Monday, August 11, 2014

Reviewing PSP's Funding Policy?

Kathryn May of the Ottawa Citizen reports, Call for federal pension policy baffles experts:
The Conservative government is developing a funding policy for the pension plans of Canada’s public servants, military and RCMP, a move that baffles experts because the plans have no real funds and own no assets.

A funding policy typically sets the framework for how to cope with risk and manage any gains and losses by adjusting the contributions paid into pension plans.

But the policy, to be crafted by consultants, would cover years of pensionable service in accounts that are nothing more than ledger records with no real assets. Pension benefits are guaranteed by law and paid from government’s main bank account — the consolidated revenue fund.

Pension expert Malcolm Hamilton said he’s puzzled why the government is charging ahead with a funding policy for the “least funded parts” of its unfunded pension plans.

“Funding is about setting money aside to pay benefits and they don’t pay benefits from those accounts, so why do they need a funding policy?” he added.

“What, if anything, does it mean to fund a pension plan that, by the government’s own admission, has no fund in which assets are held and from which benefits are paid? Beats me. This might make sense if the government was proposing to change the way its handles the pension funds but there’s no suggestion that is the case.”

The public service pension plans are like no other. They aren’t governed by the Pension Benefits Standards Act, the assets aren’t in trust or managed by a trustee, and there is no segregated pension fund owned by the plan in which pension assets are held and invested and from which pension benefits are paid to retirees.

Treasury Board is hiring consultants to come up with a “funding policy,” as recommended by Auditor-General Michael Ferguson in his recent report on the sustainability of the three plans. Bidders have until Tuesday to submit proposals for the two-phase project, which must be completed six months.

The policy is being specifically drafted for the public service pension plan but it must be “flexible enough” to be adapted for the other plans. Consultants will provide a research report, followed by a second phase of weekly consultations on proposals developed for the final policy.

A funding policy sets the framework for funding a defined benefit pension plan, including factors such as workforce demographics, stability and affordability of contributions, and the handling of surpluses or deficits. It takes into account the employer’s — in this case the government’s — financial position and risk tolerance.

Without a policy, Ferguson said the Public Sector Pension Investment Board, which manages the plans’ assets, is forced to make assumptions about the government’s tolerance for risk and funding preferences when targeting rates of return in its investment strategy.

The bid documents, however, indicate the funding policy is for the pension assets and liabilities accrued before 2000, which aren’t managed by the investment board. All the pensionable service built up before 2000 is considered unfunded.

Treasury Board officials offered no explanation on why the policy is for the pre-2000 plan other than it would “provide additional guidance” for funding and financing decisions while also “strengthening” its guidance to the investment board on investment strategies and risk management.

Hamilton, the pension expert, said a funding policy also won’t resolve the major problems critics have with the way the government records the cost of the plans on the books.

The C.D. Howe Institute has long argued the plans are not fully funded and the government is grossly understating the size of Canada’s debt and deficit — and how much it pays thousands of bureaucrats, military and RCMP.

It argues the government should adopt “fair-value” accounting like the private sector, which uses current market prices to value assets and liabilities as a means to ensure plans are fully funded in the event they are liquidated or wound down.

The timing of the proposal has also raised eyebrows, particularly among unions locked in a testy round of collective bargaining with the government over its plan to replace the existing sick leave regime with a new short-term disability plan.

Ian Lee, a professor at Carleton University’s Sprott School of Business, said the project, which includes a sweeping report on the latest trends and best practices in the pension industry, will set the stage for Conservatives to make compensation reform, including a pension overhaul, a campaign promise in the 2015 election.

