Sunday, November 23, 2008

Is Ontario Teachers' Heading for a Fall?


My last entry was about the Caisse and the major internal and external challenges it faces to come out of this crisis.

But as I stated, it isn't just the Caisse that is suffering; other large Canadian pension plans are also experiencing similar challenges.

One of those plans is Ontario Teachers. For years, those of us in the pension community were told to try and emulate Teachers.

Why? Because, as the saying goes, Ontario Teachers got it right. They took a page from the Harvard and Yale endowments, aggressively moving into alternative assets early on. They shoved billions into real estate, private equity, hedge funds, commodities, timberland, infrastructure and everything else that was supposedly not correlated to public equities.

Funny thing about correlations, they always break down when you need them the most. What you want want is for asset classes to be non-correlated when a crisis hits, not when the good times are rolling.

And in a systemic crisis like the one we are currently experiencing, only good old government bonds will help cushion the blow to the overall fund. When all asset classes are in a bubble, as is the case now, the unwinding is so fierce that only government bonds will mitigate the downside risks.


You would think this is simple to understand but so many pension funds fell victim to the illusion that risk was being managed properly by sophisticated models measuring value at risk (VaR), that nobody stopped to think about if all these asset classes are in a bubble, then what happens to our overall fund?

At Ontario Teachers, you got some exceptionally bright people working in all asset classes. But just like the Caisse, Teachers is going to get whacked hard this year and a lot of their riskier investments, especially the ones in private equity, are going to come back to haunt them.

One of the brightest people in the pension world is Bob Bertram. For many years, Mr. Bertram acted as the CIO of Teachers, helping Claude Lamoureux, their former president and CEO manage their pension investments.

This week, it was announced that Mr. Bertram will be stepping down to be replaced by Neil Petroff:

Jim Leech, President and CEO, today announced that Robert Bertram will retire as Executive Vice-President, Investments and Chief Investment Officer of the Ontario Teachers’ Pension Plan (Teachers’) at the end of 2008. Neil Petroff, currently Group Senior Vice-President, Investments, has been appointed his successor, effective January 1, 2009.

“Bob has built a world-class investment team that has been consistently recognized for its innovation in pension fund management,” said Mr. Leech. “Under his leadership, Teachers’ has achieved many firsts – gaining the right to use derivatives, buying a major operating real estate company and being early to invest in private equity, commodities, infrastructure and timber.”

“Bob brought a vision to Teachers’ that investment results could be delivered as well, or better, in-house,” continued Mr. Leech. “His success has changed the way pension plans the world over now invest their funds.”

Prior to joining Teachers’ in 1990, Mr. Bertram spent 18 years at Telus Corporation, formerly Alberta Government Telephone.

Mr. Leech noted that Mr. Petroff’s appointment reflects Teachers’ tradition of cultivating its talent internally. “We have always taken a comprehensive approach to succession. Over his career at Teachers’, Neil has served in progressively senior positions with broad exposure and management experience in a wide range of asset classes and investment products. This has prepared him to lead our investment program into the future, with its new market realities.”

Mr. Petroff has 25 years of experience in the financial industry, beginning his career in investing at Bank of Nova Scotia and continuing at Guaranty Trust and Royal Trustco. He joined Teachers’ in 1993 and has been a member of the executive management team for 13 years. He has led the international equity indexes, fixed income, foreign exchange, tactical asset allocation and alternative investment groups. More recently, as Group Senior Vice-President, Investments he has overseen all of Teachers’ asset classes and portfolios, including public and private equities, inflation-sensitive and fixed income portfolios.

Mr. Petroff earned a BBA and an MBA from York University and is a graduate of the Corporate Governance College. Together with former CEO, Claude Lamoureux and Mr. Bertram, he was recognized for innovative hedge fund portfolio management when Teachers’ was named Public Pension Fund of the Year by Alternative Investments News in 2007.

With $108.5 billion in net assets as of December 31, 2007, the Ontario Teachers' Pension Plan is the largest single-profession pension plan in Canada. An independent organization, it invests the pension fund's assets and administers the pensions of 281,000 active and retired teachers in Ontario.

