The Bondsman's "Fear of Death"?

I spent the afternoon reading a fascinating paper by Shimshon Bichler and Jonathan Nitzan, Systemic Fear, Modern Finance and the Future of Capitalism (PDF file is available here). The introduction sets out the intent of their research:

The specific focus of the article is two historical ruptures of modern finance – the periods of 1929-1939 and 2000-2010. During both periods, capitalists abandoned the conventional forward-looking ritual of capitalization, resorting instead to the backward-looking posture of pre-modern finance. In our view, these rare episodes are of great importance for understanding the nature of capitalist confidence and the capitalists’ ability to rule – as well as the possibility that this system of rule will collapse. Our inquiry seeks, first, to characterize key features of these episodes; second, to speculate on their causes; and third, to assess, however speculatively, what they might imply for the future of capitalism.

While I recommend you carefully read the entire article, I want to focus on a few passages that are particularly interesting to financial market observers and pertinent to my post. First, let's begin with the takeoff:

The capitalist class is finally seeing light at the end of the tunnel. For many months now, its analysts, statisticians and public officials have been spotting “green shoots” everywhere they look. The snowballing global recession, they say, seems to have slowed down and perhaps even ended. Managers the world over are purchasing more inputs after a period of buying much less; the factories of Asian exporters are running at full steam; raw material prices have rebounded strongly; bank lending is reviving and home owners are starting to refinance their mortgages at lower rates; and in the United States, the world’s biggest producer-consumer, initial unemployment claims seem to have peaked, while consumers are beginning to loosen their purse strings. But the most important sign that the worst of the crisis is over comes from the equity market: stock prices are the ultimate barometer of capitalist health, and they have been soaring.

The market takeoff is evident in Figure 1 (above). The chart traces the U.S. dollar price of three key indices – all world equities, U.S. equities, and the equities of the U.S. FIRE sector (finance, insurance and real estate). All three indices show a sharp, synchronized rise. In slightly more than a year, from February 2009 to April 2010, the world index gained 67%, the U.S. index 62%, and the U.S. FIRE index – previously the most battered of the three – a whopping 93%.

Suddenly, the bulls are everywhere. The greatest returns are usually earned during the initial part of a rally, and no respectable fund manager likes being beaten by a rising average. With the economy apparently bottoming out and with the stock market having been in a major bear phase for nearly a decade, investors are no longer afraid of losing money; their fear now is not making enough of it. And so arises the specter of “panic buying,” a frenzied attempt to jump on the bandwagon before the really large gains are gone.

Of course, not everyone buys this rosy scenario. Many observers continue to feel that the recent stock market rally is no more than a dead-cat bounce. In the eyes of the pessimists, investors are knee-jerking to a false start. The economic recovery, they say, will be W-shaped, and the market will re-collapse before any real boom can begin. This recession, they warn, is nasty and likely to linger for years.

Bichler and Nitzan then discuss why this debate is fundamentally wrong:

Regardless of who is right, though, there is something fundamentally wrong with the debate itself. The current news may be good or bad, revealing or misleading – but, then, investors aren’t supposed to take their cue from the current news in the first place.

To trade assets on the basis of today’s statistics is to be backward looking. It is to be retrospective rather than predictive, to react rather than initiate, to trail rather than lead. It puts investors at the tail end of social dynamics.

Needless to say, such behavior is entirely improper. According to the sacred annals of modern finance, formalized a century ago by Irving Fisher (1907) and popularized during the Great Depression by Benjamin Graham and David Dodd (1934), asset prices are forward looking: “The value of a common stock,” dictate Graham and Dodd in their immortal doorstopper, “depends entirely upon what it will earn in the future” (p. 309).

The authors then explore why investors depart from this conventional forward-looking practice:

In our view, the reason is systemic fear. Systemic fear is a class of its own. It has little to do with the periodic downswings that make capitalists cautious, and it has no connection to the dread and apprehension that regularly puncture their habitual greed. “Business as usual” is always uncertain, and with capitalism constantly in flux, investors are forever fearful about profit and wary about risk: they are concerned that earnings may not rise as quickly as they hope, or that they might fall; that volatility will increase; that interest rates will rise; and so on.

But these fears, no matter how intense, are self-contained. They pertain to the level and pattern of profit, not to its existence. They do not impinge on the normality of profit – i.e., on the belief that assets have a “natural” tendency to grow and that capitalists have the power and right to enforce and appropriate such expansion. And most crucially, they reflect the belief that expected profits, whether high or low,could always be priced to their present value. Regardless of the market’s ups and downs, the underlying assumption is that the capitalization process itself – the ritual that creorders modern capitalism and anchors its dominant ideology – will remain intact.

Occasionally, though, there arises a very different and far deeper type of fear: the terrifying thought that the entity of profit – and, worse still, the very institution of capitalization on which the entire capitalist megamachine stands – might cease to exist. This latter fear is associated with systemic crisis – that is, with periods during which the very future of capitalism is put into question. It is what Hegel meant when he spoke of the bondsman’s “fear of death”:

For this consciousness [of the capitalist bound to the steering wheel of a megamachine gone wild] was not in peril and fear for this element or that [such as falling profit or rising volatility], nor for this or that moment of time [like a sharp market correction or a declaration of war], it was afraid for its entire being; it felt the fear of death, the sovereign master [the ultimate wrath of the ruled]. It has been in that experience melted to its inmost soul, has trem-bled throughout its every fibre, and all that was fixed and steadfast has quaked within it [will capitalism survive?]. (Hegel 1807: 237)

The first time capitalists were gripped by such systemic terror was during the Great Depression of the 1930s. The second time is during the present crisis, a protracted turbulence that started in the early 2000s and is still ongoing.

Looking at the current crisis, Bichler and Nitzan write:

And then there are those, like financial commentator Gideon Rachman, for whom the problem is largely temporary. The economists, Rachman suggests, have actually made great strides in understanding how the economy works. But from time to time the delicate machine gets infected by a “new type of economic virus,” and we need to be a bit patient until the economists discover the cure (Rachman 2009).

By 2010, though, it seems that the virus continues to elude the pundits. The threat of default has spread from business enterprise to sovereign governments, with countries like Iceland, Dubai, Greece and who-knows-who-is-next flirting with bankruptcy. Participants at a special conference hosted by Soros’ Institute for New Economic Thinking at Kings College, including five Nobel-winning economists, expressed grave concern that “many investors now find it hard to judge the ‘real’ riskiness of sovereign debt.” Gillian Tett conveys the atmosphere of theoretical bewilderment and ideological anxiety:

Three years ago, it seemed inconceivable that a country such as Greece would be allowed to default, or exit the eurozone. But back then it seemed equally hard to imagine that Lehman Brothers might fail. Now that Lehman has gone, who knows what the worst-case scenario might be? Could the eurozone break up? Could Greece default? What might happen to other debt-laden nations, such as the US, if the worst case scenario occurred? The one thing that is clear is that the answers to those questions now depend as much on culture and politics as on macro-economics. . . . In this new world of sovereign risk, what really matters is a set of issues that cannot be plugged into a spreadsheet. The old compass no longer works. (Tett 2010)

The predicament is so serious that even the know-all “market” – the collective brain of the capitalist class – has become disoriented. According to Martin Wolf, chief economics commentator at the Financial Times, the markets “don’t know what to fear: will it end up in deflation, default, inflation, financial shocks, or all of these?” “Markets are unpredictable,” he informs his son, “like children. . . .” And when the youngster asks “So what’s going to happen next?” the elder, who is usually able to answer questions that most people cannot even ask, replies: “If I knew that, I wouldn’t be a mere economic journalist. . . .” (Wolf 2010)

Finally, Bichler and Nitzan ask whether capitalism is heading for systemic collapse:

The decade-long breakdown of capitalization is no fluke. The fact that for ten years now capitalists have been pricing equities based on past profit betrays deep distress. Their fear now is not only that the level of capitalization may be bumping into a glass ceiling; it is also that the very ritual of capitalization – the universal crystal ball through which they have been “seeing” the future for nearly a century – may be giving them awfully wrong signals. And when the future looks bleak, and the dominant ideology appears opaque if not misleading, there arises the specter of systemic fear.

Given the foregoing, the obvious question to ask is: does systemic fear signal the imminent collapse of capitalism?

