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Follow-Up on PSP's 2009 Annual Public Meeting
Submitted by Leo Kolivakis, publisher of Pension Pulse.
Last Thursday, I went over PSP's 2009 annual public meeting, focusing exclusively on the comments from PSP's Chairman of the Board, Paul Cantor.
Earlier this week, I noticed that PSP posted the audio that accompanied the meeting. I will follow-up on last week's comment by going over the presentation given by PSP's President & CEO, Gordon Fyfe (click here to view the entire presentation).
Mr. Fyfe begins his presentation by discussing the financing of government contributions. The actuarial required rate of return to balance PSP's assets with PSP's long-term liabilities is CPI + 4.3%.
To achieve this required rate of return, Mr. Fyfe points out that PSP needs to invest in assets that generate higher yields than real return bonds, or else assets will not match liabilities over the long-run and that will end up costing the shareholder (Government of Canada) because it will have to finance this gap.
Are you with me so far? This is pretty basic asset-liability matching. Mr. Fyfe then goes on to discuss how PSP constructs a portfolio to meet the objective of generating the required actuarial rate of return.
To do this, he shows the difference between a basic portfolio which is made of liquid public markets, and the "efficient" portfolio which is made of diversified investments, including private market investments.
He discusses PSP's "competitive advantages" which includes liquidity and net contributions to justify making more investments into private asset classes. Mr. Fyfe says that "you get higher returns" by investing in illiquid asset classes so you increase your likelihood that you achieve the actuarial rate of return (CPI + 4.3%).
Now, let me pause for a second here to discuss the claim that illiquid assets deliver higher risk-adjusted rates of return. This claim is a little phony because one of the reasons illiquid assets look as if they're generating higher risk-adjusted rates of return is because of stale pricing as these private assets are valued infrequently compared to public assets that are continuously traded.
Importantly, if you adjust for illiquidity, leverage and credit risk, only the best private equity funds handily beat the S&P 500 over a long time horizon. The same goes for private real estate funds. Keep this in mind as you read below.
You can see in the chart above (click to enlarge), that since PSP initiated its diversification strategy back in 2004, where they started introducing more private market asset classes, the efficient portfolio outperformed the basic portfolio made up of liquid public markets. However, last year, the outperformance shrunk as private market got whacked. Mr. Fyfe dismissed last year as a "once in 100 years event."
Mr. Fyfe discussed PSP's performance in detail, noting that last year PSP was a fourth quartile performer in FY2009 relative to the RBC Dexia Universe, however, they remained a second quartile performer since the start of 2004 when the diversification strategy was initiated.
Mr. Fyfe then complained that the new accounting rules (mark to market) had a profound impact on the valuations of PSP's private markets because it forced them to valuate their private market holdings at "distressed levels" at PSP's fiscal year-end, March 31st.
Given PSP's liquidity profile and net contributions over a long period of time, Mr. Fyfe rightly noted that they were not forced to sell these private market holdings at distressed levels.
What else was behind the performance of PSP's FY 2009 performance? Currency fluctuations as the weak Canadian dollar reduced performance by 2.6%.
Next, Mr. Fyfe discussed the non-bank asset-backed commercial paper holdings, the ABCP portfolio. Here I was very surprised with some of the comments. Mr. Fyfe noted that they wrote down the ABCP portfolio by 50% in by the end of the fiscal year that cost the portfolio another 1%.
What was shocking was when he said there "are no credit losses" in the ABCP portfolio and "we expect 95% of these assets to come back to us". Huh? What you talking about Mr. Fyfe? I think you're being far too optimistic on that call and the risks are that there will be further writedowns in the ABCP portfolio.
More importantly, Mr. Fyfe totally ignored the CDS portfolio which Diane Urquhart went over in her guest commentary covering PSP's 2008 results. What happened to that portfolio? Was it totally written off? If so, what are the total losses in that credit portfolio and who is responsible for these losses?
