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August 6, 2014

Unlock the Potential of Japan’s Savings

Governance reform and diversification at Japan’s largest pension fund will benefit the whole economy

Japan’s planned reform of its largest pension fund could bring far-reaching benefits to the world’s third-largest economy. If the government adopts international best practices, it will not only provide better returns to retirees, it will also boost the competitiveness and entrepreneurialism of Japanese companies.

The Government Pension Investment Fund (GPIF) has traditionally held more than 65% of its $1.3 trillion in Japanese government bonds (JGBs), but that allocation is now shifting toward a greater equity weighting. And since many other public and private pension funds in Japan use the GPIF portfolio as a benchmark, a substantial chunk of the country’s savings is set to migrate toward risk capital instead of financing Tokyo’s deficit spending.

Japan’s Welfare Pension Insurance Act requires that GPIF’s assets be invested in a “safe and efficient” manner. That should permit the GPIF to take a reasonable amount of risk in pursuit of long-term returns.

Unfortunately, the interpretation of “safe and efficient” has traditionally been that the overall portfolio of GPIF should have a risk profile similar to that of JGBs. The result has been a portfolio that lacks true asset class or geographical diversification. For those who need the fund to grow in order to have funds to pay for their retirement, this interpretation of “safe” is more likely to be damaging than protective. Nor is it “efficient,” since it lacks diversification.

“Safe and efficient” should mean a substantial level of diversification across asset classes and across geographies. In recognition of the need for change, the Abe administration released a study last November calling for diversification in the investment strategy of the GPIF, flexibility in compensation practices, and independence in the governance structure.

Pension funds including Canada Pension Plan, Ontario Teachers Pension Plan and Norges have average weightings to domestic securities of 28%, and their average compounded total return over the last eight years has been 7.76%. During the last 10 years, the GPIF’s allocation to JGBs has been approximately 68% and its eight-year average compounded total return has been 2.25%.

The changes proposed by the Abe administration are good news for the stock market, since the GPIF’s increased allocation to equities will boost stock prices. But that is a short-term phenomenon. If the fund just supplies passive capital it could actually make the allocation of capital less efficient. GPIF will need a governance structure that separates investment decisions from political ones.

The real good news is that the government has promoted what it calls a “stewardship code”—a way to invigorate the corporate culture in Japan. This should create a greater sense of accountability to shareholders and capital return to an increasingly international shareholder class. The GPIF has announced that it will require its outside asset managers to comply with the code; unsurprisingly, 130 institutional investors have now signed up, including leading global asset managers.

The stewardship code and the new JPX-Nikkei 400 Index (an index focused on return-on-equity  and similar measures) are creating incentives for improved corporate governance. For example, Amada, a large machinery manufacturer with an ROE of 3% over the past decade, was not selected for the JPX-Nikkei 400. The company later announced that it would give back all profits to shareholders (half as dividends and half as share buyback) to make sure it is selected the next time the JPX is changed. Its stock price traded 8% higher that day. It is widely expected that the GPIF will change its benchmark from TOPIX to the JPX 400 this fall.

The November report also called for institutional reform at GPIF itself. This includes more market-based remuneration and a board that is more independent from politics and government. If GPIF is to become a world leader in pension best practices—which, as the largest pension plan in the world, based in the third largest economy in the world, it should be—its governance will need to match the independence of the world’s leading pension systems.

Tokyo has identified Canadian public pension funds as a leading model. Years ago, far-sighted political leaders purposely distanced Canadian pensions from government and politics. Their boards are not filled with political figures, the government does not control their investments, and they are able to pay the compensation needed to attract top-quality financial professionals.

I ran the United States government’s Pension Benefit Guaranty Corporation and saw firsthand how too much politics surrounding the investment of a $60 billion portfolio can cost an organization billions of dollars. In 2008, we adopted a new investment policy, moving substantial portions of the portfolio from fixed income into equities.

That policy was to be implemented during the spring and summer of 2009. However, the incoming Obama administration reversed the change in PBGC investment policy, remaining in fixed income assets. Since the stock market has more than doubled since then, that decision cost the PBGC $20 billion. GPIF and the Abe administration have the opportunity to insulate the fund’s governance from such politics.

If the GPIF uses the experiences of other systems to avoid the pitfalls, it can provide better security for retirees. Tokyo will face less fiscal pressure to top up the shortfalls in pension funds. And managers will be more accountable and responsive to shareholders, improving returns. Overcoming resistance from vested interests and the temptation for political meddling won’t be easy, but Japan has much to gain if this reform succeeds.

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June 24, 2012

Corporate Pensions Need Relief

Pension plans measure their liabilities by applying a discount, or interest, rate that is prescribed by law. The lower the discount rate, the more they will have to contribute to fund their plans. Right now, defined-benefit pensions must use a discount rate based on a two-year average of AA corporate bond rates. Because these bond rates are at such historic lows, corporations are under tremendous pressure to meet their pension funding obligations.

But there is a proposal in Congress that can give companies the relief they need while also protecting employee pensions. It can also help reduce the federal deficit.

To understand what’s at stake, consider a company whose pension plan has $4 billion in assets and $5 billion of liabilities. The $1 billion in liabilities above the plan’s assets must be shown on the corporate balance sheet, and the corporation is required to amortize it over seven years, at approximately $170 million per year.

However, if the liability were calculated based on the current proposal—a 25-year average of the applicable interest rates—the underfunding would be approximately $500 million. A seven-year path to amortize that amount would be roughly $85 million annually.

So, is it good policy to allow corporations to use a longer-term, “smoothed” interest rate to amortize their liabilities? Yes it is, because the existing pension law is flawed.

The Pension Protection Act of 2006 was passed after Bethlehem Steel’s bankruptcy in 2001 and dissolution a few years later. When Bethlehem filed for bankruptcy, it met all of its pension obligations. But because the law at that time was so loose, the company could claim compliance even though its pension plan turned out, shockingly, to be only about 45% funded.

This caused a terrific hit to the Pension Benefit Guaranty Corporation, whose deficit increased by nearly $4 billion. Congress then rightly stepped in to tighten the law and protect the PBGC, which is a government-owned corporation. But the tightening went too far.

There are three parties in interest when pension legislation is passed: the PBGC, pension recipients, and corporate plan sponsors. Their priority of protection should be as follows: First are the plan sponsors, because if the companies cannot afford to keep their plans intact, there will be no pension to worry about. Second are the pension recipients, who have earned and are due their pension. Only third comes the government agency, which exists as a guarantor of last resort.

The Pension Protection Act of 2006 placed those priorities in reverse order. In order to ensure that the PBGC would not face Bethlehem-type problems in the future, the new law required much more onerous interest rates and raised the funding target to 100% of liabilities.

However, this means most corporations that pose no threat to the agency have heavier funding obligations than are necessary. The 2006 law’s funding changes protect the PBGC, but with the dramatic drop in interest rates funding becomes too difficult for many plan sponsors. So like American Airlines and Bank of America, they end up closing or freezing their plans.

Corporations should be allowed to use interest rates that are smoothed over many years. This makes sense because pension obligations are paid over decades. Moreover, pension plans do not need to be continuously funded at 100% of their current liabilities, because they are not payable now. Unfortunately, the current law treats them as if they are.

Critics of these reforms argue that interest-rate smoothing masks immediate reality and allows corporations to avoid painful contributions. But so long as a corporation is healthy, a funding target of 80% is fine. There is no need for a pension to be fully funded until it is in payout status. Think of a 401(k). By definition, it is fully funded the day you retire and stop funding it. But with a defined-benefit pension, your company continues to fund the plan after you retire.

Moreover, smoothing will mean that, when times are better and interest rates rise, companies will not be able to avoid contributions. Imagine that interest rates rose two full points. Many American pensions would then appear fully funded. Would we want sponsors to stop contributing?

This change recognizes that the best environment for corporations to be able to maintain their pensions is one that avoids undue volatility and recognizes that pensions last for decades.

These reforms have another benefit. If corporations put less into pension plans in the near term because they use a higher discount rate, they will have lower tax deductions associated with those contributions in the near term. In Washington budget math, that equates to higher tax revenues.

The Senate has passed the pension-funding reform provision as part of its version of the highway bill. Meanwhile, Senate Majority Leader Harry Reid has recently proposed using revenues from the pension reform to fund an extension of the current student-loan rate that expires June 30. But even if Congress doesn’t want to use the pension reform’s increased revenues for highways or student loans, they could, and should, give corporate pensions needed relief.

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June 9, 2010

Washington and Your Retirement

The agency that guarantees private-sector pensions is deep in the red.

The financial security of American workers who have stable and well paying jobs may be in serious jeopardy. The private pension system is underfunded by hundreds of billions of dollars, and millions could find that their pensions won’t be there when they need them. Their fate may well be determined by a small, obscure agency that most Americans do not even know exists.

The Pension Benefit Guaranty Corporation (PBGC) insures the private-sector pensions of 40 million Americans. However, it has inherent structural flaws as well as a large and growing long-term deficit.

The PBGC is governed by three cabinet secretaries, but they rarely have time to meet or focus on the agency’s problems. Meanwhile, the value of its portfolio is approximately $70 billion but the present value of its liabilities (to make good on underfunded pensions) is $92 billion. The deficit is expected to surpass $30 billion in the next 10 years. Under the law, the agency does not have federal government backing.

