Good Reading -- March 2010
Loads of good stuff this time -- enjoy!
Attached
"How a New Jobless Era Will Transform America" -- a great (but depressing) article about unemployment and its profound direct and indirect effects.
"Was It All Just a Bad Dream? Or, Ten Lessons Not Learnt" -- a great article, even by the exceptionally high standards of James Montier. Here he weighs in on the market and the lessons (not?) taken away from our recent past.
"Betting on the Blind Side" -- a good (but long) article excerpted from the upcoming Michael Lewis book The Big Short, which I look forward to reading. This article profiles Mike Burry, his fund Scion Capital, and his bet against mortgage securities.
Interview with James Montier -- conducted by and courtesy of Miguel Barbosa and his world-class blog Simoleon Sense. Montier's new book "Value Investing -- Tools and Techniques for Intelligent Investing" will no doubt be excellent.
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"Basically, It's Over" -- a very interesting but depressing parable from Charlie Munger.
"Seth Klarman’s Twenty Investment Lessons of 2008": Pure gold from the second greatest living investor. Notice the similarity to #2 above...anyone sensing a theme here? Anyone? Bueller?
"Amazing Grace" -- a nice story of philanthropy born of patience, simple living, and compound interest.
"Public Pensions Adding Risk to Raise Returns" -- Gee, what could possible go wrong here? So many amazingly stupid factors at work I'm not even sure where to begin...trying to double down now to account for years of investing mistakes? Check. Trying to catch up on decades of underfunding the benefits while overestimating the future gains? Check. Handing out fees to advisors/managers/consultants like it's going out of style? Check. Loading up on fixed income assets that are going to get absolutely crushed if (read: when) inflation rears its ugly head? Check. Misusing leverage and derivatives? Check. Playing ostrich with the discount rate? Check. This list could go on for pages...in the meantime, remember that (a) if you have a pension plan, these are the idiots "managing" it, and (b) these same idiots are driving a big chunk of the asset prices we see today.
"We're so good at medical studies that most of them are wrong" -- I'd add finance/economics/investing as another area vulnerable to this phenomenon.
"Doctor Leads Quest for Safer Way to Cure Patients" -- more medical stuff, but with another checklist theme.
Basically, It's Over
A parable about how one nation came to financial ruin.
By Charles Munger Updated Sunday, Feb. 21, 2010, at 3:30 PM ET
In the early 1700s, Europeans discovered in the Pacific Ocean a large, unpopulated island with a temperate climate, rich in all nature's bounty except coal, oil, and natural gas. Reflecting its lack of civilization, they named this island "Basicland."
The Europeans rapidly repopulated Basicland, creating a new nation. They installed a system of government like that of the early United States. There was much encouragement of trade, and no internal tariff or other impediment to such trade. Property rights were greatly respected and strongly enforced. The banking system was simple. It adapted to a national ethos that sought to provide a sound currency, efficient trade, and ample loans for credit-worthy businesses while strongly discouraging loans to the incompetent or for ordinary daily purchases.
Moreover, almost no debt was used to purchase or carry securities or other investments, including real estate and tangible personal property. The one exception was the widespread presence of secured, high-down-payment, fully amortizing, fixed-rate loans on sound houses, other real estate, vehicles, and appliances, to be used by industrious persons who lived within their means. Speculation in Basicland's security and commodity markets was always rigorously discouraged and remained small. There was no trading in options on securities or in derivatives other than "plain vanilla" commodity contracts cleared through responsible exchanges under laws that greatly limited use of financial leverage.
In its first 150 years, the government of Basicland spent no more than 7 percent of its gross domestic product in providing its citizens with essential services such as fire protection, water, sewage and garbage removal, some education, defense forces, courts, and immigration control. A strong family-oriented culture emphasizing duty to relatives, plus considerable private charity, provided the only social safety net.
The tax system was also simple. In the early years, governmental revenues came almost entirely from import duties, and taxes received matched government expenditures. There was never much debt outstanding in the form of government bonds.
