The S&P 500 (SPY) fell last week as markets gyrated between gains and losses following unimpressive industrial production, concerns over Japan, the direction of bond yields, and ultimately what the Fed will say next week. On CNBC Thursday, I argued that the big concern is that we are in a period of falling bonds and falling stocks - something which is an infrequent occurrence given the historical inverse relationship between longer duration Treasuries and equities. However, just as everyone is seemingly getting nervous about a rising interest rate environment, it does seem entirely plausible that the exact opposite occurs and we re-enter a period of falling bond yields and recovering cyclicals.

I am not convinced a correction is yet here for stocks. SuperBen and the League of Extraordinary Bankers will not risk their precious wealth effect by attempting to end quantitative easing too early. In fact, I suspect they may talk up the possibility that they will only do more given that global growth is faltering. Recent downgrades of economic activity span across multiple countries, making it hard for any central bank to do anything other than push more money into their respective economies. Schizophrenia over an end to QE will soon be replaced by the very real concerns over deflation given that, as has been the case all year, the reflation story simply is not materializing.

The irony over the last few weeks of the Fed's "confuse and conquer" strategy to tame equity markets is that the threat of QE tapering domestically in the U.S. has most hit emerging markets (EEM), with those currencies (CEW) getting hurt, and equity markets entering correction/bear market territory. Any kind of reversal in rhetoric, then, likely reverses the oversold nature of anything outside U.S. borders. With globalization, the Fed needs to be wary of their words and their actions on not just America, but everything else connected to us and the types of ripple effects and feedback loops that result.

Our ATAC models used for managing our mutual fund and separate accounts rotated, favoring bonds over stocks in the near-term. Historically, such moves have preceded corrective environments, but I'm not so sure if that is the case now. Bonds may simply be a more clear long trade than stocks are either long or short. Much clearly will depend on the tone the Federal Reserve takes, and how that impacts expectations and intermarket trends. I suspect that emerging market currencies will likely bounce rather strongly, alongside sovereign debt. In the U.S., momentum favors shorter-duration Treasuries for now, but perhaps for only a fleeting moment. Any kind of realization that the yield curve steepened too far, too fast likely means the long-duration bond trade (TLT) returns (click inage below).

• Inflation in the US is at a 50-year low, which concerns doves on the FOMC who are worried about deflation. Fiscal austerity and now sequestration are driving inflation expectations lower.
• Euro zone is flirting with deflation and the ECB is reluctant to crank up its quantitative easing or lower rates. The Fed can't ignore Europe and will step in to fill the void.
• Emerging markets have experienced a sharp selloff in recent weeks and remain on shaky grounds. Again, the Fed can't ignore what is going on in emerging markets because a crisis there would intensify global deflationary headwinds, which is exactly what the Fed doesn't want.
  

At this stage of the game, speculative-grade securities appear to be nearing an extreme. According to economic research firm Bank Credit Analyst, the average price of a bond in the high-yield index is well above par, at $105.92. "It will be difficult for prices to rise much further given that roughly 70% of public market high-yield bonds include some type of call option to the benefit of the issuer," BCA notes. "Thus, total return investors who have become accustomed to equity-like returns from high-yield bonds are liable to be disappointed buying at these prices."

In other words, there are no more seats to be added to the game of musical chairs being played out in the debt markets.

There is a possibility that high-yield securities as a whole have further to run though. Monetary authorities have vowed to maintain an aggressive policy stance in support of economic recovery, which will continue to support corporate cash flows, keep default rates from rising and perpetuate the ongoing credit-agnostic search for income in a yield-starved investment climate.

Some potentially seismic news for the private equity market yesterday, as Yankee Candle canceled a $950 million debt refinancing that would have resulted in a $187 million dividend for owner Madison Dearborn Partners. Not yet reported is that fellow Madison Dearborn portfolio company Asurion Corp. also ended its pursuit of an $850 million term loan to refinance existing debt that comes due in 2017.

To be clear, this isn't a Madison Dearborn issue. It's an industry issue.

Private equity has been propped up over the past few years by artificially low interest rates – an environment that has allowed the industry to often escape negative repercussions for its pre-crisis overspend. But now rates are rising in anticipation of next week's Fed meeting and the dreaded "T" word.

"We've all been expecting this for some time, and now it finally seems to be happening," explains a senior private equity exec. "Low rates were fun while they lasted."

To be sure, it's possible that Big Ben won't actually announce tapering of the Fed's bond buyback program – but the debt markets seem to think he will (if not next week, then soon thereafter).

And if that happens, debt refinancing are about to get much, much harder. So will getting well-priced financing for new deals (got to wonder if this has thrown a wrench into Icahn's Dell financing plans – assuming he still has Dell financing plans).

Private equity execs often blanch at the term "financial engineering," but estimates are that firms have done more refinancings for existing portfolio companies over the past year than they've done new transactions (including bolt-ons).

So if a firm really doesn't rely on financial engineering, it shouldn't have anything to worry about. But for everyone else, here's to hoping you either got your refi done already or actually have an operational roadmap for substantial growth...

The collapse of debt burdened firms that were bought up by private equity companies before the financial crisis could pose the next major risk to the stability of the UK's economy, the Bank of England has warned.

These leveraged buyouts (LBO), which are likely mature next year, pose a systemic threat that needs to be addressed, according to the Bank's quarterly update.

The warning from the Bank comes ahead of a major round of refinancing. Some £32bn of LBO debt has to be refinanced in 2014 and 2015, with a further £41bn of LBO debt maturing over the following three years.

"In the mid-2000s, there was a dramatic increase in acquisitions of UK companies by private equity funds. The leverage on these buyouts, especially the larger ones, was high," the Bank said.

"The resulting increase in indebtedness makes those companies more susceptible to default, exposing their lenders to potential losses.

"This risk is compounded by the need for companies to refinance a cluster of buyout debt maturing over the next few years in an environment of much tighter credit conditions," the Bank added.

As there was a surge in acquisitions in 2007, many of these deals will unwind next year, the Bank said: "The average maturity of UK leveraged buyouts' debt is around seven years. Given that the peak in debt issuance was around 2007, there is a significant 'hump' of maturities from 2014."

The study referenced part-nationalised lender Royal Bank of Scotland, which aggressively expanded its strategy in leveraged finance amid a "search for yield" which drove up demand for leveraged loans.

The Bank said under its new regulatory framework, which is coming into effect next month, it would take on the responsibility to protect and enhance the stability of the UK's financial system in order to prevent "future episodes of exuberance" that took place at the height of the boom before the crisis.

Where high profile (and high fee) LBOs and M&A activity drove the market in 2007, with roughly 75% of all private equity-related loans backing LBOs or acquisitions, thinly priced refinancing loans have dominated in 2013, much to investor chagrin. Indeed, so far this year only 19% of sponsor-backed loans support LBOs/acquisitions, while more than half back refinancing of existing debt, often LBO loans put in place not all that long ago. Much of the remainder back credits funding a dividend to private equity firms (institutional investors care little for those loans, as well).

The reason for the spike in refinancings, of course, is borrowing costs, which earlier in the year hovered at or near record lows, and remain attractive to issuers (though things have tightened up over the past few weeks, with a number of proposed loans pulled due to market gyrations).

LBOs, on the other hand, remain few and far between, largely because sellers and buyers remain far apart regarding price, according to LCD’s Steve Miller. There are few signs of a pickup on the near-term horizon, loan arrangers say, though there’s some speculation – or perhaps hope – that deal flow could shift into a higher gear during the fourth quarter as current screening activity reaches fruition, Miller adds.

Despite the funds being inactive, general partners — those managing the funds — still collect management fees from investors.

U.S. regulator the Securities and Exchange Commission is investigating the use of these essentially inactive funds, which critics say drain money from pension funds and other investors that would otherwise be available to reinvest or return to clients. It is part of a wider SEC probe into the private equity industry as a whole.

Hedge funds, asset managers and other alternative investment vehicles have also recently come under increased scrutiny in both Europe and the U.S. as the public and regulatory backlash since the 2008 financial crisis spreads beyond the banking industry.

The Preqin research — which is based on records of active funds managed between 2001 and 2006 that did not raise a follow-on fund after that time — found that zombie funds were sitting on shares in more than 1,700 companies.

The zombie funds returned less than 40 percent of the capital they paid in, compared with a 99 percent return for all private equity funds raised in 2003, Preqin said.

“No one is a winner when zombie funds are involved and represent a clear misalignment of interests between the fund manager and investor,” said Ignatius Fogarty, head of Private Equity Products at Preqin.

“GPs should be eager to realize investments and return capital to investors so that there is no reputational damage that adversely affects their ability to raise a follow-on fund,” Fogarty added.

Secondary buyouts, a takeover of private-equity assets by another private equity firm, offer a route out of a zombie fund and some fund managers even see buyouts as an investment opportunity.

Last month, Merchant bank Kirchner Group and Crestline Investors Inc., a hedge fund secondary buyer with $7.3 billion under management, teamed up for a joint venture aimed at taking over zombie funds.

Private-equity firms—which have raised $158.7 billion this year through Monday, according to industry tracker Preqin—are audited and increasingly hire consultants to help them value their holdings. Those third parties perform their own analyses but have to rely somewhat on what the firms tell them.

In the process, some private-equity firms appear to juice the returns intentionally to help raise new funds, according to research released in May by Greg Brown and Oleg Gredil of the University of North Carolina at Chapel Hill and Steven Kaplan of the University of Chicago.

"Some funds may be trying to convince people that they are better than they really are," Mr. Brown says.

The good news: According to the research, most firms that try to manipulate their performance fail to raise a new fund. That suggests potential investors see through the trick.

The research estimates that those firms inflate their asset values by about 20% before trying to find new investors. Afterward, the estimated values typically fall back to earth. The paper finds that top-performing funds actually tend to underreport returns.

Another paper released in February by researchers at the University of Oxford in England also found that some private-equity funds seem to increase the value of their assets shortly before raising money.

In a statement, Bronwyn Bailey, vice president of research at the Private Equity Growth Capital Council, an industry group, said: "The [Brown] paper clearly demonstrates that private-equity returns are, if anything, being reported conservatively and that investors will not invest in firms that deviate from industry-accepted valuation practices," adding that firms that can't raise new funds will go out of business.

So what is an investor to do?

For one, if you are a high-net-worth investor considering a private-equity fund, sign on only with firms whose funds have investments from major institutions, Mr. Brown says. Institutional investors do their own analyses of valuation methods to make sure a firm isn't juicing its returns, which small investors can piggyback on, he says.

University of Oxford finance professor Tim Jenkinson, one of the authors of the February research, says investors might be best served by ignoring interim returns reported in marketing materials altogether. His research found that such returns have little correlation to the funds' final performance relative to other funds.

The Toronto-based insurer and investment manager is increasing its position in Eurobank Properties S.A. – a subsidiary of one of Greece’s top lenders, Eurobank Ergasias SA – which is focused on commercial real estate and privatizations in the country and its surrounding region.

Fairfax’s stake in the property company will increase to 42 per cent, from 19 per cent, marking one of the larger foreign investments in a Greek public company since the Great Recession shook the European nation about five years ago.

Fairfax’s investment is a show of confidence from chief executive and noted market bear Prem Watsa, not only for Southern Europe’s commercial real estate market, but also for the ongoing Greek economic recovery.

“We believe that Greece has taken significant steps towards addressing many of the key areas of its economy, thus encouraging foreign investment and creating a positive momentum that will foster increased employment and development in the country,” Mr. Watsa said in a statement following the release early on Wednesday morning.

Alexis Papachelas of Kathimerini reports, The risks of a Greek collapse:

While Greece seems to be engrossed in its “success story,” the country’s partners appear more concerned with its “stability story,” in other words whether or not the country will stay on an even keel.

There are several reasons why this is what they are most interested in. Portugal is on the brink of a major political crisis; Italy seems unable to find solutions to its problems, and an out-of-control collapse in Greece would complicate this already tenuous situation.

There are also broader geopolitical reasons. The Americans and the Europeans are becoming quite frightened by the chaos in the Middle East, especially at a time when Israel is particularly isolated. Their stance toward Turkey has also changed as they grow more and more concerned by the instability there and Prime Minister Recep Tayyip Erdogan’s arrogant behavior. A Greek “accident” is seen as very dangerous in such a climate.

Of course there are those who expect Greece to fail, but argue that even if does, it will find a way to get back on its feet. The majority of international observers and officials, however, do not take the possibility of a Greek collapse so lightly.

So what is the problem? The Greek political system and public administration are nowhere near achieving reform targets, even when these are lowered. The international community is aware that it can exert pressure on Athens until the end of the year when Greece hobbles to a primary surplus. But, as that time approaches and it feels that it only has a few more months to exert influence, the more pressure it will apply. And this is where the danger lies: Greece’s creditors may cause the crash by applying too much pressure.

In the middle of it all are the markets, either in the form of large funds willing to invest in the new low-cost Greece or in the form of lenders who would like to see the Greek bond market operate again.

Prime Minister Antonis Samaras believes that maintaining calm is the top priority. He hopes that an excellent summer in terms of tourism, public works projects due to begin imminently, the TAP pipeline and some good investment news will create a positive climate come the fall.

At the same time he is equally aware that the people are about to be hit with a cascade of taxes and that if these are not collected the fiscal gap will be hard to manage. No one can predict whether there will be a sense of positive shock or an even greater feeling of misery in the fall.

All of this, meanwhile, is taking place ahead of an anticipated clash between Berlin, the International Monetary Fund and Brussels right after the German elections over whether Greece should receive a further debt writedown and a different policy mix.

• No crisis in Greek public sector: Kathimerini reports that Greece’s two biggest unions, ADEDY and GSEE, launched 24-hour general strike on Tuesday with the aim of convincing the government to withdraw its multi-bill of reforms, which is due to be voted on by MPs on Wednesday. Last week,
  Greek Administration Reform and E-Governance Minister Kyriakos Mitsotakis talked to Bloomberg about plans to sack 15,000 state employees and put another 25,000 on notice for possible dismissal. To put things in context, the 1.3 million unemployed in Greece are all from the private sector. Those 15,000 job cuts in the public sector represent 2% of the Greek public sector, which is negligible. And while politicians talk about reforms, the truth is nobody is doing anything because they fear repercussions from powerful public sector unions. 
• Taxes to bolster the public sector: To add insult upon injury, Greeks are getting hit with all sorts of taxes, a lot which still goes into into feeding the bloated public sector. The 23% VAT tax is hitting restaurants, groceries, and many other companies hard but businesses have to wait an average of 337 days to receive their value-added tax returns (if they are lucky). Moreover, Greeks are bracing for new taxes to hit real estate and their utility bills. The government is hoping to raise 7 billion euros in tax revenues, equivalent to about 3.5 percent of GDP, by the end of the year. About half of this is due to come from income tax but only 30 percent of taxpayers have made their income tax declarations so far, and I doubt the government will achieve its target. In fact, the more taxes they introduce, the less revenues are coming in.
• Greek youth waiting for an economic dawn: Bloomberg published an article on how Greeks are waiting tables and hoping for an economic dawn. The article profiles the plight of Olympia Angeli, a 28-year-old clinging to the security of working as a waitress even as her wages have fallen by half in three years. And she's part of the lucky few who has work as tourism is booming this year. The article quotes Andreas Koutras, an adviser at the Lucerne, Switzerland-based investment company SteppenWolf Capital LLC, an investment fund that holds Greek debt: “Greece has the holy trinity of crises. It has a public debt crisis, a bank crisis and a cultural-political crisis. These are self-feeding. Greece has become the lighthouse of Europe: Steer well clear of that area.” 
• Greece has tremendous potential: Despite the tone of this post, Greece has tremendous potential. It's blessed with a rich cultural history, an incredible climate, pristine beaches, and a highly educated population. But it's cursed with a political system which ensures nothing meaningful will ever get done in terms of reforming the economy for the better. Austerity has overwhelmingly hit the private sector and the country has reached the end of the line. Most sensible Greeks recognize this but the pace of reforms is frustratingly slow. I don't see a collapse but there will be some major hurdles in the coming year.

• Russians love Greece: There is a significant increase of Russian tourists in Greece. I saw this in Crete where speaking Russian is fast becoming a prerequisite to work in tourism. Russians are coveted tourists because they spend a lot of money and don't just stay at some all-inclusive resort all day (which is what most tourists on tight budgets end up doing).
• Chinese love Greek olive oil: Greek exports of olive oil and other agricultural products are booming, especially to China where the Chinese realize the health benefits of the traditional Greek diet. Italy remains the number one export country for olive oil (they buy Greek olive oil and export it as their own). 
• Athens is insanely expensive: Went to to the beach in Athens at Varkiza on the weekend. Entrance fee was 7 euros and there was an additional charge of 20 euros for four chairs and two umbrellas. A family of four pays almost 50 euros to enjoy a day at an organized beach in Athens (and that does not include food, beverages and gas which is expensive). And it was packed, which goes to show you that while Greeks are complaining, many have money (you wouldn't know there is a crisis by looking at beaches, restaurants and bars in Athens). Still, there is poverty and misery and if you look closely, you can see it. 
• Greece will always be a great vacation spot: There are many beautiful places in the world but Greece will always be among the top destinations. And while Santorini and Mykonos top the list of islands to visit, the true gems are in the Peleponnese region and islands where tourists rarely venture.You can spend 500+ euros a night to stay a luxury resort like Costa Navarino, but you can also spend a lot less to enjoy some truly beautiful spots in Greece.

The ability of U.S. public pensions to cover their liabilities weakened again, although the deterioration is slowing, two major rating agencies said on Tuesday.

Both Fitch Ratings and Standard & Poor's Ratings Service added that they expect improvements in pension finances in the near future.

Since most systems use an accounting mechanism known as "smoothing" to spread changes in assets over many years, losses related to the 2007-09 recession have persistently hurt pensions' funded levels, they said. Recent stock market gains will likely bolster improvements, but the agencies warned that public pensions still face large obstacles, namely state budget strains, an aging population, accounting rule changes and legal challenges to reforms.

The average funded ratio for all 50 states' pension plans was 72.9 percent in 2011, a drop of 1 percent from the previous year, and the median ratio was 69.8 percent, 2.2 percent lower than the year before, according to S&P. The funded ratio represents how much in assets pensions have to cover liabilities.

