Wednesday, April 18, 2012

HOOPP Leads its Peers, Up 12.2% in 2011

The fully funded Healthcare of Ontario Pension Plan (HOOPP) did it again, returning 12.2% in 2011 with assets now topping $40 billion:

With returns of 12.19 per cent in 2011, the Healthcare of Ontario Pension Plan ended the year 103 per cent funded. For the first time, HOOPP’s net assets surpassed the $40 billion mark.

HOOPP President & CEO Jim Keohane credited HOOPP’s liability driven investing (LDI) strategy for the plan’s solid funded position. This strategy was developed in the early 2000s and its purpose is to ensure that HOOPP’s investments will surpass the growth in the future pensions owed to members, also called the plan’s liabilities.

“HOOPP’s benefits are fully funded. This means that we have sufficient resources to pay every pension owed to the membership – not just now but into the future too,” says Keohane.

HOOPP has a long history of being well funded, having been at least 96 per cent funded in every valuation for over 30 years. While superior investment returns have helped keep the plan fully funded, pension governance has helped HOOPP become a model of a defined benefit plan that works.

HOOPP’s Board of Trustees recognize that there are two sides to the pension equation and actively adjust benefits and contributions as the economy changes, ensuring the Plan’s long-term sustainability. The jointly governed model ensures that the Board has focused on delivering on the pension promise to ensure retirement security for its members and employers and HOOPP has maintained stable contribution rates for over a decade.

“The best returns in 2011 were in long bonds, real return bonds, real estate and private equity. These are all asset classes which are employed heavily in our LDI portfolio. That is why funds employing LDI have achieved better results in 2011,” Keohane said.

In 2011, HOOPP entered the international real estate market, closing its first deals in the United Kingdom and the Czech Republic. HOOPP has a 10-year average net investment rate of return of 8.4 per cent, one of the best in the industry, which has added $22.9 billion dollars to the value of the Fund.

HOOPP’s 270,000 members include nurses, medical technicians, food services staff and laundry workers, and many other people who work hard to provide valued Ontario healthcare services. HOOPP members and employers contribute to the defined benefit pension and HOOPP pays out more than $1.2 billion in pensions annually.

For full details on HOOPP’s 2011 results, please see the HOOPP Annual Report. President and CEO Jim Keohane's message on page 9 was short, simple and to the point:

To say that, globally, 2011 was a turbulent year for the financial markets is to put it mildly – but at HOOPP, we’ve long held the view that it is important to anticipate volatility.

Over the very long term, investment returns have been reasonably predictable, but in the short to medium term, markets and returns are highly unpredictable.

In order to enhance our ability to deliver on the pension promise, in late 2007, HOOPP positioned itself with a more conservative investment structure.

The Plan further developed its liability driven investing (LDI) approach, which uses HOOPP’s liabilities – both the pension payments being paid now and the projected pensions to be paid in the future – as the main reference point in assessing the construction of an investment portfolio and the risk and return of a particular investment.

HOOPP’s small in-house team of investment managers anticipate the inevitable market volatility and factor it in when structuring our portfolio. The portfolio is constructed to more closely match the investment characteristics of HOOPP’s liabilities, so the value of the portfolio assets will change in sync with the value of the liabilities. Then, the investment managers carefully “layer on” return seeking strategies to get the returns required.

The LDI approach we are following is designed with the sole purpose of meeting HOOPP’s objective of “delivering on the pension promise.” And that objective isn’t just an expression for our communication materials – it’s a clear statement of how aware we are of HOOPP’s importance in our members’ lives, enabling them to retire with dignity.

This promise to our members and pensioners is the foundation of our business plan and it is a mission that has served to guide and focus our entire team at HOOPP.

Having worked at HOOPP for the past 13 years and served as the Plan’s Chief Investment Officer, my mandate as the new President & CEO is to build upon the Plan’s successes with investment portfolios designed with the future pension income needs of our members top of mind.

There were challenges from the turbulence in 2011, but with those challenges came opportunities. As in previous years, we felt that our investment approaches allowed us to meet the challenges of 2011 and we are pleased with the opportunities we were able to capitalize on.

