The Pension Problem Won’t Go Away

From Satyajit Das’s “The Age of Stagnation” aka “A Banquet of Consequences”[1]:

General Motors (GM), once a symbol of America’s industrial might, is now a token of the problems of entitlement programs. Shaped by chairman Alfred P. Sloan, who ironically was indifferent to cars, GM once produced more vehicles than all its competitors combined. In 1955, the company made unprecedented profits of US$1 billion. In the apocryphal words of the chief executive, Charlie “Eugene” Wilson, what was good for America was good for GM, and probably vice versa.

Between the late 1940s and the 1960s, GM and the United Automobile Workers, led by Walter Reuther, negotiated increased employee benefits. These included guaranteed wage increases ties to increases in the cost of living and to improved productivity, more paid vacations, pension benefits (adjusted for government-sponsored Social Security entitlements), disability benefits, and medical benefits for both workers and retirees. GM provided job security, guaranteeing payments to supplement unemployment benefits for workers made idle by plant shutdowns, In 1973, the United Automobile Workers negotiated the infamous thirty-and-out arrangements, enabling any employees with thirty years’ service to retire with full pension and healthcare benefits.

The steel, railroad, and airline industries negotiated similar arrangements for their workforces. By the late 1960s, around 45-50 percent of US workers were entitled to company pensions.

With demand buoyant, GM wanted to avoid labour unrest and lengthy disruptive strikes that would reduce profits. The firm reasoned that higher costs could easily be passed on to buyers. In the 1970s and 1980s , a weaker GM continued to increase benefits, preferring deferred payments to immediate cost increases so as to remain competitive, and obtaining agreement to changed work practices. Critics expressed concern about these future obligations, questioning whether companies could finance the payments. A young management consultant, Peter Drucker, doubted that a company could forecast its ability to meet such obligations decade into the future.[2]

Fast forward to 2017, to another bastion of America’s industrial might, General Electric (GE), whose CEO, Jeffrey Immelt, is set to depart on August 1. Immelt leaves the company with a massive pension obligation — an estimated $31-billion shortfall between pension assets and future liabilities — which will be the proverbial ball and chain around the neck of Immelt’s successor, John Flannery. But we don’t have to feel sorry for Flannery, executives have the ability to exercise real options in their favour to the detriment of the stakeholders who put in years of service at companies, only to see their pension assets mismanaged by the fiduciaries entrusted to oversee them, and by the short term myopia of maximizing shareholder value.

Think of this, GE undertook a $50 billion share buyback plan during the latter stages of Immelt’s tenure. According to Factset  General Electric bought back $21 billion in stock over the trailing twelve months ending fiscal Q3 2016, which helped reduce its shares outstanding by a massive 12.5% over that period. Rather than the lavish expenditures on share buybacks,  General Electric could have spent a portion of those funds on reducing its pension shortfall and embark on de-risking the strategic allocation of its defined benefit pension  plan portfolio. But instead, the binary decision tree outcome was squarely skewed in favour of short term gains so that executives, compensated heavily by their vested equity holdings, would benefit. Who cares a wit for the 231,000 retirees and families and approximately 242,000 current and former workers?[3] This behavior is in keeping with the narrative that all economic gains are going to those at the top of the corporate food chain (see economist Gabriel Zucman‘s chart below). The state of ethics is such that those at the top who are compensated by equity will vote in favour of their enrichment, and they can kick the can of future obligations down the road so that it becomes someone else’s problem.

income-gains Do I have an axe to grind against GE? No at all. For full disclosure I am a shareholder and my holdings of the company’s stock are modest and account for a small percentage of my RRSP. I am long the stock because of the long term view that it will be a major player in the Industrial IoT. As Nick Srnicek states in his book, “Technology after Capitalism” also know as “Platform Capitalism“:

   The competition here is ultimately over the ability to build the monopolistic platform for manufacturing: ‘It’s winner takes all,’ says GE’s chief digital officer. Predix and Mindsphere both already offer infrastructural services (cloud-based computing), development tools, and applications for managing the industrial internet (i.e. and app store for factories). Rather than companies developing their own software to manage the internal internet, these platforms license out the tools needed. Expertise is necessary, for instance, in order to cope with the massive amounts of data that will be produced and to develop new analytical tools for things like time series data and geographical data. GE’s liquid natural gas business alone is already collecting as many data as Facebook and requires a series of specialised tools to manage the influx of data.

