Thursday, April 2, 2009

Ontario Teachers' Crashes and Burns in 2008

In late November, I stated that Ontario Teachers' Pension Plan (OTPP) was heading for a fall:
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.
On Thursday, Teachers' reported its 2008 results, stating that diversification strategy fails to divert losses:
The Ontario Teachers’ Pension Plan ended 2008 with assets totaling $87.4 billion, compared to its record $108.5 billion level at the end of 2007. The fund’s investment return was -18% compared to its composite benchmark return of -9.6%.

“Our investment team fought hard against the downward pressure of the global credit freeze and subsequent stock, bond and real estate market crashes throughout the year; but market forces retained the upper hand at year-end,” said Jim Leech, President and Chief Executive Officer. “It is small consolation to us that our results are consistent with the average of other large Canadian pension plans,” he added.

The fund’s 2008 returns largely reflect its exposure to equities, non-government fixed-income securities, externally managed hedge funds and real estate – diversity that has traditionally cushioned the fund in a downturn.

The current funding shortfall is $2.5 billion; however, $19.5 billion in losses have been held back in the smoothing adjustment and will be recognized over the next four years. Accordingly, the shortfall will grow unless the investment climate turns sharply positive.

The plan’s Member Services division achieved quality service ratings of 9 out of 10 by members. It also tied for first place among similar pension plans internationally, and was rated Number One in North America.

Equities (public and private) were $34.9 billion as at December 31, 2008, compared to $50.0 billion at 2007 year-end. They returned –23.2% compared to a benchmark return of –26.4%, or $1.2 billion in value-add above market benchmarks.

The fund’s Fixed Income asset class lost $6.7 billion, largely due to credit products, externally managed hedge funds and the Canadian dollar’s decline against foreign currencies. This asset class has since adopted a more conservative fixed income asset strategy.

During the year, nominal bonds were used to fund the purchase of real return bonds (which are better matched to funding pensions) when yields spiked in response to a temporary interest rate increase. The real return bonds are recorded within the Inflation Sensitive class. As a result of this asset shift, the fund’s Fixed Income portfolio was $5.3 billion as of December 31, 2008, compared to $18.7 billion at 2007 year-end; returns were –43.6% compared to a benchmark return of 12.0%.

Inflation sensitive assets grew to $44.9 billion as of December 31, 2008, compared to $39.3 billion at 2007 year-end. These assets, which include the increased investment in real return bonds, returned 0.2% compared to a benchmark return of 6.8%

This is the third time in the fund’s 18-year history that it has registered a loss, but the first time in nine years that it has underperformed benchmark overall.

“Although we know we can’t stop market downturns, we make every attempt to insulate the fund from these shocks when they do occur,” said Neil Petroff, Executive Vice-President and Chief Investment Officer. “Our investment strategy remains defensive, but flexible enough to take advantage of market opportunities as they arise.”

The fund’s asset-mix policy was changed as of January 1, 2009 to 45% inflation sensitive, 40% equities and 15% fixed income. In 2008 it was 45% equities, 33% inflation sensitive and 22% fixed income.

Commenting on the year’s effects, Mr. Leech said: “This fund remains a solidly built, well-diversified portfolio of high quality assets. The investment team ensured we had adequate liquidity throughout the year to pay for trade settlements and make pension payments. Although we wrote down many of our investments in light of the current economic climate, we continue to hold valuable assets and we are well-positioned for the next market cycle.”

The Ontario Teachers' Pension Plan is the largest single-profession pension plan in Canada, with $87.4 billion in assets as of December 31, 2008. An independent organization, it invests the pension fund's assets and administers the pensions of 284,000 active and retired teachers in Ontario. It manages one of the largest payrolls in the country, with $4.2 billion in annual pension payments.

[Note: See 2008 performance chart, by asset class above; and, Annual Report and Results]

Quick, what does Ontario Teachers' have in common with Yale's yardstick and Harvard's horror? As it turns out, plenty.

