Monday, January 16, 2012

Are Canadian Pension Funds Trendsetters?

More on the surprising strength of Canada's pension funds. Jonathan Fowle of the Vancouver Sun reports, B.C.’s public sector pension funds remain healthy:
Gerry Tiede can’t stand it when people talk about B.C.’s public sector pension funds as if they’re a financial grenade, set to explode the province’s bottom line.

“One of the things that just really bothers me when I hear criticism of public sector [pensions] is that the taxpayer is on the hook for all of this stuff,” Tiede, a retired school principal and former chair of the B.C. Teachers’ Pension Plan, said in an interview.

“At the end of the day, 75 per cent of the pension that a person receives comes from the investment returns,” he continued, speaking in October, while he was still chair of the pension plan.

He added that all the funds are built up by contributions from employers and plan members, and then invested over time.

“Investment returns pay the bulk of the pension, not contributions and not the government.”

B.C.’s four main public sector pensions, which cover about 500,000 current and former employees, comprise about $63 billion in net assets, recent financial statements show.

According to the most recent independent analyses, the funds have between 97 per cent and 99 per cent of the assets that experts say they will need to cover all plan members throughout their retirements.

Three of those four financial assessments were done in 2008 and 2009, however, near the beginning of the world economic downturn, meaning the volatile investment climate over the past three years may have caused the plan outlooks to have changed.

The most recent report from B.C. Investment Management Corp. (bcIMC) — the entity responsible for investing the money in the pension funds — indicates it has seen a 4.5-per-cent return on its combined pension fund holdings over the past five years.

The report says this is below the expected benchmark, meaning the five-year return is about $108 million short of what had been planned.

But the same report also shows a significant improvement for its pension-related investments during the 2010-11 fiscal year, the last of the five years under consideration.

“Combined pension plan returns exceeded our clients’ return expectations — the one-year annual return, net of fees, for our combined pensions was 10.8 per cent compared to a combined benchmark of 9.7 per cent,” said the report.

In a recent interview, Ron McEachern, chair of the Public Service Pension Plan and a director of bcIMC, said he anticipates a modest shortfall in his plan, given the recent investment performance.

“Obviously 2008 and 2009 was a downturn and we were impacted like any other group, although I think by and large we weren’t impacted as profoundly as many of the other pension plans,” he said in October.

“We’re of the view that we’re going to be into a modest deficit again,” he said, adding that would mean a “modest contribution increase,” from both plan members and government.

McEachern said the $17-billion Public Service Pension Plan ended its 2002 valuation with a $546-million surplus; ended 2005 with a $767-million unfunded liability; and ended 2008 with a $487-million surplus.

“In terms of the raw numbers, we’re pretty good,” he said, adding at its valuation in 2008, the fund had 103 per cent of what would be needed to cover its expected obligations to members.

An actuarial valuation released in December — after that interview — shows that as of March 31, 2011, the Public Service Pension Plan had an unfunded liability of just $275 million, meaning it is 98-per-cent funded.

Andrey Pavlov, associate professor of finance at Simon Fraser University, said he is not intimately familiar with B.C.’s public sector plans, but added that many pension funds are struggling.

“In general, pension plans are in trouble,” he said in an interview.

“Long-term interest rates are really at an all-time low, they are next to nothing. At the same time we just experienced a big market decline. I don’t see a quick recovery on the horizon. Just those two factors make any pension plan — even if it was totally healthy and happy a couple of years ago — it puts them at risk right now.”

Valuations are done on a three-year cycle, and are calculated by an actuary who does a detailed analysis of the assets and obligations for each of the funds.

Updated reports for three of the plans are expected between now and early 2013, so the effect of low interest rates and market volatility on the health of each fund will not be clear until that point.

Nevertheless, McEachern and those who administer the other three funds say a restructuring done by government in 2000 and 2001 ensured the public is not held unduly responsible for potential shortfalls.

The reasons, they say, are two-fold.

One is that as part of the changes, government moved to a joint management structure, which sees the taxpayer share equal responsibility with plan members for contributions into the main pension fund.

