Tuesday, April 5, 2011

OTPP Gains 14.3% in 2010 But Funding Challenges Persist

On Tuesday, Ontario Teachers' Pension Plan (OTPP) announced, Teachers’ turns in 14.3% rate of return, net assets hit $107.5 billion, but funding challenges remain:
The Ontario Teachers’ Pension Plan (Teachers') today announced that it earned the largest value-add dollar amount in its history in 2010. It ended the year with $13.3 billion in investment income, representing a 14.3% rate of return, which is $4 billion above its 9.8% benchmark. Net assets totaled $107.5 billion as of December 31, 2010.

“Our investment team remained true to our investment fundamentals, taking appropriate risks to earn solid returns, while seeking the best diversification to meet our plan’s long-term needs,” said Teachers’ President and CEO Jim Leech. “Our Member Services team also had an exceptional year, scoring a 9-out-of-10 quality service rating from members, second against its peers around the world, and meeting its cost objectives.”

“Our employees exceeded expectations this year, but the plan continues to face serious funding challenges,” Mr. Leech noted. He explained that the plan is facing systemic funding problems. “The root cause of the $17.2 billion preliminary funding shortfall is a combination of factors: member longevity, retirement periods that exceed working years, low real interest rates, which reflect lower economic growth going forward, and the maturity of the plan, which now receives $1.8 billion less in contributions than it pays out annually,” he said.

The fund’s asset mix was modified in 2010, reclassifying some assets and adjusting certain target allocations. Full details of the fund’s actual asset mix and the asset mix policy are available in the fund’s annual report.

The fund’s equities portfolio holdings totaled $47.5 billion, compared to $41.2 billion a year earlier. Fixed Income assets totaled $45.9 billion at 2010 year-end, compared to $35.3 billion in 2009. The fund’s allocation to commodities increased to 5% in 2010 from 2% in 2009 and was valued at $5.2 billion at year-end compared to $1.9 billion in 2009.

A new asset classification, Real Assets, comprises real estate, infrastructure, and timberland investments. The net value of the real estate portfolio totaled $16.9 billion at year-end, compared to $14.2 billion in 2009. The infrastructure portfolio grew to $7.1 billion in 2010 compared to $5.6 billion at 2009 year-end, while the timberland portfolio declined to $2.2 billion in 2010 from $2.3 billion at 2009 year-end.

The plan’s sponsors, the Ontario Teachers’ Federation and the Ontario government, must eliminate the preliminary shortfall and file a balanced valuation in 2012 at the latest; they currently are studying the merits of filing in 2011.

With $107.5 billion in assets as of December 31, 2010, 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 295,000 active and retired teachers in Ontario. For more information visit www.otpp.com.

Teachers' also posted their rates of return compared to benchmarks:

To understand the details behind the numbers, you need to go over OTPP's 2010 Annual Report. There is an excellent discussion on the plan's funding approach and funding challenges starting on page 12 (Teachers' is the best at discussing this issue) which is a must read for all plan sponsors. Unlike the Caisse and CPPIB, Ontario Teachers' and OMERS have to manage assets and liabilities (Caisse and CPPIB are fund managers, not pension plans).

For me, the interesting discussion starts on page 25, the section on managing investments. I quote the following:
To implement our strategy, we embrace a total-fund perspective that fully integrates the individual portfolios. This way, we are able to take advantage of our expertise across the Investment Division and its support groups and to diversify the risks that the fund takes across many asset classes. Effective communication allows us to maximize the use of risk and capital across the total fund, as we select diversified assets that have the best chance of providing the investment returns needed to meet the plan’s long-term needs. We also align our compensation practices with our long-term view. We believe that our collaborative approach leads to better investment decisions and the most efficient use of the plan’s resources.
The message to all other big funds? Break down the goddamn silos and make sure the message is loud and clear that it's the total fund's performance that really counts, not just the individual portfolios. Senior pension officers have to be compensated (at least 50% if not more of their bonus) based on total fund performance, not just their individual portfolio's performance.