As Adam Smith would have expected, GDP per person grew steadily. Indeed, in the modern area it grew in real terms at 3 percent per year, decade after decade, until Basicland led the world in GDP per person. As this happened, taxes on sales, income, property, and payrolls were introduced. Eventually total taxes, matched by total government expenditures, amounted to 35 percent of GDP. The revenue from increased taxes was spent on more government-run education and a substantial government-run social safety net, including medical care and pensions.
A regular increase in such tax-financed government spending, under systems hard to "game" by the unworthy, was considered a moral imperative—a sort of egality-promoting national dividend—so long as growth of such spending was kept well below the growth rate of the country's GDP per person.
Basicland also sought to avoid trouble through a policy that kept imports and exports in near balance, with each amounting to about 25 percent of GDP. Some citizens were initially nervous because 60 percent of imports consisted of absolutely essential coal and oil. But, as the years rolled by with no terrible consequences from this dependency, such worry melted away.
Basicland was exceptionally creditworthy, with no significant deficit ever allowed. And the present value of large "off-book" promises to provide future medical care and pensions appeared unlikely to cause problems, given Basicland's steady 3 percent growth in GDP per person and restraint in making unfunded promises. Basicland seemed to have a system that would long assure its felicity and long induce other nations to follow its example—thus improving the welfare of all humanity.
But even a country as cautious, sound, and generous as Basicland could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of Basicland had created a peculiar outcome: As their affluence and leisure time grew, Basicland's citizens more and more whiled away their time in the excitement of casino gambling. Most casino revenue now came from bets on security prices under a system used in the 1920s in the United States and called "the bucket shop system."
The winnings of the casinos eventually amounted to 25 percent of Basicland's GDP, while 22 percent of all employee earnings in Basicland were paid to persons employed by the casinos (many of whom were engineers needed elsewhere). So much time was spent at casinos that it amounted to an average of five hours per day for every citizen of Basicland, including newborn babies and the comatose elderly. Many of the gamblers were highly talented engineers attracted partly by casino poker but mostly by bets available in the bucket shop systems, with the bets now called "financial derivatives."
Many people, particularly foreigners with savings to invest, regarded this situation as disgraceful. After all, they reasoned, it was just common sense for lenders to avoid gambling addicts. As a result, almost all foreigners avoided holding Basicland's currency or owning its bonds. They feared big trouble if the gambling-addicted citizens of Basicland were suddenly faced with hardship.
And then came the twin shocks. Hydrocarbon prices rose to new highs. And in Basicland's export markets there was a dramatic increase in low-cost competition from developing countries. It was soon obvious that the same exports that had formerly amounted to 25 percent of Basicland's GDP would now only amount to 10 percent. Meanwhile, hydrocarbon imports would amount to 30 percent of GDP, instead of 15 percent. Suddenly Basicland had to come up with 30 percent of its GDP every year, in foreign currency, to pay its creditors.
How was Basicland to adjust to this brutal new reality? This problem so stumped Basicland's politicians that they asked for advice from Benfranklin Leekwanyou Vokker, an old man who was considered so virtuous and wise that he was often called the "Good Father." Such consultations were rare. Politicians usually ignored the Good Father because he made no campaign contributions.
Among the suggestions of the Good Father were the following. First, he suggested that Basicland change its laws. It should strongly discourage casino gambling, partly through a complete ban on the trading in financial derivatives, and it should encourage former casino employees—and former casino patrons—to produce and sell items that foreigners were willing to buy. Second, as this change was sure to be painful, he suggested that Basicland's citizens cheerfully embrace their fate. After all, he observed, a man diagnosed with lung cancer is willing to quit smoking and undergo surgery because it is likely to prolong his life.
The views of the Good Father drew some approval, mostly from people who admired the fiscal virtue of the Romans during the Punic Wars. But others, including many of Basicland's prominent economists, had strong objections. These economists had intense faith that any outcome at all in a free market—even wild growth in casino gambling—is constructive. Indeed, these economists were so committed to their basic faith that they looked forward to the day when Basicland would expand real securities trading, as a percentage of securities outstanding, by a factor of 100, so that it could match the speculation level present in the United States just before onslaught of the Great Recession that began in 2008.
