That Slippery, Oily Slope?

Jeremy Warner of the Telegraph reports, The uncertainty over oil is a slippery slope:

The last time the oil price lost touch with gravity, which it threatens to again with the price of Brent crude now well north of $100 a barrel, it helped tip the world economy into the deepest recession since the 1930s.

Is history about to repeat itself? Much depends on developments in the Middle East, but things are once more looking perilous.

By adding to energy costs, the effect of high oil prices is to reduce the amount of money for spending on other things, thereby undermining aggregate demand in the wider economy. Eventually a tipping point is reached where confidence collapses. Given what happened as recently as 2008, you would expect OPEC to be acting quickly to prevent any further explosive increase in prices.

The wave of popular protest across North Africa and beyond has put that assumption in doubt. What happens to the world economy is not exactly a priority right now for the autocrats who dominate OPEC. Their focus is instead on survival. The big producer, Saudi Arabia, looks particularly vulnerable to further contagion in the region.

With nervousness turning to panic among key producers, this is not an environment conducive to the sort of prompt decision-making necessary to prevent the oil price running out of control again.

If the latest instability in the Middle East wasn’t enough excitement for the Energy Institute’s traditionally lively annual conference in London this week, there’s also the unprecedented divergence in benchmark oil prices to ponder.

Go back to the origins of multinational oil in the 1950s and 1960s, and it was big oil companies such as Shell and BP that set the price, with the emphasis very much on the needs of consumer nations they serviced. By the 1970s, OPEC had usurped that role. As a consumer, you either paid up or went without.

The mid-1980s saw the adoption of a more market-related system, with OPEC turning the taps on and off in an attempt to keep prices in a supposedly mutually beneficial range.

Big producers such as Saudi Arabia still sell on their own terms, but they do so by reference to a small number of benchmark prices, supposedly established by arm’s length international trading in oil.

The extent to which these benchmarks are a true reflection of the balance of supply and demand in the world economy is a matter of conjecture. The suspicion is that they owe as much to manipulation, anomaly and speculation as underlying fundamentals.

Like stock and bond markets, oil has become “financialised”. These days, it appears as much the playground of hedge funds, hoarders and financial investors as genuine users and producers. When the oil price took flight three years ago, the Financial Services Authority (FSA) dismissed claims of undue speculative influence as largely nonsense, and on the basis of “the market is always right” dogma of the time, put the phenomenon down mainly to supply constraints against a backdrop of fast-growing demand.

Not for the first time, the FSA was being naive. Price discovery in oil is at best untransparant and inexact, and at worst subject to substantial distortion. The reason this is of such vital importance is because oil plays such a big role in economic activity. To allow oil markets to become subject to the same speculative excesses as sub-prime mortgages would be disastrous. Producer and consumer behaviour are crucially determined by what the price says; when the pricing signal is wrong, economic activity will be affected in highly undesirable ways.

An unduly elevated price will eventually destroy demand, which in turn will undermine sustainable investment in new capacity to meet future demand growth. These cycles are a major influence on the ups and downs of the broader business environment.

A study by Bassam Fattouh of the Oxford Institute for Energy Studies – An Anatomy of the Crude Oil Pricing System – finds the benchmarks that determine world energy prices to be wanting in a number of important respects.

One look at the difference between the two main benchmarks – Brent and West Texas Intermediate (WTI) – immediately tells you there’s something wrong. Historically, WTI has traded at a small premium to Brent, but over the past year, a near record discount of some $15 a barrel has opened up. This in part reflects ample supply in the US Midwest (WTI is an American benchmark) and an equally pronounced squeeze on supplies of Brent. Brent is a waterborne crude, while WTI is a landlocked American benchmark, so the difference might be attributed to the US economy still being down in the dumps while Asia is booming.

But what do the now quite small quantities of oil still coming out of the North Sea have to do with Asia? The answer is virtually nothing, and yet Brent is used in some shape or form to determine prices for approximately 70pc of internationally traded oil. Markets with very low volumes of production are being used to price ones with very high production elsewhere in the world.

The traditional benchmarks might have more credibility if they were at least solidly grounded in the physically traded product, but they are not. In fact, oil markets are characterised by a complex structure of interlinked spot, physical forwards, futures, options and derivative markets, all of which feed into the benchmark price. The paper market is arguably as important in driving the price as the physical one.

Add to that the fact that no one really knows what’s going on in the world’s fastest growing oil market, China, and all the ingredients are there for a mispricing disaster.

The conclusion drawn by Mr Fattouh is that new benchmarks may be needed to reflect the emergence of Asia as the main source of growth in demand for oil. Perhaps unfortunately, we seem most unlikely to get one. As monopoly, state-owned suppliers that won’t auction their oil, the main OPEC producers are even less capable of generating credible price discovery benchmarks than Brent.

Of course, these musings may soon be largely irrelevant. It may be true that whatever the regime, the oil will keep flowing, but with Pandora’s Box now well and truly opened across great swathes of the Middle East, there’s no knowing where it will end. Short-term supply, future pricing, ownership and preferred trading partners – all these things are again up in the air.

Back in 2005, I attended a conference on commodities in London and was amazed at how much money pensions were shoving into so-called "commodity indexes" (even if they were made up of 76% oil futures). It's ridiculous to think that there is no speculation going on in oil markets. Go back to read Michael Masters' excellent testimony to the Committee on Homeland Security and Governmental Affairs. It's all happening again except this time we also have geopolitical eruptions spurring on further speculation.

The price of oil makes me nervous for one simple reason: if it shoots up, it can easily destabilize the fragile recovery taking place right now. And here is something else to ponder: higher oil price increases deflationary pressures:

...while jumps in the oil price cause inflation to rise at the headline level, it also has an adverse impact on economic activity, reducing demand which naturally serves as a deflationary force. This happens in a number of ways as higher fuel costs hamper a firm's production, which in turn forces it to lay off workers while also reducing wage pressures.

Analysts at UBS believe a $10 hike in the oil price would push up European inflation by 0.2% over one year and 0.1% over two years. They do not believe further oil prices would necessarily translate into significant inflation because of the countering deflationary forces.

According to the investment bank's simulations a jump in oil prices pushes up the energy component of the inflation index but depresses core inflation, which excludes volatile food and energy prices.

Analysis from the bank shows that a 10% increase in crude reduces core inflation by 0.1% a year after with the deflationary effects of oil shocks seem to take longer to disappear with projected core inflation still well below the non-shock level. This is because the shock is estimated to reduce economic activity for more than two years. In a extreme case scenario where the price of oil rises by as much as $50 core inflation subsequently drops by 0.25%.

For this reason UBS does not expect European central banks to be knee-jerked into action if the oil prices continue to rise amid the Middle East tensions.

'An eventual oil shock would hit the EU economy in an environment of low inflation expectations and wage deflation,' UBS says. 'For this reason we think the ECB would not be too worried about second-round effects, and would therefore not be forced to hike rates earlier.'

So while the oil shock may not result in central bankers becoming overly hawkish it could in fact have an opposite deflationary impact and reduce the need for an aggressive tightening campaign on rates.

