Monday, April 9, 2018

Making OTPP Young Again?

Last week, when I covered Ontario Teachers' 2017 results, I spoke to its CEO, Ron Mock, on a number of topics.

One of the most important topics I didn't get a chance to cover in detail was the Plan's Funding Report which is available beginning at page 7 of OTPP's 2017 Annual Report:
The plan is fully funded based on current contribution rates and 100% inflation protection being provided on all pensions. This year’s surplus has been fully allocated to the contingency reserve.

Details are provided in the Funding Valuation Summary table on page 9.

The sponsors have decided to file the January 1, 2018, valuation with the regulatory authorities and have chosen to allocate the surplus to the contingency reserve (explained in more detail on page 8). This decision is intended to reduce volatility in the funded position of the plan and facilitate stability in members’ contributions and benefits.

Now, notice since its inception, 10% of the funding source came from active member contributions, 11 % from the Ontario government (the additional 1% above the 10% member contributions is related to funding of the original plan deficit) and 79% has come from the net investment income generated by Ontario Teachers' over a benchmark over all these years.

So, in terms of sources of pension funding, investment income, not contributions, remains the most important source by far and these figures are comparable to Canada's other large pensions.

But no matter how good Teachers' investment staff are at generating investment income, when the plan ran into trouble (ie. experienced a deficit), more needed to be done to get it back to fully funded status.

In 2010, Ontario Teachers' pension plan introduced conditional inflation protection, which effectively meant that inflation protection was no longer guaranteed as it still is at OMERS and OPTrust.

Why did Ontario Teachers' adopt conditional inflation protection? Because as the plan matures, there are now almost as many active members to retired members and soon there will be more retired members than active members, so from an intergenerational risk sharing standpoint, it made sense to spread the risk of the plan more uniformly among retired members.

On page 13 of OTPP's 2017 Annual Report, it states conditional inflation protection (CIP) applies to more pension beneficiaries, it will be able to absorb a greater loss, making it a more effective risk management tool (click on image):


The way Ron Mock described this chart above to me is that conditional inflation protection will allow Teachers' to absorb a greater loss going forward and it will "make the plan young again" (no relation to making America great again).

What's crucially important to understand is that not only does conditional inflation protection address intergenerational risk sharing, it also allows the plan to breathe a little easier if they do experience a severe loss and run into problems in the future.

In effect, as more teachers retire, if the plan runs into trouble and experiences a deficit, CIP allows them to slightly adjust benefits (remove full indexation for a period) until the plan's funded status is fully restored again.

Because there will be more retired relative to active teachers, they will be able to easily shoulder small adjustments to their benefits for a period to restore the plan back to fully funded status.

This isn't rocket science. The Healthcare of Ontario Pension Plan does the same thing and so do other Ontario pension plans like the Ontario Pension Board and CAAT Pension Plan which recently hit 118% funded status, putting it right behind HOOPP in terms of the best funded Canadian plan.

Importantly, while all these plans have different maturities and demographics, they've all adopted a sensible shared-risk model which is fair to all members of their plan, active and retired members, and it ensures the sustainability of their plan for many more years.

Now, as I mentioned above, not all Ontario pension plans have adopted a shared-risk model and CIP. In particular, OMERS and OPTrust have not but that hasn't stopped them from attaining a close to fully funded status (OMERS) or fully funded status (OPTrust)

In the future, I firmly believe both OMERS and OPTrust will move away from guaranteed inflation protection (GIP) to adopt conditional inflation protection (CIP). It's not a matter of if but when and it makes perfect sense for the plan and its active and retired members.

Go back to read my coverage of Ontario Teachers' 2017 results where Ron Mock shares this with me on the plan's funded status:
  • On OTPP's success in terms of being fully funded, Ron told me the plan has intergenerational equity because when there is a deficit, active members see their contribution rates rise and retired members see a partial removal of full inflation protection. "Conditional inflation protection has worked well and made the plan young again". What Ron means is that 25 years ago, there were ten active members for every one retiree and now there are 1.5 for every retiree, and teachers live longer than the rest of the population. So by incorporating conditional inflation protection, the retired members which will grow in numbers will bear more of the burden but because a removal of full inflation protection isn't onerous on their benefits (over three or four years), they can withstand the minor adjustments to their benefit levels until the plan gets fully funded again and full inflation protection is restored (see this great clip which explains why conditional inflation is instrumental in the plan's success). By 2040, there will be ten people sharing the risk for every active member, which will make the plan a lot more sustainable and fairer in terms of generational burden. Ron added: "Conditional inflation gives us a $70 billion cushion in case the plan experiences a serious deficit."
  • It should be noted that Ontario Teachers' uses a 4.8% nominal discount rate (2.75% real) which is among the lowest fifth percentile from plans around the world. It's a mature plan with an aging demographics but as stated above, conditional inflation protection has made it young again.
In essence, along with its governance model, conditional inflation protection has allowed Ontario Teachers' to spread the plan's risk more fairly and effectively, and it's a cornerstone to the plan's success.

I would even go as far as stating every single pension plan in the world should move away from guaranteed inflation protection to conditional inflation protection as more plans experience a shift to an aging demographics, ie. more retired members relative to active members.

Below, once again, Ontario Teachers’ net assets reach $189.5 billion, up tenfold since the plan’s inception; the Plan was 105% funded as at Jan. 1, 2018. See some of the highlights from the 2017 Annual Report.

I also embedded a clip on how small adjustments to inflation protection ensure the plan's sustainability over the long run. This isn't rocket science, it's just common sense.

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