ED HARRISON: Welcome to Real Vision Access. I'm your host, Ed Harrison. And in today's episode, we have Leo Kolivakis, who's coming to us from Montreal. He is the founder and the editor of Pension Pulse, a blog all about pensions. He has a long term career in pensions, knows this space inside and out. And we're very happy to have him talk to us in particular, from my perspective, because I think that in the next downturn, we're going to have something akin to a retirement crisis that's going to be centered around pensions-- they're underfunding. And we really want to pick Leo's brain about what that involves. Leo, thanks for joining us.

LEO KOLIVAKIS: Thank you for having me, Ed. It's a pleasure for me to be here on Real Vision. And I hope we have a great discussion on pensions and markets today.

ED HARRISON: Yeah, you know-- by the way, actually, before I start in there, a lot of people have been commenting about the my mic. And hopefully, my mic is fixed. If anyone has any thoughts about whether it's fixed or not, let me know in the comments below. But Leo, let me start off here, because my comment before was about the fact that in the next downturn, we'd have a retirement crisis because of pension underfunding can you frame that issue for us? Is that actually true? How do you see it?

LEO KOLIVAKIS: So we're going into a big discussion here. Let's go back to the 2008 crisis, which I call the perfect pension storm for pensions. Why was it the perfect pension storm? You had two issues going on-- a big hit and assets, as well as a significant decline in interest rates. Now from those two things, the most important thing that people should keep in mind when thinking about the funded status of their pension plan is where are interest rates going. Why is this important? Because the liabilities of pension plans typically go out 75 to 100 years, so the duration of liabilities is a lot bigger than duration of pension assets.

And what that means is when interest rates are at an ultra low level like here and they decline, the decline in interest rates has a much more pronounced effect on liabilities. So even if assets like this here's a perfect example, S&P is up 28% total return each year to date, but the decline in long term interest rates has pushed the liabilities up. And what that means in effect is when interest rates are at a low level and they decline, the effect on liability swamps any effect on the increase in assets. This is why since March 2009, you've had the greatest bull market in US equities. However, the underfunded status of many state and local plans remains low.

In fact, I was reading data from the 2017 Pew Charitable Trust-- the data that shows that the underfunded status remains around 73% funded [INAUDIBLE]. That means they are underfunded by a certain amount. And that tells me if we do get into a protracted crisis-- and this is an important thing-- if it's not a 2008 V type recovery, but a L type recovery, where you go down and you stay down for a long time, and interest rates stay low or go negative, god forbid, we are going to run into massive, massive problems, because the starting point matters.

And if many US pension funds, which are already chronically underfunded, meaning for me, chronically underfunded, means their funded status is below 50%, they don't have the required assets to meet the long term obligations-- well, that means we can run into a scenario where they are declared insolvent. And then we run into the political game of who's going to bail them out.

ED HARRISON: Right.

LEO KOLIVAKIS: There's no doubt in my mind-- I think grow Raoul Pal talked about this as well-- there's no doubt in my mind that they will be bailed out if a crisis comes. But make no mistake, bailing out state pension funds, there will be significant haircuts as long as well benefits, right? So I think people think, oh, it's fine if they're bailed out. No, it's not going to be fine. There will be massive repercussions if they're bailed out by Congress.

ED HARRISON: So let me ask you here-- let me cut in there and take a look and ask you about the liabilities versus the assets side so everyone understands what you're talking about. So now on the liability side, that is what the pension fund has to pay out-- we're talking about defined benefit pension plans. When the interest rate goes down, all of those future payouts become more in terms of a net present value terms-- that is, in today's money terms, is that right?

LEO KOLIVAKIS: Correct. So the discount rate when the interest rates decline-- the discount rate that you're discounting those future liabilities falls and the present value of those liabilities significantly increases, again, because the duration of those liabilities is a lot bigger than the duration of pension assets. This is why in Canada, a lot of the pension plans, many of which, by the way are fully funded-- we'll get into that after-- have started moving away from bonds to invest in long dated assets like infrastructure, where they can have a better match duration match between their assets and liabilities, and also get the requisite return-- real return they require-- to meet those obligations in the long run.

The difference, though, in Canada versus the US is the discount rate that Canadian pension plans used to discount those so liabilities is significantly lower than the ones the US state plans use. In the US, they use an assumed rate of return to discount their future liabilities. It used to be 8%, now it's fallen to 7.5%. Some of the bigger plans like CalPERS dropped to 7%, and I think that's still way too high.

And basically, they will, in my opinion, have to drop it even more going forward, because the returns are not going to be there. Just look at where US 10 year yields are right now. Even if you assume a 4%-- and this is what the CalPERS CIO, Ben Meng was saying recently, and I covered this-- even if you assume a 4% risk premium on stocks, he's saying I still eed 150 basis points to reach that 7% long term target.