Whether this could drag the global economy back into recession remains to be seen.

I'm not so sure the ECB (aka the Bundesbank) really cares about anything else except for what's going on in Germany. It wouldn't surprise me if they do start hiking rates, killing the periphery economies and adding further fuel to deflationary forces. I hope I'm wrong but they never cease to amaze me.

As for the global economy, it still runs on oil. If oil prices shoot up, expect more riots, more instability, and more volatility in financial markets. The way things are going, we might be back to a time where everything is correlated to oil. This unstable environment is great for arms manufacturers, but it will wreak havoc on the global economy. Hedge accordingly.

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Will Rising Yields End the Party?

Ben Levisohn of the WSJ reports, Rising Yields Could End the Party:

With corporate profits rising and economic data coming in better than expected lately, stocks are surging. But so are bond yields—and that could spoil the party.

Bond yields and stock prices have been rising together. On Feb. 8, the Dow Jones Industrial Average touched 12233, its highest level since June 2008. The same day, the yield on the 10-year Treasury reached 3.72%, the highest since April 2010. Rates have risen for six consecutive months, the longest such streak since 2006.

Signs of a healthier economy are growing more numerous by the day. The Chicago Purchasing Managers Index, for instance, rose in January to its highest level since 1988. Corporate profits also have been better than expected; more than 70% of the companies in the Standard & Poor's 500-stock index that have reported fourth-quarter results so far have beaten earnings projections.

Yet rising bond yields can cause problems of their own. Higher yields raise borrowing costs for companies, homeowners and municipalities, especially overleveraged ones. Over time, those higher costs can be a drag on corporate profits and economic growth. Rising yields also make bonds relatively more attractive than stocks for income-oriented buy-and-hold investors.

The question for investors is when bond yields and stock prices might start to decouple. Since 1963, stocks and bonds have tended to move in opposite directions whenever the yield on the 10-year Treasury note has risen above 5%, according to data compiled by LPL Financial in Boston. When the 10-year yield is below 5%, stocks and yields tend to move in the same direction.

More recently, however, 4% yields have been a pivot point—and given the surge in yields recently, that is reason for caution. On April 5, for instance, the 10-year Treasury yield briefly rose above 4% as investors worried that the Federal Reserve would have to raise rates to tamp down inflation. During the next two months, the S&P 500 fell 12%, as U.S. economic data soured and the "flash crash" spooked investors.

"If we get to 4% and it's purely a market move, then we have a problem," says David Ader, head of government-bond strategy at CRT Capital Group LLC in Stamford, Conn.

If rates rise too quickly in coming months, that could undermine any budding recovery in housing and municipal finance, says David Bianco, chief U.S. equity strategist for Bank of America Merrill Lynch. That is because mortgage rates and municipal bond yields both track Treasurys to some extent, and an increase in borrowing costs could add further stress to these fragile areas of the economy.

Mr. Bianco says a move to 4% or higher during the first half of 2010, or above 4.5% during the second half, could exacerbate problems.

"A rise above 4% characteristically doesn't trigger an economic slowdown or recession," adds James Stack, president of InvesTech Research in Whitefish, Mont. But "it will provide a headwind."

Equities could come under pressure, too, if the gap shrinks between the 10-year yield and the overall stock market's "earnings yield," a measure of a company's earnings per share as a percentage of its stock price that is calculated by taking the reciprocal of the market's price/earnings ratio. When the difference between the 10-year yield and the earnings yield drops below zero, it can signal a shift in the market, as it did in mid-2008, before the market plunged and Treasurys soared. Conversely, the ratio crossed zero into positive territory in 2004, and stocks rallied for three more years.

Right now, the market trades at about 17.2 times trailing 12 month earnings, according to Ned Davis Research in Venice, Fla. That translates to an earnings yield of 5.82%. With the 10-year yield at about 3.65% now, the difference is about 2.2 percentage points—much less than the August peak of 3.7 percentage points. And with bond yields expected to continue their rise and earnings yields to fall, it may be only a matter of a few months before the difference disappears, says Tim Hayes, chief investment strategist at Ned Davis.

Already, signs are emerging that bond yields and stocks are poised to go their separate ways. On Feb. 3, the one-year correlation between the two measurements fell to 0.43, down from nearly 0.6 in September. (A correlation of 1.0 means two indices move in lockstep; a correlation of minus-1.0 means they move in complete opposition.) That was the weakest correlation since the beginning of 2010.

Of course, this doesn't mean investors should run for the exits. Yields remain at levels that likely signal optimism about growth rather than fears of inflation. But rising yields do mean investors should exercise caution. If yields continue to rise, they should look to more defensive sectors, including energy and staples, Mr. Hayes says.

"The question is how much higher rates will the market tolerate," he says. "More often than not, rising rates ultimately become a problem for stocks."

I like Tim Hayes and Ned Davis Research and pay attention to what their models are forewarning. Another independent research firm, BCA Research, has been warning government bond buyers to beware:

"The recent breakout of the U.S. 10-year Treasury yield above 3.5% is an important technical signal, highlighting that the macro-backdrop is increasingly turning against the bond market," said BCA Research in a recent report.

"Our global cyclical bond indicators have been bearish for some time and valuation is poor in most of the major countries. The only missing ingredient for a fully-fledged bond bear market is the start of monetary tightening cycles in the U.S. or Europe. Recent comments from Chairman Bernanke, President Trichet and Governor King give us little reason to question our call that the Fed, ECB and BoE are on hold until early 2012. Nonetheless, there is room for the market to discount a faster pace of rate normalization even if central banks do not get started until early next year."

"We are not extremely bearish on government bonds in the near term because the absence of central bank rate hikes should limit the upside for yields in the coming months. Nonetheless, we expect yields to ultimately be significantly higher on a 6-24 month horizon."

Will the bond market kill the party in equities? That depends on inflation expectations and the US jobs market. So far, the latter hasn't shown any signs of a sustained pickup but inflation pressures are building, especially in emerging markets. In fact, the ECB chief recently warned that rising food demand could drive inflation:

European Central Bank head Jean-Claude Trichet said Wednesday that food prices could keep rising due to increasing demand from emerging countries and suggested a global effort to raise production in Africa.

Changing consumption patterns in large emerging countries have fuelled food prices and “it is quite possible that this will continue for a while longer,” Trichet told the German weekly Die Zeit in an interview.

“At the same time, there are huge expanses of land in Africa which could be used for agricultural purposes,” Trichet added. “We need to provide the right incentives for African farmers in this respect.”

He called the situation “an important global issue which should be taken up by bodies such as the G20” group of developed and emerging economies.

Higher prices would not force the ECB to raise interest rates but the bank would focus on avoiding “second-round effects” whereby high oil and food prices are transformed into generalised inflation.

It would watch in particular for signs of “a wage-price spiral,” Trichet said.

Countries where economic activity is pushing inflation to levels that have begun to ring alarms, as is the case in Germany, should adopt “more restrictive” policies “to avoid the economy overheating or speculation getting out of control,” Trichet said. He noted that “Germany has also succeeded remarkably well in regaining its competitiveness over the last 10 years (and was) ... now reaping the rewards of its patient efforts.”

