Associated Press reports that two Americans are somehow still receiving Civil War veterans’ benefits. Although I’m guessing that a good deal of the media coverage devoted to this discovery will deal with the long-term economic costs of war, I’m fascinated for another reason: the Union Army plan was the first major, federal-level pension program in the United States. Today, as we wonder whether we’ll be able to continue to afford Social Security and Medicare in the decades to come, it’s astounding to discover that the original American entitlement program is still alive, and still paying out.

For those of us not currently reaping Civil War benefits, a little background: the Union Army pension originally covered those injured in battle, and in the late 1800s the program expanded to include veterans who became disabled off the battlefield as well. “Disability” was defined to include old age, and eventually veterans as young as 62, as well as their widows and children, could claim payments. Importantly, in the case of the two remaining pension recipients, children with disabilities would remain on the pension rolls even after they became adults. By 1900, the Union Army pension was the most widespread form of assistance to older adults in the United States, paying out to a quarter of the population 65 and over and accounting for almost 30 percent of the federal budget.

Even more interestingly, the pension provided a natural economic experiment: only some adults received payments, and their behavior could be compared with those, such as Confederate soldiers, who didn’t. My former MIT colleague Dora L. Costa (now at UCLA), after accounting for such variables as the health of the retiree, discovered that as of 1900, workers were vastly more likely to retire if they had the extra income boost of a Union pension. (More about this study, as well as most of the other Civil War-related information I’ve cited here, can be found in Costa’s incredibly detailed and exceptional book The Evolution of Retirement.)

The idea that people would retire if they could afford it may not seem extraordinary now, but in the years leading up to 1900, our modern concept of retirement wasn’t fully formed. Many delayed this step for as long as possible, in part because they would have no choice but to move in with their kids or extended family once their cash flow dried up. But around the turn of the century, retirement began to change. In addition to the Union Army pension, private pensions became increasingly common. More and more retirees were able to afford to live apart from their kids. Leisure started to become cheaper. And, in ever-increasing numbers, people retired who didn’t need to, in the sense that they were physically capable of work. Eventually, the idea that a “worker, after years of productive effort, has earned the right to rest” – even if that worker didn’t physically need it – would help inform the first iteration of Social Security, and, in turn, our current conception of retirement.

Today, little is known about the two remaining recipients of Union Army pensions, except that they live in North Carolina and Tennessee, and they’re almost certainly children of women who married Civil War veterans much older than them in the 1920s or ‘30s. Today, they each draw 876 dollars per year from federal coffers. It’s a price I’m happy we’re paying, if only to serve as a reminder that the way we live our lives is more malleable than we think. Whether we expect to go to high school, college, retire, or do anything else because we see our peers doing it, it’s always a good idea to stop and ask ourselves why. In the case of retirement, it’s eye-opening to discover that our current narrative is tied to a war that concluded 148 years ago.

As with many concepts that we now take for granted as a reality seemingly dictated by the laws of physics, the idea of retirement is a social construction that is subject to change. A combination of factors now challenge today’s notion of retirement. The changing nature of work, economic necessity, smaller and fragmented families, the capacity of public and private pension providers to ensure income that enables 20-plus years of not working for income as well as the desire of many retirement age people to continue working are eroding our expectations of what retirement is and should be. Sometimes big change happens slowly and is barely perceptible at any one moment. Retirement, as we know it today, is history. A new story is emerging – a narrative that will change how we individually plan and behave as well as the government and business institutions that are built to support the retirement we once knew.

The Employee Benefits Research Institute (EBRI) has today released its report highlighting the intense state of insecurity American workers are experiencing as they look forward—with ever increasing trepidation—to a retirement without sufficient money to see them through.

According to the data, American workers have very good reason to be afraid.

Per the survey conducted by EBRI, 57 percent of American workers currently have less than $25,000 in total savings and investments (excluding the value of their homes) put aside for retirement. In 2008, that number was 49 percent. As a result, almost 50 percent of the nation’s workers are either “not too confident” or “not at all confident” that they will have sufficient resources to cover the bills in their retirement—while many who are feeling a bit better about the future may just be kidding themselves.

What’s more, it’s getting worse every year.

In 2009, 75 percent of the nation’s working class had managed to put something away for retirement, even if the amount was insufficient to take care of them in a time of increasing prices and rising life expectancy. Today—just four years later—that number has fallen to just 66 percent of workers who have been able to set something aside for their sunset years.

These dramatic numbers should come as a surprise to nobody as the statistics have long made clear how badly worker income has stagnated in America since the 70’s.

As workers have increasingly struggled to pay their current bills, due to employee earnings remaining static at a time where the high end of the income scale rose to unprecedented heights, it has become all the more difficult for these people to set aside money for their retirement. Further, the decline of the private sector union movement and the end of the defined benefit retirement plans that were once provided to workers as a part of their employment package have only served to make the problem worse.

If you are somehow unaware of the historic stagnation in the wages paid to the American worker since the 70’s, these bullet points, compiled by the Center on Budget and Policy Priorities and based on the Census survey and IRS income reports, should open your eyes:

• The years from the end of World War II into the 1970s were ones of substantial economic growth and broadly shared prosperity.
• Incomes grew rapidly and at roughly the same rate up and down the income ladder, roughly doubling in inflation-adjusted terms between the late 1940s and early 1970s.
• The income gap between those high up the income ladder and those in the middle and lower rungs — while substantial — did not change much during this period.
• Beginning in the 1970s, economic growth slowed and the income gap widened.
• Income growth for households in the middle and lower parts of the distribution slowed sharply, while incomes at the top continued to grow strongly.
• The concentration of income at the very top of the distribution rose to levels last seen more than 80 years ago (during the “Roaring Twenties”).
• Wealth (the value of a household’s property and financial assets net of the value of its debts) is much more highly concentrated than income, although the wealth data do not show a dramatic increase in concentration at the very top the way the income data do.

The point is further graphically made by the following CBO chart (click to enlarge):

As for the availability of the retirement plans that were once provided in return for years of service to one’s employer, the ERBI study notes that, in 1979, twenty-eight percent of American workers were the beneficiaries of defined benefit programs which guaranteed them an income from the day they retired until the day they died.

Today, that number is just 3 percent.

And then there is the decline of the private sector union movement that, in 1970, saw membership peak at 17 million Americans holding union cards. Today that number is just 7.2 million workers.

As all of these worker punishing factors began at roughly the same time as millions of Americans who are now reaching the age of retirement would have begun saving for their non-working years, should anyone be surprised that the average American is now facing a longer retirement without anywhere enough money to pay for it?

Still, what continues to amaze are the many Americans who will find themselves facing true economic disaster as they enter retirement and yet have, these many years, supported the policies of politicians that cheered the income inequality that has created this crisis as somehow being the true expression of American style capitalism. Worse still, these are the very politicians who now seek to cut social security benefits—already insufficient to cover the true costs of retirement—and Medicare.

Soon, millions of Americans will more fully understand the dreadful price to be paid for having backed the wrong horse as the country is left to deal with a serious senior crisis brought on by two generations of employers unwilling to properly compensate workers for their contributions and public policies that rewarded this greed.

You see, while Sarah Palin and friends were quick to declare legislation designed to solve a serious social problem (yes, I’m talking about Obamacare) as the coming of “death panels”, the true death panels—the faceless men and women who formulated the corporate greed policies that will send our seniors into retirement completely unprepared—have been at work in America for many years.

One of the greatest tragedies a decent society can experience is the abandonment of its elderly. We have set the stage for that tragedy to play out in America through policies that have denied millions the opportunity to properly save for their retirement.

The question is, what will we do now?

Pensions & Investments ran a story yesterday about how the California Public Employees' Retirement System is considering moving to an all-passive portfolio. You probably didn't read it, because stories about pensions are boring.

But this story only looked boring. In fact, it was probably the most important Wall Street development you'll read this week. It's an undeniably good sign for people who care about the retirement funds of teachers, firefighters, and other public-sector employees. And it should strike terror into the heart of every hedge-fund manager and private-equity executive in midtown.

The backstory is that, for many years, public pension funds have had a love affair with so-called "active investments" — basically, hedge funds, venture capital funds, private-equity funds, mutual funds, and assorted other outside money managers who charge a fee for managing other people's money. Every year, pensions plow more and more millions of dollars into these funds, hoping for better returns than they could get by buying low-risk index funds and exchange-traded funds on their own. They're happy to pay through the nose for the privilege — most alternative asset managers charge at least a 2 percent management fee and 20 percent of profits — under the assumption that since these complex, active investments make better returns than simple, passive investments, the fees are worth it.

Except that they're usually not. In aggregate, and especially in recent years, most active management firms don't perform any better than a simple, passively managed index fund that costs nearly nothing to buy, and many expensive funds perform significantly worse. As P&I says:

Over the past 10 years, just 38% of large-cap-equity managers have beaten the S&P 500. Over five years, it shrinks to 31%, and over three years, it is just 18%, according to Morningstar Inc. Making things even harder for those trying to pick active managers is that just 9% of large-cap managers outperformed the S&P 500 over all three time spans.

Private-equity firms and hedge funds, in particular, tend to love pensions, which typically provide a majority of the money they manage. (In fact, many private-equity firms and large hedge funds couldn't exist without pensions.) But they haven't held up their end of the deal. Start with their subpar returns, and subtract their onerous fees, and you get a very bum deal for the average pension fund.

But CalPERS — a large and influential fund, which can act as a Pied Piper for lots of smaller pensions — is waking up to the fact that it's paying too much to active managers and not getting enough in return. After years of pushing for lower and lower fees from the private-equity firms and hedge funds who manage its money, CalPERS is considering saying, "You know what? Never mind," and giving up on active management altogether.

This would be a good thing! Most pension funds should not be in the business of selecting active managers, and I would cheer any pension fund that followed CalPERS's example and put more of their money in index funds and passive bond funds. Risky investing isn't always a bad thing, and it's true that some private-equity firms, hedge funds, and mutual funds have done well for their pension investors.

But if they want to handle the retirement money of America's retirees, these firms have to prove they're worth the fees they charge. And so far, they haven't measured up.

Passive investing has reached a watershed moment.

The second-largest pension fund in the United States is considering a move to an all-passive portfolio while at the same time, the largest brokerage firms are falling over themselves to push passively managed exchange-traded funds.

The California Public Employees' Retirement System's investment committee started a review of its investment beliefs last week, with the main focus on its active managers, according to sister publication Pensions and Investments.


CalPERS oversees about $255 billion in assets, more than half of which already is invested in passive strategies.

“It's sort of an exclamation mark on a trend that most are aware of,” said Chris McIsaac, managing director of the institutional investor group at The Vanguard Group Inc.

Fidelity Investments, meanwhile, has responded to the enthusiasm for passive strategies by doubling down on its agreement with BlackRock Inc.'s iShares unit. Fidelity increased the number of iShares ETFs that trade commission-free to its clients to 62, from 30, two weeks ago.

Fidelity's move came just a month after The Charles Schwab Corp. launched an ETF platform that offers investors more than 100 commission-free ETFs.

TD Ameritrade Inc., the third leg of the online brokerage world, has been offering more than 100 commission-free ETFs since 2010.

“We see don't see it as either passive or active, we see it as both. In a low-return environment, fees matter a lot,” said Scott Couto, president of Fidelity Financial Advisor Solutions.

“That's getting interest in passive investing over the short term. Over the long term, active management adds a lot of value,” Mr. Couto said.

“There will continue to be a growing interest in the passive side because cost matters to investors,” said Beth Flynn, vice president and head of third-party ETF platform management at Schwab.

“Virtually all our adviser clients use ETFs in some way, shape or form,” she said. “Usage is much lower on the individual-investor side, but growing at a pretty steady and rapid clip.”

More than 40% of individual investors plan to increase their use of ETFs over the next year, for example, according to a recent Schwab survey.

TD executives couldn't be reached for comment.

SHIFTING PREFERENCE

Passive investing is nothing new. Vanguard founder John Bogle launched the first index mutual fund in 1975. But the fund world has always been dominated by active management.

A decade ago, 86% of the $4.4 trillion in mutual funds and ETFs were in active strategies, according to Lipper Inc.

Investors' preference is clearly shifting, though. Active management's market share was down to 72% as of the end of last month, and passive funds clearly have all the momentum now.

As investors have gotten back into stocks this year, they have done so largely through passive funds. Passive funds took in $65 billion in the first two months of the year, while active funds took in $40 billion.

For anyone who has been watching fund flows over the past few years, the surge in passive strategies shouldn't come as a surprise.

Since 2003, investors have pulled $287 billion from actively managed equity funds, while investing just over $1 trillion in passive funds.

Even though the preference for passive strategies has been most dramatic in equity funds, passively managed bond strategies are gaining steam, as well.

Passive bond strategies have had $260 billion of inflows since the beginning of 2008. Between 2003 and 2007, they had $73 billion of inflows, according to Lipper.

“Indexing has proven to be a very compelling investment strategy, especially for investors with an extended investment horizon,” Mr. McIsaac said.

Costs have played a big part. They are, as Mr. Bogle likes to point out, the only thing that an investor really can control, and passive strategies are much cheaper than their active counterparts.

U.S. equity ETFs have an average expense ratio of 40 basis points, compared with an average expense ratio of 134 basis points for actively managed mutual funds, according to a recent Morgan Stanley Wealth Management research note.

What's more, a number of large-capitalization ETFs charge less than 10 basis points, while the cheapest actively managed large-cap fund charges 50 basis points.

Active managers haven't given investors much reason to stick around.

“Being active over the past 15 years has not been rewarding,” said industry consultant Geoff Bobroff.

The percentage of managers beating their benchmark has been shrinking.

Over the past 10 years, just 38% of large-cap-equity managers have beaten the S&P 500. Over five years, it shrinks to 31%, and over three years, it is just 18%, according to Morningstar Inc.

Making things even harder for those trying to pick active managers is that just 9% of large-cap managers outperformed the S&P 500 over all three time spans.

The inconsistency of actively managed returns is what prompted the review by CalPERS.

As P&I reported: “CalPERS investment consultant Allan Emkin told the investment committee that at any given time, around a quarter of external managers will be outperforming their benchmarks, but he said the question is whether those managers that are doing well are canceled out by other managers that are underperforming.”

'EVALUATING MANAGERS'

Rick Ferri, founder of Portfolio Solutions LLC, ran into the same problem while he was working at a brokerage firm early in his career.

“I spent a lot of time and money evaluating managers,” he said.

“It was a revolving door for most of them,” Mr. Ferri said. “You can't win unless you get very, very lucky.”

Mr. Ferri now runs an all-index portfolio for his clients' equity exposure. On the bond side, he still favors active management — when it is cheap.

“Sometimes that's the best way to get market representation,” Mr. Ferri said.

The $39.2 billion Vanguard Intermediate-Term Tax-Free Bond Fund (VWITX) owns 3,854 bonds and charges 20 basis points, for example. The $3.6 billion iShares S&P National AMT-Free Municipal Bond ETF (MUB), the largest municipal bond ETF, holds 2,196 bonds and charges 25 basis points.

CalPERS is expected to decide the fate of its active managers in about five months. At this point, it looks as though it could go either way.

Chief operating investment officer Janine Guilot told P&I that 27 preliminary interviews of CalPERS staff members, board members, money managers and external consultants showed a “wide disparity of views” on active management.

Mr. McIsaac isn't ready to write off active management altogether.

“There will come a period of time when active managers will do much better,” he said.

That is, if good active management can be found at a low cost.

“It's hard to find both,” Mr. McIsaac said.

The market ultimately will have the biggest say in the future of active management, Mr. Bobroff said.

“Is this the end of a trend?” he asked. “It depends where the market is going over the next five years. Your guess is as good as mine.”

The City of Philadelphia Board of Pensions & Retirement has rethought its approach to hedge fund investing and will seek to weave the funds throughout its $4.3 billion portfolio as a style rather than a separate asset class.

The more open framework, which was adopted after a portfolio review late last year, also calls for higher investment targets to private equity and hedge funds. The new portfolio mix is expected to be implemented this year.

“We have a more flexible model than most public plans that permits us to use hedge fund in real estate or bonds or equity,” CIO Sumit Handa said at IMN’s Public Funds Summit in Huntington Beach, Calif., last week. By introducing long-short strategies into buckets that have traditionally been long-only, the pension fund can more easily slot strategies to dampen volatility into its portfolio, documents indicate. 

Consultant Cliffwater played a role in the asset allocation review and will assist in the execution. The asset allocation review raised the fund’s hedge fund target to 12% from 10%.

While fund officials have as yet disclosed no manager searches in connection with the new strategy, they note that they have been in talks with managers to create special accounts. “We’ve tailored an opportunistic vehicle and we believe we have more coming,” Handa said. Private equity targets will get a boost to 14% from 9.75% and the pension plan is reviewing its pacing schedule.

Fund documents indicate that Philadelphia was working last year with managers to create private equity and hedge fund vehicles that will help it mitigate possible J-curve losses and get earlier distributions. Within the fixed-income bucket, the pension has also done away with the specificity of sub-asset classes such as “high yield,” “non-U.S.” and “emerging markets” and implemented broader categories such as “investment grade” and “non-investment grade.”

 In December, Philadelphia made a $30 million commitment to structured credit-focused Axonic Credit Opportunities Overseas fund, as the first public pension to commit to Axonic Capital, a $1.7 billion New York hedge fund that had previously only raised endowment and private pension dollars, fund documents indicated.

The pension is looking to reduce the number of managers for better risk control and higher returns. “We have too many positions for a $4.3 billion fund,” Handa said at the panel, “We’ll be scaling back on this.” The fund, which has 130 managers, has moved to make higher commitments, generally in the range of $30 million - $50 million. It also shifted 1% of portfolio assets in-house to be managed tactically. 

The latest fund manager Philadelphia disclosed it terminated was credit hedge fund manager Regiment Capital, axed in December for sitting on cash and failing to ride on the high yield and levered loan rally in 2012. Regiment didn’t immediately respond to queries.

The pension fund also restructured its real assets bucket as part of the portfolio overhaul. The target for master limited partnership was raised to 3% from 1.75%. The real estate bucket was reduced and brought under real assets; it had previously been a standalone asset class. In line with the new targets, the pension fund exited J.P.Morgan’s and INVESCO’s core real estate funds, in the view that the core real estate market was overvalued and it was time to redeem cash from both mandates.

Separately, a push to bring smaller managers into the portfolio may be brewing. “We are exploring methods to increase the number of women, minority, disabled and emerging managers into the areas of private equity, real estate and hedge funds,” according to an email from Executive Director Francis Bielli. There is currently no time frame for implementation, he stressed. 

Fred Headon and the in-house labour law team at Air Canada have learned more about pension law in the last 18 months than most lawyers will learn in a career. Over the last decade, Canada’s national airline has been steadily hit with a series of economic hardships — from the New York terrorist attacks in 2001 to the SARS crisis in 2003 and the credit crunch in 2008 — which decimated air travel and led to a series of restructurings.

During 2011 and 2012, Canada’s national airline was locked in bargaining and arbitration with its unions, which Headon, assistant general counsel, labour and employment law, says “had a major pension component.”

The company sponsors a number of defined-benefit and defined-contribution pension plans, which were a major sticking point. Under a DB plan, the employer guarantees a set pension and is on the hook for any shortfall, making it riskier than a DC plan, where employees make investing decisions and their pension depends on the performance of those investments.

In the beginning of 2012, Air Canada’s 10 DB plans were running a $4.2-billion solvency deficit and the company was making past service catch-up payments under federal regulations. It needed to deal with pension issues to move forward.

“Through that process, about three of us — on a pretty full-time basis — were involved in the bargaining given the role that pensions played. We were plugged into the discussion in a way that took up a fair bit of time.”

“It’s an area of law that not many of us studied or specialized in,” says Headon. “When you are in-house, you need to master it quite quickly.”

The legal department’s efforts paid off for the airline. “We secured approximately a $1-billion reduction in solvency liabilities [which at press time were subject to regulatory approval]. We have a template with the unions to get there.”

Headon is not alone in facing pension problems. Management is increasingly calling on in-house lawyers to help deal with pensions. It’s not just solvency issues that organizations and their in-house counsel face. Canada is undergoing an extraordinary round of pension reform at the provincial level, and almost every province has some sort of initiative underway. That, coupled with companies looking to reduce risk or possibly convert from DB to DC plans, has legal departments scrambling to keep up with the change and bring their boards up to speed on developments around pension risk.

Pension reform ‘tsunami’

“There’s a tsunami of pension reform that has been happening in the last couple of years,” says Melissa Kennedy, general counsel and senior vice president of corporate affairs at the Ontario Teachers’ Pension Plan.

As a result she is “being corralled”more and more by her general counsel colleagues and asked about pension reforms. “They are talking about pensions more than the general counsel community ever did.”

Elizabeth Boyd, a pension lawyer at Blake Cassels & Graydon LLP, agrees, adding “there has been a dizzying array of changes. It’s tough to keep up.”

Experts say there are three key areas general counsel and their legal teams need to consider when it comes to pensions: tackling solvency issues around DB plans, keeping abreast of pension law reform, and helping their company de-risk its pension obligations and mind its fiduciary duties.

Facing the solvency crunch

The biggest challenge organizations are grappling with is the growing deficits in their DB plans. At the end of 2011, 93 per cent of federally regulated DB plans were under-funded according to the Office of the Superintendent of Financial Institutions — a far cry from the early 1990s, when many ran surpluses. But that’s only part of the story — most DB plans are provincially governed and face similar problems. It’s not clear what the total liability is for underfunded DB plans in Canada. The Canadian Federation of Independent Business suggests public DB plans alone are $300-billion in deficit. Factor in billions more in red ink from private sector plans and the number starts to get very large, creating a ticking pension time bomb.

Pension deficits are not isolated to Canada. An August 2012 study by credit rating agency Dominion Bond Rating Service Limited looked at 451 major corporate DB plans in the U.S. and Canada, including 65 north of the border. It found funding deficits of US$389 billion. DBRS noted more than two-thirds of plans were “underfunded by a significant margin” and heading into a “danger zone,” the point at which reversing the deficit becomes difficult. It believes 80 per cent “is a reasonable funding threshold.”

The problem for organizations facing solvency deficits is they are required under pension law to make special funding payments to eliminate that shortfall over a tight time frame, in addition to making regular pension contributions. The money comes out of existing cash flow, which puts extra strain on balance sheets as the economy muddles along, and places companies at a disadvantage compared to competitors that do not have underfunded pension obligations.

It’s not just the private sector that’s impacted. Public pensions face the same solvency pressures. Take the Ontario Teachers’ Pension Plan, which pays out more than $4.5 billion a year to pensioners. It is considered one of the best, with more than $117-billion in assets under management, and invests around the world. In 2011, it returned 11.2 per cent, earning $11.7-billion, making it one of Canada’s most profitable entities. Its rate of return since 1990 has been 10 per cent.

Despite that performance, Teachers’ had a funding deficit in 2012 of $9.6-billion and currently its expected pensions costs over the next 70 years are growing faster than the projected value of pension assets. Teachers’ is not alone. OMERS, another big public plan, is expected to have a $9-billion deficit this year and many other public plans are in the same boat.

In fact, Manuel Monteiro, a partner at pension consulting company Mercer’s financial strategy group, estimates only one in 20 DB plans are fully funded on a solvency basis, which is a stress test pension regulators impose on plans.

He said pension deficits are not a big deal for healthy companies. “If a plan is in a deficit position, the company is required to fund that deficit. It’s not a big deal if the company you are working for is strong. If you work for a weak company that has a deficit you have to question if you will get a pension.” Take Nortel, which sought creditor protection in 2009 — a deficit in the plan means pensioners receive reduced payments.

Yves Desjardins-Siciliano, chief legal and corporate affairs officer at VIA Rail, which oversees a $1.7-billion DB pension plan that has a deficit, notes solvency is “an actuarial calculation and not an impending threat. It is an area that requires serious management attention, even at the board level.” Like many companies, he says VIA is looking at ways to address its deficit.

Low interest rates a problem

Experts say the deficit problem is twofold. First, low interest rates are the biggest contributor. Plans simply can’t keep up with the growing liabilities, because fixed-income investments — the lion’s share of most plan assets — are generating such low returns. The DBRS report notes the discount rate, which pension plans use to calculate the present value of future pension obligations, has been plummeting since 2008 and are unlikely to rise anytime soon — though they are bottoming out.

