:LPE:

Here’s an interesting microcosm of several issues in corporate Canada today. Algoma Steel, of Sault St. Marie, was effectively insolvent in the mid-1990s when it dumped its pension plan and restructured its operation — including a greater role for unions and employees in management. It is the third or fourth largest steel producer in Canada. It restructred again most recently in 2002. In other words, it has been in and out of trouble with the banks, bondholders and employees for a good long time.

During the past two or three years, the steel industry has been consolidating as demand for steel in India and China has fueled record profits, and these have helped to finance mergers, especially over smaller or insolvent producers. For example, Dofasco was recently bought by Arcelor (France) who was recently the object of a hostile take-over by Mittal (India). Stelco is still emerging from insolvency.

Algoma is awash in cash. It paid out a special dividend in 2005 to its shareholders of close to $470M. It is retaining another $200M in earnings. (Note, it has about a $100M liability in its pension fund). One of its major shareholders, Paulson, runs a hedge fund and is trying to find ways to cash out its position. It wants another special dividend. Meanwhile, potential buyers have not yet bought Algoma, but there is clearly a consolidation happening, and largely or entirely run by foreign owners. Management here is under pressure to re-invest money in the physical plant, in the pension plan, and in the employees. Management passed a “poison pill”, the terms of which I am unfamiliar with, but which would make hostile take-overs difficult.

You can see the issues. Will it be another example of “hollowing out” of corporate Canada? As long as management remains Canadian, it can resist the demands for dividend payouts to foreign shareholders over domestic spending priorities. Can it survive in a consolidated industry? Steel was in long, long decline before the recent surge in demand by two particular economies. Algoma sells largely into the US market. Activist shareholders are a mixed blessing for corporations: it depends on their particular brand of activism. Some wish to reduce executive pay or improve working conditions. Others wish to disgorge the corporation of profits. Shareholders argue that their value has not been maximized, and the poison pill is bad governance.

Paulson took Algoma to court to try and force a new date to the shareholders meeting to consider annual business, and to request them to vote on a proposal for a new dividend payout. Algoma resisted, and chose March 22 as the date for the meeting in order to obtain an income tax ruling on the effect of the dividend proposal. Paulson argues that the Board’s last payout cost US (and all foreign) shareholders too much tax. They believe the Board is incompetent for not making more shareholder-friendly policy.

Stay tuned after March 22 for the results of the shareholder vote…

The banks have begun to release year-end financial statements, and as part of that ritual, we begin to hear about executive compensation. A good time to ponder exactly what gets compensated by these grostesque packages.

Perhaps the most egregious example today is John Hunkin’s take-home pay for nine month’s work this year, ending in August: $3.75 million, and $25.7 million in deferred share units (a form of stock option), which had accumulated over his time at CIBC. His actual compensation for the 2005 year was only $750,000 and $3 million in options. Hunkin’s major achievment over the past several years was overseeing the loss of $3 billion dollars in a settlement with Enron investors, after first failing to identify anything wrong with the Enron deals CIBC was conducting. Even this compensation was reduced from his original entitlements, which were in the neighbourhood of $50 million. Someone should force him to pay it back.

Let’s see if I can make a comparison. I might make $100,000 in salary and benefits working at a law firm. That is a lot of money for most people. I think the average household income in Canada is in the neighbourhood of $70,ooo. If I were John Hunkin, I could lose my law firm $8 million (or 80 times my salary) through utter negligence, and then get a bonus for doing it. If I lost the firm $8M through poor decision-making, they would be more than justified in firing me and suing me for damages. Clearly, different rules apply to the Hunkins of the world.

Executive compensation is considered by governance critics and securities litigators to be linked to accounting fraud and other forms of securities fraud and general corporate governance problems. Shareholder activists are consistently recommending some of these options plans be ended. Executive compensation has increased far more quickly than the compensation of average workers over the past 20 years. Michael Decter wrote a book tracking the rise of the new “owner-managerial” class who have effectively awarded themselves ownership positions in the businesses they were hired to manage as employees.

