Thursday, November 23, 2017

OTPP's Barbara Zvan on Managing Risk?

This morning I had a chance to speak with Barbara Zvan, Ontario Teachers' Chief Risk & Strategy Officer. You’ll recall I spoke with Barb last month when I covered Canada's new pension hub, but I asked her if we can cover risk management in a separate topic and she graciously accepted to speak with me again today.

I sent her ten questions I wanted to cover in our conversation:
  1. What is the role of risk management in any pension plan?
  2. How does OTPP address risk in public markets?
  3. How does OTPP address risks in private markets?
  4. How does OTPP address liquidity risk?
  5. How does OTPP address funding risk?
  6. How does OTPP address benchmark risks (risks that benchmarks do not accurately reflect risks being taken)?
  7. How does OTPP use leverage to reduce overall risk?
  8. How important is qualitative risk assessment as opposed to quantitative risk assessment in your overall monitoring of portfolio risks?
  9. How critical are risk systems to monitor all risks, including operational risks?
  10. How does risk factor into OTPP's compensation scheme?
Barb began by stating risk management at a pension is about retirement security. Specifically, can the plan earn the retun needed to support the pension plan.

Her group's job is to monitor total portfolio risk and make recommendations to the Board and internally as to how certain investments in public and private markets will impact the overall risk of the plan. The Board determines the risk appetite of the plan and senior managers and the risk group work together to calibrate that risk across the different portfolios.

At this point, we started talking about conditional inflation protection which Teachers' uses when the plan runs into a deficit from time to time. OTPP has an extensive discussion on plan funding which includes the evolution of its plan and the Teachers' pension challenge (click on image):

Barb emphasized that OTPP's maturity and demographics were key factors when a decision was made to drop guaranteed indexing and partially remove inflation protection following the 2008 crisis when the plan experienced a deficit.

Again, look at the dramatic drop in the ratio of working-to-retired members, going form 10:1 in 1970 to to 4:1 in 1990 to 1.3:1 now (click on image):

You can have the best investment team in the world but there's no way OTPP can achieve fully funded status without having that lever to partially or fully remove inflation protection for a period when the plan runs into trouble to allow it to restore its fully funded status.

OTPP's aging demographics also factors into the discount rate being used to determine its future liabilities (click on image):

You can see OTPP uses one of the lowest discount rates in the public pension industry (4.8%), well below that used at large US public pensions and it still managed to be fully funded. You can read more about the discount rate OTPP uses and how it's determined here.

When it comes to funding risk, the plan's sponsors, the Ontario Teachers Federation (OTF) and the Ontario government, have a Funding Management Policy that guides their decisions on how to use any surplus funds or resolve any shortfall. To address a funding surplus or shortfall, they can:
  • Change contribution rates
  • Change the level of inflation protection for pension credit earned after 2009
  • Change other pension benefits members will earn in future years
  • Adopt a combination of these options
The key here is to spread risk across generations and make sure the plan remains fully funded to pay benefits for a very long time.

Barb told me OTPP will advise the plan sponsors on whether the contribution rate is realistic over the long term.

In terms of managing risks in public and private markets, she told me the risks in public markets are straightforward and quantifiable. Individual portfolio managers use a risk template and the risk system they use is FIS' Adaptiv.

She said since the internal portfolio managers use futures and OTC derivatives extensively, her group does spend a lot of time on counterparty risks.

For external hedge funds, a managed account platform helps them aggregate and clean the data but some hedge funds are more punctual than others in terms of providing timely information (that part I didn't get since by definition Teachers' owns the managed account and has full transparency on a daily basis unless many hedge funds are still not on the managed account).

In private markets, Barb told me a lot of the risk is qualitative and done prior to any large investment. There is a private markets risk group which attends internal meetings of the private market teams on specific deals and they look at ESG factors, how much leverage is being used to determine how much risk should be allocated to a deal. On bigger deals, they will sit on the CIO Investment Committee to make recommendations.