DBRS estimates if the discount rate rises by 2 per cent, the funding gap of almost US$400 billion would be eliminated. It’s certainly achievable given the average discount rate in 2011 was 4.84 per cent compared with 6.27 per cent in 2008.

Since companies cannot control interest rates, it means they must fund shortfalls using voluntary payments, such as BCE did in late 2012, dropping $750-million into its plan. Corporate Canada has an estimated $600-billion sitting on its balance sheet, but the reality is few companies have the luxury of writing a billion-dollar cheque like BCE did.

In fact, experts say companies are reluctant to kick extra money into pension plans because the expectation is interest rates will soon start to rise and much of the funding problem will vanish. Many simply rely on letters of credit to satisfy regulators’ concerns about shortfalls. Monteiro says, “The problem with pension plans is that once you put it in, you can’t get it back easily.”

There are also companies required by pension regulators to make catch up payments and some of those are seeking relief. Take Air Canada. It made $433 million in pension plan funding payments in 2012, which included a special past service catch-up payment of $173 million. For the last three years, Air Canada, whose pensions are federally regulated, has been making catch-up payments under special three-year pension relief regulations passed by the federal government following the credit crisis.

Air Canada projects another past service payment of $221-million in 2013. However, its Q4 financial statement notes the three-year regulation is set to expire in 2014 so Air Canada, with the agreement of five labour groups, is now asking the federal government to cap the past service payment at “acceptable levels” over the next decade or until the plans are no longer in deficit.

Under the recent negotiations with its labour groups, Air Canada secured amendments to existing plans that will reduce liabilities and will put in place a hybrid
pension regime for new employees consisting of both a defined-benefit and defined-contribution component, putting the airline at the forefront of pension reform that is bubbling through corporate Canada.

“We had an awful lot of learning to do,” says Headon. “Issues coming out of pension reform touch a large number of stakeholders.” That meant making sure the large team, which included non-lawyers such as actuaries, tax experts, and managers, were kept up to speed on negotiations.

“Lawyers are in a very good position to play a role to make sure the team has the information they need and are pulling in the same direction.”

Companies seek pension relief

Air Canada is not alone in seeking relief from hefty catch up payments. A group of six Canadian companies — which include telcos, railways, and some former Crown corporations — have long lobbied the federal government for greater solvency relief including the way calculations are made to assess pension solvency and an extension in the amount of time companies can fund their deficits. Michel Benoit, a lawyer at Osler Hoskin & Harcourt LLP who has worked with them, says, “They didn’t get what they wanted. It’s a dead issue right now.”

Canada is at a competitive disadvantage on that front. The U.S. recently modified its rules to allow a 25-year average for calculating the discount rate, rather than confining it to the past few years, which has been artificially low and leads to higher pension obligations. Some European countries are doing the same as the U.S.

Companies seem to have more luck seeking relief from provincial regulators. For example, in Ontario employers can seek to spread deficit funding out over 10 years if employees agree, so a number of companies have recently sought co-operation of their unions to take advantage of that. Some have been successful, others haven’t.

Plan design needs to change

The second primary issue driving deficits is age. Many plans were designed three or four decades ago, when the life span of Canadians was much shorter than it is today. The only way around this is to address the structure of the plan and that could mean hiking retirement ages or looking to move to a DC plan.

“Like other companies have done, we are going to look at changing the design of the plan,” which could mean moving to some type of hybrid plan or a defined contribution plan, says VIA’s Desjardins-Siciliano.

“We are looking at re-designing the plan for new employees going forward in a way that not only preserves or makes it more financially viable, but reflects the reality of the new workforce.”

He notes that while VIA has many employees with 35 or 40 years of service, the average tenure at a Canadian company today is between four to seven years and a defined-benefit plan doesn’t have the draw it did when they were set up in the 1960s and 1970s.

In fact, DB plans are declining in the private sector, largely because of the risk they entail. In a November 2012 pre-budget consultation document presented to the Senate of Canada, lobby group Fair Pensions for All points out that 57 per cent of the Canadian workforce is not covered by pensions. Defined-benefit membership coverage is declining in the private sector, dropping to 1.5 million in 2011 from 2.2 million in 2001, while in the public sector it increased over the same period to 2.9 million from 2.3 million.

Are DB plans dead?

Kennedy, for one, believes in the DB Plan, and says there are “a number of ways of dealing with the solvency issues without throwing the baby out with the bathwater” and moving to a DC plan.

She notes states like Rhode Island and provinces like New Brunswick are developing new plans that aim to provide the upside of a DB plan while limiting exposure, known as shared-risk or targeted plans.

“I think that’s the key. There needs to be shared risk.” To address its deficit issue, Teachers’ has raised contribution rates and lowered benefits and continues to look for ways to address the deficit and provide sustainable pensions.

While studies show DB plans are being shunned and DBRS even predicts their demise in 40 years, Kennedy says DB plans have advantages. “They are a lot cheaper… because you are pooling the risk.” As well, she says, a DC plan puts the risk “totally on the employees” and that may have negative long-term social policy issues if DC plans fail to provide adequate retirement resources. “You’re going to have to pay the piper at some point — if it’s not today, it’s tomorrow.”

Shared risk plans

The key, she says, is building flexibility into the plan. The low-interest rate environment and underfunding is prompting more discussions around creating hybrid plans. New Brunswick, for example, which has had a negative experience with DB plans that have gone belly up leaving pensioners with a shortfall, has introduced shared risk pension plans which attempt to combine the best features of a DB and DC plan.

They remove absolute guarantees, such as indexing, and require both employers and employees to share in the risk, as opposed to the employer assuming all the risk for shortfalls. The plans provide basic benefits, and contributions can increase or decrease depending on the performance of the plan. Additional benefits, such as indexing, depend on whether the plan meets or exceeds expectations. In a stress test of more than 1,000 scenarios, basic benefits under an SRRP were achieved in 97.5 per cent of cases and the average indexation reached at least 75 per cent of CPI. Contributions were also stable, requiring no increases above 1 per cent of payroll.

Currently, some New Brunswick public pensions are converting to the SRPPs. The age for retiring without a reduction in pension will bump from 60 to 65.

Pension law reforms

In terms of provincially governed plans, there are a number of minefields awaiting in-house counsel. Many provinces are introducing changes to their provincial pension laws. As well, the Canadian Association of Pension Supervisory Authorities has introduced an agreement respecting multi-jurisdictional plans, which Quebec and Ontario have signed.The goal is to simplify the administration of plans that operate in more than one jurisdiction and reduce oversight red tape.

Blake Cassels’ Boyd says, “We’re only now starting to understand some of the implications of what they have agreed to.” She explains the “tricky thing” with pension plans is the home jurisdiction for regulating them depends on plurality of members in a plan. That can change as the business grows and acquires or divests operations. There are also hitches in provincial laws when it comes to meeting family law obligations in a separation or divorce.

Grow in rights

Boyd says another thing to watch for in Ontario is “grow in rights,” which are contained in recent Ontario pension reforms. Now, a pension automatically vests once a person joins a plan, as opposed to after two years. As well, if a person who has accrued 55 points (age and service exceed 55) is involuntarily terminated, then they must be allowed to “grow in” to a plan’s early retirement subsidies, which Boyd says can significantly increase the cost of a plan. She adds it’s not clear what happens if someone is fired for willful misconduct. There are also issues to be determined around a voluntary versus involuntary dismissal.

Companies look to de-risk

Ian McSweeney, a pension lawyer at Osler Hoskin & Harcourt, says there is a “spectrum of possibilities,” when it comes to de-risking pension plans. At one end is managing risk through investment and making sure the investment strategy aligns with the execution and matches liabilities. In the middle is the plan design and issues such as whether a DB plan is still feasible or should a company convert to a DC. He says “conversions gets you there over time, but you still have a legacy deficit.” At the other end of the specturm is getting rid of the risk entirely through lump sum payments or annuities.

Desjardins-Siciliano says achieving better pension results can be as simple as reigning in plan costs. VIA started by applying “rigorous management oversight” of expenses related to managing the fund and it reduced cost to 30 basis points from 50, a big savings when you are managing millions of dollars. VIA is also requiring employees to contribute more of their earnings to the pension fund. Employee contribution was 30 per cent and will move to a 40-60 split.

Beware of fiduciary duties

One area where Desjardins-Siciliano says “lawyers really have to be careful and diligent is on the issue of governance.” There is a fiduciary duty on the part of the company to make sure the plan is properly managed. He says in-house lawyers have to limit the risk of conflict when it comes to hiring fund managers or plan administrators.“The obligation is one that requires lawyers at the board level to be very diligent in making sure that all the steps are taken so that — especially in a deficiency or insolvency environment — if you should, god forbid, run out of money, no one can go back and say you are negligent.” It’s the same with things like making decisions on taking contribution holidays.

Larry Swartz has seen both ends of the pension challenge. He is counsel to Morneau Shepell and a principal at the HR consulting firm, which provide pension and benefit administration services. As a lawyer, he is involved in advising his firm on its DC and DB plans and providing clients with advice on theirs.

He says one of the biggest challenges for companies is communicating with employees about their pension options in DC plans in a way that meets the employer’s obligations as a fiduciary. The role of the lawyer in pensions, he says, is helping the company manage risk. For DC plans, that risk can be in deciding how far a company goes in communicating about investment options for its employees. “You need an understanding of trust laws and fiduciary duties so that you can help realize it’s not just company money, you are providing a service for the company that is ultimately for the benefit of the employees.

“It’s an area where the more financial knowledge a general counsel has, the better they can be serving their client.”

It’s taken a while for the economy and corporate Canada to dig the current pension hole and the problem won’t be solved overnight, especially if interest rates don’t start climbing soon. Air Canada’s Headon says while there is light at the end of the tunnel, “pensions are going to remain a pretty significant part of our time for a few years yet.”

Indalex ruling clears air on priority

Employers and financiers can breathe a sigh of relief following a ruling by the Supreme Court of Canada that restores order over debtor-in-possession loans in restructurings. Normally under a CCAA application, a DIP financier is granted a super priority over other creditors, meaning they are first in line to get repaid before secured and unsecured creditors.

By granting that priority, it ensures DIP financiers will get paid, which encourages lenders to loan the much needed money to keep companies operating while buyers are pursued or to re-float financially impaired companies. Without that guarantee, lenders would be reluctant to loan money or would only do so at a higher interest rate to offset the risk they might not be repaid, notes Osler Hoskin & Harcourt LLP lawyer Ian McSweeney. “No one will lend money unless they are certain they will get it back.”

However, an Ontario Court of Appeal threw the traditional view about priorities out the window in Sun Indalex Finance LLC v. United Steelworkers and held company pensioners had priority to repayments of the DIP money by the employer.

The Appeal Court ruled Ontario’s pension laws created a deemed trust for pension shortfalls on a wind-up and there was a constructive trust, which put pensioners at the front of the line when it comes to payback. “The Court of Appeal changed the way everyone thought and the pension legislation concept of a deemed trust,” McSweeney says.

That ruling raised eyebrows among corporate and insolvency lawyers, who were waiting for the Supreme Court of Canada to weigh in. The court did that in early February in a 160-page ruling.

In a complex 5-2 decision — the judges were all over the map on some of the issues — they overturned the Ontario Appeal Court and sided with the financiers over the pensioners. McSweeney says the SCC resolved the case by ruling that a judge appointed under the federal CCAA “can make a super priority charge that trumps out the provincial deemed trust.”

McSweeney notes the case also discusses important issues, such as when an employer who acts as a plan administrator is facing a conflict of interest between the corporate interests and the fiduciary duties it owes to the employees, when a wind-up deficiency is subject to a deemed trust and discussion around constructive trusts. “There is something for everybody in that case,” McSweeney says. “[The judges] cross-agreed with each other on various points.”

Air Canada said a preliminary estimate of its pension solvency deficit has dropped to C$3.7 billion ($3.6 billion) from C$4.2 billion a year ago, reflecting a better-than-expected 14 percent return on plan assets.

Canada's largest carrier said in a recently filed annual information form that the estimate, as of January 1, 2013, was hurt by a decrease in the solvency discount rate to 3 percent from 3.3 percent. Valuations to determine the actual deficit will be completed in the first half of 2013.

Earlier this month, the airline won an extension of the cap on special payments to erase its pension fund deficit. Under the plan, which smaller rivals had objected to, Air Canada will have to pay a total of C$1.4 billion over seven years, or an average of C$200 million a year, with a minimum payment of C$150 million a year.

As an econometrician and a fund-of-funds portfolio manager, I spend much time researching quantifiable metrics to help me identify managers who can outperform consistently. There is, in fact, a rich body of literature exploring different manager selection criteria.

Academic papers have considered portfolio manager attributes, such as tenure, the CFA designation, advanced degrees, and even SAT scores; they have also examined fund characteristics, such as portfolio turnover, expense ratios, and assets under management. Practitioners, especially investment consultants, have additionally focused on more nuanced and qualitative elements such as investment philosophy, compensation scheme, turnover of key professionals, ownership structure, and succession planning.

Ironically, perhaps, most people have given up on the hope that past positive alpha can predict future outperformance with any reliability (see endnote #1). Some might even go as far as asserting that manager outperformance is mean-reverting due to cyclicality in styles and “luck.”

Some of the above-mentioned attributes may provide very incremental information on the true quality of the manager. However, most econometricians, asset owners, and investment consultants confess (although not all publicly) that effective methods for picking top quartile performers remain elusive. As one of my friends at a large Middle Eastern sovereign wealth fund famously proclaimed, “We are convinced that managers who can consistently deliver alpha exist. We are, however, also convinced that we do not know how to find them.” Perhaps, then, the science of manager selection really is about winning what Charley Ellis calls “the loser’s game.”

As my high school basketball coach was fond of reminding me, “If you can’t improve your shooting mechanics, you can still improve your field goal percentage by not forcing bad shots.” His advice is equally relevant to the investment industry: To improve your odds of outperforming, screen out the negative alpha managers. If an investor focuses on eliminating the lower quality managers from his selection universe, the odds for achieving outperformance, in the long run, would be much improved—even if hiring the best managers from the screened short list is still a crapshoot.

So, how does one win in a loser’s game? In this article, I argue that you can significantly improve your odds by employing simple rules for identifying and eliminating underperforming managers.

Predicting Long-Term Underperformance

First of all, we already know quite a bit about the predictors of poor long-term investment performance. High portfolio turnover, high expense ratios, and low active weights (Cremers and Petajisto, 2009; Sebastian, 2013) are quantifiable metrics that tend to predict underperformance in the long run. Qualitatively, anecdotes suggest that high turnover in the professional ranks, lack of organizational alignment due to poor compensation design, or deficient inter-generational transition planning also hurt long-term investment results. Both finance academics and investment consultants have been working hard on identifying quantitative and qualitative attributes which might predict underperformance.

However, given the reported negative median and average underperformance for active managers, investors will have to work much harder in screening out low quality funds and managers just to get the expected alpha for the screened universe up to zero. For example, the average mutual fund underperforms by 1.6% net of fees; screening out high fee funds merely brings the average active return above −1%. Additionally, many low quality investment organizations are savvy enough to respond to RFPs and interviews carefully so as to tick most of the boxes on a consultant’s due diligence report. The cynical perspective is that asset managers are far more adept at solving the challenge of gathering assets from asset owners than solving the challenge of producing alpha for asset owners.

Importance of Culture

So, how do we spot the lower quality asset managers who fly the colors of high quality managers? Are there other attributes predictive of long-term underperformance that cannot so easily be masked? I believe there are.

Over the past five years, Research Affiliates has engaged outside experts to learn about the transformative power of a positive and healthy corporate culture (see endnote #2). As a quant, I initially approached this new age touchy-feely voodoo magic with a great deal of suspicion. Over the years, I have come to understand and deeply appreciate the enormous impact that culture can have on the individuals who come together as a collective to drive organizational success. As I interact with different organizations and manage my own team, I have discovered that one of the most toxic culture elements for investment management organizations is the culture of blame.

Blame has many brothers, including fear, defensiveness, and self-righteousness. When the four horsemen are present, personal accountability, creativity, openness, and learning go into exile. From what I have heard and seen, when blame lives in an investment organization, professionals take joy in second-guessing investment decisions after poor short-term performance. Whether it is the board blaming the investment staff at a pension fund, or the client facing team blaming the portfolio management group at an asset management firm—the modus operandi is often righteous indignation seeking to assign fault. The logical moves for the investment professionals, in this environment, are either to get defensive and deflect blame onto others or to proactively hide poor results.

Most academics are bewildered by the existence of year-end and quarter-end window dressing of portfolios—it seems too absurd to believe that such ridiculous behavior could persist in the investment industry, where delivering alpha is the only thing that supposedly matters. But to practitioners, buying popular winners at high prices and selling the cheap beleaguered dogs are as natural as can be when one has to deal with reproachful board members or client account managers. When Apple is trading at $800 a share, they question why the portfolio manager did not buy the stock; everyone knows that Apple will take over the world. And when Apple craters to $400 a share, they proclaim that any fool knows the company is only half its former self without Steve Jobs.

Similarly, cases studies have questioned why pension funds and portfolio managers do not rebalance into risk assets after large price declines, given the documented long-term price mean-reversion pattern (Ang and Kjaer, 2011). Most practitioners would readily acknowledge that the driver of this behavior is based in organizational politics rather than investment conviction. In 2009, the ex ante sensible investment decision to rebalance into financial stocks and high yield bonds simply carried too much risk of ex post blame.

When blame prevails, toxic fear becomes the main motivator of behavior. In that culture, people tend to hide problems and/or to be uninvolved, unaware, and unaccountable with regard to anything that might look like a problem. They will not be identifying or solving problems. And a special few might just be too willing to point fingers with righteousness and, of course, with hindsight. It is difficult to imagine long-term investment success from an organization rooted in blame.

On the other hand, we would believe that superior long-term investment results can be produced by an organization which (1) unflinchingly identifies problems, (2) debates them with openness and without blame, (3) emphasizes fixing them, and (4) focuses on learning to avoid similar mistakes in the future.

Investment Organization and the Blame Game

The investment management industry, for better or for worse, is one where the short-term investment results experienced by clients provide little or no information on the true quality of the product. This might be especially true in volatile asset classes like equities where noise is especially prevalent. Given the dearth of actionable information contained in short-term performance, it is simply mind-boggling that so much acclaim and blame can be apportioned on the basis of short-term performance.

A culture of blame in an environment where outcomes are random can only lead to the most perverse behavior. When the organization’s sport is to blame, it hardly matters that the assignment of fault is based on a metric (short-term performance) with no actual informational content. Whatever ceremonial committee meetings occur to conduct the post mortem, proclaim the faults, and distil the supposed lessons—the actual learning can only be naught. After all, how can someone take true responsibility for a random bad outcome and improve his investment process to assure positive random draws in the future?

Learning agility is the most valuable currency for long-term organizational performance in a dynamic environment where new facts are constantly being discovered and new theories are proposed to account for them. However, organizations plagued with fault-finding will often perceive “needing to be right” as more important than learning. Indeed, perhaps we blame others precisely to satisfy the ego’s need to be right. Research finds that the highly intelligent and competitive people often have the greatest need to be right. The investment industry certainly has no shortage of smart, highly competitive people. When investment professionals debate in order to prove themselves right and others wrong, it eliminates the possibility for learning and so the possibility for improvement. When research analysts and portfolio managers focus on appearing to have the truth, they are implicitly committed not to seek the truth but merely to look for confirming evidence.

In my experience, a blame-oriented organization is often one that demands accountability for randomly unfavorable short-term outcomes. A by-product is wasting resources on developing skills to improve the odds of flipping heads on a fair coin.Prolonged exposure to this culture may eliminate creativity and true personal responsibility and replace them with a cynical commitment to the art of covering one’s arse. When an organization’s energy is devoted to CYA instead of creating value, it is difficult to imagine that it could deliver superior long-term investment results. Thoughtful people who build organizations for the long-term don’t tolerate a culture of blame.

Conclusion

In the end, I am an economist, not an organization behavior researcher. My biggest issue with blame in an investment organization is that it seems to be strongly positively correlated with a genuine lack of comprehension for statistics at the most senior level. Blame-oriented investment organizations revel in the drama of short-term performance—there is always something to “hold someone accountable for” (code word: blame) the next quarter. It is difficult to imagine that using short-term results to direct organizational energy and resources would create outputs of substance. If an investment management organization is dominated by people who aren’t wise enough to understand that short-term results are largely random, there can be no hope that this particular organization will be winning the loser’s game.

My advice is to avoid investment organizations with a culture of blame. They are likely very bad at statistics.

Endnotes

1. Paradoxically, many asset managers continue to be hired and fired based on recent three-year performance, despite all evidence pointing to the harm of such a practice. See Towers Watson’s (2011).
2. We have been working with Jim Dethmer’s Conscious Leadership for the past five years on learning and building a strong corporate culture.

Imagine for a moment that Congress woke up one morning, realized that the United States was suffering from a paralyzing long-term unemployment crisis, and, in a moment of progressive pique, decided to create a welfare program aimed at middle-aged, blue-collar workers.

The one thing everybody could probably agree on is that it should help all those jobless 50-somethings find employment, right?

Well, as NPR's Planet Money argues in an eye-opening story, it turns out there already is a "de facto welfare program" for those struggling Americans. The problem is, instead of getting the unemployed back on their feet, it pays them to give up work for good.

I'm talking about Social Security's disability insurance program, which over 20 years has quietly morphed into one of the largest, yet least talked about, pieces of the social safety net. Since the early 1990s, the number of former workers receiving payments under it has more than doubled to about 8.5 million, as shown in Planet Money's graph below. More than five percent of all eligible adults are now on the rolls, up from around 3 percent twenty years ago. Add in children and spouses who also get checks, and the grand tally comes to 11.7 million.

That rapid, under-the-political-radar expansion has turned the program into a massive budget item. As of 2010, its monthly cash payments accounted for nearly one out of every five Social Security dollars spent, or about $124 billion. In 1988, by comparison, it accounted for just one out of eight Social Security dollars. Because disabled workers qualify for Medicare, they also added $59 billion to the government's healthcare tab.

Are disabilities just becoming more common? According to economists such as MIT's David Autor, the evidence says no. The workforce is indeed getting older, and thus more ailment prone. But Americans over 50, who make up most disability cases, report much better health today than in the 1980s. And demographers have found that the percentage of Americans older than 65 suffering from a chronic disability has fallen drastically since then. In the end, economists Mark Duggan and Scott Imberman estimate that, at most, the graying of America's workers explained just 4 percent of the increase in the rate of disability program participation for women, and 15 percent for men, through 2004.

Instead, it seems two things have happened: Qualifying for disability got easier, and finding work got harder. As the Planet Money piece puts it, "there's no diagnosis called disability." According to the letter of the law, disability recipients must prove they are too physically or mentally impaired to hold a job. And early in the program's life, the most commonly reported ailments were easy-to-diagnose problems such as heart-disease, strokes, or neurological disorders. But after the Reagan administration began trying to thin out the program's rolls in the early 80s, an angry Congress reacted by loosening its criteria. Suddenly, subjective measures like self-reported pain or mental health problems earned more weight under Social Security's formula. Today, the most common diagnoses are musculo-skeletal issues, such as severe back pain, and mental illnesses, such as mood disorders -- health problems where the line between a disability and a mild impairment is far blurrier.

Just as the bar for disability fell, the economy turned on the working class. Factories laid off their assembly workers. The service sector picked up the slack. Wages stagnated for anyone without a college diploma. These changes have made disability more attractive for reasons both obvious and subtle. Although program's payments are small -- the average benefit is a bit over $1,000 per month -- they're not much worse than a minimum wage job.Better yet, they're indexed to inflation, meaning they sometimes rise faster than wages, and come with generous government healthcare. For former blue-collar workers who feel they've lost all hope of finding employment, or who don't want to spend their last years leading to retirement standing all day at McDonald's, disability isn't a bad offer.

It's little surprise then that, as MIT's Autor notes, disability applications tend to rise and fall with the unemployment rate (as shown in his chart below), or that most applications come from workers who have recently lost jobs.

If you're a conservative, the reasons to worry about all this are obvious. There are probably a couple million people who could work if absolutely necessary, and are instead choosing to subsist on taxpayer money. The system, from that perspective, is simply being abused.

