Tuesday, February 26, 2013

Ontario Teachers' to Absorb More Risk?

Tara Perkins of the Globe and Mail reports, Deal will let Ontario Teachers’ Pension Plan shoulder more investing risk:
The Ontario Teachers’ Pension Plan is aiming to be more aggressive in its portfolio, its CEO says, after the provincial government and teachers’ union struck an unusual deal to tackle the plan’s deficit.

“It lowers our risk profile quite substantially, from the board’s perspective, such that we can absorb a little more risk in our investment strategy,” Teachers’ chief executive officer Jim Leech said in an interview Monday. That might mean, for example, new flexibility to bolster investments in emerging markets, do more private equity deals, or put more of its money into stocks.

Mr. Leech has been frustrated because, just as the pension plan needs to boost investment returns, chronic deficits over the past decade have forced it to maintain a highly conservative investment profile. That has meant restricting equities to 45 per cent of its portfolio, a lower weighting than most pension funds.

But the fund’s co-sponsors, the Ontario government and the Ontario Teachers’ Federation, have agreed to eliminate the guaranteed inflation protection that is paid on benefits to plan members, a move that will wipe out the plan’s $9.6-billion deficit (as of Jan. 1, 2012).

The province and union have also agreed to study ways to put a permanent stop to the fund’s deficits, research that will likely look at the balance between the number of years that teachers work and the number of years that they receive benefits. In 1990, teachers worked, on average, for 29 years and received retirement benefits for 25 years; by 2011, they worked for 26 years and drew pensions for 30 years. The profession skews toward women and tends to be healthy, resulting in long life expectancy.

The province and union reached the agreement to eliminate the deficit more than two weeks ago but it has remained under the public radar as Queen’s Park settles back in after a leadership change. One of the main issues the province has been contending with is contract negotiations with the teachers, in the wake of a bitter dispute that erupted when former premier Dalton McGuinty prohibited teachers from striking last fall and then imposed new contracts on them early last month.

“It is difficult; teachers did take a reduction in benefits, but I think that ensures the sustainability of the pension plan and weathers the storm created by low interest rates and changing demographics,” Terry Hamilton, president of the Ontario Teachers’ Federation, said in an interview. “The times didn’t help the situation but it shows how we continue to work effectively with the government.”

Mr. Leech says the agreement is one of the most significant of its kind in the industry. “Pension plans have to evolve,” he said. “Plans have to show that they can evolve to the new reality, and I think what these two sponsors have done – the government and the teachers – is shown that they can make that evolution.”

Former finance minister Dwight Duncan made it clear last spring that Teachers’ pension deficit would have to be tackled through benefit reductions, rather than contribution increases, since the province matches what teachers pay into the plan.

The government and union have agreed to numerous measures over the years to eliminate deficits, and the guaranteed inflation protection had already been cut from 100 per cent to 50 per cent.

But Mr. Leech says the changes should have a more permanent impact this time, characterizing this agreement as “a dramatic move.” While the goal will still be to pay inflation protection, the need to do so is removed entirely.

“It provides us with a tool to absorb some hiccups, if there are any, because you can float the inflation protection up and down,” Mr. Leech said, adding that the sponsors have “invoked it such that, going forward, 45 per cent will be paid until further notice.” That will take effect at the start of 2015, Mr. Hamilton said.

While Teachers has not yet disclosed its 2012 annual results, Mr. Leech said it has informed the co-sponsors that, since interest rates fell further during the year, the fund is likely to report a small deficit as of the start of this year – in the neighborhood of 97-per-cent or 98-per-cent funded, he said. “But it will be much smaller … and it is easily handled,” he said.
Looks like the Oracle of Ontario has done it again, striking a deal with its stakeholders to shoulder more investment risk. This is important because given historic low bond yields, Ontario Teachers' and other pension plans dealing with chronic deficits of the past decade need to absorb more investment risk to meet their actuarial target rate of return.

And unlike others, Ontario Teachers'  uses a discount rate of 5.4% to determine the value of future liabilities, the lowest discount rate in Canada and among the lowest in the world. The demographics of their plan is the reason why they use such a low discount rate but some experts have told me the discount rate they use is extremely conservative, overstating their liabilities and understating their funded status.

Nonetheless, Ontario Teachers' recently posted an update on their website going over the agreement reached to keep Teachers' plan on sound financial footing and how the change in inflation protection has small impact on recent retirees.

Keep in mind, Ontario Teachers', OMERS and HOOPP manage assets and liabilities. They are pension plans, not pension funds, so they need to carefully consider the macroeconomic environment and figure out ways to best match assets and liabilities.

