Guest Post: Have Pensions Learned From Market Disaster?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Terence Corcoran of the National Post reports that pensions learn little from market disaster:

The Ontario Teachers’ Pension Plan released its 2008 annual report last week, ominously titled “Let us explain.” Reflecting the plan’s heavy equity portfolio and risky dips into fancy investment products, the OTPP followed other Canadian public-sector pension operations into a sea of red ink. The decline of 18% at the Teachers compares with 15.3% at the Ontario Municipal Employees Retirement System, 25% at Quebec’s Caisse de dépôt et placement and a 13.7% loss at the Canadian Pension Plan Investment Fund.

Private corporate defined-benefit pension funds faced equally challenging returns through 2008. The result is a nation of pension plans under water. The long-term survival of corporate plans, now under review in Ottawa, is in doubt. At the big public plans, survival isn’t an issue. The issue is who will pay for the blunders and losses — taxpayers or pensioners.

Teachers, which only last September renegotiated benefits to make up for a previous $12-billion actuarial shortfall, is now already short another $2.5-billion and heading for bigger declines in coming years as the big loss for 2008 — more than $19-billion — is spread out over future years. Unless the plan’s managers find some new miracle investment strategy, or the markets dramatically rebound, Ontario’s teachers and the province are going to have to cover the shortfalls by paying more or getting less.

Still more losses could emerge at the public pension plans as they continue to determine the market value of assets that are not traded. For example, Teachers had no losses in its $16-billion real estate portfolio in 2008, despite a declining real estate market.

The bigger question, though, is whether they have learned much from the meltdown. Apparently not, judging by the eagerness with which the operators of the major public funds plan to sail forth into the future in the same old leaky ship. Not only do they have continued faith in the power of equities to deliver superior returns over the long term, they seem to have even more confidence in their ability to beat the markets, despite staggering evidence to the contrary.

They have no choice. Under the actuarial models on which they are based, these big government plans must not only expose their pensioners and funding governments to high risk equity markets, they must also go out and find investment strategies that will generate even higher returns. At OMERS, the annual report puts it this way: “To fulfill the pension promise to our current and future retirees, we must produce investment returns that exceed the benchmarks for the asset classes in which we investment within an acceptable risk tolerance.”

There’s double jeopardy in all this. First, there’s the dubious premise that in the long run, equities produce higher returns than would be available if pension monies were invested in, say, federal government bonds. Second, evidence across the financial world is clearly stacked against the idea that money managers, no matter how big their portfolio and global their reach and clever their strategies, can beat the risks and generate solid returns. From Warren Buffet on down, investing is a dangerous business.

No insurance company would — or could — sell annuities based on pension model assumptions regarding equities. If the stock market were a sure thing, somebody would be selling investment products that guarantee a 6% real return. Nobody does, outside of Bernie Madoff’s world.

So why do we entrust, as taxpayers and pensioners, vast sums of money to pension managers who are expected to produce fat returns while operating in a hostile environment where no such fat returns exist? Because that’s the system the actuarial profession created — a system that is based on unsound and risky principles.

The risks and flawed assumptions have been known for some time, especially among financial economists. Pioneers in exposing the risks include Jeremy Gold and Lawrence Bader, U.S. pension actuaries who have long argued that the standard pension funding models understate the risks in equity investments and underestimate the costs of pension liabilities.

As described in their commentary in FP Comment, that leaves us with a risk-filled system that covers those risks by passing the costs on to taxpayers or future generations of pensioners. They propose a stark alternative for public pensions: All bonds, little or no equity.

There is some evidence pension plan managers have at least learned some lessons from the 2008 meltdown. At Ontario Teachers, the aim is risk reduction. “In response to 2008, we have decreased risk. We reduced our exposure to equity and credit markets and increased our allocation to inflation-sensitive assets that are well matched to paying pensions.” The equities portion of its assets will be set at 40% instead of 45%. Exposure to credit markets and hedge funds will be cut to 15% from 22%.

The push for higher returns and risk continues, however. At Teachers, managers are paid more if they can beat market benchmarks, a pay-for-performance approach that increases risk to the plan. At the Canada Pension Plan Investment Board, which currently invests more than $100-billion to secure the government pensions of all Canadians, managers are paid bonuses to earn “excess returns from active management programs.”