The agency has been without a director since the end of the Bush administration. Six months ago, President Obama nominated Joshua Gotbaum for the position, and the Senate Finance Committee just had its confirmation hearing. But one senator has put a “hold” on the nomination. At the same time, a bill threatening the financial stability of the PBGC is making its way through Congress. The Senate should vote Mr. Gotbaum in and ask him to deal with the following serious issues.

1) Climb out of the moral hazard trap. The PBGC is structured like a Ponzi scheme. It takes in pension plans that are, on average, about 60% funded; it takes in “sixes” but owes “tens.” This is not a problem now—but only so long as there are new and large plans coming into the PBGC with significant assets.

While Congress does not back its deficits, everyone in Washington assumes that it will. This puts the PBGC in the same moral hazard position as Fannie Mae and Freddie Mac: avoiding the discipline of the marketplace by relying on an assumed governmental bailout.

2) Reform the agency’s governance. The PBGC board, consisting of the secretaries of Labor, Treasury and Commerce, meets infrequently. A 2008 McKinsey report shows the need for a radical reformation. An independent board would never have allowed the agency to run up a $20 billion deficit without changing its business model.

3) Diversify the investment policy once and for all. PBGC’s goal should be to allow the agency to meet its obligations and avoid a taxpayer bailout without taking undue risk. To get there requires diversified investments in growth-oriented assets like equities, private equity and real estate, combined with more conservative fixed income investments.

The board adopted a diversified investment policy in 2008 and waited until late in the year to begin to implement it. Unfortunately, due to the politicized nature of agency decision-making the new board suspended the transition to equities at just the wrong time—in May of 2009. This back-and-forth movement has cost the PBGC at least $1 billion over the last year.

4) Staff up. Provide needed staff and up-to-date resources. In late 2008, the PBGC had 15 government employees managing $50 billion. It is simply irresponsible for an agency engaged in so complex, challenging and crucially important an exercise to lack sufficient manpower and technology to compete in the marketplace and respond promptly to reasonable opportunities. Overwhelmed and understaffed, PBGC will not be able to meet its long-term responsibilities to the American worker.

Most worrying, the PBGC is also being looked on as the potential patsy in the so-called “Create Jobs and Save Benefits Act” currently before Congress. This bill would allow underfunded multi-employer union pension plans to be shifted to taxpayers. But allowing these plans to offload their obligations would increase the PBGC deficit by at least $8 billion and would officially put Congress on the hook for these new liabilities.

Some have even urged that the federal government should guaranty or bail out state and municipal pensions. This would be disastrous, since so many state plans are horribly underfunded.

If we don’t face pension reality now our landing will only be that much harder in the future.


September 17, 2010

Institutionalizing institutional marketing – what managers should concentrate on for the next stage of marketing

Many hedge funds are trying to evolve to the next stage of fund raising – the institutional market. Reliance on High Net Worth channels is expensive in both marketing and account maintenance terms, and individual investors can be fickle and impatient. The institutional market, with its concentration of capital and professional managers, is the ideal target market.

The challenge that many successful funds now face is how to “institutionalize” their capital raising activities. The challenge, as many of them have found, is more than brochure-deep. Yes, a compelling story well presented is essential but the required changes go much deeper than that.

Alternative investment managers must understand the challenges faced by the CIOs and investment professionals to whom they are marketing.

At the beginning of 2009, the hedge fund industry was in disastrous straits. Absolute return strategies had not performed correctly; non-correlated strategies seemed to correlate; and hundreds of investors wanted rapid redemptions – to such an extent that many managers felt forced to put up gates to prevent their investors from leaving. When they could get out, many investors fled immediately, and hedge fund managers realized they needed more patient and sophisticated capital.

At the same time, many pension plans are looking more at hedge funds for a variety of reasons, including a desire for less correlated returns or for more absolute return. The right approach to alternative investments can make a pension healthier.

Even though performance for many hedge funds in 2009 and into 2010 has been strong, most managers have realized that they must do a much better job dealing with and understanding their investors. Doing this properly requires a lot more than better materials and enhanced investor relations staff.

Hedge funds and other alternative asset managers that want to gain more assets under management need do the following:

  • Demonstrate a serious approach to risk management. Today’s institutional investors are very focused on risk. However, if they are asked what specific risks they fear or what specific risks they are willing to bear, they are often at a loss. Better managers can assist their investors in coming to a more complete understanding of these questions. In doing so, they can help their investors understand the risks and various forms of volatility that come with a particular investment in a particular fund. And your firm’s culture and strategy, its very DNA, must show that risk management flows through everyone’s veins.
  • Don’t raise gates if you haven’t previously made it clear that you may. Investors hated being gated. Institutional investors can deal with gates — but only if the potential need for gates is integral to your strategy. If you feel your strategy requires that you gate, say so up front. The time to explain why you must gate is not the day you do so. But if you say you will not gate, then you must not do so, and you must figure out whatever it takes to have sufficient liquidity.
  • Be more transparent. In today’s environment, transparency is a critical item. Most investors are not going to review the daily positions that you provide to them. But when the investment staff brings your fund to the investment committee for approval and someone on the board asks if there is transparency, you have a lot better chance of being approved if the answer is yes. More to the point, if you are going to have the long-term commitment that you seek from institutional investors, you must make the relationship a two-way street. The better your investors understand your strategy, the more they will stay with you in difficult times. When I ran the Pension Benefit Guaranty Corporation, some of my greatest frustrations came when, even though we had $50 billion, we could not always answer, “What do we own?”
  • Be able to show how you generate alpha. After Bernie Madoff, everyone must be able to show what they actually do. But this point goes beyond no-more-black-boxes. Too many managers cannot explain how they actually succeed, what is their hit ratio, how do they stay with winners and get rid of their losers, how do they recognize losers, and how do they effectuate an effective shorting strategy. If you cannot answer these questions, fancy marketing materials will not help.
  • Understand the goals and constraints of large institutions. Besides segmenting the marketplace so you know which institutions are most likely to invest in your products, you must also budget appropriate ongoing contact, follow through, and sales cycle time. You must understand the very high visibility of certain investors and be prepared to deal with all kinds of “fishbowl” issues, from partisan politics to celebrity issues around hedge fund founders that can negatively affect your efforts. For example, one reason the PBGC did not invest in hedge funds was that the politics — far more than the merits — made it almost impossible to do so. You must be able to put yourself in the shoes of a highly intelligent investor — the CIO — who must deal with various procurement constraints, an investment committee or board that may not be fully conversant in the latest portable alpha strategy, and a covey of journalists who must find a way to make discussion of pension investment strategy exciting — something that is much more easily done negatively than positively.
  • Be one of the good guys. Public relations must be part of any marketing strategy. And everything is now available on the internet. Do good things and publicize them. Make sure that your firm has the kind of reputation that will make investment committee heads nod when they hear your name.
  • Be patient. If you build it, they will come. The “it” here is not the strategy. It is the relationship. If your strategy does not work, you cannot raise money. On the other hand, if your strategy does work, but you have not built the relationship — you will also fail to raise money.
  • Perform as you said you would. Performance without good marketing can succeed. Good marketing without performance cannot.

Persuading a CIO or investment staff that your fund is worthy is just the start. The more that marketers can help those staffs address the issues above, the easier it will be for them to gain the approvals to invest.

Financial Times

January 12, 2014

World’s largest retirement plan could run out of money unless it implements significant changes

The world’s largest pension plan, the Government Pension Investment Fund of Japan, holds $1.2tn in assets. It insures the retirement security of more than 100m people and, according to some analysts, it will run out of money in less than 25 years. Fortunately, the administration of Prime Minister Shinzo Abe is proposing much-needed reform.

As part of Abenomics, Japan’s cabinet secretariat and its advisory board recently released a report recommending that GPIF should become more diversified, increase its direct professional investment management and create an investment process free from politics.

With such a gigantic portfolio and the financial future of millions of Japanese citizens at stake, GPIF should pursue and implement these improvements. In doing so it can strengthen its ability to meet its obligations, as well as serve as a model for other large pensions around the world.

In a healthy, advance-funded retirement system, 80 per cent of pension payments should come from investment returns. This requires diversified investment across asset classes and geography. However, GPIF functions as a pay-as-you-go plan, with a portfolio that is invested approximately 60 per cent in Japanese government bonds, and has achieved a return of only 3.2 per cent over the past 10 years.

A long-term investor should have at least 50 per cent in “return-seeking” assets – public equities and alternatives. GPIF is a long-term investor. Its liabilities go out for decades. Yet its return-seeking allocation is under 30 per cent.

A large long-term investor should be invested across the globe to diversify risk and generate uncorrelated returns. Canada Pension Plan Investment Board has invested over 40 per cent of its assets outside its home country. GPIF has 76 per cent of its assets in Japan.

An extremely large pension scheme should invest directly around the world. This requires a large enough professional staff to take advantage of global direct investment opportunities. Canada Pension Plan has a professional investment staff of more than 800 people and manages 82.5 per cent of its assets directly. GPIF has $1.2tn in assets, a professional staff of around 70 and manages around 25 per cent of its assets (all domestic bonds) directly. For the past 10 years, Canada Pension Plan’s return has been nearly twice the return of the GPIF.

To manage substantial assets internally, GPIF will need to pay market rates, as other world-leading plans do. This may seem like a lot of money, but it saves on overall fees and produces a more independent-minded investment staff.