The strong faith of these Basicland economists in the beneficence of hypergambling in both securities and financial derivatives stemmed from their utter rejection of the ideas of the great and long-dead economist who had known the most about hyperspeculation, John Maynard Keynes. Keynes had famously said, "When the capital development of a country is the byproduct of the operations of a casino, the job is likely to be ill done." It was easy for these economists to dismiss such a sentence because securities had been so long associated with respectable wealth, and financial derivatives seemed so similar to securities.
Basicland's investment and commercial bankers were hostile to change. Like the objecting economists, the bankers wanted change exactly opposite to change wanted by the Good Father. Such bankers provided constructive services to Basicland. But they had only moderate earnings, which they deeply resented because Basicland's casinos—which provided no such constructive services—reported immoderate earnings from their bucket-shop systems. Moreover, foreign investment bankers had also reported immoderate earnings after building their own bucket-shop systems—and carefully obscuring this fact with ingenious twaddle, including claims that rational risk-management systems were in place, supervised by perfect regulators. Naturally, the ambitious Basicland bankers desired to prosper like the foreign bankers. And so they came to believe that the Good Father lacked any understanding of important and eternal causes of human progress that the bankers were trying to serve by creating more bucket shops in Basicland.
Of course, the most effective political opposition to change came from the gambling casinos themselves. This was not surprising, as at least one casino was located in each legislative district. The casinos resented being compared with cancer when they saw themselves as part of a long-established industry that provided harmless pleasure while improving the thinking skills of its customers.
As it worked out, the politicians ignored the Good Father one more time, and the Basicland banks were allowed to open bucket shops and to finance the purchase and carry of real securities with extreme financial leverage. A couple of economic messes followed, during which every constituency tried to avoid hardship by deflecting it to others. Much counterproductive governmental action was taken, and the country's credit was reduced to tatters. Basicland is now under new management, using a new governmental system. It also has a new nickname: Sorrowland.
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Charles Munger is vice chairman of Berkshire Hathaway.
Article URL: http://www.slate.com/id/2245328/
Seth Klarman’s Twenty Investment Lessons of 2008
One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea. Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.
Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
When a government official says a problem has been “contained,” pay no attention.
The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.
Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience. False Lessons
There are no long-term lessons – ever.
Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
There is no amount of bad news that the markets cannot see past.
If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
Excess capacity in people, machines, or property will be quickly absorbed.
Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
The government can indefinitely control both short-term and long-term interest rates.
The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)
Amazing Grace: Lake Forest secret millionaire donates fortune to college
Woman who lived frugally donates $7 million to alma mater
By John Keilman, Tribune reporter
March 4, 2010
Like many people who lived through the Great Depression, Grace Groner was exceptionally restrained with her money. She got her clothes from rummage sales. She walked everywhere rather than buy a car. And her one-bedroom house in Lake Forest held little more than a few plain pieces of furniture, some mismatched dishes and a hulking TV set that appeared left over from the Johnson administration. Her one splurge was a small scholarship program she had created for Lake Forest College, her alma mater. She planned to contribute more upon her death, and when she passed away in January, at the age of 100, her attorney informed the college president what that gift added up to. "Oh, my God," the president said. Groner's estate, which stemmed from a $180 stock purchase she made in 1935, was worth $7 million. The money is going into a foundation that will enable many of Lake Forest's 1,300 students to pursue internships and study-abroad programs they otherwise might have had to forgo. It will be an appropriate memorial to a woman whose life was a testament to the higher possibilities of wealth. "She did not have the (material) needs that other people have," said William Marlatt, her attorney and longtime friend. "She could have lived in any house in Lake Forest but she chose not to. … She enjoyed other people, and every friend she had was a friend for who she was. They weren't friends for what she had." Groner was born in a small Lake County farming community, but by the time she was 12 both of her parents had died. She was taken in by George Anderson, a member of one of Lake Forest's leading families and an apparent friend to Groner's parents. The Andersons raised her and her twin sister, Gladys, and paid for them to attend Lake Forest College. After Groner graduated in 1931, she took a job at