S&P said the declines in previous years were larger. The national average fell 1.6 percent in 2010 and 7 percent in 2009, according to the rating agency, which said 2011 was the latest year complete data was available.

The smaller declines could lead some "to believe that the worst is over and that pension funded levels have bottomed out," but the road to improvement "will be bumpy," it said.

Public pensions receive most revenue - more than 60 percent - from earnings on investments, which were devastated by the financial crisis. Over the last decade, funded ratios dropped from a peak of more than 100 percent in 2000, S&P said.

In its report, Fitch found states' median unfunded pension burden is equal to 3.6 percent of personal income. Wisconsin has the lowest unfunded pension obligation at zero percent of personal income and Illinois, considered the worst state for pension funding, had the highest at 19.1 percent. The agency uses personal income as a measure because it represents the "resource base that will ultimately cover the obligations."

"Pensions remain a growing pressure for numerous states' budgets. Nearly all states are pursuing reform and remain well-positioned to address these burdens. While the positive effects of reform for most are decades away, a proactive approach to managing pension challenges is a credit positive," said Douglas Offerman, a senior director at Fitch, in a statement.

Fitch said investment performance in 2012 "was relatively flat for most plans and well below their investment return assumptions," but that 2013 will likely show gains.

For the 100 largest public-employee retirement systems, cash and security holdings totaled $2.93 trillion in the first quarter of 2013, the highest on records going back to 1968, according to a U.S. Census report released last month. The previous peak was just before the financial crisis in the fourth quarter of 2007, $2.929 trillion.

For years, states had shortchanged their public pensions. When their own revenues collapsed during the recession, they pulled back further while laying off employees, effectively shrinking the pool of contributors to the pension system. Fearing public employees would not see retirement money and funds for key services would have to be diverted to pensions, almost all states rushed to reform their systems.

According to Fitch more than 38 statewide plans dropped their investment return assumptions, lowering funded ratios but reflecting "a more prudent approach to estimating the long-term asset performance of a plan."

"The vast majority of states have pursued reforms lowering benefits for future hires, which are much easier to enact, although the beneficial impact of such reforms will only manifest itself in pension metrics over decades," it added.

Meanwhile, the board overseeing governments' accounting is changing pension obligation calculations. Implementing the changes "will result in the reporting of a greater and more volatile unfunded pension liability," S&P said, especially because pensions will have to use a market valuation of assets.

The third major rating agency, Moody's Investors Service, took a slightly different tack while reviewing pensions, saying in a report last month that for more than half the states their pension liabilities are equal to at least half their annual revenue.

Voluntary participation by states and municipalities would reduce the threat of insolvency by removing the possibility of pension-plan underfunding, according to Senator Orrin Hatch of Utah, the top Republican on the Senate Finance Committee and author of the bill introduced today. The measure, which would alter federal tax law, also would permit changes in non-government retirement plans to boost employee savings at small and mid-size companies.

The legislation, S. 1270, comes as more Americans say they want to save yet can’t afford to, and as Illinois tries to fix the nation’s worst-funded state retirement system. The 18-month recession that ended in June 2009 eroded pension assets and led some governments to reduce contributions as a way to balance budgets. U.S. state and local funds lack as much as $4.4 trillion to cover promised benefits to retirees, Hatch said.

“The problem is getting more serious every day and cannot be remedied merely by fine-tuning the existing pension structures available,” Hatch said today on the Senate floor. “A new public-pension design is needed -- one that provides cost certainty for state and local taxpayers, retirement-income security for state and local employees, and does not include an explicit or implicit federal government guarantee.”

Competitive Bidding

States that want to transfer their plans to annuity companies, such as life insurers, would be required under the bill to seek competitive bids. The bond ratings of Illinois, Connecticut, Kentucky, New Jersey, Hawaii and Pennsylvania have been cut over the past three years, in part because of how those states have managed growing pension liabilities, according to Moody’s Investors Service Inc.

“The new pension structure for state and local governments will solve the pension underfunding problem prospectively while delivering retirement-income security, in the form of a deferred fixed-income life annuity, to public employees,” according to a summary of the legislation provided by Julia Lawless, a Finance Committee spokeswoman for Hatch.

“The life-insurance industry invests the assets, pays the retirement benefits and bears the risks,” the summary says. “Involvement by the federal government will be limited to certifying the tax-qualified status of the plan.”

The annuities would be re-bid every year and would be portable, following workers from job to job, Hatch said today.

Costly Solution

“Shifting to annuities is just an unnecessarily expensive approach to the issue,” said Steven Kreisberg, collective bargaining director of the American Federation of State, County and Municipal Employees. The Washington-based union has more than 1.6 million members.

“Where we have pension-funding issues in the public sector, it’s not because of exposure to risk,” Kreisberg said today in a telephone interview. “It’s simply because employers have failed to make contributions that they should have made.”

A Bloomberg National Poll published last month found that while 31 percent of Americans say they expect to save more for retirement this year, 42 percent say they need to, yet can’t.

One provision in the bill would let employers that don’t sponsor a 401(k) defined-savings plan for workers to initiate what is known as a Starter 401(k), which would let employees save as much as $8,000 a year in tax-preferred retirement accounts. The new plan wouldn’t be taxed by the federal government, though it would be regulated at the state level.

Bill’s Supporters

Hatch’s proposal has the support of MetLife Inc. (MET), the largest U.S. life insurer, as well as the U.S. Chamber of Commerce, the American Council of Life Insurers and Americans for Tax Reform, the Washington-based anti-tax advocacy group led by Grover Norquist.

Jurisdiction over rules prohibiting certain transactions involving individual retirement accounts would be transferred from the Labor Department to the Treasury Department under the bill. The Treasury Department would work with the Securities and Exchange Commission in determining professional standards for brokers and investment advisers for IRA participants.

The Treasury Department, instead of the Labor Department, also would have jurisdiction over rules pertaining to prohibited transactions for employer-sponsored retirement plans.

The nation's two largest public pension funds on Monday reported double-digit annual returns from rising stock and real estate prices, but cautioned against focusing too much on short-term performance.

The California Public Employees' Retirement System reported a 12.5 percent annual return while the California State Teachers' Retirement System announced it gained 13.8 percent for the year that ended June 30. Both had dismal performances last year-- CalPERS earned 1 percent and CalSTRS gained 1.8 percent.

CalPERS' chief investment officer Joe Dear said the fund's buy-and-hold investment strategy is working.

"When things got rough, we didn't panic," Dear said in a statement. "We stuck with our exposure to growth assets and applied the lessons we learned from the past."

Both funds outperformed their discount rates of 7.5 percent, the projection CalPERS and CalSTRS uses to meet current and future obligations.

Despite the gains, California's public pensions remain underfunded. CalPERS has an estimated unfunded liability of $100 billion, while CalSTRS reports a funding gap of $70 billion.

"This year reminds us that a pension fund measures its health over the long term and no single year can take us from underfunding to funding adequacy," said Jack Ehnes, CalSTRS' chief executive officer, in a statement.

The teachers' pension fund has been urging Gov. Jerry Brown and state lawmakers to review contribution rates because unlike CalPERS, it lacks the authority to set the contribution rate.

CalSTRS serves 862,000 public school educators and their families and has assets worth $166 billion as of June 30. CalPERS administers a $258 billion system for 1.6 million state and local government workers and their families.

Henry Jones, a CalPERS board member and chairman of its investment committee, also called for looking ahead.

"CalPERS is a long-term investor and we try to not focus too much on one year of performance," Jones said. "But obviously 12.5 is a great number and we're pleased with the performance."

Dear said in a call with reporters Monday that domestic and international stocks at the nation's largest public pension system returned 19 percent, outperforming its benchmark by nearly 1 percentage point.

Dear said CalPERS' strong performance suggests that the pension fund is resilient and won't fail despite concerns from pension critics. The fund's 20-year investment return is 7.6 percent.

"I think these numbers are convincing evidence that CalPERS has the ability to produce good return on a sustainable basis," he said.

•  Pension Funds Online reports that CalSTRS announced the selection of Pension Consulting Alliance (PCA) as the private equity consultant to its Investment Committee for the next five years. PCA will provide independent assessments of the private equity portfolio's performance. The CalSTRS Private Equity portfolio was valued at $22 billion or 14.4% of the overall investment portfolio, as of March 31, 2012.
• Pension Funds Online also reports that CalSTRS awarded Industry Funds Management (IFM) an infrastructure mandate worth up to $500m. The money is to be invested in a diversified portfolio of core infrastructure assets in North America and Europe. It is one of the largest single U.S. fund management commitments made in infrastructure.
• According to Investments & Pensions Asia, CalSTRS is looking into the possibility of expanding its international real estate portfolio and investing capital in Europe. According to its business plan for the 2013-14 fiscal year, developed with real estate consultant the Townsend Group, CalSTRS is looking "across the spectrum" – from opportunistic to core assets – in world-class cities worldwide, particularly in Asia, Europe and Latin America. 
• Pensions & Investments reports that CalPERS will take a close look at the value of external active equity managers but won’t start the review until 2014. CalPERS’ investment committee agreed at a meeting Monday to use index-tracking strategies when there is a lack of conviction that the pension fund can add value through active management. What that means for CalPERS’ several dozen external active equity managers is unclear for now. External managers run about 18% of the pension fund’s $134 billion equity portfolio.
• Pension Funds Online reports that CalPERS awarded a $500m mandate to Standard Life Investments as part of its multi-asset class (MAC) partners program. Standard Life is the first of four external managers selected to partner with CalPERS in the MAC program. The first aim of the program is to outperform the CalPERS total fund by primarily using public market assets and doing so with lower volatility and less risk. The second aim is to cultivate the sharing of information between MAC partners and CalPERS investment staff and to help develop sustainable and efficient methods of increasing the likelihood of meeting long-term CalPERS investment return goals.
• CalPERS has decided to delay launching an online database of public pension information, citing moves by a retiree group to pursue legislation that would narrow how much of that information would fall under the state Public Records Act.
• The Associated Press reports that California's two public pension systems continued to fly top officials around the globe for conferences, workshops and speaking engagements even after Gov. Jerry Brown ordered a ban on discretionary travel while the state was trying to emerge from years of budget deficits. While some travel expenses were for due diligence related to the pension funds' investments, there appeared to be non-essential trips to attend industry association conferences in Toronto, networking opportunities with traders and hedge fund managers in Europe and educational seminars in Boston and Washington, D.C.

The Public Sector Pension Investment Board (PSP Investments) announced today that it recorded an investment return of 10.7% for the fiscal year ended March 31, 2013 (fiscal year 2013) with all investment portfolios recording positive investment returns.

The solid overall performance for fiscal year 2013 was driven primarily by strong results in Public Market Equity portfolios as well as in Private Equity, Real Estate and Infrastructure. The fiscal year 2013 investment return exceeds the Policy Portfolio return of 8.6%, representing $1.4 billion of value-added over the benchmark return.

Consolidated net assets increased by $11.6 billion, or 18%, to a record level of $76.1 billion. During fiscal year 2013, PSP Investments generated investment income of $7.0 billion after expenses and received $4.6 billion in net contributions.

Over the four years since the global financial crisis of 2008-2009, PSP Investments has achieved an annualized return of 12.2%, generating $23.7 billion in investment income and $3.7 billion of value-added over benchmark returns. The comparable figures for the ten-year period are 8.2%, $25.3 billion and $1.7 billion.

"A solid company-wide effort drove strong results with all asset classes performing well," said Gordon J. Fyfe, President and Chief Executive Officer. "This sustained performance over a period punctuated by lingering economic uncertainty and market volatility indicates clearly that our strategic focus on increased diversification in Private Markets and internal active management is paying off. Our investments in Public Markets, Real Estate, Private Equity, Infrastructure and our newest asset class, Renewable Resources, all contributed to value-added over benchmark returns."

For fiscal year 2013, returns on Public Markets Equities ranged from 4.9% for the Emerging Markets Equity portfolio to 19.2% for the Small Cap Equity portfolio. The Fixed Income portfolio generated a return of 3.4% while the return for the World Inflation-Linked Bonds portfolio was 7.0% for fiscal year 2013.

In Private Markets, all asset classes posted solid investment returns led by Renewable Resources and Private Equity with returns of 16.7% and 16.0% respectively. Real Estate recorded an 11.5% investment return while the Infrastructure portfolio earned an investment return of 10.1%.

The asset mix as at March 31, 2013 was as follows: Public Markets Equities 52.8%, Nominal Fixed Income and World Inflation-Linked Bonds 20.1%, Real Estate 12.4%, Private Equity 9.1%; Infrastructure 5.1% and Renewable Resources 0.5%.

• Consolidated net assets increased by $11.6 billion or 18% to $76.1 billion.
• Investment income of $7.0 billion after expenses and value-added of $1.4 billion above benchmark return of 8.6%. 
• For fiscal year 2013, PSP Investments generated a total portfolio return of 10.7%, outperforming the Policy Portfolio by 2.1%. This is a significant outperformance.
• Gains were widespread as all investment groups (public and private markets) outperformed their respective benchmarks. The gains in private markets were exceptional but gains in public markets were equally impressive when you consider the volatility in stock and bond markets during their fiscal year.
• This was PSP's best four-year value-added performance, achieving an annualized return of 12.2%, generating $23.7 billion in investment income and $3.7 billion of value-added over benchmark returns. The comparable figures for the ten-year period are 8.2%, $25.3 billion and $1.7 billion.
• Recent investment gains have erased the impact of past investment losses, including the 23% loss during FY 2009. More importantly, over the ten year period, PSP's total portfolio return is 7.9% (net of expenses), which is significantly higher than the actuarial target rate of return of 6.1%.
• Assets managed internally increased by $7.9 billion to reach $55.8 billion. Assets actively managed internally totalled $29.1 billion, an increase of 25% over fiscal year 2012.
• PSP launched a US$3 billion commercial paper program in the United States and received AAA credit ratings from Moody’s, DBRS and Standard & Poor’s.

The five top-paid executives at the Public Sector Pension Investment Board, a federal Crown corporation, were awarded more than $16 million in total compensation for the 2013 fiscal year — a roughly 50 per cent increase over the previous year — as the organization posted record investment returns, reveals a new report.

The eye-popping payouts to executives at the federal organization — which invests funds for the federal public service, Canadian Forces and RCMP pension plans — come as the Conservative government lays off thousands of federal workers, reforms the public service pension plan and digs in its heels on contract negotiations with some federal unions.

Investment board officials note, however, the organization does not receive a budgeted annual appropriation from government like some Crown corporations, and is a self-sufficient entity that operates from the returns it earns from pension plan investments. The income earned by the investment board is allocated to federal pension funds to pay off the obligations owed to plan members.

The board’s 2013 annual report shows the total compensation awarded to the five highest-paid executives totalled about $16.3 million — almost 50 per cent more than the $10.9 million awarded in 2012.

“These awards fairly reflect our current pay-for-performance approach,” says the report, tabled this week in the House of Commons.

The pension investment board, following a compensation review, has subsequently approved changes that will, going forward, reduce the maximum potential payouts to senior executives.

Gordon J. Fyfe, board CEO, was paid $5.3 million in the fiscal year ending March 31, 2013, including $500,000 in base salary, more than $1.7 million from the short-term incentive plan, and $2.4 million from the long-term incentive plan.

He was also awarded almost $520,000 from “restricted fund units,” more than $35,000 in benefits and other compensation, and $72,200 from pension and supplemental employee retirement plans. In the previous 2012 fiscal year, he received $3.4 million in total compensation.

The incentive plans for executives, which are based on rolling four-year periods, paid “maximum or close to maximum payouts for many senior executives for fiscal year 2013,” the report says.

The hefty payouts were tied to the investment board’s strong performance over the past four years, which saw $3.7 billion of value added to the pension funds over and above benchmark returns, the report says. Over the four years since the financial crisis of 2008-2009, the investment board has achieved an annualized return of 12.2 per cent.

“It’s a pay-for-performance model. If you have good (performance), then the incentive plans have payouts, and if you don’t have the performance then they don’t pay out,” said board spokesman Mark Boutet.

“This year, it was our best performance against our benchmark in the whole history of the organization.”

Indeed, senior vice-presidents Daniel Garant (public markets investments) and Neil Cunningham (real estate investments) both earned more than $3 million in total compensation, including more than $300,000 each in base salary, and more than $1 million each in both short-term and long-term incentives.

Fellow senior vice-presidents Derek Murphy (private equity investments) and Bruno Guilmette (infrastructure investments) were paid $2.7 million and $2.1 million respectively.

Incentive compensation is the largest component of the total remuneration paid to the board’s executives, with short-term and long-term financial incentives based on rolling four-year periods. The board says the incentive compensation structure rewards outstanding performance while discouraging undue risk taking.

The Conservative government has adopted changes to the public service pension plan that, over time, forces federal workers to increase their contributions to 50 per cent and equal those of the employer. Also, the government has increased the normal age of retirement for new federal workers to 65 from 60.

The pension investment board reports to Treasury Board President Tony Clement, but it’s an arm’s-length organization that establishes its own compensation levels, say federal officials. The government directed questions back to the Crown corporation.

The organization’s board of directors — which is appointed by the government on the minister’s recommendation — approved the compensation payouts, based on a policy that “aims to maintain total compensation at a fair and competitive level.”

The federal auditor general and outside auditor Deloitte conducted a special examination in 2011 of the pension investment board’s compensation framework and found its incentive programs are comparable to industry practices.

The Public Sector Pension Investment Board is one of Canada’s largest pension investment managers, with approximately $76.1 billion of assets as of March 31, 2013.