But the failures here should be obvious to liberals, too. If the job market is so miserably weak that these workers cannot find jobs -- that they are choosing to live in government-guaranteed poverty rather than take a chance on the labor market -- we need to find a better solution than paying them to sit while their skills atrophy. As of now, that's all we seem to be doing. Despite Clinton-era changes to the program that made it possible for participants to ease back into the work force without losing all their benefits, less than one percent of Americans who go on disability ever leave the program.

Moreover, that program, is headed for bankruptcy. As of last year, Social Security's disability trust fund was on pace to run dry by 2016, which would lead to an automatic 21 percent benefit cut affecting all of the program's participants, including the millions who truly can't work because of their impairments.

Like I said, even if we wanted a new welfare program for the struggling poor, this wouldn't be the way to run it.

Keep in mind that some disabled people WANT to work but employers are less than willing to make accommodations. I'd love to work. I HAVE worked. I'm currently in school so that I can get a great job. The problem is that most employers aren't willing to work around my "absences" related to my illness. They hear chronic, frequent atypical migraine and freeze up. If more employers were open to telecommuting and flexible work hours, there would be less of a need for disability for pain related absences for people who WANTED to work.

The fourth quarter 2012 unemployment rate for people with disabilities dropped to its lowest level since the fourth quarter of 2008. The number of people with disabilities applying for Social Security Disability Insurance (SSDI) also reached a four-year low, according to a study by Allsup, a nationwide provider of SSDI representation and Medicare plan selection services.

While this may seem to indicate that the worst of the economic crisis has passed, the unemployment rate for people with disabilities was still 70 percent higher than for those with no disabilities during the fourth quarter of 2012, according to theAllsup Disability Study: Income at Risk. The full study is available at http://www.allsup.com/Portals/4/allsup-study-income-at-risk-q4-12.pdf

Specifically, the unemployment rate averaged 12.4 percent for people with disabilities and 7.3 percent for people with no disabilities during the fourth quarter of 2012. This compares to 13.7 percent for people with disabilities and 7.9 percent for people with no disabilities during the third quarter of 2012. These figures are based on non-seasonally adjusted data from the U.S. Bureau of Labor Statistics.

"The discrepancy in the employment rate between people with no disabilities and people with disabilities is concerning," said Tricia Blazier, personal financial planning manager for Allsup. "If more people with disabilities capable of working were provided the opportunity to do so, the trust fund for the Social Security disability program would be stronger. These individuals would be paying into the trust fund just as other workers do."

Beginning in 2013, the projected assets of the Disability Insurance Trust Fund will fall below 100 percent of the annual costs, according to the 2012 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (2012 OASDI Trustees Report). The DI Trust Fund is projected to exhaust its reserves in 2016.

At that time, revenues from payroll taxes will cover only 79 percent of benefits. This means there would be a 21 percent cut in benefits to the millions of people with disabilities so severe they are unable to work, as well as to their families. At year-end 2012, more than 8.8 million disabled workers received an average monthly benefit of $1,130.34, and nearly 2.1 million children and spouses of disabled workers relied on average monthly benefits of nearly $334.

SSDI Applications Continue to Decline

While the unemployment rate for people with disabilities is still significantly higher than for people with no disabilities, the number of people with disabilities applying for SSDI has declined for the second year in a row.

The Allsup Disability Study: Income at Risk shows that 638,223 people with disabilities applied for SSDI during the fourth quarter of 2012, down from 726,026 for the previous quarter. The quarterly number of applications has not dropped below this level since the fourth quarter of 2008, when there were 577,306 applications.

In 2012, 2.82 million people filed SSDI applications, compared to 2.88 million in 2011. Applications are now down 3.92 percent from the record high of nearly 2.94 million SSDI applications in 2010. The average age of people applying for SSDI is 53.

"The average age of SSDI applicants is about midway in the baby boom generation, so it's likely SSDI applications will remain elevated," Blazier said. "Because of this, more is needed to educate people with severe disabilities about their SSDI benefits. It's also important people understand their options for rejoining the labor pool if their condition improves in the future."

Many people confronted with a disabling condition wait longer than they should to apply for SSDI benefits. Often, Social Security disability applicants must wait several months or years before they receive their benefits. For example, nearly 1.89 million SSDI claims are pending with an average cumulative wait time of more than 800 days, according to Allsup's analysis of the Social Security disability backlog.

Blazier recommends individuals understand the following:

1. Who is covered by Social Security disability insurance?

To be covered, a person must have worked and paid into the SSDI program through payroll taxes (FICA) for five of the last 10 years. They also must be disabled before reaching full-retirement age (65-67) and must meet Social Security's definition of disability. Generally, this means being unable to work because of a verifiable mental or physical impairment expected to result in death, or which has lasted, or is expected to last, for at least 12 months.

2. When should someone with a severe disability apply for SSDI benefits?

Anyone with SSDI coverage who is unable to work because of a severe disability expected to last 12 months or longer or is terminal should apply as soon as possible. It can take two to four years to receive benefits, during which time many people struggle financially as a result of lost income and, often, mounting healthcare costs. The sooner someone applies the sooner he or she may begin to receive monthly benefits. They also are eligible for Medicare 24 months after they start receiving SSDI cash benefits.

3. Is SSDI representation needed?

Individuals can apply for SSDI on their own. However, there are several advantages to having a Social Security disability representative. This is especially true at the initial application. For example, more than half of Allsup claimants are awarded benefits at the initial application level compared to just 34 percent nationally.

4. Can someone with SSDI benefits ever return to work?

Yes. If a person's condition improves to the point where they can return to work, Social Security offers a trial work period, which allows someone to test their ability to work over at least nine months and receive full SSDI benefits no matter how high their earnings. In addition, Social Security's work incentives include the extended period of eligibility, which lasts 36 months. Once someone's benefits stop because they have substantial earnings, they still have five years in which benefits can be reinstated without going through the SSDI application process again -- if they must stop working because of their disability. This is known as expedited reinstatement. Additionally, it's possible to continue Medicare coverage for up to 93 months.

Individuals can determine their Social Security disability benefits using Allsup's free online Social Security benefits calculator. For a free evaluation, or for more information about eligibility for Social Security disability benefits, contact Allsup's Disability Evaluation Center at (800) 678-3276.

ABOUT ALLSUP

Allsup is a nationwide provider of Social Security disability, veterans disability appeal, Medicare and Medicare Secondary Payer compliance services for individuals, employers and insurance carriers. Founded in 1984, Allsup employs more than 800 professionals who deliver specialized services supporting people with disabilities and seniors so they may lead lives that are as financially secure and as healthy as possible. The company is based in Belleville, Ill., near St. Louis. For more information, go to http://www.Allsup.com or visit Allsup on Facebook at http://www.facebook.com/Allsupinc.

For most people, even those with bags of money, having to hand over $616 million to the government would ruin their day. For Steven Cohen, who runs hedge fund SAC Capital Advisers, it was such a relief that he went shopping -- for a Picasso. And a house. A $60 million house.

SAC, which he owns, recently agreed to two fines, one for $602 million and the other for $14 million, to settle two insider trading cases with the Securities and Exchange Commission. The settlements must be approved in court.

Not so fast, federal district judge Victor Marerro said Thursday. In refusing to immediately rubber-stamp the deal, the judge took issue with the fact that SAC was willing to pay a large fine to end the dispute, but not to admit any wrongdoing.

Permeating the story is Cohen's taste for the high life and his willingness to satisfy it publicly. Not long after the settlement was announced, news rolled in that Cohen had completed a deal to buy "Le Reve" by Pablo Picasso, a depiction of the artist's mistress, Marie-Therese Walter, for $155 million. He bought the painting from casino mogul Steve Wynn despite the fact that Wynn had accidentally put his elbow through it, prompting the need for restoration.

At about the same time came stories of Cohen's purchase of a new home in the Hamptons, an enclave for the rich and famous on Long Island in New York, where he already has a house. For the most part, stories have treated it as a colorful episode in the colorful life of a super-rich guy.

But the latest binge of conspicuous consumption may have ruffled the judge's feathers. Gary Aguirre, a lawyer in private practice who worked as a staff attorney at the SEC and helped bring down another hedge fund, Pequot Capital Management, thinks Cohen's actions suggest he is cocksure he won't be prosecuted. And Aguirre wonders whether Cohen just may be right.

"The flagrant, extravagant public demonstration of wealth is an in-your-face reaction to the SEC and the justice system," Aguirre said. "The guy's saying, 'I'll give you $600 million, and then I'll turn around and buy a $60 million house --because I can afford it."

The SEC didn't charge Cohen himself in the civil case, but it has accused several of his employees at his Stamford, Conn., hedge fund. In fact, the FBI today arrested the most senior SAC executive so far, portfolio manager Michael Steinberg, who was arraigned on charges that he traded the shares of two technology companies using inside information. He pleaded not guilty in a federal district court in Manhattan.

Federal settlements with large financial firms, as opposed to charging people criminally or at least taking them to trial on civil charges, have become a hot-button issue as resentment lingers over the longstanding coziness between government regulators and Wall Street, along with the lack of prosecutions stemming from the financial crisis. While agencies such as the SEC, underfunded and outgunned when going up against well-defended Wall Street financial institutions, have frequently chosen to settle, judges asked to approve the deals are getting sick of it.

Most notably, federal district judge Jed Rakoff refused in 2009 to accept a settlement between Bank of America (BAC) and the SEC in a case stemming from a suit over bonuses paid to executives after B of A's takeover of Merrill Lynch. Rakoff in 2011 also rejected a deal reached between Citigroup (C) and the agency, a decision now on appeal before the Second Circuit Court of Appeals.

Other judges have since refused to go along with the deals as well, but it's worth noting that those cases have all involved big banks. The ones that the government has been successfully prosecuting have charged insider trading against hedge funds such as Cohen's.

The sums paid in the settlement deals can be huge. But they have drawn criticism as little more than a cost of doing business, because the profits gained from the illicit transactions, whether insider trading in the case of Cohen's firm or the far more serious money-laundering case recently involving U.K. banking giant HSBC, are even bigger.

"What Cohen has done is to cut a deal, which allows him to pay an excise profit tax to the SEC and walk away," Aguirre said. "The judge said, 'At least we should get an admission that he's done something wrong. It just doesn't make sense to settle for that much if you haven't done anything wrong.'"

Aguirre, while acknowledging that insider trading isn't the most serious of financial crimes, argues that it undermines market stability and needs to be prosecuted.

"The only thing that stops this is for somebody to wake up in the morning in an orange jump suit," Aguirre said. "People then say, 'Hey, Charlie's in an orange jump suit! Should I really be playing this game on the other side of the line?'"

In an extensive interview with Vanity Fair from 2010, the hedgie’s art adviser Sandy Heller revealed Cohen had bought more than 300 pieces since he began collecting in 2000.  Among the works the reporter mentioned in the story were Jeff Koons’ “Balloon Dog” (which is indeed a giant statue of a balloon dog), Vincent van Gogh’s “Peasant Girl in a Straw Hat” (1890), Francis Bacon’s “Screaming Pope” and, Gerhard Richter’s “256 Farben (Colors).”

Among Steve Cohen’s most recognizable possessions is Damien Hirst’s famous shark.  Titled “The Physical Impossibility of Death in the Mind of Someone Living,” the piece features a 14-foot tiger shark pumped with 224 gallons of formaldehyde in order to preserve its body.  Cohen paid $8 million for the 22-ton piece in 2006.

With Picasso’s “Le Reve,” Cohen will add a piece that he’s been pursuing for years, and will deliver a windfall to Steve Wynn. The casino mogul apparently put his elbow through the piece in 2006 as he was showing it off to friends; he had already agreed to sell it to Cohen. Wynn didn’t force the hedgie to buy it, but rather fixed it himself. He reportedly got $45 million in insurance for breaking it, which, added to the final price tag (which was $16 million above the original price agreed with Cohen), means he made more than 43% ripping a six-inch tear into a Picasso. Not bad.

The Securities and Exchange Commission separately filed a civil insider-trading suit against him in Manhattan federal court Friday.

Mr. Steinberg appeared at a brief hearing in Manhattan federal court, dressed in charcoal pants, a white shirt and black sweater, and was released on a $3 million bond secured by his home. He nodded in response to questions from the judge, pleading not guilty.

"Mr. Steinberg was at the center of an elite criminal club where cheating and corruption were rewarded," said George Venizelos, FBI Assistant Director-In-Charge of the New York office. "Research was nothing more than well-timed tips from an extensive network of well-sourced analysts."

The development shows the government continues to aggressively pursue SAC and its employees, just two weeks after the firm agreed to a record $616 million penalty to settle two civil insider-trading suits brought by the SEC. In settling, SAC neither admitted nor denied wrongdoing.

Court approval of the larger $602 million settlement was held up Thursday, as the judge cited a pending case challenging the SEC policy of letting defendants settle without admitting or denying wrongdoing. A different judge will consider the smaller settlement.

The smaller $14 million settlement related to trading by Mr. Steinberg and another portfolio manager at SAC's Sigma unit, according to Friday's indictment and SEC complaint. The SEC said their trading resulted in more than $6 million in illicit profits and avoided losses at SAC based on confidential information.

An SAC spokesman said of Mr. Steinberg: "Mike has conducted himself professionally and ethically during his long tenure at the firm. We believe him to be a man of integrity."

Mr. Cohen, SAC's leader, hasn't been accused of wrongdoing. An SAC spokesman has said both the firm and Mr. Cohen acted appropriately and will continue to cooperate with continuing investigations.

Investors in recent weeks have sought $1.7 billion in withdrawals from SAC funds. SAC portrayed the settlements two weeks ago as a sign it was putting its troubles behind it.

The firm has sought to calm restive investors since then. Mr. Cohen, said a person familiar with the matter, recently spent $155 million to buy a Picasso painting from casino executive Steve Wynn, agreed to pay $60 million for an oceanfront property in Long Island's East Hampton, and listed a Manhattan condo for sale for $115 million.

Friday's charges against a longtime Cohen aide underscore how authorities are attempting to build a case against Mr. Cohen, who people familiar with the matter say is under investigation, and the charges could renew the public image of SAC as a firm under siege.

A federal judge on Monday is expected to rule on whether the city of Stockton, California is eligible for bankruptcy protection, a key milestone in a case likely to set critical precedents for cash-strapped U.S. cities, their employees and their bondholders.

The decision follows a three-day trial last week in which the city argued it had no choice but to file for bankruptcy after the financial meltdown devastated local tax revenues and harsh budget cuts still left the city with a $26 million shortfall.

Municipal bankruptcies have historically been rare, but troubled American cities increasingly see it as an option as they struggle with big debt loads, shrinking tax bases and massive pension and healthcare obligations. The California city of San Bernardino has also filed for bankruptcy, and some expect the city of Detroit, Michigan eventually to surpass Stockton as the biggest U.S. city to file for bankruptcy.

In the Stockton case, attorneys for bond insurers, who could potentially be forced to absorb major losses in a bankruptcy, argued the city could have done more to cut costs and raise revenues. The bondholders, who are not being paid in full under the city's interim operating plan, have also argued that pension payments made to the California Public Employees Retirement System (Calpers) should be slashed.

Bankruptcy experts expect U.S. Bankruptcy Judge Christopher Klein to find the city eligible for bankruptcy.

Michael Sweet, a lawyer at Fox Rothschild who helps local governments on bankruptcy issues but is not directly involved in the Stockton case, said the city had proven even before last week's trial that it was truly broke when it filed for bankruptcy protection last June. A municipality must be insolvent to be eligible.

"It will be hard for the judge to conclude that they weren't insolvent," Sweet said.

Stockton, a city of 300,000 residents in California's Central Valley, aims to use the Chapter 9 bankruptcy process to right the city's finances with a number of drastic measures. The city has already defaulted on some debt and allowed creditors to seize the assets - including a parking garage and a city building - and has cut payments to other municipal bondholders.

The city slashed the police department by 25% and cut other departments even more before it filed for bankruptcy. It has moved to eliminate a generous retiree healthcare plan - a major hit for many former city employees - but has not challenged pension payments to Calpers.

The retirement fund argues that under state law, pension payments cannot be reduced even in bankruptcy - an issue that is also front-and-center in the San Bernardino bankruptcy and one that could eventually find its way to the U.S. Supreme Court.

KEEPING TRADITION INTACT

Bondholders in major U.S. municipal bankruptcies have been repaid all of their principal since at least the 1930s - and Stockton's creditors don't want to see that change.

Bond insurers Assured Guaranty Corp, Assured Guaranty Municipal Corp and National Public Finance Guarantee Corp were joined by Wells Fargo Bank, the Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund in contesting Stockton's bid for bankruptcy eligibility.

Assured's net exposure to Stockton's general fund-backed debt is $158 million. A spokesman for National said the MBIA Inc unit's Stockton-related exposure is $224 million, $89 million of it tied to the city's general fund. Franklin Advisers Inc, holds $35 million of uninsured Stockton lease revenue bonds.

Lawyers for the creditors argued to U.S. Bankruptcy Judge Christopher Klein that Stockton did not meet requirements to be eligible for bankruptcy court protection.

They claimed Stockton officials did not do enough to mend the city's finances and acted in bad faith by exempting the city's largest creditor - Calpers - from concessions in a mandatory pre-bankruptcy mediation.

They also said Stockton is not really broke, and that city officials are conflicted because they have accounts with the pension fund.

James Spiotto, a municipal law specialist at the Chapman and Cutler law firm, said that attack fell flat, noting that a finding of bad faith is a high bar.

CITY FINANCES A MESS

Stockton's legal team, which includes lawyers who worked for Vallejo, California in its 2008 bankruptcy, said the city needs to maintain pensions to retain and recruit employees, especially police officers who patrol a city with one of the highest crime rates in the country.

Stockton's officials note they have slashed $90 million in spending over three years, and say that deeper cuts would threaten public safety.

Ahead of the filing, Stockton won concessions from its unions and implemented the retiree healthcare cuts but has remained at odds with all but one of its capital markets creditors.

Judge Klein said at the close of the trial on Wednesday that a verbal ruling on eligibility would likely come on Monday. A written opinion would follow, and if the judge affirms its eligibility for bankruptcy, the city could then begin drafting a so-called plan of adjustment for its debts. At the same time, the capital markets creditors would be able to appeal to U.S. District Court or a bankruptcy appellate panel.

If the city is ineligible it could operate under its current budget while seeking concessions from creditors, who could press claims against the city in state or federal court.

Stockton's spokeswoman said a plan of adjustment would largely be guided by the city's so-called pendency plan, essentially the city's $155 million budget. Because it leaves pension payments intact, Stockton's capital markets creditors could strike at them again as a plan of adjustment takes shape.

"They'll still have the point unless the judge rules on it, which I doubt he will. That will be an issue for later on," Spiotto said, adding the eligibility trial was "a battle, not the war. The real game is coming up with a plan that works."

On its first official day in bankruptcy, the city of Stockton now must grapple with the hard part of reorganizing its financial affairs — how to share the financial burden equitably among creditors while meeting its massive state pension obligations.

At the conclusion of a three-day trial, a judge on Monday formally granted the city Chapter 9 protection, over the objections of creditors who questioned whether it was fair for the city to fully meet its obligations to the state pension system while other debt holders go partly paid.

The issue — whether federal bankruptcy law trumps the California law that requires pension fund debts to be honored — could have huge implications across the state and the rest of the nation, experts say.

"The fear is that there is going to be a run on the bank," said bankruptcy attorney Michael Sweet, who has been monitoring the Stockton trial. "Everyone is going to be cutting CalPERS" payments if Stockton is allowed to do it.

California's $225 billion Public Employees Retirement System already is underfunded by $87 billion, which means there are more payments due to retirees than there is money in the system.

Stockton's biggest creditors insured $165 million in bonds the city issued in 2007 to keep up with CalPERS payments as property taxes plummeted during the recession. Stockton now owes CalPERS about $900 million to cover pension promises — by far the city's largest financial obligation.

Nearly two dozen California cities, from San Jose and Watsonville to San Bernardino and Compton, either are facing bankruptcy or financial emergencies — and their hefty pension costs are getting heightened scrutiny.

"This is just the beginning of a multi-dimensional.... well, I can't say chess game because it's not a game," said attorney Karol Denniston, a municipal restructuring expert. "There's not one thing that will fix the pension system. The net message is you can't see a restructuring when the largest creditor isn't being restructured."

Last year, the Congressional Joint Economic Committee reported that unfunded pension obligations across the nation amount to more than $2.8 trillion and may be as high as $4.4 trillion. Illinois lacks funds for nearly 72 percent of the pensions it guarantees, while California and Texas are short by more than half. North Carolina's debt is lowest but is still more than a third short of what its system has promised to pay out.

Experts say that state pension funds are acting like the banking industry before the financial collapse by engaging in risky behavior and racking up unsustainable obligations.

"In the private sector there is insurance," said Sweet. "CalPERS is working without a net. If they fail and if Stockton is allowed to impair the CalPERS payments, then who knows who's next?"

A major focus in the next phase of Stockton's bankruptcy proceedings will be whether pensions negotiated in good economic times can be cut.

"I don't know whether spiked pensions can be reeled back in," U.S. Bankruptcy Judge Christopher Klein said during his ruling on Monday. "There are very complex and difficult questions of law that I can see out there on the horizon."

Attorneys for CalPERS at times attempted to speak to the creditors' assertions that the pension fund should share any pain in Stockton's recovery plan, but the judge said their time would soon come during proceedings.

"It's no secret (creditors) have CalPERS in the crosshairs of the dispute," Klein said.

The city of nearly 300,000 has tried to restructure some debt by slashing employment, renegotiating labor contracts, and cutting health benefits for workers. Library and recreation funding have been halved, and the scaled-down Police Department only responds to emergencies in progress. The city crime rate is among the highest in the nation.

Since cities can't liquidate assets, those that declare bankruptcy must come up with a plan for creditors to forgive some of the debt.

So far, Stockton has kept up with pension payments while reneging on other debts, maintaining it needs a strong pension plan to retain its pared-down workforce.

Legal observers of the first-ever Chapter 9 bankruptcy case questioning state pension obligations expect an appeal to decide whether the 10th Amendment that gives rights to states is more powerful than federal bankruptcy code.

Either the judge will decide that CalPERS obligations must be cut and the state will appeal, or he will say state law forbids CalPERS from negotiating and the creditors likely will appeal.

"We're going to get new precedent no matter what happens," Denniston said.

Stockton, California, is eligible for bankruptcy protection, a federal judge ruled on Monday, turning aside creditors' arguments the city was not truly insolvent when it sought protection and improperly failed to seek pension concessions.

U.S. Bankruptcy Court Judge Christopher Klein's ruling permits Stockton to proceed with a Chapter 9 municipal bankruptcy case after it became the largest U.S. city ever to file for bankruptcy.

The decision is likely to increase scrutiny of how the city will handle its pension obligations, managed by the California Public Employees Retirement System (Calpers).

Stockton is being closely watched by the $3.7 trillion municipal bond market and by other cash-strapped cities.

Creditors have claimed a lack of good faith by Stockton in its decision to fully pay its obligation to the $254 billion Calpers system but impose losses on bondholders and bond insurers.

The expected move by the California city of 300,000 - along with Jefferson County in Alabama and San Bernardino in California - breaks with a long-standing tradition to fully repay bondholders the principal in most major municipal bankruptcies.

CALPERS ISSUE LOOMS

In a lengthy preamble to his ruling, Klein delivered a stinging rebuke to the so-called capital market creditors - mainly the insurers for bondholders who own hundreds of millions of dollars of Stockton debt - who had opposed the bankruptcy filing.

Klein said capital market creditors had failed to negotiate in good faith in a pre-bankruptcy mediation, as required by law, and also criticized their refusal to foot part of the bill for mediation. He dismissed their arguments that the city wasn't really broke, stating that Stockton was "by any measure insolvent" prior to its filing.

The judge also rejected the argument that city had improperly exempted the $254 billion Calpers from concessions during the pre-bankruptcy mediation. He did, however, suggest that the issue of how pension payments are treated will be a central issue in the case going forward.

"This does not mean there is not potentially a serious issue involving Calpers," Judge Klein said in reference to his ruling. "But at this point I do not know what that is." He added that there were "very complex and difficult questions of law that I can see out there on the horizon," relating to Calpers.

But those issues are properly addressed as part of the effort to finalize a so-called "plan of adjustment" for emerging from bankruptcy.