But will GE learn from GM’s mistakes? GM was forced to file for Chapter 11 reorganization in 2009, this was the biggest industrial bankruptcy in history and forced concessions from the UAW with respect to retiree healthcare entitlements and compensation. Closer to home, and on a significantly smaller scale, the Sears Canada debacle illustrates how the pension problem won’t go away. Sears Canada’s  $266.8-million deficit in its defined benefit pension plan had meant special monthly payment of $3.7 million in order to raise its funded ratio. Those special payments will be suspended, and the lawyer representing Sears Canada retirees had an expected response:

“The process that Sears Canada is following offers no protection for the retirees’ pension losses, and Sears Canada now also seeks to cut off retiree health and life insurance benefits,” said Andrew J. Hatnay, Partner at Koskie Minsky LLP. “This is a totally unacceptable situation for Sears retirees who earned their pensions and benefits during their employment service for the company.” [4]

The issues touched upon here concern the private sector, but the situation in the public sector is worse, particularly in the US system where the under funding for municipalities and states amounts to $1.3 trillion. It is high time for companies to reflect and reassess their positions surrounding future entitlement to their current and retired employees. Low discount rates for unfunded liabilities won’t go away — the cycle of central bank tightening which is all the rage amongst the financial press will make way for looser monetary policy once the business cycle turns to lower growth and eventually a recession. Moreover, the return assumptions of pension planse —Calpers cut its expected return on assets to 7%— remain too high.

We need to adjust our collective thinking on retirement age and what retirement actually entails. Japan of today is our future in the West tomorrow. There will be people working longer, and people working in their golden years. Defined Benefit plans are going the way of the dodo in the private sector but stories of entitlement debacles won’t disappear as quickly. This is a problem with no easy solution; there is no silver bullet.

[1] The phrase “Sooner or later everyone sits down to a banquet of consequences” is attributed to Robert Louis Stevenson. Das’s book “A Banquet of Consequences” was renamed “The Age of Stagnation” for the North American market.

[2] Peter Drucker, “The Mirage of Pensions,” Harper’s Monthly, February 1950.

[3] Michael Hiltzik, GE spent lavishly on shareholders, shortchanged pensions and still landed in a deep hole , LA Times, June 16, 2017.

[4]‘ Totally unacceptable’: Sears Canada looks to suspend employee retirement benefits in restructure


BOC: Easing bias before a rate cut

Nice table here from Pension Partners (via @MktOutperform )

The Race to Negative Yields (%)

And here is the Canada 10 year Government Bond (from Trading Economics)

Canada10 Year Bond (2009-2015 YTD)

On January 21, 2014 I argued that the Bank of Canada’s policy rate would continue to flat-line for the year despite market optimism to the contrary. I also disclosed that I had added long bond exposure to my personal portfolio with the view that 2014 would be a bounce back year for sovereign long bonds, specifically Canadian. Little has changed to deter the portfolio choice as the global landscape worsens.