• First, while payouts for top executives at PSP were hefty, they weren't the only big payouts in Canada. Top executives at the Ontario Teachers' Pension Plan earned more than their counterparts at PSP for the simple reason that they performed better over the last four years.
• The annual reports of Canadian pension funds discuss compensation in great detail. There are no surprises. It is based primarily on long-term incentives and reflects four-year performance. When you see a jump in compensation, it means the funds are performing well. This is good news, not bad news, and plan members should be pleased, not disappointed.
• PSP Investments and the Canada Pension Plan Investment Board are Crown corporations that operate at arms-length from the federal government and do not receive a budgeted annual appropriation from government like some Crown corporations. They are self-sufficient entities that operate from the returns they earn from pension plan investments. 
• In order to attract and retain talented individuals to manage money internally, Canadian pension funds have to compete with the private sector. Compensation in the investment management industry has come down somewhat since the crisis but it's still high. Note the heads of Canadian banks are among the best paid CEOs in North America, and according to Bloomberg, three of them rank among the most overpaid.
• Unlike banks, mutual funds and hedge funds, Canadian pension funds emphasize long-term performance. Compensation is better aligned with the interests of plan members. There is a reason why Canada's top ten are receiving accolades. It's because they are delivering exceptional results at a significantly lower cost. To do this, they got the governance right, paying their investment managers competitively for delivering long-term results. By contrast, U.S. pension funds still face huge hurdles when it comes to compensation.
• Lastly, compensation at Canadian pension funds varies. Ontario Teachers', PSP and CPPIB pay more than their counterparts, some of whom are plagued by politics and the relentless scrutiny of the media. Can you imagine the uproar if the Caisse paid out similar compensation to their top executives? It's a shame because this organization is losing excellent people who are departing the province for better opportunities elsewhere. 

• Policy portfolios matter: When I started this blog in 2008, I focused on alternative investments and bogus benchmarks. I've tried to demystify pension fund benchmarks because it's important to understand the risks pension funds take to beat their benchmarks. Admittedly, I've been overly critical and cynical in the past about alternative assets, stating the shift into private equity, real estate and infrastructure was to "game benchmarks" to handily beat them and obtain huge compensation. The truth is benchmarking alternative investments isn't easy and the shift into alternatives is a direct consequence of the volatility and low risk-adjusted returns in public markets.
• Not all policy portfolios are created equal: While I understand that policy portfolios vary from fund to fund, we need more transparency to understand benchmarks used to determine compensation at Canadian funds. For example, PSP and CPPIB have the exact same fiscal year (ends March 31st). CPPIB returned 10.1% in FY 2013, edging its policy portfolio by 0.2% while PSP returned 10.7% in FY 2013, trouncing its policy portfolio by 210 basis points (10.7% vs 8.6%). Why did CPPIB's policy portfolio deliver 9.9% during fiscal year 2013 while PSP's gained 8.6%? I looked into this and found one reason is that CPPIB uses the Investment Property Databank (IPD) as their private real estate benchmark while PSP uses cost of capital which is significantly lower. The tougher benchmark is a big reason why contribution of real estate investments to portfolio value-added at CPPIB over the last four years is significantly lower than the contribution of real estate investments to portfolio value-added at PSP during that same period. So, while I praise the excellent performance of PSP's real estate investments over the last four years, I also recognize that PSP's policy portfolio isn't as tough to beat as CPPIB's policy portfolio. The question then becomes even though PSP outperformed CPPIB in FY 2013 and over the last four years, is it fair to pay CPPIB's executives less compensation than those at PSP if they have a tougher policy portfolio to beat? Yes, based on four-year results (12.2% vs 10.8%), PSP's executives should be paid more but it's critical to understand key differences in benchmarks and that value-added over the policy portfolio varies because some benchmarks in private markets are much tougher to beat at some funds.
• Leverage matters: Another issue arises when looking at the leverage funds take to deliver their results. Some Canadian pension funds are not able to take on the leverage that others are taking. One risk manager expressed concerns over the commercial paper some Canadian pension funds are  issuing to invest in private markets. He wrote me this can come back to haunt mature funds with big deficits. Another senior officer at a large Canadian pension fund told me he cannot take the leverage that Ontario Teachers' and others take because provincial legislation prohibits it. Again, I ask, is it fair to pay top executives more if they are able to take on leverage that other funds can't? Some think so because they think the intelligent use of leverage is part of smart investment management but others worry that leverage exposes these funds to significant downside risk.
• The 2008 bonus bonanza: I was extremely critical of some large Canadian pension funds after they doled out big bonuses after sustaining big losses during the crisis. While the reality is that compensation is based on four-year returns and terms of the contract have to be honored, the optics of doling out bonuses when funds lose 20%+ during a terrible year just don't look good and exposes these funds to harsh media scrutiny. 

Alberta’s $70 billion pension-fund manager posted the strongest returns in its five-year history in 2012.

Alberta Investment Management Corp. (AIMCo) earned a 10.2 per cent net return on assets for the year ended Dec. 31, 2012, the Edmonton-based crown corporation reported Thursday.

The gain included an 11.9 per cent net return on AIMCo’s balanced funds — managed on behalf of 27 provincial pension and endowment funds — and a 2.9 per cent net gain on short-term government funds.

The overall 10.2 per cent uptick was $1.3 billion or two full percentage points above the market benchmark against which AIMCo measures its performance.

“We added $1.3 billion of returns with very little incremental risk, and it’s that combination of the two that makes last year’s results very attractive,” said Leo de Bever, AIMCo’s CEO. “The normal long-term return on what we do is around six per cent, which assumes about seven to eight per cent on equities and three to four per cent on bonds, so this was an unusual year.”

AIMCo, which recently changed its year-end to Dec. 31 from Mar. 31, partly to more easily compare its performance against its peers, posted a net return of 4.8 per cent for 2011. The returns for 2012 boosted AIMCo’s annualized net gains over the past four years to 7.9 per cent, the company said.

Despite the double-digit gains for 2012, AIMCo’s total assets under management declined slightly to $68.6 billion, as the province continued to draw down the balance of its Sustainability Fund. The so-called rainy day fund, which reached a peak of some $17 billion in 2008, held just $3.3 billion of remaining assets at the end of March.

Since 2009, a total of $26.1 billion has been withdrawn from various government and endowment funds, AIMCo reports. Offsetting that, new contributions totalled $3.6 billion during the same period, while AIMCo generated $20.6 billion of total returns.

AIMCo’s performance last year was driven largely by stellar returns on its nearly $30 billion stock portfolio, which showed a net gain of 15.2 per cent. AIMCo’s U.S. and other international equity holdings rose 17.4 per cent, while Canadian equities posted a return of 11.6 per cent.

By comparison, Canada’s benchmark equity index — the S&P/TSX Composite Index — rose just four per cent last year, net of dividends, while the S&P 500 Index gained 13.4 per cent and the Dow Jones Industrial Average rose 7.3 per cent.

“The biggest issue we foresaw last year was the end of the bull market in bonds, and that’s coming on in spades this year,” said de Bever.

Bond markets have been hammered — as have equity markets — in recent weeks as the U.S. Federal Reserve Board prepares to curb its $85 billion US of monthly bond purchases later this year.

After a sizzling first-quarter rally, the recent market correction has sharply reduced AIMCo’s net returns on a year-to-date basis to roughly two per cent, de Bever said, while warning that last year’s double-digit gains won’t likely be repeated in 2013.

Nonetheless, he said the market’s adjustment to faster U.S. economic growth and higher interest rates in future is a necessary one, and could pave the way for a resumption of stronger returns down the road.

“This might be the pause that refreshes. The bond market already is adjusting for all the right reasons, and if the stock market were to drop another 10 per cent or 15 per cent, I think I would have no qualms about staking out a bigger position (in equities),” he said.

• AIMCo earned a total fund net return of 10.2% in 2012, $1.3 billion or two full percentage points above their market benchmarks.
• The net return was 11.9% for pension and endowments clients, and 2.9% for their special purpose government funds clients.
• Public equities contributed $878 million, fixed income added $438 million, and real estate generated $115 million. 
• Private equity, infrastructure and timberlands lagged behind the very strong performance of their listed benchmarks. 
• Efforts to add value by underweighting or overweighting asset classes resulted in a gain of $141 million of value add. 
• As stated by Leo de Bever, they "added $1.3 billion of returns with very little incremental risk, and it’s that combination of the two that makes last year’s results very attractive.”

Gloria Killebrew, 73, worked for the City of Detroit for 22 years and now spends her days caring for her husband, J. D., who has had three heart attacks and multiple kidney operations, the last of which left him needing dialysis three times a week at the Henry Ford Medical Center in Dearborn, Mich.

Now there is a new worry: Detroit wants to cut the pensions it pays retirees like Ms. Killebrew, who now receives about $1,900 a month.

“It’s been life on a roller coaster,” Ms. Killebrew said, explaining that even if she could find a new job at her age, there would be no one to take care of her husband. “You don’t sleep well. You think about whether you’re going to be able to make it. Right now, you don’t really know.”

Detroit’s pension shortfall accounts for about $3.5 billion of the $18 billion in debts that led the city to file for bankruptcy last week. How it handles this problem — of not enough money set aside to pay the pensions it has promised its workers — is being closely watched by other cities with fiscal troubles.

Kevyn D. Orr, the city’s emergency manager, has called for “significant cuts” to the pensions of current retirees. His plan is being fought vigorously by unions that point out that pensions are protected by Michigan’s Constitution, which calls them a contractual obligation that “shall not be diminished or impaired.”

Gov. Rick Snyder of Michigan, a Republican who appointed Mr. Orr, signed off on the bankruptcy strategy for the once-mighty city, which has seen its tax base and services erode sharply in recent years. But the governor said he worried about Detroit’s 21,000 municipal retirees.

“You’ve got to have great empathy for them,” Mr. Snyder said in an interview. “These are hard-working people that are in retirement now — they’re on fixed incomes, most of them — and you look at this and say, ‘This is a very difficult situation.’ ”

On Sunday, Mr. Snyder fended off the notion that the city needed a federal bailout. “It’s not about just putting more money in a situation,” the governor said on “Face the Nation” on CBS. “It’s about better services to citizens again. It’s about accountable government.”

Many retirees see the plan to cut their pensions as a betrayal, saying that they kept their end of a deal but that the city is now reneging. Retired city workers, police officers and 911 operators said in interviews that the promise of reliable retirement income had helped draw them to work for the City of Detroit in the first place, even if they sometimes had to accept smaller salaries or work nights or weekends.

“Does Detroit have a problem?” asked William Shine, 76, a retired police sergeant. “Absolutely. Did I create it? I don’t think so. They made me some promises, and I made them some promises. I kept my promises. They’re not going to keep theirs.”

Vera Proctor, 63, who retired in 2010 after 39 years as a 911 operator and supervisor, said she worried that at her age and with her poor health, it would be difficult to find a new job to make up for any reductions to her pension payments.

“Where’s the nearest street corner where I can sell bottles of water?” Ms. Proctor asked wryly. “That’s what it’s going to come down to. We’re not going to have anything.”

Officials overseeing Detroit’s finances have called for reducing — not eliminating — pension payments to retirees, but have not said how big those reductions might be. They emphasized that they were trying to spread the pain of bankruptcy evenly.

When the small city of Central Falls, R.I., declared bankruptcy in 2011, a state law gave bondholders preferential treatment — effectively protecting investors even as the city’s retirees saw their pension benefits slashed by up to 55 percent in some cases.

Detroit, by contrast, wants to spread the losses to investors as well as pensioners, and hopes to find cheaper ways to cover retirees through the subsidized health exchanges being created by President Obama’s health care law.

Bill Nowling, a spokesman for Mr. Orr, said the emergency manager’s restructuring plan would treat bondholders the same as retirees in bankruptcy.

“How can we tell pensioners or city workers that we’re going to have to adjust their payments on their pensions because of decisions that they didn’t make but that affect them, but that we’re going to pay more to people who made risky investments?” he said.

In recent years, public sector pensions have often emerged as a political point of contention, earning scorn from taxpayers who work in the private sector, where defined-benefit pensions providing a guaranteed stream of income in retirement have grown increasingly rare.

But the average pension benefit in Detroit is not especially high. The average annual payment is about $19,000, said Bruce Babiarz, a spokesman for the pension funds. And it is about $30,000 for retired police officers and firefighters, who do not get Social Security benefits, he said. Some retired workers get larger pensions, though: about 82 retirees who either worked many years or had high-salaried jobs are paid pensions of more than $90,000 a year, he said.

Among them is Isaiah McKinnon, who was the city’s police chief in the 1990s and whose pension is just over $92,000 a year. Dr. McKinnon said he and other officers earned their retirement money by serving in a dangerous profession. Dr. McKinnon was shot at eight times while on the job and was stabbed twice, and he has scars from the attacks on his neck and abdomen, he said.

Dr. McKinnon, who holds a doctoral degree in education administration, is an associate professor at the University of Detroit Mercy. He expressed concern about retired rank-and-file officers whose pensions were based on salaries far lower than his.

“We’re in this predicament, and everyone has to suffer to an extent,” Dr. McKinnon said. “But the predicament and the percentage — that has to be talked about.”

Many retirees expressed a feeling of powerlessness, a sense that they stand to lose the benefits they worked a lifetime for because of things beyond their control. Motor City has lost more than a million residents over the last six decades. When it shrank its work force, it left fewer current workers to contribute to pension funds that still had to pay benefits that were earned by large numbers of older retirees who had served Detroit when it was a bigger city.

Detroit, like many other cities and states, anticipates that its pension funds will earn about 8 percent in interest each year — a target that proved overly optimistic during the recent downturn, when it fell far short.

Laws allowing workers to collect pensions even when they retired at young ages proved expensive, as did adjusting benefits for inflation. And some of the accounting measures the funds used made them look healthier than they actually were. Mr. Orr recently announced that the funds, which had reported a shortfall of around $644 million, were in fact underfinanced by more like $3.5 billion, a figure that some dispute.

But other problems are unique to Detroit. Several pension officials were accused this spring of taking bribes and kickbacks to influence investment decisions, and Mr. Orr recently called for an inquiry into possible fraud, waste or abuse in the pension system.

For some retirees, pension reductions would compound the other difficulties of living in Detroit.

Michael Wells, 65, retired in 2011 after working at the Detroit Public Library for 34 years. He said he still owed close to $100,000 on his house in Detroit, which was appraised recently at $25,000. “I’m totally underwater here,” said Mr. Wells, who is one of the plaintiffs in a union-backed lawsuit to stop the city from filing for bankruptcy and from reducing pension payments.

He said he viewed the pension as part of the overall pay he was promised. “It’s deferred income,” he said. “Had I not had a pension, perhaps I would have gotten several dollars an hour more and that would be O.K. I would have taken that money and invested it in some kind of mutual fund or stock.”

Paula Kaczmarek, 64, said that she had planned to retire from the Detroit Public Library in 2014, but that she decided to retire early because she was having health problems and she feared younger co-workers could be laid off if there were more rounds of staff cuts. (The city, which had 12,302 workers three years ago, now has only 9,560.)

“It’s not anxiety, it’s fear,” Ms. Kaczmarek said of the proposed cuts.

And many simply cannot believe that Detroit, which was once the nation’s fourth-largest city, could go bankrupt.

Dr. McKinnon recalled that when he was a young man in the police academy, he once asked a sergeant what would happen if the city went bankrupt. “ ‘The city won’t,’ ” he said the sergeant had replied. “ ‘And besides, there’s billions of dollars in the retirement fund.’ ”

K.D. Bullock had been retired from the Detroit Police Department for nearly 17 years and was working as a casino security supervisor when he encountered a problem last March —long accustomed to working on his feet, he suddenly couldn’t make it up a flight of stairs. After months of doctor’s appointments, he was diagnosed with rheumatoid arthritis, which makes it difficult for him to breathe. He not only left his job but had to begin paying others for the fix-up work he’d been doing on his historic six-bedroom house.

Now, he could be facing another hit, this time to his $2,400-a-month pension.

The pensions earned by more than 21,000 retired municipal employees have been placed on the table as Detroit enters bankruptcy proceedings with debts that could amount to $20 billion. Labor unions insist the $3.5 billion in pension benefits are protected by state law, but the city’s emergency manager has included them among the $11 billion in unsecured debt that can be whittled down through bankruptcy. A federal judge has scheduled the first hearing on the city’s case for Wednesday.

The prospect of sharply reduced pension checks has sent a jolt through retired workers who always counted on their pensions—who sometimes sought promotions just to sweeten the pot—and never imagined they could be in danger even as the city’s worsening finances finally led to its bankruptcy filing last week.

Bullock says he’s worried he’ll have to sell his home in Detroit’s historic Indian Village neighborhood, and others are wondering if they can afford a house at all.

“A number of things can happen. It just means our lifestyle is going to change — we have no way of knowing,” Bullock said of the choices facing him and his wife, Randye.

The average annual pension payment for Detroit municipal retirees is about $19,000. Retired police officers and firefighters receive an average of $30,500. Top executives and chiefs can receive $100,000. Police and firefighters don’t pay into the Social Security system so they don’t receive Social Security benefits upon retiring.

Bullock, 70, said the idea that his pension could be reduced is “a hard pill to swallow” after 27 years on the force working his way up. He said he was proud to be the first black commanding officer of the department’s communications system.

He said that pensions — and people — should be a priority over other city assets, such as artwork at the Detroit Institute of Arts, some of which could be sold to help satisfy the city’s staggering debts. But art patrons have protested the idea of auctioning off Old Masters in the museum collection. And investment funds have spoken up for the average people who could get only cents on the dollar for their investments in supposedly safe city bonds.

The ripple effects of the pension issue are touching people far beyond Detroit.

Glenda Dehn, 66, and her husband planned to spend winters in Arizona after his retirement from the police force, but since their recent divorce after 48 years of marriage, the home in Peoria, Ariz., is her permanent residence. Now she worries that she’ll have to move in with family members in Michigan.

“It would be a major life change for me and many, many others,” said Dehn, who also has a son on the force.

Likewise, police retiree Warren Coleman, 76, wonders if his other investments will be enough to support him. In his 27 years on the job before he retired as an executive lieutenant and moved to Ocala, Fla., he said he “put a whole lot of effort into getting promoted” with the rising retirement benefit in mind.

“I intended ... to do the best I could while I was there and get me in as nice a position as I could,” he said.

Not knowing what’s going to happen to the pensions — especially after paying into them and planning retirement around them— is the biggest concern for retirees right now, said Rose Roots, a 30-year city employee who retired in 1997 as a job-training specialist. She’s also the president of a retiree chapter of the American Federation of State, County and Municipal Employees. People want advice, she said, but there is little she can say.

“I’ve had some older retirees call me on the phone in tears because of their medical needs,” said Roots, 76. “I’ve never received calls like the calls I get now.”