Executive compensation highlights many problems with the way we arrange our economic activity, especially via corporations, from the old Berle and Means insight about the separation of ownership and management to the difficulty in pricing stock options through the Black Scholes formula. What hasns’t changed is bosses getting paid for screwing up and workers not getting paid enough for doing a fair day’s work.

It has been conventional wisdom in the investment world that dynamic equities outperform stodgy bonds over the long term. Bonds were considered secure, but at most index-based investments, and equities, the place you could outperform market averages. For some reason, actuaries thought it was a good idea to base their models on this wisdom. Then, about a decade ago — it may be 15 years, Zvi Bodie, a professor at Boston University, asked whether that wisdom was really true. His studies, along with a small group of finance economists, found that it wasn’t, and that in fact, sometimes the opposite was true. Well, suddenly there was an elephant in the room.

We’re seeing some of the results now. Actuaries are debating whether or not to change their investment models, and therefore, their recommendations about valuation of portfolios and plans to their clients. Their clients, which include some of the largest institutional investors in the world, are starting to shift — massively shift — the way they invest in capital markets. There will be implications for the legal standards and the regulation applied to pension, insurance and mutual funds. The legal texture of regulated investments is about to become thicker, and much more complicated. Some issues include:

+ how does this insight affect tradtionally ‘passive’ investors?
+ what is the new standard of prudence and prudent investing implied by these changes in basic assumptions?
+ when and how may regulated industries use traditionally complex and risky assets, such as derivative swaps?
+ where will the supply of long-term instruments to match long-term risks come from?
+ from a “liability driven approach” to investing, how can risks out at the extreme end of the horizon (50 years) be managed?

The Economist has summarized some of the main issues in this new movement.

The Economist reports on some modelling by a professor in Indiana who has found that a good three-quarters of equity purchases on open markets are “passive”, that is, they are picked as part of a portfolio, an index, or some group of equities intended to track the broad movement of the market.

This should not be surprising given the mandates of the largest equity investors in the capital markets: pension, insurance and mututal funds. Each of these is under some form of legal duty to invest prudently, which has historically been interpreted as passively and conservatively. PAssivity is many thigs, but in one important sense it is a measure of the appetite for risk. This appetite may be slowly changing, but it still remains largely true. Put plainly, would you want some spotty math whiz graduate student speculating with your retirement savings on derivatives in the Nikkei Index?

See the author’s website here. See the Economist’s take, here.

The Bush II goverment has proposed a ’solution’ to the rising costs of health care plans in the U.S.: private savings accounts. The New York Times sets out the major aspects of this new policy proposal. The basic idea is that people can put savings into accounts that are protected from taxation, until they are spent on health care costs. It is the same scheme used to fund retirement savings (known as 401K in the U.S.) and the equivalent of a Canadian R.R.S.P.

Where to start? Most people in the U.S. receive health care benefits through employer-sponsored health and benefit plans. Some receive it through Medicaid, public insurance plan for low-income individuals. The problem with this system is that employers — especially large employers of aging, unionized industries — have seen the costs of providing health benefits increase for the past 20 years, and they are no longer willing to provide these health benefits. This leaves former employees — many past working age — without health insurance. If you’ve ever broken a leg hiking in Montana, or had a car accident in New York, you know that it can set you back $20,000, or more if you require significant hospitalization. Most people don’t have that in available savings.

Where do rising costs come from? We don’t know for sure, but certainly three primary candidates are patented prescription drugs, physician salaries and administrative costs of health service providers.

The Bush II solution to this problem is to pretend people have enough savings to put in tax-deferred accounts to deal with future medical costs (which won’t solve the problem of medical costs or replace the loss of employer-sponsored plans). Co-incidentally, setting up an entirely new asset class will provide a massive new revenue stream (business opportunity) to Wall Street banks and insuance corporations, who would administer such health savings accounts. The administrative costs of this system are far in excess of a national single payor insurance scheme.