An independent-minded investment staff helps support another recommendation in the report: investment policy should be independent from politics. To highlight this point, I offer a cautionary tale.

The US Pension Benefit Guaranty Corporation insures the American corporate defined-benefit system. When I ran that organization, it had approximately $55bn in assets and $75bn in liabilities. Yet the investment policy called for up to 85 per cent fixed income. This gave us very little chance to meet our liabilities.

We engaged in a year-long process with the board (three cabinet secretaries), reviewing purposes, goals and the strategy of our investment policy.

We reviewed countless potential allocations, we considered how those allocations would have performed under stress, and we finally adopted an allocation of 45 per cent diversified equities, 45 per cent diversified fixed income, 5 per cent private equity and 5 per cent property. Implementation was to take place over approximately 10 months, beginning in late 2008. Despite very challenging market conditions, we began the implementation in December of that year.

However, in 2009, a new administration, with new cabinet secretaries, took office. Markets were in turmoil, so the new board abruptly decided to suspend the implementation of the new policy.

Under the planned implementation, approximately $20bn would have moved, during the spring and summer of 2009, from fixed income into equities. But the old policy remained frozen in place. Think how equity markets have performed since the spring of 2009. This failure cost the PBGC at least $20bn.

The panel’s report is correct. Making GPIF safer and sounder for the long term requires global asset-class diversification and politics-free investment. If GPIF implements these reforms, it has the potential to be one of the world’s leading financial institutions and – more importantly – will increase the chance that it can meet its liabilities for millions of Japanese.

Financial Times

April 16, 2009

Vampire Pensions Could Be a Corporate Nightmare

While economists worry about “zombie” banks holding back lending, vampire pension plans may soon be stalking a company near you. The underfunding of America’s corporate defined benefit pensions poses a daunting challenge, threatening not only their 40m beneficiaries but the entire US economy.

Recently enacted funding rules require underfunded pension plans, and that’s most of the big ones, to suck needed cash from salaries and jobs just when suffering companies need scarce resources to survive. Under 2006 legislation, companies that have underfunded pensions must put extra funds into their pension plan to close the gap within seven years. After precipitous drops in assets, most plans now have serious funding gaps.

For example, according to Watson Wyatt consulting, at the end of 2008 the pension system in the US had approximately $2,100bn (€1,589bn, £1,407bn) in liabilities but only $1,600bn in assets. That was before the downward gyrations of the capital markets this year.

Closing this gap could cost $50bn-$100bn in additional annual pension contributions at a time of unprecedented reduced corporate earnings. Some large companies have stated that such funding commitments would drive them to file for bankruptcy.

The new law was drafted to help protect pension recipients from discovering too late that their bankrupt ex-employers had seriously underfunded pension plans. When this happened at Bethlehem Steel the Pension Benefit Guaranty Corporation (PBGC), the federal corporation that insures pensions, saw its funding deficit soar by nearly $4bn, while workers missed out on $600m in pension promises. Among the problems the new law sought to deal with were:

● A significant portion of pension liabilities may not be insured above PBGC’s limits.

● Pension plans rescued are frozen, so workers over 50 see no increase in benefits during their remaining working years. This means that untold billions of dollars of expected benefits are never earned and never owed – but also never received.

● As PBGC pays the benefits it does insure, its own deficit increases by the amount of underfunding in the plan.
Avoiding these situations made a lot of sense. However, like everything else in our system, these rules were not designed with the extreme current emergency in mind. The very law that was designed to protect worker pensions runs the real risk of draining the very companies workers depend on for their livelihood and retirement benefits. Congress must change the law – and quickly.

The threat is not underfunding; it is underfunding in companies that go bankrupt. Our goal at the moment should not be to force plans towards full funding at all costs; it should be to prevent companies going bankrupt. Certainly, we should prevent pension funding rules from contributing to the companies’ – and ultimately the pensions’ – demise. But the goal should be to help responsible companies succeed, so they can fulfil their obligations to workers.

Unfortunately, current law provides only one real option to a company that cannot meet its payments. Other than woefully inadequate and inflexible funding waivers, the only choice is to seek a “distress termination” and dump the underfunded plan on PBGC – a solution that is bad for everyone.

PBGC should have the situation-specific flexibility that the Pensions Regulator has in the UK. There, companies and the regulator can reach deals that provide temporary relief. If companies can afford their contributions, even in this environment, of course they should make them. If they cannot, we need the option of the UK model. The PBGC would not have to terminate and take over plans and corporations would not have to make payments on a current basis that they cannot afford.

This kind of intermediate relief would have to come with conditions that prevent shareholders and executives from improperly benefiting while pension plans are underfunded.

Inserting a quasi-governmental authority into such negotiations is problematic.

But it is far superior to enduring the burden of a misfit law designed to protect pension benefits which instead weakens them at a time of crisis.

In their 401(k) private pensions, Americans can put in less this year if they need the money to pay bills. During this crisis, corporate pensions should be allowed to do the same.


March 7, 2012

Give Employers a Break on Pensions

Defined-benefit pension plans are under threat from two powerful forces: the 2006 legislation that was supposed to strengthen them, and the historically low interest rates that are crushing them.

The Pension Protection Act of 2006 was intended to make private-sector plans safer. The law made some improvements. But the pressure it is putting on U.S. corporations is having unintended consequences. Companies are rapidly closing pension plans because of the heavy funding requirements that have only become heavier with low interest rates.

The Society of Actuaries estimates that required contributions from employers will double over the next decade, from the average of $45 billion annually from 2000 to 2009 to an average of $90 billion from 2010 through 2019. If the law is not fixed, the corporate defined-benefit plan will soon be a thing of the past. Provisions were attached to the current Senate highway bill to make some needed changes, but they have to go further.

The 2006 legislation was prompted by the devastating collapse of Bethlehem Steel Corp. and the subsequent bankruptcies of United Airlines and US Airways. Those failures led to tremendous job losses, reduced pensions and multibillion- dollar increases in the deficit of the Pension Benefit Guaranty Corp.

Law of Worst Cases

Bethlehem Steel’s pension plan had been considered “fully funded” under the law at the time. This meant the company made all the required contributions. It didn’t mean the plan was fully funded. The law permitted aggressive valuation of corporate assets and relaxed funding standards. It turned out that Bethlehem Steel’s assets were sufficient to meet only 45 percent of its obligations. United Airlines and US Airways (LCC) faced similar gaps.

George W. Bush’s administration and Congress — Republicans and Democrats alike — tried to address this problem. Unfortunately, the legislation was written to cover the worst situations of the past without anticipating those of the present — in particular the burden that pensions face as a result of interest rates that are at historic and abnormal lows.

To relieve those pressures and make it more attractive for employers to maintain their pension plans intact, Congress should make two changes. It should allow companies to use a multiyear average of bond yields, instead of a two-year average, to calculate their pension contributions, and it should reduce funding requirements from 100 percent of liabilities to something more reasonable.

The law requires that corporations use the rate on high- quality corporate bonds to compute the present value of their pension obligations. The lower those rates are, the higher the stated value of the future liabilities will be. Current low rates are wreaking havoc on pensions’ funded status and corporations’ required contributions. In 2011, the Citigroup Pension Liability Index fell from 5.54 percent to 4.40 percent. That change alone increased pension deficits in the S&P 500 by far more than $200 billion.

This approach is inconsistent with the long-term nature of pension liabilities.

Imagine that a company will owe a retiree $35,000 annually, starting in the year 2030. It can actuarially predict with a high degree of reliability the dollar amount it will owe to the cohort of employees who will retire 18 years from now. Interest rates may rise or fall — as they surely will — between now and 2030, but the important thing is whether the corporation and the pension plan will be in a position to meet those liabilities in 2030 and beyond.

Interest-Rate Drag

The Pension Protection Act doesn’t focus on the likelihood that a corporation can pay those liabilities 18 years from today and in ensuing decades. It focuses on now. It looks at a snapshot when it should be looking at a movie. It doesn’t allow for reasonable smoothing of interest rates, even in today’s extraordinary environment.

I arrived at the Pension Benefit Guaranty Corp. shortly after Congress passed the 2006 act. It was clear to me that the law had been driven by a desire to protect against absolute worst-case scenarios (though it had not anticipated the current one). Sponsors of defined-benefit plans complained to me that the new law would result in the demise of the private-sector pension.

The effects from the rigid rules on interest rates became so severe in late 2008 that Congress gave some temporary relief, but that reprieve lasted only a couple of years. Now, in a low- rate environment even more severe than in late 2008, no relief is available.

The law needs a permanent fix. Besides changing the rules affecting interest rates, Congress should reduce funding targets — at least for healthy corporations — to a range of 80 percent to 85 percent, not the 100 percent required today. The real threat to the Pension Benefit Guaranty Corp. and to the recipients isn’t an underfunded pension plan — it is an underfunded pension plan in a company that goes bankrupt.

By comparison, an individual retirement account isn’t fully funded until the day the individual retires. At that point, it is by definition fully funded — individual-retirement-account contributions cease and withdrawals begin. But a healthy corporation’s pension plan exists long after the individual has retired. In such a situation, “full funding” is a false target that simply makes it harder for corporations to keep their pension plans going.

A defined-benefit pension plan keeps retirees more financially secure in old age and can help corporations attract employees. To preserve private-sector pension plans, Congress has to act while there is still time.

