barley of the WSJ reports, Beware Contagion From Greeks Baring Rifts:

Euro-zone politicians may be fiddling while Athens burns. Tuesday's meeting of finance ministers brought no progress on how to address Greece's funding problems and avoid setting off a financial crisis. But conditions in European markets are deteriorating. The main risk from Greece has always been contagion, and that process is already under way.

Most directly, prices of Portuguese and Irish bonds have fallen sharply, with 10-year yields rising above 11% and the cost of insuring their debt at record levels. The gap between Spanish and German 10-year bond yields is at its widest since January. The market is effectively giving no credit for any reforms or budget policies set out in the past six months.

The next link in the chain, the banking system, has been affected. In Spain, progress by banks on regaining market access has gone into reverse: Average borrowing from the European Central Bank jumped to €53 billion ($76.32 billion) in May from €42 billion in April.

Meanwhile, the contagion into core banks may be being underestimated by investors. Moody's on Tuesday said it could downgrade France's BNP Paribas, Société Générale and Crédit Agricole due to their holdings of Greek debt, and the ratings firm is looking at whether other banks could face similar risks.

Disturbingly, the worries have now reached non-financial companies, which have been virtually bulletproof this year. Investment-grade bond issuance has come to a near-standstill. The yield premium on Portugal Telecom's February 2016 euro bond over German Bunds has widened a stunning 2.3 percentage points in the last two weeks, data from Société Générale show. Italian and Spanish credits are under pressure too. The credit market now starts by pricing government risk and then works back to price debt from financials and companies, one investor says: Greece is a destabilizing influence at the center of the market's deliberations.

When German Finance Minister Wolfgang Schäuble last week proposed a seven-year maturity extension for Greek bondholders, setting up the current standoff with the ECB, he suggested there was a chance to minimize the negative impact on financial markets. That was always an optimistic hope. The reality is that markets are starting to wake up to the risks of a Greek debt restructuring. Europe's politicians need to act fast to stem the tide.

Markets have started to wake up to the risks of Greek debt restructuring? No kidding? The problem is that Eurozone politicians still have their heads up their asses (I'm sorry, calling it like I see it, and there is no way I'm going to sugarcoat this crisis). With each passing day, there is a huge risk of another international banking crisis -- and this one will make 2008 look like a walk in the park! (Had lunch with two of Montreal's most promising hedge fund managers yesterday and they're both bearish on this market).

Meanwhile, over in Greece, Reuters report that Greeks of all ages want politicians to pay:

Greek workers of all ages and professions, pensioners, students, the old and young marched on parliament in Athens Wednesday to vent their anger at the country's politicians and their austerity plans.

Tens of thousands took part in the protest rally, which follows three weeks of peaceful evening gatherings in the central Syntagma Square of people from all walks of life, tired of tightening their belts a year after Greece received an EU/IMF bailout.

"I feel rage and disgust," 45-year-old civil servant Maria Georgila, a mother of two, said in front of parliament.

"These measures are very tough and they won't get us out of the crisis. I can't believe they have no alternative."

Like others yelling "Thieves!" and raising open hands toward parliament in a traditionally offensive gesture, 38-year-old Maria Koutroumba said she felt betrayed.

"They are traitors, they've plagued the country," the unemployed woman said of the politicians as she helped form a human chain around the parliament building.

"These measures are hurting us, the ordinary people," said Koutroumba, who used to get by on short-term contracts in the private sector but is now out of work, like over 800,000 Greeks.

The jobless rate hit a record 16.2 percent in March as cutbacks to rein in Greece's huge debt burden of 340 billion euros stifled the economy further. The EU and the IMF expect the Greek economy to contract 3.8 percent this year.

Greece's international lenders have also insisted that the country sell 50 billion euros of state assets to reduce its debt mountain.

"More people must take to the streets and say that Greece is not for sale," said Koutroumba, who spent the night on the square and said she would stay as long as needed.

Greek lawmakers were due to discuss a new austerity package of 6.5 billion euros in tax rises and spending cuts this year, including higher tax on cars and restaurants and slashing the public sector workforce.

"We wouldn't be here if they (the politicians) had made sacrifices as well," said 60-year-old pensioner Panayotis Dounis, who said he had joined the non-political rally in front of parliament nearly every night for about half an hour.

BREAD AND OLIVES

Dounis said he wanted no violence at the anti-austerity rallies. Most protesters marched peacefully Wednesday, though the rally was marred by clashes between stone-throwing youths and police.

"I am willing to make sacrifices, to live only on bread and olives, but what are they (politicians) doing for us?" asked the former builder, who retired last year.

"I want them to work for four years without getting paid, for Greece, for their country," said Dounis, whose three children are jobless and who believes MPs can afford to work for free for a while.