They conclude with these thoughts:

In order to see that something is systemically wrong, we need to think not positively, but negatively. Specifically, we need to look for market patterns that are inherently inconsistent with forward-looking capitalization. The manifestation of such patterns would then prove, by negation, that the ritual is broken. The specific pattern emphasized in this paper is one in which stock prices, instead of looking into the deep future, nervously trace the ups and downs of current and past earnings. This backward-looking pattern goes against the very gist of forward-looking finance. And when it emerges – as it did during the crisis of the 1930s and again in 2000 – we can be fairly certain that capitalization has broken down and that the ruling class has lost its confidence in obedience.

A shrewd academic might have leveraged this apparent anomaly into a full-blown mechanized model, complete with a universal taxonomy of “fear-of-death” eras, a sliding scale of price-profit correlations alerting investors when to switch and reswitch between forward- and backward-looking postures, and an easy-to-follow list of “how to profit” from both. And judging by what is on sale in the analysis market, this model could end up having plenty of paying followers.

We prefer to forego this investment opportunity and instead keep our speculations tentative and free. Capitalism may survive this systemic crisis, as it survived that of the 1930s. As before, this survival may require a significant transformation – one that restructures the entire architecture of power, including its material technology and dominant ideology – and such transformation is certainly possible.

But there is also a very real possibility that the current crisis will prove too much for the capitalist class to handle. “The history of all hitherto existing society,” write Marx and Engels in the opening paragraphs of the Communist Manifesto, “is the history of class struggles.” And that struggle can end “either in a revolutionary reconstitution of so-ciety at large, or in the common ruin of the contending classes (Marx and Engels 1884: 57-58).

So far, the capitalists’ loss of confidence in obedience hasn’t elicited significance opposition – but that can change quickly. However, if the opposition fails to establish an effective and hopefully progressive alternative – an alternative that so far seems absent – it is not impossible for the reverberations of the clash, amplified by the high complexity of capitalism, to culminate in systemic collapse and collective ruin.

Tomorrow, I will go over some leading indicators that are being misinterpreted and show you why I'm more optimistic that the economic recovery will continue. As for the stock market, it is in the best interest of the financial oligarchy to reflate risk assets, and inflate their way out this mounting debt problem. Debt deflation will ultimately lead to systemic collapse and "collective ruin".

***Feedback****

Warren D. Matthei of NYU sent me these comments:

Thanks for calling our attention to this important work.

Interesting to me that a Marxist perspective is creeping into the mainstream financial press.

I am a bit surprised, however, that the authors do not cite Lenin’s seminal work-Imperialism..

http://www.marxists.org/archive/lenin/works/1916/imp-hsc/

You might also wish to research the collected work of I. Wallerstein re: world systems which details the spread of capitalism since the 16^th century, the geography of wealth extraction and, by implication, predicts the inevitable, self-fulfilling collapse of that system.

The resolution of crises in the global system has frequently entailed widespread war and destruction…”patriotism and sacrifice”.

I am skeptical about the prospects for the massive project presently underway: an atavistic reversion towards a global American Empire built on the Roman/British model; the flaw is that it seems to entail impoverishment of the American populace, and this will undermine political stability. Manipulation of public consciousness and severe domestic political repression may or may not work. I see it as a sign of desperation.

By the way---since recent rally capitalist/financier insiders have been sellers, mostly dumping their worthless paper, directly and indirectly onto the Fed’s balance sheet.

My note: I am not a Marxist-Leninist, and never will be one. George Orwell's Animal Farm convinced me of the futility of communism as a political/economic system years ago. Having said this, what we have now is corporate welfarism, and there are no rules governing modern day capitalism. CEOs should have significant skin in the game, so when shareholders lose big, they lose a huge percentage of their net wealth (Buffett is dead right about that). And I believe in a more humane capitalism, where we take care of our weak and disenfranchised. Who is taking care of the poor, the unemployed, the disabled, the elderly, and other minorities which are vulnerable to the vagaries of Casino capitalism? Our collective attitude is "let them starve".

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Comparing CPPIB and PSPIB FY 2010 Results

Given that PSP Investments reported its FY 2010 results, I think it would be useful to compare their results to those of CPPIB who reported back in May (fiscal year for both funds ended on March 31st, 2010).

First, let me apologize, as I just noticed I never covered CPPIB's FY 2010 results, only some quarterly results. Let's go back to the May 20th press release:

The CPP Fund ended its fiscal year on March 31, 2010 with net assets of $127.6 billion, an increase of $22.1 billion from the prior year end. The increase in assets essentially put the Fund back to its previous highest level reported on June 30, 2008, prior to the onset of the financial crisis. The Fund rose due to increases of $16.2 billion in investment income and $6.1 billion in CPP contributions, minus operating expenses. The portfolio returned 14.9 per cent for fiscal 2010 compared with a prior year decline of 18.6 per cent.

“The CPP Fund delivered one of its highest-ever annual returns, driven largely by strong public equity markets,” said David Denison, President and CEO, CPP Investment Board.

One of CPPIB’s goals for fiscal 2010 was to capitalize on investment opportunities arising in the aftermath of the financial crisis. During the year we were able to put our comparative advantages as an investor to good use, acquiring assets in private equity, real estate, infrastructure and private debt. Our long time horizon, distinct investment approach, available capital and specialized investment expertise allowed us to make significant investments last year that were beyond the reach of many investors.

“We have the benefit of being able to look beyond short-term market cycles, and to deal with volatility better than the majority of market participants,” Mr. Denison said. “Unlike many other investors, we did not suffer from capital or liquidity constraints last year. In fact, our experienced investment teams completed a number of significant transactions during the year.”

These included the acquisition of Macquarie Communications Infrastructure Group, as well as our partnerships with other investors to acquire IMS Health and Skype, investments which are expected to generate strong returns over the long term.

Five and 10-year Returns

For the five-year period ending March 31, 2010, the CPP Fund generated an annualized rate of return of 4.0 per cent, or $18.5 billion of cumulative investment income. For the 10-year period, the Fund had an annualized rate of return of 5.5 per cent, or $39.3 billion of cumulative investment income.

Canada’s Chief Actuary has estimated that an annualized 4.2 per cent real rate of return, or approximately a 6.2 per cent equivalent nominal rate over the last 10 years, will be needed to sustain the CPP at its current contribution rate.

This 4.2 per cent real rate of return is an annual average over the 75-year time frame used for the CPP projection, and while returns are expected to vary in individual years, CPPIB is confident it will be able to meet and exceed this rate of return over longer periods of time.

“Our five and 10-year results should be viewed in the context of the performance of major global financial markets over the same period. The past 10 years of investing have taken place during the worst calendar decade of performance for equity markets in the nearly 200 years of recorded stock market history,” said Mr. Denison. “If we look back over the span of the last 25 years the CPP Reference Portfolio, which serves as the market-based benchmark for the CPP Fund, substantially outperformed the 4.2 per cent real rate of return on a rolling 10-year basis in all periods except calendar 2008 and 2009. We are confident that with the Fund’s current portfolio composition and reasonable levels of capital market returns, we will be able to generate the returns required to sustain the CPP at its current contribution rate over the longer term.”

Performance Against Benchmarks

As noted above, CPPIB measures performance against a market-based benchmark, the CPP Reference Portfolio. It seeks to generate value-added returns above this benchmark over the long-term. For purposes of accountability CPPIB looks at performance over rolling four-year periods.

While absolute returns for fiscal 2010 were strong, value-added returns for the four-year period ended March 31, 2010, underperformed the benchmark. For the four-year period ending March 31, 2010, the annual total portfolio return underperformed the CPP Reference Portfolio by 0.34 per cent. The annual total portfolio return for fiscal 2010 was 5.87 per cent below that of the CPP Reference Portfolio, and offset the value-added performance recorded in each of the previous three years.

“The nature of the Fund’s private investments in real estate, infrastructure, private debt and private equity means their value typically lags that of the public market indices that comprise the CPP Reference Portfolio,” Mr. Denison said. “It can take additional time for appraised values of private assets to reflect public market levels, particularly in the face of a significant rally such as that experienced in global public equity markets in the past 12 months.”

“Private investment returns are expected to play out over the long-term and cannot be captured within just a 12-month snapshot. For example, we believe there is considerable value embedded in our real estate and infrastructure investments that will be realized over time,” Mr. Denison added.

You can download CPPIB's FY 2010 Annual Report by clicking here. On page 7, CPPIB's President & CEO, David Denison, discussed the key factor influencing the Fund's performance:

One key factor influencing both overall Fund returns for fiscal 2010 and the calculation of the value-added return over that same time period is an inherent valuation lag between our public and private market holdings. We now have over 25% of the CPP Fund’s holdings invested in private assets including private equity, real estate, infrastructure and private debt.