And I wrote a comment recently saying that US stock price should drop that 8% pipe dream. They're not going to get 8% over a long run. And they should really start using a lower discount rate. Now the problem is if they choose a lower discount rate--

ED HARRISON: Let me interrupt you here again and ask you about in terms of these pension companies that when you're talking about these yields being low, convexity is a problem there as well in terms of the duration. Can you give me a sense of this duration mismatch, what we're talking about in terms of asset duration versus liability duration? And how low interest rates play into that?

LEO KOLIVAKIS: Well, like I said, we know that the duration of assets typically are a lot lower than duration of liabilities. Liabilities in the typical pension fund will go out 75 to 100 years, right? Duration of the assets are a lot lower. So even if you are--

ED HARRISON: How low is-- what kind of [INAUDIBLE]?

LEO KOLIVAKIS: On average, I would say, 20 to 25 years, right? 25, [INAUDIBLE]-- you have a big duration mismatch. This is why I keep harping on his point. Pensions-- and this is the most important thing that your viewers should get in all this, is pensions are all about matching assets of liabilities. It doesn't matter if your pension plan is up 20%. If their liabilities are up a lot more, well, guess what, the funded status of your pension fund is going to deteriorate. And this is the most important critical point that people always miss the [INAUDIBLE] is not just liabilities. It doesn't matter what the return is as long as the funded status is 100%. And that's the critical point.

So if you're already in a low interest rate, ultra low interest rate environment, as we are right now, and interest rates drop, well, guess what, that duration effect is even more pronounced for the liabilities of these pension plans. And you will have--

ED HARRISON: Because of the convexity-- that is, the duration of those liabilities is falling more rapidly than you would anticipate if interest rates were higher.

LEO KOLIVAKIS: Right, correct. Correct. So the best thing, the best scenario for pension plans is we get a massive inflationary push, and inflation comes back, and interest rates go back to 6%. And therefore, the liabilities will significantly decline. Even if their assets are not doing as well in an inflationary environment, as long as those liabilities decline by more, it doesn't matter. You understand that it's all about matching the assets, liability, and duration effects of these liabilities are extremely important.

ED HARRISON: You know, the elephant in the room here I think that a lot of people think about is the concept of defined benefit versus defined contribution. That is that in the US, more and more people are doing 401(k)s, which is defined contribution. And so then they say, this doesn't really matter. You know, who cares? This is a smaller subsegment of the pension market. What's your response to that?

LEO KOLIVAKIS: So it's the wrong way of thinking and I'll tell you why. Yes, it's true-- most companies, by the way, have been dropping their defined benefit plans, shifting workers over to defined contribution plans. All that does is shift the retirement risk from the companies onto the employees, right?

The second thing I would say to that is yes, most people don't have defined benefit plans. If you're not in the public sector or if you're not part of the lucky few that still have DB plans and you're a corporation, well, guess what-- it doesn't matter, because you will get hit in other ways. And this is very important so that you can understand this.

From 2007 to 2017-- I'll give Illinois as an example, one of the worst funded state plans. The contributions went up over 400% in a span of a decade. When the state has to contribute more to make sure that these pensions are solvent, they have to get that money somewhere. And where are they going to get it? Guess what, they're going to increase their real estate taxes, which is what's been going on a lot of states.

So it's sort of like I call this a stop effect. People are watching their real estate taxes go up, and they're like, why are they going up? Part of the reason that went up is to meet the obligations of the defined benefit pensions that these states have to meet. And to meet those obligations, they have to contribute more. Obviously, there's a limit to how much they can raise real estate taxes, which is why I think there has to be somehow, a major shift that grows on the US to change the way public pensions are managed. And I would like them to shift more and adopt the Canada model.

And what I mean by that is I would like the government to not interfere in state pensions whatsoever, and to have these state pensions managed like businesses, where they have independent boards, they hire qualified people, and they are able to get the best of the best to manage assets internally across public and private assets, public and private markets. But to do that, you need to get the government out of there, and you need to get everybody on board. And politically, I just don't see that happening in the US.

ED HARRISON: And also, you also have the underfunding, which you have to take into account ahead of time. Before we move to that model, wouldn't you therefore need to top off these funds so that they have some requisite amount of funding level, let's say 90%, 95% before you move to that, so that you're not starting from a position where suddenly, you have a wholesale uptick in cuts to services or increases in taxes to make up for the shortfall?

LEO KOLIVAKIS: Well, I don't know if you need-- I wouldn't agree with you on that. But you need to move back to fully funded status to shift the governance of these state plans. I think you could do-- you can tackle this pension crisis in a multi-faceted way, i.e. start changing the governance. Start adopting, for example in Canada, we have conditional inflation protection. So if Canadian pension funds for any reason-- and they have, by the way, suffered deficits in the past-- what they do is they will either partially or fully inflation protection on the benefits side for a small period of time until these funds are fully funded again. And then they will v and maybe even give back that money once you reach the fully funded status.

