How COVID-19 Has Further Crippled the Global Pension System (w/ Leo Kolivakis)
ED HARRISON: I'm talking to Leo Kolivakis who is the founder and editor, publisher of Pension Pulse. You're a pension expert, Leo, and I'm talking to you because we're in the middle of a crisis that really I think is affecting pensions and I want to get your perspective on what the effect exactly is on pensions, their solvency and what the risks are going forward. Thanks for joining us. LEO KOLIVAKIS: Thanks for having me, Ed. I'm glad to be here and glad to talk about pensions, the pandemic and how it's affecting pension plans all over the world. The first thing I would say is the obvious, that pensions are getting clobbered on two ends. One, the assets are getting hit, spot markets are getting hit, their public and private market assets are getting hit when you have shutdowns of global-- synchronized shutdowns of global economies. The other thing I would say is they're getting hit on the liability front as interest rates declined to record low levels, and that is particularly worrisome because the funded status of these pension plans really are deteriorating fast as interest rates declined so rapidly to levels we haven't seen in decades. ED HARRISON: You and I, we were talking before we got on camera a little bit about how to think about pensions, which ones are in trouble, which ones are not. I think the takeaway that I had is a lot of it has to do with one, governance before the crisis, and two, your funding status, which are intertwined to a certain degree. Maybe you can talk about that in the context of Canada, where you are, and the United States where I am. LEO KOLIVAKIS: The way to think about this is the same way you think about any company that came into this crisis with strong balance sheets, little leverage, they will be able to weather the storm a lot better. They're going to get hit, but they're going to be able to weather the storm a lot better than companies that came into this crisis with really bad balance sheets, high leverage, and that were struggling going into this crisis. Now, let's take that into the context of Canadian, US pension funds. Canadian pensions came into this crisis very well-funded. They were fully funded or overfunded in some cases and had surpluses and that was the cushion that provided-- this is the cushion that would provide them, allows them to withstand the crisis. However, they are going to get hit, obviously, they're going to get hit, everybody's going to hit but they will be able to capitalize on the dislocation in markets across public and private markets, and probably come out of this ahead four or five years down the road, but probably they will come out of this ahead four or five years down the road. US pension funds came into the crisis underfunded, 70% funded side was the average, but many of them were below 50%, which I call chronically underfunded status. Those chronically underfunded state pensions, not only they're going to get hit on the assets and liabilities side of things, they're going to get hit because they're not going to be able to capitalize on these dislocations of markets because they need the money to pay out pension benefits. A lot of them are, I'm worried are not going to be able to recover from this crisis, especially if the duration of the crisis is a lot longer than what we are currently anticipating. That's what worries me. There's a lot of uncertainty that's still out there. I believe the duration of the crisis is very much underestimated and that's going to affect all asset management firms, including pensions. ED HARRISON: The most interesting thing in everything that you just said for me was the whole concept of being underfunded and not being able to take advantage of opportunities as they arise as we come out of this recession. I know that South Korea is a country that has come out of the first wave of the pandemic first, and I noticed on your site, you were talking about CPP IB. That's the Canadian Pension Plan Investment Board and a counterpart in the Netherlands getting into South Korea in a logistics company. Tell me, is that the thing you're talking about? Are those the opportunities that you were discussing? LEO KOLIVAKIS: Correct. Think about it this way. That deal, by the way, it was like an encore joint venture. They have already had venture with this logistics company in Asia called ESR. APG and CCPIB basically added more money to buy more logistics facilities in South Korea, and that's a long term investment theme for them, which is the Asian consumer, the rise of e-commerce, that makes absolute sense. The strong balance sheets of Canadian companies that can't overstate this is it allows them to take advantage of opportunities as they arise and take advantage of dislocations in the markets, whether it's public markets or private markets. The other thing that Canadian pension funds have, because they went into this crisis with very strong balance sheets, is they are able to leverage off their balance sheets. They're even able to borrow more to take advantage of any dislocations the markets are seeing. The reason why they do this is the cost of borrowing is cheap relative to the long term