Tuesday, March 14, 2017

Is OPTrust Changing the Conversation?

Julius Melnitzer of Benefits Canada reports, OPTrust return slides to 6% in 2016:
OPTrust’s investment return for 2016 decreased to six per cent, compared to its return of eight per cent in 2015.

Its 2016 funded status report, released on Monday, shows the fund outperformed its actuarially projected discount rate of 5.5 per cent. It also outperformed its benchmarks in its alternative asset classes, which are internally managed. Private equity earned 20.6 per cent, infrastructure yielded an 11.1 per cent return and real estate came in at 10.8 per cent.

“We had a strong year and reduced the amount of risk that we have in the plan,” says OPTrust president and chief executive officer Hugh O’Reilly.

Still, O’Reilly chose to emphasize the fact that the $19 billion OPTrust, which manages the OPSEU pension plan, remained fully funded on a regulatory filing basis for the eighth consecutive year.

“What matters most to ourselves and our members is the funded status of the plan,” he said. “So we are changing the conversation by changing the name of our filing from an ‘annual report’ to a ‘funded status report’.”

On a market value basis, OPTrust is 110 per cent funded, a slight improvement over 2015 when it was 101.1 per cent funded. The funding valuation confirmed deferred investment gains of $681 million, which will be recognized over the next four years.

“Our results mean that contributions and benefits will stay at current levels at least through 2020, which meets our goal of providing current benefit levels at current costs with a high degree of probability,” says O’Reilly. “We remain the only jointly sponsored plan with guaranteed indexing that is fully funded.”

In terms of demographics, OPTrust has an equal proportion of active and inactive members, even as the long-term decline in the ratio of active members to retirees continues. By law, the pension fund cannot decrease benefits if it sustains losses, with the sole alternative being to increase contribution levels.

“But we don’t want to be in the position of having to do that because it would put a heavier burden on our active members,” says O’Reilly.

OPTrust reduced its real discount rate from 3.55 per cent in 2015 to 3.4 per cent in 2016. The rate change increased fund liabilities by $502 million, adding greater conservatism to the its risk margins.

“This change reflects the expectation of lower long-term investment returns and reduces the risk of future losses due to investment returns falling short of the expected cost of members’ and retirees’ future pensions,” states the report.

OPTrust also diversified in 2016 by reducing its exposure to equity risks and increasing its exposure to absolute return strategies. The strategy follows the introduction in 2015 of OPTrust’s member-driven investment strategy, which focuses on harvesting different types of risk premium in a diversified manner.

“We see ourselves not as asset allocators but as risk allocators,” says O’Reilly. “Our goal is to balance the generation of short-term returns with the need to manage long-term risk effectively, and to seek stability rather than volatility.”
I just got off a conference call with OPTrust's President and CEO, Hugh O'Reilly, and its CIO, James Davis, where we spoke at length about the funded status and shift in investment philosophy.

Before I get to that conversation below, let me thank Claire Prashaw, Manager of Public Affairs at OPTrust, and Linda Fix, Hugh O'Reilly's Executive Assistant for organizing this call.

Let me begin my analysis by going over the press release, The $19 billion pension management organization increases its market-based surplus and improves its ability to meet its pension promise to members:
OPTrust released its 2016 Funded Status Report, which details the Plan's eighth consecutive, fully funded position and financial results. In 2016, OPTrust achieved an investment return of six per cent for the total fund, net of external management fees and outpaced all of its benchmarks. The organization received high scores with members and retirees rating their satisfaction with a score of 9.1 out of 10.

"The measure of success that matters the most is the Plan's fully funded status," said Hugh O'Reilly, President and CEO of OPTrust. "We are risk allocators, not asset allocators. That's why the true goal behind short-term performance is the long-term funded position. OPTrust has decreased risk and strengthened its fully funded status. That ensures our ability to pay pensions today and preserve pensions for tomorrow."

The Plan remained fully funded in 2016 on a regulatory filing basis, while the organization continued to strengthen its actuarial assumptions to enhance the long-term funding health of the Plan. The Plan's real discount rate was lowered to 3.4 per cent, net of inflation, from 3.55 per cent in 2015, reflecting increased actuarial margins and reducing the risk of future losses due to investment returns falling short of the expected cost of members' future pensions. The funding valuation confirmed deferred investment gains of $681 million at the end of 2016, which should further improve funded status in the years to come.

