CFA Society Chicago Welcomes New Members and Recognizes Volunteers!


On Thursday January 28, 2015, the CFA Society Chicago held its annual New Member and Volunteer Recognition Party at the Chicago Athletic Association Hotel. The night was especially festive as attendees filled the room, networking with new faces and catching-up with returning volunteers; as the room dined on hors d’oeuvres and enjoyed a drink or two.

The purpose of the night was to welcome new members to the society and recognize the outstanding contributions made by current volunteers, as well as the Executive Committee, the Board of Directors, and Staff members of the CFA Society Chicago.

The highlight of the night began with the awards and recognition portion led by the CFA Society Chicago Chairman, Kerry Jordan, CFA. Kerry gave a wonderful overview of the event’s purpose and encouraged new members and current volunteers alike to continue to seek out the numerous volunteer opportunities within the CFA Society Chicago Advisory Groups.

  • Annual Dinner Advisory GroupDSC_2382
  • Communications Advisory Group
  • Distinguished Speaker Series Advisory Group
  • Education Advisory Group
  • Membership Engagement Advisory Group
  • Professional Development Advisory Group
  • Social Events Advisory Group

After the introduction and overview, the DSC_2371following volunteers were recognized for their outstanding contributions within their respective advisory group:

  • Bob Cohen, CFA – Communications Advisory Group;
  • Cosmin Lucaci-Oprea, CFA – Distinguished Speaker Series Advisory Group;
  • Thomas Gerald Hillman, CFA – Education Advisory Group;
  • Deborah L. Koch, CFA – MembershipDSC_2383 Engagement Advisory Group;
  • Larry Alan Lonis, CFA – Membership Engagement Advisory Group;
  • Michael Sullivan, CFA – Professional Development Advisory Group; and
  • Mark Cichra, CFA – Social Events Advisory Group.

Next-up was the recognition of the Advisory Group Co-Chairs. The co-chairs were recognized for their time, effort, and hard work while volunteering for within the advisory groups. In addition to applauding their contributions, each co-chair received an additional complimentary event ticket that can be used for admission to an upcoming CFA Society Chicago Event.

Things wrapped up with the awarding of numerous raffle prizes to the night’s attendees. Prizes included Starbucks giftcards, numerous restaurant gift certificates, and even an overnight stay at the Sheraton Chicago Hotel & Towers with a diner for two at Shula’s Steakhouse. In the end, the night finished just as it started, as a celebration with fun had by all.DSC_2385



Distinguished Speakers Series: Kyle Bass

China has been in the news lately, and for all the wrong reasons.

“A hard landing [in China] is practically unavoidable,” legendary hedge fund investor George Soros told Bloomberg while attending the annual World Economic Forum meeting in Davos. “I’m not expecting it, I’m observing it,” he said.

The Chinese government, facing malaise from many angles, issued a swift rebuttal to the investor responsible for “breaking” the Bank of England in 1992, saying that “Soros’ challenge against the renminbi and Hong Kong dollar is unlikely to succeed, there is no doubt about that.” The People’s Daily, China’s Communist Party’s official newsletter, went a step further with the anti-speculative rhetoric and ran an article titled “Declaring war on China’s currency? Ha ha.”

You can add hedge fund manager Kyle Bass to the growing anti-renminbi chorus. Linking the current trouble in China’s stock market to origins in its banking system, Bass gave a sweeping overview of China’s banking system, its growing book of non-performing loans and the potential impact of a Chinese currency devaluation on the global economic system.

Kyle Bass, founder of Hayman Capital, came to the financial world’s attention in 2007 as one of the first financiers to make a fortune on shorting low quality pools of mortgages. The short subprime bet earned him a massive 212% return that year. Further public recognition came from Michael Lewis’ 2011 book Boomerang which examined how cheap financing around the world led to the global financial crisis. It featured Bass prominently as an investor who confidently understood what was going on, and was able to capitalize on it. One anecdote in the book described how Bass bought a million dollars’ worth of nickels from the Federal Reserve, with the belief that the meltdown value of the metal was actually worth $1.36 million. How did he explain the strange, enormous purchase of nickels to the Fed?

“I just like nickels,” he allegedly told them.

Before his speech, Bass quizzed luncheon attendees at the VIP table with the seemingly innocuous question: “Who knows how big the Chinese banking system is?” As we sat there stumped, he laughed and said “Come on, you’re CFAs, you should know this!”

Kyle Bass 1

Kyle Bass, Hayman Capital, speaks to local financial professionals at The Standard Club on January 26, 2016.

After a brief lament about the lunacy of visiting Chicago in January, Bass quickly cut to the chase with his thesis: China will go through a non-performing loan cycle, and the People’s Bank of China will be forced to devalue their currency. Hardly anyone knows how big the Chinese banking system is, Bass said, and understanding its size and the volume of non-performing assets relative to GDP is key to understanding the direction of the Chinese currency.

Just how big is the Chinese banking system? According to Bass, there are $30 trillion in bank assets on the books, and another $5 trillion in assets off the books, for a total bank asset to GDP ratio of 350%. This is roughly double the level of US banking assets to GDP before the financial crisis. If non-performing loans reach 10% at Chinese banks (that level was as high as 30% in 2001), that would represent a loss of $3 trillion, which is roughly the total level of China’s foreign exchange reserves held at the People’s Bank as of January 2016. China’s currency reserves continue to shrink as capital flows out of the country, and its central bank recorded the largest ever drop in reserves ($107.9 billion) in December 2015. If only 4% of Chinese citizens were to withdrawal the maximum $50,000 allowed, that would vaporize the entire pile of China’s $3.3 trillion in FX reserves. Many elite Chinese are already taking capital out of the country as quickly as possible and are looking to buy real assets with cash flows such as movie theaters, hotels and properties in Vancouver.