"SCORCHED EARTH" TACTICS

Bob Deis, the Stockton city manager who is largely responsible for managing the bankruptcy process, called the judge's verdict a "vindication" of the city's position. He criticized the "scorched-earth" legal strategy of the bond creditors as a waste of time and money and said the city had already spent $6 million to $7 million on the mediation and legal costs.

Assured Guaranty Ltd., one of the bond insurers, said in a statement that it "disagrees" with the Judge's ruling but that it looked forward to working with the city on a "consensual approach" to resolving its debts.

Bond insurers Assured Guaranty Corp, Assured Guaranty Municipal Corp and National Public Finance Guarantee Corp were joined by Wells Fargo Bank, the Franklin California High Yield Municipal Fund and Franklin High Yield Tax-Free Income Fund in contesting Stockton's bid for bankruptcy eligibility.

They argued that the city could have done more to cut spending and raise taxes, and that it was unfair to demand concessions from bondholders without also demanding cuts in payments to Calpers.

But Judge Klein, citing crime statistics and the city's extensive cost-cutting pre-bankruptcy, agreed that further cuts in public safety and other services were not options.

He also rejected bondholder arguments that they were not required to negotiate in good faith in the mediation, noting that it was impossible to negotiate with a "stone wall."

The Ontario Teachers’ Pension Plan delivered a 13% rate of return for the year ended December 31, but the multibillion-dollar plan continues to face pressure from sustained low interest rates and challenging demographics.

The results last year drove net assets up to $129.5-billion from $117.1-billion at the end of 2011.

“Returns earned above our benchmark directly support the goal of pension security and demonstrate the value of our approach to active investing,” said Jim Leech, chief executive of Teachers, who also announced Tuesday that he plans to step down at the end of the year.

Mr. Leech said he has informed the board of Canada’s largest single-profession pension plan about his planned retirement on Dec. 31, and a search is being conducted for his replacement.

“They’ve been running a very intensive process, looking externally and internally,” said Mr. Leech, who is turning 66 in June.

He said the plan’s investment team “successfully navigated significant risks and turmoil in the global economy” to earn “excellent” returns in 2012. Investment earnings were $14.7-billion, compared to $11.7-billion in 2011.

The 10-year annualized rate of return is 9.6% and the fund’s total value has nearly doubled since 2002, when net assets were $66.2-billion.

But despite a recent string of double-digit returns, the Teachers’ pension plan was only 97% funded as of Jan. 1, 2013.

Just last year, changes were made by the plan’s sponsors to balance plan assets and liabilities. The Ontario Government and the Ontario Teachers’ Federation agreed to make inflation protection on service credit earned after 2013 conditional on the plan’s funded status.

However, a preliminary shortfall of $5.1-billion was projected due to declining interest rates which drove up the projected cost of future benefits.

Many plans face challenges from sustained low interest rates, but the Teachers’ pension plan faces unique challenges related to demographics and years of service.

Longevity rates for teachers are among the highest in the country, and the pension plan now has 2,800 pensioners over the age of 90, including 107 who have reached or passed age 100.

The average number of years worked is 26, compared to an average 31 years on a pension.

Mr. Leech said he is encouraged that the plan’s sponsors are “committed to address the imbalance for the next valuation filing with the regulator.”

“While the defined benefit pension is far and away the superior and least expensive model for retirement financing because it pools funding, longevity and asset mix risk, it must evolve to this new demographic and financial reality,” said Mr. Leech.

“This means building flexibility into the cost of benefits to ensure their affordability for pension plan members and sponsors alike for years to come.”

Since 1990, investment income has accounted for 77% of the funding of members’ pensions, with the balance coming from member and government contributions.

Ontario Teachers’ Pension Plan, Canada’s third-biggest retirement-fund manager, posted a 13 percent return on investments in 2012, led by real estate, private equity and stocks.

Net investment income rose to C$14.7 billion ($14.5 billion) from C$11.7 billion in 2011, the Toronto-based pension- fund manager said today in a statement. The fund managed C$129.5 billion in assets as of Dec. 31, up from C$117.1 billion a year earlier.

“The investment team successfully navigated significant risks and turmoil in the global economy again in 2012 to earn an excellent rate of return,” Chief Executive Officer Jim Leech, 65, said in the statement. “This was an oustanding achievement during a challenging year.”

Ontario Teachers’ beat the 9.4 percent median return of Canadian pension funds in 2012, based on a Jan. 29 report by Royal Bank of Canada’s RBC Investor Services unit. In comparison, Caisse de Depot et Placement du Quebec, Canada’s largest pension-fund manager, returned 9.6 percent, Ontario Municipal Employees Retirement System gained 10 percent, and Healthcare of Ontario Pension Plan rose 17 percent.

Teachers’ is responsible for investing and managing pensions for about 303,000 active and retired teachers in Canada’s most populous province.

Teachers’ said public and private equity investments returned 14 percent in 2012, while fixed income holdings returned 5.1 percent. Commodities lost 1.9 percent last year.

Investments held by Teachers’ private-equity unit returned 19 percent in 2012, the pension fund said. Teachers’ Private Capital managed C$12 billion of assets at the end of the year, compared with C$12.2 billion a year earlier.

Real assets such as real estate, infrastructure and timberland returned about 15 percent. The fund’s real-estate portfolio, which had C$16.9 billion of assets, returned 19 percent for the year.

Teachers’ estimated funding shortfall was C$5.1 billion, down from C$9.6 billion a year earlier, after changes to inflation-protection guarantees for plan members were announced in February.

We use absolute return strategies to generate positive returns that are constructed to be uncorrelated to the returns of our other asset classes. Our internally managed absolute return strategies generally look to capitalize on market inefficiencies. We also use external hedge fund managers to earn uncorrelated returns, accessing unique strategies that augment returns and diversify risk.

Assets employed in absolute return strategiestotalled $12.3 billion at year end, unchanged from December 31, 2011 (click on image below). Money-market activity provides funding for investments in all asset classes, and is comparable to a treasury department in a corporation. Derivative contracts and bond repurchase agreements have played a large part in our investment program since the early 1990s. For efficiency reasons, we often use derivatives to gain passive exposure to global equity and commodity indices instead of buying the actual securities. We use bond repurchase agreements to fund investments in all asset classes because it is cost effective and allows us to retain our economic exposure to government bonds.

I’m starting with the man in the mirror
I’m asking him to change his ways
And no message could have been any clearer
If you wanna make the world a better place
Take a look at yourself, and then make a…
Chaaaaaaaange .....

— Michael Jackson

Am I a great investor? No, not yet. To paraphrase Ernest Hemingway’s “Jake” in The Sun Also Rises, “wouldn’t it be pretty to think so?” But the thinking so and the reality are often miles apart. When looking in the mirror, the average human sees a six-plus or a seven reflection on a scale of one to ten. The big nose or weak chin is masked by brighter eyes or near picture perfect teeth. And when the public is consulted, the vocal compliments as opposed to the near silent/ whispered critiques are taken as a supermajority vote for good looks. So it is with investing, or any career that is exposed to the public eye. The brickbats come via the blogs and ambitious competitors, but the roses dominate one’s mental and even physical scrapbook.In addition to hope, it is how we survive day-to-day. We look at the man or woman in the mirror and see an image that is as distorted from reality as the one in a circus fun zone.

Yet at first blush, there is a partial saving grace in the money management business. We have numbers. Subjective perceptions aside, we have total return and alpha histories that purport to show how much better an individual or a firm has been than the competition, or if not, what an excellent return relative to inflation, or if not, what a generous amount of wealth creation over and above cash … the comparisons are seemingly endless yet the conclusions nearly always positive, rendering the “saving grace” almost meaningless: everyone in their own mind is at least a six-plus or a seven, and if not for the most recent year, then over the last three, five, or 10 years. Investors thrive on the numbers and turn them in their favor when observing their reflections. That first blush becomes a permanently rosy complexion with Snow White cheeks.

The investing public is often similarly deceived. Consultants warn against going with the flow, selecting a firm or an individual based upon recent experience, but the reality is generally otherwise. Three straight flips of the coin to “heads” produces a buzz in the crowd for another “heads,” despite the obvious 50/50 probabilities, as do 13 straight years of outperforming the S&P 500 followed by … Well, you get my point. The Financial Times just published a study confirming that a significant majority of computer simulated monkeys beat the stock market between 1968 and 2011 – good looking monkeys that is.

In questioning initially whether I am a great investor, I open the door to question whether other similarly esteemed public icons like Bill Miller are as well. It seems, perhaps, that the longer and longer you keep at it in this business the more and more time you have to expose your Achilles heel – wherever and whatever that might be. Ex-Fidelity mutual fund manager Peter Lynch was certainly brilliant in one respect: he knew to get out when the gettin’ was good. How his “buy what you know best” philosophy would have survived the dot-coms or the Lehman/subprime bust is another question.

So time and longevity must be a critical consideration in any objective confirmation of “greatness” in this business. 10 years, 20 years, 30 years? How many coins do you have to flip before a string of heads begins to suggest that it must be a two-headed coin, loaded with some philosophical/commonsensical bias that places the long-term odds clearly in a firm’s or an individual’s favor? I must tell you, after 40 rather successful years, I still don’t know if I or PIMCO qualifies. I don’t know if anyone, including investing’s most esteemed “oracle” Warren Buffett, does, and here’s why.

Investing and the success at it are predominately viewed on a cyclical or even a secular basis, yet even that longer term time frame may be too short. Whether a tops-down or bottoms-up investor in bonds, stocks, or private equity, the standard analysis tends to judge an investor or his firm on the basis of how the bullish or bearish aspects of the cycle were managed. Go to cash at the right time? Buy growth stocks at the bottom? Extend duration when yields were peaking? Buy value stocks at the right price? Whatever. If the numbers exhibit rather consistent alpha with lower than average risk and attractive information ratios then the Investing Hall of Fame may be just around the corner. Clearly the ability of the investor to adapt to the market’s “four seasons” should be proof enough that there was something more than luck involved? And if those four seasons span a number of bull/ bear cycles or even several decades, then a confirmation or coronation should take place shortly thereafter! First a market maven, then a wizard, and finally a King. Oh, to be a King.

But let me admit something. There is not a Bond King or a Stock King or an Investor Sovereign alive that can claim title to a throne. All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, that an investor could experience. Since the early 1970s when the dollar was released from gold and credit began its incredible, liquefying, total return journey to the present day, an investor that took marginal risk, levered it wisely and was conveniently sheltered from periodic bouts of deleveraging or asset withdrawals could, and in some cases, was rewarded with the crown of “greatness.” Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.

Authors Dimson, Marsh and Staunton would probably agree. In fact, the title of their book “Triumph of the Optimists” rather cagily describes an epochal 101 years of investment returns – one in which it paid to be an optimist and a risk taker as opposed to a more conservative Scrooge McDuck. Written in 2002, they perhaps correctly surmised however, that the next 101 years were unlikely to be as fortunate because of the unrealistic assumptions that many investors had priced into their markets. And all of this before QE and 0% interest rates! In any case, their point – and mine as well – is that different epochs produce different returns and fresh coronations as well.

I have always been a marginal or what I would call a measured risk taker; decently good at interest rate calls and perhaps decently better at promoting that image, but a risk taker at the margin. It didn’t work too well for a few months in 2011, nor in selected years over the past four decades, but because credit was almost always expanding, almost always fertilizing capitalism with its risk-taking bias, then PIMCO prospered as well. On a somewhat technical basis, my/our firm’s tendency to sell volatility and earn “carry” in a number of forms – outright through options and futures, in the mortgage market via prepayment risk, and on the curve via bullets and roll down as opposed to barbells with substandard carry – has been rewarded over long periods of time. When volatility has increased measurably (1979-1981, 1998, 2008), we have been fortunate enough to have either seen the future as it approached, or been just marginally overweighted from a “carry” standpoint so that we survived the dunking, whereas other firms did not.

My point is this: PIMCO’s epoch, Berkshire Hathaway’s epoch, Peter Lynch’s epoch, all occurred or have occurred within an epoch of credit expansion – a period where those that reached for carry, that sold volatility, that tilted towards yield and more credit risk, or that were sheltered either structurally or reputationally from withdrawals and delevering (Buffett) that clipped competitors at just the wrong time – succeeded. Yet all of these epochs were perhaps just that – epochs. What if an epoch changes? What if perpetual credit expansion and its fertilization of asset prices and returns are substantially altered? What if zero-bound interest rates define the end of a total return epoch that began in the 1970s, accelerated in 1981 and has come to a mathematical dead-end for bonds in 2012/2013 and commonsensically for other conjoined asset classes as well? What if a future epoch favors lower than index carry or continual bouts of 2008 Lehmanesque volatility, or encompasses a period of global geopolitical confrontation with a quest for scarce and scarcer resources such as oil, water, or simply food as suggested by Jeremy Grantham? What if the effects of global “climate change or perhaps aging demographics,” substantially alter the rather fertile petri dish of capitalistic expansion and endorsement? What if quantitative easing policies eventually collapse instead of elevate asset prices? What if there is a future that demands that an investor – a seemingly great investor – change course, or at least learn new tricks?Ah, now, that would be a test of greatness: the ability to adapt to a new epoch. The problem with the Buffetts, the Fusses, the Granthams, the Marks, the Dalios, the Gabellis, the Coopermans, and the Grosses of the world is that they’ll likely never find out. Epochs can and likely will outlast them. But then one never knows what time has in store for each of us, or what any of us will do in the spans of time.

What I do know, is that, like Michael Jackson sang in his brilliant, but all too short lifetime, I am and will continue to look at the man in the mirror. PIMCO, Gross, El-Erian? – yes, we’re lookin’ good – in this epoch. If there’s a different one coming though, to make our and your world a better place, we might need to look in the mirror and make a Chaaaaaaaange … Depends on what we see, I suppose. We will keep you informed.

Man in the Mirror Speed Read

1. Investors should be judged on their ability to adapt to different epochs, not cycles. An epoch may be 40-50 years in time, perhaps longer.
2. Bill Miller may in fact be a great investor, but he’ll need 5 or 6 more straight “heads” in a future epoch to confirm it. Peter Lynch is a “party pooper.” Warren is the Oracle, but if an epoch changes will he and others like him be around to adapt to it?
3. No matter how self-indulgent you think this IO is, I just looked in the mirror and saw at least a 7. You must be blind!

William H. Gross
Managing Director

According to Institutional Investor, Rhode Island Treasurer, Gina Raimondo is at work solving the nation’s retirement dilemma, showing how tough public pension reforms can pay fiscal and political dividends.

Don’t believe a word of it.

A look behind the curtain reveals her changes to the investment portfolio of the $7 billion Employee Retirement System of the State of Rhode Island will inevitably dramatically increase both risk and fees paid to alternative investment managers, such as hedge funds and private equity firms.

There’s no prudent, disciplined investment program at work here—just a blatant Wall Street gorging, while simultaneously pruning state workers’ pension benefits. It’s no surprise that some of Wall Street’s wildest gamblers have backed her so-called pension reform efforts in the state legislature. Former Enron energy trader emerges as a leading advocate for prudent management of state worker pensions? That’s more than a little ironic.

What’s happened to date in Rhode Island is unprecedented in public pension history and, given the myriad risks involved, should be setting off alarms: A little-known money manager hired by the state’s pension to manage a paltry $5 million succeeded in getting herself elected as state Treasurer. That means she’s now responsible for overseeing the entire $7 billion.

Essentially, there has been a coup—the foxes (money managers) have taken over management of the henhouse (the pension). To make matters worse, she’s an unproven veteran of the “alternative” investment industry—the hallmark of which is a profound lack of transparency.

Here are more concerns I’ve identified related to the state’s pension that should, in my opinion, be keeping Rhode Island taxpayers and state workers participating in the pension awake at night:

Revolving-doors.“Revolving-door” concerns regularly arise with respect to hiring at government agencies and involve an individual from the regulated industry either assuming the position of regulator or a regulator leaving to join the industry he or she formerly regulated. The State Treasurer has her own revolving door baggage, as does the former CIO of the pension who recently left to join an alternative investment manager—following significant hires of alternative managers by the pension. He is being replaced by a former managing director of hedge fund research at JP Morgan. (Full disclosure: I recently reviewed some JPM hedge funds on behalf of two charitable clients and was less-than-thrilled with the out-of-this-world fees and conflicts of interest I discovered.)

Performance of Point Judith II. The pension committed $5 million in 2007 to a Point Judith II venture fund managed by the soon-to-be Treasurer. Someone should take a close look at the merits related to the decision to invest in Point Judith II, e.g. the track record of the venture manager, or fund; how the investment partnership performed (audited financials) after purchase by the pension and how Rhode Island is treated vis-à-vis the other investors in the fund at redemption/liquidation. It appears that the state pension stopped disclosing the names of its private equity holdings on its website after October 2012. That’s the last time Point Judith II shows up as a private equity holding.

25% Illiquid Investments. Pension statements I reviewed indicate that 25% of the assets are invested in alternatives that are illiquid, which includes equity hedge funds, real estate, real return and private equity. That’s massive risk.

Uncertain Valuations. The 25% of the portfolio invested in alternatives is valued based on mere appraisals, versus readily ascertainable market values. Notes to the financial statements indicate that the pension relies upon the general partners of these alternative investment funds to estimate the value of the partnership investments. Bad idea. What are these assets really worth if they had to be sold quickly—in a forced liquidation? Answer: a lot less. The pension admits, “Fair value is the amount that a plan can reasonably expect to receive for an investment in a current sale between a willing buyer and a willing seller – that is, other than a forced liquidation sale.”

Of course, since the investment performance of alternative assets quoted by the pension is based upon appraisals provided by the managers themselves—managers who are subject to a conflict of interest since they are paid largely based upon performance—the performance of these alternatives is inherently as unreliable as the appraisals.

Gorging on Opaque, High-Risk, High-Cost Investments. If alternatives assets were 25% of the portfolio at year-end, how high will the allocation to alternatives go over time - 40% - 50%?

The pension recently hired 18 more hedge fund managers, greatly increasing operational and investment risk, and dramatically increasing investment management fees. Picking a new CIO for the state pension from the hedge fund industry certainly suggests that more hedge fund investing is in the cards. Just how much investment fees are increasing is unclear because, last I looked the asset-based and performance fees weren’t being fully disclosed. The operational risks related to alternatives are not well-understood, even by industry veterans. With such a massive allocation to alternatives, the pension had better have a cutting-edge knowledge of these risks and be prepared to handle them. I don’t see anything that leads me to believe the pension is rationally assessing these investments.

Reporting of Performance of Alternatives. It appears that a HFRI Fund of Funds Index is being used to benchmark hedge funds—i.e., funds which are not fund of funds. Using a hedge FOF index (that’s easier to beat on a net basis because it involves far greater fees than hedge funds) is inappropriate, in my opinion. Hedge fund performance should be compared against a more appropriate benchmark, such as the S&P 500 plus, say, a 5% operational risk premium.

Engage Rhode Island Contributors. Any connection, direct or indirect, between the pension and donors to this tax-exempt political organization backing the Treasurer should be investigated, in my opinion. The lack of transparency and regulation related to alternative investments gives rise to almost endless possibilities for abuse and I’ve learned to expect anything.

“The cost of public employee benefits in most states and communities is unsustainable,” says the foundation’s website. Not-so-sure about that; on the other hand, it is well-established that the cost and any short-term outperformance of hedge funds are unsustainable. The cure for unsustainable pensions is unsustainable investing?

Undisclosed or Illegal Placement Agent Fees Related to Alternative Investments. Given the pervasiveness of placement agent fees and the number of alternative investments, it is likely undisclosed placement fees were paid here, in my opinion. For example, D.E. Shaw in which the fund invests discloses, “Placement agent activities of the D. E. Shaw group are conducted in the United States through D. E. Shaw Securities, L.L.C., which is registered as a broker-dealer.” Has anyone asked the managers whether any placement agent fees were paid? If so, the SEC might want to know about it.

I’m all for public pension reform—prudent contributing and investing coupled with sustainable benefits. However, when alternative investment managers take control of a state pension and recklessly dump pension assets into high-cost, high-risk alternative investments, while they slash workers’ benefits, that’s no reform. Call it what it is: a money grab.

When Utah State Auditor John Dougall started looking into the investment assumptions of his state's $20 billion pension fund, he was surprised by what he found.

The pension fund bars the public from attending its meetings and doesn't disclose many of the hedge funds in which the retirement system for public employees invests.

"I contend they should be more transparent than they are," said Mr. Dougall, who is urging Utah lawmakers to open up the pension's books and meetings to the public.

Utah pension officials say the state's open-meeting and -record laws don't apply to the retirement system. In fact, it was a big selling point with some hedge funds that agreed to manage money for the Utah Retirement Systems, said executive director Robert Newman.

While Utah's privacy is extreme (most other state pension plans have open meetings), the state isn't alone in shielding investment information from the general public and even its own members.

Disclosure practices by public pensions are drawing renewed attention after federal regulators last month charged the state of Illinois with securities fraud for failing to inform bond investors about the dire condition of the state retirement system. The state agreed to settle the charges without admitting wrongdoing.

Last month, federal prosecutors announced criminal charges against a former Calpers chief executive that exposed the sometimes-murky relationships among pensions, so-called alternative investments such as private-equity and hedge funds, and the placement agents that serve as middle men between the parties.

Many details about private-equity investments by the California Public Employees' Retirement System, also known as Calpers, and other public employee pensions in California remain shielded from the public. Private-equity investment often involves the restructuring of nonpublic companies to boost returns. Keeping the companies' financial information private can give them a competitive advantage and increase profits, pensions officials say.

Calpers discloses the private-equity funds in which it is invested, the amount of the investments and the funds' performance.

But the underlying portfolio companies of its private-equity funds are exempt from public disclosure laws. Also exempt are due-diligence material that pension officials collect when vetting particular investment opportunities.

Other states, including Texas, have formed similar exemptions. Many pension officials had to agree to shield information or lose access to private-equity funds that they are counting on to help them hit investment targets.

In February, state lawmaker Kevin Mullin, a South San Francisco, Calif., Democrat, introduced a bill that would extend similar privacy protections to real-estate investments by pensions.

Critics say the proposed legislation could prevent the public from properly scrutinizing real-estate deals. A Calpers spokesman says the fund is still reviewing the bill.

"They want to build big buildings in L.A. and keep key information about the deal secret?" asks Peter Scheer, executive director of the First Amendment Coalition, a nonprofit group that opposes the bill. "It's hard to think of a category of investment more fraught with opportunities for…corrupt dealings than real-estate development."

Pension officials say they are trying to balance accountability to the public with protecting sensitive investment ideas, and Mr. Mullin's office says it is working with free-speech advocates to find ways the bill can be amended to address transparency concerns.

Even freedom-of-information advocates such as Mr. Scheer say some secrecy is reasonable, particularly relating to venture-capital funds that invest in highly competitive technology companies. If competitors obtain sensitive details about pension investments, it could dent the funds' returns.

The tug of war over pension transparency has also intensified in South Carolina. State Treasurer Curtis Loftis has been pushing the investment commission overseeing the state retirement system to release more information about fees paid to outside money managers.

"There is this fetish for confidentially at these pension funds," said Mr. Loftis, who sits on the commission. "They don't want prying eyes to have access to this information."

In February, Mr. Loftis threatened not to fund an initial capital call on a $50 million commitment to private-equity firm Warburg Pincus LLC unless the commission agreed to give his office a printed contract for the deal.

Most commission members view private-equity contracts using a password-protected website. Mr. Loftis says he wants hard copies so his staff can review them. The commission agreed to print out the Warburg contract, but only for the treasurer to view. It wants his office to sign a nondisclosure agreement for any printouts that would be shared with his staff.

Separately, the commission in February censured Mr. Loftis for engaging recently in what it called "false, misleading, and deceitful rhetoric" about the investment commission. Mr. Loftis called the move a "public ambush."

In Utah, the state retirement system has kept its meetings and many of its money managers private without much controversy for decades. Part of that may be explained by the fund's solid investment performance and healthy funding level of about 79% of its liabilities, above the nationwide average of about 75%. The fund's 10-year annual return is 8.3%, which exceeds its target of 7.5%. "I am not aware of any other system in the country with such a high level of protection," says state audit official Dave Pulsipher.

Utah pension officials say the retirement system has been exempt from open-records and -meeting laws since its inception in the 1960s because it functions as a trust, not a typical public agency.

"We are not doing the public's business," said Mr. Newman, the pension's executive director.