In contrast to public market holdings, which are of course valued in accordance with daily observable market prices, our private holdings are typically valued comprehensively only once a year using independently verified appraisal practices.

In our experience, especially during a period where public equity markets have increased as rapidly as they have over these past 12 months, it takes additional time for appraised values to catch up to these public market levels. We recognize that investing in private market assets has had a negative near-term impact on value-add returns, but believe without qualification that this is the right strategy for delivering the kinds of returns needed to help sustain the plan over the longer term. We are confident that our private holdings will perform very well over the coming years and provide considerable value to the CPP Fund consistent with our long investment horizon.

You can click on the image above to see a breakdown of the performance by asset class. As mentioned above, Private real estate (-11.8%), Private foreign developed market equities (-9.4%), Private emerging market equities (-4.3%), and Infrastructure (-6.4%) all had a negative impact on the CPP Fund's portfolio in FY 2010.

As shown below (click on image to enlarge), the underperformance of Private Markets relative to the Policy Benchmark had a material impact on CPPIB's value added, as the 1-year value added fell by 587 basis points, and the cumulative 4-year value added fell by 34 basis points (whereas it was up 487 basis points in FY 2009).


By contrast, Private Equity and Infrastructure, up 28.8% and 7.2% respectively, were the main asset classes that allowed PSPIB to outperform its Policy Benchmark in FY 2010. Real Estate was marginally up (+0.6%), but it certainly didn't get hit as hard as CPPIB's Real Estate portfolio, primarily because the portfolio was concentrated in Canada and much more defensive as it is invested in residential, retirement and long-term-care facilities.

The significant outperformance of Private Markets at PSPIB relative to CPPIB is a little perplexing, but the portfolios differ in terms of geography, risk profile and maturity. Still, I wonder if there is something else going on in the appraisal of these investments because I am much more comfortable with the explanation CPPIB provided in its annual report. Importantly, it does take time for appraised values to catch up to public market levels, which means CPPIB will realize gains on those private market investments next year if all continues to go well in public markets.

As far as Public Markets, CPPIB outperformed PSPIB in Canadian public equities (43.7% vs. 40.4%) and public foreign developed equities (24.7% vs. 24.5%), but underperformed in public emerging market equities (45.9% vs 47.4%).

In my opinion, PSPIB has to further develop its Canadian public equities department. It was a huge mistake to let go of two seasoned Canadian portfolio managers back when I was there. Moreover, there should be more internal teams focused on global equities, developing long-only strategies and long-short strategies.

Finally, it is worth noting that CPPIB doled out huge compensation to its senior officers, much more than what PSP's senior officers received. The summary compensation table below can be found on page 73 of their 2010 Annual Report.

But CPPIB did add this note on compensation:

Consistent with our compensation framework, which measures investment performance over rolling four-year periods, fiscal 2010’s negative value-added will affect short- and long-term incentive compensation for the next three fiscal years as well. This impact is demonstrated in Table 6; the total estimated LTIP payout value as at March 31, 2010, for the named executive officers, excluding the CFO, is $2,360,400. This represents a 61% decline from the value of $6,053,822 as at the end of the previous fiscal year reflecting the impact of the negative value-added investment performance for fiscal 2010.

This business of compensation gets very messy. I will be the first to admit that it's not easy to find a proper framework of compensating senior officers who deal in private markets, especially when they are ramping up operations. Public markets is another story, either you outperform your index or you don't.

I invite you to read through CPPIB's 2010 Annual Report as well as PSPIB's 2010 Annual Report. There are similarities between these two funds, but there are also important important differences. CPP is partially funded plan whereas the plans PSPIB manages on behalf of are fully funded plans.

The annual reports contain a lot more information on these two large Canadian Crown corporations. CPPIB even lists its investment partners on page 54 of its annual report. A few funds in there caught my attention for good (and bad) reasons.

Let me end by telling you that comparing two pension funds isn't as simple as it sounds. Some comparisons are straightforward, but others aren't. This is especially true when comparing performances in private markets, which by their very nature, are much more complex and don't lend themselves easily to simple comparisons.

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PSP Investments Up 21.5% in FY 2010

The 2010 Annual Report of the Public Sector Pension Investment Board (PSP Investments or PSPIB) was tabled with the Parliament of Canada on July 21st, 2010. On Thursday, PSP Investments posted this press release on its FY2010 results:

The Public Sector Pension Investment Board (PSP Investments) announced today that it recorded an investment return of 21.5% for the fiscal year ended March 31, 2010 (fiscal year 2010), exceeding the Policy Benchmark return of 19.8% by 1.7%. The 2010 performance is one of PSP Investments’ best performances to date and reflects a return to fundamentals from the distressed valuations resulting from the liquidity crisis of the past two years.

In fiscal year 2010, consolidated net assets increased by $12.5 billion, or 37%, to reach $46.3 billion, a new high which exceeds the previous peak of $38.9 billion recorded at the end of March 2008. During fiscal year 2010, PSP investments generated net income from operations of $7.5 billion and received $5.0 billion in net contributions.

“PSP Investments’ 2010 results demonstrate the resilience of our long‐term investment strategy, which began in fiscal year 2004. At that time, we identified the corporation’s strongest competitive advantage to be long‐term liquidity provided from the large annual cash inflows expected to continue beyond 2020,” said Gordon J. Fyfe, President and CEO. “It allows PSP Investments to buy and hold Private Equity, Real Estate and Infrastructure assets for the long term, even during periods of extreme stress as we have just experienced. Unlike other investors, we were not forced to sell high‐quality assets at the most distressed time,” concluded Mr. Fyfe.

The overall performance for fiscal year 2010 was driven primarily by strong results in Public Market equities and the Private Equity portfolio. Investment returns for the public equity portfolios ranged from 20.1% for the US Large Cap Equity portfolio to 47.4% for the Emerging Markets Equity portfolio, while the Private Equity portfolio recorded an investment return of 28.8%. The Real Estate portfolio recorded an investment return of 0.6% while the Infrastructure portfolio achieved a 7.2% investment return for fiscal year 2010.

The asset mix as at March 31, 2010 was as follows: Canadian Equity 29.2%, Real‐Return Assets 20.2%, Foreign Equity 19.8%, Nominal Fixed Income 19.1% and Private Equity 11.7%.

For more information about PSP Investments’ fiscal year 2010 performance, consult PSP Investments’ Annual Report available at www.investpsp.ca.

About PSP Investments

The Public Sector Pension Investment Board (“PSP Investments”) is a Canadian crown corporation established to invest the amounts transferred by the federal government equal to the proceeds of the net contributions since April 1, 2000, for the pension plans of the Public Service, the Canadian Forces and the Royal Canadian Mounted Police, and since March 1, 2007, for the Reserve Force Pension Plan.

Its statutory objectives are to manage the funds entrusted to it in the best interests of the contributors and beneficiaries of the Plans and to maximize investment returns without undue risk of loss, having regard to the funding, policies and requirements of the Plans and their ability to meet their financial obligations.

The full 2010 Annual Report is available on-line (click here for PDF file). Obviously, PSP did a 180 degree turn from FY2009 where they lost 23% and severely underperformed their policy portfolio.

Let's begin with PSP's Chairman of the Board, Paul Cantor's message. On page 4, Mr. Cantor states:

As we can see from the latest results, a substantial portion of the unrealized losses from a year ago have been recuperated, which demonstrates the solid long-term value of PSP Investments’ assets. The fiscal 2010 results also reflect initiatives taken to benefit from the remarkable turnaround of markets.

New investment opportunities will arise as global markets continue to normalize. Given our expected annual cash inflows of approximately $4 billion, PSP Investments is in a favourable position to seize those opportunities. But risk is the handmaiden of opportunity, and we will still need to grapple with the inevitable challenges of future markets.

For PSP Investments, keeping a long-term perspective means remaining faithful to the orientation of a highly diversified portfolio that includes a significant portion of private equity and inflation-hedging real estate and infrastructure assets. Such investments increase the probability of meeting or exceeding the targeted 4.3%-above-inflation level of returns, without an unwarranted increase in risk and provide for a better match with the Plans’ liabilities.

We are mindful that PSP Investments’ legislated mandate is to “maximize returns without undue risk of loss”. The events of fiscal year 2009 made evident the need to more clearly define this notion of undue risk with our stakeholders.