The capital flight out of China takes place at a time when China is experiencing its lowest year-over-year growth since 1999, and may actually be as low as 3.6% (Hayman Capital’s estimate). Bass sees six distinct crises currently taking place within China:

  1. A stock market crash
  2. State-owned enterprise transformation
  3. An export-led industrial economy facing a shaky transition to a service-based economy
  4. Declining excess reserves
  5. Property problems
  6. Lack of confidence in the government’s ability to solve the above problems

If non-performing assets rise, that will require a recapitalization of China’s banks, which will stymie new loan creation and push the central bank closer to a large Chinese Yuan devaluation. The devaluation may exceed 15%, and Bass believes that it will likely take place overnight, as a last resort by the bank once its back is up against the wall.

What does that mean for the American investor? A hard landing in China could sap as much as 100-150 basis points from GDP from the US, according to Bass. Although US stocks may decline, Bass doesn’t forecast a huge crash, but there certainly will be deflationary pressure coming from China as a result of the devaluation. The best way to play a potential currency devaluation is by shorting Chinese renminbi, but this is a difficult exposure for an American retail investor to achieve. The best available proxy to individuals may be Hong Kong assets, which are more liquid and tradeable.

Regarding commodities, Bass believes that we are close to a bottom. He drew a line in the sand for oil and said that “a drill bit doesn’t hit the ground at $25”. Bass thinks that the CRB Index may bottom within a few months, but it would not be a good idea to go long oil ahead of any Chinese currency devaluation. The aftermath of that event could represent an attractive opportunity to add to commodity longs. The supply side will resolve an imbalance on its own as lower price levels make it unprofitable to mine and drill, but the demand picture is harder to assess. Bass is unsure how commodity demand in China, a top consumer, would be affected by a large currency devaluation. He thinks bonds still look relatively attractive despite their low yields.

Bass finished his speech with a story about a meeting between former Chinese president Hu Jintao and George W. Bush. It was difficult for the two leaders to get time completely alone. In the moment they had together, Hu Jintao privately confided to Bush that his biggest fear was “creating 20 million jobs a year”. This may prove problematic for China’s current administration as it faces its biggest test yet.

Distinguished Speakers Series: Jason DeSena Trennert


Jason Trennert – Strategas Research Partners LLC

Jason DeSena Trennert provided his thoughts, observations, and market predictions for 2016 to a sold out audience at the Standard Club on January 13th.

Trennert first addressed the drop in the market that coincided with the start of the year. He noted that historically the first weeks of January are generally a poor predictor of total year performance. He then addressed recent market commentary suggesting the United States is headed for a recession. There are three things that can create or cause a recession:

  • Inflation
  • Policy errors (think of the Japanese government raising taxes in 1988)
  • Exogenous events (oil embargo)

While not agreeing with current fiscal/monetary policy, Trennert did not consider the current policies so bad that they would push the country into recession, and with a current inflation rate around 5%, he found no reasonable catalyst for a 2016 recession. Trennert asked rhetorically why do people feel lousy and think the outlook in the near term is for a recession when we have; a continuing fall in unemployment, wage growth acceleration, and lower oil prices? The short answer is the 24 hour news cycle that focuses on the negative and unlikely (such as 2016 recession) instead of the longer-term view of expected growth.

Expanding his point of view on monetary and fiscal policy, Trennert pointed out an inefficient policy mix. Over the past eight years the Fed has used an easy monetary policy, while fiscal policy has been that of tight regulation brought on in large part by Dodd/Frank legislation. This combination has favored financial risk taking over economic risk taking or capital investment. In this period companies have received more credit for uses of cash that were more accretive (share repurchases and M&A) than they have for long-term investments like capex. Frequently changing government policies make long-term planning difficult.

Trennert 1Trennert also provided his thoughts on why the stock market will likely go up in the next few years. The number of companies listed on U.S exchanges has fallen from over 8,800 in 1997 to 5,300 in 2015. Simple supply and demand could provide the continuation of the rally of high-quality stocks. Today there are simply fewer stocks being chased by more dollars. Why aren’t more companies going public? Regulatory costs of being a public company along with the growth of the private equity industry could account for the relatively small number of companies deciding to go public.

The audience was given the opportunity to ask several, wide-ranging questions including; what is the best catalyst for continued growth? Trennert – Tax reform (an overall reduction in the tax code) would provide the biggest, most effective impact to growth in the economy. Tax code simplification would provide companies certainty with regard to long term investments which would help spur economic growth.

CFA Society Chicago Book Club:

The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

The Entrepreneurial StateAround the time we read this book, a major global growth scare was negatively impacting the financial markets.  Examples were the China slowdown which weakened emerging market exports, Japan’s ability to stimulate demand after two lost decades, and the low inflation and growth coming out of Europe.  Growth is known to be export or investment led, but a traditional catalyst has historically been technological led innovation.  Looking at Europe over the past decade, there has been a lingering question as to why Europe has not been a major innovator.  Why has the US been a major leader in technological innovation producing companies like Google or Apple?  Where are the Silicon Valley’s of Europe?  Is it possible that government led European austerity could be a major contributor to stagnant growth?  The author thinks yes.

Austerity programs in Europe have led to reduced government spending and an expectation that the private sector is going to lead the way in innovation.  Looking at the US, and despite popular opinion, the high risk and innovative catalysts for growth have not come from venture capitalists or the private sector.  It has been the State.  Against popular myth, the State doesn’t just invest in infrastructure, correct market failures, take part in countercyclical Keynesian fiscal policies, or create the right economic conditions for the private sector.  The State has actually been extremely entrepreneurial and has led the way in nanotechnology, the internet, GPS, touch screen display, SIRI, green technologies, and biotech among other things.  The State is not at the back end of innovation but at the forefront.  The issue with the private sector is that they are quite focused on short-term profits and an eventual exit strategy which has put downward pressure on the time horizon resulting in shorter term 3-5yr projects rather than the high risk and highly uncertain 15 year projects which have produced the major growth catalysts such as the internet.  While 9 out of 10 high risk investments will fail, it takes just the 1 to more than offset the other 9 failures.  While that 1 positive outlier has handsomely rewarded and offset the unprofitable investments for venture capitalists, the reward to the State has come in the form of indirect taxation revenue which has been only a fraction of the total high risk investment return and has certainly not compensated for the high risk of these uncertain long term investments.  For more State run innovation led growth to continue, we need to find a way for the high risks to be rewarded without only the fractional indirect return of taxation.