The reason they do this is very simple. It's a way to share intergenerational equity among active members and retired members. In many of these plans, which are mature pension plans, are more retired members than active members. So the fair thing to do is to share the risk of the plans equally among active and retired members.

ED HARRISON: That sort of gets back to what I was saying, though. What I'm saying is that basically if you're so underfunded like Illinois as an example, then you're moving to a much more responsible model. Almost immediately you have this hit. And if the more responsible model is there, the hits are going to be extreme in terms of the where you're coming from. Or you're going to have to make the transition over a very long period of time, where you're moving up 3% per year over a 10 year period or over a seven year period. Because if you're at 55% funding level, Kentucky or Illinois or New Jersey, it's a big problem.

LEO KOLIVAKIS: It's a huge problem. And unfortunately, what politicians are doing is-- for example, in Kentucky, they started trying to move more and more new employees over to defined contribution plans, but as we discussed before, that's not the solution. That's only going to aggravate the retirement crisis over the long run.

What you're saying is basically if we move-- and you're right, maybe we can start fixing some of the structural issues in expansions, i.e. adopting conditional inflation protection. But to do that, you have to get the unions on board, and a lot of these unions are dead set against anything that affects their benefits. And constitutionally, they are constitutionally protected on this front. And when you try to lower their benefits in any way, shape, or form, there's a huge backlash.

So I think you're right that you have to start somewhere. But I also believe part of the long term solution to the US trauma crisis is the governance of state plans needs to change-- fundamentally change-- and it needs to be moved or to adopt what I call the Canada model, where our defined benefit plans are quite honestly, the best in the world. Our retirement system is not the best in the world because we don't cover enough people in Canada as we should. However, there is no doubt in my mind are large pensions, public pensions, are the best in the world because they are run like businesses and they attract the best of the best pension fund managers who are able to invest internally across public and private markets, lowering the costs. And the long term performance actually bears out what I'm saying here.

ED HARRISON: We're going to get to that, but I actually have a question here from Tobias. It goes to exactly the conversation that you and I were just having, Leo. He says, do you see any pensions being fully funded in the next five or 10 years? Will we look back and think that this stretch into private equity was a bad idea? And let's break that down into two segments. There's the one where he's suggesting maybe it's a five to 10 year stretch here going forward. And they wouldn't still be fully funded. And then the second part is basically, people legging into private equity potentially at the wrong moment in time.

LEO KOLIVAKIS: So let's take those two questions apart, you're right. First, Tobias, I'm going to say something to you. There are state plans that are doing well. I don't want to paint a negative picture across all the states. For example, Wisconsin, one of the best state pension funds in the world-- sorry, in the United States-- is I believe, fully funded or close to being fully funded. So we need to study why is that the case. Well, they've adopted some sort of risk sharing in their plan, that's one of the main reasons why.

The state has always been topping up the pensions. They didn't take any contribution holidays, as many of these other states have done, which exacerbates their pension deficit over the long run. They're well managed, they manage more assets internally. And I would say even the CalPERS and the CalSTRS of the world, even though they're 71% funded or lower, they're not in terrible shape at all. And they're run by very, very qualified people as well. They understand these problems and they are trying to address them.

The problem is the politics, right? I mean, there's always this tension with unions and governments that don't want to contribute more to their pensions. But unfortunately, you're going to have to contribute more to these pensions one way or the other. Because if for any reason they become insolvent, well, guess what, the creditors are going to take over or something worse is going to happen. There might be a bailout, but with significant haircuts to the benefits.

So it's in everyone's best interest that these state pensions are managed well. Now let me get to the second part of this question, the private equity. I believe like Ben Meng, the CIO of CalPERS, private equity is in my mind, the most important asset class to all pensions. Why do I say this? Because not only have the historic returns proven this, private equity is where there are still in the private markets, a lot of inefficiencies that can be exploited. And if you have the right partners, you can definitely make your return objectives through this asset class.

The problem is, and this is something that the Federal Reserve Boston recently came out with a paper saying a lot of state plans are going up, more and more out on the risk curve, taking increasing risks in a lot of the alternative asset classes. And they're right in the sense that they have to take this risk, partly because the Fed has interest rates so low. So the irony in all this is you have the Federal Reserve of Boston saying, be careful, you're going out on a risk curve to make out your return objections. But on the other end, these state pension funds don't have a choice but to take risks.

It's in the way you take these risks. And this is very important. I'm going to explain something to you that's going on in Canada. In Canada, we do invest in the top private equity funds in the world. However, we also have large co-investment programs, where the general partners of private equity funds come to the pensions, and they say to them, listen, we'd like you to invest on this transaction. And on co-investments, they don't charge you fees.

So if you have the right team internally, and Canadian pension plans do-- they have qualified people are able to analyze these large transactions very quickly, turn around, go to [INAUDIBLE] saying, yes, we're going to invest in this with you, co-invest alongside you. And in