Wednesday, October 4, 2017

Canada's Pensions Piling on Leverage?

Allison McNeely of Bloomberg reports, Canada's Pension Funds Are Piling on Leverage, Moody’s Warns:
Canada’s public pension funds, among the biggest in the world, are piling on risk with leveraged bets in a chase for higher returns, Moody’s Investors Service warns.

The nation’s six biggest pension funds have increased their average leverage to 24 percent, from 19 percent in 2009, in an effort to offset the impact of declining pension member contributions and low interest rates on their cash flow and investment returns, Moody’s said in an Oct. 3 report written by analyst Jason Mercer. That’s leaving the funds exposed to volatility in the returns they’re counting on to fund future pension payouts.

“They are definitely taking on more risk, and the question I ask them is, ‘Why take on more risk if you don’t need to?’” Mercer said by phone from Toronto. ‘Why not just invest in very low-risk securities and not worry about volatility?”

Long-term interest rates in developed countries are currently about half the 4 percent real return pension plans need to remain sustainable. Canada’s biggest pension funds have been targeting returns in the double-digits with their use of leverage and investments in illiquid assets such as real estate, infrastructure, and private equity, to compensate for a lower ratio of active members to retirees drawing benefits, Mercer said.

These strategies leave pension funds more exposed to potential macroeconomic shocks such as a weaker Canadian dollar or drops in equity or credit markets, Mercer said.

To be sure, Canadian pension plans have the financial strength and ability to take on risk, and Moody’s doesn’t see a credit-rating impact from the increased leverage anytime soon, Mercer said. If a pension fund’s leverage ratio were to increase above 50 percent, Moody’s would no longer rate the fund higher than its government sponsor, he said.


Ontario Teachers’ Pension Plan has the highest leverage, 33 percent, due to their large constituency of teachers retiring early and living longer, according to Moody’s.

“As a pension plan, we focus by necessity on our asset-liability balance,” OTPP spokeswoman Deborah Allan said in an email. “Leverage is key in our portfolio construction as we manage our asset mix and reduce our liability risk.”

Many Canadian pension funds, which were among the first to establish private equity arms to take active stakes in businesses in 1990s, have set up in-house hedge funds to invest in more complex derivatives like forwards, swaps and options while also employing debt strategies.

The combined assets of Canada’s six largest pension funds nearly doubled to almost C$1.4 trillion ($1.1 trillion) between 2011 and 2016, according to Moody’s. Investment income was the largest contributor to growth, with combined earnings contributing more than C$400 billion over the past five years.

Allocation to illiquid, non-public assets increased to 34 percent in 2016 from about 31 percent in 2010, according to Moody’s. A risk with these assets is that they rely on assumptions about their value, which can only be determined once the asset is sold and adds uncertainty to portfolio performance, Mercer said.
Moody's Investor Service put out a press release, Higher leverage due to low interest rate environment raises risk for Canadian pension funds:
The exceptional credit quality of Canadian public pension funds is based on several key factors including highly-rated sponsors, high stability and predictability of future cash flows, predictable national and provincial legal systems and strong coverage of obligations by high quality liquid assets, Moody's Investors Service says in a new report. However, high leverage and less-liquid investments raises risks for pension funds.

"As in many other countries, Canadian defined benefit pension plans are facing adverse demographic shifts thanks in part to an aging baby boomer population," Jason Mercer, a Moody's Assistant Vice President says. "The active-to-retired ratio, a measure of the relative proportion of contributing members to retirees collecting benefits, has fallen for all six pension managers in the past 10 years as growth in retirees outpaces contributors."

In the absence of strong investment returns, higher contributions or reduced benefits, a lower active-to-retired ratio reduces a pension plan's funding ratio and increases the liquidity requirements of the plan. Net contributions for most pension managers have shrunk in the past few years as the relative proportion of retirees increase.