Conclusion? This is not about providing more health care, it is barely about pre-funding health care costs (in the same way we pre-fund retiurement costs), it is about providing a new way for banks to charge you fees to save your money. Lots of fees, little money.

I need some programming help. I’d like to create a little program that would: (1) receive a daily e-mail from Google News Alerts for a given keyword; (2) count the number of hits listed in the Google News Alert; (3) create three simple outputs: a line graph charting the incidence of the key term per week, month and year, as the data becomes available.

You see where I’m going with this: tracking the frequency of use of a key term, concept or, as the evolutionary theorists unapologetically say, meme. How irresistable (if crude) a tool for the analysis of mass discourse patterns: to see the relationship between the popular use of a term, (e.g.) “recession” and the more systematic metrics of that phenomena from traditional statistical sources (e.g., two consecutive quarters of contraction in GDP). We might even ask, which comes first?

Suggestions?

Some more data-bytes on pension plan use in the U.S. This time a small chart on retirement income sources/trends. You can see that today, retirees (on average) in the US obtain about a quarter of their retirement income from public (government) sources, and three-quarters from various forms of savings, including private pension plans.

The numbers in Canada reflect a larger public system. Canadian retirees obtain about a third to a half of their retirement income from public sources (not shown on graph).

These averages mask another important feature, though, and that is as you move up the income scale, the proportion of public:private income sources diminishes. As you might expect, rich people get more private income than poor people. The flip side of that is that working class people rely more heavily on public pensions than do their bosses, and so for the lower income persons, public pensions may provide over half of the total income in retirement.

In both systems, however, it is important to note that private pension provision plays an important role as income under the present configuration.

It’s like watching a car accident in slow motion. Gory, but fascinating.

Paul Martin, the Once and Future King, announced in public debate that in order to differentiate himself from pretenders to the throne, he would amend the constitution. And not just amend it, but eliminate the feared “notwithstanding clause”.

Yes, that’s right. Mr. Dithers is attacking top social priorities. He is not going to end poverty, he’s by-passing the trees, glossing racial harmony and ignoring women’s equality. He’s even avoiding his favourite places to poach ideas, and not lowering taxes or privatizing government services. He’s going to amend the constitution. What the hell is he thinking? Is he thinking? As an election promise, he would embroil us in an un-achievable policy debate with no tangible real-world outcomes.

What a strategy! I must know the name of the genius who thought this up. Can you imagine the planning conversation. Let’s see, the Man will be on national television, total audience, somewhere in the millions, maybe the most exposure he will get in a single live appearance for the rest of his life. Legacy time. Time to give people a reason to want him to stay around. Let’s roll out a … constitutional amendment. High five! We are going to RULE.

Just for clarity: in the world of soundbites, the total effective target audience who understand the allure of policy initiative: 200 consitutitonal law academics, maybe 2,000 all told including political science wonks and miscellaneous polymaths and afficionados. Total who can connect this to any practical agenda: less than 1000. Total who believe that a constitutional amendment can even be achieved (remember Meech Lake?): big, fat zero.

Not even Paul Martin thinks he can pull off a constitutional amendment. He hires lawyers. He may even be one. And a first year law student can tell you, each of Quebec, Ontario and Alberta effectively have “vetoes” to constitutional amendments, so all three would have to agree. Both Quebec and Alberta have the most to lose by eliminating the notwithstanding clause. And now the Supreme Court of Canada has permitted, even encouraged the introduction of private health insurance plans, the notwithstanding clause looks pretty good to me too.

I hadn’t expected the election to end this early. But now that it is over, let’s see, what would a Harper cabinet looks like…

The Globe and Mail has advised us of what the Editors deem to be the missing debate in the election: the so-called productivity gap.