OPTrust introduced its member-driven investing (MDI) strategy in 2015 with a singular focus to increase the likelihood of plan certainty by balancing the objectives of sustainability and stability to better align the Plan's outcomes with members' needs. During 2016, OPTrust began implementing MDI through dynamic portfolio construction of the total fund with its illiquid and liquid strategies. The Plan's net assets increased to $19 billion at year-end ($18.4 billion as at December 31, 2015).

More detailed information about OPTrust's 2016 strategy and results is available in its Funded Status Report.
About OPTrust

With net assets of $19 billion, OPTrust invests and manages one of Canada's largest pension funds and administers the OPSEU Pension Plan, a defined benefit plan with almost 90,000 members and retirees. OPTrust was established to give plan members and the Government of Ontario an equal voice in the administration of the Plan and the investment of its assets through joint trusteeship. OPTrust is governed by a 10-member Board of Trustees, five of whom are appointed by OPSEU and five by the Government of Ontario.
You can go over OPTrust's 2016 funded status report by clicking here. Interestingly, it's titled "Changing the Conversation" to focus on what Hugh O'Reilly and HOOPP's Jim Keohane think is a better measure of a pension fund's success, namely, the funded status, not the returns it delivers on any given year.

A long time ago, I did some research at PSP looking at the total return approach versus the asset-liability approach to achieve funded status. Most pension funds focus on the total return approach, taking on huge equity risk to obtain the highest return, but this approach leaves them vulnerable to severe downside risk, and if they're already chronically underfunded, it can spell doom for their funded status.

The way I explain it to people is to think of their own retirement. You can put 100% of your money in stocks but if you're trying to build a nest egg, taking a big hit on any given year can set you backs years, and this is especially troubling when you're close to retirement.

I recently had a conversation on Twitter with someone on my long biotech call. We discussed some biotechs but then he asked me why I recommended to buy US long bonds (TLT) to "sleep well at night."

I told him because I swing trade biotechs (XBI) and have some long core positions in smaller companies with huge potential, they are extremely volatile, and the truth is this rally has gotten long in the tooth. It can continue for longer than most skeptics think as there is a lot of juice in the system to propel risk assets higher, but at one point a downturn will happen and that's when there will be a massive flight to safety and everyone will be rushing to buy US Treasuries.

What can derail this market? The Fed might make a policy error and hike more often than what the market anticipates, fueling the 2017 US dollar crisis I warned of late last year. There are plenty of geopolitical risks that can derail this market too, but so far dip buyers have enjoyed a nice ride up (momentum and dip buying works until it doesn't).

The point is this, if you take concentrated equity positions in this market, get ready to have your head handed to you at any moment. That goes for retail and institutional investors.

Now, OPTrust is a pension plan focusing on managing assets and liabilities. Unlike HOOPP and Ontario Teachers', however, it's a jointly sponsored pension plan that guarantees full inflation protection no matter what (OMERS also guarantees full indexation). Also, unlike HOOPP, OPTrust has a 1 to 1 ratio of active members to retired members so it's a more mature pension plan.

In effect, what this means is that there is an added pressure on the managers of OPTrust to ensure their portfolio can better withstand any financial shock because they are focusing on obtaining the highest risk-adjusted returns or to limit downside risk as much as possible.

[Note: Finance geeks know all about the difference between a Sharpe ratio and a Sortino ratio. The Sharpe ratio and the Sortino ratio are both risk-adjusted evaluations of return on investment. The Sortino ratio is a variation of the Sharpe ratio that only factors in downside risk.]

Simply put, unlike HOOPP and OTPP, the risk of a prolonged underfunded status on OPTrust only hurts active members because by law, benefits are guaranteed for retired members (full indexation is guaranteed). So, if OPTrust  becomes underfunded, contribution rates will increase for active members and the government of Ontario (jointly sponsored plan) but the benefits will not change for retired members.

“But we don’t want to be in the position of having to do that because it would put a heavier burden on our active members,” Hugh O’Reilly said in the article above.