The Board has been addressing this question, and will be proposing a comprehensive framework in fiscal year 2011. Beyond that, internally, one of the Board of Directors’ on-going priorities entails working with management to further enhance risk management practices. Our aim is to use what we have learned from the recent crisis to further refine both our quantitative and qualitative parameters for evaluating, monitoring and mitigating risk.

It worries me that after all these years, and after experiencing the 2008 financial crisis, PSP Investments is still trying to figure out the notion of undue risk with their stakeholders. The latter are mostly to blame for this lack of proper oversight.

As I have repeatedly stated, managing pension money isn't about shooting the lights out, doubling down when things go wrong, it's mostly about managing downside risk. And managing downside risk in today's zero interest rate policy world where pension funds, sovereign wealth funds, insurance funds are all chasing indexes and "hot alternative investments" isn't as simple as people think. Importantly, correlations are breaking down a lot more often nowadays, placing a lot of pressure on senior pension officers struggling to find viable ways to minimize downside risk.

How are pension funds responding? I had lunch today with an industry contact who told me how he sees more and more pensions adopting a liability-driven investment (LDI) approach, moving assets away from public equities into fixed income. He added: "they're leveraging up their bond portfolios like crazy. It's like picking pennies in front of a steamroller...one day they'll get caught and lose their hand."

I replied: "True, this business of pension funds leveraging up their bond portfolio makes me nervous. But if senior pension officers believe we are heading for a protracted period of deflation, why risk their portfolio chasing high beta stocks, hedge funds, private equity, commodities or real estate? You're better off keeping it simple, investing a good chunk of assets in high quality government bonds, protecting your downside (but capping your upside)."

Back to the results. On page 7 of the Annual Report, PSP's President & CEO, Gordon Fyfe, had this comment on FY 2010 results:

The past two years saw the worst financial crisis since the Great Depression, demonstrating the risk of leverage and a lack of liquidity. Many investors missed the sharp rebound in asset prices starting in March 2009, having been forced to sell high-quality assets at the most distressed time.

This was not the case for PSP Investments. In fact, during fiscal year 2010 as our assets under management grew, we were able to purchase an additionnal $3.5 billion in public equities (including emerging markets where PSP has a relatively large exposure) at attractive prices.

Overall, our public equity portfolios generated an investment return of 37.9%, contributing to a strong investment performance for fiscal year 2010.

We also benefited from the high quality of our Private Market assets. Being in a position to hold on to illiquid assets that had been written down to distress valuations as a result of the liquidity crisis enabled us to generate significant investment returns, as values returned to fundamentals. The most probing example is the 28.8% return achieved in our Private Equity portfolio in fiscal year 2010.

Finally, we were able to rebalance our portfolio, at or near target asset allocation as our confidence in the strength of the rebound in public equities grew.

Gordon is right, many investors did miss the sharp rebound in asset prices starting in March 2009, and were forced to sell high-quality assets at the most distressed time. It was a matter of liquidity - those pension funds that needed it the most during the crisis were the ones who suffered the most. Other funds like PSPIB and CPPIB, were able to sit back and wait out the crisis without having to sell any of their public or private market holdings (at the market bottom).

Sure, PSP got hit on their illiquid assets in FY 2009, and had to write down their Private Equity portfolio, but as markets rallied sharply since March 2009, those assets were written back up. That's why just like those California pension giants, PSP's Private Equity portfolio had a 29% gain.

How important was that 29% gain in Private Equity? Consider this, on the bottom of page 16 of the 2010 Annual Report:

The excess return of 1.7% (compared to the Policy Benchmark) achieved during fiscal year 2010 was primarily generated by the Private Equity and Infrastructure asset classes, as well as by absolute-return mandates.

Major contributors to excess return in absolute-return mandates included externally managed debt portfolios that benefited from the effect of narrowing credit spreads. PSP Investments’ holdings in collateralized debt obligations and asset-backed term notes (referred to as asset-backed commercial paper in last year’s annual report) also were contributors to the fiscal 2010 excess return. For the fiscal year ended March 31, 2010, investments in collateralized debt obligations increased overall returns by 1.2%, as a result of $393 million in investment income generated in the fiscal year. Our investment in asset-backed term notes generated investment income of $260 million in the fiscal year, increasing the overall rate of return by 0.9%.

Tightening credit spreads and generally favorable market conditions, compared to the previous year, were the primary reasons for the increase in value of these investments. As was mentioned in last year’s annual report, the losses recorded in fiscal year 2009 financial statements related to these investments were primarily the result of stressed market conditions and not related to any significant realized credit losses.

Taking an even closer look at Private Equity's performance (page 19):

Net assets of the Private Equity portfolio totalled $5.4 billion at the end of fiscal year 2010, an increase of $1.2 billion from $4.2 billion at the end of fiscal year 2009.

Private Equity generated $1.2 billion in investment income for a rate of return of 28.8% for fiscal year 2010, compared to the Policy Benchmark return of 13.5%. The robust Private Equity performance for fiscal year 2010 was driven mainly by the direct and co-investment portfolio, which generated $489 million in investment income during the fiscal year, as well as significant performance from a select number of key partners.

On a five-year basis, Private Equity investments generated a negative 0.9% compound annualized return, compared to the Policy Benchmark negative return of 6.7% for the same period.

The Private Equity portfolio has a long-term focus. Investments are held for an average of 5 to 10 years. The Private Equity portfolio is invested globally in collaboration with strategic partners with whom PSP Investments has established relationships. PSP Investments continues to diversify its Private Equity portfolio, with direct and co-investments playing an increasingly important role. As at March 31, 2010, direct and co-investments accounted for 27% of assets of the Private Equity Portfolio, up from 21% at the end of the previous fiscal year. Direct and co-investments amounted to $1.4 billion at the end of fiscal year 2010.

Overall, the Private Equity Portfolio is well diversified both from a geographic and sector perspective. The increase in Canadian and telecom assets is mainly related to the strong performance of Telesat.

We still don't know the details about Telesat's performance, but as I suspected, the $1.5B plus secondary market sale PSP is reportedly engaged in, has more to do with a shift towards co-investments and direct investments which allows them to realize gains on their private equity investments more quickly.

Now, a note on the Private Equity benchmark. PSP does not publicly disclose the benchmarks for private markets citing "competitive reasons", but the biggest problem with PE (and infrastructure) is that it is still in ramp-up mode. I mention this because it's not fair comparing PSP Private Equity or Infrastructure benchmarks to other more mature funds that have ramped up their portfolios.

Infrastructure, led by Bruno Guilmette, is just ramping up, and earned $158 million in investment income for a return of 7.2% in FY 2010, compared to the Policy Benchmark of 3.7%:

A significant portion of the portfolio return was generated by cash distributions (interest and dividends) and realizations from direct or co-investments. Again this year, the performance was largely attributable to direct investments. Since inception (3.75 years), Infrastructure investments have generated a 6.2% compound annualized return, compared to a Policy Benchmark return 3.4% for the same period.

Real Estate, led by Neil Cunningham, has fully ramped up but has struggled in the last couple of years. Still, it is doing comparatively better than large US and Canadian funds:

Real Estate earned $28 million in investment income for a return of 0.6% in fiscal year 2010, compared to a Policy Benchmark of 7.4%. The Real Estate portfolio maintained its value during the year despite an extremely adverse market.

This is largely attributable to a strategy of investing a large portion of the portfolio in the Canadian market, which has shown more stability than other markets during this period, and the adoption of a defensive asset mix over the past three years, with a significant portion of the portfolio being invested in residential, retirement and long-term-care facilities.

On a five-year basis, Real Estate investments have generated a 6.5% compound annualized return, compared to a Policy Benchmark return of 7.3% for the same period.

Let me wind down here by commenting on overall results. While PSP Investments did bounce back solidly from last year's disaster, not missing the rally in stocks since March, the results are not as spectacular as the headline figure implies. In fact, the table below was taken from Brockhouse Cooper's Q1 Universes (click on image to enlarge):

As you see, the median one-year return for Canadian Balanced funds at the end of Q1 2010 (PSP's fiscal year ends March 31st), was 23.1% and the Brockhouse Cooper Balanced Index was up 21.2% for the year ending March 31st, 2010. Hence, while PSP delivered a solid performance, it wasn't "stellar", and PSP was lucky its fiscal year ended before the May-June period where equity markets got whacked hard.

In his message, Mr. Fyfe didn't place too much emphasis on the annual result, focusing more on long-term results:

While we are pleased with our strong performance in fiscal year 2010, one cannot fully judge the effectiveness of a long term investment strategy like PSP Investments’ on the basis of a single year’s results — good or bad.