"Weaker net cash flows make funds more dependent on market performance to maintain current funding levels, but low interest rates hinder the funds ability to make returns strong enough to offset the net cash flow pressures," says Mercer.

Moody's says funds that increase leverage and illiquid assets to ensure they can generate returns sufficiently high enough to mitigate the funding pressures from aging demographics and low interest rates also increase the pension fund's asset risk in the event of a market correction.

Pension managers facing cash flow pressures as a consequence of the low interest rate environment have adapted by combining scale, leverage and investment strategies. Through a mix of investment returns, increasing leverage and member contributions, Canadian pension funds have substantially increased their scale; and are among the largest pension managers globally.

Between 2011 and 2016, the combined assets of the six largest Canadian pension managers nearly doubled to almost CAD1.4 trillion. Investment income has been the largest contributor to this asset growth, with a combined earnings contribution of over CAD400 billion in the past five years.

The average leverage of the largest six funds has increased to 24% from 19% since 2009. This strategy entails higher risks for pension managers since leverage magnifies not only gains, but also losses.

The report "Canada - Public Pension Managers: Aging population, low interest rates drive higher investment risk, a credit negative," is available to Moody's subscribers at https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1057573.
OMG! Canada's pension overlords are piling on leverage so they can juice their returns to justify their multi-million dollar compensation even though they have captive clients? You don't say, eh!

Now that's a great gig! Sign me up! As long as rates stay low and central banks are in control, share buybacks continue, stocks keep soaring to record highs, it's smooth sailing. Even if we get a financial shock, no problem, one bad year like 2008 is fine, compensation is based on four or five-year rolling returns.

But what happens if deflation strikes the US and we enter the worst bear market ever, sending rates to record lows or negative territory, clobbering public and private assets all around the world for a decade or longer?

That's when things get really sticky for all pensions all over the world, not just Canada's large pensions. Pensions better hope Janet in Wonderland is right but I'm warning you, with global inflation in freefall, now is the time to come to terms with the global retirement reality.

But it isn't Canada's large pension funds I'm worried about. I'm far more worried about US pension storms from nowhere even if US public pensions aren't piling on the leverage like their large Canadian counterparts are.

However, even though large US public pensions don't have the governance, risk monitoring, and internal capabilities to do a fraction of  what Canada's large pensions are doing internally and with their external partners, they too have been piling on the leverage since 2009, significantly increasing their allocation into private equity where leverage on LBOs is at the highest since the financial crisis, real estate and hedge funds where they're getting squeezed on fees as their funded status keeps degenerating.

And unlike Canada's large pensions which enjoy a AAA credit rating allowing them to lever up, most US public pensions are so woefully underfunded that they are being targetted by rating agencies. Even if they wanted to lever up like Canada's large pensions, they can't because either a) their investment policy forbids it, b) they don't have the governance or internal capability or c) they don't have the required rating to emit bonds investors love.

Go read this excellent BVCA report on risk in private equity. I note the following on funding risk:
When reflecting on the last financial crisis, some investors faced severe funding issues. The most prominent case was from the university endowment of Harvard Management Corporation who issued a bond of more than USD 1bn to fund their future capital calls and considered selling a private equity portfolio of around USD 1.5bn, when the average discount on the secondary market was between 40% and 50%. Even CalPERS (the largest US pension fund) sold some of their listed stocks in order to be prepared for potentially paying future capital calls for private equity funds according to an article in the Wall Street Journal.

Listed private equity vehicles which ran an over-commitment strategy experienced similar issues. APEN, a Swiss-listed vehicle had to go through significant restructuring, adding a new financial structure as well as selling on the secondary market so as not to lose any of its private equity assets. It should be noted, however, that many pension funds and insurance companies investing in private equity did not have to take drastic measures during this time period and were able to cope with the change in cash flow profile because they managed their risks from the outset by limiting their allocation to private equity. Additional reasons for the limited allocation to private equity have been the possibility for them to match it with their incoming cash flows, the possibility to liquidate other liquid assets beforehand and having more diversified portfolios.
If you ask me, Canada's large pensions are in great financial shape (fully-funded or near fully-funded status) and their ability to lever up offers them a huge advantage over their US and global counterparts.