But the ECB president cautioned that German output had not yet returned to levels seen before the global financial and economic crises.

Trichet downplayed notions that some Germans were becoming more sceptical of the 17-nation eurozone because they might have to provide substantial financial support for weaker members in the coming years. “Deep down, everybody is aware of the importance of our historic project,” he said.

Even though global inflation is on the rise, the WSJ reports that traders of U.S. federal-funds futures seemed to have less faith that price pressures will force the Federal Reserve to begin lifting its key short-term rate by the end of this year:

The central bank's funds rate target has remained inside a lowest-ever range of 0% to 0.25% since December 2008, but the market had recently forecast a higher rate by year's end after some encouraging economic data and inflation worries.

However, Federal Reserve Bank of Chicago President Charles Evans--a voting member of the rate-setting Federal Open Market Committee--said Thursday that unemployment is still too high and overall inflation to low for the Fed start raising rates.

Evans and other Fed officials this week signaled that the central bank will likely complete its current quantitative easing program as scheduled at the end of June. The program, also known as QE2, refers to the Fed's purchase of $600 billion in U.S. Treasurys to keep longer-term rates low and help speed up the economic recovery.

Evans explained that recent food and energy price increases account for only a small percentage of overall inflation.

Outside the U.S., inflation appears to be a bigger worry, which is primarily responsible for Friday's steepening of the yield curve.

A steeper curve means the market anticipates longer-term rates rising while shorter-term rates stay low.

European Central Bank Executive Board member Lorenzo Bini Smaghi warned that the ECB may have to raise rates if global inflation pressures build.

"It is a key challenge for monetary policy to avoid spillovers and maintain inflation expectations in check," said Bini Smaghi in an interview published Friday in the daily newsletter Bloomberg Brief.

Bini Smaghi's comments came on the same day that producer prices in Germany--Europe's largest economy--jumped 1.2% in January and 5.7% on an annual basis. The annual figure was the highest since October 2008.

Meanwhile, U.S. federal-funds and the bulk of the most-actively traded Eurodollar futures contracts priced in lower short-term rates on Friday, due in part to traders' desire for safe investments ahead of the long holiday weekend.

Safe-haven bids were tied to continuing turmoil in the Middle East, including citizen protests in several countries and escalating tensions between Iran and Israel.

At Friday's settlement, January 2012 fed-funds futures--measuring expectations for the Dec. 13 FOMC meeting--priced in a 54% chance for the committee to raise the funds rate to 0.5%. That's down from a 64% chance at Thursday's settlement, and a 94% chance at last Friday's settlement.

Longer-dated February 2012 fed-funds futures were no longer fully priced for the first rate hike to occur at the Fed meeting in late January of next year.

The February 2012 contract priced in a 94% chance for a 0.5% rate, down from being fully priced for the move on Thursday. A week ago, the same contract had also priced in a 40% chance for a further tightening to 0.75%.

A 0.75% funds rate is no longer factored into the February 2012 contract.

Also, a large-volume options trade performed Friday signaled expectations for a continued rally in prices--equal to lower implied rates--for second year Eurodollar futures contracts.

Brokers reported a trading firm performed 30,000 to 40,000 spreads, simultaneously buying and selling call options, aiming for June 2012 Eurodollar futures price to reach 99.125 before the calls expire in June of this year.

At the 99.125 strike or underlying futures price, June 2012 Eurodollars would reflect expectations for the implied London interbank offered rate, or Libor, to fall to 0.875%.

Libor expectations are calculated by subtracting the Eurodollar futures price from 100.

At Friday's settlement, June 2012 Eurodollar futures were 3.5 basis points higher at 98.615, projecting Libor to reach 1.385%.

Eurodollar futures reflect market expectations for changes in the three-month Libor, which is the rate that banks charge each other for borrowing U.S. dollars.

The three-month dollar Libor is also viewed as a benchmark for lending to businesses and households, and it's frequently considered as a surrogate for U.S. fed-funds rate expectations.

Elsewhere, inflation pressures are building and so are expectations of rate hikes. Unveiling the Bank of England’s quarterly inflation report on Wednesday, Mervyn King, the governor, bent over backwards to insist no decision had been made on whether, or when, the monetary policy committee should raise interest rates:

Yet, aside from a few traders in the sterling currency markets, the consensus remains that a signal on rates has been given and the next move is likely to be as little as three months away.

“The February inflation report contained two important messages,” said Simon Hayes, economist at Barclays Capital. “The first is that the MPC is leaning towards a rate rise over the next few months. The second is that the envisaged policy tightening is small and gradual and may yet be subject to delay, depending on the evolution of the data.”

Mr Hayes’s comments were echoed by many other long-term MPC observers.

The process by which economists have come to this conclusion is highly technical. Malcolm Barr, economist at JPMorgan, says it requires enlarging the Bank’s trademark fan chart showing the likely path of inflation and applying a large ruler against it to measure changes.

The reason economists have been reduced to reading the runes is Mr King’s habitually circumspect presentation on the day of the inflation report. Observers must wait for the monthly publication of the MPC minutes to discover the numbers behind the Bank’s forecast.

On Wednesday he said only that the Bank’s inflation forecast was “based on the assumption that Bank rate follows a path implied by market rates...”

A look at the interest rate futures market shows that in 12 months rates are expected to be 1.358 per cent, implying three, quarter point rate hikes by then. By August, the markets expect rates to be more than 1 per cent, suggesting two increases will have taken place by then.

Mr King, however, went to great lengths to insist the MPC “does not endorse the market path for interest rates”. “We never do,” he said.

What this tells me is that inflation pressures are building but it's too early to call for rate hikes in the US. In Europe and England, rate hikes are likely in the next few months, but expect a gradual approach if they start hiking rates.

And what about the stock market? Will the bond market kill the party in stocks? Isn't that always the case? This typically is the case, but it's not that simple. Even if central banks start hiking rates, there is so much liquidity in the global financial system that stocks will continue grinding higher and in some sectors, another bubble is already underway. In other words, rising yields will not end the party anytime soon but they will put pressure on stocks and force asset allocators to rethink their asset allocation.

But for now, I wouldn't be too concerned about rising bond yields. And don't forget, despite what some smart economists are writing, deflation isn't dead. Fairfax Financial, one of the best funds in the world, is still positioned for deflation with 89% of its equity exposure hedged through total return swaps on the Russell 2000 and S&P 500. They took a hit last quarter but might eventually turn out to be right with this deflationary macro call. If deflation fears reappear, funds should be preparing by scooping up government bonds as yields rise. Deflation might turn out to be the surprising call of the next decade.

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UK's £80 Billion Pension Blunder?

Ruth Sutherland and James Salmon of the London Mail report, £80bn wiped off value of pensions after inflation rate was underestimated for 12 years:

A staggering £80billion has been wiped off the value of pensions because the rate of inflation has been underestimated for 12 years, it emerged last night.

Millions of pensioners relying on occupational schemes have been left hundreds of pounds short each year because their retirement benefits have not been increased to reflect the full rise in inflation.