On risk management, I note the following (pages 25-26):
Our risk management activities are focused on the ultimate risk facing the plan – the risk that the plan’s assets will fall short of its liabilities (the future benefits owed to members). We recognize that funding risk can come from assets or liabilities. The asset risk is obvious; investments can, and do, decline in value periodically. The biggest risk to plan assets is a decline in equity markets.

...

The liability risk is less obvious but has a significant impact on the plan’s funding status. A 1% shift in the real interest rate assumption impacts projected liabilities by approximately $25 billion on a funding basis. Finally, increased life expectancy also augments pension costs.
On setting asset mix targets, OTPP published this comment (page 27):
During the year, we reviewed and clarified our asset-mix policy by reclassifying some assets and adjusting certain target allocations. These changes were undertaken to enable us to make better asset-mix decisions for the pension fund and to improve our reporting. For example, absolute return strategies and money market securities were previously reported in the fixed income asset class. These assets and the performance associated with absolute return strategies are now reported separately. The fixed income asset class now holds primarily nominal bonds and RRBs. This allows us to more clearly report assets and performance.
On absolute returns strategies, OTPP explains (page 28):
We employ absolute return strategies in a number of departments to enhance the fund’s overall returns in an effort to meet the plan’s long-term needs and minimize funding shortfalls. The goal of these absolute return strategies is to generate positive returns that are uncorrelated to our other asset classes.

Absolute return strategies (which are managed internally) generally look to capitalize on market inefficiencies and also include external hedge fund assets that are managed to earn consistent, market neutral returns while diversifying risk across multiple managers, strategies and styles.

Assets employed in absolute return strategies and external hedge funds totalled $11.4 billion at year end compared to $11.7 billion at December 31, 2009. The change in the value of our hedge fund investments at year end resulted from reducing our exposure to some of these investments, as well as the impact of the rising Canadian dollar, which affected valuations for U.S.-denominated hedge funds.