This Moody's analyst Jason Mercer isn't telling me anything new. Back in 2008, Ontario Teachers' crashed and burned precisely because it was taking on a lot more directional leverage than its counterparts. That year, the Caisse suffered a $40 billion train wreck, but that had nothing to do with leverage, and more about investing in dumb ABCP paper to trounce their bogus benchmark.

Other large Canadian pensions suffered huge losses in 2008. Only HOOPP got it right discovering the hoopla of boring old bonds.

Still, despite those heavy losses, all of Canada's large pensions came back strong in subsequent years using their internal investment savvy, partnering up with the right external partners doing a lot of co-investments to reduce fees, wisely leveraging up their portfolio and relying on their shared-risk model, all of which allowed them to regain their fully-funded status relatively quickly.

Sure, Ontario Teachers' uses the most leverage. The Oracle of Ontario also uses the lowest discount rate among Canadian and US public pensions, reflecting its aging demographics.

Along with HOOPP, OTPP is using leverage wisely in many areas:
  • Hedge funds: Using a portable alpha strategy, OTPP swaps into stock and bond indexes to invest a sizeable amount in top hedge funds all around the world that offer a high Sharpe ratio and non-correlated returns (HOOPP is smaller than OTPP and doesn't invest in external hedge funds yet but it recently committed capital to an external CLO manager). Most of the hedge funds in Ontario Teachers' (and CPPIB) are on Innocap's managed account platform to control liquidity and other risks very closely.
  • Internal absolute return strategies: Both OTPP and HOOPP do a lot of arbitrage strategies internally that require expertise. These arb strategies and other strategies (like risk-parity) require the use of leverage. This is intelligent levering up one's portfolio to reduce overall risk.
  • Internal repo operations: Both OTPP and HOOPP do a lot of repos in their fixed income portfolio, effectively leveraging up their bond portfolio. Again, this is wise and requires internal expertise you need to pay for. 
  • Emitting bonds to invest in private markets: All of Canada's large pensions (or almost all) are now issuing bonds to expand their investments in private markets (real estate, infrastructure, private equity and natural resources). Again, this is smart leverage, using capital markets to borrow cheaply to invest in an investment that will offer excellent long-term cash flows. 
  • Not just OTPP and HOOPP: Other large Canadian pensions engage in similar activities to varying degrees but it's fair to say that HOOPP and OTPP maximize their use of leverage.
I can go on and on but the point I'm making is to take all these articles on Canada's pension funds levering up with a shaker, not a pinch of salt. Remember, they have a long investment horizon, manage liquidity and funding risks very closely and aren't using leverage in stupid ways.

It is also worth noting that following the 2008 crisis, some Canadian pensions (most notably OTPP), tightened up their liquidity risk management considerably and took a new approach at looking at portfolio risk. 

But I'm not only going to criticize Moody's Jason Mercer here. I also think Canada's large pensions are to blame because they poorly communicate their use of leverage and how it's an integral part of their strategy to reduce, not raise, overall risk and better match assets with liabilities.

In an email exchange with HOOPP's Jim Keohane and David Long following this comment on their CLO commitment, I told Jim he needs to address HOOPP's use of leverage head-on in a YouTube presentation. I would say the same thing to Ron Mock, Bjarne Graven Larsen, and all of the CEOs and CIOs at Canada's large pensions.

Don't keep mum on your use of leverage, explain it and explain why it's an integral part of your overall strategy in better matching assets with liabilities.

Below, risk parity has been one of the trendiest investment strategies in the world since the financial crisis. But what exactly is risk parity and how does it work in practice? The FT's Robin Wigglesworth explains how the intelligent use of leverage can reduce overall risk.

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