“I think this report is the first step in that journey,” he said. “They will run as the party with the courage, conviction and ability to reform the largest employer in Canada by modernizing its sick leave, pay, benefits and pensions. These are fundamental changes and they will seek a mandate from Canadians to do it.“
Are you confused after reading this article? Let me try to clear things up a little. Basically, PSP Investments has a twofold mandate:
  • Managing the funds transferred to it by the Government of Canada for the Canadian Forces, the Reserve Force, the Public Service and the Royal Canadian Mounted Policy pension plans (the “Pension Plans”) in the best interests of the contributors and beneficiaries; and
  • Investing its assets with a view to achieving a maximum rate of return without undue risk of loss, having regard to the funding, policies and requirements of the Pension Plans and their ability to meet their financial obligations.
But PSP Investments isn't responsible for all the liabilities that go along with these plans. If you read its profile, it clearly states:
PSP Investments was incorporated as a Crown Corporation under the Public Sector Pension Investment Board Act in 1999. Our investments will fund retirement benefits under the Plans for service after April 1, 2000 for the Public Service, Canadian Forces, Royal Canadian Mounted Police, and after March 1, 2007 for the Reserve Force.
The key thing to remember is PSP isn't responsible for all the assets and liabilities of the Plans, only those accrued after April 1, 2000 for the Public Service, Canadian Forces, Royal Canadian Mounted Police, and after March 1, 2007 for the Reserve Force.

Now, because of the demographics of these Plans, PSP's members are young workers (unlike the members covered in the plans pre-2000 for the Public Service, Canadian Forces, Royal Canadian Mounted Police, and pre-2007 for the Reserve Force), and PSP Investments is taking in more money every year than it's paying out in benefits.

In fact, PSP Investments isn't paying out any benefits. As it currently stands, it is managing assets of a relatively young plan and enjoys roughly $4 billion a year in net inflows and it doesn't have to worry about paying any benefits until 2035 when the members of the Plans they manage retire and start receiving benefits.

And even then, the ratio of workers to pensioners will be big enough not to worry about these outflows. By contrast, more mature plans like Ontario Teachers have older members and more pensioners than active workers, so Teachers' is paying out a lot more in benefits than it gets in contributions from their active workforce and the Ontario government (plan sponsors). This places pressure on Ontario Teachers to manage assets AND liabilities extremely closely as well as to manage liquidity risk more tightly than other plans.

PSP Investments isn't a pension plan in the strict sense and neither is the Caisse, CPPIB, AIMCo or bcIMC. These are large pension funds which manage assets only, not liabilities like Teachers, HOOPP and OMERS do.

But they still have to manage assets with regard to their liabilities which is why they need a funding policy which is approved the their plans sponsors, outlining the allowable risk framework which their sponsors are willing to accept in order for them to meet their required actuarial rate of return.

In the case of PSP and CPPIB, the Office of the Chief Actuary of Canada (OCA) is in charge of evaluating the funded status of the Plans they manage, putting out actuarial reports on these and other plans they have to evaluate. But the OCA isn't in charge of funding policies, only actuarial reports.

Things gets a little tricky because PSP manages assets of fully funded plans whereas the CPP is a partially-funded plan, which means the CPPIB doesn't have to fully match assets with liabilities, but I don't want to confuse you too much, so let's ignore that aspect for now.

The main point I want to convey is that funding policies matter a lot, especially for more mature pension plans which are paying out more in benefits than they're receiving in contributions. The Canadian Association of Pension Supervisory Authorities (CAPSA) put out guidelines for funding policies providing key elements of a proper funding policy.

Why is the Treasury Board moving ahead to determine a funding policy for PSP? I suspect it's partially to answer the criticism of the Auditor General of Canada, but it may also be that they're preparing the groundwork for PSP to manage the assets and liabilities accrued before 2000 of these Plans. If that happens, the funding policy will be even more critical.

But even if it doesn't happen, PSP still needs a clear funding policy to provide a clear risk framework for their activities. A funding policy should also spell out what happens if the Plans are underfunded. For example, if it's a risk-sharing plan, the policy might state that in the case of a pension deficit, cost-of-living adjustments will be scrapped or contributions hiked until the deficit is wiped out.

And the funding policy isn't the only thing that PSP needs. As I recently discussed when I went over PSP's FY 2014 results, the Treasury Board needs to hire outside consultants to conduct a thorough performance audit of their investment activities, making sure the benchmarks they use to evaluate their performance reflect the risks they're taking in each investment activity.

Finally, Jordan Press of the Ottawa Citizen reports, PS pension fund seeing healthy growth:
The public sector pension fund posted one of its best returns since the economic downturn in 2008 as it sunk its money into European airports and more Manhattan real estate.