Don’t be fooled — it is a bait-and-switch. There may be a “productivity gap”. If there is, the Globe’s fix is typically one-sided and unlikely to fix it as much as transfer money to the already-wealthy.

This issue lurks each year on business pages, just waiting for a chance to pop up and justify the economic policy decision du jour. A detailed discussion is beyond a single posting, but some points to keep in mind.

+ Productivity is considered good because it means more things get produced by fewer resources, and therefore, there is a more efficient production process and more produce for consumption.

+ The Globe conflates productivity (output per units of input, where output is goods and services and inputs are labour, equipment and capital) with labour productivity (output per hour of labour input). They are different. To increase labour productivity, you only have to reduce wages, or let them be eroded by inflation. You can guess where this goes.

+ Query whether one simple cause of lower productivity — higher wages on one side of the equation, or higher capital investment per worker — are bad things. Although the ratio of product to inputs lowers, wages and capital investment are often considered good for economic growth as a whole.

+ The particular mix of capital and labour being more efficient can also be tricky. Did computers (capitsal investment) make people more efficient per hour worked? Difficult to measure that in a single variable, let alone an economy.

+ Historical measurements of productivity average 3-4% annually before 1980 and 2% or less in more recent decades. Put any measurements you hear in that context. We still don’t know if there is a limit to increases in efficiency; an implied reduction in increases in efficiency gains as economies develop.

+ Canada’s rates of productivity are comparable to the US (although lower, generally, hence the “gap”) and even lower than other OECD countries. Query whether under conditions of globalizations, including wage competition and capital mobility, differential productivity rates can be sustained.

+ Equally, query what the role of the state is in ensuring productivity. The Globe recommends tax cuts and subsidies to corporate research and development budgets. How surprising. But we also know that corporations are awash in cash today (see prior blogs) and prefer to spend it on costly and inefficient mergers and acquisitions. More corporations than ever are owned by non-Canadian owners, who have no incentive to develop Canadian productivity fixes. We also know that much innovation occurs outside corporate research budgets, and inside public institutions. Better, surely, would be direct government investment to avoid leakage. However, that would be less market-driven innovation. How, then to innovate?

Mary Walsh in the New York Times is reporting a decline in the number of defined benefit plans, and a drop in pension plan provision to workers overall. There are so many issues to discuss here, but one in particular is the comment on corporate management’s ability to manage money.

Defined benefit pension plans are managed by the plan sponsors, in other words, the employers. Employers hold a pool of money (usually, contributed by the employer and employee), to pay out to retirees in retirement. This is the “deferred wage” bargain of an employee who accepts a lower wage today in order to obtain wages in retirement. Once saved, those wages are invested. In theory, defined benefit pension plans should be risk neutral for corporations, whose lives are indefinite. Some positive investment returns on good years will be averaged out with poor investment returns in bad years, and therefore risk is spread out across a larger time horizon. (Natural persons, however, cannot spread risk beyond their own natural lifetime).

As a result of this unlimited horizon, corporations (or governments) should be able to smooth out the risks of bad experiences in equity markets like that of 2000-2003. This should be an “expected” occurence that the prior run-up in the market was going to bring about. The run-up should average out the run-down.

However, during the run-up, people managing pension funds assumed that such run-ups would last a long time, and made unrealistic assumptions about future price-earnings rations, yeild on assets and future rates of interest. All turned out to be wrong.

Now, if defined benefit plans are being cut, then this is an implicit if not explicit acknowledgement that those managing the funds cannot be managed properly. No-one is surprised by this evidence. However, it is rarely the focus of commentary.

An even more cynical commentary might point out that wages concessions were given in the 1980s and 1990s, in return for a promise to pay pensions at a later date. Now plan sponsors are admitting they can’t pay the bill. Why they didn’t plan better to keep their promises is an important part of this story.

It is also useful to see the reduction in pension plans for what it will mean today: a wage cut. If corporations are suggesting pension plans are too expensive, they are suggesting employees are too expensive, both when they work and after they retire.