At home, in an era of what I believe are low rates for a very long time, financial repression is killing the spending capacity of retirees. A not so small point is that the front end of Canada’s baby boom generation began retiring last year. That is a trickle; a flood of retirees will follow. Central banks are relying on reduced interest rates to spark credit creation (and in turn a greater stock of private debt) to spark consumption. The price of real estate remains at a high in nominal terms in major cities like Toronto and Vancouver and household debt to income ratios remain high as well. To keep the not so virtuous cycle of consumption going will require the central bank to more encourage credit creation and asset price inflation to spur the industry that is growing –real estate development– however with the federal government attempting to balance its budget the output gap that the BOC calculates as a guide (but necessarily a final decision making metric for policy) is likely to expand rather than contract. With slack only increasing and knock on effects from oil’s price decline yet to be felt in the numbers that drive markets, 2015 will be another year of easy monetary policy. Absent increases in real wages of working and middle class workers there will be no spike in effective demand within the Canadian economy that will be sustainable. If anything, the case is now being made by Ted Carmichael and others for a policy rate cut. I agree with this view. While a rate cut on January 21 is unlikely the language leaning toward an easing bias may occur in the coming months. Reading the tea leaves of monetary policy statements is more art than science. If the BOC’s dovish language is enough then it will stand pat as long as it can but as the data flow increases and core inflation falls we will see a rate cut this year.

The scheduled announcement dates for BOC policy rates in 2015 are:

Wednesday 21 January
Wednesday 4 March
Wednesday 15 April
Wednesday 27 May
Wednesday 15 July
Wednesday 9 September
Wednesday 21 October
Wednesday 2 December

George Magnus on Boom and Bust

Fast forward to 4:00

George Magnus, former chief economist at UBS, in conversation with RT’s Erin Ade on the emerging markets sell off, the concern with China, the demographic challenges facing advanced economies as well as Russia and China, and an assessment of Ben Bernanke’s tenure as FED chairman.

BOC’s benchmark policy rate to continue flatlining

The Bank of Canada is set to release its interest rate announcement and Monetary Policy Report tomorrow morning at 10 AM (ET). There is an expectation of no policy rate change and the possibility of an easing bias by market participants. The former appears a good bet given the flow of economic data recently, from employment falling by 46,000 in December to  inflation remaining below the BOC’s 2% target yet remaining just within the central bank’s (1% to 3%) operating band.

 The chart below illustrates three metrics, 2 observable the other an estimate, that BOC watchers pay close attention to: core inflation (in dark blue), the BOC target (i.e. policy) rate (in teal), and the output gap (in brown measured against the right Y-axis). It is the latter that should be reason enough to believe that the BOC policy rate will continue to flatline for the short term (2 years) as the slack in Canada’s economy continues to widen despite a low nominal central bank policy rate, credit extension by the banking sector, and federal and provincial governments that are running budget deficits.  


My personal view is that there is no reason for the BOC policy rate to move up before the 2015 Federal elections. The Conservative government of Stephen Harper will be running, according to its Executive Director Dimitri Soudas,  on a platform of supposedly ‘strong, stable leadership’ (below).dimitri.soudas
Moreover, there is the determined effort on the part of the current Conservative Federal government to ‘balance the books’ and return Canada to the promised land of budget surpluses. For a graphic on how federal governments from the time of Lester B. Pearson’s Liberals to Stephen Harper’s Conservatives have fared in this endeavour, see this graphic from the CBC.

The idea of conflating the budget of a federal government with that of a household is attractive but it doesn’t work for Canada; it can for other nations, such as those under the monetary straitjacket of European Monetary Union, but it doesn’t make sense in the Canadian context. Every nation has a particular political economy to deal with that is the legacy of history and goepolitical relations. Moreover, the nature of a nation’s currency –is it sovereign or is it shared or pegged to global reserve currency– is worth considering as is the composition of that nation’s debt ownership.

Currently, the Canadian context is one where the household sector has taken on an increasing amount of debt –both residential mortgage and consumer– that will be serviced for the coming decades and at the same time the federal government has gone into deficit spending mode since the 2008 financial crisis.

Debt to income ratio in Canada

Debt to income ratio in Canada


The Bank of Canada understands this and has made the explicit assumption in previous Monetary Policy Reports that the business sector would drive growth in the economy through capital investment. That hasn’t happened.