The money market asset class provides funding for investments in other asset classes, which is comparable to a treasury department in a corporation. Derivative contracts and bond repurchase agreements have played a large part in our investment program since the early 1990s. For efficiency reasons, we often use derivatives to gain passive exposure to global equity and commodity indices in lieu of buying the actual securities. We also use bond repurchase agreements to fund investments in other asset classes because it is cost effective and allows us to retain our economic exposure to government bonds.
In terms of performance by asset classes, here are some bullet points taken from the 2010 Annual Report:
  • Canadian equities (both public and private) totalled $9.3 billion at year end compared to $8.4 billion at December 31, 2009. They returned 14.6% compared to a benchmark return of 13.8%. On a four-year basis, these equities generated a 2.2% compound annual return, underperforming this category’s four-year benchmark by 1.0 percentage point.
  • Non-Canadian equities (both public and private) totalled $38.2 billion at year end compared to $32.8 billion at December 31, 2009. They returned 9.4% compared to a benchmark return of 5.9%, or $1.0 billion above the benchmark in 2010. On a four-year basis, these equities generated a -1.3% compound annual return, outperforming this category’s four-year benchmark by 3.1 percentage points.
  • Private equity investments (included in the above totals for Canadian and non-Canadian equities) totalled $12.0 billion at year end compared to $10.0 billion at December 31, 2009. Teachers’ Private Capital returned 19.0% compared to a benchmark return of 7.1%, or $1.1 billion above the benchmark. On a four-year basis, these assets generated a 2.6% compound annual return, outperforming this category’s four-year benchmark of -1.2%.
  • Fixed income assets totalled $45.9 billion at year end compared to $35.3 billion at December 31, 2009. They returned 9.9% compared to a benchmark return of 9.5%, or $0.1 billion above the benchmark for this asset category. On a four-year basis, these assets generated a 7.3% compound annual return, outperforming this category’s benchmark by 1.0%.
  • The fund’s policy allocation to fixed income increased in 2010. RRBs were previously reported in another asset class. Holdings of government bonds – both nominal and RRBs – were increased by $14.9 billion at attractive prices. Nominal bonds went on to perform well as interest rates fell during the year. RRBs performed very well, which partially offset the impact of declining real interest rates on the plan’s pension liabilities. We have returned to reporting only traditional fixed income investments in this asset class. For clarity, we are now reporting absolute return strategies under a separate category.
  • We invest in commodities, which typically mirror short-term changes in inflation, as a hedge against the cost of paying inflation-protected pensions. Investments in commodities totalled $5.2 billion at year end compared to $1.9 billion at December 31, 2009. The increase in the portfolio was due to a decision to raise the asset-mix target for commodities from 2% to 5% in 2010. The portfolio returned 3.2% compared to a benchmark return of 3.3%. The one-year benchmark reflects the impact of the stronger Canadian dollar. On a four-year basis, these assets generated a -7.0% compound annual return, matching this category’s four-year benchmark.
  • Investments in real assets – real estate, infrastructure and timberland – are good long-term investments for the pension plan because they provide returns that are linked to changes in inflation and act as a hedge against the cost of paying inflation-protected pensions. Over the past 10 years, these investments have played an increasingly important role in helping us to meet our performance objectives and minimize risk.
  • Prior to 2010, these assets were held in our former inflation-sensitive category along with RRBs and commodities. RRBs are now included in the fixed income asset class and commodities were established as a separate asset class. Infrastructure and timberland, previously one portfolio, are now reported as separate portfolios. Accordingly, the assets and performance of each are reported separately.
  • Real assets totalled $26.2 billion at year end. These assets returned 13.9% compared to the benchmark return of 5.5%, or $1.8 billion above the benchmark. On a four-year basis, real assets generated a 6.3% compound annual return, outperforming this category’s four-year benchmark by 1.0 percentage point.
  • Real estate delivered strong performance on both an absolute and value-added basis. The net value of the real estate portfolio totalled $16.9 billion at year end compared to $14.2 billion at December 31, 2009. It returned 16.9% compared to a benchmark return of 7.7%, or $1.3 billion above the benchmark for this category. On a four-year basis, the real estate portfolio generated an 8.2% compound annual return, outperforming this category’s four-year benchmark by 1.2 percentage points.
  • Infrastructure investments totalled $7.1 billion at year end compared to $5.6 billion at December 31, 2009. Infrastructure assets returned 13.0% compared to a benchmark return of 4.0%, or $0.6 billion above the benchmark. On a four-year basis, these assets generated a 2.8% compound annual return, matching this category’s four-year benchmark.
  • Timberland investments totalled $2.2 billion at year end compared to $2.3 billion at December 31, 2009. These holdings returned -3.1% compared to a benchmark return of -0.2%, or $0.1 billion below the benchmark. Performance was affected by decreased U.S. demand stemming from the housing market slowdown. On a four-year basis, these assets generated a 2.1% compound annual return, consistent with this category’s four-year benchmark.
Some of my comments on OTPP's 2010 investment performance. First, the bulk of the value added came from private markets: private equity, real estate and infrastructure. These asset classes trounced their benchmarks in 2010, which tells me the benchmarks are not properly reflecting the risks they're taking (note: I was asked to write a piece on pension fund benchmarks for a major publication where I will clarify this topic in great detail).

Second, while I applaud Teachers' asset mix modifications which enable them to make better decisions for the pension fund and improve their reporting, I think it's only fair to clearly report the performance of public equities as well (you have to deduce it).

Third, and somewhat odd, Teachers' states that absolute return strategies and money market securities were previously reported in the fixed income asset class "but are now reported separately" and yet I couldn't find details on the benchmark or performance of this portfolio which represents a sizable chunk of assets (assets employed in absolute return strategies and external hedge funds totalled $11.4 billion at year end). I'm obviously missing something here but Teachers' has to do a better job reporting on these investments, separating out the performance of internal alpha vs. external absolute return strategies.

In terms of executive compensation, you can click on the table below for details (page 67):


Finally, Tara Perkins of the Globe and Mail reports, Teachers prepares to tackle funding shortfall:

The sponsors of the Ontario Teachers’ Pension Plan are considering taking early action, such as boosting contributions or cutting benefits, to tackle a growing shortfall in funding.