Mr. Newman says that, if the pension has to fully comply with state public-disclosure laws, it could jeopardize its relationship with hedge funds and other so-called "absolute return" money managers, which make up 15% of the pension fund's defined-benefit investments.

Many hedge funds agreed to do business with Utah partly because the pension was exempt from disclosures, Mr. Newman said. In some cases, the exemption has allowed the pension to gain access to detailed information about the hedge funds' investment positions, helping Mr. Newman and others assess risks.

The pension fund plans to work with the state legislature over the next few months studying ways it might increase disclosure. Mr. Newman said he wasn't opposed to opening up portions of the pension-board meetings to the public.

Fitch Ratings said on Monday that local government pension liabilities vary largely for the more than 1,000 local governments it rates, and in some cases it expects the underfunded retirement systems will become a "source of budgetary pressure."

"The situations that pose the greatest concern remain those in which the plan's funded ratio is exceptionally low and contribution levels are already high relative to the budget and rising," the agency said in a special report.

A pension's funded ratio measures the amount of money a retirement system has on hand against its liabilities. A pension with a ratio of around 80 percent is considered well-funded.

The Pew Center on the States recently estimated that U.S. cities have a combined pension shortfall at least $99 billion.

The underfunding and high costs of late have pushed a few cities toward bankruptcy and into protracted political fights with unions. And as cities such as Stockton, California, file for bankruptcy, many in the $3.7 trillion municipal bond market are wondering if the creditors or the pensioners will be paid first.

Fitch said that local governments' pension burdens figure into its credit ratings because unfunded pension liabilities "represent a future claim on government resources."

Earnings provide 60 percent of pension funds' revenues. When investments tumbled during the financial crisis, local and state governments were pressed to make up for the shortfalls. Many struggled to pitch in the extra money as their own revenues buckled under the strain of the 2007-09 recession.

More than half of local governments send money to state-administered retirement systems, but Fitch said "pension contributions remain a source of budgetary pressure for local governments" regardless of whether they participate in a statewide plan.

Since the downturn, almost all states and most local governments have changed the benefits and financial structures of their pension plans. But "in most cases," Fitch said, "pension reforms have only affected new hires, in which case the budget benefits accrue only gradually."

"Where reforms have included current employees or retirees...more substantial and immediate reductions in current funding requirements and unfunded liabilities have resulted," it added. "However, in some situations these changes are being litigated."

The new Governmental Accounting Standard Board's rules set to take effect over the next two years are a "step in the right direction toward better transparency and comparability of government pension liabilities," the rating agency said, adding it does not expect any major rating changes due to these new pension accounting standards.

Under new GASB standards approved in June, state and local governments will post their net pension liability -- the difference between projected benefit payments and the assets set aside to cover them -- on their financial statements.

Also under the new rules, pensions with insufficient assets to cover their obligations will have to project lower rates of return on their investments, closer in line to the yield on a municipal bond.

"The lack of consistently available data across plans to which local governments belong ...poses an analytical challenge for evaluating local governments," the agency said. "Fitch expects that GASB's enhanced pension reporting standards will result in considerably more data to evaluate local governments."

Mayor Rahm Emanuel, who built a reputation in Washington as a blunt problem solver, is grappling with one of the nation's biggest municipal-pension shortfalls, setting up a showdown with labor unions as he stakes his first term on reshaping city government.

The former chief of staff to President Barack Obama inherited a retirement system for teachers, firefighters and other city workers that is underfunded by almost $24 billion—and the bills are starting to come due.

Under Illinois law, the city schools in coming months must resume regular payments to the teachers retirement system at a cost of $404 million a year, or nearly 8% of current Chicago education spending. Mr. Emanuel also faces a state mandate to more than double payments to the pension funds for police, firefighters and other unions.

If these payments were funded by property taxes, his administration estimates residents would face a 150% increase—an option Mr. Emanuel says he won't consider.

His other options also are tough. Mr. Emanuel could try to reach agreements on benefits cuts with individual unions, though such efforts so far have fallen flat. Or he could bypass unions by persuading the Illinois legislature to trim pension benefits for city employees and current retirees or give the city the power to do it.

Much of this could come to a head in the next two months as the legislature grapples with its own huge state-worker pension problems and Mr. Emanuel is pushing for Chicago to be part of any resulting legislation.

Mr. Emanuel's assessment: Workers are paying into a retirement system that makes unrealistic promises, and the city is offering benefits it can't pay. "The system today as constructed is not honest to the employees and is not honest to the taxpayers," he said in a recent interview.

Chicago is one of the most dramatic examples of a fiscal crunch that many states and cities face as underfunding, market losses on pension investments and stagnant tax revenue push some pension funds toward insolvency. Mr. Emanuel's national reputation and the city's long history as a cradle of organized labor could make Chicago a key battleground as public-sector unions fight to fend off attempts to claw back benefits.

Mr. Emanuel won his office in 2011 with little union support as he pledged to shake up the old order. Since then, he has brokered a labor deal at the city's convention center, extended the school day and balanced the city's $8.3 billion budget.

His relationship with several unions has been rocky. Last month, police sergeants overwhelmingly rejected a pension deal the Emanuel administration saw as a model. The mayor faced off with the teachers union last September in a seven-day strike that didn't address the ballooning pension costs but instead concerned teacher evaluations and layoffs tied to school closings. More recently, the teachers led a pushback against the mayor's plan to shutter more than 50 schools.

One recent bright spot for Mr. Emanuel has been a decrease in violent crime. While high-profile crimes such as the murder of 15-year-old honors student Hadiya Pendleton grabbed headlines, the murder rate overall dropped 40% in the year's first three months.

Mr. Emanuel says that pension costs loom over any progress the city makes. Within three years, his administration estimates, annual pension costs for city workers other than teachers will reach $1.1 billion, compared with less than $500 million this year, squeezing services from tree trimming to police patrols.

"There's a set of choices. Reform pensions and continue to be able do other things that are essential for a great city—or make pension payments and do certain things to the rest of the budget that are not part of a great city," Mr. Emanuel said.

A recent study by the Center for Retirement Research at Boston College of 128 county and municipal pension funds found Chicago with three of the 12 most underfunded systems. Chicago is in "a shockingly bad situation," said Alicia Munnell, the center's director.

Chicago has chronically underfunded its retirement systems, setting its annual contribution to the pension funds through a state formula rather than amounts set by actuaries. For the teachers fund, the schools were allowed to pay less than actuaries required. Data from the Boston College study show Chicago on average contributed less than half of what actuaries required between 2007 and 2010, while the vast majority of the cities and counties it looked at paid 100% or more.

Earlier this year, Mr. Emanuel's administration and leaders of the police sergeant's union reached a preliminary four-year contract with a 9% raise in total. In exchange, union leaders pledged to support efforts at the state level to solve the pension issue by reducing cost-of-living increases for current retirees, raising the retirement age and increasing worker contributions.

Union members rejected the deal by a 6-to-1 margin last month, with rank-and-file officers pushing the sergeants to shoot it down. For some officers, the deal belied the mayor's statements that he wanted to work with unions to resolve the pension shortfall. "To me, being a partner shouldn't mean my way or the highway," said Mike Shields, president of Chicago's largest police union.

Sarah Krouse of Financial News reports, US pension lifeboat in need of ‘comprehensive’ reform:

The fund that deals with insolvencies of US “multiemployer” pension plans could be exhausted within just three years, a federal watchdog has warned.

Multiemployer schemes typically cover a number of employers across unionised sectors such as construction, trucking and transportation.

The report on Monday by the Government Accountability Office said the multiemployer unit of the Pension Benefit Guaranty Corporation, the US agency that acts as an insurance fund pension plans, is in need of “comprehensive” reforms.

The number of insolvencies among multiemployer schemes is likely to double by 2017, the report said.

As a result, the insurance fund for those schemes is likely to run dry in 10 to 15 years, the agency warned, but could be exhausted in just two or three years if there are two large insolvencies.

GAO said: “Congress should consider comprehensive and balance structure reforms to reinforce and stabilise the multiemployer system.”

The pension lifeboat is akin to the UK's Pension Protection Fund and covers both single and multiemployer pension plans.

Options for reform include higher charges for employers that leave multiemployer plans or reducing accrued benefits for plans likely to become insolvent, the report said.

Multiemployer schemes tend to be more popular in the US, with 1,500 multiemployer plans in the US covering 10 million workers. A major complication for those plans is the way risks are shared, so that if one employer goes bust, the remaining companies must pay for unfunded benefits of remaining workers. This compares with the UK where many multiemployer schemes are segregated to isolate risk.

The PBGC is a government agency that is privately funded by insurance premiums that are set by Congress as well as investment income, settlements from company bankruptcies and the assets of schemes for the agency acts as a trustee.

A number of US multiemployer schemes have taken steps to improve their funding status since the financial crisis, increasing employer contributions and reducing employee benefits.

Despite this, data from the agency shows that the number of plans that are already insolvent or are expected to become so within 10 years has increased from 90 schemes in fiscal 2008 to 148 plans in fiscal 2012.

As a result, the PBGC’s potential liability has shot up to $7bn in fiscal 2012 from $1.8bn in fiscal 2008. During that time frame, the fund’s assets have only reached $1.8bn.

Overall, the agency covers the pensions of 43 million workers and retirees.

The federal program that protects workers in multiemployer pension plans expects to be exhausted in 10 to 15 years, and the financial hit will most likely land on retirees, a new report said this week.

The Government Accountability Office said the Pension Benefit Guaranty Corporation will be overwhelmed because so many multiemployer plans are so seriously underfunded that they will soon be unable to meet their obligations to retirees.

The plans have suffered from various factors, including losses in the stock market, the impact of the recession on the companies that sponsor the plans, and the growth in the ranks of the retired.

The report recommends Congress consider reforms to allow for the restructuring of the plans, in which a number of companies, bargaining with a union, join in a single pension plan for their employees.

There are about 1,500 such plans, covering more than 10 million workers, the report said. Workers affected are in such diverse fields as grocery stores, hotels, restaurants, theaters, construction and trucking.

GAO reported that 24 percent of the plans are critically underfunded, and an additional 16 percent are underfunded enough to be considered endangered.

“While most critical status plans expect to recover from their current funding difficulties, about 25 percent do not and instead seek to delay eventual insolvency,” the report said, citing figures from the 107 plans it surveyed.

The report says the number of plans that are insolvent is expected to more than double in the next four years. A plan is considered insolvent if it cannot pay pension benefits at federally guaranteed levels for a full plan year.

“PBGC is at risk of having neither sufficient tools to help multi-employer plans deal with their problems nor the funds to continue to pay benefits beyond the next decade under the multiemployer insurance program,” Joshua Gotbaum, director of the PBGC, told a House committee in December.

Beneficiaries are certain to feel the impact. Many plans, struggling to stay solvent, have already reduced benefits and increased employer contributions – which, in turn, reduced the amount of money employers could devote to pay raises or other benefit programs.

When a multiemployer plan becomes insolvent, PBGC sends it money to keep benefits flowing to retirees and to fund the plan’s administrative operation. The aid is nominally a loan, although the money is almost never repaid, the report said.

Two large multi-employer plans are currently expected to become insolvent within the next 20 years. If one of them becomes insolvent sooner, the PBGC could run out of money in as little as two to three years, the report said.

“Comprehensive action must be taken to shore up the PBGC for future generations of employers and retirees,” said the Partnership for Multiemployer Retirement Security, a partnership of business and trade groups, in a statement.

“There is no easy way to address some of the challenges facing these plans, the GAO recognized what we know to be true – we need balanced solutions supported by both business and labor that do not put taxpayers at risk,” the statement said.

The GAO report, based on input from representatives of the pension plans as well as other industry experts, recommends that Congress change the rules governing multiemployer plans to address the penalties employers face for withdrawing from the plans, and to ease the restrictions on the design of the plans’ benefits for retirees.

In February, the National Coordinating Committee for Multiemployer Plans issued a proposal of its own, called “Solutions not Bailouts,” which recommends changes in regulations to allow for more flexibility in plan design and a broader ability to limit benefits when a plan is in deep financial trouble.

While some pension plans are set up and maintained by single employers, in multi-employer plans, beneficiaries who work for a number of companies are pooled into a single plan, with the terms negotiated by a union. The plans allow smaller employers to share risk, and allow workers to keep their pension benefits if they move from one company to another, as long as both companies participate in the plan. Single-employer plans are protected by a different PBGC trust fund.

The GAO report is the latest in a series of studies of the health of private pension plans, the impact of the 2008 financial crisis, and the steps the plans have taken to shore up their solvency. All of the studies have pointed toward a looming crisis that cannot be handled under the current legal and regulatory rules.

When a company is in bankruptcy or facing financial hardship, at some point it might have to face the question of whether to terminate its defined benefit pension plans. This is a difficult decision, and hard as a plan sponsor tries, termination might turn out to be the only option.

But there is a related question that frequently does not get the same level of attention, much to the detriment of the plan's participants. In the event the plan is terminated with insufficient funds, who should serve as the trustee of the terminated pension plan, ensuring the remaining plan assets are fairly distributed to the plan's participants?

Congress passed the Employee Retirement Income Security Act of 1974 as a way to address a number of perceived flaws in the pension system, including termination of pension plans leaving participants without the pensions upon which they had been depending. Title IV of ERISA established the Pension Benefit Guaranty Corp. to administer a mandatory government pension insurance program, guaranteeing pension payments of underfunded terminated plans up to legal limits. In addition to the insurance guarantee, ERISA provides another layer of protection for employees by allowing for the appointment of a successor trustee to administer the plan.

The successor trustee has a number of critical fiduciary responsibilities, including exercising a broad array of powers over the remaining plan assets and how they are distributed to participants, serving as the eyes and ears of the plan participants, investigating and identifying potential financial claims that might be brought on behalf of the plan, bringing lawsuits in connection with those claims when appropriate and generally ensuring that the participants receive as large a share as possible of the benefits they earned.

ERISA establishes a framework for the appointment of the successor trustee, making clear the federal agency responsible for insuring the failed pension — the PBGC — “may request” its own appointment. But the statutory scheme, and particularly the provision authorizing compensation for the trustee, also suggests Congress did not expect the PBGC would routinely act as the trustee. Nonetheless, since its creation in 1975, the PBGC invariably has sought and secured the role of trustee in connection with the terminated pension plans it insures, almost always by agreement with the prior plan administrator. In most cases, plan administrators readily agree to the PBGC's appointment, probably assuming they have no choice in the matter, and that the PBGC will be a competent trustee.

In the past decade, the problems of allowing the PBGC to serve as plan trustee have become increasingly apparent. Two fundamental problems are evident.

The first is that serving in this dual role — as both the federal agency responsible for guaranteeing pensions and as the fiduciary trustee of the participants of the terminated plan — has imposed overwhelming administrative burdens on the PBGC that are, unfortunately, beyond its ability to handle.The PBGC serves as the trustee for more than 4,300 terminated plans and 1.5 million beneficiaries. Predictably, the logistics associated with such large numbers has proved too much for a single trustee, with the agency taking up to a decade to make its final benefit determinations as to plan asset allocations in the larger and more complicated plans. Because participants may not challenge their share of the asset allocation until the benefit determinations are finalized, these excessive delays impose a significant hardship on plan participants, and it is common for a plan participant in a larger plan to pass away well before the PBGC finalizes his benefit determination. Even then, the determinations are not only slow, but rife with errors, often as a result of the PBGC outsourcing the work to unqualified contractors. These errors have been the subject of numerous critical reports by the PBGC's inspector general, who recently described the PBGC's audit process as “seriously deficient,” noting that problems originally detected in 2007 continue unabated.

The second problem with agreeing to the appointment of the PBGC as the plan's trustee is that the PBGC has an inherent conflict of interest. ERISA makes clear the statutory trustee is a “fiduciary,” whose guiding concern is supposed to be the welfare of plan participants.But the PBGC's insurance program is funded by plan sponsor insurance premiums, and because of this lack of public funding, the PBGC is often concerned with its own fiscal bottom line. This can create a conflict because there are many times in the process where the best interests of the participants are completely counter to the financial interests of the agency. One good example of this is when it comes time to estimate the remaining plan liabilities and assets. A true fiduciary would want as accurate an estimate as possible, in order to ensure the participants get every conceivable penny out of the funds that were contributed by the sponsor for their benefit. The PBGC, however, has the exact opposite incentive; any underestimation of plan assets, or overstatement of plan liabilities, works to the PBGC's benefit, at the direct expense of the participants' rightful share of plan assets.

The PBGC's conflicts and limitations as successor trustee were on full display in February as the agency fought against its removal as trustee for the US Airways Pilots Plan. After the PBGC issued formal benefit determinations in the US Airways Plan in 2007, participants contacted the PBGC to ask that it investigate potential claims that might exist on the plan's behalf. In 2009, the union representing the US Airways pilots sued the PBGC in federal court, alleging the PBGC had failed meaningfully to investigate or prosecute claims on behalf of the plan, and asking the court to replace the PBGC with an independent fiduciary. In February, the court held a three-day bench trial on the pilots' allegations, during which the court heard testimony from a number of witnesses regarding the agency's practices in dealing with its trusteed plans. The court also heard testimony from the PBGC's expert witness (a former general counsel of the agency) who sought to defend the PBGC by arguing that, because of the PBGC's conflicting interests, its fiduciary obligations as a statutory trustee are less than the obligations of other fiduciaries. Indeed, the crux of her argument was that while independent trustees must act solely in the interests of a plan's participants and beneficiaries, the PBGC by definition cannot do so because it has competing statutory obligations, and that its fiduciary obligations must therefore be less. The court has not yet issued its ruling, and the plaintiffs have offered a significant amount of legal authority to dispute the notion that the PBGC's fiduciary obligations are less than those of other trustees; nonetheless, it is clear that however the court rules, plan administrators are now on notice that the PBGC believes that it cannot and will not afford plan participants and beneficiaries with the same level of fiduciary care that an independent fiduciary would render.

These concerns were likely why Congress made the appointment of the PBGC as trustee merely optional, and did not envision its uniform and routine appointment. They also illustrate why the current practice of appointing the PBGC as trustee in every case should be revisited. An independent fiduciary will not suffer these same distractions or conflicts.

It is accordingly important that, when a pension plan's termination is considered, the administrator of the current plan considers whether it truly is in the best interests of the participants to agree to the PBGC's appointment as statutory trustee. Great care should be given to whether the appointment of a different trustee would better serve the participants. In fact, the current plan administrator's failure to at least consider the option of appointing an independent trustee can open a fiduciary up to potential liability during the plan termination process.

However, there is some indication that plan administrators are beginning to question the wisdom of such action. For example last year, as the law firm Dewey & Leboeuf LLP began the process of liquidation, the PBGC sought the firm's agreement to have the plan terminated and have itself appointed as the successor trustee. Firm management (the named administrator of the plan) refused, initially opting to appoint an independent fiduciary to deal with the plan's administration. Ultimately, the PBGC was able to convince Dewey to agree to its appointment as successor trustee as part of a broader settlement, but the fact that the trusteeship issue was part of the settlement discussions at all suggests that prudent plan administrators are beginning to see that the question cannot just be taken for granted.

While the level of compensation for a trustee is not specified in the statute, ERISA does anticipate that successor trustees will need to be compensated, and indeed the statute's only requirement is that both the PBGC and the court play a role in setting the compensation level to ensure that plan assets are not unnecessarily depleted. In larger plans with significant assets, the revenue that the plan assets generate (post-termination) is more than sufficient to fund a reputable independent fiduciary. While the PBGC currently uses the investment returns from trusteed plans for its own operations, a fiduciary could certainly conclude those returns could be put to better use in retaining a dedicated independent fiduciary who did not face the same conflicts and institutional inefficiencies that plague the PBGC.

A plan administrator, acting as a fiduciary, will want to undertake with great care the responsibility of implementing a decision to terminate a plan to ensure the termination process ultimately chosen does the least harm possible to employees who have earned their pensions over the course of a lifetime.

Editor’s note: Miller & Chevalier Chartered is representing retired US Airways pilots in a lawsuit (Thomas G. Davis, et al., plaintiffs, vs. PBGC) accusing the Pension Benefit Guaranty Corp. of unlawfully depriving benefits to the group. Mr. O'Toole is a counsel in that case. The law firm isn’t involved in the case mentioned in this commentary.

It has been said that an actuary is someone who really wanted to be an accountant but didn't have the personality for it. See who's laughing now. Things are starting to get very interesting, actuarially-speaking.

Federal bankruptcy judge Christopher Klein ruled on April 1 that Stockton, Calif., can file for bankruptcy via Chapter 9 (Chapter 11's ugly cousin). The ruling may start the actuarial dominoes falling across the country, because Stockton's predicament stems from financial assumptions that are hardly restricted to one improvident California municipality.

Stockton may expose the little-known but biggest lie in global finance: pension funds' expected rate of return. It turns out that the California Public Employees' Retirement System, or Calpers, is Stockton's largest creditor and is owed some $900 million. But in the likelihood that U.S. bankruptcy law trumps California pension law, Calpers might not ever be fully repaid.

So what? Calpers has $255 billion in assets to cover present and future pension obligations for its 1.6 million members. Yes, but . . . in March, Calpers Chief Actuary Alan Milligan published a report suggesting that various state employee and school pension funds are only 62%-68% funded 10 years out and only 79%-86% funded 30 years out. Mr. Milligan then proposed—and Calpers approved—raising state employer contributions to the pension fund by 50% over the next six years to return to full funding. That is money these towns and school systems don't really have. Even with the fee raise, the goal of being fully funded is wishful thinking.

Pension math is more art than science. Actuaries guess, er, compute how much money is needed today based on life expectancies of retirees as well as the expected investment return on the pension portfolio. Shortfalls, or "underfunded pension liabilities," need to be made up by employers or, in the case of California, taxpayers.

In June of 2012, Calpers lowered the expected rate of return on its portfolio to 7.5% from 7.75%. Mr. Milligan suggested 7.25%. Calpers had last dropped the rate in 2004, from 8.25%. But even the 7.5% return is fiction. Wall Street would laugh if the matter weren't so serious.

And the trouble is not just in California. Public-pension funds in Illinois use an average of 8.18% expected returns. According to the actuarial firm Millman, the 100 top U.S. public companies with defined benefit pension assets of $1.3 trillion have an average expected rate of return of 7.5%. Three of them are over 9%. (Since 2000, these assets have returned 5.6%.)

Who wouldn't want 7.5%-8% returns these days? Ten-year U.S. Treasury bonds are paying 1.74%. There is almost zero probability that Calpers will earn 7.5% on its $255 billion anytime soon.

The right number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I'm being generous, -1%.

So what to do? I recall a conversation from 20 years ago. I was hoping to get into the money-management business at Morgan Stanley. I wanted to ramp up its venture-capital investing in Silicon Valley, but I was waved away. It was explained to me that investors wanted instead to put billions into private equity.

One of the firm's big clients, General Motors had a huge problem. Its pension shortfall rose from $14 billion in 1992 to $22.4 billion in 1993. The company had to put up assets. Instead, Morgan Stanley suggested that it only had an actuarial problem. Pension money invested for an 8% return, the going expected rate at the time, would grow 10 times over the next 30 years. But money invested in "alternative assets" like private equity (and venture capital) would see expected returns of 14%-16%. At 16%, capital would grow 85 times over 30 years. Woo-hoo: problem solved. With the stroke of a pen and no new money from corporate, the GM pension could be fully funded—actuarially anyway.

Things didn't go as planned. The fund put up $170 million in equity and borrowed another $505 million and invested in—I'm not kidding—a northern Missouri farm raising genetically engineered pigs. Meatier pork chops for all! Everything went wrong. In May 1996, the pigs defaulted on $412 million in junk debt. In a perhaps related event, General Motors entered 2012 with its global pension plans underfunded by $25.4 billion.

In other words, you can't wish this stuff away. Over time, returns are going to be subpar and the contributions demanded from cities across California and companies across America are going to go up and more dominoes are going to fall. San Bernardino and seven other California cities may also be headed to Chapter 9. The more Chapter 9 filings, the less money Calpers receives, and the more strain on the fictional expected rate of return until the boiler bursts.