A 0.3 per cent a year underestimate of the effects of inflation over 12 years comes to 4 per cent.

John Ralfe, one of the UK’s leading independent pensions consultants, said: ‘In simple terms, for every £100 of pension you are receiving, you should be getting £104.’

Details of the blunder come just days after the Bank of England admitted that inflation this year is likely to rise from 4 to 5 per cent.

High inflation can be devastating to pensioners because their incomes fail to keep pace with rising costs and the real value of their savings dwindles.

The Bank admitted to the miscalculation in its quarterly Inflation Report, saying the Consumer Price Inflation should have been 0.3 per cent a year higher between 1997 and 2009.

The figure was lower because the Office for National Statistics failed to take into account changes in the prices of clothing and shoes which were affected by hefty discounting in the sales.

The ONS changed the way it records the prices of clothes and shoes in January last year.

The impact on Retail Price Inflation would have been even greater but the Bank did not disclose how much. Most pensions are linked to the RPI and rise in line with that figure.

The Bank said the miscalculation was the responsibility of the ONS. It means that for 12 years, the increases to pensions for inflation have not reflected the true rise in the cost of living.

More than 17million people were either pensioners or deferred pensioners in final salary schemes in 2009 and could be affected.

John Broome Saunders, actuarial director at BDO Investment Management, said: ‘If you went to every final salary pension scheme in the UK and recalculated the benefits using the right inflation figure, you would increase the total value of pensions by around £80billion.

‘This is pretty shocking stuff at a time when people are worried about their pensions. It is certainly very worrying that the government statisticians didn’t get this right.

‘It is yet another thing reducing people’s confidence in the Government’s management of pensions.’

Mr Saunders said the value of entitlements to final salary pensions from employers, the public sector and local government was around £2trillion. The 0.3 per cent underestimate over 12 years comes to 4 per cent, or £80billon.

The true impact on pensions may be even greater because most are increased either in line with RPI or earnings, both of which are normally higher than the CPI figure.

John Prior, a pension consultant with Punter Southall, said: ‘This will affect anyone who has been in a final salary scheme over that period.

‘It includes people who are already retired and deferred members, or people who have left a company but not yet drawn their pension.

‘It would indirectly affect current employees because their pay rises and pensions may have been less.’

The ONS said: ‘This is not a blunder. Our figures aren’t wrong – we have simply improved the way we calculate inflation.’

But Laith Khalaf, from financial advisers Hargreaves Lansdown, said: ‘Pensioners have a tough time battling inflation as it is. They will be up in arms that their income has been held back in this way.’

Simply improved the way you calculate inflation? What a joke! Anyone who's been paying higher gas prices, higher food prices and higher clothing prices doesn't need some government statistician telling them that inflation is running higher than the 'official' government figures.

According to the states the Bank of England's latest quarterly Inflation Report, the ONS "picked up seasonal falls in prices during the winter and summer sales, but did not fully capture the recovery in prices after sales had finished". The study looked at clothing prices in Euro-area countries and estimated the impact on the UK's consumer prices index (CPI) if more accurate clothing prices had been included. The report suggested that there would have been an even larger impact on the other headline inflation index, the retail prices index (RPI).

Mark Reynolds of the Express reports, Millions Lose in Pensions Blunder:

Pensioners were cheated out of £80billion during 12 years of Labour rule, it was revealed yesterday.

In a bitter blow to millions, the Bank of England’s February inflation report showed the Consumer Prices Index between 1997 and 2009 was 0.3 per cent a year higher than official figures had previously stated.

Experts say this miscalculation by the Office for National Statistics cost the average final salary pension holder hundreds of pounds a year.

Outraged pension groups said there was currently no way for any of the eight million people affected to claim compensation.

Dr Ros Altmann, director general of the over-50s group Saga, complained: “How much pain do pensioners have to endure?”

John Broome Saunders, actuarial director at BDO Investment Management, said: “Had the inflation calculation been done correctly, many final salary scheme members would now find themselves entitled to a pension around four per cent higher.

“This doesn’t just affect pensioners – deferred scheme members have also been denied a similar level of increase.”

Many pension schemes link payouts to the Retail Price Index, which is directly affected by the level of CPI.

Richard McIndoe, head of pensions at Strathclyde Pension Fund, said: “Pensioners will feel aggrieved when they see this, and they think they should have received four per cent more.

“In reality, however, there is not much to be done about it. The official inflation figure is still the official inflation figure.” Joanne Segars, chief executive of the National Association of Pension Funds, said: “It’s true that state and occupational pensions would have been higher if this new measure had been applied. But all that pension schemes can do is work with the figures they have been given.”

The CPI error stemmed from the misreporting of clothing prices. The inflation report said: “Previous collection methods may have biased down estimates of CPI clothing prices.”

Last night a spokesman for the Office for National Statistics said: “ONS has improved its methods for collecting clothing prices as part of its development programme but this does not mean that there were measurement errors or misreporting in the past. The Bank of England agrees with ONS that the improved collection practices for clothing better reflect current consumer behaviour.”

But Saga’s Dr Altmann said much now needed to be done to protect pensioners.

She said: “The Bank of England needs to get a grip and show its determination to combat the ravages of inflation on savers and signal its intent to start raising interest rates.

“At the moment savers and pensioners are being hit by low interest rates and high inflation, and Saga is deeply concerned.

“We believe that a small rise in interest rates would send a positive signal to increasingly desperate savers, without having an adverse effect on the economy.

“The sooner the Bank acts, the better.

“Pensioners have already been hit hard by the economic crisis. They are suffering from extremely low interest rates and very high inflation, which means that the value of their savings is being eroded.”

Falls in stock markets and rising inflation have led to a typical 65-year-old now entering retirement with a private pension of just £7,666 a year.

This is almost half the officially recognised income needed to maintain an adequate standard of living.

We'll see if the Bank of England starts raising rates anytime soon. Like most central banks, they're more concerned about banks than pensioners. And remember, the name of the game remains reflate risk assets and inflate your way out of this financial mess.

Finally, the BBC reports that it is unlikely that members of the public could reclaim any lost money or ask for an increase in pension or benefit income:

The National Association of Pension Funds pointed out that pension increases are dependent on published inflation rates, which remain as they were.

"It's a theoretical argument," explained Ros Altmann, Saga Group director general.

"You would have to prove that this is the only element of inflation that needed to be changed," she said.

The policy of the Department for Work and Pensions is that it will only change benefit rates if the official inflation figure is recalculated and republished.

A DWP spokesperson said: "Inflation figures are determined by the ONS who regularly do work to improve their methods of calculation.

"Any changes in methodology do not mean that previous inflation rates were incorrect."

But changes in methodology which are in line with what the public has known for years, namely, that inflation is grossly underestimated, only proves that pensioners and workers are getting squeezed on all fronts. After all, wages and pensions are linked to CPI. Welcome to the new normal, which is pretty much the same as the old normal except dressed in different clothing.

***Update***

Bernard Dussault, former Chief Actuary of Canada, sent me these comments:

This UK CPI error is much larger than the one (0.1%) made by Statistic Canada each month over 5 years from March 2001 to March 2006.