It’s important to note that, while HOOPP invests for the long term – where pension contributions made today are used to fund benefits that may not be paid out for 40 or more years – we also pay close attention to the short term.

This is why HOOPP has remained fully funded, despite the challenging financial climate, for the last three years.

This is the cornerstone to the solid foundation of success that my predecessor, John Crocker, helped to create. I would like to acknowledge and thank him for his service. I look forward to working with the HOOPP team as we navigate through the changing healthcare landscape and an uncertain economic climate to enable our members to realize their financial goal of a well-deserved retirement.

I've said it many times before, and I'll say it again, along with Denmark's ATP, the world's best hedge fund/ pension fund, HOOPP is one of the best defined-benefit plans in the world. Jim Keohane met up with Lars Rohde, ATP's chief investment officer, many years ago and learned a lot from the way they manage assets and liabilities.

Many other pension plans need to learn from HOOPP's approach and governance model. In fact, I think I should write a case study for Harvard's Business Review juxtaposing HOOPP's approach which relies almost exclusively on internal managers to that of Ontario Teachers' Pension Plan (OTPP) which relies on a mix of internal and external managers.

Both plans are excellent, both delivered exceptional returns in 2011 (OTPP was up 11.2%) but only HOOPP can claim to be fully funded which means their over 270,000 plan members will not face any increase in retirement age, rise in contributions, or cuts in benefits. In short, HOOPP is a true testament for boosting the case for defined-benefit pensions to workers across the public and private sector.

So where did HOOPP go right in 2011? On page 20 of the Annual Report, you see a breakdown of active management and relative performance (click on image below).

Active management return, or “value added”, came from a variety of sources within both the liability hedge and return seeking portfolios – contributors included interest rates, corporate credit, real estate, absolute return strategies, private equity and asset allocation.

The contribution of active management to total portfolio returns -- 232 basis points or 2.32% -- is simply astounding. Most pension funds are happy when they deliver 50 basis points (0.5%) over their benchmark portfolio. And what's even more incredible is that they delivered these results by maintaining very low operating expenses (from page 25):
HOOPP’s 2011 operating expenses were $139 million or 0.33% of assets, up 7.8% from $129 million in 2010. This increase related primarily to higher staffing costs associated with HOOPP’s infrastructure growth and variable compensation resulting from superior returns.

In 2011, HOOPP continued to enhance self-service options for members and a web-based portal for employers that was launched in 2010. Work continued on a multi-year project to modernize technology and processes supporting the annual collection of member data.

HOOPP also continued to expand membership and convey the value of the Plan by proactively managing our brand and maintaining strong stakeholder relationships including its government relations program.

HOOPP continues to offer a very cost-effective way for our members to save for their retirement as compared to other investment vehicles, with investment expenses costing just over 0.23%, which is significantly lower than individual retirement account alternatives, where the expense ratios can be up to several times higher.
The lower costs of large defined-benefit plans is a major advantage driving their outperformance over defined-contribution plans. Moreover, HOOPP makes ongoing efforts to identify, assess and, when appropriate, mitigate risks inherent in its day-to-day operations. These operational risk management activities include:
  • regular reviews of internal controls – with a particular focus on areas of higher risk – including ensuring a sustainable internal control framework is in place across the Finance division’s functions and activities, especially those that involve orsupport financial reporting
  • ensuring that as new systems, applications and processes are designed and implemented, a review of the effectiveness of controls is made part of pre-implementation analysis and planning, and changes are made where appropriate
  • maintaining a Code of Business Conduct and supporting policies that include a fraud policy and a whistle-blower protection policy to help emphasize the importance of the roles, duties and responsibilities of all employees, including duties and responsibilities in the mitigation of fraud risk; and, periodic Board reviews of Board policies to ensure they are kept up-to-date
  • maintenance of a business continuity program with regularly-tested disaster recovery and business continuity plans to ensure HOOPP can – in the event of disruption – recover its critical systems at an off-site location and carry on core operations.
You'll notice my added emphasis on fraud policy and whistle-blower protection. My eyes have seen way too many shenanigans in the pension industry. I can't over-emphasize the need to protect whistle-blowers in any organization, especially in the pension world where power is often concentrated in the hands of a few key decision makers.