Perhaps the best measure of success is to look back at PSP Investments’ performance since fiscal year 2004, when we began implementing our diversification and active management strategy. During this seven-year period, we have achieved a net 5.8% annualized real rate of return (i.e. after subtracting expenses and inflation), exceeding the 4.3% real rate of return objective. This investment return was achieved despite experiencing the worst deterioration of financial markets since the 1930s in fiscal year 2009.

With the prospect of positive net cash flows of more than $4 billion per year in the near future, and positive net contributions expected for the next two decades, PSP Investments’ strategy remains sound. Moreover, at a time when some asset classes are still distressed, we are well positioned to capitalize on investment opportunities.

True, but over the last five years, PSP's returns are 4.4% while the Policy Benchmark returned 5.3% (click on first chart above). Despite this long-term underperformance, PSP's senior officers enjoyed another stellar year in terms of compensation. Once again, top compensation went to senior officers in the Private Markets. Derek Murphy, First Vice-President of Private Equity, garnered the largest compensation among senior officers, earning $1,543,265 for FY 2010.

The summary compensation table below was taken from page 46 of the 2010 Annual Report (click on image to enlarge):

The Chairman of the Board defended PSP's compensation practices:

During fiscal year 2010, PSP Investments completed a thorough analysis of its overall compensation practices and procedures and evaluated their compliance with the recommendations of the G20 Working Group which are based on the Financial Stability Forum Principles for Sound Compensation Practices. This self assessment concluded that PSP Investments’ compensation programs and policies are consistent with the G20 Recommendations, and that compensation programs are effectively designed to reduce the potential for rewarding excessive risk taking.

In the interest of sound governance and impartiality, the Board and the Human Resources Compensation Committee also mandated Deloitte & Touche LLP to conduct an independent review of PSP Investments’ assessment. Deloitte & Touche LLP confirmed PSP Investments’ level of compliance with the G20 Recommendations.

But union leaders representing federal civil servants aren't happy with compensation and other governance issues at PSP. In fact, the Public Service Alliance of Canada (PSAC) shared these concerns with me:

1- the return of the PSPIB must be put in perspective: There is a 21.5% return for fiscal year ending March 31^st 2010, but over the same period time the S&P/TSX Composite Index increased by 34.6%.

2- PSPIB has underperformed against the established policy benchmark in 5 of the 10 years since commencement of operations.

3- A total of $4.2 million in incentive bonuses (annual and deferred) paid to the top 6 executive officers of PSPIB in fiscal 2010 in comparison with a total of $3.8 million in incentive bonuses (annual and deferred) paid to the top 6 executive officers of PSPIB in fiscal 2009 - an approximate increase of 10%

4-The Unions are still prevented from serving on the PSPIB.

5- The Federal government is currently contemplating even higher contribution rates on behalf of employees.

It's easier to defend bonuses when the PSP Fund performs well as it did in FY 2010. But as I stated before, nobody should have received any bonuses last year after that disastrous performance. And given that PSPIB is underforming its Policy Benchmark over the last five years, I can see why some are concerned about the level of compensation doled out to senior officers during that period.

As far as board representation, I do feel that unions of all three key stakeholders should have some representation on the Board. This may not please other board members who are nominated, but unions have every right to have representation on that Board (right now, the Act governing PSPIB prevents union members from sitting on the Board).

Let me end this long comment by noting something Mr. Fyfe wrote in his message:

An on-going priority to successfully implement our 2012 strategic plan has been the recruitment, development and retention of the top talent required to effectively manage a large and complex investment fund.

As we round out the leadership team, PSP Investments’ pool of human resources has acquired the critical mass and collective expertise that enable us to shift our primary focus from recruitment to professional development and succession planning. Accordingly, we are conducting talent reviews with middle management, developing formal succession plans and implementing a structured approach to the development of new managers, while continuing to refine our hiring practices.

I am happy to hear that PSP is placing priority on recruiting, developing and retaining top talent. My measure of success at any investment shop - be it a pension fund, a mutual fund, or a hedge fund - is the turnover rate at these places.

Unfortunately, the turnover rate at some long-term pension funds has been abysmally high in recent years. This is totally unacceptable and a clear sign of managerial weakness. I mention this point not to target anyone in particular, but because I believe in retaining good people and developing them as they progress in their career.

Finally, let me personally congratulate Gordon and his senior team for delivering solid results in FY 2010. I haven't always been easy on PSP but I am able to give credit where credit is due.

And while some think I want PSP to fail, nothing can be further from the truth. Gordon came through for me at a very difficult time in my life, offering me an incredible opportunity to work in a field I truly love. My experience at PSP was for the most part a positive one where I learned a lot about various asset classes in both private and public markets. Montreal is better off for having PSP's business office here and I wish them many more years of success.

***Feedback on PSP's FY 2010 Results***

A senior pension officer shared these thoughts with me:

Telsat looks like the outlier sized direct PE investment that is going well. Satellite is an area that is getting more valuable, regulatory changes and spectrum requirements mean that while they bought this asset for a very high price it should provide a decent medium term return potential, although their old satellites are of waning value by nature. Deals are apparently imminent on their sale of pe funds, probably some structured deal of sorts. So it appears they will free up capital and be a force to be reckoned with going forward. But it all remains a large experiment with people who remain unproven investors.

Like CPPIB, they have not provided any net value since their creation versus and all Canadian bond portfolio, nor has PE made any money since inception, even after currency gains. Yes, it is still (relatively) early days, etc. but the bottom line is these places take way too much risk before they are operationally seasoned, and people have had a chance to work together. And, it looks like the strategy is, “we survived, now we will take advantage of others who failed and all the opportunities out there”. This is naïve. Few others actually failed, and the global glut of capital means returns for risk remains highly problematic. They have few if any advantages as investors other than their non-taxable status which they generally pay away to the sellers of assets due to the competitive market out there. I think that in the next ten years, once again these places will add no value (make no money).

And he added:

I don’t mean to be too negative, it’s just that being accountable means at a Board they need to revisit the entirely of what they are trying to achieve, and whether it is possible. They obviously think staying the course is appropriate, but if they don’t say stop, or slow down, who will? Looks like a self perpetuating organization, which is why there shouldn’t be many of these created, and why they should be capped in the amount of capital allowed to any one organization. The govt. needs more diversity of approaches, even if that costs economies of scale (which may not exist beyond a certain point anyway).

Note that the Dutch pension giant ABP is essentially setting the stage to exit PE as a line of business. They are recognizing the reality of the glut of capital, and why be illiquid if you don’t get paid for illiquidity?

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California Pension Giants Bounce Back

Earlier this week, Michael B. Marois of Bloomberg Businessweek reported, California Teachers Fund Earns 12% After Record Loss Last Year:

The California State Teachers’ Retirement System, the second-biggest U.S. public pension fund, earned 12.3 percent in the year ended June 30, led by gains in stocks and bonds that offset losses in real estate.

Calstrs, as the Sacramento-based fund is known, ended the fiscal year with $129.8 billion under management, up from $118.8 billion a year earlier. Stock holdings earned 14.5 percent and its bonds rose 12.3 percent, the fund reported today. Investments in private equity funds rose 21.7 percent, while real estate fell 12.4 percent.

“We’re not out of the woods yet,” Calstrs Chief Investment Officer Christopher J. Ailman said in a statement. “The American economy suffered a near-death experience in 2008, and it’s going to take some time to fully recuperate from that.”

The gain comes as the fund that provides benefits for 833,000 public school and community college teachers plans to ask lawmakers in 2011 for an increase of as much as 14 percent to what the state and school districts already pay toward employee retirement benefits.

The fund lost 25 percent in 2009, led by a 43 percent drop in real-estate and a 28 percent decline in private-equity. The pension said in January that its unfunded liability, the difference between assets and anticipated future costs, had almost doubled to $42.6 billion since June 2008.

The fund’s board in June voted to launch a commodities program as part of an inflation-linked asset class. The category can account for as much as 5 percent of holdings.

Commodity prices surged 23 percent last year as the outlook for global economic growth, led by China, the fastest-growing consumer of raw materials, spurred demand for metals, energy and grains. Higher prices have drawn increased interest from hedge- fund managers and pension funds.

The California Public Employees’ Retirement System is the largest public pension fund in the U.S., with $201.5 billion of assets as of June 2.

