Archive for September, 2011

Understanding Pension Plans (CFA III) – 1

Tuesday, September 27th, 2011

One of the largest investors in hedge funds, mutual funds, and alternative asset classes, including private equity, timber, and commodities is the pension fund.  As an analyst or a portfolio manager, it is essential to understand the purpose of pension plans, how they are structured, and how they allocate risk.

A pension plan is a portfolio of assets (securities, hard assets) that can support future retirement benefits.  The promise to pay these benefits in the future is a key responsibility of the plan sponsor.

The plan sponsor is the company, non-profit, or government agency that funds the pension plan through periodic payments.

The plan participants are the individuals who receive the pension benefits as they are paid out from the pension plan.

There are also four main types of pension plans, the defined contribution plan, the profit-sharing plan, the defined benefit plan, and the cash balance plan:

1) Defined Contribution Plan: is a pension plan whose retirement payout expectations are framed by contributions to the plan by the plan sponsor.  The liability to the sponsor is only the plan contribution, not the benefit received by the plan participants.

2) Profit Sharing Plan: is a defined contribution plan, where the contributions to the plan are determined by the plan sponsor’s profitability.

3) Defined Benefit Plan: is a pension plan that is framed by the benefits paid to plan participants instead of by the contributions.  Benefits are calculated by taking to account years of service, expected return, expected salary, and other factors that will be explained later.

4) Cash Balance Plan: is a defined pension plan that maintains individual account records for plan participants.  This plan shows each member’s accrued benefits and manages accounts instead of an actual fund.


Funded Status: relationship between PV (present value) of the pension plan assets and the pension plan liabilities.

Underfunded: PV (present value) of pension plan assets here is less than the PV of the pension plan liabilities.  When plans are underfunded, the may require the sponsors to make special contributions to the plan in addition to regular contributions.

Fully Funded: PV (present value) of pension plan assets here is greater than or equal to the PV of the pension liabilities.  Sponsors can temporarily stop making contributions to the plan’s asset base when the PV of assets > PV of liabilities.

Surplus: difference between the PV of pension plan assets and the PV of pension plan liabilities.


Active lives: the number of plan participants who are not currently receiving pension payments and are still working to save for retirement.

Retired lives: the number of plan participants currently receiving benefits (retirees).

Accumulated Benefit Obligation (ABO): is the total PV of pension liabilities to date, assuming no further accumulation of benefits.

Projected Benefit Obligation (PBO): (PBO) is the ABO  plus projections of future employee compensation increases.  The PBO is the pension liability for a going concern and is the liability figure used in calculating funding status.

Total Future Liability: is the measure of pension liability that is the most comprehensive, because it takes into account not only changes in workforce and inflation in benefits, but salary increases as well.  Total future liabilty is used when setting long term objectives and goals for the plan within the IPS (Investment Policy Statement).

For graphics and links, please visit the Leverage Academy blog. Syndications may not capture the entire article.  LA also reaches thousands through its syndications.  If you wish to write an article or contribute, please feel free to e-mail the address below (Tom).

Please visit and check out our curriculum tab to sign up for our intensive investment banking, private equity, global macro and sales & trading courses in Boston & New York.  Classes will also be held online, live through video feeds at these locations.  Questions?  Feel free to e-mail thomas.r[at] with your inquiries or call our corporate line.

Soros Says the U.S. is Already in a Double Dip Recession – Defining Balance Sheet Recessions

Sunday, September 25th, 2011

Soros recently asserted that Europe could be more dangerous to the global financial markets than the default of Lehman Brothers in 2008, because of the political stubbornness of European policy makers.   He has been saying this for over two years now, while government officials continue to ignore him, focusing instead on making bold statements and causing riots.  In a brilliant move, Soros returned investor capital at the end of July to avoid the eyes of the public.  I am sure he is now short sovereigns via CDS, currencies, and synthetic instruments, while he continues to donate to the poor in Eastern Europe like a modern day Robin Hood.  Since March, Italian CDS has more than doubled, and French and Belgian CDS spreads will continue to creep higher as the sovereign crisis persists.  How are Greece, Italy, Spain, and Portugal supposed to grow their way out of debt, as deficit cutting reduces European GDP growth to less than 1%?

The public doesn’t trust officials to make timely decisions to protect the EU.   The PIIGS (Ireland and Italy included) pose an insurmountable task for the region, as the combined nations have far greater GDP and net leverage than Germany, the only country that will be supporting the EFSF with a AAA rating. Italy itself has €1.2 trillion of debt, which is  more than Germany, and France may be downgraded in the next 6 months, which is evident in how much its CDS spread has widened over the past 2 months.  France also cannot print money like the United States, and certainly should have been downgraded beforehand, sharply decreasing the effectiveness of the stabilization facility in the EU. A French downgrade would not only endanger French banks, it would create counterparty risk for its U.S. partners as well.  Soros has already claimed that the U.S. is currently in a double dip recession, which I personally think to be true.