The gap between the pension fund’s assets and the amount of benefits it has promised to pay in coming decades will be almost impossible to eliminate through investment returns alone, a fact made clear Tuesday when the plan reported its 2010 results.

Although Teachers’ investment portfolio posted record income above its target benchmarks during the year, that wasn’t enough to stop its funding deficit from growing to $17.2-billion from $17.1-billion, as liabilities outpaced assets.

Now the fund’s investment professionals are in a bind. “Just at a time when we need greater returns, we can’t take the risk to do it,” said Teachers chief executive officer Jim Leech.

While unsettled financial markets are compounding the fund’s headaches, its biggest problem is demographics. And the issues it is grappling with are ones that many other pension funds around the world will soon find themselves facing as well, Mr. Leech said.

“This is a plan that is maturing. We’ve been saying that for a decade, and now we’re seeing it in front of our eyes,” he told reporters at a press conference in Toronto.

As a group, teachers have been at the forefront of a number of major demographic and lifestyle shifts; a slew of them were hired to educate the baby boomers, meaning that the profession over all skews older than most. In addition, teachers in general tended to quit smoking and adopt better eating and exercise habits earlier than other workers, Mr. Leech said.

As a result they are living longer, even while retiring earlier. And the profession has more women than most, adding to the longer lifespan.

On average, Teachers’ members now draw a pension for 30 years, after working 26 years. In 1990, on average, they received benefits for 25 years after working 29 years. About 45,000 Ontario teachers who are members of the plan are expected to retire over the next decade.

Those trends, coupled with losses stemming from the financial crisis, have created a problem that needs to be addressed quickly. While the pension plan is solid and could pay benefits for years to come even with no changes, its sponsors – the Ontario Teachers’ Federation and the provincial government – must come up with a plan to ensure there will be money to pay pensions to the province’s young teachers decades from now.

“The investment department did exceptionally well, but we are still saddled with a $17-billion deficit,” said Mr. Leech, whose total compensation amounted to $3.9-million in 2010, up from $2.3-million a year earlier.

The plan’s sponsors are required to make a filing with regulators by 2012 demonstrating how they will bring the plan into balance. Since 2005, they have taken actions to shore up the plan, including special contribution increases, but it has become clear that this is not a short-term situation. Having spent the better part of two years thinking about the issue, the sponsors are now considering making that filing this year, ahead of schedule, a move that would give it a jump start on tackling the problem. No decision has been made yet, and to make a filing this year, the sponsors would have to do so by September.

Along with demographics, a good portion of the pension plan’s problems relate to trouble in the economy and financial markets. The fund posted a $19.03-billion investment loss in 2008, and low interest rates are continuing to cause headaches.

A 1-per-cent change in the plan’s real interest-rate assumption has about a $25-billion impact on its funding valuation. It takes $900,000 in assets to finance a typical $40,000 pension when real interest rates are 1.5 per cent, compared with $735,000 when they are 3 per cent.

Shortfalls are causing more pain for young teachers because there are fewer working teachers paying into the plan and more retired teachers drawing benefits than in the past. That means Teachers’ investment team can’t take large risks. The percentage of its assets in equities, a relatively riskier asset, dropped to 45 per cent in 2010, from 61 per cent in 1994.

The pension plan’s assets now stand at $107.5-billion, below the peak of $108.6-billion in 2007. The plan took in $2.7-billion in contributions last year while paying $4.5-billion in benefits, leaving a gap of $1.8-billion that is projected to grow in coming years.

You can watch Jim Leech, President and CEO of OTPP, discuss the 2010 annual results at the bottom of the press release (they should post these videos on YouTube with an embed code). I thank Deborah Allen, Director, Communications and Media Relations at OTPP for letting me know when the results would be made available. Any errors, omissions or points of contention in this blog post will be corrected as soon as OTPP gets back to me with a written response which I will gladly publish in an update at the end of this comment.

Below, Malcolm Buchanan, retired General Director of OSSTF, is interviewed at the Congress of Union Retirees of Canada Convention in Ottawa on the pension crisis by Ish Theilheimer of Straight Goods News, October 7, 2009 (HT:Gary).

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