nearby Abbott Laboratories, where she would work as a secretary for 43 years. It was early in her time there that she made a decision that would secure her financial future. In 1935, she bought three $60 shares of specially issued Abbott stock and never sold them. The shares split many times over the next seven decades, Marlatt said, and Groner reinvested the dividends. Long before she died, her initial outlay had become a fortune. Marlatt was one of the few who knew about it. Lake Forest is one of America's richest towns, filled with grand estates and teeming with luxury cars, yet Groner felt no urge to keep up with the neighbors. She lived in an apartment for many years before a friend willed her a tiny house in a part of town once reserved for the servants. Its single bedroom could barely accommodate a twin bed and dresser; its living room was undoubtedly smaller than many Lake Forest closets. Though Groner was frugal, she was no miser. She traveled widely upon her retirement from Abbott, volunteered for decades at the First Presbyterian Church and occasionally funneled anonymous gifts through Marlatt to needy local residents. "She was very sensitive to people not having a whole lot," said Pastor Kent Kinney of First Presbyterian. "Grace would see those people, would know them, and she would make gifts." Groner never wed or had children — the sister of one prospective groom blocked the marriage, Marlatt said — but with her gregarious personality she had plenty of friends. She remained connected to Lake Forest College, too, attending football games and cultural events on campus and donating $180,000 for a scholarship program. That allowed a few students a year to study internationally, including Erin McGinley, 34, a junior from Lake Zurich. She traveled to Falmouth, Jamaica, to help document and preserve historic buildings in the former slave port. The experience was so satisfying that she is trying to get Lake Forest to create a similar architectural preservation program. "It affected my (career ambitions) in a way I didn't expect," she said. But Groner was interested in doing more, so two years ago she set up a foundation to receive her estate. Stephen Schutt, Lake Forest's president, knew of the plan for the past year, but had no idea how large the gift would be until after Groner passed away Jan. 19. The foundation's millions should generate more than $300,000 a year for the college, enabling dozens more students to travel and pursue internships. Many probably wouldn't be able to pursue those opportunities without a scholarship: 75 percent of the student body receives financial aid, Schutt said. But the study and internship program is not the end of Groner's legacy. She left that small house to the college, too. It will be turned into living quarters for women who receive foundation scholarships, and perhaps something more: an enduring symbol that money can buy far more than mansions. It will be called, with fitting simplicity, "Grace's Cottage."
Public Pension Funds Are Adding Risk to Raise Returns
By MARY WILLIAMS WALSH
States and companies have started investing very differently when it comes to the billions of dollars they are safeguarding for workers’ retirement.
Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.
But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.
“In effect, they’re going to Las Vegas,” said Frederick E. Rowe, a Dallas investor and the former chairman of the Texas Pension Review Board, which oversees public plans in that state. “Double up to catch up.”
Though they generally say that their strategies are aimed at diversification and are not riskier, public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.
The Texas teachers’ pension fund recently paid Chicago to receive a stream of payments from the money going into the city’s parking meters in the coming years. The deal gave Chicago an upfront payment that it could use to help balance its budget. Alas, Chicago did not have enough money to contribute to its own pension fund, which has been stung by real estate deals that fizzled when the city lost out in the bidding for the 2016 Olympics.
A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.
Pension funds rarely trumpet their intentions, partly to keep other big investors from trading against them. But some big corporations are unloading the stocks that have dominated pension portfolios for decades. General Motors, Hewlett-Packard, J. C. Penney, Boeing, Federal Express and Ashland are among those that have been shifting significant amounts of pension money out of stocks.
Other companies say they plan to follow suit, though more slowly. A poll of pension funds conducted by Pyramis Global Advisors last November found that more than half of corporate funds were reducing the portion they invested in United States equities.
Laggards tend to be companies with big shortfalls in their pension funds. Those moving the fastest are often mature companies with large pension funds, and who fear a big bear market could decimate the funds and the companies’ own finances.
“The larger the pension plan, the lower-risk strategy you would like to employ,” said Andrew T. Ward, the chief investment officer of Boeing, which shifted a big block of pension money out of stocks in 2007. That helped cushion Boeing’s pension fund against the big losses of 2008.
Shedding stocks gave Boeing “material protection right when we needed it most,” Mr. Ward said. By the time the markets had bottomed out last March, Boeing’s pension fund had lost 14 percent of its value, while those of its equity-laden peers had lost 25 to 30 percent, he said.