In terms of benchmarks in private markets, she told me "there's no free lunch" and that all managers are paid on "return on risk". There are no custom benchmarks based on holdings (like CPPIB does) but they capture higher leverage and other risk factors.

On the topic of total leverage which I covered here and here this year, Barb told me the demographics of the plan determine the discount rate and leverage is used to offset the mismatch in assets and liabilities and improve the overall Sharpe ratio of the total portfolio. She also told me some investments in commodities are made through futures and swaps which increases the leverage (OTPP also repos its extensive bond portfolio just like HOOPP).

However, increasing leverage goes hand in hand with liquidity risk management which OTPP takes very seriously. They stress test their portfolio often and make sure they have enough liquidity on hand to make their pension payments.

I asked her if OTPP has access to credit, why not borrow if the plan suffers a cash crunch? She wisely answered: "Because in times of stress, there are no guarantees you will have aaccessto credit markets."

We ended our discussion by talking about the increasing role of ESG and climate change and incorporating them into the plan's risk framework. She told the Canadian Coalition of Good Governance (CCGG) is working on some research that will come out shortly on this topic.

Two years ago, Ontario Teachers' and CPPIB (rightly) refused to divest from fossil-fuel assets and Barb had plenty to say on this topic:
We don’t support divestment; we’re much more in the camp of supporting engagement – working with companies, understanding what they are doing, how they are managing these risks, backing them when they are putting things in place,” Barbara Zvan, senior vice-president for asset mix and risk at Teachers, said in an interview.

“Those are conversations we did not have four or five years ago that we are starting to have today. … I don’t think we generally take the activist route. We would rather work privately with engagement.”

Ms. Zvan said climate risk cuts across a number of sectors – not just oil and gas companies or coal-burning utilities – and long-term investors such as pension plans are working hard to get a better understanding of the vulnerabilities. Clear guidance from policy-makers on carbon pricing and other climate strategies is critical, she added.

Teachers agreed last summer to pay $3.3-billion for oil and gas holdings owned by Calgary-based Cenovus Energy Inc., but it has also purchased renewable energy companies, including Calgary-based Blue Earth. For its part, the CPPIB is leading a group that agreed to purchase Encana Corp.’s DJ Basin oil and gas assets in Colorado for $900-million (U.S.), but that deal has been delayed for six months.

Ms. Zvan said the Teachers fund assesses each transaction on its merits, with a clear eye to long-term risks as the world transitions to a low-carbon economy. “It’s really about trying to embed it in a broader risk framework,” she said. Pension funds are particularly vulnerable to disruption in the fossil-fuel sector because they invest for the long term to safeguard retirement funds for people who are not even in the work force yet.

Teachers has also balked at proposals from a United Nations-supported group called Principles for Responsible Investing that is urging institutional investors to disclose their own “carbon footprint” and their plans to reduce investments in fossil fuels. Ms. Zvan said such high-level reporting “is not that informative” because it lacks context, and that the pension fund prefers to be guided by its statement of principles by which it manages risks and takes advantage of investing opportunities.
Interestingly, when I spoke to OPTrust's CEO Hugh O'Reilly about that plan's decision to butt out tobacco for good he told me "the carbon footprint for trucks and trains is much larger than it is for pipelines," so he doesn't support calls to divest from fossil-fuel assets (but for cigarettes he does because the end product is addictive and lethal and no amount of corporate engagement will change that).

Lastly, I asked Barb if there is anything that worries her about today's inflated markets. She told me she is "always worried about whether OTPP can meet its objective."

I want to thank Barbara Zvan for taking the time to talk to me earlier today. I asked her to read over my comment and if there is anything to change or add, I will edit it as soon as possible.

Below, Barbara Zvan, OTPP's Chief Risk & Strategy Officer, talks about the evolution of responsible investing and the role it plays in helping them meet their fiduciary duty to its members.

And even though Barb didn't get into specifics on what worries her in these markets, OTPP's Executive Vice-President and Chief Investment Officer, Bjarne Graven Larsen, recently sat with BNN to discuss whether markets are too good to be true. Great interview, listen to him carefully.

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