This means all losses, or surpluses, are shared equally between the government and the plan members. Previously, any losses were the sole responsibility of government.

It also means decisions about the direction of the plan are made jointly by representatives of government and members.

“We have joint cost sharing, joint risk and so we’re in it together. It’s really different than the old days of pension plans,” said Brendan Dick, chair of the Municipal Pension Plan.

“Our members are paying for it,” he added. “It’s really deferred wages for their retirement.”

The second way government moved to cushion taxpayers from losses, trustees say, is by changing the way the plans cover benefits for retired members, such as Medical Service Plan premiums, extended health and life insurance benefits.

Instead of these benefits being paid directly by government, as they had been in the past, they are now funded out of a separate account — the so-called inflation adjustment account — filled by contributions from government and members, and which allows for much greater discretion on what benefits are covered.

In some plans, this discretion means the benefits are no longer covered.

“When I first became a trustee in 2000, our [Teachers’] plan had enough money in the inflation adjustment account that we paid MSP premiums, the dental premiums and the extended health care premiums for all retirees,” said Tiede.

“But in 2002, we stopped paying the MSP premiums, so that cost our retired members about $650 per year. In 2003, we stopped paying the dental premiums. That cost our retired members about $540,” he added, saying earlier this month the plan also stopped paying premiums for extended health care.

“When people say that government is on the hook for everything, I respond and say, ‘No, actually our retired members have been on the hook,’” he said.

The new benefit structure has been the subject of a class-action court challenge since 2004, however, meaning its future is somewhat uncertain.

The challenge specifically involves the Public Service Pension Plan, and alleges the government improperly off-loaded responsibility for benefits such as MSP onto the plan’s board of trustees.

The case was dismissed in its initial phase, though a judge heard an appeal last June, and a ruling is thought to be imminent.

Tiede also pointed out that while previous inflation increases are guaranteed in the plan, future lifts are not.

“Retired teachers have no guarantee that they’re going to get cost-of-living increases in the future. We have given them in the past, but there’s no guarantee,” he said.

“That’s because it’s funded out of a different fund, we call it our inflation adjustment fund. That is one that’s funded through negotiations between the partners,” he added, saying the other three funds have a similar approach.

“The government and the BCTF [B.C. Teachers’ Federation] negotiate and decide how much they are going to contribute into the inflation adjustment account. Then we as trustees have that money and we have to give that money out in fair and transparent ways.”

The structure positions B.C.’s plans as something of a hybrid between defined benefit and defined contribution arrangements, where core benefits are guaranteed, but others are determined based only on what’s available.

SFU’s Pavlov said he believes the most responsible move would still be for public sector plans in B.C., and across North America to move more significantly toward defined contribution plans.

“For those plans where you have a substantial defined benefit component, I think they’re in trouble and they need to prepare themselves for a low-growth, high-inflation environment, which is the worst of both cases,” he said, adding he believes inflation adjustments are bound to happen, regardless of the discretionary structure.

“Any company or business or government should be switching to defined contribution. It’s just completely unfair to have a defined benefit plan. In many cases, [for holders of such plans] it’s going to be like winning the lottery,” he added.

All four plan chairs said in recent interviews that the prefunded model, and the changes made by government in the early 2000s, have all led to a more stable and transparent system that helps to ensure predictability for taxpayers, and financial stability for members.

“I think our plan is healthy,” said John Wilson, chair of the College Pension Plan.

“We’re paying upfront for what we’re doing and we’re 99-per-cent funded so I’ve put in all the money that will be needed to pay my pension.”

Tiede added he believes the changes will mean B.C. will avoid some of the crisis situations in other jurisdictions around the world.

“One of the best moves that was ever made in British Columbia was when our plans went to the joint trusteeship model,” he said.

“Most of the horror stories that come out of the United States and the U.K., the funds are 60-per-cent funded or 50-per-cent funded,” he added, saying these low levels are often reached through a combination of overly optimistic forecasts and not enough funding.