The bottom line is that high levels of government austerity can significantly curb long term innovation and growth.  Especially considering that economies can’t rely on the private sector to invest in the high risk and uncertain areas that can be the major turning points or catalysts for growth.  If the State could have a much greater combined direct and indirect return on their investments, then perhaps the State would have a much greater pool of assets to invest towards high risk investments which could accelerate long term growth.


Upcoming Schedule:

February 16, 2016: The Age of Cryptocurrency: How Bitcoin and Digital Money are Challenging the Global Economic Order by Paul Vigna and Michael J. Casey

March 15, 2016: My Side of the Street: Why Wolves, Flash Boys, Quants, and Masters of the Universe Don’t Represent the Real Wall Street by Jason DeSena Trennert

April 19, 2016: While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis by Roger Lowenstein

To sign up for a future book club event, please click here:

CFA Society Chicago Book Club:

Rise of the Robots: Technology and the Threat of a Jobless Future by Martin Ford

Martin Ford, a software engineer by trade, projects a veryrise-of-the-robots-side bleak future for the working prospects of humanity.  In a world that sees its share of apocalypse futures through Hollywood movies and TV shows, one can easily dismiss the premise of his book as another alarmist tale.  However, as the reader pushes through the seemingly endless examples of worker displacement in global commerce, it starts to sink in that maybe we are in for a rough time.  With the arrival of self-driving cars, automated tellers, digitalized customer service machines, 3-D printers, computer written news articles, drone delivery systems, and robotic assembly lines one starts to wonder if there is anything that cannot be automated.  Even in our own industry robo-advisors and computer trading systems are burgeoning industries.

The cause of all this technological advancement, in Mr. Ford’s view, has been the shortsightedness of capitalists driven by extending their bottom line by cutting expenses, increasing productivity and demanding less expensive labor.  After all, in a demand driven economy what happens if there is no demand as individuals find themselves short on the resources needed to buy the goods produced?  This new economy is driving inequality and it will only continue to get worse.  Education has been no panacea as graduates find themselves prepared for a world in which their skills are no longer required.  The top will continue to grow and the masses will be left to fend for themselves.

The reality is that policy makers and regulators are woefully behind the curve, and given today’s dysfunctional governments, why would anything change.  His solution is for an immediate $10,000 minimum guaranteed income for all.  How that is the magic number is lacking in derivation, but he defends the concept in order to keep the demand engine going in a jobless future.  He highlights a large array of taxes to pay for this transfer of wealth (carbon tax, VAT, wealth tax, technology tax, etc.), and defends the transfer to face the oncoming scenario where a majority of the population is not working.    Although the large majority of the change is out in the future, say 2050, we need to start now to ease the transition, and give the policy makers time to adjust the income guarantee and tax structure in the future.

At the club’s meeting we shared our ideas of this potential new world.   We felt that the book was a bit short on detailed specifics, as Charterholders who crave detailed data generally are when faced with a conceptual thesis.   But overall we felt the time spent was very enlightening.

First we talked about the time frame, mostly agreeing that it usually takes much longer than experts, like Mr. Ford, initially foresee.   However, we had difficulty denying that in the far future his reality of limited workers (those to keep the technology running) would not come to fruition.   We discussed changes in our industry that were examples of technological change.  The group contemplated and had big discussions on how does society, and namely democracy, work when the vast majority of voters are not productive.   In a short term practical discussion, we talked on how to position investments to take advantage of the changing world.

This was the second book we embarked upon looking at the future of technology this year (the other being Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies written by Erik Brynjolfsson and Andrew McAfee – see previous blog), and each highlighted that the world was changing very fast and society needs to start addressing the changes.  We all agreed these are very important challenges and would recommend everyone to read one or the other to get a sense of the dynamics that are changing our world.

Upcoming Schedule:

January 19, 2016: The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

February 16, 2016: The Age of Cryptocurrency: How Bitcoin and Digital Money are Challenging the Global Economic Order by Paul Vigna and Michael J. Casey

March 15, 2016: Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control by Barton Waring

To sign up for a future book club event, please click here:

Corporate Tax Evasion or Avoidance?

On December 16th, CFA Society Chicago hosted a timely panel discussion focused on US corporate tax policy and how it compared to the tax policies of other nations.  The current policy motivates US companies to move profits to overseas subsidiaries where corporate taxes are much lower.  Corporate tax inversions may become more common; these will become an important political issue as the election year unfolds.

Mr. Graziano began the event with a presentation entitled “Corporate Tax Risk, The Thin Gray Line”.  He makes the case that US Corporate Tax Policy is not competitive on a global basis.  The US has not cut its corporate tax rate in over 25 years and has the highest tax rate (35%) of any developed country. This antiquated tax policy has motivated US corporations to take action to avoid paying tax in their home country.

The method whereby US companies are able to enjoy the lower tax rates of foreign countries has led to the storing of corporate cash in the country where the lower tax is paid.  Many multi-national US companies now have large cash holdings in countries other than the United States.  The ramifications of these large cash holdings being held abroad by US corporations was discussed at length in the presentation and during the panel discussion.  To repatriate the cash, US corporations would have to pay the 35% federal tax along with any state tax.

Panel Discussion:

Mr. Graziano began the panel discussion by asking if it thinks that US corporations have an economic (or moral) obligation to pay a repatriation tax.  The panelists were unanimous in their opinion that there is not an obligation.  The US has created its own problem in this regard due to its inability to reform these policies.

There was a brief discussion as to how a US value added tax (VAT) might help to replace lost tax revenue if the corporate tax rate was lowered.  The possibility of repeating another “one-time” tax repatriation holiday as was done in 2004 was also discussed.  The panelists were convinced that another “one-time” tax holiday would not solve the problem.  There was very little evidence that the US economy benefitted from the 2004 tax holiday.