As discussed yesterday, OMERS' ultimate strategy is to shift almost half their assets into private markets, which they will manage internally, to boost returns. Ontario Teachers' has a somewhat more diversified asset mix, which includes significant investments in internal absolute return strategies and external hedge funds.

Teacher's states the following in their asset mix overview:
We use bond repurchase agreements to fund investments in all asset classes because it is cost effective and allows us to retain our economic exposure to government bonds. For efficiency reasons, we also use derivatives to gain passive exposure to global equity and commodity indices in lieu of buying the actual securities. Derivative contracts and bond repurchase agreements have played a large part in our investment program since the early 1990s.

In addition, absolute return strategies enable us to earn positive returns that are uncorrelated to other asset groups. We employ these strategies internally to capitalize on market inefficiencies and we complement our own activity by using external hedge fund managers. The use of external hedge funds provides us with access to unique approaches that augment performance and diversify risk.
As previously stated in my comment on the Oracle of Ontario, HOOPP and Teachers' both use derivatives and repos extensively but there are key differences in their approach:
HOOPP does almost everything internally while Teachers' will often use external managers for investment activities they can't replicate internally. Both funds use repos extensively, leveraging up their stock and bond portfolios, saving millions in the process (instead of having some custodian do it off balance sheet, charging them insane fees).

The big difference, however, is Ontario Teachers' takes directional leverage whereas HOOPP doesn't (repos are matched by money market instruments, not invested in hedge funds, private equity and real estate). I have heard figures that Teachers' is leveraged up to 50%, which works well in good years, but goes against them in bad years like 2008, when they crashed and burned.
What will be interesting to see is whether the ability to increase investment risk will mean a cut in the directional leverage they take. Doubt it will but they have the right governance to oversee these risks.

One thing Teachers' did after the 2008 crisis is change compensation for senior managers to decrease 'blowup risk'. I discussed this recently in a comment on excessive risk-taking at public pension funds.

The other thing Ontario Teachers' did after 2008 was take a hard look at how they manage liquidity risk. Ron Mock, Senior VP, Fixed Income and Alternative Investments at Teachers', told me they manage it a lot more tightly, always looking ahead 18 to 24 months.

On this topic, Jim Keohane, President and CEO of Healthcare of Ontario Pension Plan (HOOPP), shared these wise insights with me in a recent comment on pensions taking on too much illiquidity risk:
I find this whole discussion quite interesting. Private assets are just as volatile as public assets. When private assets are sold the main valuation methodology for determining the appropriate price is public market comparables, so you would be kidding yourself if you thought that private market valuations are materially different than their public market comparables. Just because you don’t mark private assets to market every day doesn’t make them less volatile, it just gives you the illusion of lack of volatility.

Another important element which seems to get missed in these discussions is the value of liquidity. At different points in time having liquidity in your portfolio can be extremely valuable. One only needs to look back to 2008 to see the benefits of having liquidity. If you had the liquidity to position yourself on the buy side of some of the distressed selling which happened in 2008 and early 2009, you were able to pick up some unbelievable bargains.
Moving into illiquid assets increases the risk of the portfolio and causes you to forgo opportunities that arise from time to time when distressed selling occurs - in fact it may cause you to be the distressed seller! Liquidity is a very valuable part of your portfolio both from a risk management point of view and from a return seeking point of view. You should not give up liquidity unless you are being well compensated to do so. Current private market valuations do not compensate you for accepting illiquidity, so in my view there is not a very compelling case to move out of public markets and into private markets at this time.
Many pension funds learned the value of liquidity the hard way during the 2008 crisis. When they needed it the most, they didn't have it and were forced to sell public market assets at distressed levels to shore up their liquidity. Keep this in mind the next time someone tells you that pension funds are long-term investors and can take on unlimited amount of illiquidity risk. That's pure rubbish and smart guys like Jim Keohane and Jim Leech know it.

Finally, Jim Leech, President and CEO of Ontario Teachers' Pension Plan (Teachers'), recently issued a call to action in his keynote speech to the National Summit on Pension Reform in Fredericton. In his remarks, Leech introduced a new pension funding documentary, co-produced by Teachers' and Cormana Productions, entitled Pension Plan Evolution - A New Financial Reality (watch it below or here).

Also embedded a recent CNBC interview with Jim Leech where he discussed how an energy self-sufficient U.S. could cause a "seismic" market shift. Jim also discussed Teacher's asset allocation and where he thinks opportunities lie ahead.