returns they can make across public and private markets. Unfortunately, many US pension funds are not able to do this. They're not able to leverage for a lot of reasons, but primary reason is their balance sheets are terrible. ED HARRISON: Let me ask you then, in terms of let's say that there's more downside risk coming, and therefore even the Canadian pension companies can have some of them, can have some underfunding, what are the mechanisms through which pension companies can deal with that underfunding going forward in terms of topping up their balance sheet. I know there are things like inflation, getting rid of the indexation, but maybe you can give me the whole panoply of things that they can do. LEO KOLIVAKIS: Canadian pension plans which manage assets and liabilities, Ontario Teachers' Pension Plan, Healthcare of Ontario Pension Plan, HOOPP which you already had an interview with Jim Keohane, which I thought was a great interview, they are able to do several things, but one of the primary things they're able to do is-- well, first of two things, they lowered the discount rate even more and their discount rates are already extremely low relative to what US pension funds are discounting their future liabilities. Second, they are able to implement conditional inflation protection, where for a period of time, pensioners will receive less inflation protection until the plan is fully funded again and then they can restore that inflation protection, even restore it retroactively, which is what they've done in the past whenever they run into problems. That is a huge mechanism, a huge lever that allows them to address any underfunded status they will encounter in the future because of this crisis. A lot of US pension funds, in fact, almost all of them I know, except maybe for Wisconsin cannot do this, and that's an issue. ED HARRISON: Then what do you do if you can't do that? How do you deal with the underfunding to bring it back up to a level that's adequate? LEO KOLIVAKIS: Well, in the US, the problem is what they're going to have to start doing is taxing more at the worst possible time. Already, you have an economy that's getting decimated with 26 million plus people being unemployed all over the US, and now you're going to start taxing businesses and corporations to talk about underfunded public pensions. Can you imagine how this is going to play out on Main Street? Then at the same time, you're bailing out big banks, big hedge funds, big private equity funds, and so this is why I think what's going to come to the end, when we reach a point, I won't call it a boiling point. We're not there yet, but when we do reach that point, I think there's going to be a mass [?] of public pensions. Unfortunately, they won't be addressing the structural issues, i.e. the lack of governance and other issues that are affecting these pensions. This is going to create what I call zombie pensions. The reason why they're going to bail out these pensions to be quite honest with you is they're bailing out Wall Street and the big private equity funds and hedge funds, which use these public pensions as perpetual funding mechanisms. ED HARRISON: What about where the Fed is acting in terms of municipal bonds? How does that play into it? LEO KOLIVAKIS: The Fed is basically nationalizing all asset classes. The Fed's balance sheet is going to the moon as far as I can tell so far. The problem with what the Fed is doing as it's helping pension stabilize some of their assets and it's helping states, but it's not going to be enough to help the underfunded status of these pensions. Buying municipal bonds, unless the Fed starts buying pension obligation bonds massively, which I don't see that happening, there's going to be a day of reckoning. We're not there yet. We're not close to being there yet, but when it happens, it will be very concerning for a lot of pensioners and members of these public pensions. ED HARRISON: When you say it'll be concerning, the first thing that comes to mind, I think we were talking about this just before, is Mitch McConnell. They were talking about the second bailout in the US, and they talked about municipalities and states and he was like, no, we're not even going to go there yet. In fact, I think that they should go bankrupt first before we do anything. The first thing that came to my mind when he said that is pensions, meaning that these pensioners are going to get into problems because that's the first thing that they'll cut when they have the opportunity in bankruptcy. Well, how does that feed into what you're thinking and also about the bailouts? LEO KOLIVAKIS: Well, Mitch McConnell has said some silly things. I think Paul Krugman completely destroyed him in his recent article saying that this is ridiculous at a time when Mitch McConnell and the Republicans gave away these big corporate tax breaks and though no fault of their own, many states are facing fiscal challenges. You're going to start cutting and it's not a red state or blue state problem, it's an all-state problem here. Many, many chronically underfunded pensions are going to suffer, and Mitch McConnell should be careful what he says in terms of the bailouts given what's been going on right now