For years Teachers' was touted as one of the best pension funds in the world, engaging in "cutting edge" investments and risk management, taking the lead, going where no other pension fund dared to go, compensating their senior staff like private investment superstars.

Well, Warren Buffett said it best: "It's only when the tide goes out that you learn who's been swimming naked."

And for years, Teachers' was swimming naked. Let's read the Results Q&A posted on their site:

1. Are pensions safe given the size of the 2008 loss?

Members’ pensions are defined by a formula based on their years of service and average earnings and are not dependent on any one year’s investment results. In addition, the law protects pension benefits members have already earned. If you are retired, legislation protects your lifetime pension benefits. If you are working, the pension credit you have already earned is also protected by legislation so that your accrued pension cannot be reduced retroactively. Contribution rates and pension benefits to be earned in future years, however, can be adjusted by the plan sponsors - the Ontario Teachers' Federation (OTF) and the Ontario government - during a teacher’s career in response to funding surpluses or shortfalls.

Also keep in mind that the pension fund is still worth more than $87 billion and we pay out approximately $4 billion a year in pension benefits.

2. Why is there a funding shortfall in 2009 when the plan sponsors resolved one last year?

The OTF and the Ontario government resolved a $12.7 billion shortfall projected at the beginning of 2008. However, due to investment losses, low real (after inflation) interest rates and rising pension obligations, the plan’s funding valuation shows a further funding shortfall as at Jan. 1, 2009.

Like many pension plans, we smooth investment gains and losses over five years. As a result, despite the $19.0 billion loss in 2008, the projected shortfall is currently only $2.5 billion; however, unless the investment climate turns sharply positive, it will grow as large losses from 2008 are recognized over the next four years. See 2009 Funding Shortfall.

3. How long will it take to earn back what was lost in 2008?

We can’t predict how long it will take. The global economic crisis is serious and continuing. We expect recovery will be gradual. A large part of our losses are unrealized, resulting from solid investments we still hold that are marked down in the current climate. We’re a long-term investor and can hold on to our investments until markets recover.

4. Have you changed your investment strategy in response to the current investment climate?

Our long-term investment strategy has not changed, but we are taking a defensive stance in light of current market uncertainties.

We believe that a diversified portfolio of assets is appropriate for earning the returns to pay pension benefits over the long term. We continue to be a long-term investor in equities, fixed income and inflation-sensitive assets, including our significant portfolios in real estate, infrastructure, and private equity. However, we have reduced investment risk by lowering our exposure to equity and credit markets to levels appropriate for today’s market conditions. We have also increased our liquidity requirement (cash on hand) to ensure we can meet all our payment obligations and take advantage of new opportunities that meet the plan’s long-term risk-and-return profile.

5. Why was your performance so far below benchmark?

Our fund return was 8.4 percentage points below benchmark. Much of that underperformance is attributed to our fixed income asset class; our inflation-sensitive asset class also underperformed its benchmark, but to a lesser extent.

The main benchmark for fixed income is government bonds - virtually the only type of investments that did well in 2008. We had diversified our fixed income portfolio in recent years to include credit products and hedge funds, which are not reflected in our benchmark. These investments produced favourable returns for several years but were hurt by the credit crisis. Consequently, not only did we experience losses, there was a large difference between our actual performance and the portfolio benchmark.

6. Can you explain your 43% loss in fixed income?

Our fixed income asset class, which includes more than government bonds and treasury bills, lost $6.7 billion in 2008. The return just for our bond portfolio was actually $1.2 billion or 6.4%.

The loss came from three areas: losses on credit products ($3.7 billion) and hedge funds ($0.9 billion), and the decline in the Canadian dollar against other currencies that caused additional losses ($3.3 billion) resulting from currency hedging and the settlement of derivative contracts (equity and commodity swaps) written in U.S. dollars. We have changed our strategy for fixed income to decrease risk in this portfolio and concentrate on more conservative fixed income investments.

7. What are credit products and why did they fail?

Credit products are pools of debt instruments that investors can purchase. They can be pools of bank or auto loans, credit card debt or mortgages that have been packaged as a new set of securities (for example, commercial mortgage-backed securities). These securities are assigned a credit rating and bought by investors according to their risk tolerance.

