Friday, July 31, 2009

Pension plans need to change to meet new economic realities

Pension plans cannot safely assume that they will continue forever. Although wind up is seldom imminent, there is no guaranty that it will be foreseen well in advance of the event. The pace of corporate changes is increasing, with failures and mergers that would have been unthinkable only a few years ago. Public sector plans will also be affected as accounting rule changes highlight the real costs of these plans and taxpayers question why they should fund benefits that no one else can afford.

DB pension plans are maturing. In many plans, the retired population significantly exceeds in size the active population. In these cases, the plan’s expenditures may exceed its receipts. The cost of benefits for active employees is of less relative importance than making investments that match the pension payment outflows each month. Pension security for retired and nearly retired members must be given much higher priority in these plans.

Historically, pension funds have relied on the growing wealth creation of companies to cover future benefit obligations. In many sectors wealth creation has slowed significantly and may not return to former levels. Companies need to bite the bullet and be honest about what they can afford.

The hiring freezes that are occurring in business and government are far more troubling for DB plans than excess layoffs. DB plans depend on constant ins and outs to help keep costs stable year to year. A hiring freeze cuts out the new younger employees which are needed to keep costs down. While government assistance can mitigate layoff issues, the government cannot force firms to hire. In some industries new jobs have simply dried up. Great care will be needed to avoid having an aging plan membership making the plan's current financial situation worse.

Monday, July 27, 2009

Risky investments

There is an interesting table in the August 17, 2009 issue of Canadian Business that shows the investment returns earned by some of the largest pension plans in Canada. The returns are shockingly poor, particularly considering the amount of expertise hired by these plans to keep everything in order.

The last published one year returns, the 10 year average returns to the last date published and the yield on 10 year Canada bonds for the same period were:

Casse de depot: -25.0%, 3.6%, 4.9%
CPP Investment Board: -18.6%, 4.3%, 5.0%
Ontario Teachers Pension Plan: -18.0%, 6.6%, 4.9%

In a recent article in The Gazette, Alban D'Amours, who was the head of the risk management committee of the Caisse de dépôt et placement du Québec put part of the blame for their loss on tainted non-bank asset-backed commercial paper (ABCP). When asked about these risky assets, he stressed that the Caisse didn't take more risks than what was laid out in its risk policy. But one has to question why any investment at all was made in ABCP and how could a risk management policy for a “public” fund allow this to happen. The questions are the same for all of these plans: who is really bearing the risk of a financial shortfall and, if it’s the public who will have to pay up in the end, how are the potential costs to the public taken into account in the risk policy of the pension plan?

D'Amours, like other managers of the Caisse, refused to shoulder any of the blame for what they call a "perfect storm" that hit the pension fund by surprise. This reminds me of a comment by Warren Buffett, “it’s only when the tide goes out that you learn who’s been swimming naked.”

Here’s the view from actuarial researchers Lawrence N. Bader and Jeremy Gold from their paper, The Case Against Stock in Public Pension Funds:

“Current funding and investment practices are costing taxpayers dearly. We are not directly addressing the losses of the past few years, which we can all hope are temporary, but the poor decision-making that stems from failure to understand the risks of equity investment.”

Essentially, equity or similar investments by these plans involves many risks besides the market risks:

• intergenerational taxpayer conflicts (risk transfers masquerading as risk sharing),
• undercharges to employees’ compensation packages for the value of the pensions,
• employee claims on pension surplus, and
• higher governmental borrowing costs (once new accounting rules bring forth the real plan costs and liabilities).

This may be an opportune time to start dealing with these issues and to make sure the public interest is served in the process. If there are additional costs, which is likely, let’s deal with them now so as a country we can be more competitive for the future.

Friday, July 24, 2009

The New Now

The current downturn appears to be different from past recessions. For the first time, in a long time, we are questioning the economic models that have been fundamental to how we do business. Conventional economic theories based on “rational expectations” and “efficient markets” do not explain the most important dynamics underlying the economic crises. These theories depend upon people rationally pursuing their economic interests. But, these theories no longer provide an adequate explanation for what is going on. Something has fallen apart.

Keynes offered an explanation. His ideas went much further than his macroeconomic views on government spending in a downturn. He also developed the notion of “animal spirits”. That is to say, much of our economic activities are neither fully informed nor rational, and instead are often governed by noneconomic motives – our animal spirits. These are a combination of preferences, gut instincts, social values, experiences, loves and hates.

The reason for this is that we are operating under so much uncertainty that we cannot possibly make choices based upon the weighted average of quantitative benefits multiplied by quantitative probabilities. As a result, our decisions, frequently, are not rational in the traditional economic sense and, as a consequence, the economy fluctuates as is does. Political involvement or non-involvement in business, consumer confidence, wealth perspectives, the treat of global warming, and so on, all support new theories based on animal spirits, or in modern terms; behavioral economics.

We appear to be experiencing a restructuring of the social, cultural and economic orders. Some commentators have suggested that the changes are more reminiscent of the “vertigo years” of 1900 to 1913, rather than those following the 1929 crash. The vertigo years resulted in a new normal. Those years captured the dislocations that occurred as society and business moved from agricultural and rural to industrial and urban. Today the movement is different, but globalization, neo-Keynesian economic models, reregulation of the financial sectors, changing consumer behaviors, shifts away from manufacturing and industrialization are all pointing to new business models, slower economic growth and labor dislocations.

In a short essay by McKinsey’s worldwide managing director, Ian Davis, he noted some of the broad implications of restructuring the economic order:
• For some organizations - survival
• Significantly less financial leverage
• An expanded role for government
• Regulatory restructuring
• New levels of transparency and disclosure
• Increased financial protectionism
• Global financial coordination and transparency.

All of these changes will impact pension plans and the work and expectations of actuaries.