A 16.3 per cent return brings the total value of the investment fund, which is fed by pension plans for public servants, the RCMP and military reserves, to $93.7 billion, according to its annual report. That amounted to an increase of $17.6 billion from the almost $80 billion recorded one year earlier.

If it continues to grow as planned, the fund — the fifth largest in the country — expects to more than quadruple in value over the next 20 years and be worth $425 billion by 2035, just when it will see more money flowing out to pay benefits than it receives in contributions and investment income.

The figures should only add to the ongoing battle between the government and public sector unions about the future and sustainability of the pension plans. Ian Lee from Carleton University’s Sprott School of Business suggested the government could use the figure for more leeway in making changes to the pension system, but shouldn’t avoid making changes based on the projections.

“The government should not be saying, ‘Oh, well, they’re projecting a big fat number … so we’re clear sailing,'” Lee said.

“Any statement about the future is a projection. It’s not a statement of fact.”

If things go wrong — such as lower than expected interest rates or bad investments — “the government is on the hook,” Lee said.

“They’re trying to maximize and get bigger and better returns because they know that down the road they’re going to have an awful lot of people claiming (benefits),” he said.

Pension reform has returned to the national agenda earlier this year when the Tories unveiled “target benefit” pension plans for Crown corporations and federally regulated industries. Public service pensions aren’t part of that proposal, but unions have expressed concerns that their plans could be next for such change after the government raised the age of retirement and employee contributions.

The government has a $152-billion pension liability that it must fund. That amount could easily rise if public sector pensioners live longer: In May, auditor general Michael Ferguson said an extra year or three could increase that liability by between $4.2 billion and $11.7 billion.

A spokesman for the investment fund said the $152-billion liability is for pensionable service before 2000. After that time, payments come out of the fund.

To remain afloat, the investment board has to keep real investment return — overall returns minus inflation and expenses — at 4.1 per cent annually. Over the last 10 fiscal years, the real return was about one per cent above that target.

In the last year, the fund bought a high-rise office building on Park Avenue in New York City; spent $1.5 billion for several airports, including ones in Athens, Budapest and Sydney, that combined handle about 95 million passengers a year; and invested in farmland in Latin America.

“Those assets reduce the risk for the portfolio,” said fund spokesman Mark Boutet. There may come a time when the fund will need to unload those assets to pay for pension benefits, “but that time is far out,” he said.

The top five executives, meanwhile, had their compensation reduced. They earned $13.7 million in compensation, a decrease of 16 per cent from the $16.3 million recorded in 2013.

Those declines came after an outcry from opposition critics last year over a 50 per cent increase in executive payouts between 2012 and 2013.

Gordon Fyfe, who left as CEO in June, took home $4.2 million in total compensation in the last fiscal year, a $1.1 million decrease from the $5.3 million the previous year. Like those of other executives, much of Fyfe’s compensation came from bonuses atop of his base salary of $500,000.

The Public Sector Pension Investment Fund, by the numbers

$97.3 billion: Value of the fund at the end of the 2014 fiscal year

$17.6 billion: Increase in value between the 2013 and 2014 fiscal years

35%: Percentage of funds in foreign investments

$13.7 million: Total compensation to the top five executives at the fund

$4.2 million: Total compensation former CEO Gordon Fyfe received in the last fiscal year

4.1%: Average increase, after costs and inflation, in the fund’s value needed to meet future pension obligations

0.9%: Average increase above the 4.1 per cent the fund has achieved over the last decade

$425 billion: Projected value of the fund by 2035
No doubt about it, PSP Investments is growing fast and it will be another Canadian juggernaut (it already is), but along with that growth comes many risks which need to be properly accounted for. Their senior managers and board of directors are doing a good job but more needs to be done on the governance front and the Treasury Board has to take the lead there.

Below, Ron Mock, CEO at the Ontario Teachers' Pension Plan, says the fund has obtained a 10 percent return since its inception by investing globally across sectors like infrastructure, real estate and bonds. Good interview which I forgot to embed in my last comment on the pension tsar's harsh hedge fund lesson.

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