Panelists were unanimous in their belief that the antiquated US corporate tax rate puts US corporations in a difficult predicament. Under the current laws, corporations are incented to move cash and business overseas to the detriment of the US economy.  In this environment, tax inversion transactions that make American companies subsidiaries of a parent company in another country can be expected to increase.

Unfortunately, there is no easy solution without bipartisan support for reform.

Ron GrazianoModerator: Ron Graziano, CPA

Mr. Graziano is a Director at Credit Suisse and serves as the Global Accounting & Tax Strategist with the HOLT advisory service of Credit Suisse.


Barry Jay EpsteinPanelist: Barry Jay Epstein, Ph.D., CPA, CFF
Dr. Epstein is a Chicago based financial reporting expert, author, and litigation consultant. In his work with Epstein & Nach LLC, he has consulted and/or testified in over 120 cases.


Anna GreenPanelist: Anna Green, CPA
Ms. Green is a Tax Partner with PwC Chicago’s Industry Tax Practice. She is responsible for managing a team of professionals providing tax accounting advice to large corporate clients.


Robert M. WilsonPanelist: Robert M. Wilson
Mr. Wilson is an investment officer and research analyst at MFS Investment Management. He is responsible for working with portfolio managers to integrate ESG (environmental, social and governance issues) into the investment decision making process

Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back under Your Control

Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back under Your Control

Book Recommendation: Waring, M. Barton. Pension Finance – Putting the Risks and Costs of Defined Benefit Plans Back under Your ControlNew Jersey: John Wiley & Sons, Inc., 2012. Print.

This article provides a detailed, technical overview of one of my favorite books on how to effectively manage defined benefit pension plans. M. Barton Waring does an amazing job of simplifying this highly complex topic while providing incredible insights—that every investor should understand—on risk and return. By the way, if you’re looking for information on how an individual can effectively plan and save for retirement (using 5th grade math), then I’d suggest you click here to readThe Retirement Lifeguard. 

About the Author

M. Barton Waring is a financial economist and lawyer, and an active researcher in pension finance and investing. He retired in 2009 from his role as Chief Investment Officer for investment strategy and policy, emeritus, at Barclays Global Investors. Mr. Waring is well known in the pension industry for his many thoughtful and often prizewinning articles. He serves on the editorial board of theFinancial Analysts Journal and as an Associate Editor of the Journal of Portfolio Management” (cover).


I highly recommend Pension Finance to you with its very timely guidance on the management of defined-benefit pension plans. Mr. Waring presents a complete treatment of the overall pension accounting system on a market-value basis for the purposes of improving plan management. Even if not adopted for financial reporting purposes, implementation of a mark-to-market based pension accounting system with a surplus optimization investment strategy could provide significant benefits to both labor and management. Waring also presents a thorough discussion of risk management and investment strategy. In short, with better economic information and more informed risk management strategies, better pension plan management decisions can be made and defined-benefit plans can be well funded and managed with lower risk.

The Need for Economic Pension Accounting Information

The following quotation aptly describes Waring’s view of the need for economic pension accounting information:

“While it may appear that going to market value accounting causes new problems for the plans, the fact is that it doesn’t – the plan’s status is what it is, regardless of the accounting. But economic accounting brings a benefit, a clear-eyed view of what is really going on in the plan, a means of understanding the plan’s true financial condition, a means of understanding the true cost of benefit changes, and a means of understanding the true level of contributions needed to support the benefit promises. It even provides a path to investment strategies that reduce risk to the deficit and to contributions. So while there may be short-term pain, the path to longevity for pension plans must include economic accounting and actuarial approaches. Traditional accounting and actuarial work held sway as plan solvency declined; the path back is to use better tools (225).”

The total unfunded pension plan debt for all plans (public and private) in the United States is estimated to be at least $4 trillion dollars (2). The size and complexity of this crisis as revealed through current actuarial and accounting methodologies have provided misleading information to both plan sponsors and participants. The fact that the pension funding crisis is as bad as it is should tell us that the current approach is not working. This is big money and it’s intended to be available to solve the most difficult financial problem that most people face during their lives: safely accumulating the means to retire comfortably after their working years are over (4). Clearly, these are significant issues for employers and employees alike and Waring provides an objective analysis that can assist in both labor negotiations (such as recognizing the Full Economic Liability which includes both off-book and on-book liabilities) and pension plan management. In addition, Waring outlines 22 Propositions which are important pension finance principles that may come as a surprise to many.

Weaknesses of Traditional Actuarial Asset/Liability Studies

Several of the traditional pension management tools have simply not delivered the desired results. Actuarial asset/liability studies have led to recommended portfolios of 80% equities and 20% bonds or 60% equities and 40% bonds (187). Yet, the portfolios do not hold enough long bond durations to hedge the liability which means that in declining interest rate environments the liability goes up dramatically while the value of the fixed income assets barley follow (188). On the equity side, these high allocations could increase your deficit by 10% of assets every time the market falls by 10% which adds significant volatility (146). The studies often over-complicate the analysis with Monte Carlo simulations which are misused as an “actuary in a box” (185). Waring explains that asset/liability studies are not needed as “surplus optimization” handles the investment strategy problem perfectly .

The Surplus Optimization Solution = LMAP + RAP

Surplus optimization controls the economic “surplus” (or deficit) of the plan. First, the interest rate and inflation risks of the liability stream (future benefit payments) are hedged through a Liability-Matching Asset Portfolio (LMAP). This is the single biggest risk management decision of the plan and hedging the economic liability can reduce over half of the variance of the plan (179). The accounting always follows the economics, if not sooner than later, and this approach will then significantly reduce the volatility in pension expense and contributions (20). Second, a Risky Asset Portfolio (RAP) can be added in a risk-controlled manner, if desired, but this is completely optional. One approach for the RAP would be to put in place an improved Dutch system: If the sponsor wants to invest in risky assets over and above an LMAP hedging portfolio, it must be fully funded – and then some. This policy can be improved by quantifying it: The cushion should be established relative to the surplus risk generated by holding the RAP in such a way as to manage the probability of becoming underfunded (261).