Both the majority of the EU and the United States are in a global double dip already not only because of policy mistakes, but due to unsustainable leverage, overspending, broken healthcare and education systems, and corrupt governments. Recent real estate, manufacturing, and confidence numbers, along with revisions down in the earnings of major metallurgical coal and transportation companies in developed countries support my thesis (look at tickers ANR, WLT).  Alpha Natural Resources recently cited a sharp decrease in coal demand for steel production in Asia, reflecting weakness in both its U.S. and ex-U.S. clients.  In the U.S., real estate usually contributes 15% to GDP growth, and it is showing no chance of recovering (HOV), as most sales over the past two years have been distressed sales driven by investors, not families or single buyers.  Developed economies are slowing down quickly, as elected officials argue over who is more important than the other.  The S&P 500 ex-dividends is at the same level it was in 1998, the FTSE MIB in Italy is down 30% on the year (40% from April), and the emerging market index (EEM) just broke its 2010 lows.  Many European financial institution equities are down 60%+ to date.  Markets are broken, as the CME has to raise margins every other day to bring down the prices of precious metals, which are rising in the face of fiat destruction and future inflation risk.  Poverty has reached 15% in the United States, unemployment is over 9.2%, underemployment is about 17%, and local government cuts have resulted in the layoffs of countless public employees, like the recent 3,000 teachers who were fired in Providence, Rhode Island.

There are 44 million people on food stamps in the United States, which is supposed to be the wealthiest nation, and the land of hope for many immigrants.  Over 30% of the U.S. population pays more than half their gross income on rent, since incomes (adjusting for inflation) have not increased since 2000.  With rents projected to increase 3-4% in metropolitan areas over the next year, even the educated poor may be driven out of cities or on to the streets. The land of hope? Why don’t you ask my hardworking university friends about hope, who are much more qualified than some of their U.S. peers, but cannot get jobs and improve the quality of our economy due to the difficulty of obtaining visas.  This country was built by immigrants, who are now blocked out of entering the nation. Teen unemployment also hit decade lows this past month.

According to New York-based Economic Cycle Research Institute (ECRI), which tracks some 20 large economies contributing about 80% of the world GDP and provides critical information about upturns and downturns of economic cycles to money managers, we will know within the next 60 days whether we are in a recession or not.  ECRI’s Lakshman Achuthan has been one of the most accurate forecasters for economic cycles over the past decade.   He argues that the 2008/2009 recession was different than the sharp recession of the 1980s, “This is very different than the early 1980s. The issues that ail the U.S. economy and the jobs market today are not things that result from nearby events. What we’re living through and dealing with now has been building for decades,” he says. “If you look at the data, you see that the pace of expansion has been stair-stepping down ever since the 1970s, on all counts — on production, how much can we produce, how many jobs can we create, how much money do we make, how much do we sell. These are all trending down.” In the deep recession of the 1980s, GDP growth was 5%+ coming out of it…our growth in Q111 was revised down to 0.4%, and will be less than 2% for the year. Don’t believe me? Check on your own.

“If we do have a double-dip recession, Achuthan says, the people who are already having trouble finding work and paying bills are already in a depression and that they “are going to suffer more.”  ”It poses massive problems for policymakers because a new recession automatically increases all of these expenditures out of the public sector, while at the same time dramatically decreasing all their revenue,” he says. “So there’s even less ability to help the people who are hurting the most.”

Although I am not a fan of Roubini for his sensationalist gloom and doom scenarios, he does do decent research and predicted a 60% chance of a double dip in the U.S. three weeks ago.  The United States is in a balance sheet recession, as the economist Richard Koo, a strategist at Nomura, predicted may happen back in 2009.   Most of the growth we have experienced has been the result of continued fiscal and monetary stimulus from the United States government over the past three years, as well as inventory restocking.  The biggest driver of this slow and painful recession is that more stringent underwriting standards for real estate lending and small business lending are slowing down aggregate demand and GDP growth.  Koo argues that once you have a balance sheet recession, people focus on paying down debt, making the situation much worse over time.   The government has to increase fiscal stimulus for the entire duration of the private credit contraction cycle to overcome private deleveraging.  Unfortunately war and internal conflict has made this impossible in the United States as our debt to GDP nears 100%. Since the private sector has moved away from profit maximization to debt minimization, newly generated savings and debt repayments enter the banking system but cannot leave the system due to a lack of borrowers.  The economy here will not and cannot enter self-sustaining growth until private sector balance sheets are repaired.