In late 2007, when the subprime mortgage crisis erupted, the value of some assets underlying certain credit products dropped. Investors became increasingly concerned about the quality of the loans backing these investments, which caused the market for them to dry up even though their default rates remained low. As a result, we had to write our investments in these areas down to less than what they originally cost, producing losses in 2008.

8. Given the losses in 2008, are equities appropriate investments for pension plans?

Since Teachers’ investment program began in 1990, the pension fund has earned more than $86 billion in investment income – much of that due to equities – and has paid out about $45 billion in pension benefits to teachers. We believe equities can help to pay pensions in the future, as they have in the past.

The recent increase in market volatility is a concern. We have lowered our allocation to equities to 40% from 45% (combined public and private equity) to lessen the short-term market risk. Inflation-sensitive investments (such as real-return bonds, infrastructure and real estate) are now our largest asset class.

We have to take an appropriate level of risk to earn returns to pay pensions. We also have to think about the long-term prospects for equities. What goes down generally comes back up in the next market cycle. For value investors like Teachers', market slumps mean price/earnings ratios are now lower and prospective returns for many companies are higher. But as always, we have to be careful and selective.

9. How well did your risk systems work in 2008?

Our risk systems did their job, but no risk system could have predicted that all markets would decline so dramatically and simultaneously. Our primary method of managing investment risk is broad asset diversification; however, the past year was unprecedented because virtually every asset class dropped. As a result, we showed our largest-ever loss.

Risk systems use historical data to model how much money could be lost under certain market conditions. Because some market conditions in 2008 were extraordinary - for example, credit spreads widened to an extent previously unseen - we underestimated the severity and global contagion of what started as a U.S. credit crisis in 2007. Going forward, our risk systems will include 2008 market experience, which will help model losses in extreme conditions, as well as broader stress tests outside of historical data for catastrophic events.

Our risk systems identified our largest risks as market conditions deteriorated in 2007 and throughout the past year. We dealt with them as much as possible but we could not avoid losses. We are making improvements to our systems to keep pace with the increased complexity of investment products and to model a wider range of improbable events. Our goal is to continue to have state-of-the-art systems.

10. Why did Teachers’ executives receive bonuses for the 2008 results?

Incentive compensation for executives and investment managers reflects performance relative to market benchmarks over four-year periods. This year’s payments result from three very strong years of market outperformance (2005, 2006, 2007) and one bad year (2008). The below-benchmark performance in 2008 had a large negative impact on this year's incentive payments and will significantly reduce compensation levels through 2011.

Total incentive compensation for investment staff dropped by 40% ($27 million). Payments for the five senior executives named in our annual report were half of last year's level. A full explanation is available in the Chair's message and compensation sections of our annual report.

Your feedback

We appreciate your feedback on how well we communicated our financial results. Please complete a brief online and confidential survey.

You'd appreciate my feedback? Sure, no problem. Where do I begin? Let me start with that last point, incentive compensation for executives and investment managers.

Who cares if payments for the five senior executives named in your annual report were half of last year's level? OTPP lost 18% or $19.5 billion. None of those senior executives should be getting any bonus whatsoever. PERIOD.

Moreover, I would immediately impose a freeze on all bonuses until the fund recoups those losses. If Teachers' imposes high water marks on those hedge funds it invests with, then they can set one up for themselves and set a good example for the rest of their peers.

While they are at it, I would appreciate it if Teachers' can explain how the performance benchmarks (see above) reflect the underlying beta and risk of each investment activity. If you want to get paid the big bucks, then I suggest you prove to your stakeholders that compensation is aligned with their best interests.

Importantly, if the benchmarks used to evaluate each and every investment activity do not reflect the underlying risks of these activities - be it liquidity risk, credit risk, leverage, or other risks - then your compensation structure is fundamentally flawed.