In developing the LMAP, you match the accrued liability’s total return sensitivity by matching (1) the dollar real interest rate duration and (2) the dollar inflation duration (147). This effectively provides immunity of the surplus or deficit of the plan to market risk and thus protects the funding level. In addition, it addresses a key goal of pension managers which is to stabilize the economic normal cost which is the expense accrued to the sponsor in this period for benefits that will be owed to employees at their future time of retirement and stabilizes future contributions.

Benefit Policy Drives Costs and Contributions (not discount rates)

The actuarial funding method concept is another relic of the past that should be eliminated. This approach assumed that future benefits would be paid out of contributions plus earnings on the investment. In reality, the funding method was a “balancing act” in which contribution levels were experimentally adjusted up or down while the “expected” rate of return assumption was adjusted up and down as well. The temptation was to select higher “expected” rates of return to reduce contributions as well as reduce the “valuation” of the liability (196). In short, the required rate of return should not be used for the management of the pension plan. When holding a LMAP, contributions are really just a function of the benefit policy plus or minus some minor gains or losses from the RAP (if held).

Adding Exotic Assets is Not the Answer

Waring makes a huge point of the fact that plan sponsors and strategists agonize over which new asset classes to add to their portfolios (e.g. hedge funds, venture capital, exotic beta classes, etc.). Yet there is no “magic” asset class that always goes up and that you are able to accurately choose in advance. He reminds us that finance theory is quite clear on this matter and that the Risky Asset Portfolio (RAP) should be a market-capitalization weighted portfolio of all risky assets. Otherwise, we are assuming that our asset manager has some specific, unique market knowledge that suggests he can outperform the market over a finite period of time on a risk-adjusted basis. In reality, the results will be a random outcome and not a good strategic decision (145).

Taking More Risk is Not the Answer

Some sponsors may attempt to “pay for the plan” by adding even more risky assets to the portfolio (146). However, the point cannot be under emphasized that sponsors will not “get” the “required” or “expected” rate of return on their investments over time. In fact, a realized (actual) return is drawn from a wide distribution of returns if you’re investing in risky securities (213). Market returns can be quite volatile and long periods of bad luck (realized returns less than expected returns) are just as likely as long periods of good luck (1980s-1990s) (40). The market declines of 1998, 2002 and 2008-2010 damaged the asset side of most plans as well as significantly increased deficits. This type of volatility typically adds to the deficits because sponsors typically don’t want to make up the loss with contributions. In the end, the deficits are left in place hoping that they will go away in the future. They could potentially or they could also get worse, much worse.

Hoping Time Reduces Risk is Not the Answer

Another common misconception is that risk goes away over the long term but in fact it accumulates with time. The standard deviation of returns increases by the square root of the number of years. For example, if the time horizon is 25 years then the standard deviation of returns (risk) over the period is five times wider (√25 years = 5)  than the one-year standard deviation of returns. The risks to wealth accumulate with time and we must remember that markets will fail to meet the expected return assumption (39).

First Hedge the Liability – It’s the Single Biggest Risk

The key conclusion is that the biggest single risk to hedge in a pension plan is the liability. Sponsors spend a lot of time focused on asset allocation decisions which can only marginally help the plan while ignoring the decision to hedge the liability. In short, sponsors should do three things in this regard (1) hedge the interest rate risk of the liability (2) revisit the risk tolerance decision, it is a real investment decision (3) be very careful about any active or tactical decisions that require special skills in order to yield success (146).

Measure the Big Picture: The Full Economic Liability

The process really begins with gaining a full understanding of the economic cost of the plan. The “Full Economic Liability” FEL is the proper starting point for a plan sponsor to gain a complete picture of the on-book and off-book economic liability (63). The off-book liability will inexorably make its way on book eventually. Waring points out that an economically determined accrued liability and its associated normal cost method will accrue portions of the full economic liability related to current employees onto the books over time. On some agreed basis, which will generate the economic accrued liability whose form can be chosen and interpreted as an acceptable funding target for benefit security purposes.

Since the ABO (Accumulated Benefit Obligation) and PBO (Projected Benefit Obligation) are accrued “subsidiary” measures of the liability by definition they leave something off the table. That something is the portion which is still unaccrued for both current and future employees. Waring suggests that wise management teams do consider the off-book (non-legal) obligation and they consider its value when talking to labor during negotiations.

Discount the Liability at Real Risk-free Interest Rates

In order to determine the proper economic value of the liability in today’s dollars one must use market-based discount rates. Some people continue to believe that the expected rate of return on the asset portfolio is the appropriate economic discount rate to use when valuing the liability (future benefit payments). This is still used quite frequently for state pension plans. Yet, the only rates of return we have the power to “require” are the rates on the risk free spot rate curve for a particular time horizon. And the correct rate to use is the spot rate curve for inflation protected government securities (real risk-free interest rates) which is hedgeable. Therefore, you can finance these benefits with little risk to the plan sponsor. Although the accounting liability increases with a lower discount rate the actual economics of the plan (actual cash flows for the benefit payments) are not changed and also cannot be magically reduced if someone elects to use a higher discount rate. In fact, a higher discount rate establishes the rate you must earn on funds borrowed from employees to pay future benefits. From this perspective, if sponsors guarantee higher returns on risky assets which are not realized then they are eventually faced with the realization that the liability was higher than they originally thought and that planned contributions were too low – a “double whammy” (200).

Select a Normal Cost Method that Improves Benefit Security 

A key component of pension expense is normal cost. Waring uses the term “Full Economic Normal Cost” which represents the expense accrued in this period for benefits owed to employees at their retirement (also called service cost) however, it does not contain the panoply of other items such as investment returns, financing costs, etc. which are in service cost. There are many different normal cost methods: ABO – accumulated benefit obligation, PBO – projected benefit obligation, present value benefits or “initial funding method”, the “cost prorate constant dollar method” or Entry Age Normal (EAN) cost methods which is a level payment approach. Ironically “normal cost” does not affect or control costs over the long term. Rather, costs are a function of the benefit promise.