STATCAN's error represents an average lump sum of about $30 for each CPP recipient, $30 for each OAS recipient and $125 for each federal pensioner (i.e. public sector retirees). This assumes average pensions of $6.000, $6,000 and $25,000, respectively (e.g. 0.5% times $25,000 equals $125). Total additional pension tab would have been about $150 m for each of CPP and OAS and $25m for public sector superannuation plans.

Government decided to adjust the CPI prospectively, but not retroactively because it would have given rise to the re-opening of too many important salary negotiations in Canada.

And here is a copy of the Globe and Mail article published August 16, 2006 soon after the error was disclosed by STATCAN:

Statscan admits five-year inflation mistake
TAVIA GRANT
Wednesday, August 16, 2006

Canada's federal statistics-gathering agency admitted yesterday it mistakenly understated the country's inflation rate over the past five years.

Statistics Canada said the overall consumer price index was miscalculated, on average, by a tenth of a percentage point between early 2001 and March of this year.

A glitch in a computer formula meant the agency was wrong about the price of hotel and motel rooms during the period: Statscan had reported that room rates fell 16 per cent when they really rose 32 per cent. The error in that CPI component threw off the whole index.

Statscan said it didn't catch the mistake earlier because anecdotal evidence suggested Canada's tourism industry was facing tough times, hence the price pressure.

It's an embarrassing blunder for an agency that's been lauded by the likes of The Economist magazine and the International Monetary Fund as being the best of the best.

The consumer price index is one of the most closely watched monthly economic indicators because the Bank of Canada uses it to help set interest rates.

The index, which includes data on what shoppers pay in stores and hair salons and at the pumps, also influences old-age pensions, rental agreements, child-support payments and wages.

The error isn't enough to have swayed the Bank of Canada on any past interest-rate decisions. It does, however, erode confidence in an agency that, just in April, acknowledged Canadian productivity last year was twice the level that was previously announced.

"I think it will raise more questions," said Doug Porter, senior economist at BMO Nesbitt Burns Inc., who noticed in March that the hotel inflation rate looked odd. "It's one of the more common issues that we deal with, whether CPI is accurately capturing the real inflation that people face. Unfortunately, this episode just further heightens that issue."

The CPI is never revised and won't be this time. Statscan and other agencies around the world have agreed not to revise inflation numbers because that could wreak havoc on all the contracts, such as wage settlements, that rely on the inflation data.

Mr. Porter continues to believe the CPI is accurate and that Statscan does a good job of tracking it. "I still think it's the best measure of inflation we have."

Other economists were taken aback by the glitch, reported by Bloomberg News yesterday and which first surfaced as a footnote in Statscan's June price inflation, released July 21.

"It's a surprise and [so is] the fact that it was going on for a long period of time and they hadn't caught the miscalculation up until this point," said Mark Chandler, senior financial economist at Scotia Capital in Toronto. "It opens questions on how many other components are suffering from something like that. It does hurt their credibility a little bit."

The Bank of Canada said the error hasn't caused it to rethink its past interpretation of the economy, nor is the central bank reassessing its economic outlook.

"The bank has great confidence in the overall reliability of the CPI as a measure of inflation," spokesman Jeremy Harrison said.

The bank, along with most economists, is aware that there's a margin of error. A study last year by the central bank found that Canadian CPI overstates inflation by about 0.6 percentage points a year.

Canada's monthly consumer price index tracks the prices of more than 600 separate goods and services in 169 classes. The CPI division employs about 150 people across the country who work on collection, computation, analysis and research, according to Tarek Harchaoui, assistant director of the division. Statscan employees spend hundreds of hours every month checking numbers and doing quality control, he added.

On the world stage, Statscan is highly regarded. In two surveys conducted by The Economist in the 1990s on world statistical agencies, Statistics Canada ranked No. 1 both times. More recently, the International Monetary Fund reviewed Canada's CPI in 2003 for adherence to international standards and found it complied with 15 out of 15 measures of quality.

That's not to say the agency is immune from criticism. Some have questioned how it measures car insurance and house prices. The price of clothes, which has dived in recent years, may also become a subject of debate, one economist said.

For many Canadians, this will simply confirm suspicions that inflation is rising at a faster pace than what the government says. But, as economists have noted, consumers tend to notice when prices go up and not realize that costs for, say, a new computer or a coffee maker, have actually fallen over the years.

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Fraud Bailout Fund Hits Wall?

Theresa Tedesco and Barbara Shecter of the National Post report, Fraud bailout fund hits wall (HT: Pierre):

A recent proposal by a group of Quebec-based advocates to create a shareholder insurance fund for victims of financial fraud could put the province on a collision course with Canada's big banks.

The Coalition for the Protection of Investors (CPI), an organization comprised of academics and financial industry representatives, says a compulsory indemnity fund to protect against fraud for Quebec, which has suffered numerous high-profile investor scandals in recent years, is running into resistance from the major chartered banks.

Robert Pouliot, a co-founder of the coalition that tabled the proposal last month, says the country's large financial institutions have indicated they are not interested in financing a universal insurance fund for investors, arguing the industry already provides investor protection through IIROC.

"There is resistance to the concept of restitution," explained Prof. Pouliot, a director at the Canadian Foundation for the Advancement of Investor Rights (FAIR), who teaches corporate governance and fiduciary risk at the Universite du Quebec a Montreal. "What the banks don't want is to be taxed directly to finance the fund or made responsible for indemnifying investors."

Officials at the major banks confirmed they were "aware of this discussion," but declined to comment further, saying it is being reviewed by the Investment Industry Association of Canada (IIAC).

The national trade association for investment dealers began considering the Quebec proposal Tuesday at a meeting of its compliance committee.

"The proposal is interesting but it's at a very early stage," said Michelle Alexander, a director of policy at IIAC. The initial response from the industry, she said, is that while the Quebec proposal "highlights the need for more investor education and literacy," there is already protection for investors who use advisors and firms monitored by the industry self-regulatory agency -- the Investment Industry Regulatory Organization of Canada (IIROC).

Last month, the cap on settlements reached through IIROC-brokered arbitration was increased to $500,000 from $100,000.

Mr. Pouliot and the Quebec-based investor coalition asked the provincial government and the province's Autorite des marches financiers last month to consider creating a mandatory indemnity fund. Investors would fund it through premiums and financial advisors covered by the fund would make contributions.

An independent board of directors, based in Quebec and composed of industry participants, would collect and invest the money. Premiums charged to investors would be determined based on the risk practices of investment managers and financial advisors in an asset class. Investors would pay basis points annually according to the risk levels in each of the funds in which they invest their money.

Each year, investment managers and financial advisors would be rated on their fiduciary practices by comparing the quality of the practices with the actual performance of the asset class. For example, if the fund's performance is good but the fiduciary practices are suspect, it would be deemed risky and designated accordingly.

Ultimately, the goal is to improve fiduciary practices in an industry with assets valued at more than $1-trillion, while providing fraud insurance for investors. "If you choose a fiduciary riskier manager, then your premium will be higher. It's the consumer's choice," Mr. Pouliot said.