On Wednesday, ai5000 reports, CalSTRS Thanks Alternatives for Positive Returns:

The $129.8 billion California State Teachers' Retirement System (CalSTRS), the nation’s second-largest public pension fund, posted its first gain in three years, partly attributing its growth to successfully boosting its allocation to alternatives.

“We’ve taken steps to position the portfolio for long-term growth, but we’re not out of the woods yet,” said Chief Investment Officer Christopher Ailman. “The American economy suffered a near-death experience in 2008, and it’s going to take some time to fully recuperate from that. This year’s performance is a solid start along that road to recovery.”

In the year ended June 30, the plan returned 12.3%, boosted by a 21.7% return in its private equity portfolio. After falling by about 25% in its last fiscal year, the CalSTRS Board and investments staff is seeking recovery by:

• Expanding its target asset ranges to avoid having to sell at a loss.
• Temporarily shifting 5% of the portfolio from global equities to fixed income, real estate and private equity to take advantage of the distressed market.
• Permanently shifting 5% of the portfolio from global equities to create a new absolute return asset class for inflation-protection.
• Adopting a new asset allocation mix to further diversify the portfolio and decrease its stake in the global stock market.
• Launching the Innovations and Risk unit to explore new investments such as a macro global hedge fund strategy, commodities and microfinance.

As of June 30, 2010, the portfolio holdings consisted of 51.7% in U.S. and non-U.S. stocks, 22% in fixed income, 14.5% in private equity, 10.1% in real estate, 0.9% in absolute return assets and 0.8% in cash. Its five-year strategic asset allocation targets are 47% U.S. and non-U.S. equities; 20% fixed income; 15% real estate; 12% private equity; 5% absolute-return strategy for inflation protection, including hedge funds, infrastructure and commodities; and 1% cash.

Separately, the fund today issued a statement applauding financial regulatory reforms, joining with its partner state pension funds and plan sponsors in applauding meaningful financial regulatory reforms signed into law today by President Obama.

"We now have in place safeguards to help prevent a repeat of the 2008 market collapse which has hurt all investors, large and small," the fund said in a statement.

"We also have tools for investors that will bring appropriate transparency, accountability, and management of risk at the corporate level. Regulators and investors must remain vigilant and alert to restore and maintain the integrity of our capital markets and the accountability of its participants."

I am not so sure we have safeguards in place to prevent a repeat of 2008, but some financial reforms were way overdue. As for CalSTRS's performance in private equity, lots of opportunities presented themselves in distressed markets over the past year and to their credit, they capitalized on them.

The launching of the Innovations and Risk unit to explore new investments such as a macro global hedge fund strategy, commodities and microfinance is interesting. I wonder if they are going to develop strategies internally, or farm them out to investment managers.

CalSTRS was not the only California pension giant reporting their performance. Last week, Calpers posted its best returns in 3 yrs as markets gain:

The California Public Employees' Retirement System, America's biggest public pension fund, said on Thursday its investments earned 11.4 percent for the year ended June 30, marking their best performance since 2007.

The Sacramento, California-based pension fund known as Calpers said in a statement that over the 12 months ended in June its assets increased to $200 billion. In the previous fiscal year, Calpers suffered its biggest-ever annual loss when returns dropped 23.4 percent as markets were hard-hit by the financial crisis.

Helped by recovering financial markets, investments in private equities, global bonds and stocks all delivered double-digit gains, the fund said in a news release.

"With the exception of real estate, all of the asset class had positive returns for the year," said Calpers' chief investment officer, Joseph Dear. "We're definitely in the recovery mode with the opportunity to capture future returns because of our long-term investment horizon," Dear who came to Calpers a year ago to help stabilize investment returns said.

The fund, whose picks are followed closely in the investment community, said its investments in stocks gained 14.4 percent as its bond holdings rose 19.5 percent. Private equity funds performed even better, posting a 30.9 percent gain.

Its bets on real estate, however, soured, falling 37.1 percent.

Calpers also said it is working on a new plan for how to allocate capital in public stocks, private companies, bonds and other fixed income, real estate and inflation-linked assets like commodities, infrastructure and forestland.

Some of those real estate deals are coming back to haunt CalPERS. Global Pensions reports it's now being sued by a nonprofit charity over the release of records concerning its US$100m investment in a controversial residential property firm.

But despite the terrible performance in real estate, CalPERS and CaSTRS bounced back, much owing to public stocks, but also owing to their private equity portfolios which capitalized on opportunities in distressed markets.

The question now is how will these giants perform in the next five years? Bouncing back from 2008 lows was the easy part, but they are still heavily underfunded and need to address their skyrocketing pension deficits. That's more complicated and will require tough political decisions ahead.

I think these giants need to think carefully about a course of action to continue making money and more importantly, controlling downside risk. Farm out some funds to top hedge funds, but keep and eye out for smaller talented managers where you can get more "bang for your buck". Use your size not to muscle managers on fees, but to leverage off their expertise, building your own internal absolute return teams. Most of all, make sure you're paying for alpha, not leveraged beta.

CalSTRS is right about developing their global macro hedge fund portfolio (hopefully, some of that will be internal). I still think in a low interest rate environment with lots of uncertainty, there is a premium for liquid strategies where risk can be controlled more easily.

On Wednesday, Federal Reserve Chairman Ben Bernanke told Congress the U.S. economic outlook remains “unusually uncertain.” This simply means that rates will stay low for a protracted period until the Fed feels the risks of deflation have been completely thwarted. But as John Makin of the American Enterprise Institute reminds us, the rising threat of deflation is real, and these pension giants better tread carefully or risk suffering steep losses in their investment portfolios again. Let's hope that post-2008, they're better prepared for what lies ahead.

***Links to Annual Reports***

Please note annual reports for FY2010 are not available yet. When they are, you will be able to read CalSTRS's annual report by clicking here, and CalPERS's annual report by clicking here.

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Social Security to Tackle State Pension Woes?

Mary Williams Walsh of the NYT reports, Facing Pension Woes, Maine Looks to Social Security:

Lawmakers in Maine have found an unusual tool for tackling their state’s pension woes: Social Security.

Just as workers in the private sector participate in Social Security in addition to any pension plan at their companies, most states put their workers in the federal program along with providing a state pension.

Maine and a handful of others, however, have long been holdouts, relying solely on their state pension plans. In addition, most states have excluded some workers — often teachers, firefighters and police — from the national retirement system and its associated costs, 6.2 percent of payroll for the employer and an equal amount for the worker.

Now, Maine legislators have prepared a detailed plan for shifting state employees into Social Security and are considering whether to adopt it. They acknowledge it will not solve their problem in the short term but see long-term advantages.

Some variation on this idea could ultimately appeal to other states grappling with their own exploding pension costs and, in extreme cases, quietly looking for help from Washington. In troubled states, some employees have wondered whether they might be allowed to begin paying in and collecting from the federal system even before they have contributed a career’s worth of taxes.

The potential effect on the Social Security program is hard to estimate. Maine’s proposal would mean new members and a small additional source of payroll tax revenue for the federal system.

Even if it fully embraces the proposal, Maine will have to come up with a considerable sum to sustain its existing pension plan, presumably through some combination of taxes and service cuts. After a phase-in period, Social Security would cover part of state retirees’ benefits, with the state pension as the remainder. Many pension plans in corporate America coordinate their benefits in this way.

The proposal has the advantage of not reducing promised benefits, guaranteed by the constitution in many states. The change would not be cheap, but it would reduce the role of Maine’s pension fund and thus the risk of having to suddenly cover giant losses down the road.

A Social Security spokesman said the agency did not expect many of the holdout states to join, citing the cost of participation. The only other state known to have talked recently about adding Social Security is Louisiana.

More than six million public employees work outside the Social Security system, including roughly 1.7 million teachers in California, Illinois and Texas, and nearly two million employees of all types in Alaska, Colorado, Massachusetts, Nevada and Ohio, as well as Louisiana and Maine. For years, these and other states have insisted they could provide richer pensions at a lower cost, both to workers and taxpayers, because of investments.

Some of those states’ pension plans now have shortfalls so large that they need outsize contributions. Virtually all state pension funds have had big losses in the last two years, but the go-it-alone states appear especially vulnerable.

Not only are these states trying to provide richer benefits with smaller contributions than the payroll tax for Social Security, but they have promised to do it for workers who can retire 10 and sometimes 20 years younger.

With pension costs ballooning and taxpayers lashing out, many workers in states with deeply underfunded plans fear their benefits will be cut. Those being asked to put more into their pension funds complain they feel caught up in Ponzi schemes. Some wish they had been part of Social Security after all.