A couple of observations here. Mr. Bertram was scheduled to retire a year after Mr. Lamoureux retired. And given the state of the markets, I am sure he is looking forward to move on and watch it all from the sidelines.

Also, don't worry about Bob Bertram's retirement. For many years Ontario Teachers fought hard to compensate their employees just like the private sector. With his long-term incentive plan and generous retirement benefits, Mr. Bertram was among the highest paid pension officers in the world, collecting several millions in the last few years alone and being compensated almost as much as Claude Lamoureux.

But you got to keep in mind that compensation is tied into performance and performance is based on beating benchmarks. Unfortunately, Teachers' does not publish benchmarks for each and every internal and external investment activity and they lump investment activities together in broader categories like "inflation-sensitive" asset classes.

If you go to page 83 of the 2007 annual report, you'll see investment returns and related benchmarks, but read the fine print and check out the footnotes:

For example, footnote (1) states that fixed income includes currency policy hedge trading, internal absolute return strategy investments and alternative investments. Moreover, footnote (2) states that for the period January 1, 2006 to June 30, 2006, mezzanine debt was included in Canadian and Non-Canadian equities. Beginning July 1, 2006, mezzanine debt is included in Fixed Income due to a change in benchmark.

And what were the benchmarks for each of these investment activities and do they reflect the risks and beta of the underlying investments?

A bit lower on that page we read that effective January 1, 2007, certain benchmarks have been revised to reflect changes in investment strategy and objectives.

Huh? You are changing benchmarks and you are not publishing a separate report to explain in detail each and every benchmark you are using to evaluate and compensate your senior pension officers?

This is totally unacceptable for a public pension fund that invests billions on behalf of hard working teachers of Ontario who get compensated a fraction of what the Ontario Teachers' senior pension officers get in terms of compensation and retirement benefits.

I am making the latter point not because I have a problem compensating people for performance in investment management, but because for far too long compensation in these "sophisticated" pension funds was based bogus benchmarks that do not reflect the risks of the underlying portfolio.

My biggest beef is with private asset classes like real estate, private equity and infrastructure, but I also warn people to scrutinize the benchmarks used to evaluate external hedge funds and internal absolute return activities.

Importantly, in any investment activity, when you see someone trouncing their benchmark year in and year out, STOP AND THINK about whether that benchmark accurately reflects the underlying risks of the portfolio.

Unfortunately, we do not get enough transparency regarding benchmarks of each investment activity and financial audits by auditor generals or some accounting firm do not cut it.

Large Canadian public pension funds have become too "sophisticated" for their own good. Regulators are way behind the curve and we are in desperate need of major governance reforms to deal with the Mother-of-all crisis that is currently hitting pension funds.

Again, stakeholders need to first acknowledge their own shortcomings in properly supervising these large funds and they need to work on passing laws to increase transparency (performance results should be quarterly) and perform independent performance and operational audits on large funds at least once a year, if not twice a year.

The Ontario Teachers' investment and compensation models have been exported to other large Canadian and global pension funds, but unfortunately, so has the lack of proper disclosure on the benchmarks used to compensate senior pension officers.

Stakeholders should demand a separate document that clearly explains benchmarks and compensation for each and every internal and external investment activity. This document, along with the independent performance and operational audits, should be publicly available so that all stakeholders can view it and scrutinize how pensions investments are being managed.

Am I dreaming? Perhaps, but I can guarantee you that if we not move ahead to bolster the governance of these large funds, then taxpayers are going to be on the hook for billions of dollars.

Now, getting back to Teachers, this is going to be a very tough year. Apart from the drubbing in global equities, there are rumors of large losses in the fixed income department. I can't substantiate any of these rumors, nor can anyone else, but we do know that Sean Rogister, the former Senior Vice-President Fixed Income abruptly left the organization and was replaced by Ron Mock, the current Senior Vice-President, Fixed Income and Alternative Investments.