Although the Quebec-based coalition has not held direct talks with the Toronto-headquartered major banks, the industry group indicated it will not likely endorse the universal compensation fund now on the table.

"We would like to work with the coalition to discuss the initiative and see if we can find the right framework that best supports the investing public and the investment industry," said the IIAC's Ms. Alexander.

While Quebec Finance Minister Raymond Bachand announced last month that the province's securities commission would hold consultations to examine the proposal, he also expressed concern about adopting a plan that would be an additional burden to investors.

Some industry participants in Quebec, which already has a limited fund to compensate victims of financial fraud, warned that mandatory adoption of the fund could isolate the province from the rest of Canada.

Others expressed concern over so-called moral hazard, that investors will take unnecessary risks or be less prudent with their money if they know their losses will likely be recovered.

But Mr. Pouliot dismisses the concern saying, "Just because you have car insurance doesn't mean you drive dangerously. It doesn't make people any more negligent."

Most of the retirement savings in Canada are channelled toward the banks, but Mr. Pouliot questions whether that's because investors believe the large banks are best able to provide restitution in the event of fraud.

"We're not protecting against market risk. We're not talking about free or idle money or blind protection," Mr. Pouliot said. "Just because you think the banks have more money they'll pay you back if something happens. You should go to the banks because they are really good, not because you feel better-protected."

If Quebec formally adopts the indemnity fund as mandatory, the banks will be forced to participate -- and the coalition expects that to create momentum elsewhere in the country.

"If Quebec could launch it, the rest of Canada will buy into it because consumers across the country will want the protection," Mr. Pouliot says.

I met Robert Pouliot in August before leaving for Greece. We discussed this indemnity fund in vague terms and I was skeptical because I knew the big banks would fight the proposal. But Mr. Pouliot is a stand-up individual who has gotten this far and I won't be surprised if he succeeds in this venture.

On Thursday, I had lunch with my former boss from PSP Investments, Pierre Malo. We talked about a lot of things including this proposal for an indemnity fund. Pierre is very concerned about defined-contribution plans. "People spend more time shopping for a car than understanding their investments." I told him flat out: "Defined-benefit plans are no panacea but defined-contribution plans are a disaster which will only ensure more pension poverty".

It's sad how we expect people to do well with defined-contribution plans when the truth is there is no way they can succeed in these wolf markets dominated by high-frequency traders, big banks and big hedge funds. They're like lambs being led to their slaughter. Don't get me wrong, you can make money if you're in the right stocks or sectors, but you got to be lucky, have nerves of steel and you got to be on top of things. For the majority of the population, this is simply impossible.

An indemnity fund would pressure professional fund managers to be a lot more responsible. That's why the big banks are so dead set against it. Because if they're negligent, they're going to end up paying for their mistakes. They prefer the status quo where investors are clueless and helpless so they can continue raping them with outrageous fees.

It makes me sick to my stomach and one day I'm going to write a blog post on how to make money by taking everything you learned about investing and chucking it in the garbage. That's how strongly I feel about the shenanigans the investment industry keeps getting away with. The amount of nonsense that goes on in the stock market is criminal. Yes, the time has come for a fraud bailout fund but I fear that it will go broke when the next financial crisis hits us.

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Will Climate Change Cost Pensions Trillions?

Michael Bow of Professional Pensions reports, Ignoring climate change risk will cost schemes trillons:

Schemes must factor in climate change risk to their asset allocation strategies over the next two decades or face losing trillions of pounds, Mercer warns.

Research from the consultant - commissioned by a group leading schemes including BT Pension Scheme - anticipated climate change policy will account for 10% of a pension fund's portfolio risk by 2030, with costs hitting about £5trn by 2030.

Mercer said funds could combat the growing policy risk headache by diversifying their portfolios away from equities and bonds into "climate sensitive" assets.

These include infrastructure, real estate, private equity, agriculture land, timberland and sustainable assets. Mercer forecasts a portfolio trying for a 7% return could cancel out the climate change risk by allocating 40% of its funds to these assets.

The Environment Agency, participants in the research, welcomed the switch to a policy-led asset allocation strategy.

Environment Agency head of environmental finance and pension fund management Howard Pearce said: "We think all pension funds will need to adopt a climate change-proofed financial investment strategy in the future to enable them to fulfil their fiduciary duties.

"We also want our pensioners to retire into a similar environment than we enjoy today and not one that is affected by the extremes of climate change that could reduce their life expectancy."

Mercer also predicted the increased investment in low carbon technology would increase portfolio risk by 1% but be offset by a predicted investment of about £2.5trn by 2030 in this area.

Mercer chief investment officer Andrew Kirton said: "Institutional investors should be factoring long-term considerations, such as climate change, into their strategic planning.

"Mercer is pleased to have had the opportunity to kick start such strategic discussions with a group of leading global investors."

Mercer used its ‘TIP' framework to judge the impact of climate change, a formula allowing pension funds to manage risk based on low carbon technology (T), physical impacts (I) and climate policy (P).

Emma Boyde of the FT reports, Pension funds plan action on climate change risks:

At least two pension fund sponsors of a research project into the risks for investors of climate change intend to change or advise changes in their asset allocation as a result of the findings.

The collaborative project*, led by Mercer, the investment consultants, found that climate change policy could contribute as much as 10 per cent to portfolio risk over the next 20 years and identified asset classes that could be beneficiaries as well as those that were likely to be negatively affected.

“The risk numbers indicate this is a very real risk,” said Helene Winch, director, head of policy at BT Pension Scheme Management, adding that she intended to pass the information back to BT’s risk management teams.

BT’s pension scheme is one of 14 global insitutional investors that supported the research, which also received the backing of the International Finance Corporation and Carbon Trust.

Speaking afer the launch on Tuesday, Howard Pearce, head of environmental finance and pension fund management at the UK’s Environment Agency, another of the partners, said the Agency’s scheme would change its strategy as a result of the findings.

The research team, led by academics from the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Vivid Economics, an economics consultancy, examined four scenarios that could take place in the next 20 years. The two most likely scenarios, the research team decided, were that there would be a regional divergence in response to climate change issues, or worse, there would be a delayed response leading to harsh policy measures in perhaps a decade. The two least likely scenarios, it concluded, were that strong internationally co-ordinated action would take place or that there would be significant climate breakdown in the next 20 years.

It looked at those four scenarios and considered three broad risks to portfolios: technology (investment flows into new technology); impact (real physical impact of climate change); and policy (international and domestic agreements and regulatory responses). The team concluded that continued delay in climate change policy action and lack of international co-ordination could cost institutional investors thousands of billions of dollars over the coming decades.

It found investors could benefit under most scenarios from increased allocation to infrastructure, real estate, private equity, agricultural land, timberland and sustainable assets. Under certain scenarios, even the likely scenario of delayed action, certain asset allocations were found to have a negative likely outcome.

The modelling was applied to a hypothetical “typical” portfolio with 34 per cent in developed large-cap equities, 13 per cent in emerging market equities, 18 per cent in global government bonds, 26 per cent in investment grade credit and 9 per cent in property.