“We estimated that the strategy saved our company in the short term right around $4 or $5 billion of funded status,” he said.
Boeing and other companies seeking to reduce their investment risk are moving into fixed-income instruments, like bonds — but not just any bonds. They are buying and holding bonds scheduled to pay many years in the future, when their retirees expect their money.
The value of the bonds may fall in the meantime, just like the value of stocks. But declining bond prices are not such a worry, because the companies plan to hold the bonds for the accompanying interest payments that will in turn go to retirees, not sell them in the interim.
Towers Watson, a big benefits consulting firm, surveyed senior financial executives last year and found that two-thirds planned to decrease the stock portion of their companies’ pension funds by the end of 2010. They typically said their stock allocations would shrink by 10 percentage points.
“That’s 10 times the shift we might see in any given year,” said Carl Hess, head of Towers Watson’s investment consulting business. Economists have speculated that a truly seismic shift in pension investing away from stocks could be a drag on the market, but they say it would not be long-lasting.
Corporate America’s change of heart is notable all on its own, after decades of resistance to anything other than returns like those of the stock markets. But it’s even more startling when compared with governments’ continued loyalty to stocks. When governments scale back on the domestic stocks in their pension portfolios these days, it is often just to make way for more foreign stocks or private equities, which are not publicly traded.
Government pension plans cannot beef up their bonds that mature many, many years from now without dashing their business models. They use long-range estimates that presume high investment returns will cover most of the cost of the benefits they must pay. And that, they say, allows them to make smaller contributions along the way.
Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.
(Corporate plans do their calculations differently, and for them, investment returns are a less important factor.)
The problem now is that bond rates have been low for years, and stocks have been prone to such wild swings that a 60-40 mixture of stocks and bonds is not paying 8 percent. Many public pension funds have been averaging a little more than 3 percent a year for the last decade, so they have fallen behind where their planning models say they should be.
A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions.
But plan officials say they cannot.
“Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.
The $30 billion Colorado state pension fund is one of a tiny number of government plans to disclose how much difference even a slight change in its projected rate of return could make. Colorado has been assuming its investments will earn 8.5 percent annually, on average, and on that basis it reported a $17.9 billion shortfall in its most recent annual report.
But the state also disclosed what would happen if it lowered its investment assumption just half a percentage point, to 8 percent. Though it might be more likely to achieve that return, Colorado would earn less over time on its investments. So at 8 percent, the plan’s shortfall would actually jump to $21.4 billion. Contributions would need to increase to keep pace.
Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.
If Colorado could somehow get 9 percent annual returns from its investments, though, its pension shortfall would shrink to a less daunting $15 billion, according to its annual report.
That explains why plan officials are looking everywhere for high-yielding investments.
Mr. May, in Wyoming, said many governments were “moving away from the perceived safety and liquidity of the investment-grade market” and investing money offshore, but he said he was aware of the risks. “There’s a history of emerging markets kind of hitting the wall,” he said.
Last year, the North Carolina Legislature enacted a measure to let the state pension fund invest 5 percent of its assets in “credit opportunities,” like junk bonds and asset-backed securities from the Federal Reserve’s Term Asset-Backed Securities Loan Facility, an emergency program created to thaw the frozen markets for such securities.
The law also lets North Carolina put 5 percent of its pension portfolio into commodities, real estate and other assets that the state sees as hedges against inflation. A summary of the bill issued by the state’s treasurer and sole pension trustee, Janet Cowell, said it would provide “flexibility and the tools to increase portfolio return and better manage risk.”
But some think they see new risks.
“It doesn’t pass the smell test,” said Edward Macheski, a retired money manager living in North Carolina. “North Carolina’s assumption is 7.25 percent, and they haven’t matched it in 10 years.” He went to a recent meeting of the state treasurer’s advisory board, armed with a list of questions about the investment policy. But the board voted not to permit any public discussion.
Wisconsin, meanwhile, has become one of the first states to adopt an investment strategy called “risk parity,” which involves borrowing extra money for the pension portfolio and investing it in a type of Treasury bond that will pay higher interest if inflation rises.