Roots said her pension payment is “well below” the $19,000 annual average for municipal employees. “At this point I can’t even guess at what may happen that may force me to make changes,” she said.

Retirees are putting their hopes in state lawsuits filed by the pension funds. They argue that pensions are protected by the Michigan Constitution and should not be part of the bankruptcy process. The bankruptcy judge will likely rule on whether federal bankruptcy law supersedes the state guarantee.

The impact of the decision could fall heavily on retirees who had low-paying jobs and got small benefits checks.

Michael Woodson began receiving a disability pension of less than $500 a month after he said he fell off a truck while working for the sanitation department. The 57-year-old, who uses a walker, lives in a rugged neighborhood “in the heart of Detroit.”

“My concern is just (living) every day,” he said. “When you come from where I come from, things like this happen all through your life. ... I’ve been a blue-collar worker or less all my life. You learn to struggle.”

Coleman, the Florida retiree, said he’s not only concerned about his future, but also the city he served. He remembered working during the 1967 riots, and worries about the anger if thousands of people lose most of their income in the bankruptcy process.

“I see some big problems as a possibility,” he said.

The city’s $2 billion General Retirement System lost $16 million in fiscal 2011 when it wrote off a housing development near Sarasota, Florida, that collapsed after the real-estate bubble burst, according to pension fund records. The $3.1 billion Police and Fire Retirement System lost about $15 million on 1,100 vacant acres 30 miles east of Dallas that was to be sold to homebuilders.

A 2006 loan guarantee for a Westin hotel and condos in downtown Detroit cost the funds $14 million.

That was just in real estate. The funds lost more than $20 million investing in a telecommunications company started by a Detroit businessman, $30 million on a cargo airline and almost $70 million on collateralized debt obligations -- derivative securities backed by a pool of bonds, loans and other assets. 

The British Columbia Investment Management Corporation (bcIMC) today released its combined pension plan returns for the year ending March 31, 2013 as part of its 2012–2013 Annual Report. With a one-year annual return of 9.5 per cent, net of fees, the results exceeded a combined benchmark of 7.8 per cent and added $1.5 billion in value to bcIMC's pension plan clients.

“Our domestic real estate and public equities portfolios were the primary drivers of our positive results last year,” said Doug Pearce, Chief Executive Officer/Chief Investment Officer of bcIMC. “On behalf of our clients, we began significantly increasing asset allocations towards real estate and infrastructure in 2011, and this heavier weighting to real assets is beginning to drive investment returns.”

There were a number of highlights from the past year, including:

• Committing $3.4 billion to investments that span real estate, infrastructure and renewable resources, which included the purchase of the Canada Post site in downtown Vancouver and Open Grid Europe GmbH
• Creating a thematic investing strategy and adding four new funds to give exposure to themed assets, renewable resources, emerging markets and companies with high environmental, social and governance ratings
• Becoming a Qualified Foreign Institutional Investor in China , which allows bcIMC to invest in companies listed on Chinese stock exchanges
• Increasing internally-managed equity assets by over $1.5 billion and saving about $4.0 million in external manager fees
• Being ranked first in North America, and sixth globally, by the Asset Owners Disclosure Project in its global climate investment index that assessed asset management and climate risk disclosure
• Acquiring over 990 acres of developable land and completing six developments, adding over 876,400 square feet to our domestic real estate portfolio
• Receiving an unqualified audit opinion on our Service Organization Controls Report (Canadian Standard for Assurance Engagements–CSAE 3416)
• Increasing our global portfolio to $102.8 billion of gross managed assets, up by $7.3 billion from the previous year.

"I am also pleased with the investment returns for the 10-year period. bcIMC delivered an annualized return of 8.2 per cent against a combined benchmark of 7.8 per cent. As a result, our investment activities contributed $3.2 billion in added value for our pension plan clients," added Pearce.

As of year-end, bcIMC had over $100 billion in gross assets under management. The portfolio includes six major asset classes: Fixed Income (22.9 per cent or $23.6 billion), Mortgages (3.4 per cent or $3.5 billion), Private Placements (4.5 per cent or $4.6 billion), Public Equities (46.6 per cent or $48.0 billion), Real Estate (17.3 per cent or $17.8 billion), and Renewable Resources and Infrastructure (5.3 per cent or $5.4 billion).

The Supreme Court has ended three years of uncertainty for thousands of members of the Lehman Brothers and Nortel pension schemes as it ruled that they had a fair claim on the collapsed companies’ assets.

In a landmark case that has implications for all future insolvencies, the Court ruled that the schemes had an equal claim on assets alongside other creditors.

Had the case gone against them, the Lehman and Nortel members could have been forced below other creditors in the repayment queue at collapsed companies and set a precedent for administrators across the board.

The outcome was hailed by experts and those involved in the wrangle as a “victory for common sense” that shored up the rights of 40,000 members of Nortel’s scheme and 4,000 former staff at Lehman.

Experts also said it was more likely that both schemes would avoid being forced into the Pension Protection Fund, the lifeboat for retirement funds that pays out less to retiring members.

Nortel, a Canadian telecoms company, collapsed in 2009 leaving a pensions deficit that at the last count stood at £2.1 billion. It followed the spectacular demise the previous year of Lehman Brothers at the height of the financial crisis, with a deficit in its UK pension scheme of £148 million.

The complex case centred on a so-called “financial support direction” issued by the Pensions Regulator in 2010 after administrators were brought in at both companies.

A financial support direction is a demand that companies or their administrators have to stand behind a scheme financially and is ordered if the regulator thinks is a danger that current and future pensioners will not be paid.

In some cases this can involve an injection of cash, or even shares or other assets.

In a joint claim, the administrators argued that the regulator’s demand should be disregarded as an “unprovable debt” as it was issued after the administration.

In response, the regulator said that the financial support direction should be treated as an expense or debt, meaning that the pension scheme had a priority claim on assets or would rank as an equal, unsecured creditor.

Jonathan Land, a partner at PwC who advised the Nortel scheme trustees, said: “This ruling determines once and for all that FSDs will rank alongside other unsecured creditors in UK administrations.

“This is the fairest result and after three years of litigation UK pension schemes and insolvency practitioners will be thankful they finally have clarity on the issue.”

Tony Bugg, global head of restructuring and insolvency at law firm Linklaters, which advised Lehman’s administrators, said: “The concern before today’s decision was the Pensions Regulator had the power to boost the ranking of its claim simply by waiting for a target company to enter administration. The Supreme Court unanimously agreed that Parliament [under the 2004 Pensions Act] cannot have intended such an unfair and arbitrary result.”

The Pensions Regulator welcomed the ruling and said it had never had any intention of frustrating the process of administration. Had the financial support direction been ruled as having no effect, the liability would fall down a “black hole”, the regulator said.

Experts said that the ruling, which overturned a 2011 judgment by the Court of Appeal, would also simplify other company restructurings and future corporate insolvencies.

There had also been a concern that the Pension Protection Fund would have come under considerable strain if it had been forced to take on the liabilities of the Nortel scheme.

Claims from a corporate pension scheme should not rank above other creditors in insolvency proceedings, the Supreme Court ruled on Tuesday, overturning lower court judgments that put pensioners’ interests ahead of others.

The original case was brought in 2010 by administrators to Lehman Brothers and Nortel Networks. They challenged the pensions regulator’s right to bring a legal proceeding, known as a financial support direction, to stand alongside those of other creditors’ claims on the proceeds after a corporate insolvency.

Lower courts had decided they must either rule that pension debts are an administrative expense to be paid ahead of unsecured creditors, or risk the unravelling of legislation designed to protect benefits. Their rulings gave priority to the pension claims.

But legal experts warned that if the lower court judgments stood, as a knock-on effect, companies with defined benefit pension schemes would have to pay much more to access credit.

Kevin Pullen, a partner at law firm Herbert Smith, which represents the Nortel creditors, said that the challenge was made because the regulator did not have a formal claim outstanding seeking a set sum, on the date that Nortel sought administration.

For its part, the regulator’s procedures do not require it to specify an amount when it seeks an FSD. It merely needs to show why an entity should be responsible for offering financial support to a scheme.

The pension scheme was Nortel’s largest unsecured creditor with a deficit of £2.1bn – representing the cost of buying annuities for its pensioners. The comparable figure for Lehman is £148m.

The Regulator argued it could not have made such claims because they take months to prepare and it did not have access to the information to compile them.

Mr Pullen said that despite Wednesday’s ruling, the Nortel administrators will continue to challenge the regulator’s right to bring the financial support direction, and will ask for the matter to be aired before the regulator’s tribunal.

But legal experts welcomed the decision, saying it clarifies where pension debts rank in insolvency proceedings.

Charles Maunder, partner and head of the banking, restructuring and insolvency team at law firm Michelmores, described the judgment as “a victory for common sense and fairness to all creditors”.

Stephen Soper, the pensions regulator’s executive director for defined benefit funding, welcomed the Supreme Court ruling.

“This will be welcome news for many thousands of pension scheme members and will provide clarity to insolvency practitioners on how to treat a pension scheme liability,” he said.

“In this case, the regulator was forced to defend against arguments that an FSD issued against an insolvent company would be ineffective and disappear down a ‘black hole’.”

Such a ruling would have posed serious threats to the finances of the Pension Protection Fund which insures the underfunded schemes of insolvent employers, he added.

The verdict was the result of a case brought by the administrators of the UK divisions of investment bank Lehman Brothers and Canadian telecoms group Nortel, and is viewed as a "landmark" because of its implications for other companies that go bust where pension schemes are in deficit.

Nortel, the Canadian firm which collapsed in 2009, had a £2.1bn shortfall in its European scheme. The pension entitlements of more than 40,000 workers were implicated. The funding gap at the UK division of failed investment bank Lehman was far smaller at £148m.

UK pensions watchdog The Pensions Regulator had submitted a claim when Nortel and Lehman went into insolvency asking for pension members to be paid ahead of other claims. It used a mechanism known as a "Financial Support Direction" (FSD) to do this. But the Supreme Court yesterday ruled the pensions should not be ranked above other unsecured creditors in an insolvency.

The FSD, introduced in legislation in 2004, is designed to protect employees in under-funded schemes by trying to ensure companies support their pension promises. But, according to insolvency practitioners and lawyers close to the case, FSDs create uncertainty for scheme members and inadvertently increase the chance of schemes being pushed into the Pension Protection Fund, the "lifeboat" arrangement for funds of failed businesses which are in deficit.

PwC, adviser to the trustees of the Nortel UK pension funds, said it was a "great result for members of pension schemes", enabling insolvency practitioners "to make quicker distributions to all creditors".

Lenders to companies whose schemes are in deficit, or others seeking to restructure such firms, are expected to be reassured. Giles Frampton of R3, the insolvency trade body, said: "The Nortel decision is to be welcomed in that it appears to restore a fair balance between the rights of pension funds and other creditors in administrations."

Chasing pension money from parent companies who have gone bust has been materially weakened, after the Supreme Court ruled that the UK Pensions Regulator's financial support directions (FSDs) and contribution notices no longer have priority in a line of creditors.

Overturning a previous Court of Appeal judgment from 2011, Lord Neuberger, Lord Mance, Lord Clarke, Lord Sumption, and Lord Toulson concluded that the Pensions Regulator does not rank ahead of any creditors, including unsecured creditors, banks, and bondholders, and should instead be considered pari passu: that is, equal.

The ruling, which happened this morning, in the matter of the Nortel Companies, in the matter of the Lehman Companies, and in the matter of the Lehman Companies (No. 2), has widely been heralded as a success for common sense. If the court had decided to uphold the Court of Appeal's findings, any large pension deficit would likely have swallowed up all assets recovered after an insolvency, leaving all other creditors with nothing.

Another unintended consequence of the original judgment was that businesses with final salary pension schemes may have found it more difficult to borrow money, as the decision of the lower courts saw liabilities ranking as an expense, increasing the costs of lending. This should also have been dealt with by the court's decision today.

"The concern before today's decision was that the Pensions Regulator had the power to boost the ranking of its claim simply by waiting for a target company to enter administration. The Supreme Court unanimously agreed that Parliament cannot have intended such an unfair and arbitrary result," said Tony Bugg, global head of restructuring and insolvency at Linklaters, who also advised the Lehman Brothers' administrators.

"An insolvency pits employees, pensioners, suppliers and other creditors against one another each fighting for a share of a limited pool of funds. The Supreme Court rightly decided that only the clearest of legislative intent should enable one group of creditors to claim priority over another.

"In the context of an insolvency regime which already gives some creditors preferential treatment, it is right that these decisions should be for Parliament to decide."

A Pyrrhic Victory for the Regulator?

Jennie Kreser, partner at law firm Silverman Sherliker, told aiCIO the judgment meant the likelihood of recovery for pension schemes has been "somewhat reduced".

"The Supreme Court said that in coming to its decision, it has overturned a line of cases (which the court below couldn't do) as they were contradictory and not consistent with corporate insolvency situations, having been based on individuals who were insolvent.

"This will be a disappointment to the Pension Regulator and to the members of pension schemes who will, as a result, find their position weakened when trying to bolster schemes with significant deficits, who would otherwise look to other group companies for help."

But the Regulator's statement suggested it welcomed the clarity the Supreme Court had provided, and cheered the fact it had successfully argued against a suggestion that an FSD issued against an insolvent company would be ineffective and "disappear down a black hole".

The Regulator had originally pushed for FSD liabilities to be considered an administration expense or as a provable debt. Even though the administrative expense argument was ruled out by the Supreme Court, the regulator was happy to have the provable debt argument sustained.

Stephen Soper, the Pensions Regulator's executive director for defined benefit funding, said: "This will be welcome news for many thousands of pension scheme members and will provide clarity to insolvency practitioners on how to treat a pension scheme liability.

"Since the challenge was first made, we have made clear that we have no intention of frustrating the proper workings of the administration process. Today's judgment will provide clarity to the UK's restructuring and rescue practitioners that FSD liabilities have to be recognised in insolvent situations but do not have priority over administration expenses or secured debts."

Another potential downside was highlighted by law firm Allen and Overy: the surrounding legislation needed fixing in a number of areas, including in relation to overseas enforcement of FSDs.

"Because this decision now makes it work for FSDs in UK insolvencies, I can't see a root and branch reform of the FSD aspect being likely now," Jason Shaw, senior associate at the firm, said.

The Pension Protection Fund's head of restructuring and insolvency, Malcolm Weir, said the PPF had always argued FSDs and contribution notices should be treated as provable debts, and that the organisation would now look at the judgment to assess the implications for the Nortel and Lehman schemes, and any future recoveries it may make as an unsecured creditor.

The full judgment can be read here.

What does this mean for Lehman and Nortel Network's pension schemes?

In a nutshell, don't expect a swift happy ending.

Both schemes are currently in the Pension Protection Fund assessment period, with Nortel entering in March 2009, and Lehman Brothers' entering in two separate tranches in October 2008 and August 2009.

The Pensions Regulator has issued FSDs to target companies associated with both pension funds-Lehman Brothers' targets were issued with an FSD in September 2010 and Nortel's targets received their FSD on June 25, 2010.

Both sets of targets referred the matter to the Upper Tribunal court, contesting the grounds for the FSD issuance, and both cases were then stayed, awaiting the outcome of the Supreme Court hearing.

Following today's judgment, those Upper Tribunal cases can now resume, resulting in one of two options: either the Upper Tribunal sides with the Regulator and grants permission to hand down the FSD, or it sides with the targets.

Both results could also find themselves subject to appeal, if a point of law can be found, meaning the cases could escalate to the Court of Appeal. There's also parallel cases being heard in the US and in Canada to determine the claims of the Nortel trustees, which were submitted off the back of the FSD issuance. Those are listed to take place in January, 2014.

All of which means it's unlikely the members of both schemes will have closure on the ongoing legal rows for many months to come, if not years.

When Greece ran into financial trouble three years ago, the problem soon spread. Many observers were mystified. How could such a little country set off a continental crisis? The Greeks were stereotyped as a nation of tax-dodgers who had been living high on borrowed money for years. The Portuguese, Italians and Spanish insisted that their finances were fundamentally sound. The Germans wondered what it had to do with them at all. But the contagion was powerful, and Europe’s economy has yet to recover.

America seems in a similar state of denial about Detroit filing for bankruptcy (see article). Many people think Motown is such an exceptional case that it holds few lessons for other places. What was once the country’s fourth-most-populous city grew rich thanks largely to a single industry. General Motors, Ford and Chrysler once made nearly all the cars sold in America; now, thanks to competition from foreign brands built in non-union states, they sell less than half. Detroit’s population has fallen by 60% since 1950. The murder rate is 11 times the national average. The previous mayor is in prison. Shrubs, weeds and raccoons have reclaimed empty neighbourhoods. The debts racked up when Detroit was big and rich are unpayable now that it is smaller and poor.

Other states and cities should pay heed, not because they might end up like Detroit next year, but because the city is a flashing warning light on America’s fiscal dashboard. Though some of its woes are unique, a crucial one is not. Many other state and city governments across America have made impossible-to-keep promises to do with pensions and health care. Detroit shows what can happen when leaders put off reforming the public sector for too long.

Inner-city blues

Nearly half of Detroit’s liabilities stem from promises of pensions and health care to its workers when they retire. American states and cities typically offer their employees defined-benefit pensions based on years of service and final salary. These are supposed to be covered by funds set aside for the purpose. By the states’ own estimates, their pension pots are only 73% funded. That is bad enough, but nearly all states apply an optimistic discount rate to their obligations, making the liabilities seem smaller than they are. If a more sober one is applied, the true ratio is a terrifying 48% (see article). And many states are much worse. The hole in Illinois’s pension pot is equivalent to 241% of its annual tax revenues: for Connecticut, the figure is 190%; for Kentucky, 141%; for New Jersey, 137%.

By one recent estimate, the total pension gap for the states is $2.7 trillion, or 17% of GDP. That understates the mess, because it omits both the unfunded pension figure for cities and the health-care promises made to retired government workers of all sorts. In Detroit’s case, the bill for their medical benefits ($5.7 billion) was even larger than its pension hole ($3.5 billion).