Mr. Fyfe ended off by stating that PSP is bringing assets internally and by presenting the annual return by business unit as at March 2009 (click on image below to enlarge):
Notice how they presented performance without also presenting the performance of each business unit's benchmark? Given that equity markets rallied sharply since March, it's hardly surprising to see the overall portfolio is doing better this year.
What will be interesting to see is how PSP values their private market holdings at the end of their fiscal year (March 31st, 2010). If they value them in accordance to the new accounting rules, they risk not generating anywhere near what private markets generated in the past.
This means that unlike the last five years, PSP will not be able to claim "significant value added" from their diversification into private markets. In their presentation, I would have liked to have seen the overall performance of the PSP Fund by fiscal year along with the performance of private markets and the performance of the benchmark of those private markets.
During question period, Mr. Fyfe got grilled by NDP member of Parliament, Thomas Mulcair. Mr. Mulcair took jabs at at Mr. Fyfe for not appearing before the Standing Committee of Finance, for holding the meeting during Parliament's question period (so reporters don't cover it), for not speaking one word of French during the presentation. (To be fair to Mr. Fyfe, I have heard him speak in French and I know he values Canada's bilingualism).
But a more important and critical question from Mr. Mulcair was his question of why PSP does not disclose its benchmarks in private markets, citing "competitive reasons". Mr. Fyfe raised an odd argument about "if you were selling your house" would you want to let people know what the lowest bid you'd be willing to accept.
Mr. Fyfe also used the excuse that PSP is competing with hedge funds, private equity funds and other pension funds. Huh? This is news to me. Maybe someone should remind Mr. Fyfe and Mr. Cantor that PSP is a Crown corporation of the Government of Canada and that they should lead by example, disclosing all relevant information to all their stakeholders, including Canadian taxpayers.
Mr. Mulcair did exactly that and asked Mr. Fyfe and Mr. Cantor not only what the private market benchmarks are but how often they were changed since PSP diversified into private markets in 2004.
Given that millions of dollars of bonuses were awarded to Mr. Fyfe and senior officers of private markets at PSP, all stakeholders have a right to know what the benchmarks for private markets are and whether or not they reflect the "beta, credit risk, leverage and illiquidity risk" of the underlying portfolio.
Importantly, Mr. Mulcair and other members of Parliament should ask the Auditor General of Canada if a thorough performance, operational and fraud audit was ever conducted on PSP Investments since they diversified into private markets (apart from the regular financial audits which rubber stamp the annual report). Unless this is done, nobody will ever know whether the bonuses were based on merit or on gaming silly benchmarks in private markets that do not take into account the risks of the underlying investment portfolio.
Finally, just to hammer in that last point, please read Kip McDaniel's article on Canadian pension funds in the winter issue of ai5000. As you read the article, and the comments from Leo de Bever, President & CEO at AIMCo, relate them back to Mr. Fyfe's flimsy explanation as to why PSP does not disclose its private market benchmarks.
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PSP needs to invest in assets that generate higher yields than real return bonds, or else assets will not match liabilities over the long-run
Higher yields indicate higher risk. There seems to be an implied assumption that higher risk assets will always generate higher yields. The meaning of risk has been forgotten. The flip side of risk is the potential for higher losses, otherwise it isn't much of a risk. Seems to me pension funds are playing a game here, knowing full well it's not their retirement money on the line.
Very true, to generate higher returns, you need to take on risk. The big bets in private markets might come back to haunt them again, especially if we head into a protracted period of deflation. Regardless, if PSP or CPP or anyone else does invest in private markets, then they should clearly dsiclose their benchmarks. That's called practicing best standards in governance of public pension funds.
Leo, totally unrelated, but wanted to say ur "inch by inch" post struck a note. I played hs fb myself. but have made the transition from meathead to quant over the years. Always enjoy ur stuff, as a big bear, it has helped me stay grounded(& solvent)
The tragedy (and comedy) of the Pension Plan is in your 4th paragraph. "The shareholder (Gov of Canada) will have to make up the shortfall. That's the taxpayer - or again, the person with the least pension income will have to fill the gap for the "pension rich public sector".
Leo - step out of the pension catastrophe for a moment and give us a report on CMHC.