Although all of the normal cost methods must terminate at the full funding requirement, the speed or pace of the accumulation of the accrued liability must be observed carefully. Therefore, it has an important impact on benefit security. Waring prefers the economic version of the EAN method because it makes sense to those who think of a pension as a constant proportion of the overall pay package which is then useful in both budgeting and benefit negotiations and seems to be the right compromise between labor and management (98).

The practical point is that if the “notional normal cost” entries were in fact real monetary contributions which were calculated similar to a payment amortizing a debt (253) and placed into a liability-matching asset portfolio then the possibility of becoming underfunded through investment results will be substantially eliminated. In this case, the pension assets would grow following the same line as the on-book accrued liability. The funds would ultimately be there to pay the liabilities when they come due.

Utilize Mark-to-Market Management Accounting Information

Waring recommends the use of this economic mark-to-market “management accounting” picture because today’s smoothing and amortization of pension accounting data is not a hedge and does not provide risk control. There are no “smoothed” assets to purchase to hedge against a smoothed liability (248). An economic hedge on the surplus/deficit will naturally smooth out pension expense and contributions and is a superior approach. The fact is that conventional amortization and smoothing of data actually add risk rather than reduce it.

Importantly, even if the formal accounting continues to be done on a conventional basis (until political and regulatory changes are made IASB, FASB, GASB) moving to an economic accounting view for management of the plan is highly recommended. In addition, once the underlying economic risks of the plan are properly measured, the conventional accounting risk measures will also be under control. In short, it provides guidance to discover what’s really going on “under the hood” of the plan.

Be Good Stewards: Act on Behalf of the Beneficiaries 

Plan sponsors must be good stewards of the plan assets that are required to provide for employees in their old age. Across the industry, confusion and fear has led many plan sponsors to switch to defined contribution (DC) plans because they provided more clarity of both cost and accounting for such plans. However, Mr. Waring contends that the best defined-contribution (DC) plan is still not as good as the worst defined-benefit plan. Why? Because, defined contribution plans have not been shown to accumulate the level of resources an employee needs to adequately be prepared for retirement. For example, one detailed study showed the average account value for employees over the age of 60, that has been in a DC plan longer than 30 years, was only about $180,000 which is too low to provide for retirement (224). Waring points out that DC plans don’t seem to be the answer but that DB plans can be saved if one first recognizes the need to measure them on an economic basis and then optimize the surplus of the plan.

Face the Problem Head On

Mr. Waring believes the best way to address the problem is to face it head on. The advantages will be to establish more certain costs now and minimize the probability of further negative surprises later. Managing the accounting is not the route to controlling pension-funding risk or cost. Rather, only good benefit policies and some lucky investment returns will help. And good policies can only come from meaningful economic information.

Pension Finance is an excellent read for anyone in the defined-benefit pension plan administration or management roles. I completely enjoyed Pension Financeand applaud Mr. Waring for his forthright analysis of the subject.

Distinguished Speakers Series: Dan Fuss, CFA

Blog_FussDan Fuss, CFA and former member of the CFA Society Chicago, spoke to a packed house at the University Club of Chicago on December 3. Fuss has over five decades of investment experience and joined Loomis, Sayles & Company in 1976. He’s Vice Chairman of the firm’s Board of Directors and manages the firm’s flagship Loomis Sayles Bond Fund, as well as a number of other fixed income offerings. Fuss has earned numerous accolades over the years including Morningstar’s Fixed Income Fund Manager of the Year, the Institutional Investor Money Management Lifetime Achievement Award, the Lipper Excellence in Investing Award, the CFA Society Milwaukee Lifetime Achievement Award, and was named to the Fixed Income Analysts Society’s Hall of Fame.

During his talk, Fuss focused on what he calls the Four Ps: Peace, Prosperity, People, and Politics. Starting with peace, he discussed the growing conflicts in the Middle East, Eastern Europe, and South China Seas. While he brought up the Cold War and the challenges faced by governments and leaders then, he remains optimistic about the issues facing the world today. Fuss believes that world leaders can work together to solve these problems.

Fuss also believes that in the United States, despite a gridlocked Congress with little appetite for increased spending, the nation’s share of military spending is likely to rise, especially given the geopolitical climate. That’s “prosperity,” or lack thereof. With rising military spending, the government will need more revenues and those revenues can come from two sources: debt and taxes. Higher taxes, he says, will push more investors to favor tax-exempt muni bonds and which will have implications for the taxable bond market.

Fuss’ “people” is focused on changing demographics, which is not just a challenge faced by the United States.  All developed countries are aging and those aging populations require more resources, especially healthcare, which is another reason he expects taxes to increase. Fuss also believes that this demographic shift will increase the demand for bonds because private and public sector defined benefit plans will need to rely more heavily on bonds, rather than stocks, for liability matching.

As for politics, Fuss was not optimistic. He believes the Senate and the “ruckus” House will continue to be unable to deal with serious issues facing the country. This means the United States may be a ways from solving some of the issues facing it today, including the demographic shift and the resulting impact on government revenues.

Though not an official “P,” Fuss also talked briefly about the Federal Reserve. He noted that, despite the Fed’s domestic mandate, it has been more transparent about its consideration of global issues in determining the timing and magnitude of increasing interest rates. While many believe that if the Fed doesn’t raise rates this December it won’t move in 2016 because it’s an election year, Fuss disagrees. That said, he believes the chance of a rate hike in December remains 50/50, despite the recently positive statements by Chairwoman Janet Yellen. In all, Fuss anticipates a slight upward pressure on interest rates and a slight downward pressure on P/E ratios because of these aforementioned “Ps” and is positioning his portfolios cautiously.

CFA Society Chicago Book Club:

No Ordinary Disruption: The Four Global Forces Breaking All the Trends by Richard Dobbs, James Manyika, Jonathan Woetzel

No ordinary disruptionEverything can be measured, and what gets measured gets managed.” So reads the motto of one of the world’s most pre-eminent consultancies, McKinsey & Co. This month’s CFA Society Chicago Book Club Selection, No Ordinary Disruption: The Four Global Forces Breaking All of the Trends, is written by three men from McKinsey and they truly take this tagline to heart. The “four global forces” in the title include: urbanization, the challenges of changing demography, technological advance and acceleration, and growing interconnectedness of the global economy. Major news outlets have focused on these forces in some form or another for many years (or perhaps decades), but the main value that this book brings is its focus on anecdotes and “measurements.”