Now, if you ask me, the fact that there is no risk sharing between active members and retired members at OPTrust makes the task of its senior managers that much harder. Why? Because unlike HOOPP and Ontario Teachers' (OMERS also guarantees full indexation), when the plan is underfunded, the only option is to increase contributions, not to partially or fully remove inflation protection on benefits, which is typically the mechanism of choice at these pension plans to restore the fully funded status.

What does this mean for OPTrust? It means they really have to focus on their funded status more closely than everyone else and need to focus not only on obtaining the highest risk-adjusted returns, but also on minimizing downside risk on any given year.

This is why they are not focusing on the Fund's overall return being 6% net in 2016 but are rather placing the focus on their funded status. High returns accompanied by huge volatility and huge downside risk are simply not acceptable and could spell doom for OPTrust's active members.

Yes, it's true that Ontario Teachers' and HOOPP are also focusing on their funded status and obtaining high risk-adjusted returns to minimize their funded status volatility (and contribution rate) but unlike OPTrust, they have an additional option (remove full inflation protection) when their plan runs into a deficit, so they are able to withstand more downside risk than OPTrust. And in the case of HOOPP, it has more active members than retired members, so it's not as mature as OPTrust, OTPP and OMERS and can take more risk if it wants to because it has more contributions than what it pays out in benefits.

And thus far, I've only discussed the ASSET side of the equation, but as I keep stating in this blog, the primary determinant of pension deficits is low interest rates. The lower they go, the higher liabilities go and since the duration of liabilities are higher than the duration of assets, lower rates will exacerbate pension shortfalls in the future, especially if we enter a prolonged period of debt deflation.

Are you with me thus far? I know it's a lot to digest but the key thing here is that the investment focus of OPTrust is one of maintaining a fully funded status but with an extra twist of really focusing on managing downside risk.

As Hugh O'Reilly and James Davis, OPTrust's CIO, explained to me, if they suffer a loss, it's active members that bear the brunt of it.

With this in mind, James and Hugh really went into detail in terms of their investment approach, putting pension certainty -- which is comprised of stability and sustainability -- at the forefront of their investment approach.

And James was very blunt: "We don't need to make returns that put our plan at risk of suffering a big downturn."

He said the portfolio is diversified across risk premium. This is what member-driven investing (MDI) is all about, making sure the entire portfolio is properly diversified in terms of risk premium to "increase the likelihood of plan certainty for members by balancing the objectives of sustainability and stability."

James brought up a good point. He said they do their own asset-liability modeling in-house and allocate risk across every asset class and look underneath to make sure they're taking the right risk exposure. Most pensions don't do this and they end up being overexposed to the equity risk factor.

At OPTrust, they go beyond traditional risk factors like equity and credit to look at alternative risk factors like momentum, value and other factors to really make sure they're properly diversified and focused on minimizing downside risk.

Since they just started implement the MDI approach last year, they are investing with external managers to leverage off their expertise in order to eventually be able to develop these strategies in-house.

OPTrust has already brought a lot of assets internally in public markets to lower the cost of managing these assets and they're developing these new strategies in-house with the aid of external managers to eventually be able to manage more assets in-house.

In private equity, they invest and co-invest with funds but as James told me, "they're not looking to fill buckets" and will use liquid markets to fulfill their allocation to illiquids if they're not fully invested.

In infrastructure, they have done extremely well by investing primarily directly through co-sponsored deals with their strategic partners. Their focus is on the mid-market, with cheque sizes of $100M to $150M and where there is less competition.

Bonds are used as part of their liability-hedged portfolio and "they are essential to protect against the risk of deflation" (music to my ears!). James told me that on top of alternative risk factors, they also look a macro risk factors and divide it up into four economic quandrants similar to Bridgewater's All-Weather strategy (music to Ray Dalio's ears!).

The key here is to make the portfolio as resilient as possible to downside risk. They want to outperform on a risk-adjusted basis no  matter whether the market is up, down or sideways.

In essence, they're transitioning from being an asset allocator to being a risk allocator or put another way, transitioning from being an asset manager to a pension manager.