Pensions Investments

December 3, 2015

States offer promise in addressing retirement crisis

The Department of Labor’s recent proposal to allow states to create retirement savings programs for private-sector employees is finally doing something about America’s coming retirement crisis. Republicans and Democrats should support it.

Corporations and small businesses struggle to balance profitability with genuine concerns for employees’ well-being. Defined benefit plans have long-dated, volatile, expensive and risky liabilities that can be beyond the ability of many employers to manage or afford. And for small businesses, even offering a 401(k) plan can be a challenge. It can be expensive and it can be very complicated legally, as compliance with the Employee Retirement Income Security Act and fiduciary duties can be daunting.

A tidal wave of baby boomers will retire in coming years. They will live longer in retirement than any previous generation, but they are less prepared for retirement than their parents were. Longevity is a blessing, but it makes planning and saving for retirement more challenging than ever before — especially for those who are unprepared. It may be late to solve these problems for boomers, but the generations that follow will face the same issues.

The problem is hard to see because it will not show up through any dramatic event. There is not a looming cash crunch like the debt limit to concentrate everyone’s focus. Rather, the gradual erosion of living standards for the elderly will be the depressing norm.

For most Americans, defined benefit pensions are a thing of the past. In 1983, more than 60% of workers had defined benefit pension plans. That number has now fallen to about 25%. In a defined contribution plan, such as a 401(k), all the risk, all the investment responsibility and all longevity planning are on the shoulders of the individual rather than the company that in the past would have provided the defined benefit plan.

Only half of all private-sector workers are enrolled in any employer-provided retirement savings plan, whether defined benefit or defined contribution. Unfortunately, even for those who do have a 401(k) or individual retirement account, the news is only slightly better. According to the Federal Reserve System, the median combined 401(k) and IRA balance for working households approaching retirement is barely more than $100,000. That may sound like a lot, but that only allows a 70 year old to count on income of $4,000 to 5,000 a year.

Many workers have modest amounts in savings accounts not designated for retirement, or they might have equity in their homes. Yet, even if we count those assets, Boston College’s Center for Retirement Research estimates the aggregate “funding gap” for at-risk households to maintain living standards exceeds $7 trillion.

With Social Security (if it exists at all), other social programs, some savings and family support, most seniors will not experience devastating poverty and crushing loss. But the secure retirement they expected — with hobbies, some travel and family time, maybe financially assisting grandchildren — will just not materialize. Plans for that trip to the Great Wall of China will run into a wall.

Without action, baby boomers and the generations to follow will have to adjust their vision of retirement, old age, longevity and standard of living to a new, discouraging point of view. It seems great to live longer, but what if we simply cannot afford to do so?

It does not have to be this way. Other countries have found solutions, and many individual states in this country are seeking solutions, too.

In Australia, every employer is required to contribute 12% of pay to a retirement plan, called superannuation funds. In the Netherlands, employer and employee participation in the retirement system is mandatory, and about 20% of each employee’s pay goes toward his or her pension. And when they retire, they must receive an annuity rather than a lump sum.

In 2012 the United Kingdom launched the National Employment Savings Trust, a system that is required for employers and automatic but voluntary for employees. This allows lower-income workers, in industries that do not offer retirement benefits, to develop some level of low-cost, long-term retirement savings.

It is easy to understand why Washington does not address this issue. The dysfunction of our nation’s capital does not need description here. Beyond that, this topic is complex, involves mathematics and a focus on the fact that we will all die, and it at least touches on the famous third rail of American politics — Social Security.

Some states, however, are trying to take action. In 2012, California passed the Secure Choice Retirement Savings Trust Act. The law aims to create a system in which small businesses will be required to provide payroll deductibility for employees to put 3% of pay into a retirement system to be professionally managed by an institution akin to the California Public Employees’ Retirement System. Enrollment will be automatic but employees can opt out. The California Secure Choice Retirement Savings Investment Board has been meeting monthly for two years in the process of designing investment and retirement plans and communications strategies.

Other states like Illinois have enacted similar legislation. Still others have wanted to follow these leads, but the states have been concerned their approaches might violate various terms of the dense, prohibited-transaction-waiting-to-happen federal legislation known as ERISA. The Labor Department’s announcement Nov. 16 of new rules make clear that these plans would not violate ERISA. That is a posture with which both Republicans and Democrats should be able to agree. These rules will allow states to be laboratories to address this pressing problem.

In the absence of federal action on pension reform, these state initiatives offer some promise. But they still will require significant contributions to make them work. Remember that the Dutch system is the envy of the world because it requires savings of about 20% a year into a retirement plan. There is no free lunch — or retirement plan.

If we can all learn to save more, and we make these changes to the system, then we might avert the crisis. With increases in longevity, maybe we’ll live long enough to see the change.

Pensions Investments

June 27 2012

Why GM is a Pension Plan Leader

General Motors announcement that it will pay lump sums or annuities to more than 100,000 pension recipients is a game-changer. For years, corporations have been looking for ways to derisk their pension plans, to limit their liabilities and to avoid the volatility that comes with an underfunded plan. There have been many ideas circulating, but for real and substantial derisking, nobody wanted to “go first.”

Federal pension legislation passed in 2006 has put tremendous pressure on corporate defined benefit pension plans. For a law carrying the name The Pension Protection Act, it has imposed some onerous obligations on corporations that want to keep their pension plans intact. It requires corporations use AA corporate bond rates to value their liabilities. So in today’s interest rate environment, the stated value of pension liabilities is at historic highs. As a result, the average funded ratio in the S&P 1500 is around 75%, and overall unfunded pension obligations are nearly $500 billion. At the same time, the law requires more aggressive actions by most plan sponsors to amortize their underfunding over seven years toward a target of full funding.

These factors will cause required pension contributions to double over the next 10 years. So it is no surprise that corporations have looked for solutions. GM is known to be a sophisticated manager of its pension liabilities and is a thought leader in this industry, so in coming weeks corporate boards will be occupied with the question “What are we doing?” And numerous other corporate sponsors will soon follow suit in considering all their derisking options.

One solution is liability-driven investing, which tries to use asset allocation or derivative overlay strategies to make the performance of a plan’s assets rise and fall in parallel with the plan’s liabilities. If you could invest 100% in AA corporate bonds with same duration as your liabilities, your assets and liabilities would rise and fall together as interest rates changed. However, many plan sponsors believe that if they adopt LDI, they are either locking in their deficit or throwing in the towel with rates so low.

Some corporations have considered a “buy-in,” in which they purchase an annuity from an insurance company as an asset of the plan, and that annuity is designed to meet specific liability-related cash flows in the future. This can also be done more flexibly and more cheaply without the insurance company in certain situations. This allows the company to avoid the settlement accounting charges that can accompany a complete defeasance in the purchase of annuity buy-outs.

Another option is issuing debt to fund the plan. This can make a lot of sense, because pension underfunding is a form of leverage and rating agencies increasingly are looking upon pension underfunding as debt. Moreover, because rates are so very low, it can be a good time to take this action. It is not suitable for all sponsors, but can make sense for many. However, many CFOs resist the idea of “crystallizing” this debt.

Each of these tools is designed to provide some relief from the crushing obligations of the PPA. However, while the PPA increased pressures, it also offered one particular form of relief — lump sums.

Before 2006, the discount rate for calculating liabilities paid in a lump sum was 30-year Treasuries. The PPA changed that rate to a corporate bond rate that was phased in over five years. That phase-in period concluded on Jan. 1. So now, a corporation that is considering paying lump sums can use a rate similar to AA corporates to calculate the value of the liabilities it extinguishes in a lump-sum payment. This essentially fully extinguishes the GAAP liability, and it provides the retiree with full value.

Lump sums are not for everyone, or for every liability. If they are paid directly out of plan assets with no additional contribution to the plan from the sponsor, the plan’s funded ratio will fall. Some CFOs will not want the plan to become smaller, because they will lose potential earnings that can be attributed to the pension. If the corporation considers funding lump sums with cash, finance officers will have to consider whether that is the best use for that cash — or perhaps whether to issue debt to fund the lump-sum payments.

The most likely solutions will be combinations of these tools, and they will vary for every company. But whatever approach sponsors take, expect to see a flurry of derisking of pension plans in coming months. It has often been said that what is good for General Motors is good for the country. That may or may not be true, but what’s good for the General Motors pension plan is certainly worth thinking about for others.

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November 17, 1995

Break Up the Legal-Aid Monopoly

Mayor Rudolph Giuliani is rightly challenging a monopoly: not a business behemoth, but the Legal Aid Society, which is responsible for defending thousands of poor New Yorkers, most of them black and Hispanic, in the criminal courts.

The society, a private organization, provides essentially all legal services to the city’s poor criminal defendants. The Mayor has proposed letting other potential defenders bid on 20 percent of Legal Aid’s annual caseload of 270,000 clients, for which the society now gets about $63 million from the city.

There are plenty of potential competitors — county bar associations, neighborhood legal-aid groups, and private law firms — that would bid on the work. They should be allowed to do so, because if Legal Aid lawyers go on strike — as they have three times — our criminal courts would be thrown into disarray, as they were during the last strike in 1994, or could even grind to a halt. And just as with phone companies and garbage haulers, competition could lead to improved performance by lawyers for the poor.

Yet listening to the City Council debate the Mayor’s plan this week, one might have thought his goal was to deprive poor people of their right to counsel.