Officials of the State of Wisconsin Investment Board declined to be interviewed but provided written descriptions of risk parity. The records show that Wisconsin wanted to reduce its exposure to the stock market, and shifting money into the inflation-proofTreasury bonds would do that. But Wisconsin also wanted to keep its assumed rate of return at 7.8 percent, and the Treasury bonds would not pay that much.
Wisconsin decided it could lower its equities but preserve its assumption if it also added a significant amount of leverage to its pension fund, by using a variety of derivative instruments, like swaps, futures or repurchase agreements.
It decided to start with a small amount of leverage and gradually increase it over time, but word of even a baby step intoderivatives elicited howls of protest from around the state.
The big California pension fund, known as Calpers, was already under fire for losing billions of dollars on private equities and real estate in the last few years. So far it has stayed with those asset classes, while negotiating lower fees and writing off some of the most troubled real estate investments.
It announced in February that it had started looking into whether it should lower its expected rate of investment return, now 7.75 percent a year. It has embarked on a study, but a spokesman said that process would not be done until December, safely after the coming election.
We're so good at medical studies that most of them are wrong
By John Timmer | Last updated 6 days ago
It's possible to get the mental equivalent of whiplash from the latest medical findings, as risk factors are identified one year and exonerated the next. According to a panel at the American Association for the Advancement of Science, this isn't a failure of medical research; it's a failure of statistics, and one that is becoming more common in fields ranging from genomics to astronomy. The problem is that our statistical tools for evaluating the probability of error haven't kept pace with our own successes, in the form of our ability to obtain massive data sets and perform multiple tests on them. Even given a low tolerance for error, the sheer number of tests performed ensures that some of them will produce erroneous results at random.
The panel consisted of Suresh Moolgavkar from the University of Washington, Berkeley's Juliet P. Shaffer, and Stanley Young from the National Institute of Statistical Sciences. The three gave talks that partially overlapped, at least when it came to describing the problem, so it's most informative to tackle the session at once, rather than by speaker.
Why we can't trust most medical studies
Statistical validation of results, as Shaffer described it, simply involves testing the null hypothesis: that the pattern you detect in your data occurs at random. If you can reject the null hypothesis—and science and medicine have settled on rejecting it when there's only a five percent or less chance that it occurred at random—then you accept that your actual finding is significant.
The problem now is that we're rapidly expanding our ability to do tests. Various speakers pointed to data sources as diverse as gene expression chips and the Sloan Digital Sky Survey, which provide tens of thousands of individual data points to analyze. At the same time, the growth of computing power has meant that we can ask many questions of these large data sets at once, and each one of these tests increases the prospects than an error will occur in a study; as Shaffer put it, "every decision increases your error prospects." She pointed out that dividing data into subgroups, which can often identify susceptible subpopulations, is also a decision, and increases the chances of a spurious error. Smaller populations are also more prone to random associations.
In the end, Young noted, by the time you reach 61 tests, there's a 95 percent chance that you'll get a significant result at random. And, let's face it—researchers want to see a significant result, so there's a strong, unintentional bias towards trying different tests until something pops out.
Young went on to describe a study, published in JAMA, that was a multiple testing train wreck: exposures to 275 chemicals were considered, 32 health outcomes were tracked, and 10 demographic variables were used as controls. That was about 8,800 different tests, and as many as 9 million ways of looking at the data once the demographics were considered.
The problem with models
Both Young and Moolgavkar then discussed the challenges of building a statistical model. Young focused on how the models are intended to help eliminate bias. Items like demographic information often correlate with risks of specific health outcomes, and researchers need to adjust for those when attempting to identify the residual risk associated with any other factors. As Young pointed out, however, you're never going to know all the possible risk factors, so there will always be error that ends up getting lumped in with whatever you're testing.
Moolgavkar pointed out a different challenge related to building the statistical models: even the same factor can be accounted for using different mathematical means. The models also make decisions on how best handle things like measuring exposures or health outcomes. The net result is that two models can be fed an identical dataset, and still produce a different answer.
At this point, Moolgavkar veered into precisely the issues we covered in our recent story on scientific reproducibility: if you don't have access to the models themselves, you won't be able to find out why they produce different answers, and you won't fully appreciate the science behind what you're seeing.