*Climate change scenarios - implications for strategic asset allocation, (Feb 2011)

You can read the Mercer report by clicking here. It provides a thorough discussion on climate change and its potential impact on various asset classes. There is a lot of uncertainty surrounding climate change but pensions should be thinking hard about how it and other secular trends will impact their portfolio. Will climate change cost pensions trillions? I doubt it. Moreover, it will present pensions with new opportunities. In fact, I firmly believe that pensions stand to make very profitable investments in both private and public markets if they play this theme wisely.

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Pension Managers Face Firing for Badmouthing?

Cristina Alesci and Henry Goldman of Bloomberg report, NYC Pension Managers May Face Firing for Badmouthing:

Newly hired managers for part of New York City’s $108 billion pension might be fired if they criticize workers’ benefits, according to a trustee of the police retirement fund.

Joseph Alejandro said he proposed that the fund’s board be able to dismiss future managers who disparage a public pension, “its beneficiaries or any trustees or employees.” The Employees’ Retirement System is also considering the provision, he said. Blackstone Group LP’s chief strategist, Byron Wien, strained relations with New York unions last year when he said benefits are “too generous.”

“The intent isn’t to chill analysts who provide legitimate information,” Alejandro said in an interview yesterday. “We are trying to prevent money managers from taking positions that are essentially opinions based on political viewpoints.”

Unions across the U.S., including the American Federation of State, County and Municipal Employees, are rallying members and lobbying lawmakers to counter what they call an assault on recession-weary working people by governments trying to lower costs. New York Mayor Michael Bloomberg, who presents his 2012 budget this week, has made trimming pension expenses a priority for his third term.

The mayor, confronting a $2.4 billion deficit in a $67.5 billion spending plan for the fiscal year beginning July 1, has proposed that new workers must reach 65 to collect full benefits. He would also increase worker pension contributions and end an annual $12,000 payment to retired police and firefighters that costs at least $600 million a year.

Freedom of Speech

Restricting pension-fund managers’ comments wouldn’t run afoul of freedom-of-speech rights under the U.S. Constitution, said Charles Sims, a First Amendment lawyer at Proskauer LLP, a New York-based firm. The amendment applies only to government actions, he said.

“Even considering a public pension board to be part of government, it still can require confidentiality or other speech restrictions in a contract,” Sims said.

The proposal is being reviewed by the New York City comptroller’s office, which oversees pensions, said Alejandro, treasurer of the Patrolmen’s Benevolent Association. Michael Loughran, a spokesman for Comptroller John Liu, declined to comment. Harry Nespoli, chairman of the Municipal Labor Committee, didn’t return a message left with his office.

No Discussions

The Fire Department Pension Fund is also considering the provision, Alejandro said.

Tom Butler, a spokesman for Steve Cassidy, firefighters- union president, denied that his union is in discussions about such language. Zita Allen, spokeswoman for Lillian Roberts, executive director of District Council 37, the city’s largest municipal union, declined to offer an immediate comment.

“There have been no such discussions” with trustees of the United Federation of Teachers, said Richard Riley, a spokesman for the union’s president, Michael Mulgrew. A telephone call to the office of the Board of Education Retirement System wasn’t answered.

The city’s five pensions had $108.6 billion of assets at the end of November, according to the comptroller’s office.

Nycers, with more than $38 billion, paid $140.6 million in fees to investment managers in the year that ended June 30, according to its website. The $22 billion Police Pension Fund paid $80 million.

Fees Paid

The Teachers’ Retirement System, with $39 billion of assets, paid about $100 million in management fees in the previous fiscal year, the latest publicly available figure. The Board of Education Retirement System, with $2.6 billion of retirement assets for administrators and non-teacher school workers, paid about $9.8 million. The $7.2 billion Fire Department Pension Fund doesn’t post pension information on its website.

Blackstone, the world’s largest private-equity firm, has been trying to mend relations with the pensions after Wien’s comments. Its president, Tony James, met in May with representatives from one of the five plans that have $750 million committed to the firm. He also sent a letter addressing Wien’s remarks to the head of the New York City Employees’ Retirement System. Blackstone’s spokesman, Peter Rose, declined to comment.

Best Returns

“Investment decisions should be focused on how to generate the best possible returns,” said Marc LaVorgna, a spokesman for the mayor. “The decisions should be agnostic in almost all respects.”

The city’s annual pension costs, now about $7.5 billion, will increase to about $9 billion by 2016, from $1.4 billion in 2002, the mayor has said. That’s about 12 percent of New York City’s budget for next year, according to the November spending plan.

Pension and benefit costs are “simply not sustainable” and the mayor and labor leaders must compromise on changes to the retirement plan, Council Speaker Christine Quinn said today in her State of the City speech.

Blackstone’s dust-up with the city’s pensions came as the firm diversified beyond private equity, its third-largest business at the end of last year by assets under management. Chief Executive Officer Stephen Schwarzman’s push has meant hiring personnel not in the buyout business, whose clients include pension funds.

It would be difficult for a pension fund to terminate its current commitments to a manager because of the long-term nature of the private-equity asset class, said Andrew Wright, a partner at Kirkland & Ellis LLP in New York.

Illiquid Securities

“It’s one thing for an investor in a hedge fund to submit a redemption request,” he said. “It’s another thing for an investor to seek to cash out of a closed-ended private equity fund that makes investments into illiquid securities over a 10- year period.”

Efforts to cut retirement costs have spawned protests from beneficiaries, including lawsuits. An Afscme advertising campaign called “Stop the Lies: Public Service Workers Under Attack” tries to shift the blame for state deficits away from employees and onto corporations and Wall Street.

Afscme points out that its average member earns less than $45,000 a year and that average pensions are about $19,000 annually.

I must admit that I find it ridiculous for anyone on Wall Street to badmouth public service workers, claiming that their benefits are "too generous". Sure, there are abuses related to pension spiking and double pensions, but it's simply wrong to claim that public sector workers enjoy "generous benefits". And this from a veteran Wall Street strategist who got 9 out of 10 predictions wrong in 2010 (to be fair, I agree with Byron Wien, stocks are heading much higher).

I bet Tony James had a nice long discussion with Mr. Wien telling him to keep his mouth shut because those pensions have been very good to Blackstone over the years, making senior executives very rich as they collected nice juicy fees. In fact, today I checked out Blackstone's stock price, which has rallied sharply since last summer (but still not back to IPO price).

Such are the perils of going public. You can no longer escape public scrutiny. Take note Carlyle because when you go public, you better make sure nobody on your payroll pisses off public sector employees and their unions.

Does this mean I'm pro-union and anti-Wall Street? Hell no! Most unions make my blood boil but then I just look at the banksters on Wall Street who collected outrageous bonuses after being bailed out by US taxpayers and think to myself Madoff kept good company. Moral of this story: stop badmouthing people who you know will never in a lifetime of working hard earn a fraction of the outrageous bonuses you collect in a year. Keep your mouth shut and don't badmouth the hands that feed you those nice juicy fees.

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US Budget Raising Pension Premiums?