“Our fund is so far beyond that, that it’s quite amazing.”

I agree with Tiede, British Columbia's public pension funds are quite amazing. I rarely discuss their results but bcIMC has delivered outstanding results over the last ten years, even when you take the 2008 crisis into account. You can read highlights from their latest annual report covering 2010-2011.

The Fund recorded a one-year annual return of 10.8 %, net of fees, for combined pension plans in the 2011 fiscal year. This exceeded a combined benchmark of 9.7% and provided over $685 million in additional value, net of all investment management fees.

Another fund out West worth tracking is the Alberta Investment Management Corporation (AIMco). I didn't cover their 2010-2011 annual report but they also delivered strong results. In the Q & A, president and CEO, Leo de Bever, made these comments:
AIMCo’s absolute fiscal year return of 10.3% on pensions and endowment assets, and 8.2% on total assets including short-term government funds mostly reflects above average market returns. Active management returns are inherently volatile. Their contribution was negligible this year, but did add $750 million over the last two fiscal years. Most of our challenges were in unlisted assets; valuations often lag when listed markets do well, as they have done recently. Restructuring costs for underperforming historical private equity assets detracted about 0.2%. Rapid growth in recent years to many unlisted categories gave rise to usual lags in return relative to listed benchmarks.
In a recent Reuters article, de Bever said AIMco is prepared to fill gaps left by government crises:
Leo De Bever, head of the Albera Investment Management Corp, likes the kind of assets that most investors wouldn't touch, like a broken forestry program in Australia, owned by an army of investors and facing legal problems that would take a decade to unwind.

"So we walked into the receiver and said, 'Look, we have the cash and we have the patience to do this, and nobody else can'," De Bever told Reuters in an interview about AimCo, which manages the pension assets of workers in Canada's energy heartland of Alberta.

De Bever said that under the C$415 million ($407 million) deal for Great Southern Plantations, the fund snapped up all 640 parcels of forestry land - 2,500 square kilometers.

"And we bought it very cheaply because these assets went at a discount given that no one had the patience to work this out."

That type of deal-making - a joint venture with the Australia New Zealand Forest Fund in January 2011 - may soon be typical as Canadian pension funds bail out government projects around the world.

AimCo, with C$70 billion in assets under management, is one of a clutch of Canadian pension funds with the patience to take advantage of problem investments that take equal doses of creativity and expertise to resolve.

"On the infrastructure side, a lot of governments are running out of cash," said De Bever, who came to AimCo in 2008 after serving in roles as varied as chief forecaster for the Bank of Canada, chief economist for Crown Life Insurance and executive vice-president at Manulife Financial.

"They are running big deficits and they are looking for private sources of finance to build power plants and sewers and water and roads and all that sort of thing."

De Bever, who as a high school student in Holland planned to become a politician, sees business opportunity in California, where AimCo was at one point close to investing in water treatment plants.

He's also keeping an eye on the electrical transmission network in the United States, which needs several hundred billion dollars to revamp infrastructure that dates back to the 1970s.

In emerging markets, said De Bever, deals are bubbling to the surface as struggling European banks back away from non-core projects.

He is now less keen, though, on Latin America, where AimCo struck a couple of big deals in the last couple of years, in power lines and toll highways.

"We are coming to the conclusion that the tide may be shifting," De Bever said. "There was a period of about five years when Canadian pension funds were tripping over each other in Latin America but my sense is that some of that may, in the next two or four years, be shifting back to North America."

Interesting comment on Latin America and I had no idea Leo de Bever had political aspirations when he studied in Holland. Canada should only be so lucky to have him as one of our leaders. He's definitely a pension boss with a penchant for change.

Other Canadian pension fund managers are also getting international recognition. Jim Leech, the head of the Ontario Teachers’ Pension Plan, has made a British top ten list:

And it’s not just any top ten list. The Telegraph has published its ranking of the major power brokers to watch at the upcoming World Economic Forum, a gathering in Davos Switzerland that attracts a who’s who of the globe’s business elite. As the Telegraph points out, this year’s gathering will include everyone from European politicians to members of the Saudi royal family to legendary investor George Soros, the CEOs of many of the world’s top banks, and more than a few billionaires.