Singer Vassilis Theodorakopoulos, 32, who performs in various places to make ends meet, has been camping in central Syntagma Square for the past 20 days.

"All of these governments must vanish," he said. "We want to reorganize Greece away from any memorandum, the EU and the IMF."

If I were an ordinary Greek citizen, I would be enraged as well. While Greece's elite are parking their money offshore in Cyprus, Switzerland, UK and Germany, most Greeks are struggling to get by on crumbs, bearing the brunt of the strict austerity measures being imposed on them. There is no long-term game plan on creating jobs, much like in the US where the jobs crisis is getting worse. I think politicians from around the world should carefully listen to professor Robert Shiller below on how to revive America's 'animal spirits'.

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TimberWest Sold to PSPIB and bcIMC

Gordon Hamilton of the Vancouver Sun reports, TimberWest unitholders approve $1 billion sale to pension funds:

Unitholders of TimberWest Forest, the largest landowner in B.C., approved the sale of the company Tuesday to two public pension funds, a move that president Paul McElligott said should result in better decision-making on the company’s Vancouver Island lands.

“We look forward to a new future as a private company,” McElligott said after unitholders voted 98 per cent in favour of the $1 billion deal.

In an interview, he said TimberWest’s structure as a publicly-traded company worked well until the U.S. housing downturn led to a collapse in lumber demand. TimberWest had thrived on selling logs into modern sawmilling sector that has developed in the U.S. Pacific Northwest.

“The U.S. economic downturn had a very punishing effect on this sector, and I think private ownership is more patient capital; it’s a longer-term view. You are not under the same kind of pressures to shore up short-term income and profits because there’s a quarterly analyst’s report being produced in a few weeks,” he said.

“I expect it will result in better decision-making,” he said of the new ownership structure.

TimberWest owns 327,000 hectares of land, mostly along the eastern spine of southern Vancouver Island.

The forest company’s new owners, the British Columbia Investment Management Corporation (bcIMC) and the federal Public Sector Pension Investment Board (PSPIB), plan no management changes, Gordon Fyfe, president of the Public Sector Investment Board said in an interview. The two pension plans are buying the company for $1.03 billion in cash, including assumed debt, which will return $6.16 a stapled unit to unitholders.

Fyfe said he can speak only for his own pension board, but described TimberWest as an ideal match for the board’s liabilities — making pension payments for the federal employees whose money they are investing.

Timberlands have 50 to 55-year harvest cycles, are not very liquid and are subject to market fluctuations, attributes that make them more attractive as a long-term investment, he said.

“If markets aren’t great, you don’t have to cut trees,” he said.

The transaction still requires approval under the Competition Act and by the B.C. Supreme Court. The sale is expected to be finalized before the end of June.

While Timberland is not correlated with stocks, institutional investors need to understand that there are risks in timberland investments:

Despite their appeal, timberland investments can present considerable risks to institutional investors. The primary risks of timberland investing are market uncertainty (fluctuation of timber and timberland prices associated with macroeconomic conditions such as the health of the housing market), relative illiquidity compared to stocks and bonds (the absence of an organised timber exchange can make it difficult to find a buyer), and environmental risks, which are the focus of this report.

Add to this forest fires, insects, regulations and tariffs. Moreover, with so much money flowing into this asset class, future returns will not be as strong as past ones. But Timberland does have unique characteristics that can help hedge a pension portfolio during downturns.

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Air Canada's Great Pension Divide?

CBC reports on Air Canada's great pension divide:

One of the key issues that had Air Canada management and union negotiators talking right up to the Monday midnight strike deadline was pensions. The Canadian Auto Workers union — which represents the airline's 3,800 sales and service agents — says the pension changes proposed by Air Canada would make new hires "second-class workers."

What is Air Canada proposing?

The airline wants the CAW to agree to a number of changes to the pension program that its customer service employees pay into. The union says Air Canada's demands for pension concessions are not negotiable.

There appear to be two major stumbling blocks:

• The airline's demand for pension cuts that could see new retirees having their pensions being chopped by an average of 40 per cent, according to the CAW. (The airline says the cuts aren't that big.)
• The airline's demand that all new hires into the bargaining unit be routed into a new, defined contribution pension plan, rather than joining the current employees' defined benefit plan.

What's the difference between these two types of pension plans?

The latest figures show that only about six million Canadians — roughly 40 per cent of employees — were members of a registered pension plan at the start of 2010. About half were in the public sector and half in the private sector.

For those with pensions, the two main kinds are defined benefit plans (75 per cent of those with a pension plan) and defined contribution plans (16 per cent of all pension plan membership). The rest are in some kind of hybrid plan.

For employees, a defined benefit plan is the gold standard in the pension world. Air Canada's current pension plan for its customer service reps is this kind of plan.