Consequences and solutions
It's pretty obvious that these factors create a host of potential problems, but Young provided the best measure of where the field stands. In a survey of the recent literature, he found that 95 percent of the results of observational studies on human health had failed replication when tested using a rigorous, double blind trial. So, how do we fix this?
The consensus seems to be that we simply can't rely on the researchers to do it. As Shaffer noted, experimentalists who produce the raw data want it to generate results, and the statisticians do what they can to help them find them. The problems with this are well recognized within the statistics community, but they're loath to engage in the sort of self-criticism that could make a difference. (The attitude, as Young described it, is "We're both living in glass houses, we both have bricks.")
Shaffer described how there were tools (the "family-wise error rate") that were once used for large studies, but they were so stringent that researchers couldn't use them and claim much in the way of positive results. The statistics community started working on developing alternatives about 15 years ago but, despite a few promising ideas, none of them gained significant traction within the community.
Both Moolgavkar and Young argued that the impetus for change had to come from funding agencies and the journals in which the results are published. These are the only groups that are in a position to force some corrections, such as compelling researchers to share both data sets and the code for statistical models.
Moolgavkar also made a forceful argument that journal editors and reviewers needed to hold studies to a minimal standard of biological plausibility. Focusing on studies of the health risks posed by particulates, he described studies that indicated the particulates in a city were as harmful as smoking 40 cigarettes daily; another concluded that particulates had a significant protective effect when it comes to cardiovascular disease. "Nobody is going to tell you that, for your health, you should go out and run behind a diesel bus," Moolgavkar said. "How did this get past the reviewers?"
But, in the mean time, Shaffer seemed to suggest that we simply have to recognize the problem and communicate it with the public, so that people don't leap to health conclusions each time a new population study gets published. Medical researchers recognize the value of replication, and they don't start writing prescriptions based on the latest gene expression study—they wait for the individual genes to be validated. As we wait for any sort of reform to arrive, caution, and explaining to the public the reasons for this caution, seems like the best we can do
Doctor Leads Quest for Safer Ways to Care for Patients
By CLAUDIA DREIFUS
Dr. Peter J. Pronovost, 45, is medical director of the Quality and Safety Research Group at Johns Hopkins Hospital in Baltimore, which means he leads that institution’s quest for safer ways to care for its patients. He also travels the country, advising hospitals on innovative safety measures. The Hudson Street Press has just released his book, “Safe Patients, Smart Hospitals: How One Doctor’s Checklist Can Help Us Change Health Care from the Inside Out,” written with Eric Vohr. An edited version of a two-hour conversation follows.
Q. WHAT GOT YOU STARTED ON YOUR CRUSADE FOR HOSPITAL SAFETY?
A. My father died at age 50 of cancer. He had lymphoma. But he was diagnosed with leukemia. When I was a first-year medical student here at Johns Hopkins, I took him to one of our experts for a second opinion. The specialist said, “If you would have come earlier, you would have been eligible for a bone marrow transplant, but the cancer is too advanced now.” The word “error” was never spoken. But it was crystal clear. I was devastated. I was angry at the clinicians and myself. I kept thinking, “Medicine has to do better than this.”
A few years later, when I was a physician and after I’d done an additional Ph.D. on hospital safety, I met Sorrel King, whose 18-month-old daughter, Josie, had died at Hopkins from infection and dehydration after a catheter insertion.
The mother and the nurses had recognized that the little girl was in trouble. But some of the doctors charged with her care wouldn’t listen. So you had a child die of dehydration, a third world disease, at one of the best hospitals in the world. Many people here were quite anguished about it. And the soul-searching that followed made it possible for me to do new safety research and push for changes.
Q. What exactly was wrong here?
A. As at many hospitals, we had dysfunctional teamwork because of an exceedingly hierarchal culture. When confrontations occurred, the problem was rarely framed in terms of what was best for the patient. It was: “I’m right. I’m more senior than you. Don’t tell me what to do.” With the thing that Josie King died from — an infection after a catheter insertion, our rates were sky high: about 11 per 1,000, which, at the time, put us in the worst 10 percent in the country.