In the long run, defined-contribution plans that most corporations have embraced will also be adopted by local and state governments. Meanwhile, though, all the knobs and levers that can be pulled to delay Armageddon have already been used. California, through Prop 30, has tapped the top 1% of taxpayers. State employers are facing 50% contribution increases. Private equity has shuffled all the mattress and rental-car companies it can. Buying out Dell is the most exciting thing they can come up with. Expected rates of return on pension portfolios are going down, not up. Even Facebook FB +3.55% millionaires won't make up the shortfall.

Sadly, the only thing left is to cut retiree payouts, something Judge Klein has left open. There are 12,338 retired California government workers receiving $100,000 or more in pension payments from Calpers. Michael D. Johnson, a retiree from the County of Solano, pulls in $30,920.24 per month. As more municipalities file Chapter 9, the more these kinds of retirement deals will be broken. When Wisconsin public employees protested the state government's move to rein in pensions in 2011, the demonstrations got ugly—but that was just a hint of the torches and pitchforks likely to come.

Meanwhile, it's business as usual. California Gov. Jerry Brown released a state budget suggesting a $29 million surplus for the fiscal year ending June 2013 and $1 billion in the next fiscal year. Actuarially anyway.

Or as Utah Rep. Jason Chaffetz told Vermont Gov. Peter Shumlin, upon learning at a 2011 House hearing about that state's unrealistic pension assumptions: "If someone told me they expected to get an 8% to 8.5% return, I'd say they were probably smoking those maple leaves."

The most important thing to remember when reading these articles is that interest rates are the main driver of pension liabilities. This is because the duration of liabilities is longer than the duration of assets, which in plain English means any decline in interest rates will widen pension deficits because liabilities will grow much faster than assets.

Due to the unrealistic low yield used in computing pension liabilities, the funding ratios are grossly understated. International accounting standards applying to the valuation of pension liabilities do not provide realistic, reliable or sensible values and thereby make a bad situation look unduly worse and too alarmist.

...the "risks of not owning bonds is huge" because there is an asymmetric tradeoff depending on whether interest rates rise of fall. In particular, the duration of most pension plan assets is shorter than the duration of their liabilities (for HOOPP, it is 12 vs 15), so if long bond yields fall by one percentage point, it will be destructive. "If we enter a Japan scenario, you will get killed not owning bonds." Conversely, if rates rise, your liabilities will go down more than your assets, so you will not be hurt as much.

...the assumption that discount rate is too low largely depends on another assumption: that central bankers can prevent deflation. Regardless of what academic economic theories say about the effectiveness of monetary policy to stop deflation, there is a REAL risk that they can only do this in the short run and that a Japan-like lost decade(s) scenario is now upon us in the developed world (as demographics would suggest).

If rates remain low and stay there, or even fall further, a Japan-like situation means equities enter a long term bear market. Against this type of shock, funding ratios are underestimated. This risk goes hand-in-hand with deteriorating state and local budgets making it more likely that these governments skip pension contributions to balance budgets. So demographics, equity risk, interest rate risk, and inflation risk are not independent, and must be treated holistically to really understand whether or not current funding ratios are 'too alarmist'.

With so much riding on macroeconomic "theory" about the long term effectiveness of the radical and untested policy measures of the last 4 years, adding equity-like risk to the asset side of the balance sheet in an effort to close the gap is not prudent long term risk management for a pension fund. If monetary policy falls short of expectation, the short run volatility of these assets can easily overwhelm the advantage of being a long term investor who is able to step into risk assets when everyone else is selling.

It is only a pension fund who limits exposure to this shock now who will be in a position to "grab yield" buying heavily discounted bonds and clipping premium selling insurance after the storm (see HOOPP), thereby dealing with funding risk tactically instead of reacting to it. That means going against the herd right now, shunning short duration, illiquid assets in the hope of closing a gap with the latest "historically back-tested" trend in asset class allocation. Yes you may under-perform your benchmarks in any one year or even over a couple of years, but ultimately its no consolation that you outperformed your peers by 2% for 3 years when you're down 40% in year 4. Sadly, five years after 2008, we are right back to the same short term thinking that created some of the worst problems of that period.

What should be very alarming is that after four years of an all-in monetary and fiscal policy, Bernanke and Draghi are both still warning about deflation risk. Setting aside the hyperinflationary conspiracy theory that seem to dominate intelligent macroeconomic policy debates these days, it's clear that these guys are in a position to know what is going on systemically, and have tried and continue to try everything in their power to prevent this outcome. Yet the 10-year US Treasury bond yield is still below 2%. Furthermore, we are in front of a major reversal of one of the two pillars of the recovery to-date from fiscal stimulus to austerity. In the EU, we already have a sense of what this reversal means for long term growth prospects.

Despite public outcry, German executive pay continues to grow. While most people in the country are gradually becoming concerned about whether their retirement pensions will be adequate, many top executives can look forward to worry-free golden years.

There are no longer many certainties in the lives of Edwin Eichler, Olaf Berlien and Jürgen Claasen. At the moment, the three former executive board members of steelmaker ThyssenKrupp don't know what the future holds for them. Will they be able to find new jobs, or are they simply no longer capable of being placed?

They were let go at the end of last year after ThyssenKrupp posted a loss of €5 billion ($6.5 billion). There had been some failed business deals in North and South America, and the supervisory board wanted to send a message. Now the three managers are tainted with the reputation of being the personification of failure.

But there is one thing the three men can depend upon: a generous pension that should enable them to lead a carefree life. Eichler and Berlien will each receive €402,000 a year. Claasen, who had a shorter tenure on the executive board, will receive half that amount.

Tidy Rate of Return

The terms under which the men will receive their benefits are also favorable. Instead of having to wait until their 67th birthdays, like normal employees, they will begin collecting benefits at age 60. The managers won't even have to worry about external hardships, like rising inflation. At ThyssenKrupp, executive pensions are "adjusted annually according to the Consumer Price Index."

In other words, a tidy rate of return is guaranteed. And the executives' families will also be taken care of.

Should one of the former directors die, the steelmaker will continue to pay his wife 60 percent of his pension. In the case of Eichler and Berlien, their spouses would receive €241,000 a year. Each child entitled to support would qualify for another 20 percent the original pension, or €80,400. And although ThyssenKrupp would only provide benefits to the children of its former executives "until the age of 25," there are "certain well-founded cases" in which benefits would still be paid "until age 27."

ThyssenKrupp, like all corporations listed on Germany's DAX stock index of blue chip companies, spends a lot of money on the retirement pensions of its top executives. The total pension commitments are valued at €6.2 million for Berlien, €7.8 million for Eichler and €2.5 million for Claassen.

German carmakers are even more generous. The current record holder is Daimler CEO Dieter Zetsche. His pension commitments are currently worth €39.6 million. VW CEO Martin Winterkorn can expect to see benefits worth a total of €23 million, and even VW human resources chief Horst Neumann will receive about €18 million.

Industrial gas producer Linde and electric utility E.on have to set aside €16 million each for their respective CEOs, Wolfgang Reitzler and Johannes Teyssen, while VW is saving €14.8 million for its chief financial officer, Hans Dieter Pötsch. The list of benevolent deeds for top executives could go on and on.

Self-Service Mentality

The numbers reveal a self-service mentality among corporate leadership that stands in sharp contrast to the financial sacrifices executives often demand of their employees.

When it comes to compensation, corporate executives in Germany have now stepped beyond the level at which society still tolerates social injustice. Triggered by the €20 million that VW CEO Winterkorn would have been paid in 2012 if his contract had not been amended, a national debate began over equality and fairness. Even Chancellor Angela Merkel weighed in, saying: "Exorbitance is unacceptable in a free and social society."

Winterkorn decided to forego some of the money to which he was contractually entitled, which was probably not a very painful sacrifice for him. Including a second salary as head of Porsche Automobil Holding SE, Winterkorn received €15.3 million.

Anshu Jain, the co-CEO of Deutsche Bank, also wanted to send a small message. He declined a bonus in the millions, because if he had accepted it he would have earned more money than his fellow board member and chief executive Jürgen Fitschen, which wouldn't have gone over well at the bank.

Winterkorn and Jain apparently sense that there are limits to income growth. Besides, the German government reacted more quickly than many had expected.

Shareholders To Set Salaries

Under a new law the government intends to pass after the federal election in September, shareholders will determine the amount of executive compensation in the future. This is currently done by supervisory boards, in which representatives of labor and capital work out the details behind closed doors.

But as well intentioned as the new legislation is, it is unlikely to change much. Shareholders are interested in high profits and rising stock prices. To them, whether a chief executive who promises and guarantees these results earns €5 million or €15 million is somewhat irrelevant.

Still, the government's quick reaction shows how seriously it takes the problem. It doesn't want to hand over the subject of social justice to the opposition Social Democrats and the Left Party. "I understand perfectly well how people can only shake their heads at some salaries that are completely out of line," says Chancellor Merkel.

Pensions Easy to Hide in Disclosures

It is precisely because of the fact that the salary debate in Germany has become so heated that pension commitments for executives hold a special appeal. There's a reason for this, too: They are easy to hide in financial reports.

After SPIEGEL reported the pension claims of several corporate leaders last year, a few supervisory boards confessed that it wasn't an issue they had focused on until then. The supervisory boards at Daimler and VW indicated that pension commitments would no longer be as generous, at least for new contracts given to senior management. But in reality, the value of pension commitments has increased substantially once again.

ThyssenKrupp has to place €32 million in reserve for the pensions of its directors, while Siemens keeps €52 million in executive pension reserves, Daimler €82 million and the Volkswagen Group €104 million. Each of these amounts is about 20 percent higher than in the previous year. The value of the pension claims of Daimler CEO Zetsche, for example, increased from €29 million to €39 million in one year.

There is an actuarial explanation for this miraculous increase, but it only reveals a further problem with the retirement pensions of senior management.

Daimler, for example, guarantees Zetsche an annual pension of €1,050,000. The automaker has to form a reserve for the anticipated payments. The amount of this reserve depends on how much interest the money earns until the company has to pay pension benefits. Because interest rates for safe investments have declined, the Stuttgart-based company has to place a larger sum in reserve to be able to pay its CEO the guaranteed pension later on.

Unfair Advantage

Zetsche can look forward to something of a guaranteed pension. He and other executives know how much money they will receive in retirement, no matter what happens in between, since their employers assume the risk of falling interest rates.

Of course, ordinary employees who make private arrangements for retirement and buy life insurance policies don't have this guarantee. If interest rates in capital markets decline, the amount that will be paid out to them in old age is reduced. In light of the debt problems in the euro zone, more and more Germans are worried about slowly being deprived of some of their retirement income in this manner.

It is already impossible to justify the difference between senior executive and ordinary employee compensation. A number of DAX companies have now reacted to this imbalance. At ThyssenKrupp, Daimler, Linde and RWE, for example, managers who are newly appointed to the executive board receive a so-called contribution-oriented pension.

In addition to salaries, bonuses and profit sharing, the companies pay several hundred thousands of euros into an account for the pensions of top management. Over the years, this adds up to a handsome company pension for the executives. But the companies know how much money they are actually spending for their managers' retirement benefits. And if interest rates fall, they no longer have to constantly increase the amounts paid into the fund.

Should Executives Even Get Pensions?

This is a small improvement, and yet it doesn't address the underlying issue: Why do companies pay their senior executives a pension at all? After all, they are also expected to accept a certain amount of risk.

Employees are advised to save money in a private pension account, because the pension required by law is unlikely to allow them to maintain their standard of living. Factory workers and office employees are expected to set aside a portion of their earnings. But the top executives, who earn salaries in the millions and for whom saving money shouldn't be a problem, have no need to save, because their employer pays their luxury pension. When it comes to their own retirement pensions, top managers show a pronounced tendency to hedge their bets.

The amounts in question can no longer be justified. Pension commitments in the double-digit millions "are hard to defend from an ethical standpoint," says Christian Strenger, "even if there are contractual claims."

The former head of the DWS investment fund is a member of the German government's Corporate Governance Commission, which develops proposals for good corporate governance. Strenger is critical of the fact that "supervisory boards are unable to put a stop to such excesses."

"Salaries cannot be unlimited in a social market economy" like the one in Germany, says Berthold Huber, the head of the IG Metal metalworkers' union, referring to the country's model of capitalism, which encourages free markets but also includes support for organized labor and a comprehensive social system. Nevertheless, he and his fellow labor leaders, in their capacity as supervisory board members, have not stood in the way of corporate executives receiving generous pensions in addition to their salaries. Sometimes this acts as a hidden salary increase.

A Discrete Way of Padding Salaries

"Pension commitments are a very popular way to make sure managers get more money without attracting notice," says Peter Dehnen. As a member of the steering committee of the Association of Supervisory Boards in Germany, he has seen how companies have increased pensions for top management at times when management salary increases seemed unjustified, because the companies were imposing wage freezes on ordinary employees.

Pension commitments have developed into "an unregulated area in which some executives have essentially secured a second salary for themselves," says Ulrich Hocker of the German Protective Society for Security Holdings. Because all companies establish their own rules, with some granting executives pensions at 60 while others wait until the managers turn 63, it is already difficult to compare payments among different companies.

In general, Hocker thinks it would be a good idea "if managers paid for their own retirement pensions and perhaps received a higher salary in return." Executives could still hardly expect to face poverty in old age, but the process would be "fair and, for outsiders, comparable and transparent."

Many details are currently tucked away in the legal language on the back pages of company reports. E.on, for example, invented the term "third pension situation" for longstanding executives. The first situation occurs when a manager leaves the company at 60, and the second situation applies if he becomes disabled. So far, so good. But if the company decides not to renew the executive's contract, perhaps because of poor performance, E.on does not refer to this as firing the executive, but rather as a "third pension situation."

In that case, the manager receives an "early pension" of between 50 and 75 percent of his last base salary. In the case of current E.on CEO Johannes Teyssen, this would be €930,000 -- a year.

If you want to understand the forces that are shaping democratic capitalism, I have a terrific book for you. It’s Chrystia Freeland’s Plutocrats, the winner of this year’s Lionel Gelber Prize for the best English-language book on international affairs. (I was the least illustrious member of the stellar jury, and I got to read a lot of wonderful books.)

Plutocrats is an intimate portrait of the world’s new super-elites, some of whom Ms. Freeland has gotten to know well. None of them are cartoon villains. They are a genuine meritocracy – men (and they’re all men) who worked their way up to dominate the tech world or finance. They honestly believe that what’s good for them is good for the rest of us, and they’re hurt and baffled that not everyone agrees.

One of the good guys in this book is Mark Carney, the Bank of Canada Governor who’s heading to the Bank of England. In 2011, he had a showdown with Jamie Dimon, the head of JPMorgan Chase (by some measures, the world’s largest bank). At a meeting of leading bankers in Washington, Mr. Carney explained why he supported a new set of international financial rules that would constrain the banks and cost them money. Mr. Dimon’s response was a rant; he called the rules “cockamamie nonsense” and “anti-American.”

Mr. Dimon, a self-made man who ascended to the pinnacle of Wall Street by way of Harvard Business School, sincerely believes that regulatory overreach is stifling the financial system. Mr. Carney believes that plutocrats need to be reined in when their interests collide with ours. They’re on different sides of a titanic struggle for power. The battle is a test of our ability to defend democracy from the plutocrats when the markets don’t work the way they’re supposed to.

As Ms. Freeland writes, the super-elites are often the product of a strong market economy. But as their influence grows, they can become its opponents. They claim they’re pro-market, but what they really are is pro-business. Ms. Freeland cites University of Chicago professor Luigi Zingales as saying they use their lobbying power to tilt the playing field, not to level it. “As a result, serious tensions emerge between a pro-market agenda and a pro-business one.”

You’d think the crash of 2008 would have taught Wall Street some humility. Instead, those tensions are as bad as ever. Last year, Mr. Dimon’s firm got into a mess with “whale trades” – a series of huge bets on derivatives that blew up. JPMorgan suffered large losses. But the scary part is that nobody in charge had a clue what was going on. A damning Senate investigation has concluded that bank officials ignored the warning signals and misled regulators and the public. In other words, nothing has changed. Wall Street is still unable to police itself, and the regulators are unable to police it, either.

There are no simple answers to these problems. The fundamental challenges of democratic capitalism won’t be resolved by a wealth tax or by redistributing more money from rich to poor (although making sure no bank is too big to fail might be a good idea). As Ms. Freeland writes, the credibility of capitalism itself is at stake. “Businessmen who cannot even persuade their own children that business is a morally legitimate activity are not going to succeed, on their own, in persuading the world of it.”

Karl Marx was supposed to be dead and buried. With the collapse of the Soviet Union and China’s Great Leap Forward into capitalism, communism faded into the quaint backdrop of James Bond movies or the deviant mantra of Kim Jong Un. The class conflict that Marx believed determined the course of history seemed to melt away in a prosperous era of free trade and free enterprise.

The far-reaching power of globalization, linking the most remote corners of the planet in lucrative bonds of finance, outsourcing and “borderless” manufacturing, offered everybody from Silicon Valley tech gurus to Chinese farm girls ample opportunities to get rich. Asia in the latter decades of the 20th century witnessed perhaps the most remarkable record of poverty alleviation in human history — all thanks to the very capitalist tools of trade, entrepreneurship and foreign investment. Capitalism appeared to be fulfilling its promise — to uplift everyone to new heights of wealth and welfare.

Or so we thought. With the global economy in a protracted crisis, and workers around the world burdened by joblessness, debt and stagnant incomes, Marx’s biting critique of capitalism — that the system is inherently unjust and self-destructive — cannot be so easily dismissed. Marx theorized that the capitalist system would inevitably impoverish the masses as the world’s wealth became concentrated in the hands of a greedy few, causing economic crises and heightened conflict between the rich and working classes. “Accumulation of wealth at one pole is at the same time accumulation of misery, agony of toil, slavery, ignorance, brutality, mental degradation, at the opposite pole,” Marx wrote.

A growing dossier of evidence suggests that he may have been right. It is sadly all too easy to find statistics that show the rich are getting richer while the middle class and poor are not. A September study from the Economic Policy Institute (EPI) in Washington noted that the median annual earnings of a full-time, male worker in the U.S. in 2011, at $48,202, were smaller than in 1973. Between 1983 and 2010, 74% of the gains in wealth in the U.S. went to the richest 5%, while the bottom 60% suffered a decline, the EPI calculated. No wonder some have given the 19th century German philosopher a second look. In China, the Marxist country that turned its back on Marx, Yu Rongjun was inspired by world events to pen a musical based on Marx’s classic Das Kapital. “You can find reality matches what is described in the book,” says the playwright.

That’s not to say Marx was entirely correct. His “dictatorship of the proletariat” didn’t quite work out as planned. But the consequence of this widening inequality is just what Marx had predicted: class struggle is back. Workers of the world are growing angrier and demanding their fair share of the global economy. From the floor of the U.S. Congress to the streets of Athens to the assembly lines of southern China, political and economic events are being shaped by escalating tensions between capital and labor to a degree unseen since the communist revolutions of the 20th century. How this struggle plays out will influence the direction of global economic policy, the future of the welfare state, political stability in China, and who governs from Washington to Rome. What would Marx say today? “Some variation of: ‘I told you so,’” says Richard Wolff, a Marxist economist at the New School in New York. “The income gap is producing a level of tension that I have not seen in my lifetime.”

Tensions between economic classes in the U.S. are clearly on the rise. Society has been perceived as split between the “99%” (the regular folk, struggling to get by) and the “1%” (the connected and privileged superrich getting richer every day). In a Pew Research Center poll released last year, two-thirds of the respondents believed the U.S. suffered from “strong” or “very strong” conflict between rich and poor, a significant 19-percentage-point increase from 2009, ranking it as the No. 1 division in society.

The heightened conflict has dominated American politics. The partisan battle over how to fix the nation’s budget deficit has been, to a great degree, a class struggle. Whenever President Barack Obama talks of raising taxes on the wealthiest Americans to close the budget gap, conservatives scream he is launching a “class war” against the affluent. Yet the Republicans are engaged in some class struggle of their own. The GOP’s plan for fiscal health effectively hoists the burden of adjustment onto the middle and poorer economic classes through cuts to social services. Obama based a big part of his re-election campaign on characterizing the Republicans as insensitive to the working classes. GOP nominee Mitt Romney, the President charged, had only a “one-point plan” for the U.S. economy — “to make sure that folks at the top play by a different set of rules.”

Amid the rhetoric, though, there are signs that this new American classism has shifted the debate over the nation’s economic policy. Trickle-down economics, which insists that the success of the 1% will benefit the 99%, has come under heavy scrutiny. David Madland, a director at the Center for American Progress, a Washington-based think tank, believes that the 2012 presidential campaign has brought about a renewed focus on rebuilding the middle class, and a search for a different economic agenda to achieve that goal. “The whole way of thinking about the economy is being turned on its head,” he says. “I sense a fundamental shift taking place.”

The ferocity of the new class struggle is even more pronounced in France. Last May, as the pain of the financial crisis and budget cuts made the rich-poor divide starker to many ordinary citizens, they voted in the Socialist Party’s François Hollande, who had once proclaimed: “I don’t like the rich.” He has proved true to his word. Key to his victory was a campaign pledge to extract more from the wealthy to maintain France’s welfare state. To avoid the drastic spending cuts other policymakers in Europe have instituted to close yawning budget deficits, Hollande planned to hike the income tax rate to as high as 75%. Though that idea got shot down by the country’s Constitutional Council, Hollande is scheming ways to introduce a similar measure. At the same time, Hollande has tilted government back toward the common man. He reversed an unpopular decision by his predecessor to increase France’s retirement age by lowering it back down to the original 60 for some workers. Many in France want Hollande to go even further. “Hollande’s tax proposal has to be the first step in the government acknowledging capitalism in its current form has become so unfair and dysfunctional it risks imploding without deep reform,” says Charlotte Boulanger, a development official for NGOs.

His tactics, however, are sparking a backlash from the capitalist class. Mao Zedong might have insisted that “political power grows out of the barrel of a gun,” but in a world where das kapital is more and more mobile, the weapons of class struggle have changed. Rather than paying out to Hollande, some of France’s wealthy are moving out — taking badly needed jobs and investment with them. Jean-Émile Rosenblum, founder of online retailer Pixmania.com, is setting up both his life and new venture in the U.S., where he feels the climate is far more hospitable for businessmen. “Increased class conflict is a normal consequence of any economic crisis, but the political exploitation of that has been demagogic and discriminatory,” Rosenblum says. “Rather than relying on (entrepreneurs) to create the companies and jobs we need, France is hounding them away.”

The rich-poor divide is perhaps most volatile in China. Ironically, Obama and the newly installed President of Communist China, Xi Jinping, face the same challenge. Intensifying class struggle is not just a phenomenon of the slow-growth, debt-ridden industrialized world. Even in rapidly expanding emerging markets, tension between rich and poor is becoming a primary concern for policymakers. Contrary to what many disgruntled Americans and Europeans believe, China has not been a workers’ paradise. The “iron rice bowl” — the Mao-era practice of guaranteeing workers jobs for life — faded with Maoism, and during the reform era, workers have had few rights. Even though wage income in China’s cities is growing substantially, the rich-poor gap is extremely wide. Another Pew study revealed that nearly half of the Chinese surveyed consider the rich-poor divide a very big problem, while 8 out of 10 agreed with the proposition that the “rich just get richer while the poor get poorer” in China.

Resentment is reaching a boiling point in China’s factory towns.“People from the outside see our lives as very bountiful, but the real life in the factory is very different,” says factory worker Peng Ming in the southern industrial enclave of Shenzhen. Facing long hours, rising costs, indifferent managers and often late pay, workers are beginning to sound like true proletariat. “The way the rich get money is through exploiting the workers,” says Guan Guohau, another Shenzhen factory employee. “Communism is what we are looking forward to.” Unless the government takes greater action to improve their welfare, they say, the laborers will become more and more willing to take action themselves. “Workers will organize more,” Peng predicts. “All the workers should be united.”

That may already be happening. Tracking the level of labor unrest in China is difficult, but experts believe it has been on the rise. A new generation of factory workers — better informed than their parents, thanks to the Internet — has become more outspoken in its demands for better wages and working conditions. So far, the government’s response has been mixed. Policymakers have raised minimum wages to boost incomes, toughened up labor laws to give workers more protection, and in some cases, allowed them to strike. But the government still discourages independent worker activism, often with force. Such tactics have left China’s proletariat distrustful of their proletarian dictatorship. “The government thinks more about the companies than us,” says Guan. If Xi doesn’t reform the economy so the ordinary Chinese benefit more from the nation’s growth, he runs the risk of fueling social unrest.