Adding even more incentive to take risks and raise compensation, the CPPIB plans to borrow money on the market to give it greater leverage as it scours the globe in search of excess returns in private deals, infrastructure projects and other assets. Teachers is reportedly looking at doing the same thing.

The future of Canada’s pension plans, public and private, remains at risk, despite the lessons offered by the 2008 meltdown.

The article got me curious about Ontario Teachers’ real estate portfolio. If you read carefully the 2008 Annual Report, it clearly states on page 40 that real estate portfolio lost money:

The real estate portfolio totalled $16.2 billion at year end compared to $16.4 billion at December 31, 2007. The portfolio returned -4.3% compared to a benchmark return of 7.0%, or $1.8 billion below the benchmark. On a four-year basis, these assets generated an 11.7% compound annual return, outperforming this category’s four year benchmark by 4.9 percentage points for $2.1 billion in total value added.

Real estate is considered a good fit for the pension plan because it provides strong, predictable income. These assets are managed by our wholly owned subsidiary, Cadillac Fairview. Its aim is to maintain a well-balanced portfolio of retail and office properties that provides dependable cash flows.

The real estate portfolio earned income of $936 million in 2008 primarily from lease arrangements for retail and office space. At year end, the occupancy rate of the retail space was 95%, while the office occupancy rate was 94%. In addition, new investments and development activities were undertaken during the year.

Despite these results and activities, the overall portfolio value decreased in 2008 as the global slowdown forced property valuations lower worldwide. Publicly-traded real estate investments also declined along with equity markets.

But I missed something in my last comment on Teacher’s disastrous results. The math simply doesn’t add up. If the portfolio was valued at $16.2 billion at year end compared to $16.4 billion at the end of 2007, then that represents a 1.2% loss compared to a benchmark return of 7%, or $1.34 billion below the benchmark (8.2% of $16.4 billion). Then why does Teachers’ claim they lost -4.3% or $1.8 billion below the benchmark? Shouldn’t the portfolio be valued at $15.7 billion if it lost 4.3% in 2008?

[Note to Teachers’: If I am missing something, I’ll be glad to hear Teachers’ “explanation”. One reader wrote me back that one possible explanation is that “they may have injected additional monies into the portfolio and lost all the new money.”]

But leaving this error aside for now, Mr. Corcoran’s larger point is more important. The focus is on higher returns so they beat market benchmarks, a pay-for-performance approach that increases risk to the plan.

Ontario Teachers’, CPPIB and even PSPIB are all borrowing money on the market to give them greater leverage as they scour the globe in search of excess returns in private deals.

You might want to stop here and reflect on this. Why are these funds borrowing on the market? Yes, it’s cheap, but do they really need the added leverage on their balance sheets?

I think it all boils down to taking more risk so that they can ensure they beat those bloody benchmarks and collect their big bonuses at the end of the year.

A while back, these “sophisticated” pension funds figured out they weren’t going to beat the benchmarks in public markets, so they focused their attention on private markets where they can create bogus benchmarks out of thin air and collect huge bonuses while they boast of adding significant value added.

This worked very well for years while the sun was shining. But now that the alternative investment Ponzi scheme is imploding (as it was almost exclusively built on leverage), this game plan isn’t working any longer.

So what will pension fund managers do? My bet is that they will tinker with the benchmarks in private markets so that they can easily beat them, allowing them to collect huge bonuses once again.

One small problem. The game is over, maybe for good.

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  1. fresno dan

    Really enjoy these posts on pensions, expecially when they are so learned and interesting.
    Being in the gubermint myself, my TSP (an equivalent to the 401k) has a calculator to estimate your long term returns – you could choose 6%, 8%, or 10%. Ha, Ha, Ha – Ow, I hurt myself laughing. I thought I was conservative for extrapolating my investment at 6%! In the long run, I expect to get my money back…I expect to be dead by than, but eventually I’ll show a gain.

  2. Anonymous

    The bank of England employee pension scheme made a tidy increase in the value of their portfolio last year, by getting out of equities and transferring to government bonds. This shows it was entirely possible and reasonable to expect pensions to show no losses at all for last year. It is purely that the management of certain pensions schemes followed a very bad strategy.