Some of this is the unfortunate side-effect of a happy trend: Americans are living longer, even in Detroit, so promises to pensioners are costlier to keep. But the problem is also political. Governors and mayors have long offered fat pensions to public servants, thus buying votes today and sending the bill to future taxpayers. They have also allowed some startling abuses. Some bureaucrats are promoted just before retirement or allowed to rack up lots of overtime, raising their final-salary pension for the rest of their lives. Or their unions win annual cost-of-living adjustments far above inflation. A watchdog in Rhode Island calculated that a retired local fire chief would be pulling in $800,000 a year if he lived to 100, for example. More than 20,000 retired public servants in California receive pensions of over $100,000.

Money (That’s what I want)

Cleaning up the mess in local and state government will take time. Circumstances vary widely from place to place, but a good starting-point would be to abandon the accounting tricks. Only when the scale of the problem is made clear can politicians persuade voters of the need for sacrifice.

Public employees should retire later. States should accelerate the shift to defined-contribution pension schemes, where what you get out depends on what you put in. (These are the norm in the private sector.) Benefits already accrued should be honoured, but future accruals should be curtailed, where legally possible. The earlier you grapple with the problem, the easier it will be to fix. Nebraska, which stopped offering final-salary pensions to new hires in 1967, is sitting pretty.

Yet sooner or later, some of these problems will end up in Washington, DC. In Detroit, a judge ruled this week that federal bankruptcy law trumps a state law that makes it impossible to reduce pensions. But the issue will arise again, and will not be truly settled until it reaches the Supreme Court. Many places like Detroit will surely have to break some past promises—and rightly so. And given the size of many of the black holes, the state or federal government may have to help out. Taxpayers should not bail out feckless local governments or investors who should have known the risks. But they should help pensioners left stranded through no fault of their own. Some state and municipal workers do not qualify for the federal Social Security system; they get only the pensions promised by their employer. If these do not materialise, there should be a backstop to ensure that they receive at least a basic pension.

Americans in virtuous states and cities will be just as furious about their tax dollars flowing to Detroit and other distressed places as Germans are about euros going to southern Europe. But the truth is that America’s whole public sector still operates in a financial never-never land. Uncle Sam offers an array of “entitlements” that there is no real plan to pay for. Barack Obama is on his way to joining George W. Bush as a president who did nothing about that, while Republicans in Congress imagine they can balance the books without raising taxes. The government spends more on health care than many rich countries and still does not cover everyone. America’s dynamic private sector is carrying on its back an unreformed Leviathan. Detroit is merely a symptom of that.

"Sadly, what is happening in Detroit will happen in many more U.S. cities struggling with crippling public debt. The articles serve as a painful reminder that public pensions are not as sacred as people think. When the money runs out, pensioners face huge cuts to their pensions as cities try to assuage bondholders to keep lending them money."

Detroit pensioners woke up last Friday to shattered retirement dreams, and the haunting question that people around the world are now asking themselves is, "What about mine?"

In its bankruptcy filing last week, the city declared its pension and benefit commitments to be part of its debt, leaving a Federal judge to decide how to distribute Detroit's remaining assets between pensioners and other creditors.

From a business point of view it is all quite rational. Over the years, the city government made more promises than it could possibly afford to pay. About $18 billion more.

But there's more happening here than rational business decisions. In bankruptcy, when there just isn't enough money to go around, each of the creditors takes a share of the hit. This time they are expected to get between 10 and 20 cents for every dollar they are owed — and that includes the city's pensioners.

People who have worked a lifetime for the city, responsibly choosing a job and sticking with it because they knew it included a safe pension, abruptly have to think again.

They could have taken their skills and commitment elsewhere, taken risks and pursued more adventurous jobs, sailed around the world or lived cheap on the beaches of Goa, or taken a flyer on a career as an actor or novelist. In other words, they could have lived like the grasshopper instead of the ant in the Aesop's Fable — making enough for a roof and entertainment week to week but never setting a penny aside for the long winter ahead.

And eventually relying on social assistance in their old age. As the Wealthy Barber author David Chilton has said, people without a pension generally don't save enough.

But the pension contributors in Detroit weren't the fabled grasshoppers, they were the ants. They were the responsible ones who considered the future and planned ahead so they could pay their own way. They chose jobs with salary agreements that included the promise of a fund for their retirement.

Every month money was taken from their pay. Every month, the paperwork showed that their employer had added its share to the pension pot. Periodically a form would arrive in the mail telling them how much they would get if they continued working until the age of 65. But all the time the paperwork was a lie.

And as I mentioned last week, there is a growing view that the crisis in Detroit may not be unique, that there are more public-sector bankruptcies to come. Others have weighed in on the subject since, some seeming to blame pensioners for the growing potential financial crisis, saying they are taking more than their share.

The point they're missing is that pensions are crucial to a healthy economy.

As everyone keeps telling China, until the country develops a reliable social safety net, a consumer-led society can never take off. Employees must be able to trust their pensions will actually be there when it comes time to draw on them, or their ant-like personalities will force them to hoard even more when they're working, instead of recirculating that cash into the economy.

And safe pensions do exist. The best ones are those that money managers give themselves.

In this type of blue ribbon pension there is no promise to pay on some future day. The money is set aside in a separate account. It is well managed in diversified investments. Its future value, and thus the amount added to the fund each year, is determined by realistic long-term rates of interest. It is not based on a 30-year-old promise by some now-defunct politician and subject to the whims of whoever is calling the political shots today.

Detroit has shown that the promises of politicians don't last 30 years. And neither do the promises of companies.

Canada's own Nortel, the airlines and the Detroit auto makers themselves are just a few of the private firms proving that promises given years ago to inspire loyalty when workers were desperately wanted are worth nothing when the workers are no longer needed.

As the blue-ribbon pensions show, money actually set aside and invested wisely over a 40-year working life provides a reliable retirement income. Stocks really do return 8 per cent over the long term. Bond returns are low now, but many years in the last 40, bonds were paying double-digit rates.

But as with those blue ribbon pensions, the secret is that the money must actually be set aside and invested by honest, qualified professionals. Pension funds that do that, like the Ontario Teachers Pension Plan, or the Canada Pension Plan, provide reliable returns.

Without that, a promise to pay is only as good as the changing fortunes of the organization making the promise.

Pensions backed by promises from governments with relatively low debt, like Canada's, are safe for now. And as CBC's Amber Hildebrandt has reported, in Canada cities are backed by their respective provinces if things go sour.

Other governments and companies are not in such good shape. In the wake of Detroit, employees and unions making deals with healthy governments and private sector employers must learn not to accept promises. They must demand that cash be set aside now, placed in a well-run fund, and managed for the long term.

Either that or the ants might as well join the grasshoppers. Buy a sailboat, and don't come home till you are old and sick and looking for social assistance.

At the height of the financial crisis in 2008, a group of famous hedge fund managers was made to stand before Congress like thieves in a stockade and defend their existence to an angry public. The gilded five included George Soros, co-founder of the Quantum Fund; James Simons of Renaissance Technologies; John Paulson of Paulson & Co.; Philip Falcone of Harbinger Capital; and Kenneth Griffin of Citadel. Each man had made hundreds of millions, or billions, of dollars in the preceding years through his own form of glorified gambling, and in some cases, the investors who had poured money into their hedge funds had done OK, too. They were brought to Washington to stand up for their industry and their paychecks, and to address the question of whether their business should be more tightly regulated. They all refused to apologize for their success. They appeared untouchable.

What’s happened since then is instructive. Soros, considered by some to be one of the greatest investors in history, announced in 2011 that he was returning most of his investors’ money and converting his fund into a family office. Simons, a former mathematician and code cracker for the National Security Agency, retired from managing his funds in 2010. After several spectacular years, Paulson saw performance at his largest funds plummet, while Falcone reached a tentative settlement in May with the U.S. Securities and Exchange Commission over claims that he’d borrowed money from his fund to pay his taxes, barring him from the industry for two years. Griffin recently scaled back his ambition of turning his firm into the next Goldman Sachs (GS) after his funds struggled to recover from huge losses in 2008.

As a symbol of the state of the hedge fund industry, the humbling of these financial gods couldn’t be more apt. Hedge funds may have gotten too big for their yachts, for their market, and for their own possibilities for success. After a decade as rock stars, hedge fund managers seem to be fading just as quickly as musicians do. Each day brings disappointing headlines about the returns generated by formerly highflying funds, from Paulson, whose Advantage Plus fund is up 3.4 percent this year, after losing 19 percent in 2012 and 51 percent in 2011, to Bridgewater Associates, the largest in the world.

This reversal of fortunes comes at a time when one of the most successful traders of his time, Steven Cohen, founder of the $15 billion hedge fund firm SAC Capital Advisors, is at the center of a government investigation into insider trading. Two SAC portfolio managers, one current and one former, face criminal trials in November, and further charges from the Department of Justice and the SEC could come at any moment. The Federal Bureau of Investigation continues to probe the company, and the government is weighing criminal and civil actions against SAC and Cohen. Cohen has not been charged and denies any wrongdoing, but the industry is on high alert for the possible downfall of one of its towering figures.

Despite all the speculation and the loss of billions in investor capital, Cohen’s flagship hedge fund managed to be the most profitable in the world in 2012, making $789.5 million in the first 10 months of the year, according to Bloomberg Markets. His competitors haven’t fared as well. One thing hedge funds are supposed to do—generate “alpha,” a macho term for risk-adjusted returns that surpass the overall market because of the skill of the investor—is slipping further out of reach.

According to a report by Goldman Sachs released in May, hedge fund performance lagged the Standard & Poor’s 500-stock index by approximately 10 percentage points this year, although most fund managers still charged enormous fees in exchange for access to their brilliance. As of the end of June, hedge funds had gained just 1.4 percent for 2013 and have fallen behind the MSCI All Country World Index for five of the past seven years, according to data compiled by Bloomberg. This comes as the SEC passed a rule that will allow hedge funds to advertise to the public for the first time in 80 years, prompting a flurry of joke marketing slogans to appear on Twitter, such as “Creating alpha since, well, mostly never” (Barry Ritholtz) and “Leave The Frontrunning To Us!” (@IvanTheK).

As their returns have fallen, the biggest hedge funds have started to seem more like glorified mutual funds for the wealthy, and those rich folks might start to take a harder look at whether they’re getting their money’s worth. This could be an encouraging development for the world economy, considering that hedge funds provided huge demand for the toxic mortgage derivatives that helped lead to the financial collapse of 2008. At the same time, the tens of billions that pension funds have plowed into funds such as Bridgewater’s All Weather Fund—down 8 percent for the year as of late June, according to Reuters, compared with a 10.3 percent rise in the S&P 500—mean that the financial security of untold numbers of retirees could be threatened by a full-scale hedge fund meltdown.

For the moment, that possibility seems remote. The age of the multibillionaire celebrity hedge fund manager may be drawing to a close, but the funds themselves can still serve a useful purpose for prudent investors looking to manage risk. Let the industry’s recent underperformance serve as a reality check: No matter how many $100 million Picasso paintings they purchase, hedge fund moguls are not magicians. The sooner investors realize that, the better off they will be.

While many hedge funds fared better than the stock market during the financial crisis, and rode the 2009 recovery back to health, they have been confounded by sometimes violent market moves over subsequent years.

Since January 2010 the average equity hedge fund has produced profits for its investors, after fees, of just 14.5 per cent, according to the research group HFR.

Over the same period an investor in the S&P 500 earned, with dividends, a 55 per cent return: a total which 85 per cent of equity hedge funds have failed to match, finds HFR.

Stock trading specialists at hedge funds fared even worse than their peers managing humdrum mutual funds – 83 per cent of mutual fund managers who invest in large-cap stocks and try to beat the S&P 500 have failed to do so, according to the research group Lipper.

Among all mutual funds investing in stocks, one-third are ahead of the market, and the average investor return is 44.5 per cent from the start of 2010 to the end of June this year, Lipper finds.

The comparison may be unfair to some funds which do not aim to beat the market. Some within the industry argue that hedge funds are behaving as they should, performing better as markets plunge, but lagging behind as they steadily rise.

“We haven’t changed our advice,” said Edward O’Malley, hedge fund consultant for Cambridge Associates, “In the same way . . . we weren’t advising clients to exit hedge funds in favour of long-only funds after the crisis.”

While mutual funds are restricted to simple activities such as choosing cheap companies, hedge funds typically try to use leverage to magnify returns. They may also use hedging to mitigate losses, or sell short stocks in the anticipation of falling prices.

As pension funds embraced the use of cheap index funds over the last decade, such advantages were pitched as a way for hedge funds to improve portfolios.

Yet the poor performance of the last three years now far outweighs hedge funds’ resilience through the worst of the crisis. Over the past five years the S&P 500 with dividends has delivered average annual returns of 7 per cent, while equity hedge funds have produced just 1.7 per cent, according to HFR.

...some big investors seem to buy hedge funds much the way the rest of us pick hotel rooms or buy breakfast cereal.

According to a global survey by Deutsche Bank in December, a third of big investors don't require hedge funds to have a track record before investing in them. Three-quarters of pension funds—and half of insurers and endowments—hire outside consultants to conduct due diligence on their hedge funds instead of doing it themselves. Some pension funds, I am told, even decline to review the exact holdings in their hedge funds because they don't want to be held accountable for the quality of their analyses.

What makes big investors so willing to close one or two eyes—and pay through the nose for the privilege—is the pipe dream of safety and outperformance.

Everyone wants double-digit returns in a world of paltry bond yields. Trillions of dollars are chasing the few managers who can earn high returns on a few billion dollars apiece. Clients pay on average up to 2% of assets and 20% of profits—and occasionally as much as 3% and 50%, as the government alleges at SAC.

"You should pay hedge-fund managers all that extra money so they don't lose you a lot of your capital in bad markets," says Elizabeth Hilpman, chief investment officer at Barlow Partners, which invests exclusively in hedge funds. "But many institutional investors want it all: They want the downside protection and the huge outperformance."

Big institutions are among the most desperate performance-chasers on the planet. "The consultants tell them they can get 8% [annual returns] by playing the same game that's being played by everyone else, if they just play it better," says Keith Ambachtsheer, an expert on pension strategy at KPA Advisory Services in Toronto. "But the math doesn't work."

Many hedge-fund managers, such as Seth Klarman of the Baupost Group, James Simons of Renaissance Technologies and George Soros of the Quantum Fund, have made their clients rich. But only one in 10 institutions reported earning at least 10% on hedge funds in 2012, according to the Deutsche Bank survey. But one-third expect their hedge funds to return at least 10% this year.

So far at least, that doesn't look likely. The HFRI Fund Weighted Composite, an index of hedge-fund performance, gained 3.55% in the first half of this year; it was up 6.36% for all of 2012.

Despite their recent trailing returns, most hedge funds still charge the same high fees. As the great economist Tibor Scitovsky explained decades ago, when sellers of a complex product or service are the only ones who fully understand what they are selling, buyers can't objectively distinguish quality. The result: an automatic oligopoly in which sellers compete on the appearance, not the reality, of high quality.

Perhaps we should be indicting—not criminally, but intellectually—an entire ecosystem. Yes, plenty of hedge funds are guilty of exploiting their clients with lavish fees for flaccid performance; some might even be breaking the law. But their clients are far from blameless: "Sophisticated" institutional investors still insist on believing in a Tooth Fairy that can somehow miraculously provide market-beating returns for everyone. Maybe that is the biggest crime of all.

• The rise of alternatives powerhouses: Take a look at how Blackstone has evolved from a private equity giant to an "alternatives powerhouse," investing in PE, real estate and hedge funds. Other private equity giants are following suit but Blackstone remains the leader in alternatives and is best poised in a rising rate environment. As money gets increasingly concentrated in the hands of these alternatives powerhouses, they will play a key role in influencing industry trends.
• More direct investments in hedge funds: While many pensions will invest in hedge funds via the Blackstones of this world, others are shunning funds of funds and investing directly into hedge funds. Sophisticated Canadian pension funds like Ontario Teachers', the Caisse, and CPPIB, have been investing directly in hedge funds for years and so do other Canadian funds. The same will happen in the United States where investors first foray into hedge funds might be through a Blackstone but eventually they want to build internal capabilities to invest directly. Of course, there will always be legal concerns at some U.S. public pension funds which will prevent them from investing directly into hedge funds. These public pension funds will never invest directly. 
• Lower alpha, lower fees: Hedge funds aren't dead but lower alpha will put increasing pressure on the industry to lower fees. It's already happening as many hedge fund managers realize to stay competitive and align interest with their investors, they need to lower fees. Big institutions writing big tickets are negotiating hard on fees and so they should. The last thing they want is to pay hedge fund managers "2 and 20" (2% management fee and 20% performance fee) so they can beef up their marketing group and become large, lazy asset gatherers sitting comfortably on billions.
• Start-ups are dying: Some of the world’s biggest hedge funds, including Marshall Wace, Millennium Management, CQS and BlueCrest Capital Management, are among firms that are capitalizing on a difficult environment for start-ups, hiring potential managers who might once have considered setting up on their own.I think it will become increasingly difficult for hedge fund start-ups. Having said this, sophisticated institutions will work with top funds of funds to invest in a portfolio of start-ups. Also, large family offices and established hedge fund managers will be a source of new funds for start-ups. 

The Windsor Star published an article by Craig Trudel of Bloomberg, Big improvement in pension plays, GM and Ford say:

While drawing car buyers and praise from the likes of Consumer Reports, General Motors Co. and Ford Motor Co. are getting a grip on pensions that will free up cash to develop future hits.

Over the long term, this should allow more spending on the core business and less on retirees. That in turn creates a brighter outlook for the companies, which are already delivering more competitive cars like the Chevrolet Impala and Ford Fusion, and better-than-estimated profits.

"It's one less thing investors have to worry about on the risk side," said Michael Razewski, a New York-based principal at Douglas C. Lane & Associates, which oversees $3.1 billion, including Ford shares. "The less Ford has to focus on funding the pension, the more they can focus on driving innovative products and services and meeting customer demand."

"We won't have to allocate as much capital to pensions as we have the last couple of years and certainly this year," Bob Shanks, chief financial officer of Dearborn, Mich.-based Ford, said. "That will give us the ability to take the cash that we're generating and invest it in other parts of the business that can support further growth."

Ford's pension plans were underfunded by $18.7 billion last year. Only Detroit based GM, with a shortfall of $27.8 billion, General Electric Co. and Boeing Co. had bigger holes at the end of 2012, according to data compiled by Bloomberg.