As a lawyer who has represented indigent defendants pro bono and sued the system for failing to provide adequate counsel, I know this is one of the most important tasks a lawyer can perform. The state’s power is awesome. While government does not provide megaphones to protect First Amendment rights or car fare to church to support religious freedom, it does insure that those who cannot afford a lawyer will get one.
The support for competition is not a criticism of the Legal Aid Society. It deserves credit for good work on tight budgets. Its high-quality criminal division attracts some of the city’s best lawyers. But the evidence suggests that allowing other bidders will help the poor get even better representation.

Neighborhood Defender Services, a private legal-aid group in Harlem, is nearing the end of a five-year experiment of representing neighborhood defendants. It has generally gotten lighter sentences for its clients than Legal Aid has for comparable defendants — which is, after all, the task of a defender.

In 1990, the Office of Court Administration, citing a lack of quality-control standards in the Legal Aid contract, said it would seek alternative lawyers for juvenile defendants. Legal Aid quickly renegotiated the contract to the city’s liking — and to the benefit of the young clients. This would not have occurred without the threat of competition.

Yes, it may seem surprising to use the traditional Republican approach of free-market competition to insure criminal defendants’ rights. It would surely be easier for any politician to take a get-tough stance and call for harsher sentencing and higher bail. Poor criminal defendants, after all, are hardly a powerful voting bloc. But constitutional protections this important transcend politics.

It is no criticism of the Legal Aid Society to say that competition can improve performance, often in ways we cannot forsee. But we must recognize the dangers of monopoly, especially one vulnerable to strikes, and make sure that lawyers are always available to poor defendants.

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January 29, 1993

Stop the Porn Explosion

How do you explain to a child that the Doll House across the street is not for children but is a topless bar with lap dancing? Or that the movie “Edward Pe-nishands” is not an instructional toilet-training video?
Residential areas across the country have recently been inundated with adult video stores and topless and even bottomless bars. The problem is difficult: freedom of speech must be respected, but no one wants advertisements for “Debbie Does Dallas” plastered on neighborhood walls.

Americans have been taught a healthy respect for the First Amendment. We hesitate to express opposition to pornography and are loath to regulate it. But New York City should follow the lead of other municipalities by issuing zoning regulations to protect neighborhoods from the crime and quality-of-life problems that come with it.

Since 1989, sex businesses in midtown Manhattan have increased by nearly 40 percent. In Chelsea, community groups have demonstrated against a growing concentration of adult video stores; on East 53d Street, two such businesses opened within 30 yards of each other in the same month; a few blocks north, around the corner from an “upscale” topless bar, the owners of a soon-to-be vacated restaurant have received only three offers to occupy the space, each from a topless establishment; and in Queens, a topless bar stopped serving alcohol so it could ignore State Liquor Authority regulations and go bottomless.

Several factors are blamed for this explosion of sex businesses. Voyeurism and masturbation are forms of safe sex in the age of AIDS. People have VCR’s. In recessions, landlords will rent to anyone who can pay. And in New York, cleanup of 42d Street has pushed these businesses to other areas.

Regulating the content of these businesses violates the First Amendment. To avoid such problems, some officials advocate trying to persuade sex businesses to operate more discreetly. But the voluntary approach rarely works. If getting rid of lurid signs and flashing lights were good business, owners would do it on their own. Prurience is profitable; sex sells.

Nonetheless, in Young v. American Mini-Theatres and in City of Renton v. Playtime Theatres, the U.S. Supreme Court upheld the use of zoning laws to restrict sex businesses. Paradoxically, it is not permissible to regulate these establishments simply because they are offensive — though it should come as no surprise that businesses that degrade women and encourage misogynistic violence would generate an increase in crime and prostitution.
Rather, zoning codes are intended to address quality-of-life issues. They may impose reasonable time, place and manner restrictions on sex businesses if it can be shown that the businesses generate social problems. While zoning changes cannot prevent the blatant exploitation of women, they can address other negative effects. In Detroit, adult theaters cannot be within 500 feet of a residential area. In Buffalo, sex businesses must be 1,000 feet apart. And in Boston, these establishments can only be located in the infamous “combat zone.”

Why does New York City lag behind other cities in efforts to combat the ill effects of sex businesses? The sex industry is powerful. It generates billions of dollars each year, and it benefits from the protection of not only the First Amendment but, occasionally, of organized crime as well. In addition, political correctness seems to demand an unthinking fealty to free expression without regard for its negative effects — even when the Constitution allows us to regulate them.

A year ago, Councilman Walter McCaffrey of Queens and I introduced legislation to keep certain sex businesses 500 feet away from residentially zoned areas. Yet no progress had been made on the proposal in the City Council, nor has Mayor David Dinkins shown any support.

Instead, the Department of Consumer Affairs wants to get out of the business of regulating topless bars completely because the constitutional issues are so complex. Thus, while the department advocates a law against loud discos within 200 feet of a legal residence, nothing is done to address topless or bottomless dancing establishments, no matter where they are.

We are fortunate to live in a country that protects its citizens’ rights, and the First Amendment is the paramount protection. But responsible lawmaking requires a careful, nuanced balancing of competing interests. So Debbie may do Dallas — but not in New York City’s neighborhoods.

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May 16, 1992

Why I’m Not Marching in Washington

New York City should receive more Federal funds. But you will not see me marching in Washington today to make that point.

What’s more important is that while the city would benefit from additional Federal finances, its largest problems lie closer to home. With a budget of $30 billion, the city ought to have properly maintained, clean streets — with more police officers on them — safe and effective schools and health care for the needy.

Instead, the city’s Department of Transportation, which gets Federal funds, has dug up 14th Street for necessary repairs, hurting businesses and causing congestion, only to announce that, after the work is completed, the Transit Authority will rip up portions of it for other work.

We raise taxes by hundreds of millions of dollars to put more police officers on the streets, but we cut police department civilian personnel, resulting in an increase of officers behind desks. Sanitation department employees work a half day for a full day’s pay and get a $17 to $23 bonus because they spend the half day on two-worker instead of three-worker trucks. Our public schools spend nearly three times as much per pupil as parochial schools, yet the parochial schools are safer and provide better education. With this management, when Federal funds are limited, can Washington can really consider our city a good investment. Would you invest in a corporation run this poorly? I wouldn’t.

The marchers are likely to point out that the Government’s financial contributions to New York City, as a percentage of the city’s budget, shrank from 1980 to 1990. But Washington’s share of those budgets became a smaller slice of the pie, in part because the city profligately expanded the pie. It added 50,000 employees to the payroll, giving us 575 municipal employees for every 10,000 residents, compared to 344 in San Francisco, 199 in Philadelphia, 146 in Chicago and 145 in Los Angeles.

Critics who say the Bush Administration lacks an urban policy are misguided. It has long recognized that existing approaches are wasteful, and has proposed new ones that invest in people. It wants to eliminate outmoded programs such as job training that provides few marketable skills, and the bureaucracies that surround them. Jack Kemp, the Secretary of Housing and Urban Development, has advocated helping the urban poor to own their apartments or manage their housing projects. He has energetically supported the creation of urban enterprise zones, which offer tax incentives to create businesses in blighted areas.

Home ownership, tenant management in U.S.-owned or subsidized housing projects and entrepreneurship in enterprise zones all encourage creativity in business development and provide people with a stake in their community and power to improve their environment. They seek to reduce poor people’s dependence on the Government to manage their housing and provide their incomes.

Although proposals for enterprise zones have been part of G.O.P. urban policy since the early 1980’s, the House Democratic leadership — and some Republicans — showed little interest until this year. The Democrats cynically attached the enterprise zone proposal to a tax bill President Bush had pledged to veto. Now after the Los Angeles rioting, when it is evident that bipartisanship is necessary to save our cities, some Democratic leaders — along with more Republicans — are expressing genuine interest in these proposals.

So, if the marchers want more funds for housing, I agree. If they seek more for mass transit, I hope they succeed. But if they really want something new from Washington, they should urge the House Democratic leaders to approve an urban agenda that brings useful ideas to the table.

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September 21, 1986

Pinochet Risks Further Chaos

In response to an attempt on his life earlier this month, Gen. Augusto Pinochet is persecuting not just the violent left but also the moderates in the Chilean opposition – the very people who are best able to lessen the increasing risk of a blood bath in his country. By eliminating the middle, General Pinochet risks unleashing the chaos he claims to be preventing.

The Chilean opposition is made up of two factions – one that advocates a violent overthrow of the dictatorship and another, more moderate group that prefers to oust the dictator through political means. Those who profess nonviolence act as a buffer between the regime and the radicals, taking up the frustration of the left while defusing some of its more disruptive tendencies. Their slogan is ”our hands are clean,” and at demonstrations they hold their hands up, open palms forward, signifying their rejection of violence. General Pinochet is using the assassination attempt to justify a crackdown on both factions of the opposition.

The state of siege imposed this month is likely to silence the moderates, suffocating all hope of nonviolent change. The closing of opposition publications and the harassment, arrest and expulsion of church leaders and human rights workers will leave those who oppose General Pinochet with few alternatives to the radical left. In this, the crackdown plays right into the hands of those on the left who would like nothing more than to see Chile plunged into a civil war. Everyone in Chile will be forced to pick a camp, and discoveries of large weapons caches indicate that both sides will be well armed.