Here are the key points of defined benefit plans:

• DB plans guarantee a pre-set lifetime pension after a certain number of years of service. The better plans include partial or full indexing for inflation.
• Both the employee and the employer contribute to this type of plan.
• It's the employer's responsibility to make sure the plan is properly funded to pay the promised benefits.
• It is the employer that must make up any plan shortfall.

Defined contribution plans, on the other hand, sport some key differences:

• The level of payout is not guaranteed. These plans are often not indexed for inflation.
• You and/or your employer contribute a set amount of money each year.
• Your retirement income is based on how the pension plan's investments perform.
• Since there is no specific pension payout guarantee, the employer is not on the hook for future pension plan shortfalls.
• Pension risk with this type of plan is transferred from the employer to the employee.

Aren't defined contribution plans becoming more common?

Yes, especially in the private sector. Statistics Canada says the number of private-sector employees covered by defined-contribution schemes rose by almost 400,000 people between 1991 and 2006. At the same time, the number of private sector workers covered by defined-benefit plans fell by 270,000.

Defined benefit plans are still the most common plans, with 75 per cent of those with a registered pension plan having a DB plan. But 10 years ago, that figure was 85 per cent.

Private companies are increasingly switching over their pension plans to the less-costly defined contribution arrangements in order to reduce the potential cost of their pensions, Statistics Canada said.

"Although [defined contribution] plans have some undeniable advantages for employees, their increased prevalence suggests a transfer of risk from employers to workers since 1991," the agency said.

Why is the airline asking for pension concessions?

Since Air Canada is responsible for making up shortfalls in its pension plan, it says it has no choice but to insist on concessions. The airline says it had a pension deficit of $2.1 billion at the start of 2011.

"This deficit is not sustainable and has not been sustainable for most of the decade, as it puts at risk both the viability of the company and the pensions of all employees," says Air Canada spokesman Peter Fitzpatrick.

Federal pension legislation requires Air Canada to make hefty payments in coming years to address that deficiency. By the airline's estimate, it will have to make $550 million in past and current pension contributions in 2014 alone.

Air Canada spokeswoman Isabelle Arthur says the airline has 26,000 active employees in its pension plan, which has to provide pensions for 29,000 retired workers, "so we have to find a solution that ensures that Air Canada remains a viable company."

Why is the union fighting so hard on this issue?

The CAW says making new hires join a new, defined contribution pension plan weakens the existing defined benefit plan because all new contributions would be diverted into the new plan.

Defined contribution plans, which offer no guarantees of final pension payouts, also create (in the CAW's words) a two-tier system "which would make second-class workers of future generations."

The CAW, along with two other unions representing Air Canada workers, jointly pledged last month to fight any further attempts by the airline to reduce or eliminate their defined benefit plans.

The union also notes that the airline's top managers continue to make millions of dollars annually and enjoy generous guaranteed pensions.

To be fair, I don't know the details of the dispute, but Air Canada is doing what most private companies with defined-benefit (DB) plans are doing, cutting benefits and shifting new entrants into defined-contribution (DC) plans. Basically, new employees get screwed and older ones get squeezed.

What I do know about Air Canada's pension plan is that it was poorly managed for years. The new team running Air Canada's pension is much better, much more sophisticated and they strive to match assets and liabilities using both public and private investments. But the pension deficit they inherited is enormous, leaving them an impossible task of closing an ever widening gap. That's why the company is fighting the unions hard on pensions. But as the deadline approaches for a strike at Air Canada, union leaders are paying close attention to a fight over pension, and by the looks of things, this fight is just getting started.

***Feedback***

Bernard Dussault, the former Chief Actuary of Canada, was kind enough to share his thoughts on Air Canada's pension dispute:

It is not the first time that I hear the representative of a defined benefit plan sponsor saying, like Air Canada spokeswoman Isabelle Arthur (“the airline has 26,000 active employees in its pension plan, which has to provide pensions for 29,000 retired workers, so we have to find a solution that ensures that Air Canada remains a viable company"), that the high ratio of pensioners to active members of the pension plan causes financial hardship to the sponsoring company. This is a myth. When a private plan is fully funded, this ratio has no impact whatsoever on the financial status of the sponsor because all money required to pay all future benefits to existing pensioners is already “in the bank” (i.e. the pension fund). Air Canada’s pensions-related financial hardship is mainly (if not exclusively) caused by all contribution holidays taken so far by the sponsor.

For a different perspective, read Jonathan Forethought Risk blog comment on Air Canada. Jonathan states that he believes that the divide was caused by a mismatch of risk, not contribution holidays. In fact, he demonstrates that Air Canada has been making regular contributions to its fund. I think mismanagement by the previous pension fund officers and contribution holidays are to blame.

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