Marx would have predicted just such an outcome. As the proletariat woke to their common class interests, they’d overthrow the unjust capitalist system and replace it with a new, socialist wonderland. Communists “openly declare that their ends can be attained only by the forcible overthrow of all existing social conditions,” Marx wrote. “The proletarians have nothing to lose but their chains.” There are signs that the world’s laborers are increasingly impatient with their feeble prospects. Tens of thousands have taken to the streets of cities like Madrid and Athens, protesting stratospheric unemployment and the austerity measures that are making matters even worse.

So far, though, Marx’s revolution has yet to materialize. Workers may have common problems, but they aren’t banding together to resolve them. Union membership in the U.S., for example, has continued to decline through the economic crisis, while the Occupy Wall Street movement fizzled. Protesters, says Jacques Rancière, an expert in Marxism at the University of Paris, aren’t aiming to replace capitalism, as Marx had forecast, but merely to reform it. “We’re not seeing protesting classes call for an overthrow or destruction of socioeconomic systems in place,” he explains. “What class conflict is producing today are calls to fix systems so they become more viable and sustainable for the long run by redistributing the wealth created.”

Despite such calls, however, current economic policy continues to fuel class tensions. In China, senior officials have paid lip service to narrowing the income gap but in practice have dodged the reforms (fighting corruption, liberalizing the finance sector) that could make that happen. Debt-burdened governments in Europe have slashed welfare programs even as joblessness has risen and growth sagged. In most cases, the solution chosen to repair capitalism has been more capitalism. Policymakers in Rome, Madrid and Athens are being pressured by bondholders to dismantle protection for workers and further deregulate domestic markets. Owen Jones, the British author of Chavs: The Demonization of the Working Class, calls this “a class war from above.”

There are few to stand in the way. The emergence of a global labor market has defanged unions throughout the developed world. The political left, dragged rightward since the free-market onslaught of Margaret Thatcher and Ronald Reagan, has not devised a credible alternative course. “Virtually all progressive or leftist parties contributed at some point to the rise and reach of financial markets, and rolling back of welfare systems in order to prove they were capable of reform,” Rancière notes. “I’d say the prospects of Labor or Socialists parties or governments anywhere significantly reconfiguring — much less turning over — current economic systems to be pretty faint.”

That leaves open a scary possibility: that Marx not only diagnosed capitalism’s flaws but also the outcome of those flaws. If policymakers don’t discover new methods of ensuring fair economic opportunity, the workers of the world may just unite. Marx may yet have his revenge.

What a really stupid interview. Thanks for alerting us to the New Nonsense. She fails to realize that we're in a debt deflation."Inflating our way out of debt" can only occur ON CREDIT. And this will deflate economies all the more.

The S&P 500 stock index's stunning run since the start of the year has made many bullish analysts look conservative.

As the benchmark S&P .SPX has roared to record highs this year with a gain of more than 11 percent, many Wall Street analysts have been forced to concede their prior targets were too low and adjust accordingly.

In fact, it has taken less than four months for the S&P to surpass year-end 2013 targets of about two-thirds of the strategists polled by Thomson Reuters in December. Of 47 analysts surveyed, 30 of them expected to see this year end at a level already exceeded by the index.

The midyear targets are even more lopsided, as the S&P is above the midyear forecast for 27 of the 28 analysts who estimated where the index would be by the end of June.

"When we started the year at 1,425 that implied about a 15 or 20 percent total return," said Phil Orlando, chief equity market strategist, at Federated Investors, in New York, who has a 1,660 year-end target for the index.

"Here we are now 3 1/2 months into the new year and stocks are up 11, 12 percent - there's not a whole lot left. Either there's going to be a pullback at some point, or maybe things really get even better than we thought and our 1,660 target is too low."

The more recent Reuters poll in March showed some analysts had revised targets following the strong start to the year, with the S&P above the midyear target for 21 of 34 analysts surveyed and the full-year target for 18 of 43 analysts surveyed.

The run has been notable for its resilience. As investors buy into weakness, dips are short-lived while bears are forced to cover short positions and asset managers chase performance.

So far this year, the S&P has only experienced three consecutive losing sessions once, and the deepest "correction" was a brief 2.8 percent slide in late February.

Thomas Lee, U.S. equity strategist at JPMorgan in New York, this week decided to throw in the towel on a call for a correction, saying in two recent notes to clients that his 1,580 target for the year-end S&P "seems low." Data in the last six weeks has not been as weak as some expected, and the equity market managed to look past it, anyway.

Lee, in his commentary, notes that JP Morgan estimates 2013 currently is the worst year for active-manager performance since 1995, with an estimated 68 percent of funds falling short of their benchmark. Fund managers, as a result, are taking on more risks in order to play catch-up, he wrote.

Now that Lee is more bullish, he noted the biggest risk to this new view is "that the market begins to correct just as we capitulate on it happening. That is potential irony."

Fred Dickson, chief market strategist at D.A. Davidson & Co in Lake Oswego, Oregon, who is maintaining his target of 1,450 for midyear and 1,500 for the year-end sees a strong likelihood of a significant pullback, partly due to the current market structure which contains a large number of program-driven traders that follow trends.

"It will take a combination of fundamental events to pull people from a buying mode onto the sidelines and when that happens we will start to see prices decline. As those prices decline the program traders flip the switch from buy to sell or buy to short and you get a fairly rapid 8 to 10 percent decline," said Dickson.

One potential catalyst for a pullback could be company results as the pace of earnings season begins to pick up.

Earnings for S&P 500 companies are expected to grow at a modest 1.1 percent in the first quarter, down from a January forecast of more than 4 percent, according to Thomson Reuters data. Just 6 percent of companies have reported thus far, but companies so far have been notably pessimistic, with a 4.7-to-1 ratio of negative to positive warnings.

"The only thing that happens now is do we start to see something in the company earnings reports - these are really important because that is where the rubber meets the road," said Gordon Charlop, managing director at Rosenblatt Securities in New York.

Next week 74 S&P companies are expected to report results, across a wide swath of sectors. Financials dominate the week, including reports from American Express Co (AXP), Goldman Sachs (GS), Bank of America (BAC) and Citigroup Inc (C).

Internet companies Google Inc (GOOG) and Yahoo Inc (YHOO), along with Dow components Johnson & Johnson (JNJ), Coca-Cola (KO), McDonald's Corp (MCD) and General Electric (GE) also report results.

In addition to earnings, investors will also scrutinize regional manufacturing data from the New York and Philadelphia Federal Reserve banks, the Fed's Beige Book and data on consumer inflation and housing starts.

Technical analysts face a conundrum.

A laundry list of widely followed chart signals are screaming “sell.” But lately, whenever stocks pull back, investors are waiting, telling their brokers “buy.”

That’s making the stock market rally a frustrating experience for many technicians. They believe what their charts are telling them, but the market isn’t cooperating.

“This is an unwarranted, unhealthy and thoroughly frustrating uptrend,” said Tom McClellan, editor of The McClellan Market Report. “But it is an uptrend.”

The Standard & Poor’s 500-stock index has extended its march to record highs, helped by stepped up interest in U.S. stocks from individual investors and money coming in from overseas.

But many technicians feel compelled to continue warning that a significant pullback may be imminent. They point to a wide variety of negative signals, from “bearish engulfing” patterns to reaching Elliott Wave objectives, and from bearish momentum “divergences” to declining participation.

“Nobody likes a bear in a bull market,” said Richard Ross, chief global technical strategist at New York broker dealer Auerbach Grayson. “But I have to stay true to what I do. It’s my job to point out the glitches in the matrix,” Mr. Ross said.

The best performing sectors this year are health care, consumer staples and utilities, which have historically been viewed as defensive. In addition, European and emerging markets continue to struggle, commodities prices are still trending lower, and Treasurys have rallied sharply over the last month, all of which warn that a defensive posture is warranted (click chart below).

Mr. Ross said investors should keep in mind that a rise in the S&P 500 doesn’t necessarily prove the bearish case wrong. Considering how many intra- and inter-market signals suggesting a top is near, he maintains conviction in his methodology. “I’d have to be wrong on a whole bunch of things before I’d believe I was wrong on stocks,” he said.

And yet, the S&P 500 surged 1.2% to an all-time high of 1587.73 Wednesday, busting out of the narrow 1.5% range the index had been stuck in over the last month.

Helping fund the gains, TrimTabs Investment Research said the U.S. equity mutual funds and exchange traded funds it tracks have taken in $60 billion in new money so far this year, which is already the highest in any full year since 2004.

The question for technicians is, does the study of the behavior of European and emerging markets, commodities and cyclical and non-cyclical sectors even matter, when money is pouring into the stock market?

Technicians maintain that the answer is “yes,” because over the longer term, it matters more where the money is going than how much is coming into the market.

Robert Sluymer, technical analyst at RBC Capital Markets, said many of his mutual fund and pension fund clients, who seek to outperform the broader market, are more interested in knowing what’s outperforming and what’s underperforming than what the S&P 500 is doing.

“I’m pretty agnostic on the market in general,” Mr. Sluymer said. “My job is to identify what is leading the market, and what isn’t.”

He recognizes that the overall trend of the S&P 500 may still be up, but he continues to point out to clients the “significant shifts in leadership underneath the index” that might normally be construed as warning of a near-term pullback.

For example, Mr. Sluymer noted the industrial sector had peaked relative to the S&P 500 in late February, and has been trending lower ever since (click chart below).

That’s what makes the current rally so difficult for technicians to follow.

“The bets that are working here…are not the type of bets, or trades, I’d be wanting to make at this point,” Auerbach Grayson’s Mr. Ross said. “That’s the conundrum.”

These historically more defensive groups are ripping to new highs. These sectors are the reason that US Stock Market Averages are anywhere near highs. A lot the components of the market aren’t participating. I speak to all different kinds of investors every day and a common theme I’m hearing is that their portfolios are underperforming the broad averages. They read that US Stocks are making all-time highs, so they look at their portfolios and wonder why theirs are not at new highs, and haven’t been for months. My explanation to them is that, in reality, the “market of stocks” peaked in January. So unless your “portfolio” is the SPX Index you’re not performing as well as that average.

We’re in a current market environment that is being driven by just a few sectors. The majority of the others have been drifting lower for 4 weeks. So as participants that own stocks, not the SPX Index, we need to recognize where the strength is coming from. If you trade E-mini contracts or just trade $SPY all day, then this doesn’t affect you. But most people are in individual names or spaces.

And even when you look at the index itself, the S&P500 has really been trading sideways for 4 weeks. It hasn’t gone anywhere while it’s been in this Christmas light formation of up day/down day/up day/down day for what I understand is a record amount of days.

So careful what you read in the headlines about all-time highs. There are weak sectors within the market, and there are some really strong ones. The bulls want to see some rotation out of the defensives and into the sectors that have been struggling if this market is going to keep grinding higher. The bears want to see follow through from the struggling ones and have the leaders play catch-up to the downside.

I find that it’s a helpful exercise to look at the components of the market and see how they’re faring against each other and also against the broader average. I guess we’ll see how this develops.

While many talk about the trend in U.S. stock prices, no one is talking about the trend in conditions which are clearly signaling deflation despite the Fed's $85 billion/month. With commodities down (cost-push), and the jobs market still not signaling any real acceleration (demand-pull), the two most basic forces of inflation aren't doing much at all. This is what Ed Dempsey and I have been stressing since the end of January with many ignoring what internal price is clearly saying.

This is one of the most risk-off risk rallies in history, which is highly deceptive given what is causing it. I went from calling this a market which could be set up for a correction in late January to the honey badger stock market which simply does not care about negativity in nearly every other area of the investable landscape.

However, make no mistake about it - something's gotta give. There will be a Spring Sync. Either absolute price movement will converge on the downside to intermarket deterioration, or that deterioration through time will resolve itself and the next fat pitch comes in the cyclical trade. If the former, it is entirely possible a sharp sell-off occurs despite Fed intervention. If the latter, cyclicals have the potential to make any year to date gains in stocks look more like a rounding error.

Thrice burned, twice shy. After experiencing steep funding shortfalls in their defined-benefit retirement plan obligations three times in a row over the past generation, corporate plan sponsors are finally fighting back, with an array of innovative weapons designed to reduce their pension liabilities.

Such pension “derisking” approaches include lump-sum payouts to vested, terminated employees; liability-driven investment (LDI) strategies that match up plan assets with pension liabilities by moving from equities to long-term bonds; and the one currently making headlines — annuitization, the transfer of a sizable percentage of pension obligations to an insurance company for a paid premium. These tactics join more-traditional approaches, such as freezing and closing pension plans. Taken together, they constitute a sea change in pension-plan treatment.

Just in time, too. “Since the financial crisis reared, there has been this stark realization by large plan sponsors that they have taken on a huge amount of equity risk,” says Evan Inglis, principal and chief actuary at The Vanguard Group. “They have these gigantic pools of assets now creating risks for the shareholders investing in them — risks they are not in business to manage, and risks that shareholders don’t want them to manage.”

Jim Davlin, vice president of finance and treasurer at General Motors, puts it this way: “We’re in the business of making great cars — that’s our core competency. It’s not managing pension investments to provide a lifetime income to folks.”

Although pension plans traditionally were thought of as long-term obligations with long-term investment horizons best suited to equities, the Pension Protection Act of 2006 (PPA) and new accounting rules changed the game, requiring sponsors to recognize their plans’ funded status each year on their balance sheets. “The sponsor’s finances are impacted on a much shorter basis, with potential shareholder repercussions,” Inglis says. “No longer are these obligations considered an investment issue. Now, sponsors realize this is a corporate finance issue.”

Catching On

Finance evidently is up to the task. Various studies indicate widespread study and action on each of the aforementioned derisking and other asset-management strategies. In a survey of 428 defined-benefit plan sponsors by Aon Hewitt, 60% are somewhat or very likely to undertake LDI strategies, moving from equities to long-term bonds as funded status improves. In another survey of 125 corporate pension sponsors worldwide, published by SEI, 57% are also pursuing LDI strategies, as are 74% of more than 100 corporate defined-benefit pension plans in yet another study, by Cutwater Asset Management.

Lump sums paid to vested employees whose jobs have been terminated are also catching on widely, with 39% of respondents in the Aon Hewitt survey likely or very likely to make a lump-sum offer in 2013. Ditto annuitization, once the backwater of derisking tactics and on more solid ground today. “If you count the number of transactions in the U.S. and the UK over the last six years, roughly $100 billion in funding obligations have now been annuitized,” says Gary Knapp, managing director, insurance and liability-driven strategies, at Prudential Fixed Income.

Prudential, for one, is now on the hook for approximately $35 billion of GM’s and Verizon’s pension obligations. Other big-name companies transferring a portion of their pension liabilities to insurers in recent years include GlaxoSmithKline ($1.3 billion transferred), Rolls-Royce ($3 billion), and British Airways ($1.9 billion).

Despite these innovative measures, the big question is whether or not pension derisking is just another fad, given that funding levels have risen with the equity markets and the slight uptick in interest rates. Although the aggregate pension deficit among plan sponsors in the U.S. is an eye-opening $482 billion as of January, that number is down $74 billion from the previous January, effectively erasing the funding erosion that occurred in 2012, according to a Mercer study. If the economy continues to improve, will derisking go the way of other well-intentioned tactics?

The answer is a resounding no, say pension analysts at Mercer, Aon Hewitt, Vanguard, and Fidelity, all insisting that derisking has sturdy legs. Says John Beck, senior vice president and national retirement practice leader for retirement consulting at Fidelity Investments: “Something has changed.”

Putting Finance in Charge

That something is born from experience. Three times over the past 30 years, aggregate plan-funding levels crashed when the fast-moving equities market ran out of gas — in the early 1990s, the early 2000s, and most recently in 2007–08, when the financial crisis took hold. “During these equity bull markets, pension plans were growing much bigger in size relative to the companies that sponsored them, creating much more potential to have an impact on the sponsors financially if and when the market turned south,” Inglis says.

This stellar performance, investment-wise, created a false sense of security, “masking the potential risks,” he explains. “The plans grew bigger, with more and more employee participants, and by the 2000s they were really big — overfunded by a significant margin. Then, markets collapsed and interest rates dropped, causing precipitous and substantial declines in funding.”

GM’s Davlin remembers the pain. “Our pension liability was so large as a percentage of our market cap that each time funding went down, the rating agencies and others doing financial evaluations considered this a substantial debtlike obligation,” he recalls. “As our funding status changed, we’d go from no debt one year to dramatically high debt the next year. Not only did we have this great liability, we also had significant asset-return risks — hoping our assets would earn their expected rate of return — and longevity risk, the possibility of [pensioners] living longer than was actuarially quantified decades ago.”

The first two times that plan funding swooned, most plan sponsors did little to reduce their liabilities, figuring funding levels would recover. (They did.) “Rather, companies looked at fixing the plan design,” says Ari Jacobs, global retirement solutions leader at Aon Hewitt. “They closed plans to new hires or went to the further extreme of freezing the defined benefit for all participants. That was pretty much the extent of the reaction.”

The third time was different. Thanks to the financial crisis and a one-two regulatory punch — the PPA and new pension accounting rules issued by the Financial Accounting Standards Board in 2007 (FAS 158) — plan sponsors now had to recognize their funding shortfalls on their balance sheets on an annual basis. The response to the rules, by and large, has been pension derisking — getting the liabilities off the balance sheet or reducing the investment risk. The solutions comprise lump-sum offers, annuitizations, and LDI schemes.

“Many of the clients I’m working with recognize the need for a more permanent derisking solution that does not put their business at financial risk to another market downturn or drop in interest rates,” says Fidelity’s Beck. Inglis agrees: “Sponsors had not learned from the two previous debacles how to manage their pension risks. These lessons now learned, finance is in charge.”

Annuitization: GM and Verizon

Leading the effort at GM is Davlin and his team, as part of his role under CFO Daniel Ammann. The giant automaker has pursued several actions to get its pension funding in order, including closing the plan to new participants to limit the growth in these liabilities and transitioning active employees to its defined-contribution plan, “all of which we will continue to pursue,” Davlin says.

Other steps were “bigger,” he acknowledges. “We needed to do more than just limit the growth in our liability; we wanted to transfer some of it to get it off the balance sheet.” For its 118,000 U.S. salaried retirees, GM first offered a voluntary lump-sum payout to a subgroup of 44,000 (13,000 accepted) and then annuitized the pensions for the rest. “These individuals get the same check every month they previously received, only now the name of the company paying is Prudential,” Davlin says. “This is actually safer for them, as Prudential is a more highly rated credit counterparty [than GM]. This is their core business.”

Together, the two tactics moved $28 billion of liabilities off GM’s books in 2012. “We’ve stopped plan growth, reduced the liability, and sort of contained the risks,” Davlin says. “We’ve decided not to wait for things to get better. I only wish in hindsight that when we were overfunded by 7% that we took the opportunity to do it then.” Better late than never.

Verizon was the other poster child for annuitization last year, via its transaction with Prudential to shift $7.5 billion in pension obligations to the insurer. During a recent earnings call, CFO Fran Shammo said the deal was part of the phone company’s “overall pension derisking strategy, which will reduce our exposure to funding and income statement volatility caused by changes in investment returns, discount rates, and longevity risks.” The transaction, he said, would lower Verizon’s future contribution requirements.

Beyond these two very large deals, most pension-annuitization transactions have been below $500 million in size. Deals in 2012 other than GM and Verizon totaled about $2 billion, says Jacobs of Aon. “There has not been a lot of activity,” he says. “Even $35 billion in a year is a drop in the bucket when you consider the $2 trillion in pension funds out there.”

He adds, “I’m not saying that there won’t be another megadeal or two this year, but these things take time to hatch.” Jacobs says that current ultralow interest rates might dissuade companies from locking into rates below where they believe the market’s fair value really is. “They’re on the fence thinking, ‘I’ll wait for rates to rise and then take advantage of this at a somewhat lower premium.’”

Prudential’s Knapp has a more optimistic view. “This is definitely the time to investigate annuitization,” he says. “While many sponsors may find this more attractive when interest rates rise and their funded status improves, it all depends on the eye of the beholder — your conviction when rates will rise and what you will do if they don’t.”

Easy Lumps

Aside from annuities, the other tactic gaining traction is lump-sum payouts. Like rival GM, Ford Motor went this route in 2012, as part of the pension-derisking strategy it has followed since 2007. The decision was predicated in large part on PPA regulations that kicked in last year allowing companies to calculate the lump sums using yields on A, AA, and AAA bonds, rather than treasury rates. Consequently, pension liabilities can essentially be settled at the same rates used to measure them.

“The government sets the procedure and the rate at which the lump sums are calculated,” says Neil Schloss, Ford Motor vice president and treasurer. “You get it done at essentially close to 100% of liability.”

Ford also closed its plan to new participants in 2004, although it has not frozen the plan for existing active employees. Like many other plan sponsors, it also has an LDI strategy in place. “We’ve moved from public equities to fixed income and other alternatives, which turned out to be fortunate for us, as we missed much of the downturn [in stocks],” says Schloss. The company was at 55% fixed income at the end of 2012, but 80% in fixed income is the company’s long-term target allocation.

In effect, Ford is doing everything that GM is doing, other than annuitization. Asked why, Schloss answers: “GM and Verizon paid a good-size premium to transfer the liabilities, although I personally think they did a neat thing. But lump sums are done at no premium, at a market-rate value to the liability. Retirees who take them get 100% of a funded liability on the present value of future cash-flow streams. The benefit to the pensioner does not change. The rest is all accounting and market valuations.”

The downside to lump sums? “You need the assets to pull it off,” says Gordon Fletcher, partner in the financial strategy group at Mercer Investments.

Ford offered a lump-sum payment to some 90,000 of its pensioners. The company has not publicly stated the take-up rate, but has said it was able to shed $1.2 billion in pension liability. (An Aon Hewitt study indicates the average election rate for lump sums is 55%.) At year-end 2012, Ford’s pension plan remained underfunded by $18.7 billion. Says Schloss, “We’ll continue to evaluate options we have from both the liability side and the asset side as we go forward.”

Mix and Match

While lump sums and annuitizations get a lot of press, much of the action among large pension plan sponsors has been the pursuit of LDI strategies — carefully matching up their assets and liabilities to minimize risk.

Here’s how it works: A pension plan is really a series of future payment promises stretching out many years. So, by buying the right bonds (also a series of future payment promises), plan sponsors should be on the receiving end of these payments at the approximate time they need to make contributions to retirees. “When you buy bonds that make payments at the same time as the pension plan payments are due, the value of the bonds changes in the same way the pension liability changes when interest rates change,” Inglis explains.

Thus, if interest rates drop and a sponsor has bought long-term bonds, the change in their value should be commensurate with the change in the pension liability, and the net impact on their funded status is minimal. “The volatility in the bonds is the same kind of volatility in the liabilities, so you can match them up,” says Inglis. “This way, you hedge against a lot of the risk.” (click image below)

Given the current low interest rate environment, many sponsors are “dollar-cost-averaging” into these strategies by way of a “glide path.” Sponsors define a glide path based on the plan’s maximum funding level relative to its liabilities — that is, as the plan’s funding status improves, the sponsor gradually moves assets from equities to long-term bonds. “You could create a glide path that says when you get to 80% funded status, you will move 5% of equities to bonds, and when you get to 85%, you will move another 5%,” Fletcher explains. “When you get to 100% funded, you should be pretty much all in bonds, which would mean you’re virtually derisked and completely funded. For many sponsors, this represents pension nirvana.”

What’s the downside? “You have to move away from equities and the potentially higher upside they may provide,” Inglis says. “This gets back to the main point: Can you really afford to have a long-term perspective of the pension plan when your shareholders don’t have that long-term perspective of your company?”

Jacobs agrees. “The old school was growing assets through equities, which traditionally increased in value over time more than fixed-income assets, providing enough income to handle the liabilities,” he says. “The new school is having your assets and liabilities matched and moving at the same rate.”

Down the line, everyone seems to be in accord that the old school is closed up for good. “We’re seeing activity across the board on derisking, irrespective of the industry and the size of the plan,” says Fletcher. “Almost every plan sponsor is consistently looking at this.”

Inglis is reading the same tea leaves. “We might see a bit of a lull this year if rates remain the same and equities continue to rise,” he says. “But if rates do go up, it means plans will be better funded, thereby making both lump sums and group annuities cheaper. Pension derisking will continue. But you can’t wait forever to do it.”