The first half of the book focuses on the forces themselves and where we find evidence of their existence. The center of global economic growth has been moving east for some time and many Chinese and Indians (among others) find themselves commanding a larger standard of living. Meanwhile, “The West” has been fraught with stagnation and labor’s replacement with capital in many industries due to technological advances. Furthermore, the demography of many developed nations has produced more retirees per working person. Each of these facets is well laid out with stories of real life examples in the development of smarter and less expensive robots, the crises affecting aging developed economies, and the rise of emerging markets.

The second half of the book begins to falter a bit with the prescription on what to do about the changes coming. Almost every single course of action recommended would be common in MBA programs or even undergraduate studies of business. Employers and companies are encouraged to adapt to this new environment we find ourselves on the brink of.  Which skills will be necessary aren’t named specifically, but the emphasis is really on the ability to change. This reflects the true challenge going forward in managing that which is measured.

Overall, the book provided for a great discussion on what the future will look like and how it affects the investment profession. Even though its prescriptions weren’t always insightful or groundbreaking, the idea of a different economy and investment environment can be both frightening and exciting. We will continue to watch these factors to see where they take us going forward.


Upcoming Schedule:

January 19, 2016: The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

February 16, 2016: TBD

March 15, 2016: Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control by Barton Waring

To sign up for a future book club event, please click here:



Financial speakers don’t come with a higher profile than billionaire Mohamed El-Erian, whose resume lists a staggering body of achievement: Chair of President Obama’s Global Development Council, Chief Economic Advisor at Allianz, former Co-CIO and CEO at PIMCO and Bloomberg columnist and author.

As attendees milled around the large meeting hall of the Streeterville Sheraton, our annual Society dinner began with soft jazz in the background and steak and salmon slowly finding their way to tables. Experienced investment executives and new Charterholders alike shook hands and networked while dining, excited about the prospect of hearing from one of the preeminent minds in the investment world.

Kerry Jordan, CFA, current Chairman of the CFA Society Chicago, opened the proceedings with a video message from Paul Smith, President and CEO of the CFA Institute, who explained the genesis of the CFA Society Chicago to commemorate our 90th anniversary as an organization. This was no ordinary annual dinner; it was a milestone for our organization and an occasion to celebrate our past and look towards our future.DSC_2216

Each attendee also received a book published by the CFA Society Chicago titled “Celebrating 90 Years” to take home with them. The book, which the Society’s Communications Committee spent over a year preparing, shares biographies of our pioneers, financial news articles from years past and photographs of important places and people who helped shape our organization’s history. As Co-Chairman of the CFA Society Chicago Communications Committee, I’d like to extend my gratitude to everyone who worked on the history project and helped make it happen: many thanks to all of you who spent long weekends in various libraries researching and crafting this excellent book.


New Charterholders being recognized at the 29th Annual Dinner


Kerry Jordan, CFA thanked Paul Smith for his remarks and switched gears to honor the four individuals marking their 50th year as Charterholders. The new class of 177 recently-minted Charterholders was also toasted, with Jordan reminding the audience just how difficult it is to pass all three exams and the massive amount of time and effort expended to earn a CFA Charter. Jordan reiterated the benefits and reach of the CFA Charter, stating that there are now local societies in 71 countries, with over 300 universities globally incorporating the CFA curriculum into their programs.


Priscilla Perry – Hortense Friedman, CFA, Award for Excellence

The Hortense Friedman, CFA, Award for Excellence was presented to longtime Harris Bank analyst Priscilla Perry. Perry’s biography mentioned that she needed to pass all 3 exams, not just 2, as some Charterholders were given the CFA designation with only two passing exams earlier in the program.


Priscilla Perry & CFA Chicago Past Chairmen

Jordan then discussed her own personal journey towards becoming Chairman of the CFA Society Chicago. She quipped, in reference to former Chair Heather Brilliant, who had been recently promoted to CEO of Australasia at Morningstar, that she liked the trend of recent CFA Chicago Chairs receiving a ‘Chief’ in front of their job title.

“We’re getting to you Mohamed, just a couple more things,” Jordan said to laughs in the audience as she listed off the event sponsors and graciously thanked them for their kind support.


Left to Right: Chris Vincent, CFA, Kerry Jordan, CFA, Mohamed El-Erian

Immediate past Chairman Christopher Vincent, CFA was asked to introduce Mohamed El-Erian. In his introduction, Vincent mentioned the parlor game that he likes to play with other company leaders of “who has the most CFA Charterholders” but that he usually prefers a per capita measurement, which favors William Blair.

Dressed in a dark suit and a blue tie, El-Erian made his way to the stage amidst thunderous applause, pausing to take a few pictures with Christopher Vincent, CFA and Kerry Jordan, CFA.  The format for the presentation was a one-on-one chat, a la a Charlie Rose interview. Questions from CFA Society Chicago members were solicited ahead of time, with Jordan to act as the interviewer while she and El-Erian sat in armchairs on the Sheraton ballroom stage. Jordan mentioned a few of the questions that had been tossed out, including “How crazy is Bill Gross…really?”, to which El-Erian stared straight ahead with the slightest smirk on his face, wisely declining to offer any thoughts around his old boss at PIMCO.

Given El-Erian’s vast array of job, media and government responsibilities, how does he spend a typical day, a CFA charterholder wanted to know?

While at PIMCO, he would rise at 2:45 AM to compensate for the 3 hour time difference between California and New York, but now El-Erian sleeps in…until 3:30. The audience audibly gasped upon hearing this, realizing that building a net worth of $2.3 billion doesn’t always come with a lot of sleep.