This is the same criticism I level at all pension funds that use bogus benchmarks, especially for alternative investments. For example, how does CPI + 500 basis points reflect the leverage risk or the market beta of Teachers' real estate investments?Answer: it doesn't. It's a sham that during the good years allowed Teachers' to easily beat this benchmark, claiming they were adding significant market value.

I quote the following from page 40 of the 2008 Annual Report:

The real estate portfolio totalled $16.2 billion at year end compared to $16.4 billion at December 31, 2007. The portfolio returned -4.3% compared to a benchmark return of 7.0%, or $1.8 billion below the benchmark. On a four-year basis, these assets generated an 11.7% compound annual return, outperforming this category’s fouryear benchmark by 4.9 percentage points for $2.1 billion in total value added.
If you ask me, that CPI+500 basis points is going to be a tough benchmark to beat, especially if deflation sets in. But for years, it was an easy benchmark to beat because it did not reflect the underlying leverage or beta of this asset class.

For private equity, we do not even know what benchmark is being used because they merge it with public equities. Another sham. You are merging illiquid investments that use tons of leverage with liquid investments with no leverage and not adding a significant spread to reflect this risk? But for years, Teachers' was boasting of significant added value in private equity.

I quote the following from page 37 of the 2008 Annual Report:

Private equity investments (included in the above totals for Canadian and non-Canadian equities) totalled $9.9 billion at year end compared to $9.0 billion at December 31, 2007.Teachers’ Private Capital returned -12.7% compared to a benchmark return of -19.3%, adding $137 million in value. On a four-year basis, these assets generated a 12.0% compound annual return, outperforming this category’s four-year benchmark by 7.9 percentage points for $1.7 billion in total value added.
What exactly is the benchmark for private equity and does it incorporate leverage, credit risk and beta? If not, then it is a flawed benchmark.

The other thing that got my attention were the losses in Fixed Income. According to the 2008 Annual Report, bonds totalled $11.5 billion at year end compared to $20.0 billion at the end of 2007 - a massive 43% haircut!

Teachers' states that "the loss came from three areas: losses on credit products ($3.7 billion) and hedge funds ($0.9 billion), and the decline in the Canadian dollar against other currencies that caused additional losses ($3.3 billion) resulting from currency hedging and the settlement of derivative contracts (equity and commodity swaps) written in U.S. dollars."

I quote the following from page 38 of the 2008 Annual Report:

Absolute return strategies, which are managed internally, and external hedge funds totalled $14.9 billion at year end compared to $12.3 billion at the end of 2007. Some assets were reclassified from the previous year to be included in absolute return strategies, which explains the increased value shown despite losses. The goal of these strategies is to generate positive returns regardless of movements in the broad markets. We include absolute return strategies in this asset class because they normally provide steady income, similar to bonds, but with an additional risk allocation aimed at adding value above the benchmark; however, these strategies
were the main contributor to losses and underperformance in 2008.

Losses of $3.7 billion on absolute return strategies resulted mainly from credit products, including commercial mortgage-backed security (CMBS) swaps, credit default swaps, and other structured credit products. All of these strategies were exposed to credit markets at the beginning of 2008. During the year, credit spreads reached extraordinary levels in all sectors of the market including investment-grade securities. We took steps to reduce our credit and hedge fund exposures early in the year, which prevented larger losses. We expect that we could see further volatility in our returns in this portfolio as credit markets continue adjusting to global liquidity problems.

External hedge fund assets were valued at $7.8 billion at year end compared to $9.9 billion at the end of 2007. These assets are managed both directly and in fund-of-funds structures, and are designed to earn consistent market-neutral returns while diversifying risk across multiple managers, strategies and styles. During the year, we repatriated $2.0 billion from external managers to reduce our overall hedge fund exposure. Even with these mitigating actions, $0.9 billion in losses were incurred.

I looked at page 76 of the 2008 Consolidated Financial Statements, and saw that $2.26 billion were losses in credit derivative CDS. Why was Teachers' selling CDS in the first place? This reminds me of another large Canadian pension fund which according to Diane Urquhart was also selling CDS (except they called it CDO to make it more palatable).