"We've made good progress since the end of last year from a pension-funded position perspective, given the rise in interest rates that's clearly helped our overall funding position," GM CFO Dan Ammann said. On a conference call he said the stronger fund "gives us more rather than less flexibility."

Both automakers have taken big steps to contain their pension costs for salaried workers. A year ago, GM said it would spend as much as $4.5 billion to shift salaried retirees to a group annuity handled by a unit of Prudential Financial Inc. The annuity, and lump-sum buyout offers to 42,000 retirees, was forecast by GM to shave $26 billion from its pension load.

Ford is also offering lump-sum buyouts to salaried retirees. The automaker has said it wants to eliminate remaining shortfalls in its pension funds by mid-decade.

For several years, GM and Ford could blame Treasury yields, a benchmark in their pension calculation, for at least part of their shortfalls. Yields plunged after the 2008 financial crisis as the Federal Reserve embarked on unprecedented bond-purchase programs to lower borrowing costs and encourage spending.

Interest rates have risen the last two months after Federal Reserve Chairman Ben Bernanke said the central bank may reduce its asset purchases this year and stop in the middle of 2014 if economic growth meets policy makers' projections.

The increase in rates will help reduce the funding needs at all types of pensions, whether run by corporations or governments. Detroit, long dubbed the Motor City, this month filed the largest municipal bankruptcy in U.S. history and is struggling under a large unfunded pension obligation that could lead to benefit cuts for 30,000 current and former city workers.

Detroit's cries of betrayal are not being felt by the car companies which took the decision to offload pension risk to insurers so they can focus on their core business. Others will follow their lead.

Thanks to rising rates and an injection of cash, Ford Motor Co could be in a positions that would have been unthinkable only a few years ago - with a fully funded U.S. pension fund.

Ford, which went through a searing restructuring in 2006, but avoided the bankruptcy route of its rivals General Motors and Chrysler, could cut its U.S. pension shortfall by half or even more by the end of this year from $9.7 billion at the end of 2012, according to securities analysts and Reuters calculations.

And the gap could be eliminated by the end of 2014 provided interest rates rise as economists expect and the stock market remains robust. That may give Ford added resources to pay down debt, invest in its businesses, or boost dividend payments, analysts said.

"It is a true obligation of the company right now and it's taking quite a bit of capital," Ford Chief Financial Officer Bob Shanks said of the automaker's pension gap in an interview.

"Once we get it fully funded, de-risked and sort of put it in a box, it gives us the ability not to worry about it so much and take future cash flow and put it wherever we want," he said.

If Ford fully funds its U.S. pension plan by the end of next year that would be quicker than many analysts had expected. GM could be about one to two years behind Ford in closing its U.S. pension gap, said Guggenheim Securities LLC analyst Matt Stover.

But critical to this scenario is that interest rates used to calculate retiree pension obligations continue to rise. Ford would also have to be willing to contribute at least $1 billion in 2014 to close its U.S. pension gap, analysts said.

Eliminating the shortfall is "possible by the end of 2014 and it's going to be because interest rates climb," said Stover, who predicts Ford's U.S. pension plans will be underfunded by about $4 billion by the end of 2013.

Ford's U.S. pension obligation was $52 billion at the end of last year, while GM's was about $82 billion.

GM was the first of the U.S. automakers to establish a pension plan in 1950 as part of the "Treaty of Detroit," a contract negotiated by legendary United Auto Workers union leader Walter Reuther. Ford and Chrysler followed suit.

But by the mid-2000s, pensions and other retiree benefits became an ever-increasing liability that automakers said added as much as $2,000 to the cost of a vehicle and put them at a disadvantage against foreign rivals.

Since then, GM and Ford have both taken steps to "de-risk" their pension plans by closing off their plans to new participants, offering lump-sum buyouts and shifting to more conservative investments.< Last year, GM cut $29 billion, or one-fifth, of its global pension liability when it shifted management of white-collar pension plans for 118,000 salaried retirees to a unit of Prudential Financial Inc. But underfunding remains an issue, partly because that shortfall is viewed by credit ratings agencies as debt.

Ford plans to inject $5 billion cash into its global pension plans this year to help reduce the underfunding - though some of that will go towards pension plans elsewhere in the world.

To put the underfunding and Ford's cash injection in context, the automaker spent $5.5 billion in 2012 on product development, building factories and other capital expenditures.

A $4 BILLION BOON

Companies calculate the present value of their future pension liabilities using a so-called discount rate, which is based on corporate bond rates. A higher rate means lower liabilities, meaning that a company doesn't have to set aside as much cash now to pay retirees in the future.

Based on the most optimistic scenario laid out by actuarial firm Milliman, higher rates alone could narrow Ford's pension gap by about $4 billion by the end of 2014. Stover said higher rates could close about half of Ford's U.S. pension shortfall.

"The auto companies have always been associated with having these big pension liabilities," Citi analyst Itay Michaeli said. "It becomes a frustration for investors to deal with more volatility on top of already volatile industry dynamics."

Closing the U.S. pension gap "takes an element that has arguably weighed on investor sentiment and just takes that issue away," Michaeli added.

The discount rate, which is based on corporate bond yields and is used to determine the present value of payments they make over the life of their plans, has risen this year to 4.74 percent in June from 3.96 percent in December, according to Milliman.

By the end of 2013, the discount rate could be as high as 5.04 percent, and by the end of 2014 it could be up to 5.64 percent, Milliman estimates.

A smaller pension gap would likely pave the way for Standard & Poor's to upgrade Ford's credit ratings upgrade to investment grade, Michaeli said. That would allow the automaker to fund the remaining U.S. pension gap with unsecured debt.

"By issuing debt, what you're doing is freeing up free cash flow," he said, adding that could be used to boost dividends, develop new vehicles or pay off debt.

For Ford, a one percentage point increase in the discount rate alone could lower its U.S. pension liability by $2.3 billion, Shanks said during Ford's second-quarter earnings call.

Last year, S&P 500 companies posted record shortfalls in their pensions and other post-employment benefits (OPEB), threatening to leave America’s future retirees empty-handed.

Despite double-digit gains in the markets in fiscal year 2012, the underfunding of S&P 500 pensions climbed to $451.7 billion—up from $354.7 billion in 2011 and $245 billion in 2010, according to a report by S&P Dow Jones Indexes.

OPEB shortfalls also ballooned to $234.9 billion in 2012, compared with $223.4 billion in 2011 and $210.1 billion in 2010.

As a result of the growing gap, the funding status of company pensions fell to 77%. The OPEB funding status was significantly lower—22%.

“The double-digit equity gains of 2012 were no match for the artificially low interest rates, which vaulted pension liabilities into record underfunding territory,” says Howard Silverblatt, author of the report and senior index analyst with S&P Dow Jones Indexes.

While this trend, for the most part, spares current retirees in the United States, it jeopardizes the retirement prospects of those who are still working.

“The American dream of a golden retirement for baby boomers has dissipated for most,” Silverblatt explains. “For baby boomers, it may already be too late to safely build up assets, outside of working longer or living more frugally in retirement.”

He says younger workers need to start saving early, so they can have time to compound their returns. “Corporations have shifted the responsibility to them, and if they don’t step up now, they won’t have anything for retirement,” he warns.

The S&P Dow Jones Indexes report also shows that estimated pension return rates have been falling for 12 consecutive years. They tanked to an estimated 7.31% in 2012, 7.60% in 2011 and 7.73% in 2010.

Discount rates have been on the decline, too. They fell to 3.93% in 2012—down from 4.71% in 2011 and 5.31% in 2010, significantly increasing projected obligations.

Young workers may want to start counting on something other than company pensions to fund their retirements.

It turns out that the plans of S&P 500 companies are underfunded to the tune of $451.7 billion, a number that has grown some 27 percent in just the last year alone, according to data released Wednesday by S&P Dow Jones Indices.

While firms have plenty of cash to cover older workers currently on the payroll or in pension plans, that may not be the same once the younger generation gets ready to stop working.

"The good news for current retirees is that most S&P 500 big-cap issues have enough cash and resources available to cover the expense," Howard Silverblatt, senior index analyst at S&P Dow Jones Indices said in a report. "The bad news is for our future retirees, whose benefits have been reduced or cut and will need to find a way to supplement, or postpone, their retirement."

Pension underfunding has been a persistent problem for corporate America for years.

Though many workers have switched to 401(k) plans over the years, pensions still have far more workers—91 million to 51 million.

The combination of poor investment choices along with low interest rates have pushed "pension liabilities into record underfunding territory," Silverblatt said.

This year actually was supposed to be better for pensions under an accounting trick Congress approved in 2012.

The move would allow corporations to use a 15-year average of bond yields, rather than the current level, to calculate their obligations.

However, even that didn't work.

Pension return rates fell for a 12th straight year in 2012. slipping to 7.31 percent from 7.6 percent in 2011 and 7.73 percent the year before. That performance has been triggered by falling discount rates, which dropped to 3.93 percent in 2012 from 5.31 percent just two years before.

A number of companies have tried to reach settlements with employees to reduce their obligations, a process known as de-risking.

General Motors, Ford and Verizon Communications all took significant measures, including offering lump-sum payments and annuity purchases for former vested participants and retirees, according to consultant firm Milliman, which measures the obligations of 100 companies.

The firms included in the Milliman 100 reduced their burdens by $45 billion, but were still left overall with a record shortfall.

GM, for instance, reduced its obligation by $30 billion but still had a $111 billion deficit.

While Fed policies of near-zero interest rates and $85 billion in money creation each month have helped boost the S&P 500 stock index, pension-burdened companies have been hammered.

"Because the Federal Reserve has announced that it plans to keep interest rates low through 2014 (and perhaps longer, until the overall unemployment rate reaches 6.5 percent), there is little expectation that rising discount rates will contribute to improvements in the funded status of the Milliman 100 pension plans," Milliman said in a report.

S&P's Silverblatt said young workers should be paying attention.

"For baby boomers it may already be too late to safely build up assets, outside of working longer or living more frugally in retirement," he said. "For younger workers, they need to start to save early, permitting time to compound their returns for their retirement. Corporations have shifted the responsibility to them, and if they don't step up now, they won't have anything for retirement."

As interest rates go up, defense contractors offer this positive spin: Pension liabilities could go down, easing employees’ anxiety about the future of their retirement benefits and freeing up some of the billions of dollars these companies contribute each year to keep up with plan obligations.

Executives from both Northrop Grumman Corp. and Lockheed Martin Corp. addressed during calls with investors this week the potential impact on pension obligations of the rising interest rates. In June, interest rates stood about 75 basis points above the estimated 4.5 percent rate assumed at the end of 2012.

“Higher interest rates could improve our funded status to around 90 percent or so, from the 83 percent level that we had at the end of last year,” said Northrop chief financial officer James Palmer during an investors’ call Wednesday.

Because pension payouts run so far into the future — 60 to 70 years to cover the lifespan of all participants — a company’s plan must predict how much it needs in the short term to cover future payments. That’s done by using an assumed discount rate based on the interest rate of fixed-income securities. The lower the discount rate, the higher the assumed pension obligation. In recent years, low interest rates have caused obligations to skyrocket, which has been a major drag on earnings for defense contractors.

To put the increase in perspective, for every 25 basis point change in the discount rate, Northrop’s pension expense goes down $65 million, and Lockheed’s $145 million. According to Mercer LLC, a New York City-based financial services consulting firm, the funded status of S&P 1500 companies' pension plans reached 88 percent at the end of June, compared to 74 percent at the start of the 2013. It’s the highest level since October 2008.

"The defense industry is subject to the same challenges as the S&P 1500, and recent market moves will have helped funded status in that sector,” said Nick Davies, a Mercer principal, who noted that companies should take into account long-term strategic corporate finance goals, as well as shorter term market conditions.

Indeed, companies do take a hit from higher interest rates as well. As Palmer noted, they also reduce returns on the fixed income and international portions of the investment portfolio.

“Pension assumptions are set at the end of the year. And if we look back into the past, a lot can change between now and then,” Palmer added.

Northrop has paid $543 million toward its pension in the first half of fiscal 2013, while Lockheed has paid $1.5 billion in pension contributions to date, meeting its annual requirement set by the federal government.

Unfunded pension liability for defense companies remains high. According to their most recent earnings released this week, Northrop Grumman Corp. carries $5.43 billion on the books, for example, and Lockheed Martin Corp. $14.78 billion. Those totals are always subject to change as well, noted Lockheed chief financial officer Bruce Tanner on a Tuesday conference call with investors.

“Overall, if we were to set the market today, we would expect to have a positive adjustment” if interest rates held, Tanner said.

Tanner noted, however, “I would remind you that between now and the end of the year, we typically do sort of accrual settings that look at the current population of employees to see what has changed."

One of the bigger changes we're watching [for] is a new sort of standard mortality rate. From a good news perspective, all of us are going to live longer… from the bad news perspective, it says liabilities are likely going to be increasing per pension. So that will have a bit of a mitigating effect.”

A year ago, Moody's Investors Service claimed in a report that because certain defense contractors have large pension obligations relative to their market capitalization, they're good candidates for selling their pension plans to annuity firms.

Kevin Landry, a veteran of Boston private equity and one of its biggest personalities, died Thursday after a long battle with lung cancer. He was 69.

Landry was the longtime chief executive of TA Associates in Boston, working on such investments as Biogen Idec, now a pharmaceutical giant, and Continental Cablevision. He was widely respected in private equity circles for his work ethic, honesty and deep knowledge of the business. But he was beloved by legions of friends and clients for his blunt manner, his smash shot in tennis, and a seemingly boundless energy he brought to everything from flying jets to supporting women’s hockey at Harvard.

“For many of us, Kevin Landry was TA Associates. He joined the firm directly from Wharton, long before any of us knew of TA, and before a great many of you were born,’’ the firm’s chairman, Richard Tadler, said in a note to the staff Thursday. “He hated to lose and didn’t do anything halfway. Whether on the golf course or the tennis court, fishing or sailing, on the motorcycle or in the air, Kevin reveled in a challenge, physical or intellectual.”

A rare breed in the buttoned-down investment world, Landry could always be counted on for straight assessments of the economy, bankers, and politics. He never hesitated to speak his mind, even when his views were unpopular: He criticized the favorable tax treatment partners in his industry enjoy, and he called out lenders for being careless in the run-up to the financial crisis.

Recruited by venture capital pioneer Peter Brooke, Landry first took a job with TA in 1967. At the time, he didn’t know what venture capital was, Landry told the Globe last year.

An active Harvard University alumnus, Landry was a big supporter of the school, along with his wife Barrie, and they sent their two daughters there. They funded the school’s Jeremy Knowles Undergraduate Teaching Laboratory, an interdisciplinary teaching space supporting learning across the sciences and engineering, and endowed the women’s ice hockey coach position.

In 2010, Landry was awarded the Harvard Medal, the highest honor the university gives to alumni for extraordinary service.

“Kevin Landry was a great Harvard citizen,” Harvard president Drew Gilpin Faust said in a statement. “He enthusiastically supported academics and athletics, thoughtfully engaged in philanthropy, and eagerly shared his perspectives with deans and other leaders across the University, always with equal measures of candor and care.”

Landry took on cancer with the same upbeat fury he brought to the rest of his life. He was diagnosed in 2010 and given less than a year to live. But with aggressive treatment, he stayed active and continued to work. He retired last year after 45 years with TA, when he felt he couldn’t maintain his usual pace.

Still, he stayed sharp and continued to see friends and spend time with family. He also maintained a steady correspondence, sending e-mails with news, observations, and his classically acerbic critiques of liberal politicians.

Even as he dealt with cancer treatment, Landry told the Globe last year, “Look at the totality of my life. I’ve been so lucky.”

Landry’s partners at TA recently made a $10 million gift to Harvard to endow the Landry Cancer Biology Consortium and the Landry Cancer Research fellowships. The gift will fund research on cancer biology and treatments, including lung cancer studies.

TA Associates said on Thursday its former chairman, Kevin Landry, whose more-than-four-decade career with the private equity firm helped shape its industry, has died at 69 of cancer.

In a posting on its website, TA Associates called Landry a private equity pioneer, a relentless competitor and a generous benefactor. As a 24-year-old MBA graduate, he joined the firm in 1968 as its second hire and helped transform it from a small venture capital investor to a global private equity firm.

In 1978, Landry played a key role, together with Nobel laureates Walter Gilbert of Harvard and Phillip Sharp of MIT, in starting Biogen Idec Inc, a biotechnology company that has grown in market value to $52 billion.

Landry later opposed the rise of the debt-saddled buyouts in private equity and developed a reputation as an old-fashioned investor with a focus on good management, free cash flow and clean balance sheets.

Since 1982, when he became managing partner, the internal rate of return on TA Associates' investments, net of all fees and expenses, consistently beat the market and private equity benchmarks, the firm said.

His due diligence skills expanded beyond private equity. As a pilot of his own jet, he subscribed to written and recorded accounts of the Federal Aviation Administration's accidents and incident reports to avoid the mistakes of less-skilled pilots.

In the book "A Vision for Venture Capital," Landry is credited with finding about $2 million in checks inadvertently disposed of by a TA Associates secretary in the late 1970s. The money was part of a $10 million capitalization fund.

Landry located the garbage truck, the dump site and finally the checks' final destination at a recycling plant. After a search through bales of trash, the checks were found, according to the book.

Landry served on numerous corporate boards, including those of Biogen, Ameritrade Holding Corporation, MetroPCS Communications and Standex International Corporation.

He stepped down as chairman last year as his health deteriorated but continued to serve as a senior adviser. Survivors include his wife, three children and nine grandchildren.

Boston-based TA Associates has invested in more than 425 companies around the world and has raised $18 billion in capital from investors since its inception in 1968.

Landry has often gone against the tide. When his younger partners wanted to do Internet deals in the bubble of 1999, he allowed it only briefly.

“There was generational tension. So I said, ‘OK, we will consider some early-stage investments,’” Landry said. Then he shut it off in March 2000 — just as the market peaked.

In 2007, when some in private equity were celebrating easy credit markets, he predicted dire consequences for the economy, which proved painfully accurate.

And while he generally opposes raising taxes, he says he can’t defend his industry’s advantageous tax treatment, which allows people like him to pay much lower tax rates on their earnings.