At one point during our conversation, I asked them if given their relatively smaller size, they need to write bigger cheques to fewer external managers to gain a better strategic relationship.

Hugh and James surprised me by saying "no" and Hugh went on to say "small is beautiful in the pension landscape, we can be innovative and thoughtful."

James said that "strategic relationships go both ways" and Hugh reiterated that same point stating "we have strategic relationships not only with external managers but with all our service providers."

Let that be a lesson to all you big and small pension fund managers, it's not the size of your cheque that always gets you the best strategic relationship (but there's no doubt it helps!).

Anyway, I quite enjoyed my conversation with Hugh O'Reilly and James Davis, both of them are very nice to have taken the time to talk to me.

I urge all of you to go over OPTrust's 2016 Funded Status Report, the Report to Members and management's report on Changing the Conversation which explains portfolio construction and other items I didn't cover in-depth  (click on image):


You can also see the breakdown of total Fund's performance for 2016 by asset class and the geographic exposure (click on image);


On pages 27-29 of OPTrust's 2016 Funded Status Report there is a discussion on all these asset classes. Below, I copied and pasted some passages worth noting:
  • While markets reacted favourably to the U.S. election, we remain cautious due to continued uncertainty. Given we are late in the economic cycle, the potential for policy mistakes is high, while the geopolitical risk has also risen
  • Valuations remain stretched and debt levels remain elevated. Our focus is on building a robust portfolio that is not overly reliant on equities as the generator of investment performance. We seek broad diversification that will allow us to harvest risk premia in different economic environments. Our goal is to increase pension certainty, not earn outsized returns by taking excessive risk.
  • In 2017, we will continue to reposition our total fund portfolio towards a more balanced set of risk factor exposures. Increased exposure to absolute return strategies will help during heightened market volatility and a challenging macroeconomic environment. We expect to grow this part of our portfolio over time.
  • Over the course of 2016, we saw a modest rebound in the Canadian dollar, in response to higher oil prices. Our unhedged currency exposure, which is mostly in U.S. dollars, resulted in a drag on performance of -0.7%.
Lastly, in the spirit of transparency, I embedded the compensation of OPTrust's three highest paid executives below (click on image):


I forgot to ask Hugh and James if their comp is based on funded status or beating overall benchmark. One thing that isn't clear in the report is the benchmarks used for each asset class and the overall value added over the benchmark (my bad if I didn't read this correctly).

I mention this because compensation has to be based on something tangible, and while part of it can be funded status, another part has to be beating some benchmarks which accurately reflect the risks, illiquidity and leverage of the underlying portfolio (there is a discussion on compensation but again, it wasn't clear to me).

Also worth noting that OPTrust, like HOOPP and OTPP and others, really does a good job in keeping expenses low (click on image):


Let me end by thanking Hugh O'Reilly and James Davis for taking the time out of their busy schedule to talk to me. If there is anything that needs to be edited or clarified, I asked them to get back to me and I will edit this comment as needed.

For the rest of you, please take the time to subscribe to this blog or donate via PayPal on the top right-hand side under my picture. Writing these comments is a lot more work than it looks like and I appreciate the financial support from people who value my work.

Below, Hugh O'Reilly, OPTrust's President and CEO, discusses changing the conversation to focus on their fully funded status. Listen carefully to what he says, he explains why the conversation needs to change to focus on a plan's funded status.

Also, Bloomberg’s Lily Jamali spoke with Hugh O’Reilly about the fund’s investments and priorities. Watch this interview below.

Hugh is super nice and made me laugh at the end of our conversation when he said: "Toronto has a great pension ecosystem. We all believe in the same god but practice different religions."

Update: Hugh O'Reilly shared this with me: "In terms of how we are compensated, there is a direct link to maintaining the plan’s fully funded status (we use three different metrics), but that is likely a topic all on its own. One last thing, we are great admirers of our peer plans."

Claire Prashaw, Manager of Public Affairs at OPTrust also shared this: “We use a mark-to-market approach with our MDR. We also have value add stats based on Management Benchmarks (160 bps value add in 2016 and 180 bps pa since inception). We would add that value add is secondary to our funded status and point out 2008 as the example of the danger of focusing on value add.


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