in the US. I think what's going to happen is you're going to see many public sector unions come out and say, no, we have a right to our public sector pensions. Even in Kentucky, which is a mutual-called state, there was a huge pushback from teachers and other public sector workers when they started cutting defined benefit plans prior to the COVID-19 pandemic hitting them. I just don't see how that's a responsible statement from a politician to say and again, I come back to this if you have a catastrophic event where you see a lot of pensions going under, they will be forced to bail them out regardless of what Mitch McConnell says, there will be a massive bailout of these pensions, I guarantee you this. ED HARRISON: You're speaking definitely to the politics of it all, because let me run how I'm thinking about it from a political perspective, let's use the Fed as an example. The Fed is buying up all sorts of investment grade, and even junk bonds for fallen angels. The whole concept is, look, we don't know if these individual companies were irresponsible before the crisis or not, we're just going to indiscriminately buy it to provide liquidity to the market as a whole because we want to take liquidity onto the national balance sheet, because that's what we do as the Fed. Then, if you at the same time, apply the same logic you can't really say, we know for a fact you, Chicago, you, Illinois, you were irresponsible and you, North Dakota, you were responsible, therefore, we're not going to apply the same logic to you, we're just going to let you indiscriminately go bankrupt. Quite the opposite. Is that the politics that are going to play out in terms of how people are going to see it, bailing out corporations, but letting other people on the hook? LEO KOLIVAKIS: What you described on the economic front is what I call the Japanification of the US economy, which is the Fed basically nationalizing the stock and bond market and allowing a lot of these fallen angel companies to survive, when many of them should, quite frankly, should be bankrupt. When you're thinking about it, though, on the state side of things, it's a bit different. The US federal government can issue its own currency and has the ability to issue a lot of debt. Basically, that debt can be monetized by the federal treasury after. Yes, if again, if we get to the point where many, many state pensions are on the brink of insolvency, they won't look at oh, Illinois, you mismanaged your pensions for years therefore, we're not going to give you a bailout. It's going to be a blanket bailout for everyone unfortunately. Again, the problem with that is you're not addressing structural issues. You're just allowing these pensions to go on mismanaging money. I should be careful when I say this, it's not mismanaging money in the sense that people that are working on these public pension funds are very, very incompetent but there are structural issues that need to be addressed, meaning the state governments have way too much interference and they're not run like businesses. They're not run with the best intentions and aligning the interests of members of that plan over the long run with the way the pensions are being managed right now. This is why they've run into so much trouble on top of the fact that states have not top them up, discount rates remain way too high. There's no conditional inflation protection. Some of the benefits were outrageous for the states, including Illinois, and just a whole host of structural issues that were never dealt with, but the biggest issue that I keep going back to is governance, because if you don't get the governance right, then everything else is irrelevant. ED HARRISON: Let's go to thinking about some of the things that are popping up right now in terms of pensions, because you write about things on the fly as they're occurring. One thing I thought that was interesting was AIM Co, that's the Alberta Investment Management Corporation. You talked about how they were selling volatility, and obviously when volatility rose, that cost them a lot of money. Is that, number one, a viable investment strategy for a pension fund going forward and two, were they being responsible in terms of taking those risks? Because obviously, they were getting returns during the Great Financial Crisis, the period after that. LEO KOLIVAKIS: Canadian pension funds are a lot more sophisticated than US pension funds in the sense that they hire very, very qualified people internally to manage assets in order not to farm them out to hedge funds to do the same strategies. This particular volatility selling strategy, selling volatility was not just on AIM Co, but by many key pension funds. Unfortunately, what happened in March was a spike in volatility was so unprecedented and the duration that spike was unprecedented, that the particular strategies got into trouble. If you understand the way they're engaging this sold volatility was using variant swaps and if you understand the mechanisms, when in these negatively convex strategies, you get a very abrupt spike in volatility that's really unprecedented, the losses mount so quickly that you don't have any way to get out because nobody's going to take the other