“He’s highly, highly principled. To a fault sometimes,’’ said Andy McLane, one of Landry’s longtime partners. “It sets a great example here about doing the right thing, taking the high road. He doesn’t tolerate people who hide things. He wants people to tell the truth.”

Landry, who grew up in Arlington and Andover, said he learned about honest dealing from his father, a teenage runaway who became a neurosurgeon and insisted that his five children tell the truth. He graduated from the Middlesex School, and is one of seven in his extended family to go to Harvard, including his two daughters.

He started as a physics major and decided it was too hard, switching to economics. He didn’t make terrific grades, he says, but “I probably had more fun than they had.”

Landry, however, always combined savvy with luck. In a favorite story among his college friends, they’d planned a raucous party at Harvard’s Quincy House one night. While most of the group wound up suspended afterward, Landry escaped punishment. He had decided to go away for the weekend.

As one of his friends, money manager Michael Holland of New York, wrote, “Kevin Landry: Lucky or smart? Yes.”

After Harvard, Landry entered the Army Reserve, where he learned to be a helicopter mechanic (not a great one, he says) and then to the University of Pennsylvania’s Wharton School to study finance. In 1967, Landry landed a summer job at TA Associates, which was just getting off the ground. He impressed TA’s founder, venture capital pioneer Peter Brooke, even though, Landry now confesses, he didn’t know what venture capital was.

Even as a young man, Brooke recalled, Landry was the most confident person he’d ever met. When Brooke offered Landry a permanent job, and tried to persuade him to stay instead of finishing at Wharton, Landry said no thanks.

After graduation, and another stint with the Army Reserve, a spot was still waiting for Landry at TA. The firm was doing small deals then, from $50,000 to $150,000, mostly in technology. Landry’s first deal: an investment in computer printer company.

In the 1970s, Landry became interested in genetic engineering, then a controversial field still far from commercial success. At a 1978 meeting in Geneva with a group of scientists, Landry was persuaded of one company’s potential. TA invested about $1 million to help start Biogen, which would become a giant in multiple sclerosis drugs and help establish Cambridge as a biotech hub.

“This was before biotech was biotech,” said Phillip A. Sharp, an MIT scientist who cofounded Biogen. “There was no word, ‘biotech.’ ”

About 1981, when Brooke left to start another Boston private equity firm, Advent International, Landry took over as chief executive. He worked on deals in the financial sector, such as Datek Online, a trading company that was merged into Ameritrade Holding Corp., and Keystone Group, an investment firm.

TA differs from many buyout firms in that it focuses on investing in established, profitable companies, rather than troubled firms or turnarounds.

The approach has paid off handsomely for investors. Over the past 40 years, TA has delivered returns averaging 20 percent annually, compared to about 9.5 percent for the Standard & Poor’s 500 stock index.

Such returns also made it easier to attract new investors to the firm’s funds, one of Landry’s chief responsibilities. Asking for money is not a job that many people enjoy, but Landry, as usual, tackled it with relish.

“The more challenging the better,’’ Landry said. “I almost view it as a war. A hundred prospects? Let’s go see ’em. It was fun.”

But two years of chemotherapy took a toll. When he decided to retire, Landry told clients, “There are too many days when my energy level, and even my intelligence level, cannot match my enthusiasm for the task at hand.”

A few weeks ago, New York billionaire hedge fund trader Daniel Loeb, who has $66 million in Rhode Island state pension funds, made nearly 10 times that when he sold 40 million shares of Yahoo stock, two years after buying a stake in the Internet giant and orchestrating Marissa Mayer’s hiring as CEO.

In the spring, another billionaire hedge fund manager, Paul Singer, who has $70 million in Rhode Island pension money, made headlines for buying up Hess Corp. stock and forcing a board shakeup to prod the oil company to pursue fracking for natural gas. The jury’s still out on that deal.

And last year, Ken Garschina, who has $64 million in Rhode Island pension assets, stumbled in his nearly $2-billion bet on a Canadian telecommunications giant, contributing to his Mason Capital’s 7-percent decline for 2012.

So it goes in the world of hedge funds, where sophisticated money managers have invested large pools of money for wealthy investors, private foundations, universities and, increasingly in recent years, public pension funds.

Around the globe, 18 hedge funds are putting $1 billion of Rhode Island pension money to work— in Asian futures, Midwestern commodities, global currencies, distressed securities, startup companies and residential mortgage-backed securities. They employ such investment strategies as short-selling, leverage, risk arbitrage, spread trading and structured credit.

One of the state's hedge-fund managers, D.E. Shaw, is the chief financial backer of Deepwater Wind, the Providence-based energy firm that last week won a federal auction to develop wind farms off the coast of Rhode Island and Massachusetts.

In the view of Rhode Island Treasurer Gina M. Raimondo and the State Investment Commission, as well as many outside investment experts, putting 14 percent of the state’s $7.5-billion pension fund into hedge funds is a prudent move to lower risk and volatility. This is especially vital after the 2008 stock market crash wiped out 25 percent of the state pension fund, and with Rhode Island needing to write a huge check every month — totaling more than $924 million last year — for retiree benefits.

With interest rates so low on bonds — the traditional “hedge” against stock-market losses — many investment professionals argue that hedge funds offer better protection from another stock-market tumble. The logic is that by investing in things that are not correlated to the stock market, hedge funds will smooth out the roller-coaster ride. They won’t soar as high, but won’t dip so low, preserving capital when stocks go down.

But a growing number of critics attack hedge funds as over-hyped, risky and costly investments that have lagged behind strong stock-market gains. The only people getting rich from hedge funds, the skeptics say, are the Wall Street tycoons who run them, raking in high fees while retirees and working men and women see their retirement benefits slashed.

For the 2012-’13 fiscal year ending June 30, Rhode Island’s hedge fund portfolio earned 11.22 percent, trailing the Russell 3000 stock index of 21.46 percent. The state’s overall $7.5-billion pension fund gained 11.07 percent in 2012-’13. Had the hedge fund money been invested in stocks, the pension fund could have earned $100 million more based on the Russell index. During the same period, the state paid out $200 million less by suspending cost-of-living allowances to retirees.

On top of that are the high fees — an average management fee of 1.7 percent of assets, plus an average performance fee of 20 percent on any profits.

Those fees totaled an estimated $45 million on hedge fund gains of about $140 million for 2012-’13, according to a Providence Journal analysis of hedge fund data provided by the treasurer’s office and confirmed by the state’s private hedge fund consultant.

Public employee unions nationally and in Rhode Island, as well as a growing chorus of others in the investment community, have questioned hedge funds. A July 11 Bloomberg Businessweek cover story was headlined, “The Hedge Fund Myth.”

Raimondo’s strategy

Raimondo, a Democrat and former venture capitalist who is contemplating a run for governor in 2014, has been criticized for pushing a strategy that results in paying millions more in management fees while lower-income retirees go without cost-of-living increases. In the fall of 2011, as the Investment Commission she chairs was voting to hire hedge funds, Raimondo spearheaded an overhaul of the state pension system that reduced the unfunded liability by $3 billion, in part by partially moving state workers from defined benefit to a 401(k)-style defined contribution plan.

A key component was a suspension of cost-of-living allowances. With lower hedge fund returns a drag on the pension fund’s growth, retirees will have to wait longer for the retirement system to recover from past underfunding so they can regain their COLAs.

“They’re turning the pension fund into a fee machine for Wall Street,” said Daniel Pedrotty, of the American Federation of Teachers (AFT) in Washington. “In the years since 2008, the stock market has roared back. Hedge funds have not. It’s a disturbing story.”

Raimondo won national acclaim as a pension reformer, including a 2012 “urban innovator” award from a conservative New York think tank, the Manhattan Institute, which advocates for defined-benefit plans. Three of the hedge fund managers Rhode Island hired — Loeb, Singer and Garschina — are trustees of the Manhattan Institute; last spring, their funds were placed on an AFT watch list for being hostile to union workers.

The treasurer says she doesn’t like the high fees, but has a fiduciary obligation to look at the bigger picture — the welfare of the pension fund. She says she doesn’t recall meeting Loeb, Singer or Garschina, and that the selection of their hedge funds was vetted by the Treasury’s staff and outside consultant, and approved unanimously by the Investment Commission. Of Loeb’s Third Point Partners, the state’s highest-performing hedge fund with a 29.46-percent return in 2012-’13, she said, “I’m proud of his accomplishments.”

During a discussion of hedge fund fees and transparency at an Investment Commission meeting this spring, Raimondo said: “I’m troubled by the fees. It’s too much money. But my job is to maximize returns. We’ve reduced risk substantially. … A year and a half ago we sat around this table talking about how we’ve got to protect people’s pensions. We put in place a risk strategy. We monitor these guys. It’s working. So I say, let’s stay the course.”

Risky business

Critics call hedge funds risky business. But proponents warn that big investors ignore them at their own risk.

The average public pension plan has 1.2 percent of its money in hedge funds and 11 percent in alternative investments, according to the 2013 Wilshire Trust Universe Comparison of plans with more than $1 billion. But that average includes plans that don’t invest in hedge funds. Of those public plans that do invest in them, many are in the 5-percent to 10-percent range, says a Wilshire analyst.

Rhode Island, whose 14-percent hedge fund portfolio is part of its 26-percent stake in alternative investments, including venture capital and real estate, is not alone. In 2013, overall hedge fund assets are expected to increase by 11 percent, to a record $2.5 trillion, according to a Deutsche Bank survey.

Public pension plans are the largest single investors in hedge funds, according to a recent report by Preqin, a New York financial data firm.

Alfred Winslow Jones is credited with launching the first hedge fund in 1949. He used leverage — borrowing — to buy more stock. And he used short-selling — borrowing shares in anticipation they would decline in value — to avoid market risk when stocks dropped. Given his “hedged” position, his fate was not determined by whether the market rose or fell, but by his choice of stocks.

Over the years, hedge funds became more complex. Today, there are more than 9,000 funds, chasing more than two-dozen investment strategies. Some hedge fund managers have made headlines for their excesses, yachts and mansions, and for insider trading and the mortgage derivatives that helped fuel the 2008 financial collapse. Two weeks ago, federal prosecutors in Manhattan announced the indictment of SAC Capital, one of the country’s most successful hedge funds (but not one of Rhode Island’s funds), on insider-trading charges.

Still, investment advisers say hedge funds have a place in a prudent investor’s portfolio. Some point to universities, including Brown University, which have higher allocations than public pensions. Brown reports having 24 percent of its $2.6-billion long-term pool, which includes endowed and university funds, in hedged strategies and another 24 percent in private equity.

The key is to focus not solely on returns, but the risk associated with achieving them.

“Risk is very important,” says Eileen Neill, a managing director at Wilshire Associates who works with large pension funds, including state plans in Iowa and Wisconsin.

To average investors, she says, risk is the danger of losing their principal. But to institutional investors, risk is the level of volatility associated with making money. And since the 2008 crash, risk to pension funds is the danger of “missing your objective so much that you risk insolvency, and have to put in external capital,” says Neill. That’s why more public plans have added hedge funds.

Raimondo echoes that. Hedge funds are not about outperforming the stock market in good times, she said in an interview, but providing a safety net in bad. During a 2011 Investment Commission meeting to consider adding hedge funds, she urged the board to start thinking about risk the way investors traditionally think about returns.

Without hedge funds, the state pension fund lost 25 percent of its value — $2 billion — in the 2008 financial collapse; with hedge funds, the losses would have been $500 million less, according to the state’s hedge fund consultant, Cliffwater. According to the treasurer’s office, 5 of Rhode Island’s 18 hedge funds suffered double-digit losses in 2008 — 3 in the teens — while the S&P 500 stock index dropped 37 percent.

With the state still digging out of that hole and paying more than $70 million a month to retirees, Raimondo says, “it’s essential to preserve capital and minimize risk. How do you do that? Hedge funds.”

“Managing money is a lot harder than it’s ever been,” she says. “The thinking was, ‘Let’s pick hedge funds that provide us with the tools we don’t have now, so we don’t have another 2008.’ … This hedge fund portfolio is designed for a different market, one that will capture most of the upside but not all of the downside.”

Her chief investment officer, Anne-Marie Fink, notes that the recent stock market dip provides an example. Faced with fears of rising interest rates and a slowdown in China, stocks were down 2.7 percent in June, compared with 0.7 percent for the state’s global equities hedge funds; bonds were down 1.6 percent, compared with 1.1 percent for the state’s “absolute returns hedge funds” group, which invests in currencies and commodities.

Risk is plotted as a mathematical formula in which the returns of different types of investments are arranged on a graph, to show how far they deviate from the average return. The higher the standard deviation, the riskier it is, like a roller coaster that lurches up and down, leaving investors with a lot of butterflies in their stomachs.

A safer investment rises more gradually, with fewer dramatic dips, so that when it does go down it doesn’t have as far to travel to reach the top again.

Stephen L. Nesbitt, CEO of Cliffwater, the state’s hedge fund consultant, produced a report for the Investment Commission this spring, charting Rhode Island’s first 18 months in hedge funds, through April 30, 2013. The standard deviation for the hedge fund portfolio was just over 2 percent, compared with just under 6 percent for the entire Rhode Island pension fund and about 7 percent for a traditional mix of 60 percent stocks, 40 percent bonds.

Nesbitt’s message: “Your hedge funds are behaving the way they were intended to.”

Not everyone agrees

In April, prominent investment manager Robert Arnott told CNN that most hedge funds have been “a disappointment” and rejected the argument that they generate better risk-adjusted returns. To prove it, Arnott’s colleagues at Research Affiliates took a portfolio with a basic mix of 60 percent stocks, 40 percent bonds and studied what would happen if it was gradually shifted, 10 percent at a time, into hedge funds. The result: returns went down, and risk went up.

The study concluded that a pension fund would have performed better with a passively, less expensively managed blend of commodities, real estate and other assets.

Simon Lack, a former Morgan Stanley hedge fund trader and author of “The Hedge Fund Mirage,” has become a leading guru of hedge fund skeptics. Lack writes that “if all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would be twice as good.”

But investment expert Brian Portnoy, author of “The Investor’s Paradox,” says Lack misread the data and that hedge funds actually beat Treasury bills over time.

Gordon H. Dash, a University of Rhode Island finance professor who teaches a class in hedge funds, says Raimondo’s strategy is correct, and that it can’t be fairly judged in the short term and during a bull market.

“These strategies, properly executed, do work,” said Dash. “Indexing [investing in funds that track the stock-market index] is always offered as an alternative, but the problem is that when the market tanks, the index tanks. And then your funding to pay pension obligations is in jeopardy. You have to have a hedge in place.”

Still, critics such as Ted Siedle, a pension investigator and Forbes contributor who is critical of Raimondo, and who is investigating the Rhode Island fund for a state public-employees union, warn that that doesn’t mean hedge fund investors can get their money out quickly.

A “lock-up” prevents investors from withdrawing money before a specified period, usually one or two years. In a “soft lock-up,” money can be withdrawn, but with a penalty. A “gate” prevents investors from withdrawing too much money at once. For instance, Paul Singer’s Elliott Associates, which has $69 million in Rhode Island pension money, limits withdrawals to 25 percent twice a year, with a 1.75-percent fee, plus 60 days’ notice.

Last winter, Rhode Island got out of two underperforming hedge funds, serving notice in December and January and getting $89 million of $91 million back by the end of June. (The remaining money will be returned in 2014, after an audit confirms the numbers.)

Fee fights

There are two ways to view hedge fund fees: a necessary evil or an unnecessary gouging.

Either way, they add up to a significant chunk of change, which helps explain why 7 of Rhode Island’s 18 hedge fund managers are billionaires who made Forbes’ list of the richest 40 hedge fund managers last year.

In Rhode Island’s first 20 months in hedge funds, from November 2011 through June 2013, the state paid $61 million in fees — $16 million for 2011-’12 plus the estimated $45 million last year. In addition, the state paid $2.5 million last year in fund expenses.

Raimondo notes that a sizable chunk of Rhode Island’s pension fund — 47 percent — is in low-cost, indexed stocks and another 14 percent is in low-cost bonds. Excluding hedge fund fees, the state reported $17 million in fees in 2012-’13. Adding the hedge fund fees for last year, the total would climb to an estimated $62 million.

Hedge fund advocates say it’s important to view the bigger picture — the positive risk-adjusted returns that hedge funds deliver, even after those fees are deducted. They invoke Oscar Wilde’s definition of a cynic: “A man who knows the price of everything and the value of nothing.”

But financial advisers who say the cardinal rule of investing is to lower your fees cite Benjamin Franklin: “A penny saved is a penny earned.”

Advocates argue that investors pay for the hedge fund traders’ skills and acumen, and in some cases sophisticated mathematical algorithms and computer programs.

A Cliffwater report on one of Rhode Island’s global equity funds, Davidson Kempner Institutional Partners, which has $62 million in state pension money, cites an example of the firm’s research-driven approach to investing in distressed companies. In evaluating a business, the report says, the fund’s research analysts develop “a strong understanding of the restructuring and legal process.”

“For example, the analyst focused on transportation has created a model to evaluate structured securities secured by planes,” the Cliffwater report says. “For each security, he has analyzed the types, ages and manufacturer of each plane to understand how valuable the collateral [the planes] is to the market.”

Fink, Rhode Island’s chief investment officer, cites another example involving the Indus Asia Pacific Fund, which invests $43 million of Rhode Island pension money in Asian countries. In China, where government statistics on growth and inflation aren’t always reliable, the fund hires people to go into supermarkets and other stores to price commodities, such as chicken, rice and gasoline, and create an independent database to measure inflation.

“That’s expensive,” says Fink. “When we pay high fees we want to ensure that we’re generating a good return. If somebody’s charging 2 and 20 [percent] and it’s two guys with a Bloomberg [terminal], that’s not worth it. We want to make sure we’re getting value for our money.”

Consequently, Fink says, she visits the offices of the hedge funds Rhode Island invests in, and pays attention to the size and experience of the staff, as well as its investment strategies. She cited one of the state’s most expensive hedge firms, D.E. Shaw & Co., which charges a 25-percent performance fee and a 2.5-percent management fee, and manages $64 million for Rhode Island.

