Integrating the blog with the website

I have moved the blog to the website
I am hoping to increase production and continue to provide insight on a more regular basis.
Please have a look at the website and provide feedback - it can only help me improve

Moving Forward from the Financial Crisis

The Society of Actuaries risk management section is publishing a collection of essays on Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis and my essay on Actuaries and Assumptions is included.

I discuss the general difference between historically-based probabilistic assumptions and economic optimization assumptions. The point being that in cases where economic optimization can rationally be chosen by an economic agent, we should factor that in to actuarial models rather than using historical usage rates.

I would be interested in comments or questions at jj@forethoughtrisk.com

Equities - Canada vs Global

I will be participating in an online debate on Canadian equities versus Global equities - what will provide superior returns and risk-adjusted returns over the next few years?
The debate is organized by the Canadian Investment Review and can be found here (I believe only members can access the debate)
Log-in, have a look and comment on the debate!

Japan - the new new QE

With the US embarking on QE2, it may be instructive to observe Japan's experience, whether or not one believes that the US faces similar macro issues to Japan.

Japan is an economy in deflation, a situation which has lasted the better part of 15 years. For many years Japan subsidized its exports by printing money to buy Treasuries and maintaining a relatively weak Yen but when 2008 hit and all hell broke loose, so did the Yen. And there is nothing worse than an economy in deflation with an appreciating currency. Bring on QE4.0 Japanese style: buy REITs.

What does this mean?
It lends support to real estate in Japan

So how does that help?
If real estate remains stable or actually appreciates then the consumer will feel richer potentially enticing them to spend today rather than wait for goods to get cheaper tomorrow due to deflation.

Will this work?
Unlikely - if we focus on demographics, Japan's population has been shrinking since 2007 (see Wikipedia listing under Demographics of Japan) with fewer births than deaths and no net immigration. This despite one of the longest average life expectancies in the world at 81.25. Think about it: will a more valuable piece of real estate entice older Japanese to spend more readily?

The US should take note, however, and observe how Japan plays out. If this succeeds it may be the trump card Ben Bernanke is looking for.

What is the risky decision?

We often evaluate decision-making risk relative to status quo as opposed to overall risk and I find this problematic. We assume that the status quo is our risk benchmark and that may be incorrect. And defined benefit plans are the perfect example.

Pension fund managers and trustees think of Liability-Driven Investing (LDI) as a risky decision: rates are low and equity markets are still 30% off their highs (at least in the US), and converting some equity holdings to fixed income would be a foolish decision, they claim. Although I personally think rates are lower than they should be, the context of the decision is where I have an issue. Those making the claim assume that the risky decision is to engage is risk mitigation, since historic wisdom suggested that a 60/40 equity to fixed ioncome ratio is appropriate. What they should be aware of, however, is that the current asset mix is an active bet that equities will outperform fixed income. And there is risk in maintaining that mix.

Risk-based Premia

After a few spectacular failures (Nortel, GM) the pension world is not the wonderland it used to be. Both employees and regulators should consider the safety of their pensions when valuing their personal balance sheet.

As an employee:
Consider the future of your company and the likelihood of its survival. It may encourage you to save more lest you end up getting 60-something cents on the dollar like the Nortel pensioners. Your biggest decision will be when you leave the company - do you take a commuted value and truncate your risk to the pension fund's potential demise or do you retain the pension inside the fund?

As a regulator:
Consider the survival of a company. Use default swaps as a guide. Examine the solvency ratio of the company's pension fund. Consider its asset mix relative to the exposure of its liabilities. What is its net risk exposure? Should a company with matched assets and liabilities and a 105% solvency ratio pay the same PBGF/PBGC (pension benefit guarantee fund/corp) premium as one with a significant mismatch and a 75% solvency ratio? Now that is an easier question to answer than the same one with the second fund also having a 105% solvency ratio....after all the greater mismatch has a wider array of potential solvency ratios one year hence.

Call it risk based charges on the regulator side and employees better managing their credit risk.

Pension Fund Leverage

Is it only me who cringes when pension funds issue debt or create "special purpose vehicles" (I know I date myself on that last one).
With respect to SPV's, the sense is that pension funds have tremendous internal investment expertise which they can share with the rest of the world. There are 2 issues:

1. Taking your eye away from your fiduciary duty to pensioners
2. The obligation to hold the equity piece

Yes, SPV's are a thing of the past, but pension funds issuing debt? And using derivatives to leverage their hedges? The bottom line is that leverage introduces risk and if one cannot justify leverage ex-ante or especially ex-post (after something blows up) then it may not be the right approach for a pension fund.

SEI Survey

A recent survey by SEI points to over 50% of pension funds moving to some form of Liability Driven Investing (LDI) mandate. Of course, defining that term is an imprecise science with plenty of debate. The range includes the hard-liners like Towers Perrin who advocate a 100% allocation to Fixed Income as part of its definition of LDI to softer versions with some allocation to equities.

To me, it is not about the actual asset allocation, but about education. It is about recognizing that risk emanates from the liability side of the balance sheet, not just the assets of a pension plan. It is about understanding that as a pension fund manager you are de facto short fixed income and likely inflation. These are not easy markets to navigate and the outlook is fairly bifurcated between doomsday prophets and cheerleaders of economic growth. And with respect to fixed income and inflation the picture is as murky as ever.

It is therefore imperative to understand, measure and interpret your risk based on an entire entity not single parts of that entity.

Bill Gross

Well, how do you like that - Bill Gross singing my tune

Time to take chips off the table

The panic of early 2009 has receded. Equities have rallied by 50% from the lows. Pension funding ratios are marginally better (corporate bond yields have decreased which means liability values have increased).