Some of General Pinochet’s worst fury has been directed at human rights organizations, long a pillar of the moderate opposition. Since the assassination attempt, two people with close ties to human rights groups have been arrested; priests involved with those groups have been detained or expelled; threats and intimidation have increased. Last week, the General stated bluntly: ”Now the war is going to begin from our side, and we are going to be tough, and all those people involved in human rights and such things are going to be expelled from the country or locked up.”

One of those who has been expelled is the Rev. Pierre DuBois, a French priest with close ties to the Chilean Human Rights Commission and the Vicaria de la Solidaridad, a human rights group associated with the Roman Catholic Church. The pastor of a dirt-poor ghetto known as La Victoria, he adamantly opposes General Pinochet, but he is also known for his efforts to defuse the violence that is common in La Victoria.

I spent a few days there last November during a national protest. I saw three members of the Manuel Rodriguez Patriotic Front – a leading group in the armed opposition – walk down a main street shooting pistols in the air, exhorting residents to join their struggle against the regime. Parishioners sought out Father DuBois, who pursued the three men and demanded that they leave the area.

The next day, as the protest continued, police and paratroopers swept through La Victoria, firing tear gas, shotgun shells, rubber bullets and real bullets. Finally, the police managed to close off one end of a main street, while neighborhood people hid around corners at each intersection, screaming insults and throwing rocks. As the soldiers slowly moved up the street, firing at the crowds, Father DuBois, a nun and another priest stepped into the street between the two groups and walked toward the soldiers. Not knowing how to respond, the soldiers piled into their armored personnel carriers and drove away. It was hard to imagine a more graphic illustration of the mediating role played by people like Father DuBois and human rights groups like the Vicaria. The United States gives Chile no foreign aid and has very limited leverage over General Pinochet. The possibility of voting against pending multilateral loans in the World Bank and the Inter-American Development Bank is one of the few levers at hand. Chile has the highest per capita foreign debt in Latin America and just last year it lifted a state of siege in response to United States abstentions on similar loans. Washington ought to use this tool again to end the current state of siege and stem the polarization that threatens to destroy any hope for a return to democracy in Chile.


March 21, 2013

Pension Plans Evolve into Quasi-Insurers

Plan-sponsoring companies shift assets to fixed income to the point where the plans resemble annuity-provider portfolios. Are companies qualified to run the new-look plans?

Corporations with defined-benefit pension plans are beginning to recognize that having a pension plan is just like having an insurance subsidiary. Increasingly, corporate boards are realizing that insurance subsidiaries are not core to their business, so they must decide either to run the pension plan like a life-insurance company or get an insurance company to run it for them.

The federal government does not regulate insurance companies, but in a strange twist, legislation passed in 2006 has made private-sector pension plans look more and more like insurance companies. Many corporate pension plans are shifting their asset allocations heavily toward fixed income to the point where the plans look more like the portfolios of an annuity provider. In some instances, the pension plan can loom so large that the pension liabilities can swamp the market cap of the corporation.

This can mean the company’s success is based on meeting and managing the annuity liabilities it has effectively insured, rather than on its success in its core business. Corporate boards are increasingly focused on this issue. And for some companies, where the size of the pension obligation is large compared with the size of the company, shareholders are asking, “Why do I want to invest in this manufacturing company when it is really in the insurance business?”

In a classic example of the law of unintended consequences, legislation that was designed to make pension plans safer has turned out to be their death knell. Corporations cannot handle the short-term volatility the law has imposed upon them — of course they can’t: they aren’t insurance companies. And for companies that cannot withstand this funding volatility, de-risking has become imperative.

The Pension Protection Act (PPA) of 2006 requires that corporations value their pension liabilities each year using a measurement approximately equal to AA corporate-bond rates, which are at once-in-a-generation lows. One such measure, the Citigroup Pension Liability Index, has moved from 6.48% to 4.05% in the past five years. That means a liability valued at $1 billion five years ago could be as high as $1.5 billion today.

The PPA was supposed to protect pensions, but its short-term focus on a long term problem has forced corporate-plan sponsors into a classic liability mismatch. Short-term funding obligations based on a freeze-frame of current interest rates create volatility that a true long-term investor might choose to withstand. (A real insurance company would face less volatility because it would require more expensive premiums and higher funding levels.) But corporate sponsors cannot withstand that volatility in annual funding contributions, so they are freezing or terminating their plans.

Individuals will have less retirement security as a result of this legislation, but one can understand why a shareholder would say, “I want to invest in this company’s core competence, not in a midsize industrial corporation with a gigantic insurance company on the side.”

Recognizing that a pension plan is an annuity insurer leads to two essential options: run it more like an insurance company or pay an insurance company to do it for you.

Outsourcing the insurance subsidiary to a proper insurance company can eliminate the pension liability entirely. General Motors and Verizon took substantial steps, through mega-annuity purchases, to limit the risk they face in their pension plans by striking deals for Prudential to take them over entirely. Ford, GM, and NCR announced they would pay lump sums to certain pension participants, and numerous corporate-plan sponsors issued debt and used the proceeds to fund their pensions.

To operate the pension like an insurance company principally means increasing funding levels and buying high-grade bonds along with overlays. Funding contributions can be made out of cash flow, with company stock, up to a relatively low limit, or the corporation can issue debt and use the proceeds to fund the plan. Ford and Goodyear are among the companies that have recently issued debt to fund their plans.

Issuing debt can make sponsors uncomfortable that they are “crystallizing” debt that is contingent. But the pension is real debt. It is floating-rate debt that the corporation definitively owes. That is borne out by the fact that the ratings agencies regularly look upon these transactions as leverage-neutral while mitigating risk. Besides, if the idea is to run the insurance subsidiary more like an insurance subsidiary, remember that no insurance provider would be permitted to operate at the 75%-funded level that is currently typical in North America.

Other sponsors feel that funding up to a liability that is so high when interest rates are so low is too painful and they should wait. Also, if rates rise enough to make the plan overfunded, those funds cannot be recovered. However, most corporations can issue debt so cheaply in current markets that, combined with the tax deductibility of pension contributions, the effect can be net present value and cash-flow positive. Besides, who thought rates could go lower in 2009 . . . or 2010 . . . or 2011. . .?

In addition to increasing funding levels, corporations will likely continue changing their asset allocations such that they look more like an insurance company. In anticipation of a possible annuity purchase, many corporations are considering asset transitions that will make their portfolio more in sync with the portfolio an insurer would want in such a transaction.

Traditionally, the rule of thumb for corporate pensions’ asset allocations was 60% equities and 40% fixed income. Today it tends to more like 50/40/10, with the 10 being alternative investments. Many corporate plans have gone much further in de-risking their portfolios. Ford has stated its intention to move to 80% fixed income, and NCR has stated a goal of 100% fixed income. If the goal is to invest like an insurance provider, a company would need a portfolio that was as high as 80% high-grade corporate bonds (and had much higher funding levels).

There are other ways to move in the direction of running the plan like an insurer that do not go quite so far. Plan sponsors can adopt a dynamic de-risking plan whereby their asset allocation becomes more conservative, but only in a step-wise manner as funded status changes. Or the plan can invest in certain kinds of bonds with cash flows designed to match the cash flow needs of the pension plan. And captive insurance can also provide potential solutions.

Plan sponsors can also take advantage of a 2012 change in law that makes lump-sum calculations more favorable than they had been in the past. More importantly, the GM transaction also made clear that lump sums may be used to pay people who are already retired and in pay status: a change in the pension landscape that makes lump sums a more attractive and more widely available option.

And, of course, plan sponsors can use a “buy-in” to immunize their plan or a buyout to completely eliminate it through an annuity purchase with an actual insurance company. Those transactions can be as complex as an M&A deal and can require many months and numerous work streams and negotiations: after all, it is essentially the “sale” of a subsidiary.

It would be better if the law made it easier for corporations to maintain their pensions intact: more working people would have more retirement security, and corporations would face less volatility in their required contributions. But as long as the law forces the short-term/long-term mismatch, more corporations will be asking, “What are our plans for our insurance subsidiary?”


March 28, 2014

Why Corporate Pension Relief Makes Sense… Permanently

In the debate over whether to extend unemployment benefits, Congress is considering using pension funding relief to help pay the cost. Extension of unemployment benefits may or may not be a good idea, but extension of pension relief certainly is.

Defined benefit pensions have faced tremendous pressure in recent years from the one-two punch of the Pension Protection Act (PPA) of 2006 and, more recently, historically low interest rates that were barely imaginable when that legislation was passed. The relief under consideration would alleviate some of that pressure, making plan sponsors less likely to shutter open schemes and raising revenue—all at the same time.

The PPA and related legislation required that corporations use a discount rate essentially equivalent to AA corporate bond levels to value their pension liabilities. The lower the rate, the higher the value of liabilities and underfunding. The law required corporations to amortize approximately one-seventh of their underfunding each year. The intensity of this funding pressure has caused many corporations to freeze or close their pensions.

But this outcome is not necessary: Pension liabilities never come due all at once. They are paid out over decades. To allow the snapshot of today’s interest rates to dictate the size of contributions holds corporations hostage to the lower interest rates of right-now. It creates a terrible mismatch of long term liabilities measured by rates frozen at any given moment. Using a smoothed discount rate reflecting the movement of interest rates over the decades during which the liabilities will be paid out makes far more sense.