It goes without saying that the main topic of discussion at the gathering will be the European sovereign debt crisis, but the Telegraph’s list is more of a nod to the importance of emerging markets, technology and telecom. And, with Mr. Leech’s inclusion, a small nod to infrastructure.

“Under Jim Leech, the Canadian pension fund, better known as Teachers, is considered one of the key investors in infrastructure assets in the world,” the Telegraph writes. “With governments desperate to boost the economy with infrastructure projects, yet with little money to do it, Leech is on many leaders’ must-see list, including David Cameron’s.”

Teachers’ and its fellow Canadian pension plans, including CPPIB, Omers and AIMCo, have increasingly been making a name for themselves in recent years as global deal-makers. Teachers’ closed a $625-million deal for Camelot Group Ltd., which operates the U.K. national lottery, in 2010, and then teamed up with Borealis Infrastructure (a part of OMERS) to invest in High Speed One, the rail link from London to the Channel Tunnel. More recently, on this side of the pond Teachers’ has been in the spotlight for its seemingly successful partnership with the hedge fund Jana Partners LLC, which prodded McGraw-Hill Cos Inc. to restructure by carving itself up into new divisions.

The Telegraph's other power brokers include Zhang Xiaoqiang, vice-chairman of the Chinese national development and reform commission, and Sheryl Sandberg, the chief operating officer of Facebook.

You can read the full top ten list here
Finally, Neil Faba of Benefits Canada reports on why OMERS is changing gears:

In recent years, many pension plans have looked to private investments to mitigate some of the risk of public markets. For OMERS, this shift began in 2004. At the time, the fund—which has pension commitments to more than 400,000 members in Ontario—had an investment mix of 82% public market and 18% private investment holdings. But a new strategy adopted that February started OMERS on the road toward an asset mix goal of 53% public markets and 47% private holdings.

The principal reason it was done was to reduce our exposure to the volatility of the capital markets, especially public equity. The second reason was to acquire assets that would give us as predictable as possible long-term cash returns to fund the pension plan,” says Michael Nobrega, president and CEO of OMERS since 2007. (He previously headed Borealis, OMERS’ infrastructure investment entity founded in 1998.)

Of course, says Nobrega, the decision to change the asset mix was the easy part. Actually putting the wheels in motion has meant transferring about 35% of the fund’s $53 billion in assets to private markets—and making sure the investment choices are ones that management can live with for the long haul.

“It’s not an easy exercise. You want assets you can live with for 25 years,” says Nobrega. “To do that, you have to keep your investment criteria in place. It’s easy to go and buy assets, but it’s a question of buying them at the right price, managing them properly and adding value to them later on.”

In the driver’s seat

Once OMERS management had adopted the new investment strategy, the next decision it made was to use what Nobrega calls a “direct-drive” approach: actively managing its assets in-house where possible. This meant getting the right people and expertise in place to find suitable assets for the fund and establishing the HR capability and technology needed to manage it all.

According to Nobrega, much of the fund’s success comes from the organization’s “horizontal structure.” Separate internal groups manage the plan’s assets—Oxford Properties (real estate), Borealis Infrastructure, OMERS Private Equity and OMERS Capital Markets—each with its own CEO, investment team and results targets.

“A pension fund makes money in two ways: it leverages its capital, and it leverages its people. And the best leverage is to have people with ownership responsibility [to leverage the capital].”

But even with strong investment teams at home, he believes that finding the best investments requires “boots on the ground” worldwide. To that end, OMERS has opened two branch offices. The London office opened in 2008 and now has a staff that speaks seven languages and gives the fund a foothold to explore investment opportunities across Europe. A formal New York office (OMERS Private Equity and Oxford Properties previously had small individual teams in the city) followed in the fall of 2011.