Markets feel a bit sluggish here. Some negative technicals have been cropping up.

Time to reduce equity exposure.

Liability driven investing (LDI) is being discussed, but it is not an all or nothing proposition. It is possible to transition to lower equity weights and now is the time to consider doing so.

Pension Risk

Interesting article on public pensions:

http://www.washingtonpost.com/wp-dyn/content/article/2009/10/10/AR2009101002360.html

I am not sure that ramping up risk is the right solution but it would be in line with the attitude of banks this past decade...if you need to keep up with peers (or in pension case, liabilities) just keep increasing leverage (risk) and if worst comes to worst (it did and likely will again in the case of pensions) government will be there to help out. Certainly with respect to public plans government backing is explicit; it was less so for the banking industry but that did not seem to stop them.

Nortel Pensions

And now this news piece to add to the murky waters of pensioners as company creditors. Not many employees consider the credit risk of their retirement funds when in a DB plan. A new regime has emerged. Pensioners need to be aware that the bankruptcy of their company may put their pension at risk.

Catch up Strategy

The gambling credo of doubling down may work for some but I remain fearful for the State of California and the PBGC. See here

Totally irresponsible if you ask me, but if you don't have to pay the price for failure, then what are you really risking? Like those who bought overpriced houses largely with banks money, it was the banks who ended up with the major losses. So too the State & Federal Government.

Longevity Hedging

The newest form of Liability Driven Investing involves longevity hedging. When I mentioned here that one of the reasons BP was closing their defined-benefit plan to new employees was due to longevity, I suggested that one solution was to raise the retirement age. This would give the employer a longer period over which to contribute and a shorter period over which to pay out from the plan.

Another approach is for pension plans to actively hedge their longevity risk. Who are the buyers? There are companies that benefit from an aging population, such as pharmaceuticals and retirement residence owners. And there are hedge funds that perceive the huge underlying demand from pension plans as driving implied life expectancy levels out to a point that they are tempted to step in.

More to come....

Deflation and the Run of the Bulls

Paul McCulley of PIMCO fame has a recent article on the fear of deflation and its relationship to monetary policy. Taking a page out of Helicopter Ben's playbook, McCulley asserts that fear of deflation requires the Fed to maintain "inappropriate" monetary policy in order to conquer the demon which has plagued Japan for the better part of two decades.

While I think many would agree with that assertion, the point is there are few beneficiaries and many casualties of such a policy, if it is successful. The beneficiaries are debt-holders, such as the US Treasury and all those who irresponsibly overborrowed against their house to overconsume in the short-term. The worst casualties are retirees on fixed pensions whose buying power has declined in equal measure to the policy's success. Current workers who have saved will also suffer as the value of their savings decline in real terms.

There are really 2 questions that mus be pondered:

1. is the fear of deflation real?; and
2. can the Fed really enginner inflation when Japan has not been able to?
   

One point to ponder with respect to the US / Japan comparison: in the mid-90s, the US castigated Japan for maintaining zombie banks on life support rather than allowing them to fail and then driving on...is TALF and the assortment of other programs the Fed has engineered not doing precisely that?

Comments welcome...

GM, Nortel...Public Pensions?

At an event last night, somebody remarked to me that he would not be confident as a participant in a public pension; this from an individual who earlier confessed that in the past he was envious of friends who were teachers and their pension plans.

At issue is a lack of confidence in the entire retirement system and the individuals running pension assets. Also at issue is the lack of knowledge of risk on an integrated basis: risk which includes both assets and liabilities. Finally, with respect to public plans, at issue is the ability to beat an inflation-tied liability.

Is my friend's fear justified?

Partial Solution to the Pension Crisis

Recent headlines include CPP cutting benefits for those retiring before age 65, while BP is closing their defined benefit plan to new employees due to adverse results arising from (among other obvious issues) increased life expectancy.

I have held to the notion for a long time that the only way my peers and I will ever see benefits from CPP is if the retirement age is raised. It is only after reading about BP's situation that I realize this is a necessary fix for all DB plans. Some other side benefits incude:

• allowing defined contribution participants extra years to make up for recent poor performance
• demographically, it keeps more participants in the work force which will reduce the strain we will find ourselves in as baby boomers retire
• for US participants, reduced health care costs as active members of the work force are less likely to complain of ill health
• adjust to the new realities of longer life span
  

The solution must be implemented gradually, but to me it is obvious that beginning in 2010 the entire world should begin a 5 year campaign of raising the legal retirement age to 70. Anyway, when was the last time you saw an ad for "Freedom 55"?

GM Pension

Who else out there is concerned about the precedent the GM pension bailout creates?

If you were a member of a company on the verge of bankruptcy with an underfunded plan, what would you think?

S&P Resistance

200 d moving average proved too formidable and I suspect we test the lows over the summer. May not be lead by financials this time, but I would look to hedge downside risk here.

GM Pension

In case anyone has missed it, pensions have become the centrepiece of negotiations on GM's potential bailout.

I understand why the unions have negotiated so hard for better pensions; what I am not sure is why they were so comfortable with the risks in the plan as of a year ago. The plan's deficit apparently exploded from 4.5B to over 7B under the watchful eye of the Investment Committee, GM executives and union representatives.

The lesson from this saga is clear (even if the provincial or federal government participate in teh pension bailout): union representatives must oversee all aspects of compensation for their members. This surely includes monitoring the future viability of those benefits. Time for union officials to read up on pension fund risk.