If the government tries to cut spending too aggressively in 2012-2013, Koo thinks that we would fall into the same trap President FDR fell into in 1937 and that Prime Minister Ryutaro Hashimoto fell into in 1997.  The deflationary gap created by a lack of credit creation and fiscal stimulus “will continue to push the economy toward a contractionary equilibrium until the private sector is too impoverished to save any money.”  The economy will collapse again, and the second collapse will be worse than the first.  It will be difficult to convince people to change their behavior in this scenario.

In a typical recession, private sector balance sheets are not hurt very badly, and most still express profit maximizing behavior.  People borrow money and spend as interest rates are lowered.  In a balance sheet recession, consumers refuse to borrow even if rates are at 0%.  This results in asset prices collapsing and banking crises.  Banks then cannot lend into the private sector, and the government becomes the borrower of last resort, at extremely low rates, because banks don’t need to hold capital against government loans.  When people use money to pay down debt, they withdraw money from their bank accounts and pay it back to the banks, so both deposits and the money supply shrink, which actually caused the Great Depression.  For example, 88% of Obama’s tax rebates have been used to pay down debt.

Let me put it in perspective:

According to Koo, “The Board of Governors of the Fed in 1976 estimated that deposits lost in Depression-era bank closures and through increased hoarding of cash outside of the banking system explained just 15% of the almost $18 billion decline in deposits during the period. Meanwhile, bank lending to the private sector plunged 47%, or by almost $20 billion, from 1929 to 1932. The conventional wisdom is that lending fell because banks panicked in response to dwindling reserves and forcibly called in loans. But that same Fed study shows that bank reserves did not actually fall during that period, when borrowings from the Fed are taken into account. In addition, a survey of almost 3,500 manufacturers, undertaken in 1932 by the National Industrial Conference Board, showed that fewer than 15% of the firms surveyed reported any difficulty in their dealings with banks.”
If bank closures, cash hoarding and heartless bankers didn’t cause the Depression, what did? ”There’s only one possible alternative explanation for that era’s dramatic shrinkage in deposits and loans — or, at least, for the 85% of those shrinkages that can’t be attributed to the traditional villains. And that is that firms were reducing their debt voluntarily. At that time, the Fed tried to increase money supply by pumping reserves into the system, but with everyone paying down debt, the multiplier was actually negative, so it produced no results whatsoever.”
And companies became hellbent to pay down debt because — “The price of assets purchased with borrowed funds (as most had been, during the Roaring’20s) collapsed after the stock market crash, and companies’ leverage had already gotten extremely high before the Crash. In other words, companies in the 1930s faced the same balance sheet problems as Japanese firms confronted in the 1990s. The lesson we learned from our experience in Japan is that with the government borrowing and spending money, the money multiplier will stay positive, and that’s basically how Japan kept its GDP growing throughout its Great Recession. So we have a situation where fiscal policy is actually controlling the effectiveness of monetary policy. It’s a complete reversal of what almost everyone alive today learned in school — that monetary policy is the way to go. But once everyone is minimizing debt instead of maximizing profits, all sorts of fundamental assumptions go out the window.” Just like a severe asset price crash on leverage caused crises for the U.S. in the 1930s and for Japan in the 1990s, our real estate driven recession is more than just a manufacturing slowdown or a simple policy mistake.
In the U.S. we had over 150 bank closures last year, and have had 72 in 2011.  Banks are reticent to lend, but the real problem continues to be that there is less demand for money, and deleveraging will continue to weigh on growth for years. There are many parallels Koo describes with the Japanese crisis as well, which I will discuss in another article.
The worst part of our current situation in the U.S. is that new bank capital adequacy standards are making it even more difficult for banks to encourage private lending.  So banks do not wish to lend, lending standards have increased dramatically, and citizens don’t want to borrow…and now with a flat yield curve, I don’t understand how financial institutions are going to dig their way out of this mess with profits either. Thank you Ben Bernanke.  Your “operation twist” policy has eroded all profit potential for financial institutions in 2012.  Let the deleveraging continue…

Cheers, Singh

“As I said there is nothing wrong with failing. Pick yourself up and try it again. You never are going to know how good you really are until you go out and face failure.”
-Henry Kravis

For graphics and links, please visit the Leverage Academy blog.  Syndications may not capture the entire article.  LA also reaches thousands through its syndications.  If you wish to write an article or contribute, please feel free to e-mail the address below (Tom).

Please visit and check out our curriculum tab to sign up for our intensive investment banking, private equity, global macro and sales & trading courses in Boston & New York.  Classes will also be held online, live through video feeds at these locations.  Questions?  Feel free to e-mail thomas.r[at] with your inquiries or call our corporate line.