The PPA was passed in the aftermath of the bankruptcy of Bethlehem Steel and other catastrophic failures. When Bethlehem Steel declared itself bust, many were shocked to see that the company’s pensions were less than 50% funded, even though it had complied with all legal requirements for pension funding. The Pension Benefit Guaranty Corporation (PBGC) was hit with a huge obligation that increased its long-term deficit by many billions of dollars.

When Congress passed the PPA, its focus was more on the health of the PBGC than on maintaining a robust defined benefit pension system. If every private sector pension plan were always fully funded, then the PBGC would never face another threat. But if every corporate pension plan were always fully funded, neither corporations nor pension recipients would gain the benefit of long-term investing that can reduce the cost of maintaining a pension. Such an onerous requirement will cause many companies to terminate their plans.

It would be wonderful if all corporations’ pensions were always fully funded. But imagine a healthy company that always maintains its pension at 80% funded. So long as that company is in operation and keeps its plan funded at that level, the investments can grow and the pension plan will always meet its obligations. That company poses little threat to the PBGC.

The threat to the PBCG does not come from underfunded pension plans. It comes from underfunded pension plans in companies that go bankrupt. By the time companies file for bankruptcy they have generally stopped funding their pensions anyway, regardless of legal requirements. In trying to protect the PBGC too much, Congress made maintain plans too difficult, expensive, and volatile, which is why so many have already closed.

In an ironic twist of only-in-Washington arithmetic, the change Congress is considering is counted as a revenue raiser. It was used two years ago to help pay for a transportation bill. That bill offered smoothing—but for only three years. It raised $9 billion in revenue. The current proposal to fund unemployment benefits would last for five years and, due to certain corridors in the relief, would raise about $6 billion. A permanent change would raise over $100 billion. In the near term, corporations would put less current funding in their plans. Less in near-term contributions equals less in near-term deductions, equals less in “tax expenditures,” and is therefore a revenue raiser.

However, lest anyone think this bodes ill for the long-term health of pensions, understand that when rates rise in the future, corporations would not receive complete relief by marking their liabilities way down. In fact, in flush times for pensions—good investment returns, higher interest rates, lower liabilities, better funded status—corporations could not take the funding holidays of the past. Rather, they would have a less volatile, more predictable obligation in good times and bad times.

Whether Congress uses those funds for extension of unemployment or another purpose is a different question. But a bill that makes maintaining pensions more attractive to corporations without reducing long-term funding obligations—and raising billions of dollars in the process—sounds like a clear winner even in today’s political climate.


June 14, 2011

Pension Quandary in Valuing Liabilities

From aiCIO Magazine’s Summer Issue: Legislation has been proposed in Congress that would force states to publish their liabilities using corporate rates. This all leads to the question: What really is the right rate? 

What is the value of your liabilities? This is a question that should be easy to answer. After all, we read articles daily that discuss the funded status of various pension plans. Obviously, in order to state the funded status, someone must have been able to figure out the difference in the value of plan assets and plan liabilities.

Yet here is the rub: The “value” of your liabilities is not the same thing as the liabilities themselves. For most American pension plans, if you know you have to pay a pipefitter $50,000 in the year 2031, you also know that number will not change. Whatever happens to interest rates over the next 20 years, you know that you owe that pipefitter, $50,000. That is your liability.

Yet, when you need to state the “value” of that liability in today’s dollars, that is where the difficulty begins. Let’s assume the pipefitter is 55 years old, is expected to retire at age 65, and is expected to live to be 85 years old with no survivors. Also, let’s assume that your pension plan has just frozen, so the pipefitter is no longer able to accrue additional denned benefits. If you use the interest rate on AA-rated corporate bonds as prescribed by the Pension Protection Act, the present value of that liability is approximately $349,000.

However, let’s assume that the pipefitter is a state employee. In that case you—the pension plan—do not use AA-rated corporate rates to value liabilities; you use your expected rate of return on assets. For most states, that is somewhere around 7.5%. So, the same pipefitter with the same life expectancy and retirement age with the same $50,000 annual payments due from age 65 to estimated age 85 has a value of about $256,000. In each case, the actual value of the obligation is the same—20 x $50,000, or $1 million. So why should the present value of the liability be different

This is more than an academic question. The Pension Protection Act essentially requires the use of AA-rated corporates for private-sector plans. Government accounting standards, however, rely on the expected rate of return on assets. Legislation has been proposed in Congress that would force states to publish their liabilities using corporate rates. This all leads to the question: What really is the right rate? Or is there really only one right rate?

It is appealing to argue that states should value their liabilities the same way corporate pensions do, and this certainly has some merit. But, in the end, it is somewhat facile to simply make this assertion and leave it at that. That assertion assumes that the way corporates measure liabilities is the right way. Is it? If it is the right way for corporates, does that necessarily mean it is right for public plans? Or should liability valuation differ depending upon who is asking and why?

Corporations are required to use specified discount rates for multiple purposes. The accounting standard allows various companies to be evaluated by investors in a consistent way. Since a pension promise is an obligation of the corporation, it should be treated the same as any other corporate debt and should be valued as such. Using AA-corporates as a surrogate for cost of capital may be a little conservative, but that helps lead to better funding, and it is more akin to the way that an insurer would look at the liabilities. Moreover, since corporations are not perpetual and always face the risk of bankruptcy, it is important that accounting standards and public policy encourage high degrees of funding so that, in the event of bankruptcy, the PBGC is not burdened unfairly.

States, on the other hand, have a different cost of funds, perpetual existence, the unlikelihood that an insurance company will ever take over their liabilities, and a clear understanding that time and investing are part of how they intend to meet their obligations. They do not report earnings per share, and you cannot own shares in them. States argue that achieving a 7.5% rate of return is realistic, particularly over decadeslong time horizons. According to Callan Associates, median public pension fund investment returns were 8.7% and 8.8%, respectively, for the 20-year and 25-year periods ending December 31, 2010. The problem in state plans generally has not been the long-term performance of the assets. It has been a problem of proper funding.

It is obvious that many states will face tremendous pressures regarding pensions in coming years. Many are facing them right now. Solving them, however, has less to do with the selection of the correct interest rate and more to do with proper funding practices, fund structures, and investment policies. Whatever the interest rate, we still have to pay the pipefitter.


September 12 2011

Risk Instigation?

From aiCIO Magazine’s Fall 2011 Issue: Charles Millard on what Dodd-Frank proposed reforms mean for pensions. 

The Dodd-Frank legislation was designed to lessen certain risks in our financial system. However, the regulations that will be enacted in the wake of Dodd-Frank will make the use of derivatives much more complex for pension plans, which are increasingly focused on risk mitigation in their portfolios. The ultimate structure of those regulations is not yet final, but the drafts currently in circulation will create significant burdens and make it harder for pensions to hedge their risks.

Imagine you have 10% of your portfolio indexed to the S&P. You are worried that it is overvalued or that you have too much exposure to that source of beta, or you think interest rates are going to change (higher or lower) in the next couple of months and you want to be protected against ways that movement might harm your portfolio. You are acting intelligently to mitigate risks.

Today, you can call a few trading partners—likely partners with whom you have an ISDA and have transacted before. They already have determined that these instruments are suitable for you, so your trader and theirs agree to terms for an index-based swap on the S&P or an interest-rate swap to protect you against an unfavorable change in rates. In the course of a few hours or less, you will have priced your trade competitively, concluded your transaction, and protected your portfolio from the risks that you saw as important.

If current regulatory proposals are finalized, those two simple transactions will likely face significant new regulatory requirements. This list is not meant to be exhaustive.

First, before the trade takes place, you will need to determine whether you are a “commercial end user.” The idea of an end user is that you are not a speculator or an investor, but rather are in this market and need to protect yourself against certain risks. If you are not an end user, your trade most likely will have to be cleared at a clearinghouse and transacted on a regulator-approved trading platform. If you are an end user, then, pursuant to a narrowly crafted exemption, you may not be required to transact your swap in a clearinghouse.

You may think that hedging S&P beta for a pension fund is similar to hedging jet fuel for an airline. However, the proposed regulations in this area indicate that pension plans will be regulated as “financial end users.” If that is their status in final regulations, all their standardized derivatives will have to be cleared. If, however, the transacting entity is a “commercial end user” (or if pension plans are able to persuade regulators that they should not be regulated as financial end users and instead be exempt from the clearing requirements), that still does not exempt the transaction or parties from all regulatory concerns. Even if you are a “commercial end user,” information about your swap will have to be reported to a swap data repository “as soon as technologically practicable.”

If you are a “commercial end user,” the determination whether a particular trade is exempt from the clearing requirements still will vary from swap to swap. The proposed rules do not simply ask about the nature of your entity as a hedging/protecting “end user.” They also look at the transaction and require that it not be “in the nature of,” among other things, “investing.” So, if you hoped not only to protect against risk, but also to generate a positive return on the transaction, then you may be subject to clearing requirements anyway.

So, now, if you are subject to clearing requirements, your swap will have to be executed on a Swap Execution Facility (SEF), if one is available. In those situations, you may not simply call a counterparty directly to transact. Traditional bilateral negotiation, whereby one party uses telephone, e-mail, or other communications to contact a potential counterparty to negotiate a security-based swap, will not be an acceptable method of transacting for cleared swaps. You also may not call various parties seriatim to transact.