“They employ 1,000 people. They have 55 Ph.D.s running all these crazy statistical models,” said Fink.

The D.E. Shaw Composite International Fund gained 18.9 percent over the past year and has averaged 10.9 percent over the past three years, according to Cliffwater, which monitors the hedge funds. So far this year, it’s up 9.58 percent.

Hedge fund critics, however, say investors could put their money to work more cheaply and effectively elsewhere.

“Why are you paying performance fees for someone who’s underperforming the market?” asks Barry Ritholtz, managing partner of Fusion Analytics Investment Partners in New York and a financial author and commentator.

The explosive growth of hedge funds and pools of money to invest makes it harder for everyone to be the smartest guy in the room, says Jay Youngdahl, a visiting fellow at the Initiative for Responsible Investment at the Hauser Center for Nonprofit Organizations at Harvard University.

“Paying 2 and 20 percent, you’d need to earn a ridiculously high return,” he says. “While lightning strikes from time to time, it seldom strikes in the same place, and most of us never get hit.”

A recent study by a pair of Maryland think tanks found that the 10 state pension systems paying the highest fees often had some of the worst investment returns. In contrast, the Maryland Public Policy Institute and the Maryland Tax Education Foundation found that the 10 states with the lowest fees generated the best returns.

The study, which didn’t focus exclusively on hedge funds, examined fees in 46 state pension funds; Rhode Island was not included because the authors say they didn’t have access to data for the 2012 fiscal year.

While money managers claim they have a “secret sauce” to consistently beat the market, many “buy and sell publicly traded securities (i.e., ‘hedge funds’), so this idea is simply ‘old wine in a new bottle,’ ” the study said. By indexing a larger portion of pension portfolios — 80 to 90 percent — to stocks and bonds, the study contends, states could collectively save billions of dollars, while reducing their unfunded liabilities by tens of billions.

Raimondo says Rhode Islanders should focus less on fees and more on results — the protection for public employees and retirees from another catastrophic stock market collapse. After fees are deducted, Rhode Island’s hedge funds are still earning double-digit returns.

“We’ve reduced risk by 10 percent, and part of that is moving into these alternative investments,” said Raimondo. “They’re the best in the business, whether or not they have some colorful, overly paid hedge fund managers. They’ve delivered strong returns over time.”

• Top funds: Rhode Island is invested with top hedge fund managers. Their external consultant, Cliffwater, is one of the best at providing advice on hedge funds to institutional investors.  Third Point, Elliott Management, Mason Capital and D.E. Shaw are all hedge funds with long, exceptional track records. Still, top brand name funds don't always deliver exceptional results and they need to be closely monitored just like any other hedge fund.
• High fees vs good results: Raimondo says Rhode Island should focus more on results and less on fees. She has a point, after all what counts are returns net of all fees. But when a $7 billion public pension fund pays $61 million in fees to hedge funds, it's a lot of money and critics will claim this is another example of the secret pension money grab. In Canada, public pension funds are increasingly bringing assets internally, lowering costs, and controlling for liquidity and operational risks. $61 million can pay a lot of good salaries but U.S. pension funds don't have the governance structure of their Canadian counterparts (compensation is too low), thus relying almost exclusively on external managers.
• Downside risk protection: Raimondo also points out that hedge funds protect against catastrophic stock market collapses like the one we experienced in 2008. Take this with a grain of salt. Most hedge funds charge alpha fees for leveraged beta. When the stock market collapsed in 2008, a lot of them, including top funds, got clobbered and experienced significant losses. The very best of them recovered nicely but most are still struggling. And while it isn't fair (and downright stupid) to compare hedge funds' performance with that of stock market indexes, once you factor all the risks of investing with hedge funds --  including liquidity, operational, and other risks --  you have to also take into consideration the opportunity cost of investing in these strategies. Cliffwater claims Rhode Island would have lost much less had they been as heavily invested in hedge funds in 2008. This may be true but their analysis doesn't factor all the liquidity issues that arose back then when funds closed the gates of hedge hell or the high fees that it would have cost them to invest in all these hedge funds.
• Benefits of hedge funds: While I'm skeptical of the industry as a whole and worry that many public pension funds are getting raked on fees,  I'm a firm believer that there are huge benefits in investing with excellent hedge funds. The same goes for top private equity and real estate funds. Pension funds can cultivate long-term relationships with these external managers and reduce the "beta" risk of their portfolio. They can do so by leveraging off the expertise of these external managers to improve their asset allocation decisions. How much should public pension funds allocate to hedge funds and other alternatives? The average allocation to alternatives is 26%, with most of the money going to private equity and real estate. I think pensions should always be thinking about their liquidity risk and figure out where they're comfortable. Also, they need to recognize that these investments are complex and require a specialized skill set. If they don't have it internally, they need to seek this expertise from external consultants or top funds of funds and make sure that their is solid alignment of interests.

Robert Farzan of Bloomberg reports, Is the Smart Money Getting Out?:

As markets break all time highs, there are signs that the smart money, as it’s called, is keen to get out.

Data compiled by Bank of America Merrill Lynch show that institutional investors have been net sellers of stock since late June, while retail clients have been net buyers since early June (their longest buying streak since late 2011). The blog ZeroHedge quipped: “So it would appear the ‘real’ great rotation is passing the hot-potato of liquidity-driven stocks from the ‘smart’ money to the ‘dumb’ money once again.”

Bloomberg’s Devin Banerjee took inventory of how buyout shops prefer to sell into the bull market (the Standard & Poor’s 500 index is up 152 percent since March 2009). He reports that the private equity industry’s focus on exits has reduced the volume of leveraged buyouts this year, with the number of deals announced declining 20 percent, to 3,047 worldwide, from the same period last year.

One example is Fortress Investment Group (FIG), which in 2007 became the first publicly traded private equity and hedge-fund manager. Yesterday, Fortress said its second-quarter pretax distributable earnings more than tripled to $148 million from a year earlier. The alternative asset manager, which is busy preparing public offerings, has already exited the remaining investments in its first buyout fund.

“It’s a difficult environment to find really attractive things when the markets are robust as they are,” Fortress Co-Chairman Wes Edens said yesterday on an investor conference call. “This is a better time for selling our existing investments than making new investments,” concurred his fellow co-chairman, Peter Briger. “There’s been more uncertainty that’s been fed into the markets.”

According to Banerjee, in the last quarter private equity giant Blackstone (BX) sold shares in three companies—General Growth Properties (GGP), Nielsen Holdings (NLSN), and PBF Energy (PBF)—and took three public, including SeaWorld Entertainment (SEAS). Blackstone’s second-quarter economic net income of $703 million more than tripled its year-earlier showing. “With credit markets hot and equities strong, this is a better time for selling assets than for buying,” Blackstone President Tony James said on a July 18 call. “Activity levels seem to be shifting from the U.S., which has been our focus over the last couple of years, to Europe, where there’s more distress, and Asia and emerging markets, where liquidity issues are arising.”

Leon Black’s Apollo Global Management (APO), which oversees assets worth $114 billion, made $14 billion in proceeds from the sale of holdings from the first quarter of last year to the first quarter this year. “It’s almost biblical: There is a time to reap and there’s a time to sow,” he said at an April conference. “We think it’s a fabulous environment to be selling. We’re selling everything that’s not nailed down in our portfolio.”

Buyout shops are all taking advantage of hot credit and equity markets to realize on their investments and reap the gains.

The implications for public pension funds are huge. According to a report by Wilshire Associates, U.S. public pensions booked a median gain of 12.4 percent for the 12 months through June, powered by a surge in U.S. stock prices to a record. The funds chalked up an annualized three-year median return of 11.4 percent while their assets surpassed a pre-recession peak to reach $2.9 trillion, according to U.S. Census Bureau figures.

If the rest of the year continues to hum along like the first half, public pensions will continue booking solid gains. However, if Byron Wein turns out to be right, the second half of the year will be a lot rockier and public pension funds heavily exposed to public equities risk experiencing big losses.

John Mauldin recently put out a comment, "Can It get Any Better Than This?," where he notes the following:

To many investors, developed markets appear healthier and stronger than they have in years. Major equity markets are rallying to record highs; corporate credit spreads are tight versus US Treasuries and getting tighter; and broad measures of volatility continue to fall to their lowest levels since 2007.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but prices do not always reflect reality. Moreover, the combination of high and rising valuations, low volatility, and a weakening trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

Let’s take the S&P 500 as an example. It returned roughly 42% from September 1, 2011, through August 1, 2013, as the VIX Index fell to its lowest levels since the global financial crisis. Over that time frame, real earnings declined slightly (down about 2% through Q1 2013 earnings season), while the trailing 12-month price-to-earnings (P/E) ratio jumped 44%, from 13.5x to 19.5x. That means the majority of the recent gains in US equity markets were driven by multiple expansion in spite of negative real earnings growth. This is a clear sign that sentiment, rather than fundamentals, is driving the markets higher.

One way to monitor speculation is to watch low-priced stocks. These are often more volatile and favorites of those who like their stocks a little on the trashy side. The Ned Davis chart below (click on image) shows that low-priced stocks – as represented by the 25th cheapest stock in the S&P 500 – have had quite a run. The current reading of $15.51 is approaching the $16 level that was a warning flag for the last two big market tops.

Single digit stocks are rapidly disappearing from the S&P 500. According to Bloomberg data there are just 8 such stocks in the index today compared to 20 one year ago.

As the table within the chart shows, the S&P 500 struggles when this measure cross the $16 mark.

Be warned!

It is also worth noting that the attempts by the bears to derail the bull train have been largely unsuccessful so far this year. Sure, the market paused when Cyprus made headlines. And yes, the "taper tantrum" in May/June did produce a garden-variety pullback of -5%. But beyond that, it's been the bulls' ballgame this year.

In fact, the +18.2% year-to-date gain for S&P 500 through July 31, qualifies as one of the best first-seven-month gains in history. According to the computers at Ned Davis Research, the 2013 gain through July is the best since 1997 and the 11th best since 1929. No wonder the bears are frustrated!

The question, of course, is where do we go from here? The bear camp is howling about another overbought condition and the fact that valuations are beginning to move away from fair value. The glass-is-half-empty gang also continues to moan about the idea that the Fed's ZIRP (zero interest rate policy) is the only thing keeping the indices afloat. Thus, our furry friends contend that the current rally is not going to end well and that we should be bracing for a replay of 2008.

As I've mentioned a time or twenty, we don't play the prediction game at our shop. No, we like to be opinion-agnostic and merely try to stay in line with what the market IS doing at all times. This approach does get us whipped around a bit when the market is in an "iffy" state, but it also keeps us on the right side of the market's really important moves, the vast majority of the time.

However, it is also nice to have some sort of idea as to what to expect next. So, this morning I thought we'd look at the statistics on what strong gains from January through July tell us about the coming months. And then tomorrow, we can revisit the cycle composite to see what the cycles say about August.

Since the end of World War II, a gain of at least 15% for the S&P 500 through the end of July has been a good omen for the rest of the year. Of the twelve times the S&P has put up gains of 15% or more in the first seven months of the year, the market has finished higher at the end of the year eleven times, or 91.7% of the time.

Although the 1987 case skews the stats a bit, the average gain for the following five months of the year after a gain of 15% in the January through July period has been +4.3%. And if we take out the 1987 program trading-induced disaster, the average increases to +6.7%.

However, in doing the math one thing jumped out at me. Over the August through December periods, the gains tended to be either small or significant. For example, of the eleven cases we reviewed where the market finished higher after a strong seven-month start, the S&P finished the ensuing five months higher by less than 2% on five occasions. And for the six cases when the market was stronger during the August-December period, the average gain has been nearly +11%. In other words, after a strong gain in the first seven months of the year, history shows the bulls either continued to romp - or - limped home into the end of the year.

On a near-term basis, the stats are less conclusive and also less encouraging. Since the end of WWII, the S&P has only been higher during the month of August 42% of the time and has only been higher three months later one-half of the cases. Thus, in short, it looks like August could be a toss-up.

However, looking longer term, the first seven-month surge appears to have lasting benefits for those holding stocks. Since 1929, the S&P 500 has been higher over the next six months 72% of the time. And then looking out a year, the market has finished higher 83% of the time since the end of WWII and sported an average gain of nearly 12% during the period.

To be sure, history rarely, if ever repeats. However, in the markets, history often rhymes with near-term events. As such, it appears that if the bulls can muddle through that last summer month, they could be rewarded going forward. Granted, the pace of the gains is likely to slow. But the key is that if history can repeat to some degree, the bears may continue to be frustrated.

Canadian companies are facing higher pension costs after an influential group published new research that suggests workers are living longer than previously thought.

For the first time, the Canadian Institute of Actuaries (CIA) commissioned studies based on Canadian lifespans, rather than relying on data from the United States. The studies found that life expectancies are on the rise: A 60-year-old man, for instance, is now projected to live another 27.3 years, up from 24.4 years.

The numbers matter to business because most corporate pension plans use the institute’s mortality tables as a starting point when calculating the future cost of pensions. Towers Watson, a consulting firm, says that while the impact will vary from one pension plan to another, acceptance of the new mortality tables could “immediately increase pension accounting liabilities by 5 to 10 per cent for many plans, potentially impacting corporate income statements and balance sheets.”

The firm noted that the change comes just as corporate treasurers began to hope that rising stock markets and interest rates would improve the fortunes of their pension plans, many of which are badly underfunded.

“We are edging closer to a crisis,” said Jim Leech, chief executive officer of the Ontario Teachers’ Pension Plan. “Pension plans and sponsors need to come to grips with the volatility in the marketplace and the fact that people are living longer, and therefore have to save more.”

The new mortality tables will not have a direct impact on Teachers, one of Canada’s largest pension funds, because it has its own records dating back to 1917 and so crafts mortality tables based solely on the lifespans of teachers. But Mr. Leech knows the added burdens that assumptions about longer lifespans can cause. Like the general population, teachers are living longer, and that finding has already been worked into Teachers’ assumptions of future costs.

“Since I’ve been CEO, we’ve adjusted the mortality table three times – in 2007, 2010 and again in 2012,” Mr. Leech said. “Cumulatively, those three changes amounted to just under $10-billion of increase in liabilities.”

Teachers had $129.5-billion of assets at the end of last year.

The Canadian Institute of Actuaries’ new numbers are based in large part on a study of pensioners in the Canada Pension Plan and Quebec Pension Plan, which looked at the mortality of people who were collecting from those plans between 2005 and 2007.

The draft tables suggest that the life expectancy of a 60-year-old man is 2.9 years longer than under the current tables, while the life expectancy of a 60-year-old female is 2.7 years longer (rising to 29.4 years from 26.7 years), Towers Watson points out.

Jacques Lafrance, president of the Canadian Institute of Actuaries, said that most corporate pension plans rely on these mortality tables, although they might make their own adjustments based on their employee base. For instance, companies with white-collar employees might expect longer lifespans than average, while companies in the mining sector might expect shorter lifespans, he said.

He added that plans with more active workers and fewer retirees will generally face a larger impact than those with the reverse situation. The new mortality table will have an impact on the cash contributions that must be made into plans, as well as the way corporations account for their plans on their books.

“What the new table is showing is that we were somewhat wrong with our prediction, that it was not conservative enough, and that in fact people are living even longer than we expected,” Mr. Lafrance said.

Mr. Leech said pension plans and sponsors need to address longer lifespans by changing the rules around pensions.

“The retirement age needs to go up,” he said. “Guaranteed benefit levels shouldn’t necessarily have all the bells and whistles. Things like early retirement provisions, the ability to retire when you’re 55, it’s nice but somebody has to pay for it. … These things need to be made contingent, so they’re not guaranteed; they’re there if there is enough money for them.“

The CIA’s draft mortality tables are open for comment until the end of September.

The pension funding gap of Britain's top companies has widened in the past year despite billions of pounds of corporate cash being injected into retirement schemes, a report said on Tuesday.

Pension consultants LCP said pension scheme deficits for companies in the UK's FTSE 100 blue chip stock index grew to 43 billion pounds at June 30 compared with 42 billion a year before, as fund assets didn't generate enough cash to cover obligations.

The finding is an illustration of the impact of repeated rounds of "quantitative easing", under which the Bank of England has been buying back bonds to boost economic growth, contributing to a sharp drop in the yield on British government gilts - a staple investment for pension funds.

Pension funds have been left searching for higher-yielding investments such as real estate while they wait for gilt yields to turn higher.

The problem is not small, given FTSE 100 member companies remain responsible for pension liabilities worth nearly 0.5 trillion pounds, according to LCP.

"The (pension fund) deficit remains stubbornly high in spite of 21.9 billion pounds in company contributions," LCP said in its 20th annual survey of FTSE 100 company pension schemes.

The consultancy - whose deficit estimate is based on the companies' own actuarial forecasts for their pension obligations - also noted Britain has seen many governmental and regulatory changes, including the "auto-enrolment" initiative.

"Pension planning continues to be blighted by seemingly constant regulatory and legislative change," said LCP partner and report author Bob Scott.

Milliman, Inc., a premier global consulting and actuarial firm, today released the results of its latest Pension Funding Index, which consists of 100 of the nation's largest defined benefit pension plans. In July, these plans experienced a $26 billion increase in asset value and a $2 billion increase in pension liabilities. The pension funding deficit dropped from $182 billion at the end of June to $158 billion at the end of July.

"The last 12 months were the best 12-month period for corporate pension funded status in the history of our study," said John Ehrhardt, co-author of the Milliman Pension Funding Index. "We've seen gains in nine out of the last 12 months for a total improvement of $388 billion. Just to put that improvement in its proper perspective, consider that the total projected benefit obligation for these 100 pensions stood at $762 billion when we started analyzing these 100 plans 13 years ago. This has been a historic rally for pensions—hopefully it will continue."

Year-to-date, assets have improved by $60 billion and the projected benefit obligation has been reduced by $172 billion, resulting in a $233 billion improvement in funded status and increasing the funded ratio to 89.7%.

Looking forward, if the Milliman 100 pension plans were to achieve the expected 7.5% median asset return for their pension plan portfolios, and if the current discount rate of 4.73% were maintained, funded status would improve, with the funded status deficit narrowing to $128 billion (91.7% funded ratio) by the end of 2013 and $44 billion (97.2% funded ratio) by the end of 2014.