Catheters are inserted into the veins near the heart before major surgery, in the I.C.U., for chemotherapy and for dialysis. The C.D.C. estimates that 31,000 people a year die from bloodstream infections contracted at hospitals this way. So I thought, “This can be stopped. Hospital infections aren’t like a disease there’s no cure for.” I thought, “Let’s try a checklist that standardizes what clinicians do before catheterization.” It seemed to me that if you looked for the most important safety measures and found some way to make them routine, it could change the picture.The checklist we developed was simple: wash your hands, clean your skin with chlorhexidine, try to avoid placing catheters in the groin, if you can, cover the patient and yourself while inserting the catheter, keep a sterile field, and ask yourself every day if the benefits of catheterization exceed the risks.
Q. WASH YOUR HANDS? DON’T DOCTORS AUTOMATICALLY DO THAT?
A. National estimates are that we wash our hands 30 to 40 percent of the time. Hospitals working on improving their safety records are up to 70 percent. Still, that means that 30 percent of the time, people are not doing it.
At Hopkins, we tested the checklist idea in the surgical intensive care unit. It helped, though you still needed to do more to lower the infection rate. You needed to make sure that supplies — disinfectant, drapery, catheters — were near and handy. We observed that these items were stored in eight different places within the hospital, and that was why, in emergencies, people often skipped steps. So we gathered all the necessary materials and placed them together on an accessible cart. We assigned someone to be in charge of the cart and to always make sure it was stocked. We also instituted independent safeguards to make certain that the checklist was followed.
We said: “Doctors, we know you’re busy and sometimes forget to wash your hands. So nurses, you are to make sure the doctors do it. And if they don’t, you are empowered to stop takeoff on a procedure.”
Q. HOW DID THAT FLY?
A. You would have thought I started World War III! The nurses said it wasn’t their job to monitor doctors; the doctors said no nurse was going to stop takeoff. I said: “Doctors, we know we’re not perfect, and we can forget important safety measures. And nurses, how could you permit a doctor to start if they haven’t washed their hands?” I told the nurses they could page me day or night, and I’d support them. Well, in four years’ time, we’ve gotten infection rates down to almost zero in the I.C.U.
We then took this to 100 intensive care units at 70 hospitals in Michigan. We measured their infection rates, implemented the checklist, worked to get a more cooperative culture so that nurses could speak up. And again, we got it down to a near zero. We’ve been encouraging hospitals around the country to set up similar checklist systems.
Q. IN YOUR BOOK, YOU MAINTAIN THAT HOSPITALS CAN REDUCE THEIR ERROR RATES BY EMPOWERING THEIR NURSES. WHY?
A. Because in every hospital in America, patients die because of hierarchy. The way doctors are trained, the experiential domain is seen as threatening and unimportant. Yet, a nurse or a family member may be with a patient for 12 hours in a day, while a doctor might only pop in for five minutes.
When I began working on this, I looked at the liability claims of events that could have killed a patient or that did, at several hospitals — including Hopkins. I asked, “In how many of these sentinel events did someone know something was wrong and didn’t speak up, or spoke up and wasn’t heard?”
Even I, a doctor, I’ve experienced this. Once, during a surgery, I was administering anesthesia and I could see the patient was developing the classic signs of a life threatening allergic reaction. I said to the surgeon, “I think this is a latex allergy, please go change your gloves.” “It’s not!” he insisted, refusing. So I said, “Help me understand how you’re seeing this. If I’m wrong, all I am is wrong. But if you’re wrong, you’ll kill the patient.” All communication broke down. I couldn’t let the patient die because the surgeon and I weren’t connecting.
So I asked the scrub nurse to phone the dean of the medical school, who I knew would back me up. As she was about to call, the surgeon cursed me and finally pulled off the latex gloves.
Q. WHAT CAN CONSUMERS DO TO PROTECT THEMSELVES AGAINST HOSPITAL ERRORS?
A. I’d say that a patient should ask, “What is the hospital’s infection rate?” And if that number is high or the hospital says they don’t know it, you should run. In any case, you should also ask if they use a checklist system.
Once you’re an in-patient, ask: “Do I really need this catheter? Am I getting enough benefit to exceed the risk?” With anyone who touches you, ask, “Did you wash your hands?” It sounds silly. But you have to be your own advocate.