Arguably, businesses require signals from the consumer in order to have the confidence to enact capex. Say’s Law need not apply for most companies: supply does not create its own demand. The decision in favour of capex is demand driven. Absent that effective demand, businesses can propel growth via a combination of increasing efficieny or financial engineering. The former prescription has meant offshoring, outsourcing, and hiring more workers as temporary and, increasingly, the autommation of work that requires fewer and more specialized workers (if any as the graphic below concerning the decoupling of productiviy and employment illustrates).


The latter prescription has meant, at best, bringing leverage onto a company’s balance sheet as a catalyst to translate modest top line sales growth into robust bottom line profitability and, at worst, aggressive revenue recognition to make a balance sheet and income statement look better than it really is.

Fundamentally, the deficits of one sector emerge as the surpluses of another. If we consider the debt burden of most Canadian households in terms of the stock of liabilities divided by the flow of income, we recognize that the moribund income growth entails curtailing future discretionary consumption. Canadians have brought forth a lot of future consumption by taking on mortgage and consumer debt. This requires debt servicing. Furthermore, the demographic factors facing Canadian society are a challenge that this country’s policy makers are inadequately prepared for. As the dependency ratio increases, the growth trajectory decreases: older Canadians, many of whom have saved inadequately for retirement, won’t consume as they did during their working years.

The Bank of Canada will continue to cling to the hope that the sagging loonie will spur greater demand for Canadian exports and thus make their heretofore forecasts appear more credible. This is more faith and hope then scietific reasoning as the flipside to this is that it will make capital expenditures more expensive as that is invoiced in USD. The Canadian dollar remains a petrocurrency:

CAD remains a petrocurrency

CAD remains a petrocurrency

Head winds to growth:

  • Household deleveraging
  • Government deficit reduction
  • Aging demographics

Tail winds to growth

  • A depreciating currency
  • Credit expansion
  • Easy monetary policy

Market rates will continue to ebb and flow on the steady trickle of economic and financial data. Mortgage rates, in turn, will go up and down as a result based on the risk appetitite of the major banks. What won’t change is the policy rate: the Bank of Canada will be circumspect in articulating an easing bias as it won’t want to further inflame a housing market that is becoming expensive for most Canadians yet, in the face of the head winds facing the economy it is unlikely how the slack out of the economy will disappear over the coming years.

(Full disclosure: the author’s views are his own and he added allocation to XLB iShares in anticipation that 2014 would be a bounceback year for Canadian Long Bonds)

Do you get rewarded for ‘risk’?

Treasuries (TLT), corporate bonds (LQD), and stocks (SPY) returns after 7 years (Source: Tom Brakke @researchpuzzler )

Pension plans take note: Above is a chart posted by Tom Brakke (Twitter handle: @researchpuzzler ) and his post is here (Hat Tip: Tejus Sawjiani). My point in posting his fascinating chart is that pension plans are forced into asset allocations that favour riskier asset classes but is this the right approach? We cling to a paradigm of greater risk giving you greater reward but if this supposition were true then why has the investment industry been quick in pushing low volatility products? Whether we like to acknowledge it or not, macro counts for a lot more than investment analysts believe. Value investing works when macro factors align not in spite of those factors. By the same token, the resurgence in equities after the financial crash of 2008 has been due to flow of funds aided and abetted by the reflationary policies of central banks. (I have written on my personal thoughts vis-a-vis Bernanke’s version of quantitative easing here.) Will the visible hand of central banking continue to reflate equity markets or will funds flow back to US treasuries and corporate bonds as the global economy faces the reality of overcapacity, low effective demand and household deleveraging?

Related posts: 2014: Equities Meltup and 2014: A Deflationist’s Perspective

10 Trillion in Cash – Where is it going?

What happens to financial capital looking for a return? In this case, that financial capital is 10 Trillion dollars and, as US equity returns attest this year, those funds have been deployed in risk assets.

In this video FT’s John Authers speaks with Avi Nachmany, co-founder of Strategic Insight.

Charts from the video are below:

Flows into Passive funds and ETFs increasing


Cash in search of a return

Great Rotation Out of Bonds?