side of that trade. What surprised me was, quite frankly, why they weren't able to pull the plug earlier. Again, I understand that given the unprecedented situation, and given that the losses mount so quickly, maybe that was one of the reasons they weren't able to this. I have to say for a lot of years, pensions were collecting-- Canadian pensions were collecting 6% to 10% plus on these type of strategies annually, and doing it very, very well and managing the risks appropriately. Unfortunately, with any selling volatility type of strategy, if you're not really careful on understanding the risks of the strategy, it can really blow up. I don't know exactly what happened here, because I know the people at AIM Co were very, very competent. Obviously, something went wrong in terms of the risk management of that strategy, whether it was the positions they were taking relative to the size of the pension plan. When you have a $3 billion, whopping 100 billion dollar pension plan, that's significant. This is something they will have to review internally, and I know that there are a lot of questions being asked by their clients and by their board, and they will come with a transparent statement in the annual report to explain exactly what happened. Now, people are asking me whether or not Canadian pensions or any pensions should be doing these type of strategies, my answer is, if you have the competence to do it properly internally, why not? Ontario Teachers' and HOOPP have been doing these strategies for a long time, and they've been doing very well, because they have derivatives experts who are able to manage the risks of these strategies. It's all about managing the risk. If you can do it internally, as opposed to farming it out to hedge funds who're going to charge you a ton of fees on it, why not? ED HARRISON: That leads to the next question about private markets, because Canadian pensions in particular, are very forward looking in terms of taking that on to their balance sheet. That is taking it in house in terms of investing in private markets where other pension companies in the US as an example are using private equity companies. You and I, we were talking earlier before we got on this call about Neiman Marcus and CPP IB buying them in 2013, and how that is now likely to go to bankruptcy. The first question I have is, what does that say about private market and Canadian pensions getting involved in that in terms of A, returns and returns going forward and also B, in terms of the diversification of that strategy versus stocks and bonds? LEO KOLIVAKIS: Neiman Marcus was a core investment of CPP IB I did with Ares Management, a big private equity shop and unfortunately, Neiman is encountering problems not being able to pay its interest payment on its $4.8 billion loan. The ramifications of this aren't just with CPP IB, in fact, I was reading this morning, OMERS, which its real estate subsidiary of Oxford Properties Group owns Hudson Yards in New York. One of their biggest anchor tenants was going to be in Neiman Marcus and they have concessions on that. There's going to be a few, a lot of Canadian pensions are going to get hurt if Neiman Marcus goes bankrupt, we'll see. I'm not privy to what's going on in the background. CPP IB and Ares are trying to figure out a solution. CPP IB has the liquidity to help even in the short run if that's the case, however, what I can tell you is many private markets are getting hit. Airports, toll roads, infrastructure assets, which the Canadian pension funds have invested quite a bit in, malls, hotels, office spaces, private equity especially private equity that got into energy, thinking there was going to be a major recovery and we see what's going on with oil prices and the energy markets. There's going to be a world of hurt, private debt, by the way, which is a major asset class for Canadian pension funds, which is lending money basically to medium sized businesses, which many of them are going to go bankrupt. There's going to be a world of hurt. However, we're not going to see that right away. There's a bit of a lag I say of three months to six months before those assets are marked to market. Canadian pensions, though invest directly, US pensions are also going to get hurt in their private equity investments. They're paying fees to funds, and many of these funds are going to have terrible returns and are also going to get hit on in private markets. It's a matter of thinking about it over the long term. For example, airports are shut down all over the world. Not all airports, but many of them are, but if you think about it, at one point, people are going to start traveling and airports are going to open up again. Yes, over the one or two-year period, you're going to have a major decline in revenues in these airports, but over long one, will need to come up and make a lot more money than investing in bonds, for example. Public markets, I'll come back to this. The reason why Canadian pension funds are fully unprecedented public markets is there's a lot of volatility in public markets. They are looking to get the best risk adjusted returns over the long run and diversifying across public and private markets and in private