David Wessel of the WSJ reports, Budget Would Raise Pension-Insurance Cost:

President Barack Obama's budget proposes to raise premiums the Pension Benefit Guaranty Corp. charges employers by $16 billion over ten years and, in a significant policy shift, would levy higher premiums on the riskiest companies.

The PBGC insures defined-benefit pension plans, those that promise a monthly sum based on years of service and wages. Its $80 billion portfolio, mainly assets of pension plans it has taken over, is $23 billion short of the current value of pensions it has promised to pay. Premiums are supposed to make up the difference. Total premium revenues last year were $2.2 billion.

Both the fiscal commission appointed by Mr. Obama and another, private one recommended increasing PBGC premiums to close the long-run deficit. "Premiums are much lower than what a private financial institution would charge for insuring the same risk, but unlike private insurers (or even other similar agencies, such as the Federal Deposit Insurance Corp.), the PBGC is unable to adjust the premiums it assesses…to cover potential liabilities," the Obama-appointed commission said in its report. "This has led to chronic and severe underfunding of the agency."

Rather than seeking a simple increase, the administration is asking Congress to give the PBGC authority to fashion a new approach in which premiums would be linked to the financial health of the employer sponsoring the underlying pension plan.

Currently, two similarly funded pension plans, one sponsored by a well-financed company and another sponsored by a shaky one, pay the same premiums even though the latter is at much greater risk of sticking the PBGC with its pension promises. Under the proposal, the agency could charge the latter company a higher premium. The approach resembles one used to price bank-deposit insurance. Since 2007, the FDIC has grouped banks into four categories and charged riskier ones higher premiums.

Under the Obama proposal, the changes wouldn't take effect for two years—at the earliest—to give the agency time to devise the new system and go through a formal rule-writing process. Among big issues to be resolved are the factors to use in assessing the riskiness of the employers and how much more to charge riskier companies. About one-third of employers whose pensions are insured by the agency have credit ratings below investment-grade; they would be hit harder by the premium increases.

"This proposal is both good government and better for business," said PBGC Director Joshua Gotbaum. "It protects retirement security while encouraging and rewarding responsible business behavior."

Some employers and unions are concerned higher premiums would lead businesses to freeze or even terminate pension plans. The American Benefits Council, which lobbies for big companies with defined-benefit pension plans, said it would carefully examine the plan to boost premiums and make the riskiest companies pay more.

"The employer community and the Obama Administration share a common goal of helping sponsors of defined benefit pension plans maintain those plans," Council President James A. Klein said in an email. "We want to understand how this idea either resembles or differs from past proposals regarding linking premiums to creditworthiness."

The group recently complained to Congress about PBGC rules and its approach to businesses. "Employers are fleeing the defined-benefit-plan system…they are freezing their plans, and…certain well-intended PBGC policies can actually threaten business viability and increase PBGC liability," the council's Ken Porter testified in December.

Of workers with defined-benefit plans, 22% are in plans that have been closed to new workers or ceased accruing benefits for some or all participants, the Labor Department says.

The collapse of several big pension plans has increased the PBGC's long-term deficit in recent years. In the past, Congress has raised premiums after the agency reported big deficits. The last time, in 2005, Congress lifted the premium on single-employer plans from $19 a worker annually to $30 and indexed it to inflation. Today, the current basic premium is $35. With various add-ons for underfunded plans, the average premium is close to $65.

The PBGC was created in 1974 after some workers lost pensions altogether when their employers went under. It guarantees basic benefits for 44 million American workers and retirees with defined-benefit pensions, a shrinking fraction of the work force, and is currently responsible for paying current or future pensions for about 1.5 million. The Labor Department says about half of all private-sector workers participate in employer-sponsored retirement plans of any sort, and, of those, an increasing majority have 401(k) or other defined-contribution plans, which aren't covered by PBGC insurance. Government employees are more likely to have defined-benefit pensions, but their pensions generally aren't covered by PBGC insurance.

The president's fiscal commission, led by former Clinton White House Chief of Staff chief Erskine Bowles and former Sen. Alan Simpson (R., Wyo.), recommended PBGC premiums increase by $16 billion over 10 years, the same as the new Obama budget. A private deficit-reduction panel, chaired by former Sen. Pete Domenici (R., N.M.) and former Clinton budget chief Alice Rivlin, proposed a 15% increase in the basic premium, among other changes. It recommended that premiums for underfunded plans be linked to the riskiness of their investment portfolios.

Timothy Inklebarger of Pensions & Investments reports, PBGC could increase premiums under budget proposal:

The Pension Benefit Guaranty Corp. would be given new authority to increase premiums on the retirement plans it insures, saving the agency an estimated $16 billion over the next decade, under President Barack Obama’s fiscal year 2012 federal budget proposal released Monday.

The PBGC’s pension insurance system is underfunded by about $23 billion, with about $80 billion in assets and $103 billion in liabilities, but is currently unable to adjust premiums to reflect a company’s financial condition or risk to its retirement plans, PBGC spokesman Jeffrey Speicher said in a telephone interview.

“This will both encourage companies to fully fund their pension benefits and ensure the continued financial soundness of PBGC,” according to the budget proposal for the fiscal year beginning Oct. 1.

PBGC Director Joshua Gotbaum said in a telephone interview that, previously, Congress has raised the premiums across the board, regardless of the financial stability of a company or its retirement plan. (Congress most recently raised the premium in 2005 to $30 a year per employee and indexed it to inflation bringing the current premium to about $35 a year per employee.)

Under the proposal, the increases would be at the discretion of the PBGC, similar to the model used by the Federal Deposit Insurance Corp.

Mr. Gotbaum said the proposal also aims to phase in the increases, so companies are not hit all at once. The phase-in would “avoid hitting pension plans hardest when the economy is at its worst,” he said.

Mr. Gotbaum noted the proposed change in giving the PBGC authority would take at least two years to study the PBGC before it could be implemented.

The budget also resurrects two proposals from the fiscal year 2011 budget that were not adopted. One establishes mandatory automatic workplace pensions and another would double the tax credits available to small companies for establishing or administering a new retirement plan.

The automatic workplace pension proposal would require employers that do not offer a retirement plan to automatically enroll employees in a direct-deposit IRA account. Employees would be allowed to opt out of the plan.

The tax credit proposal for establishing a retirement plan would double the credit up to a maximum of $1,000 a year from $500 for three years for the startup expense of establishing or administering a new retirement plan. The proposal aims to “make it easier for small employers to offer pensions to their workers in connection with the automatic IRA proposal,” according to the budget proposal.

The budget reduces spending at the Department of Labor by 5% from 2010 spending levels to $12.8 billion. The Labor Department’s Employee Benefits Security Administration’s budget would be $198 million in fiscal year 2012, up 22% from fiscal year 2011 and up 28% from fiscal year 2010.

In fiscal 2010, the PBGC reported a $23 billion deficit, near its all-time high of $23.5 billion in fiscal 2004. The US government is right to introduce new proposals to deal with this deficit. If the PBGC is unable to pay pension promises it insures, taxpayers are on the hook. Premiums should be linked to the financial health of the company (plan sponsor) and increases phased in to avoid hitting pensions that got clobbered during the recession.

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