Worse still, some pension funds used government balance sheets to sell credit default swaps, which are basically insurance policies on credit default obligations. Unlike AIG, they did not sell CDS on subprime mortgages, but once the credit crisis spread to all credit tranches, including tranches with triple-A credit ratings, it exposed these funds to material losses.
In a recent speech, the Governor of the Bank of Canada, Mark Carney, stated, “As liquidity in many funding markets has dried up, so has embedded leverage in many pension funds”. I submit to you that the opaqueness of many of the large public pension funds and their increasing exposure to complex derivatives and internal and external investment strategies are hiding the true embedded leverage of these funds.
In conclusion, I want to end with a series of recommendations.
First and foremost, we need to legislate greater transparency in both public and private pension funds. In particular, there should be full disclosure of benchmarks used to evaluate all internal and external investment activities; performance results in public markets need to be reported every quarter and results for private markets on a semi-annual basis; finally, the minutes of the board of directors should be publicly available for public pension funds.
Second, financial audits conducted by auditors need to be augmented by comprehensive performance, operational, and fraud audits by independent industry experts. These audits should be conducted on an annual basis, and the results should be publicly available.
Third, pension plans need to implement sound risk management policies. Plan sponsors have a responsibility to communicate their risk tolerance for the overall fund, focusing on minimizing the downside risk in the policy portfolio. Importantly, pension fund managers should get compensated for active risk based on clear benchmarks that reflect the risks of the underlying investments, i.e. risk-adjusted returns.
Fourth, whistle-blower policies need to be strengthened so whistle-blowers are encouraged to come forth and disclose any wrongdoings at public pension funds.
Fifth, regulatory authorities need to augment their resources to deal with the challenges at private and public pension funds, as well as other institutions of the shadow banking system; for example, insurance companies and unregulated hedge funds. It is time for the Canadian government to invest more in bolstering regulatory bodies so they can attract more qualified people who understand the increasingly complex investments that these institutions are investing in.
Finally, I have not discussed my thoughts on dealing with the crisis at private pension plans, but my thoughts are that we need to seriously consider scrapping private defined benefit and defined contribution plans, replacing them with a series of large public defined benefit plans that are subjected to the highest governance standards.
I thank you for your time and welcome your questions and comments.