markets, they're able to do a lot of direct deals and infrastructure, completely direct in private equity through co-investments with their partners. I think over the long run, they're going to capitalize on many dislocations that are going on in the markets right now. They're going to come out ahead, however, over the next year, there's no question in my mind, especially if the duration of this crisis continues longer than what most people anticipate, there's no question there's going to be a world of hurt in Canadian pensions, and quite honestly, global pensions. ED HARRISON: Basically, what you're telling me is that yes, there is diversification to going public and private markets. My next question for you has to do with liquidity then in terms of the ability to help in these situations because I think that the Neiman Marcus situation is a leading example of where things could go. I don't see Neiman Marcus as a brand that is destroyed. In fact, I've heard the Wall Street Journal was talking about Hudson Bay's Saks Fifth Avenue wanting to take over that brand and they've been wanting to take that brand over for a number of years now. That's a potential outcome from this, is that they merge in some capacity, but at the same time, it could be that Ares and CPP IB have the liquidity to be able to help Neiman Marcus through this difficult time. Do you think that Canadian-- having taken these private investments in-house, that they're in a position to be able to provide liquidity that public markets wouldn't be able to provide or that PE companies that are-- just PE companies wouldn't be able to provide? LEO KOLIVAKIS: 100%. I know for a fact they are looking at all these liquidity needs of all their portfolio companies, including-- it's not just Neiman, there's a lot of portfolio companies that these Canadian pensions that they need some liquidity to be able to withstand the storm, and then they will come out ahead and what the Canadian pension funds are doing right now is they're evaluating the liquidity needs of all these portfolio companies, whether they're small or big, and they're trying to see, okay, how can we help you get through this so that this investment, which we believe is a great investment over the long run, will able to withstand the storm and come out ahead over the long run? The focus right now is over the long run. If there's short term liquidity needs, the good thing is Canadian pensions have a ton of liquidity to provide through various mechanisms. They can do this and help these companies get through this. ED HARRISON: I want to wrap it up by pulling some threads together. I'm thinking about it in terms of something that you were telling me the last time that we spoke about defined benefit versus defined contribution pension plans. The sense that I get is we're now going through a reckoning, if you will, in terms of stability of various pension systems and governance. One of the things is that obviously, defined contribution tells you is that there's more stability over the longer term. Coming out of this, do you think that it shows the model of defined contribution or defined benefit as being better, or has your thinking changed on that level? LEO KOLIVAKIS: My thinking has not changed on that level, my thinking remains that over the long run, people are much better served by well-governed defined benefit plans that diversify their assets across the world, across public and private markets. Pretty much what the Canadian model is, what I would like to see that model, more and more individuals being able to access that model, whether it's in Canada or across the world. The key here is to have well-governed pensions who're able to manage money properly in the best interests of their members, and then invest that money appropriately across public and private markets throughout the world. I think that model is the model that will ensure we have less pension poverty in developed nations. What I worry about right now is with interest rates at record low levels, the reality is defined contribution plans which are mostly being invested in public markets are not going to generate the required returns that people need to have good retirement savings in a capital level. The other problem with defined contribution plans is they don't pool investment risks, they don't pool longevity risks so you can outlive your savings very easily. There's just a whole host of problems with defined contribution plans. They are great to help people save money. 401Ks are great savings vehicles, but they become the de facto pension plans for too many Americans. The reality is too many Americans are going to fall through the cracks because they're not going to have enough money to retire through these it seems. ED HARRISON: Unfortunately, we have to leave on that pessimistic note, but I think that that's the appropriate way to end it. Leo, I really appreciate you talking to us and stay safe and I hope to speak to you again soon. LEO KOLIVAKIS: Thank you, Ed. Stay safe, stay healthy. JUSTINE: If you're ready to go beyond the interview make sure to visit realvision.com where you can try real vision plus for 30 days for just $1. We'll see you next time right here on real vision.