I had a chance to ask Jim Keohane these four questions yesterday:
1) Asset allocation delivered 0.5 per cent of active management. Are you able to share a bit more on where you made important shifts and when?

2) Real estate and private equity results were good as well but not much detail in terms of where you made money. Do you have anything to add here?

3) Public stocks delivered benchmark returns. Where are your absolute return strategies concentrated, in fixed income?

4) Does a major backup in bond yields worry you? How will it impact your LDI strategy?
Jim was kind enough to respond promptly:
1. The value add due to asset allocation was a result of an overweight position in US equities and in investment grade corporate credit which was put in place in October. We use valuations as our criteria for asset mix, and at that time we felt that equities were 20% undervalued based on our work, which is an extreme reading. Also, credit spreads were discounting a default scenario which would be extremely unlikely given the strength of corporate balance sheets.
2.Private equity results were driven by realizations on a few investments which were made in the market lows of 2008. Real estate was strong across the board, but the biggest contributor largely was an increase in value of our industrial portfolio. HOOPP has a large portfolio of industrial buildings which had lagged in the recovery, but did very well in 2011.
3. On page 20 of the report you can see a breakdown of the contribution to returns by strategy. Some of the equity related strategies show up in equities, some of the fixed income strategies show up in fixed income, the credit absolute in credit, and there is a separate category for absolute return strategies.
4. We don't expect a major backup in rates until we see some strength in the economy, however, a backup in bond yields would still be positive overall for the fund. The duration of our liabilities is still significantly longer than the duration of our assets, so our surplus would improve under a rising rate scenario. Given the nature of our holdings, under that scenario we would have been better off not having a liability hedged portfolio, and we may produce a lower return than some of our peer funds, but we will meet our objective of having our assets outperform our liabilities.
Interestingly, Boyd Erman of the Globe and Mail also asked Jim about what happens to he LDI portfolio when rates move up:

When rates turn around, HOOPP’s returns from the liability hedge portfolio may disappear. But it shouldn’t matter, at least from a funding point of view, which is the way HOOPP looks at it.

Mr. Keohane says that the present value of the liabilities should go down as well. In fact, it should go down more than the value of the hedge portfolio because the duration of the liabilities is longer.

“So a rise in interest rates would improve HOOPP’s overall funded status because the assets will go down in value more than the liabilities under a rising interest rate scenario,” he said in response to queries from Streetwise.

This is something that very few critics of the LDI approach understand, much to their detriment. Jim Keohane and the folks over at HOOPP have mastered this approach through the intelligent use of derivatives and by knowing where to take active risk on their asset allocation.

I also asked Jim Keohane about the amount of leverage HOOPP uses in terms of repo activity on their bonds. Jim responded:

We do repo our bond portfolio. When we assess which bonds we are going to invest in, the repo value is certainly one of the important factors we consider in our purchase. Repoing bonds is simply a way of trying to maximize the return on our fixed income assets. Almost every fund does bond lending via their custodian, so they have the same leverage in their portfolio as well. Because it is done by the custodian it shows up on the custodian’s balance sheet rather than their own balance sheet, but the same leverage exists. We do not take directional leverage using repo funds, so the activity is simply a spread trade with very little incremental risk to the overall fund. We have broken down our return streams in considerable detail in the annual report, and repo is a very small component of that return.

And he added:

I would agree that we have an unusual balance sheet that very few funds could replicate. We do have leverage but there is very little risk in that leverage. Our use of these alternative strategies is what has allowed us to reduce our equity exposure, so our use of these types of funding strategies reduces overall portfolio risk.

Below, watch Jim Keohane's report to members (can also click here to watch it). I also want to thank John Crocker, HOOPP's former President and CEO as well as Andy Moysiuk, HOOPP's former Head of Private Capital. Andy has been one of my greatest supporters and as Jim told me, "a very positive contributor to HOOPP."

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