    Would you honestly want your pension money to be shifted from equities to commercial retail space rental at this point. I know it is not that simple but it does not appear to be a well thought out risk adverse strategy. The question then becomes how do you reward pension administrators when they really do a good job as it appears the bonuses are driving their actions. What solutions would you propose and how should the regulation be changed?

  3. Clark80

    The return stated for the real estate portfolio is most likely accurate if you consider that total return equals the change in market value AND the income derived from the assets. The notes state that real estate is an appropriate investment due to its predictable income stream, so if the market value is down roughly 1.2% , the income earned must have been close to 5.5% of the original value in order to arrive at +4.3%

  4. stilettoheels

    [Note to Teachers’: If I am missing something, I’ll be glad to hear Teachers’ “explanation”.]

    The OTPP may acquire and/or dispose of buildings and/or ownership interests in buildings during the course of the year.

    In 2008 in the regional shopping mall space, it increased its ownership stake in the Rideau Centre, Ottawa from 31% to 69% and sold its 100% interest in The Bay Centre, Victoria.

  5. Leo Kolivakis


    On the real estate, I edited my note:

    [Note to Teachers': If I am missing something, I'll be glad to hear Teachers' "explanation". One reader wrote me back that one possible explanation is that "they may have injected additional monies into the portfolio and lost all the new money."]

    Clark80, the return they reported was -4.3%, not +4.3%, so the math does not add up.

    >>stilettoheels, even if they disposed of the Bay Center in Victoria, that cash goes into the portfolio.

    The end value of the real estate portfolio must include income generated and any appreciation or loss of the market value of these investments.

    Again, the only possible explanation is what someone wrote me, which is why I edited my note. They may have injected additional monies into the portfolio and lost all the new money.



  6. stilettoheels

    Back of the envelope the so-called -4.3% return on real estate combines flows (income) and stock (assets). OTPP marked down assets by $1.67 billion offset by income of $0.94 billion.

    See here.

  7. Charles Butler

    Think about the spot they’re in.

    Unless things have changes in the decade I’ve been gone, Teachers is on the hook for 80% of the last five years of a retiree’s salary – indexed at 2 points below the CPI. Lots of teachers retiring with 85 points are looking at pensions of $50,000+ a year. Tack on the possibility that efforts to salvage what brought them, and everyone else, down will bring on inflation and increase the claims on the fund and you can imagine them dreaming of finding returns somewhere or somehow.

    The fact is that they cannot comply with their contractual obligations now. Fixed income is merely the low risk road to sure bankruptcy, so they might as well go bust trying to save themselves.

    One has to think that the returns they got from picking up the pieces of the 1990’s southern Ontario commercial property disaster made them a little cocky. They were kings of the hill for a good spell.

  8. doc holiday

    This said it all yesterday, and thus I refuse to go beyond this point of clarity:

    FYI: Warren also believes there are “dangers inherent” in the approach taken by treasury secretary Tim Geithner, who she says has offered “open-ended subsidies” to some of the world’s biggest financial institutions without adequately weighing potential pitfalls. “…

    She said she did not want to be too hard on Geithner but that he must address the issues in the report. “The very notion that anyone would infuse money into a financially troubled entity without demanding changes in management is preposterous.”

    Obabma and The Bushies are preposterous, we need reform today!!!

    Sorry about this OT, but there is nothing left to say about the on-going corruption; it’s time to act and the following link provided by Yves earlier is the change America must demand, versus the bullshit change that Obama is spitting out!

    Ok, there is this great interview with Moyers and William Black…..but what more do we need America?

    No more debate, we need action today to put the crooks in prison or ….

  9. Anonymous

    Concur doc holiday,

    Talk is cheep, its time for action. The further this travels down the road the bigger the mess to clean up will be. Americans need to re-establish the rule of law of ALL. No exceptions out of so called “necessary convince” for our own good or so they say.

    Criminals always have a good story about how they were really the victim, in the crime. Their is no beast called white color crime, just crime, a LAW BROKEN, thats all and should be investigate and if found guilty punished, other wise the hole republic is just a big joke.

    Rule of law for all or we can just call for anarchy and then settle things in that construct.


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