After an early wakeup, El-Erian does some of the same things we all do. He looks to find out what is going on in the world, takes his dog out and makes his daughter breakfast. Sometimes when he lies down at 9 pm to sleep (he aims for about 6.5 hours of sleep a night), he starts tossing and turning and obsessing about how many hours of sleep he’ll get if he can’t fall asleep promptly at 9 pm. Then, El-Erian said, he might begin calculating his 3 day sleep moving average and his 5 day sleep moving average, to chuckles in the financially-oriented audience.

El-Erian has been a fan of the Mets since 1968 and said he was a bit worried about presenting in front of a room full of Cubs fans shortly after his team knocked the North Siders off in the NLCS. “Well, about 20% of you are on my side,” he said, referencing the much smaller Chicago White Sox fan base.

The nature of the conversation shifted as Jordan moved the conversation to the Fed’s decision on whether to raise rates in December. “What are the odds?” Jordan asked.

“High,” El-Erian responded. “But why are we obsessing with 25 basis points?”


Keynote Mohamed El-Erian

El-Erian had three observations on the current Fed watch:

  • We’ve been living in a non-normal world and we are addicted to the Fed’s help. The Fed has had some missteps in communicating with the market about its plans, and this will likely be the most gradual tightening in Fed history.
  • The Federal Reserve probably won’t raise rates during every meeting and will stop raising rates well below the historical average seen in previous tightening cycles.
  • The world has become a very asymmetrical place, with the ECB moving in a different direction than the Fed and many central banks are out of alignment with respect to their monetary policy. This will likely lead to more foreign exchange and equity market volatility and higher interest rate differentials going forward.

“The Fed is dying to get off of 0%,” said El-Erian, “and the longer they are unconventional with monetary policy, the lower the benefits and the higher the costs.”

Over the past 10 years, society has bet on a growth model with finance, seeing it as an engine of prosperity for the economy. Countries like Iceland greatly expanded the size of banking within their economies with the belief that you can grow a lot with an expanding financial center. “Finance,” said El-Erian, “just got too big.”

Another observation El-Erian made was that the global political system was not stepping up to its economic governance responsibilities. In his mind we need a political system that steps up and a financial system that serves society as a whole to counter the effects of volatile markets and uncertainty around interest rate increases.

He talked about a recent investment he made in a firm that provides credit for very low income individuals, stating that “credit card debt can ruin you.” Technology is changing everything we do, and behavioral finance is now being used to help improve access to credit. The new generation of millennials expects “interaction anytime, anywhere” and companies need to build their strategy around this fact. In 10 to 15 years, Millennials will comprise the main customer base for most firms. El-Erian mentioned peer-to-peer lending, seen on platforms such as Lending Club, as part of the disruptive force currently taking place within finance, enabling individuals to interact in ways that would previously require an intermediary such as a bank. Technology has given rise to a broader trend of individual empowerment, and firms that ignore this change will find themselves rapidly disrupted. El-Erian used the example of the Hilton hotel chain taking a century to build 700,000 rooms while Airbnb accomplished this in a few years. “Starwood is being disrupted by people who never built a hotel in their life,” he said.

Jordan then turned the conversation towards the topic of student loan debt. Over $1.4 trillion is owed by students and this amount has tripled in just a few years, making many consider the student loan market to be the next subprime-like domino waiting to fall. As El-Erian explained, the return on higher education has gone down as the costs have increased, with an increasing household concentration of educational debt. Some options to fix this situation include broader use of community college, an earlier start for financial literacy programs and increasing the transparency around the student loan market, which El-Erian described as very low. “When you have a debt overhang, it impacts everyone,” El-Erian stated, saying that the options of bailing out delinquent borrowers or having an entire segment of society of being crushed by student loan debt are both highly unpalatable.

In El-Erian’s mind, one of the best ways new charterholders can prepare for a successful career would be by learning the languages of emerging economies, particularly Mandarin and Cantonese. The emergence of a much larger global middle class also points to an increased need for financial advice. Another less positive trend El-Erian highlighted was the “hollowing out” of the middle class in the West, resulting in a barbell-style society of poor and rich with few in the middle.

In terms of the investment landscape, El-Erian said it is no longer about products, it’s about solutions. You can’t expect to lob an array of diverse products at consumers and hope for them to construct a solution, the investment industry needs to build solutions for them.

One attendee wanted to know El-Erian’s views on the topic of active versus passive investment. In El-Erian’s mind, there shouldn’t be a debate because there is room for both approaches. Passive investment can be problematic in some asset classes, which El-Erian detailed in an example from earlier in his career while working as an emerging markets bond portfolio manager. At the time, Argentina represented 20% of an emerging markets index, but PIMCO made the decision that the country wasn’t a good credit risk and decided not to allocate any of its capital to Argentine bonds. Some commentators characterized this decision as irresponsible because it was such a large holding in the index and its exclusion would inject a huge tracking error into the PIMCO emerging market fund. Over time, PIMCO’s decision not to invest in Argentina turned out to be a huge success as the country defaulted in 2001-2002, and the exclusion of its bonds in PIMCO’s fund led to strong benchmark outperformance. For this reason, when default and liquidity risk is high, active management is very important. But in some asset classes, active management doesn’t really add much value, El-Erian opined.

Liquidity drives many investment decisions in fixed income and this risk factor has grown in importance as the buy side has increased market participation as sell side participation has declined, resulting in what El-Erian termed “the delusion of liquidity” currently going on in markets.

El-Erian listed three items he would expect economists to name as top initiatives needed to drive economic growth, including structural reform, the fundamental imbalance between the will to spend and the size of the wallet (“Germany has the wallet but not the will, Greece has the will but not the wallet”), and reducing what he sees as excessive levels of debt in the financial system. Publicly-traded markets are especially prone to manipulation by Fed policy, and El-Erian continues to move assets from public markets to cash and private markets as new index highs are reached.

Lastly, Jordan asked El-Erian about what he thinks of the future of finance. El-Erian laughed and said “They always say be afraid of the last question”, stating that he had recently created a Twitter account and was amazed by that platform, and that the future is generally very hard to predict.

To view 29th Annual Dinner pictures online please visit: