Leverage and Canada's Pension Promise

In a recent article published in the Globe and Mail, Leverage is the key to meeting Canada’s pension promise, Alex LaPlante and Serguei Zernov of the Global Risk Institute note the following:

Investors have been operating in a chronic low-interest rate environment since the financial crisis and have had to look for opportunities to generate higher yield, and pension funds are no exception. While using leverage requires advanced knowledge of the theory and practice of investments, pension plans with investment management sophistication can benefit from leverage in strategic asset allocation.

Indeed, sophisticated Canadian pensions have been using leverage for years to add to their returns and the authors note that even though leverage isn't a free lunch, it gives pension fund managers the ability to expand the set of possible portfolios to meet the objectives with a better risk/return trade-off:

As pension funds have targets expressed as return expectations, rather than in risk-adjusted return expectations, the best diversified portfolio that doesn’t use leverage may not be be able to meet the goals. As the asset owner faces fixed costs, their impact on performance is also higher at lower levels of expected returns. The leveraged portfolio of a pension plan with a return target of 6.5 per cent may outperform the portfolio without leverage at the same risk level by more than 1 per cent under realistic assumptions. This is a large margin for a long-term investor (and pension funds can have liabilities stretching out 30 years). Even if only half of the value is realized, it is still economically significant.

One hundred basis points of added return might not sound like a lot but compounded over many years, that additional return from leveraging the portfolio is very significant. Even half that return is significant over the long run.

So what's the problem? If leverage makes perfect sense in a low-rate, low-return environment, offering a well-diversified portfolio a higher risk-adjusted return, then why aren't all pension plans implementing it to take advantage of the additional source of income?

That's where things get messy. Some pensions are simply not allowed to leverage up their portfolio, others lack the internal expertise to do this properly and others might be too underfunded to take on and manage that extra liquidity risk and other risks which come with leverage.

There are also a lot of misconceptions regarding the use of leverage and what risks it exposes a pension plan to. In February, CAPSA put out a communiqué reviewing the use leverage at pension plans.

CAPSA had established the Leverage Working Group back in 2016 with a mandate to:

• conduct research, review existing rules, evaluate guidance and reporting requirements relating to the use of leverage;
• engage with industry experts and plan administrators that actively employ leverage; and,
• provide pension regulators with a better understanding of pension plans’ use of leverage, including the extent of its use, and its potential benefits and risks.

Among its key findings, it differentiates between "financial leverage" which involves borrowing funds and "synthetic leverage" which involves the use of derivatives and states that leverage can exist at a pension fund level or be embedded in its investment holdings (eg. hedge funds, private equity funds).

Other key findings from the CAPSA communiqué include:

• While leverage is often associated with higher risk (increasing exposure to riskier asset classes to seek higher returns; amplifying exposure to potential gains and losses), the risk profile of leveraged investment strategies can be quite different when viewed from the perspective of a pension plan’s balance sheet rather than from an asset-only perspective. Leverage can be aimed directly at reducing certain risks in investment portfolios and pertaining to the liability side of the balance sheet.
• Key risks associated with leverage use include credit risk, liquidity risk, counterparty risk, refinancing risk, and governance risk.
• There is no simple measure of leverage that effectively captures either the extent or the risks associated with its use. Current disclosures and regulatory reporting including a pension plan’s annual report, do not provide sufficient clarity regarding its use.
• Leverage, especially the use of synthetic leverage, requires sophistication and a considerable understanding of the risks involved and how to actively manage them.
• While a pension plan’s use of leverage must be considered in assessing the riskiness of its investment activities, that assessment requires a more holistic analysis of the overall quality of its risk management strategy (i.e. the procedures and controls in place for managing the risks associated with leverage use).

Now, Canada's large pensions are extremely sophisticated and all of them are able to take advantage of synthetic and financial leverage to boost their returns. Moreover, they have the procedures and controls in place for managing the risks associated with leverage and manage these risks very tightly.

And it's not just large public pensions. Some very sophisticated private pensions in Canada are also taking full advantage of leverage to add to their returns. At Toronto's annual spring pension conference, Marlene Puffer, President & CEO of CN Investment Division, explained how they got their board's approval to prudently leverage their balance sheet.

Given that CN's pension is a very mature $18 billion pension plan where there are three retired workers for every active member, they need to make sure they have the $1 billion a year to cover payouts every year, so you can be sure they're managing liquidity risk very tightly.

Similarly, yesterday I covered IMCO's building blocks and highlighted how its CIO Jean Michel previously headed Air Canada's Pension Plan where he and his team used all sorts of strategies, including leverage, to bring that plan back to fully funded status after the 2008 financial crisis plunged it into a deeply underfunded position (Vincent Morin who succeeded Jean Michel at Air Canada Pension went into detail with Chief Investment Officer on how they restructured that plan to improve risk-adjusted returns).

In both these cases, you have a) strong sponsor support for the intelligent use of leverage (both synthetic and financial) and b) the requisite internal expertise to implement sophisticated strategies and properly monitor and manage the risks of these strategies.

But it's Canada's large public pensions which garner most of the attention when it comes to their use of leverage. Most of it is negative and perpetuates certain myths, but some comments are a lot more balanced and analytical.

Last August, Martha Porado of Benefits Canada wrote a great comment on how Canadian pension funds are using leverage (PDF is avalable here).

In her comment, she explores why Canadian pension funds are issuing bonds in local and foreign currencies, how the State of Wisconsin Investment Board took on a strategy that leveraged its safer assets (high-grade bonds) to boost performance, how the top eight pension plans in Canada were counter parties in 15 to 35 per cent of all outstanding repurchase agreements and reverse repos reported by Canadian financial institutions on their balance sheets (in 2015), how they use derivatives extensively to improve their risk-adjusted returns.

I like how she cites someone from OTPP to explain their commercial paper program:

The Ontario Teachers’ Pension Plan stresses that its own bond issuances are a useful way for it to diversify its funding sources. “[Ontario Teachers’ Finance Trust’s] commercial paper program provides low-cost funding for desired terms that supports our investment strategies and internal liquidity requirements. The diversification of funding sources, away from the dependence on bank balance sheets, has been important at a time when capital and liquidity regulations have been changing,” said Audrey Gaspar, managing director of treasury and integration.

“An added benefit has been that the non-Canadian dollar issuance provides a natural hedge against the currency risks in a multi-currency portfolio of investments.”

All the major Canadian pension funds have a AAA credit rating and are running similar commercial paper programs.

For example, S&P Global Ratings performed an in-depth review of CPPIB in 2017 and issued it a AAA credit rating. That's why CPPIB is able to issue all sorts of bonds, including green bonds in local and foreign-denominated currencies.

You might wonder why CPPIB or any of Canada's large pensions have commercial paper operations and are issuing bonds. Put simply, when the cost of borrowing is low, it's a very efficient use of capital, allowing them to capitalize on opportunities as they arise.

What if we get another 2008 crisis? There too, the ability to borrow will allow them to capitalize on opportunities as they arise (for example, to pick up distressed assets on the cheap).

The way I see leverage is it's a critical part of the toolkit to add value to the overall portfolio while maintaining diversification across public and private makets. It's simply a way to improve the overall risk-adjusted return of a pension plan's portfolio.

And it's not just Canadian plans that are levering up their portfolios. In Europe, consultants have been warning defined-benefit plans to embrace levered and complex strategies or face widening funding gaps as the low-growth, low-interest rate environment persists.

Let me end by reminding you what HOOPP's CEO Jim Keohane recently told me about leverage: "What looks like leverage is just an inflated balance sheet. Others use custodians so it's not on their books but it's still there, we just internalized it, saving money and that allowed us to gain incremental returns. Out of 700 employees, roughly half are in IT, allowing us to mark all our assets to market daily and build our capabilities to move collateral and better manage our cash flows around swaps"

In other words, HOOPP is running a very sophisticated operation but the focus is very simple, to deliver on the pension promise.

So, is leverage the key to Canada's pension promise? No, good governance is the key which allows these pensions to hire experts who use all the tools available to deliver on the pension promise.

That's why The Economist calls Canada's large pensions maple revolutionaries, they're  setting the bar high when it comes to pension governance and long-term performance.

Below, an older clip where the FT's Robin Wigglesworth explains why risk parity has been one of the trendiest investment strategies in the world since the financial crisis.