“Had I known back then, I would not have stayed in Illinois,” said John Gebhardt, a university employee in that state, which keeps teachers and university personnel out of Social Security. He has even offered to pay both his own and his employer’s payroll tax to join Social Security, but was told no.

Maine lawmakers who support shifting state workers into Social Security say they believe it would be fairer. Social Security may not be sexy, but it is portable.

A recent study in Maine underscored the penalty paid by the mobile work force. Only one in five state employees stays around long enough to get a full pension. The majority leave, taking neither a pension nor any Social Security credits with them. This practice, not investment gains, has sustained the state’s pension system.

“The current system is immoral,” said Peter Mills, who, as a state senator, started the push to join Social Security. “It takes younger people and feeds off of them. You can withdraw from teaching at age 40 and realize you’ve got nothing to look ahead to for your old age.”

Dallas L. Salisbury, president of the Employee Benefit Research Institute, said he was surprised by how few public workers ever got pensions in Maine, where he provided advice on a pension overhaul. He said he checked and found similar turnover in other states.

Whether Maine joins Social Security or not, painful choices must be made. The state pension fund lost $2.25 billion in 2008, and taxpayers will have to replace the lost money. But they have less time to do so than most states, thanks to tough financing rules in the constitution. Projections show that Maine will not have enough money to do much else in the coming years if it adheres to those rules.

“It’s going to rip the guts out of our budget,” said Mr. Mills. “I don’t think you can find a budgetary parallel in my lifetime, and I’m 67.”

Unlike laggard states, including Illinois and New Jersey, Maine had in recent years been making its required pension contributions annually, and it avoided the common mistake of sweetening benefits when markets were strong.

Its looming fiscal crisis stems primarily from investment losses, points out Sandy Matheson, executive director of the state plan. “Maine is almost like a petri dish,” she said, showing how things can go awry even if a state is responsible.

Mr. Mills, a Republican, initially envisioned shifting workers into Social Security and a 401(k) plan. But he now views Social Security combined with a traditional pension as a safer option. That puts him on common ground with Democrats in the statehouse.

The proposal may meet resistance, however, because it does not fill the gaping hole in the state’s pension fund.

A shift into the federal program is also hard to plan because Social Security has a financial imbalance — one that will worsen as the population ages. At some point, Congress is expected to either raise taxes or cut benefits.

Still, Social Security’s future is easier to predict than that of a state pension fund, because its pressure stems from broad demographic trends, not the vagaries of the stock market. Social Security keeps its reserves in conservative Treasury securities.

“You’ve got reviews taking place all over the country,” said Mr. Salisbury. Most places are asking painful questions about their investment strategies. But what Maine has discovered, he said, is just how expensive it really is to provide a guaranteed retirement benefit.

It's interesting to note how some states are now looking at Social Security as an answer to their pension woes. What I don't get is why weren't these state pension funds allocating more into "conservative Treasury securities" before the crisis hit?

Instead, they were taking stupid risks trying to achieve unrealistic returns based on rosy investment projections. Moreover, they were all being advised by the same pension consultants with absolutely no skin in the game, telling them to invest more in public equities and alternative investments like hedge funds, private equity, and real estate.

Pension funds are not just about making huge gains, it's also about protecting the portfolio against downside risk. And in a zero-interest rate (ZIRP) environment, good old government bonds are about the only thing that will protect you, especially if a protracted period of debt deflation is what lies ahead.

My theory is plain and simple: the Fed will do everything it takes (including buying stocks) to make sure this outcome never happens. Their policy is to keep interest rates at zero as long as possible, reflate risks assets, and hope that mild inflation creeps back into the economic system.

How does this work? You keep interest rates at zero for as long as possible, let banks borrow at next to nothing, and let them trade away in their prop desks, investing those funds in all sorts of risk assets all around the world that can deliver higher yields. What else? Banks can borrow at at historic low rates and develop their credit card business, locking in a nice spread as they fleece consumers. Unfortunately, with ZIRP, banking is all about trading and spreads and very little goes to actually lending money to businesses that need it.

Anyways, back to Social Security. Mary Williams Walsh of the NYT also reports that Social Security is paying roughly $50 million a year too much to people who collect state pensions but fail to declare that income.

No wonder a majority of Americans are losing confidence in Social Security. Susan Page of USA Today reports, Faith in Social Security system tanking:

Battered by high unemployment and record home foreclosures, most Americans seem to have lost faith in another fundamental part of their personal finances: Social Security.

A USA TODAY/Gallup Poll finds that a majority of retirees say they expect their current benefits to be cut, a dramatic increase in the number who hold that view. And a record six of 10 non-retirees predict Social Security won't be able to pay them benefits when they stop working.

Skepticism is highest among the youngest workers: Three-fourths of those 18 to 34 don't expect to get a Social Security check when they retire.

The public's views are more dire than the calculations of Social Security's trustees. Last year, they projected the system would begin running in the red in 2016, as the Baby Boom generation retired, and the trust fund would be exhausted in 2037.

Even then, Social Security — which celebrates its 75th anniversary next month — could finance about three-fourths of current benefits through the payroll tax.

The downbeat outlook reflects "all the attacks on Social Security that we have this total crisis in the program," says Alicia Munnell, director of the Center for Retirement Research at Boston College. What's more, she says, "the fear and distrust as a result of the financial collapse and the Great Recession has spilled over into people's expectations generally, that you can't count on anything."

Well-informed or not, public attitudes could affect the debate over what to do about Social Security, a subject that is likely to be raised when President Obama's deficit commission delivers its report in December.

"It makes it easier to make some of the changes that we are inevitably going to have to make," says Maya MacGuineas, president of the Committee for a Responsible Federal Budget. "We could make changes and still have people collecting more in benefits than they're expecting to see."

So far, however, resistance hasn't eased against steps such as raising the retirement age or increasing Social Security taxes. The only policy options that command majority support are imposing the payroll tax on all the wages of higher-income workers — the amount is now capped — and limiting benefits for wealthy retirees.

Confidence in Social Security has significantly eroded since 2005. The percentage of retirees who predict cuts has jumped by 24 points, even though benefit levels have never been cut for current retirees. In that time, the number of non-retirees who doubt they'll get benefits has risen by 10 points.

The poll of 1,020 adults, taken July 8-11, has a margin of error of +/–4 percentage points.

Most people are reeling following the 2008 financial crisis. They got screwed in the stock market, and they fear Social Security will not be there to support them during their retirement years. However misplaced those fears are, they're real, and states are now looking to tap into Social Security to deal with their pension woes?

They should first look at bolstering the governance of their public pension plans (read Forbes article, Self-Dealing Threatens Florida Pensions). Social Security is already stretched, and tackling state pension woes is the last thing it should be called upon to do.

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Onex, CPPIB Unite in Bid to Buy U.K. Firm

Tara Perkins of the Globe & Mail reports, Onex, CPPIB unite in bid to buy U.K. firm:

Onex Corp. and the Canada Pension Plan Investment Board are joining forces on the proposed takeover of a major British manufacturing and engineering company, just as the U.K. begins its own “hollowing-out” debate.

Toronto-based Onex and the CPPIB have not launched a formal bid but have proposed a deal, worth more than $4-billion, for Tomkins PLC. Due diligence on the company is now “at an advanced stage,” Tomkins said in a statement Monday.

The proposed takeover comes as North American suitors take advantage of a sluggish British pound to target U.K. companies. Earlier this month, for example, the Ontario Teachers’ Pension Plan closed its £389-million ($625-million) acquisition of Camelot Group Ltd., which operates the U.K. national lottery.

Coupled with the lingering effects of the global recession, fears are mounting that a number of British companies will be scooped up by foreigners.

While the concern has not hit the level witnessed in Canada in 2006 and 2007, when the Canadian business community was consumed by the “hollowing-out” debate, it’s unusual for the British to be bothered about this issue.

The tables have turned and Canada now finds itself portrayed as one of the prowling foreigners. But it’s the country’s pension plans and private equity players, not publicly listed corporations, that are on the hunt.

“In Canada, our corporate profits have rebounded fairly strongly and our credit markets are still flowing,” said Toronto-Dominion Bank economist Francis Fong. “And of course the dollar is providing a pretty significant boost.”

While the pound has depreciated and the Canadian dollar has surged since 2007, “it’s more about the ability of firms to find funding,” he said.