“I think we made a good decision to open our offices in New York and London. That has really helped us in terms of sourcing investments,” he comments. “To get to where we want, we need to do two things: find the right people, and deploy the capital. Those two offices have helped us attract people we couldn’t attract to Toronto, because they want to live in New York or London. And they’re also part of the networks in those locations, which gives us an advantage in getting to the assets.”

The assets, of course, are the key. OMERS’ asset mix is now about 60/40 in favour of public markets. And while Nobrega says he’s less concerned about the exact mix than making sure that the assets held are right for the fund, he does see areas where OMERS can continue to grow its private holdings.

For one, Nobrega is bullish on Western Canada. He points out that Canada ranks at or near the top in global production of potash, uranium and oil and gas, and many of those commodities come from west of Ontario. In addition, business is booming in the region, and OMERS already holds a significant piece of that growth. The fund’s holdings include about 25% of Class A office space in Calgary; in Edmonton, that figure is 10%.

“Between now and 2015, assuming the world continues as it is, the GDP of Western Canada will be approximately that of the rest of Canada,” says Nobrega, adding that OMERS’ investment in the region—which he already estimates is higher than that of any other Canadian pension fund—is bound to increase as that GDP share grows.

Long road ahead

Nobrega likens the shift in OMERS’ strategy—and the building of a strong investment team and technology base—to the development of a luxury vehicle, which requires time and attention to bring it to a successful market launch.

“I think OMERS is well positioned today, after building this thing for about 10 years. I believe we’re very far ahead of many plans. I think we’ve gone past the design stage to building the team and test driving the car,” he says. “Now we’re in the production stage.”

So far, that production has been good, though not without its struggles. Since 2004, the plan has earned average annual returns of 8.11%. Despite this, the plan is only 92% funded, and the funding deficit tripled in 2010 to $4.5 billion. But Nobrega is confident that the current strategy will generate average annual returns of between 7% and 11%, return-ing the fund to surplus as early as 2016.

OMERS also sees opportunity for follow-on investments coming out of its holdings in Western Canada. As the country works to meet its 2020 emissions targets of 17% below 2005 levels, for example, corporations in the oil and gas sector will be increasingly in the spotlight.

“As political pressure builds, [Western Canada] will have to look at its environmental record. [With] growth in the commodity business, there will be opportunities for growth in the environmental business,” through new technology, Nobrega adds.

That need for technology will be addressed, in part, by entrepreneurs with new ideas. OMERS Ventures launched earlier this year with $180 million to invest in new companies over the next three years. While that allocation represents just a drop in the bucket of OMERS’ overall asset holdings, it’s not insignificant when compared with the roughly $1 billion that the Canadian Venture Capital Association estimates is invested in Canada annually.

Nobrega says that while venture capital investments would typically be on the riskier end of the spectrum, many of the companies that OMERS will look to invest in will already have benefited from the initial seed investments offered through governments and university funding, and will be established enough to align with the fund’s goals for global growth and sustained returns.

“It’s our intention to be the parent for some of the serious innovation in the country. And we hope the [venture capital investment] ecosystem will go from $1 billion to $10 billion annually over the next five years. That’s what we need in this country. Our intention in making this step is to encourage others to join us.”

OMERS should also take my advice and start seeding emerging hedge fund managers in Canada. Dave Finstad is now in charge of the hedge fund program over there and I think he can do something very interesting if he takes the right approach.

As for OMERS' ambitious ventures into private markets and their "bullish bet on Western Canada", it all remains to be seen. I know they have the skill set and agree that private markets buffer against the insane volatility of public equities but they're not a panacea and depend highly on conditions in public markets. Also, my readers know my long-term views on Canada are quite bearish to say the least. When our real estate bubble bursts, it's going to be ugly.

Whatever the case, our public pension funds are global leaders and I just provided a small glimpse as to why. They are led by smart people who are not afraid to take intelligent risks. For the most part, they got the governance right and continue to deliver strong results in difficult markets. Think it time our federal and provincial governments expand our defined-benefit pension plans so all Canadians can enjoy a secure and decent retirement.

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