Ron is one of the sharpest guys I ever met in the pension world. Through our conversations, I learned a lot about operational and investment due diligence on hedge funds. One of the things that Ron taught me is to scrutinize operational risk, including the relationships among senior staff and when you see senior guys leaving a hedge fund, you got to immediately red flag it and ask why.

I think the same goes for pension funds. When you see senior pension officers abruptly leaving a major public pension fund with no press release explaining why, your antenas should be raised. It typically signals something is up and I believe stakeholders have a right to know exactly what is going on.

Then there is the Bell Canada (BCE) mega buyout deal. Boy did Teachers pick the wrong time to buy out BCE!

Forget about the fact that BCE's earnings crumbled in Q3, look at the current state of credit markets. As BCE recently launched a debt buyback, signaling that the deal may go through, junk bond yields subsequently soared to record levels as the global economy declines.

Add to this the issue of BCE's pension shortfall, which the Globe and Mail's Andrew Willis recently mentioned in his Streetwise blog:

As if investors didn't have uncertainties around the BCE buyout, there are new concerns that the telecom company's pension shortfall could undermine the deal.

BCE has already flagged the fact that its pension is under funded, and there are rumours on Friday is that the stock market's slide has made the problem much worse for buyers and lenders.

The nasty line of speculation goes like this: The under-funding problem is now so severe that BCE's auditors can't provide a solvency opinion on the plan.

The $35-billion takeover is being led by the Ontario Teachers Pension Plan, no stranger to funding shortfalls, with Citigroup and Deutsche Bank leading the lending group. BCE officials could not be reached for comment.

No one is saying the pension problem could derail the deal. In fact, experts are saying quite the opposite.

In a report on these issues at the end of October, when BCE published its shortfall, Scotia Capital told clients: “We do not believe an increase in required pension funding by BCE would in constitute a material adverse change.”

The investment dealer said a global issue such as a decline in the value of pension assets is not the kind of problem that lets buyers wiggle out of takeovers. In addition, Scotia Capital analyst John Henderson ran the numbers and found the funding shortfall could be repaid over up to 10 years without undercutting the security promised to lenders, or the returns expected by the buyers.

Quarterly results from Canada's largest phone company showed BCE is concerned with the funding its pension. Last year's annual report showed BCE had $14.8-billion in its pension fund, while actuaries say it needs $15.7-billion to pay the benefits promised to employees. So BCE started the year with a $900-million shortfall.

BCE's pension plan, known as BIMCOR, had 58 per cent of its assets in stocks at the beginning of the year. Canaccord Capital analyst David Lambert calculated in late October that the BIMCOR has likely incurred a $2.3-billion loss, and is now underfunded to the tune of $3.2-billion. Obviously, the recent market meltdown has made things even worse.

“While this pension plan shortfall may not qualify as a material adverse change according to the relevant clause in the definitive agreement, it could increase the deal risk,” said Mr. Lambert.

Increase the deal risk? More like torpedo it! This was a dumb deal in the first place and now that Michael Sabia, the former outspoken CEO of BCE has left that organization, what is the point of completing the deal?

Importantly, does Ontario Teachers really think they will turn a profit out of this deal or are egos driving this deal now?

It seems that the Caisse is betting the deal will go through. Canada's biggest pension fund manager bought more BCE Inc. stock last quarter as the price traded below the buyout offer from an investor group.

Good luck to both of them! If you look at recent activity on BCE shares, you can see that market participants are increasingly worried that this deal will not go through. I bet you that the big international banks that originally signed onto the deal are now seriously looking at break-up fees, ready to walk at any time.

Do you blame them? Look at the current environment - it's not exactly an environment ripe for mega buyout deals. In fact, I heard that things are so dire that two private equity titans recently met up in Libya of all places to raise funds!

In closing, Ontario Teachers is also going through its own issues. On top of suffering its own pension shortfall, Teachers is highly exposed to alternative investments that are cratering this year.

Looking at that picture above from their 2006 annual report, I can't help thinking that Teachers may be juggling more than it can handle and they are now going to stumble and crash like the rest of their peers who followed their lead.

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