It was Chicago-based Kraft Foods Inc.’s $20-billion purchase of Cadbury, which closed in January, that first ignited concerns in Britain, which has traditionally been secure in its business prowess and hasn’t been worried by takeovers.

An independent takeover panel is in the midst of a review of the relevant laws, which Business Secretary Vince Cable has suggested are too loose, and the new government is looking at the issue. “I want to throw some sand in the takeover process,” the Daily Mail quoted Mr. Cable as saying this month. But, he added: “We don’t want to put up a sign that says: ‘Britain is not open to business.’”

There is discussion about whether a greater proportion of the shareholders of a target company should be required to approve a deal, or whether higher merger fees should be used to curb the flow of deals. Those pushing for a new regime of takeover laws are already dubbing them the “Cadbury Law.”

“Foreign firms swooped on two British energy and industrial giants with takeover bids worth £9.3-billion today, raising fears that another swath of British assets will fall into the hands of overseas owners,” the Evening Standard said Monday. In addition to the bid for Tomkins, International Power said talks have resumed about a reverse takeover by France’s GDF-Suez.

Just as a weak currency shouldered much blame in Canada’s hollowing-out debate – which raged after the takeovers of a series of blue-chip firms such as Alcan, Falconbridge, Inco and Dofasco – the weak British pound is being pointed to in the U.K.

The financial crisis took its toll on Canada’s pension and private equity players, but the pain they felt is overshadowed by that of many major financial players and corporations in other countries. The International Monetary Fund is projecting worldwide economic growth of 4.5 per cent this year, with Canada’s pegged at 3.6 per cent while the U.K. economy is expected to grow by 1.2 per cent.

Canadian pension funds are gaining new clout internationally because of their size, sophistication, and ability to partner up and work together, Charles Baillie, the former CEO of TD Bank who is now chairman of Alberta Investment Management Corp., said in an interview last week. “You’ll see much more international exposure because of the ability to band together and make meaningful bids.”

This time around, CPPIB has joined forces with Onex, which has a history with auto parts companies, such as the acquisition of the beleaguered Automotive Industries Holding Inc. Onex turned it around and sold it at a profit to Lear Corp. Tomkins’ businesses stretch from auto parts to bathtubs.

Tomkins also said Monday that its sales improved during the first half of 2010, but it’s unlikely that it will be able to keep up the momentum in the second half of the year due to “global economic uncertainty coupled with recent downwards trends in some macro indicators.”

The company’s CEO, James Nicol, 56, is highly respected in Canada. He left his job as president and chief operating officer of Magna International Inc. and joined Tomkins in 2002. Tomkins’ finance director, John Zimmerman, 46, worked in Toronto for Braxton Associates in the early 1990s. Both men sit on Tomkins’ board.

Interestingly, Philip Inman of the Guardian reports, Canadian pension funds move in as UK counterparts sell up:

As domestic pension funds sell their stakes in British companies, their place is increasingly taken by pension funds from Canada.

The $127bn (£84bn) Canada Pension Plan Investment Board, which is bidding for Tomkins, already owns stakes in about 35 companies including chemist Alliance Boots, US retailer Dollar General, internet phone operator Skype and US phone-equipment maker Avaya.

The pension fund manager, stung by a near 20% loss in 2009, has made offers for a string of companies hit by the financial crash and directs 25% of its holdings into private equity deals – more than any UK pension fund.

In the past year it bid $5bn alongside TPG, one of the most aggressive US private equity firms, for IMS Health of Connecticut.

Buying Tomkins, which is described by several analysts as a bargain, would add to a growing list of major stakes in large corporations by Canadian pension funds.

The Ontario Teachers Pension Plan holds a 27% stake in Northumbrian Water and was rumoured earlier this year to be supportive of a full takeover. The latest speculation allies the Ontario fund with the Abu Dhabi Investment Authority to take the utility private.

In March the Ontario fund spent £389m buying the lottery operator Camelot after it beat private equity firm CVC in an auction.

The Canada Pension Plan is the equivalent of the UK's state second pension, formerly known as Serps, with one key difference. In the UK, national insurance contributions are used to pay current pensioners and the remainder is diverted into general government spending. The Canadians take the remainder and invest it.

The pension plan's investment board is a separate unit with a constitution that allows a wide range of holdings.

A focus on large, longer term purchases dates back to the 1990s when the fund decided its size warranted diversifying into lucrative private equity-style deals. Returns between 2004 and 2007 averaged more than 10%.

Some UK funds have attempted to mimic the success of the Canadian funds with increased support for private equity and hedge funds.

The University Superannuation Scheme, which provides an occupational retirement income for academics, has boosted so-called alternative investments to close an £8bn deficit.

But the culture of UK funds and many of the rules surrounding scheme funding have discouraged direct investment in companies. Until a few years ago most occupational schemes were more the 70% invested in equities with the remainder in cash, property and bonds.

The steep stock market decline of 2003 and accounting rules changes encouraged fund trustees to cut the risk of falls in value with a shift from shares to fixed income bonds.

Critics of UK funds argued the move, while it minimised the impact of declining stock markets and avoided the steep falls that hurt the Canadian funds, effectively locks them into low growth investments and prevents them from making strong gains in the future.

It's true that UK funds have adopted a liability-driven investment approach, moving more towards fixed income and allocating less to public shares. Some UK funds have shifted more assets into alternatives, but most funds have cut risk across the board.

So what's the right thing to do? It depends. The Canada Pension Plan (CPP) is a partially funded plan and the CPP Fund (CPPIB) is in an enviable position because contributions are expected to exceed annual benefits paid through to 2021 and there is no need to use current income to pay benefits for another 11 years.

Moreover, despite the setback in 2008, CPP assets have grown over the last ten years, a point made by Jean-Claude Ménard, Canada's Chief Actuary in his testimony at the House of Commons Standing Committee on Finance last April:

The average pension fund return for OECD countries was negative 19% (nominal) for the first ten months of 2008. The CPP Fund declined by $13.8 billion over the final nine months of 2008. Still, the CPP assets of $111 billion represent four times the annual benefits paid. In comparison, ten years ago, the assets represented less than two times the annual benefits paid.

In this environment, it is important to reconfirm that the structure and design of the first two pillars of Canada’s retirement income system is unique and will allow the OAS Program and CPP to fare better than many of their private pension counterparts. In addition, steady-state funding, which is the partial funding approach employed by the CPP, remains the optimal funding approach for the CPP.

Although the financial markets are currently quite volatile and the value of CPP assets will fluctuate over the short-term, it is the ongoing contributions made by working Canadians in addition to long-term investment performance that will determine the Plan’s ability to meet its commitments to plan members.

As I've stated it before, a handful of funds like CPPIB, are able to take on more liquidity risk than more mature pension plans that are managing assets and liabilities more closely. Those funds are not able to tie up a big portion of their assets in private markets because they need the liquidity to pay out benefits.

And what can go horribly wrong for CPPIB? One word: Deflation. If a protracted period of debt deflation engulfs the developed world, then CPPIB will be sitting on a ton of public and private equities that will be losing value.

Who will be in a better position if a long deflationary era awaits us? Funds that allocated to high quality fixed income assets, because the only thing that will protect your downside if deflation develops is long-term government bonds.

Are CPPIB and other Canadian pension funds going on an overseas buying spree doing the right thing? I think so. Given the strong Canadian dollar, and the expertise to co-invest in private markets, they should be putting some of the long-term capital to good use. Let's just hope that deflation doesn't rear its ugly head.

***Feedback***

A senior pension officer sent me this comment:

If you compare CPPIB's performance to bond returns since its inception, the bonds did better. The creation of CPPIB and taking on equity risk has not, as yet, provided Canadians any benefit. No one seems to want to acknowledge this. Private or public equity is a moot point, and it appears privates underperformed publics, although it is hard to get this data from their reports, but it is certainly the case on an IRR basis.

Allowing these failed non-taxed pools to crowd out strategic industrial (taxable) buyers of important assets is bad public policy and anti-capitalist. Onex and others are also largely representing non-taxable investors. At one time PE arbed the tax advantage to its investors benefit, now it just overpays and the sellers get the benefit. This is all unsustainable.

These are legitimate points, however, CPPIB will argue that over the long-run, taking on public and private equity risk will yield substantial gains. As I've argued, that all depends on the environment we're heading into and right now, we simply do not know if deflation, inflation or something in between will prevail. Also, keep in mind what the Chief Actuary of Canada said about the assets now representing four times the benefits, as opposed to ten years ago when they just represented two times the benefits.

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