Even though, in the past, your swaps may not have been subject to initial margin, under the proposed rules, all cleared swaps will be subject to initial and variation margin. This will make these transactions more costly. The requirement of initial margin may decrease the risk that financial end users place in the system. However, because pensions likely will be considered financial end users, the Dodd-Frank legislation will have the effect of making it more expensive for pension plans to hedge their risks.

The regulatory burden that now looks like it will be imposed by Dodd-Frank is complex. However, beyond those detailed complexities lies one other potential result: The Department of Labor has introduced a definition of “fiduciary” under ERISA that potentially would make a swap dealer who followed the CFTC’s due diligence and disclosure requirements into an ERISA fiduciary. In general, this means that, if you propose something to an ERISA plan, you cannot act as an ERISA fiduciary and then carry out the transaction you have proposed—even if you have met the normal definition of fiduciary in recommending and transacting.

Fortunately, most of the regulatory changes described above have not been finalized. However, it would be a shame if, in the name of taking risk out of the system, we made it harder for pension plans to ­mitigate risks in the first place.


April 9, 2013

Why it Is Time to Diversify US Social Security

Last week, Japan’s largest pension fund, the Government Pension Investment Fund (GPIF), revealed that it is reviewing its asset allocation. As part of Japan’s movement toward “Abenomics,” the pension will be cutting back on its highly concentrated (67%) allocation to Japanese sovereign debt.

The GPIF is realizing that, besides the interest rate risk they take with such a large fixed income holding, they are also incredibly concentrated in one asset class, in one nation. Diversifying Japan’s national pension fund investments is wise—and US Social Security should do the same.

Social Security faces the same issues other pension funds face: longevity risk, reliability of funding sources, asset management. Yet, the Social Security trust fund is completely undiversified in its portfolio. That portfolio is entirely composed of obligations of the United States Treasury. This makes it riskier than it should be. Unlike practically all pensions in the world, Social Security is invested entirely in one asset class, in one country—an approach that would be illegal under US law for corporate pensions. More diversification would provide greater long-term security for the fund and would provide the opportunity for the national retirement system to be healthier and better funded over time.

In the United States, we tend to think of Social Security as something distinct from pension plans. But essentially, it is the same thing. Contributions go into a pool that covers all of us until we die. In a corporate pension plan, the plan sponsor makes the contributions (employees do not see this contribution to the pension plan as part of their compensation, though employers surely see it as a cost of employment); in most public plans employees and the government both see themselves as “contributors” to plans (indeed many public negotiations are about how much the employee will contribute); and in Social Security our “contributions” are taken in payroll taxes that are targeted for Social Security.

Most pension plans pursue prudent and diverse investing to allow growth and reasonable security of their assets over decades. The world’s best pension plans have highly diversified investments that are not concentrated in one asset class or one country. The Teacher Retirement System of Texas is one of the world’s leading investors and has only 22% invested in bonds, and that is not all in treasuries. The Canadian equivalent of Social Security is called the Canada Pension Plan. Its funds are invested by the Canada Pension Plan Investment Board (CPPIB), a completely independent investment organization with hundreds of employees and senior offices as far away as Hong Kong. It has 34% in fixed income. Texas Teachers has returned 7.2% over the past 10 years. CPPIB has returned 6.7% over the same periods.

The Employee Retirement Income Security Act (ERISA), a federal law that regulates private sector defined benefit plans, actually creates a fiduciary requirement that pension plans prudently diversify their investments. The current “investment policy” of Social Security (investment entirely in treasuries) would violate that federal law if Social Security were governed by it.

Over the last 10 years, the annualized return on 30-year government bonds has been 5.8%. That is only a point or so below Canada’s returns, but remember: according to the official website of the Social Security Administration, ten years ago, at the end of 2002, the Social Security Trust Fund held $1.4 trillion. That one percent difference, compounding annually on $1.4 trillion over ten years would have been about $150 billion! 

The return on US treasuries is often spoken of as the “risk-free rate.” Yet we know that no investment is risk free, and the 2011 downgrade of the US credit rating suggests that some investments today are sounder than American sovereign debt. More important than the risk of loss (negligible) is the risk that returns will be lower and riskier than a more diversified investment portfolio would provide. This is particularly true today as many market participants anticipate that rates could rise substantially and quickly; if that were to happen, the value of Social Security’s portfolio could drop significantly.

Plans like Texas Teachers and CPPIB invest heavily in private equity and hedge funds. They’re sophisticated, long-term investors able to analyze the risks and rewards of those investments. Social Security should not go that far. But a sensible start would be to diversify a bit out of its current “one asset from one country” policy. Those more diverse investments should not just go into one asset class, but into a globally diversified portfolio that will provide for a safer and stronger future for our economy and for Americans’ retirement.

In Japan, it is traditional for investors to hold large amounts of the nation’s own debt. Yet even with that tradition, the GPIF has concluded that a two-thirds allocation to the nation’s own debt is too high. If two-thirds is too high in Japan, then 100% is surely too high in the US.


January 7, 2013

Pension Reform Could Stem DB Plan Closures

The fiscal cliff has not been avoided, but it has been pushed out. The debt ceiling is looming, and the long-term deficit of the United States is still unaddressed. In that context, there is a way to reform pension law and raise as much as $100 billion that could be used to reduce the deficit. If this idea were adopted, it could have repercussions for pension investment policy and asset management strategies, as well as help long-only asset managers to operate in a more certain investment environment.

In the private sector, defined benefit (DB) pension plans – a source of retirement security for millions of Americans – are slowly becoming a thing of the past. In a recent meeting in Washington, a prominent senator asked a group of pension plan representatives what Congress can do to strengthen corporate DB pension plans. Unfortunately, for many plan sponsors in the U.S, these calls for reform are coming much too late.

After all, more and more, corporate pension plan sponsors are freezing or closing their DB plans. Many more plan sponsors will do so – which would mean fewer mandates for asset managers to pursue.

But this can be changed if Congress embraces real reform in its pension laws. The right reform will make companies less likely to terminate their pensions, and in many cases existing manager mandates – and raise billions in revenue for plan participants at the same time.

Pensions use a legally mandated discount rate to measure the value of their liabilities. When the interest rate is lower, those liabilities are higher. When the interest rate is at historic lows, as it is today, liabilities and pension underfunding are at historic highs.

Under the pension law passed in 2006, corporations must amortize about one-seventh of their underfunding each year. So, when the underfunding gap is abnormally large, the required contribution is then unduly painful – so much so that corporations look for ways to close their plans. An unintended consequence of the Federal Reserve’s low-interest-rate policy is that many corporations are terminating their pension plans. The right response to this problem is to reform U.S. pension law so that the short-term position of interest rates today does not inflict so much pain on DB plan sponsors that corporations close their plans.

Remember today’s interest rates are kept artificially low by an aggressively accommodative Federal Reserve and the sovereign debt crisis in Europe. Are these institutions and trends really the best predictors of long-term fixed income returns?

The discount rate should not be based on the interest rates we see right now. It should be based on what we think those liabilities are likely to cost over decades. An average, or a smoothed, interest rate makes much more sense. For example, the average of the Citigroup Pension Liability Index (CPLI) for the past three years is approximately 5%; the average of that same rate for the last 25 years is approximately 7%.

If corporations were permitted to use an average of interest rates over the last 30 years, then their obligations would be much easier to meet today. They should still have to amortize their underfunding toward an appropriate standard of funded status, but they should be able to use an interest rate that is more likely to reflect rates over the long time-horizon of pension liabilities.

Keep in mind that this is not a one-way street. The way the law is written today, if interest rates spike higher, the stated value of liabilities will immediately drop, according to the legally-mandated discount rate pensions use to measure their liabilities. Corporations would be able to claim that their pensions were fully funded, and they would have to make no contributions at all.

In contrast, under the interest-rate-averaging proposal, contributions would be required all the time, but on a more manageable and predictable basis. That would not only provide a boost for DB plan sponsors and, by extension, asset managers, but it would also help with federal deficit reduction and the fiscal cliff issues that have been only temporarily resolved.

Congress is already aware that this reform can raise substantial revenue. If smaller pension contributions are made in the next 10 years, then there will be less in tax deductions for those contributions. Using Washington math, decreasing deductions equals increasing revenues.

This past summer, Congress passed legislation that allowed some interest-rate smoothing. However, that provision really only provided relief on a decreasing basis over three years. Numerous corporate pension executives have told me that provides little real relief. Many have decided not to take advantage of it because three years from now they will face these same problems. If Congress were to make this legislation permanent, corporations would be more likely to keep their pensions in place. It’s estimated that such a move could raise between $70 billion and $100 billion more than the $9 billion generated from the existing provision.

If Congress takes this action, corporate DB pension plans would be able to pursue investment strategies that are focused on long-term returns rather than funded-status volatility. If the law remains as it is, expect continued interest in conservative liability-driven investment (LDI) and de-risking strategies, which could lead to pensions missing out on alpha-generation opportunities, as well as continued closing of corporate DB pension plans.

The federal government has always had trouble getting pension legislation right. However, it is generally good at avoiding disaster. While solving the immediate problems of the fiscal cliff and debt ceiling, Congress also can and should address the long-term issue of retirement security for millions of working people. If such pension reform does pass, it would also be a boon for the asset management industry due to the potential to maintain or increase the number of DB pension plan mandates.