Derisking: Caution Applies

Derisking is a hot topic right now for good reason: corporate bond interest rates are down, hiking pension liabilities. But it’s not for the faint of heart. Here are some caveats to consider:

• With the stock market breaking records, will migrating from equities to long-term bonds as part of a liability-driven investing strategy miss the party and lead to “regret risk”?

• For every $100 in liability, pension plans have only $77 of assets, according to Standard & Poor’s. While annuities freed General Motors and Verizon from many pension promises, many plans are not willing or are not able to fund the full value of an annuity purchase.

• Lump-sum buyouts are a great way to shrink pension-plan volatility. The difficulty again is having enough in assets to do it. There are also accounting rules governing unrecognized plan losses, which can be troublesome in a lump-sum transfer.

• Freezing plans is another option, but it has limited impact on derisking — you’re only restricting the buildup in new liabilities.

The “cult of equity” is poised to become history for UK defined-benefit schemes, as the country’s pension fund managers move to favour corporate bonds and alternative investments, a new survey reveals.

More than a third of the UK pension schemes (41 per cent) that participated in Aon Hewitt’s Global Pension Risk Survey for 2013 expect to reduce their exposure to UK equities in the next 12 months, while more than a quarter (28 per cent) hope to pare back their allocations to global equities.

At the same time as equities are falling from grace, alternatives are gaining a following.

One-third of participating UK pension funds hope to increase their exposure to alternatives. A similar percentage are accessing derivatives and raising their allocations to active strategies as well.

“We expect to see further demand from trustees for asset solutions such as diversified growth funds and even more use of derivatives as pension schemes strive to reach their long-term objectives,” says John Belgrove, a senior partner with Aon Hewitt’s investment consulting team.

Pension funds’ shifting asset allocations are due to one reason. As their struggle to reduce giant deficits deepens, the focus on developing increasingly sophisticated asset management strategies that offer equity-like growth and bond-like volatility is sharpening. In other words, schemes want to reduce their risks while freeing up capital to be used for the purpose of filling deficits.

Schemes with more than £1bn in assets seem the most committed to diversification, with a net 37 per cent of those taking part in this research looking to increase their bond holdings in the next year.

And the survey results offer yet more evidence that the managers of UK pension funds no longer see equities as the primary source of portfolio growth.

“Despite an equity performance of around 70 per cent from the low point of 2009, pension schemes continue to display a desire to move away from the asset class,” says Mr Belgrove.

“The focus for the future is on risk management through hedging and diversification.”

Aon Hewitt analysed the investment approaches of more than 220 UK schemes, with a combined £300bn in assets.

China's state pension fund has renewed its calls for an expansion of its assets under management to meet a growing need for pensions as society ages.

The fund's party secretary, Dai Xianglong, was quoted by Xinhua yesterday as saying that the central government should transfer 30 per cent of capital gains it receives from state-owned enterprises (SOEs) to the National Social Security Fund (NSSF).

The government should also transfer any of its shareholdings in SOEs in excess of 51 per cent to the pension fund, Dai said. SOEs currently assign 10 per cent of their shares to the fund during their initial public offerings.

He said the NSSF hopes its assets under management will grow to three trillion yuan (HK$3.8 trillion) by 2020 from 890 billion yuan now.

"The call highlights the pension fund's ambition to expand at a time when China has difficulty in meeting expected future pension liabilities," said Hu Xingdou, an economist at the Beijing Institute of Technology.

The NSSF, set up in 2000, serves as a strategic reserve fund for the central government to support future social security spending. It has also been entrusted with managing certain government funds for several provinces.

Started with 20 billion yuan from the Ministry of Finance, the NSSF has since grown on the back of contributions from fiscal appropriations, transfers of shares from SOEs upon their listings, lottery sales revenues and returns on its own investments, which yielded an annualised 8.41 per cent in the 11 years to 2011.

"About one-quarter of China's population will be older than 60 in 20 years, and one-third by 2050," Dai said. "The rapid pace of ageing calls for pension expenditures to grow as fast."

By 2033, the pension funding gap - the expected shortfall between provisions and disbursements - could reach 68.2 trillion yuan, or 38.7 per cent of estimated gross domestic product, if the mainland's population and pension policies remain the same, a research report by Fudan University in Shanghai concluded last year.

But the State Council has unveiled a plan to increase spending on social security. Under a directive on deepening the reform of income distribution, the cabinet said in February that SOEs would be asked to transfer an additional 5 per cent of their annual net profits to the central government by 2015, with an unspecified portion going to the NSSF.

SOEs now hand over up to 20 per cent of their profits to the central government. Last year, their contributions totalled 87.5 billion yuan, accounting for 7.9 per cent of the combined net profit of the SOEs controlled by the central government. Only 8 per cent of that sum was used to replenish the NSSF and increase other spending to improve social security last year, official data showed.

World gold prices will pick up over time as a global economic recovery gains traction, a senior official of China's $482-billion sovereign wealth fund said on Wednesday.

Gold has fallen about 18 percent so far this year after an unbroken 12-year string of gains. It rebounded to $1,381.80 an ounce on Wednesday after tumbling to $1,321.35 the previous day.

"Gold is still the most important (component of) reserves of the economies. The fast growth of emerging market economies means that the supply of gold will not be that much," said Jin Liqun, chairman of the supervisory board of China Investment Corp.

"Gold prices should go up over the long-term," he said on Wednesday on the sidelines of a business conference, but did not give an exact timeline.

He said the current decline in gold prices would moderate if the U.S. economy recovered this year and debt distress in the euro zone economies eased.

CIC's investment exposure to gold was limited, Jin said.

"We invest in gold as part of investment instruments, but not on a big scale," he said. "We have been doing well on this aspect."

The company's 2011 annual report showed it had no gold investment in its portfolios.

CIC is looking to invest in European companies where there is access to high-level technologies, Jin said.

"European countries have very good technology. There have well-managed companies that are having difficulties because of macroeconomic problems," he said.

CIC would also continue to explore investment opportunities in neighbouring countries in Asia and in Japan despite tension between Beijing and Tokyo, he said.

CIC, which manages a slice of China's foreign exchange reserves -- the world's largest at $3.44 trillion -- still has some cash at its disposal from its last government injection of cash in 2011, Jin said.

"We are not rushing to get more money at this moment, but eventually when we invest all of the resources. I do believe CIC will need new money in the future," he said, when asked if the sovereign wealth fund would request a new capital injection.

Blackstone LP is upping the ante in Asia, looking to raise the largest real-estate fund ever devoted to the region at a time when economic growth there shows signs of slowing.

The private-equity giant, which has become one of the world's biggest real-estate investors, plans to raise up to a $4 billion real-estate fund exclusively focused on China and other Asian markets, according to people with knowledge of the matter.

The target amount for the fund, which will be Blackstone's first devoted to Asia, is twice what the firm initially indicated it intended to raise. It also would be the largest Asia property fund raised, according to data tracker Preqin.

Blackstone believes there is opportunity because property values have fallen in many Asian countries as economies have cooled, say people familiar with its thinking.

The Asia fund is another sign that investors are willing to venture into emerging markets in search for yield, as interest rates are near rock bottom. Blackstone also may have sensed an opportunity in a region that many of its rivals have avoided, approached cautiously or pulled out of.

"There's not a whole lot of competition out there," said Timothy Walsh, director of the council that manages New Jersey's state pension fund, which last month committed $500 million to the new Blackstone Asia fund. "Just a few niche guys."

A Blackstone spokesman declined to comment on the new fund or fundraising in Asia. The firm is expected to provide some details about the Asia fund during its first-quarter earnings call on Thursday.

While Asian economies are among the fastest-growing in the world, offering a strong foundation for rising commercial-property prices, recent economic data has been less encouraging. Beijing said on Monday that gross domestic product growth slowed to 7.7% year over year in the first quarter. Economists say slower China growth could have a negative ripple effect throughout the Pacific Rim.

Some big U.S. pension funds that are investors in Blackstone's global funds say they aren't ready to commit to a new fund that focuses entirely on property in Asia. "We don't need to be pioneers," said Dennis MacKee, spokesman for the Florida organization that manages that state's pension fund, which has invested in two Blackstone real-estate funds. "We're a little more cautious."

Still, some Asian real-estate executives already are predicting Blackstone will meet its fundraising goal.

"Three billion dollars to $4 billion is not a difficult target for Blackstone in Asia," said Collin Lau, former head of real estate for China Investment Corp., the country's sovereign-wealth fund, who now runs Hong Kong-based investment firm Bei Capital.

For months, executives at Blackstone have been saying Asian real estate has great potential. "It's a very important initiative for us to become the most active, opportunistic real-estate investor in Asia," said Stephen Schwarzman, Blackstone's chairman, in a January earnings call.

Similar to its global and European funds, the new Asia fund will have flexibility to invest equity in all types of properties and to buy debt, say people who have been briefed on the fund.

Blackstone generally doesn't comment on its real estate-fund returns, but according to a memo from the New Jersey pension fund, Blackstone is projecting a net annual return of 18% for its $13.3 billion global fund that concluded fundraising last year. That fund also is investing in Asian real estate. The private-equity firm is projecting a 12% return for its global fund that completed raising money near the peak of the market in 2007, according to New Jersey.

Several private-equity firms have stumbled in the region. In China, for instance, some foreign investors made aggressive bets on the country's luxury housing market in the past few years, only to get burned after the government moved to rein in excessive speculation.

A fund run by J.P. Morgan Asset Management, for example, lost a high-end apartment building in the Chinese city of Dalian to foreclosure last summer after sluggish sales put the firm in violation of loan covenants.

Some firms have exited or scaled back in the region. Bank of America Corp. sold the former Merrill Lynch Asian real-estate assets to Blackstone in 2010, while Citigroup Inc.sold its Asian real-estate investment platform to Apollo Global Management. American International Group Inc.sold its Asian fund business to Invesco in 2010.

In India, Apollo is in arbitration over one of the deals it inherited from Citigroup: an $80 million investment in Delhi developer BPTP Ltd. Citigroup had expected to exit its investment through an initial public offering but wasn't able to do that when the IPO market soured. The two sides now are disputing how BPTP should go about selling assets to repay Apollo.

Even U.S. firms that recently raised or are rolling out pan-Asian funds aren't attempting anything on the same scale as Blackstone. Angelo Gordon & Co., of New York, closed a $616 million Asian property fund. AEW Capital Management, a Boston-based real-estate investor, is raising a $500 million fund that will invest in major Asian cities, such as Singapore, Hong Kong and Seoul. LaSalle Investment Management in Chicago is looking to raise $750 million to invest in Asian property.

Blackstone began buying Asian real estate in 2006 but made equity investments of only about $102 million over its first three years in the region, according to the New Jersey memo.

Since 2010, as Asia emerged from the global economic downturn, Blackstone has stepped up the pace, making about $1.5 billion in equity investments in Asian property. It now has 48 people real-estate professionals in the region, a staff roughly the same size as it has in Europe.

U.S. public pension funds and life-insurance companies are building up potentially dangerous levels of risky investments that could threaten their solvency, the International Monetary Fund warned Wednesday.

It is a gamble that could harm not only on pensioners and insurance customers, but also on the financial system, the IMF said in its Global Financial Stability Report.

Returns from traditional investments and contributions have dwindled during the recession. And as the Federal Reserve lowered interest rates to try to revive growth, those firms have been unable to match their funding levels with future liabilities.

For example, the IMF says public defined-benefit pension plans won't be able to fund nearly a third of their future obligations based on their current portfolios.

That funding shortfall has encouraged pension funds and insurance companies to bet on higher risk, and potentially higher-return, investments to meet those needs.

To be sure, the IMF says the Fed's actions are essential to reviving U.S. and global growth. But the cheap cash and low interest rates don't come without a cost.

The fund says that at the weakest pension funds, money mangers have boosted their holdings of alternative investments such as hedge funds and financial derivatives to about a quarter of their assets from virtually zero in the last 10 years.

Life insurance companies, meanwhile, have tried to compensate for the lower returns by renegotiating policy terms and getting rid of some insurance benefits. But there is a limit to what they can do, and so many insurance companies have bulked up on riskier investments too.

Most pension funds and insurance firms have cash on hand to weather near-term shortfalls, the IMF said.

"But a protracted period of low rates could depress interest margins further and erode capital buffers, potentially driving insurance companies to further increase their credit and liquidity risk," the IMF said.

The IMF said pension funds need to address their future funding shortfalls "without delay," through "restructuring benefits, extending pensioner's working years and gradually increasing contributions to close funding gaps."

At the same time, some insurance companies may need to get rid of some of their more costly products and restructure their investment portfolios to meet future needs.

U.S. pension funds, especially poorly funded plans, are increasing their risk exposure to dangerous levels in the current low-interest-rate environment, according to a report from the International Monetary Fund.

The Global Financial Stability Report states that vulnerabilities are growing in the U.S. credit markets while pension funds and insurance companies are moving into more risky assets.

“Reduced market liquidity could amplify the effects of any future increase in risk-free rates,” the report states.

Public DB plans have gone from fully funded in 2001 to a 28% shortfall at the end of 2012. In that same time period, weaker funded plans have increased their allocations to alternatives to 25% from virtually zero, which exposes plans to more volatility and liquidity risks, according to the report. Low interest rates have led plans to search for higher yields elsewhere.

“Low yielding assets may induce excessive risk taking in a search for yield, which may manifest itself in asset price bubbles,” the report states.

The IMF recommends pension plans engage in active liability management operations immediately, including restructuring benefits, extending working years and gradually increasing contributions to close funding gaps.

“An undesired buildup of excesses in broader asset markets is a potential risk over the medium term,” according to the report. “Asset reallocations of institutional investors to alternative asset managers, excess cash holdings by those asset managers, the decline in underwriting standards, and the sharp rise in bond valuations are all intertwined. Constraining those potential excesses is a financial stability imperative.”

A new universal supplemental pension plan is one of the key proposals by a blue-ribbon panel to provide financial security for elderly retirees in Quebec.

A committee of experts examining the province’s underfunded retirement system recommended Wednesday that Quebec take the bold and innovative step of creating what it calls a “longevity pension” where, at age 75, retirees would receive an additional income.

As workers live longer and retire earlier, enormous pressure is being placed on existing private and public pension plans. Those managed by the Quebec Pension Plan alone are underfunded by $41-billion, the committee reported. The committee recommended that, to improve their solvency, the workers and employers need to restructure the plans over a five-year period.

The experts also called for the implementation of a voluntary retirement savings plan.

The Quebec government said it will hold public hearings and act quickly on some of the report’s recommendations.

“A bill [on a voluntary savings plan] was being prepared and will be tabled soon,” Premier Pauline Marois said in the National Assembly on Wednesday.

However, the government appeared less anxious to take a position on the committee’s longevity plan proposal. Ms. Marois invited the opposition parties to take part in a non-partisan debate next fall in seeking solutions to the serious financial problems facing the province’s retirement-income system.

In creating the longevity plan, the government should allow easier withdrawals from retirement savings, the committee recommended.

The committee confirmed that a growing number of workers were outliving their savings at a time when almost half of the four million workers in Quebec – or 47 per cent – have no group retirement plan. Their only source of income after retirement will be benefits from the Quebec Pension Plan and federal Old Age Security.

The longevity plan recommendation would be an additional way to require workers to contribute to another mandatory pension plan to ensure an adequate source of income in the latter years of their retirement.

“The status quo is not a solution,” said committee chairman Alban D’Amours, who was the former president and CEO of Desjardins Group. “The objective here is that everyone be given access to a reliable pension income.”

The proposed longevity plan would be fully funded by employer and employee contributions, and all workers – regardless of income – would be required to contribute. The plan’s cost was estimated to be the equivalent of 3.3 per cent of earnings shared equally between workers and employers up to a maximum contribution of $840 a year per employee.

Earnings at 75 years of age would be the equivalent of 0.5 per cent of earnings up to a maximum allowed by law. For instance, a young worker earning the maximum allowable income, $51,000, and who paid $840 a year into the plan, would receive $14,564 a year as a supplemental income at age 75.

The experts also concluded that while defined benefit plans provided the best protection at lower cost, several plans remained in serious financial difficulty. As many as 72 per cent of the plans had a degree of solvency of less than 80 per cent.

“Increasing life expectancy, early retirements, an aging population, the decrease in interest rates and financial market volatility have made the weaknesses blatantly obvious,” the report stated, adding that hopes of a market turnaround to correct the problem was an “illusion.”

The committee of experts recommended the government allow for more flexibility for negotiations between company management and employees to solve the financial problems facing the defined benefit plans. The objective the committee insisted on was to help workers plan their financial security in preparation for retirement.

“The longevity plan allows people to save more and it will cost a lot less than if we did nothing,” Mr. D’Amours said at a news conference. “Our entire pension system is coming under attack. If we do it [the longevity plan] today it is a savings plan. But if we do nothing, tomorrow it will become a tax.”

However, the business community expressed concerns that the new longevity plan amounted to a new tax on small and medium size companies. The Canadian Federation of Independent Business estimated the new plan could cost $5-billion a year – a heavy burden for many small companies and their employees to carry.

If proposals to fix the province’s ailing pension system become law, working Quebecers would pay $843 a year, and their employers would add an equal amount to fund a proposed new “longevity pension.”

And before the report was even presented Wednesday, Premier Pauline Marois said legislation to do just that is being prepared and would be presented soon.

Marois called for unanimity among all parties in the assembly, “to protect the retirement of those who have contributed all their lives to retirement plans and others who have not, who need more support.”

The longevity pension is the main recommendation in a 219-page report presented Wednesday by seven pension experts after 18 months of behind-the-scenes consultations and deliberations.

Benefits under the new plan would be paid starting at age 75 — on top of federal Old Age Security and existing Quebec Pension Plan benefits, adding as much as $14,564 a year to a pensioner’s income.

Quebecers are retiring earlier and living longer, putting unsustainable pressure on private pension plans.

The panel of experts was named by the Liberal government of Jean Charest in 2011 because private pension plans in the province have a shortfall, which has grown to $41 billion, between the money they have and the pensions they are committed to paying out.

But the panel, headed by Alban D’Amours, former head of Quebec’s Desjardins financial co-operative movement, broadened its focus to the restructuring of the province’s pension regime, looking 40 years ahead.

The looming problems are considerable.

The proportion of Quebecers working and paying taxes will drop to two working Quebecers for everyone over 65 by 2030.

As well, interest rates on investments average 2.3 per cent, far from the 10-per-cent-plus returns once promised by financial planners, touting, “Freedom 55” — the dream of stopping work 10 years before the usual retirement age.

Volatile financial markets suggest there is no respite ahead and Quebecers must make pension adjustments.

About 2.4 million working Quebecers have no private pension plan to supplement their government pensions.

The longevity pension would leave Quebecers with a 10-year period after the normal retirement age of 65 when they would have to either count on personal savings or continue working.

The committee makes no recommendation to raise the retirement age, but Luc Godbout, a Université de Sherbrooke tax expert and panel member, said too many Quebecers now claim their Quebec Pension Plan benefits at age 60 and their Old Age Security at 65, getting less than they could should they keep working and defer their government pensions.

By setting 75 as the age additional benefits would be paid, the committee sends a signal that there is no advantage to early retirement, and suggests that Quebecers save more before they retire.

“We are reinventing savings,” D’Amours said.

And while D’Amours stressed payments into the longevity pension are “not a tax,” Martine Hébert, Quebec vice-president of the Canadian Federation of Independent Business, called the new charge a “payroll tax” that would add to the burden on small businesses in the province, making them less competitive.

D’Amours said calling it a payroll tax is “a bad reading” of the plan, conceived to be 100-per-cent capitalized, meaning that everything paid into the plan will be paid out, without taxpayers contributing.

“It allows people to save more,” he said. “It allows small businesses to assume their responsibilities.

“And it will cost less than what we would have to pay eventually if nothing is done in 10 or 15 years, when the problem of longevity will be even more apparent.”

Without the longevity pension, pensioners with diminished resources would turn to government, seeking relief paid “with our taxes,” D’Amours said.

Yves-Thomas Dorval, president of the Conseil du patronat du Québec employers’ group, suggested the government could reduce other payroll taxes to ease the burden, but said overall the D’Amours report is positive.

“There are measures that will encourage people to work longer,” Dorval said.

He said contributions to pay the longevity pension would remove about $2 billion a year from the economy.

“That is a large impact,” Dorval said.“On the other hand, it is like a transfer for later because it is money that will be used later.”

While primarily intended to help Quebecers with no pension plan, the longevity pension would also ease some of the pressure on private pension plans.

The report’s authors explained that employers could adjust their private pension plans, reducing employees’ payroll pension deductions by a corresponding amount.

And the private plans would not duplicate the benefits of the longevity pension after age 75, easing the underfunding problem for company pensions.

The committee also proposed measures favouring negotiations to resolve the underfunding problem in a 15-year time frame.

Another proposal would allow an employer to unilaterally abolish secondary benefits, such as retirement at full pension before age 65.

• Mr. Alban D'Amours, Committee Chair; President and CEO of the Desjardins Group (2000-2008)
• Mr. René Beaudry, actuary; Partner, Normandin Beaudry
• Mr. Luc Godbout, tax specialist, Université de Sherbrooke
• Mr. Claude Lamoureux, President and CEO, Ontario Teachers' Pension Plan (1990-2007)
• Mr. Maurice Marchon, economist, HEC Montréal
• Mr. Bernard Morency, Executive Vice-President, Caisse de dépôt et placement du Québec
• Mr. Martin Rochette, lawyer; Senior Partner, Norton Rose 

The Institut de la statistique du Québec estimates that at the end of 2012, private defined-benefit pension plans in Quebec had a total deficit of $40.6 billion. Also, 74 per cent of defined-contribution plans were only 80-per-cent solvent.

The problem affects both private and public-sector employees, as well as those with no pension plan except federal Old Age Security. The federal payout can be supplemented by the Canada Assistance Plan, and the more generous Quebec Pension Plan, funded by employee and employer contributions.

About 40 per cent of Quebecers have savings sheltered from the taxman in Registered Retirement Savings Plans, leaving 60 per cent of Quebecers with no retirement savings.

Now, Quebecers can claim a reduced pension, under the Quebec Pension Plan from age 60.

Quebec’s average retirement age in 2011 was 60.9 — compared with 62.7 in Ontario and the Canadian average of 62.3.

While Quebecers are living longer, retirement incomes are not always indexed to offset inflation.

Some employees, such as those who worked for once-solid companies like Nortel Networks and Abitibi, are not getting the pensions they were promised.

Quebec’s municipalities say they have a combined $5-billion deficit in meeting their obligations under defined-benefit pensions for civic employees — or about $100,000 for each employee.

Montreal Mayor Michael Applebaum has told the D’Amours committee that raising city taxes to cover pension deficits is not a foreseeable solution.

“It is a question of equity for Montrealers who, for the great majority, do not have a pension plan,” Applebaum said.

Éric Forest, president of the Union des municipalités du Québec, told The Gazette in an interview Monday that there is no single recipe to solve the problem, but he appealed to the government to “give us the tools” to work out agreements with public-sector unions.

The Conseil du patronat du Québec employers’ group told the D’Amours committee Quebec should consider raising the retirement age to 67 from 65, noting the finding of economist Pierre Fortin that since widespread public-pension plans began in Quebec in the 1960s, people are working 10 years less, on average, and draw pension benefits 20 years longer.

Conseil du patronat president Yves-Thomas Dorval said raising the retirement age is the easiest way to deal with the pension problem, while raising taxpayers’ contributions would have a negative impact, reducing investment and consumption spending, while holding down job creation and wages.

“It will touch everyone,” Dorval said.

And while some boomer-generation employees, in good health and with children still studying, are putting off retirement, most pension plans remain geared to retirement at 65, with early retirement at 55.

But Quebecers can expect to live much longer after that. The Institut de la statistique du Québec calculates that between 1980 and 2011, the life expectancy of Quebecers rose to 81.8 years from 75, with women living four years longer than men on average.

In Quebec between 1971 and 2011, the number of people over 65 doubled to 16 per cent of the total and will continue to rise to 28 per cent of Quebec’s population by 2051.

A study last year found that in the year 2000, there were five people working for everyone over 65 in Quebec, falling to four working to every one over 65 in 2010, and by 2030, there will be two people working for every Quebecer over 65.