And the Governor of the Bank of Canada thinks that embedded leverage at pension funds has been reduced? I got news for him and others who think like this. The amount of leverage going on across all asset classes at Canada's large public pension funds is a scandal.

If you think AIG was the only one selling CDS, you were wrong! Except unlike AIG, public pension funds were smart enough (or at least they thought so) not to sell CDS on subprime CDOs. It didn't really matter because once the cancer spread across credit markets, they got clobbered too, exposing some serious counterparty risk.

All the sophisticated risk management in the world can't help you when you're investing in highly leveraged illiquid strategies. When nobody is hitting your bid, you're toast.

After viewing Teachers' results, one senior industry expert wrote me the following:

No one understood or valued liquidity. Compensation has been linked to the appearance of sophistication; if you didn't embrace exotica, you'd be viewed as dumb. If you stayed traditional, then surely everyone can do that, so you can't make the case for pay. Slam the boards!!! They are the ones who fell for the prestige of apparent sophistication. No one seems to name these Boards!

The Boards are to blame because they are ultimate fiduciaries governing these funds. Of course, Boards often take their cues from senior executives and they are often too intimidated to ask the right questions. This is why I recommend annual performance, operational and fraud audits be conducted by independent industry experts specializing in these areas.

Jim Leech, Ontario Teachers' President & CEO, was quoted in the Toronto Star today:

"It hurts to fall off a horse but you've got to pick yourself up and say 'OK, what did we learn?"' said Teachers' president and CEO Jim Leech.

"If you have a strategy that works for six or seven or eight years in a row, sometimes it's hard to shoot that strategy in advance of hitting the wall," he added. "It makes you humble."

Humility is good, especially after you lost 18% in one year and collected over $2 million in total compensation (click third table above). I guess Mr. Leech won't be taking any more pictures with an apple in his mouth for any major newspaper. But I would like to see him freeze his bonuses until the fund recoups its losses.

[Note: If you're going to run the fund like a giant hedge fund, then high-water marks are appropriate. I would also ask him for clawbacks on past bonuses, but that is highly unlikely too! As I stated in the past, pension fund managers are paid too much for the results they claim to be delivering.]

Going forward, Karen Mazurkewich of the Financial Post wrote on how Ontario Teachers' is changing tack after the 18% drop:

This was not the way he would have liked to begin his tenure as president and chief executive of Ontario Teachers' Pension Plan, but if there is one lesson Jim Leech says he can take away from posting the worst returns in the history of OTPP is that it "makes you more humble."

After eight straight years in the top quarter of Canadian pension plans, OTPP announced that the pension plan lost $21.1-billion of its asset base, which represents a negative 18% rate-of-return for the year ending Dec. 30, 2008. The fund's total assets have dropped from $108.5-billion to $87.4-billion.

The median return for the large Canadian pension plans was a negative 18.4% in 2008, which means the star managers at OTPP are now running in the middle of the pack.

"It's not what either of us expected," said Mr. Leech, who along with Neil Petroff, chief investment officer, faced journalists and took it on the chin. "It hurts to fall off the horse," he added.

In losing such a large chunk of its assets, OTPP has erased four years of investment gains. Mr. Leech did praise Mr. Petroff for "keeping people focused during the noise." And he added if there is one consolation it's the fact that Canadian pension funds by far have out performed their U.S. and U.K. counterparts.

Whereas OTPP's lost 19.4% of its assets, U.S. heavyweights such as the California Public Employees' Retirement System (CalPERS) which saw its assets shaved by 33%. OTPP also outperformed the Caisse de dépôt et placement du Québec which reported a record 25% loss of its asset base.

The biggest bite out of the OTPP apple came from its equities portfolio which posted a $15.1-billion loss, which represents a negative 23.2% return. But that was expected after the fall market crash and even beat its benchmark of negative 26.4%.

The unexpected $6.7-billion hole the fund is now digging out of is the collapse of its fixed income asset class, which saw a negative return of 43.6%, due largely to losses racked up by products like credit default swaps.

OTPP is "substantially reducing" its exposure to these products, according to Mr. Petroff. "It made us a lot of money (in previous years), but the market has changed and we have to adapt," he said.

OTPP started shifting into more conventional fixed-income strategies in January, 2008. As a result, the team managed to reduce some of its exposure. "[Mr. Petroff] saved billions for doing that as quickly as he did," said Mr. Leech. OTPP's reliance on external hedge funds has also been reduced. In 2007, OTPP had investments in 200 hedge funds; today they are only in 50.

OTPP recorded a modest drop of 4% in its real estate portfolio -- which is one of the toughest portfolios to value. In fact, there is a significant discrepancy among the real estate portfolios within pension plans.

For example, the Caisse de dépôt took a 22% write down and OMERS recorded a 6% increase. Mr. Leech said the fund took "great rigor" with its mark-to market writedown.

As a result of its overall poor returns, OTPP announced a shift in its asset-mix policy, giving greater weight to inflation sensitive investments such as infrastructure. This portfolio will grow from 33% to 45% of its overall assets at the expense of equities and fixed income.

With such a fundamental shift in asset allocation, OTPP has signalled it will be looking to make some big plays -- most likely in infrastructure.

Despite the hit to its balance sheet, Mr. Petroff said OTPP still has "tremendous amount of firepower," and has "innovative ways to fund transactions." One way to raise cash, he said, might be to issue debt.

The CPPIB announced it would raise between $2-billion to $5-billion in commercial paper and bonds, and OTPP might follow suit.

This setback of 2008 only adds to the pension fund's existing blues. OTPP is facing a huge solvency deficit of $19.5-billion in part due to the low interest rate, which has reduced bond yields from 4.5% return plus inflation in the early 1990s, to 1.6% today.

The greater weight to inflation-sensitive assets should be monitored carefully, especially if deflation sets in. Teachers' is making a huge bet here and the benchmarks need to reflect the risks that are being taken.

Finally, the article mentions the Caisse de dépôt, so I wanted to mention that Bloomberg reported that BCE Inc. paid former Chief Executive Officer Michael Sabia about C$21 million ($16.6 million) last year before the company’s proposed sale to an investor group which was headed by Ontario Teachers' collapsed:

Sabia, who left BCE on July 11, received a C$729,167 salary, according to the company’s management information circular, filed with Canadian securities regulators today.

He also got an annual bonus of C$3.13 million, one-time “privatization transaction related payments” of C$1.25 million, and other compensation of C$14.6 million. That last payment includes C$9 million in severance, the filing shows.

BCE’s proposed C$52 billion sale to a group led by the Ontario Teachers’ Pension Plan collapsed on Dec. 11. Sabia, 55, became CEO of the Caisse de Depot et Placement du Quebec, Canada’s largest pension-fund manager, on March 13.

Sabia started receiving an annual pension of C$968,750 in September, the filing also shows. His pension, which represents 40 percent of his best consecutive 60 months of earnings, may rise by as much as 4 percent a year, the document says. The total value of Sabia’s accrued pension obligations is C$14.9 million, the company said today.

After accepting the job at the Caisse last month, Sabia agreed to give up his pension, two years of bonuses and any severance payments if he leaves.

BCE, based in Montreal, is Canada’s biggest phone company.

Well, now we know why Mr. Sabia agreed to give up his pension, two years of bonuses and any severance payments if he leaves. He could easily afford it, but I would rather see him get paid for delivering results.

But as far as Ontario Teachers' is concerned, their stakeholders need to implement comprehensive performance, operational and fraud audits by independent experts. The complexity of their investments requires specialized knowledge to review if appropriate risks are being taken across all investment activities.

And as far as the Ontario government's plan to expand Teachers' mandate to manage assets of smaller plans, I say hold off on that decision until you complete these comprehensive audits.

Better yet, just give this mandate to the Hospitals of Ontario Pension Plan (HOOPP) whose results show they focused on minimizing their downside risk by investing in government bonds. Nothing fancy or "sophisticated", just good old common sense.

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