Fully Funded OPTrust Gains 1% in 2018

Benefits Canada reports, OPTrust remains fully funded, lowers discount rate in ‘worst year for markets’:
In addition to remaining fully funded and lowering its discount rate, the OPSEU Pension Trust returned one per cent in 2018.

This compares to a 9.5 per cent return in 2017, six per cent in 2016 and eight per cent return in 2015.

The plan’s real discount rate was lowered to 3.15 per cent, net of inflation, from 3.30 per cent in 2017. This move added conservatism to the plan’s funding valuation by calculating a higher liability value, which helps to protect the plan from future market volatility, noted the OPTrust in a press release.

“OPTrust’s objective is to maintain the funded status of the Plan without taking excessive risk,” said Doug Michael, interim president and chief executive officer of the OPTrust. “In the worst year for markets since the global financial crisis, we maintained our fully funded status for the tenth consecutive year and increased the long-term stability of the plan by lowering our discount rate.”

The OPTrust also noted it received high service scores from members and retirees, with service satisfaction at 9.1 out of 10. As well, it touted its risk management for helping to improve the plan’s funded status, maintain stability and increase its ability to weather a severe market downturn.

“As the world continues to change at an increasingly rapid pace, OPTrust’s members can know their pension plan is stable and secure,” said Michael. “We remain focused on the long term rather than day-to-day changes within the market. For our members, the funded status is the measure that matters.”
OPTrust released a press release, OPTrust lowers discount rate, remains Fully Funded for tenth consecutive year:
OPTrust today released its 2018 Funded Status Report, which details the Plan’s financial results and funded status. OPTrust achieved an investment return of one per cent for the total fund in 2018. In addition to remaining fully funded, the Plan lowered its discount rate, already the second-lowest of Ontario’s public sector plans. The organization also received high service scores, with members and retirees rating their service satisfaction as 9.1 out of 10, a top-six placement in a global benchmarking survey.

“OPTrust’s objective is to maintain the funded status of the Plan without taking excessive risk,” said Doug Michael, Interim President and CEO of OPTrust. "In the worst year for markets since the global financial crisis, we maintained our fully funded status for the tenth consecutive year and increased the long-term stability of the plan by lowering our discount rate.”

Implemented in 2015, OPTrust’s Member-Driven Investing (MDI) strategy seeks to increase the likelihood of Plan certainty by aligning outcomes with members' needs. Superior risk management has helped to improve funded status, maintain stability and increase the Plan’s ability to weather a severe market downturn, like the one experienced by the global economy in 2008. OPTrust once again reported in accordance with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), having become one of the first plans to do so in 2017.

“As the world continues to change at an increasingly rapid pace, OPTrust’s members can know their pension plan is stable and secure,” said Michael. “We remain focused on the long term rather than day-to-day changes within the market. For our members, the funded status is the measure that matters.”

The Plan remained fully funded in 2018 on a regulatory filing basis, while actuarial assumptions continued to be strengthened to enhance long-term funding health. The Plan’s real discount rate was lowered to 3.15%, net of inflation, from 3.30% in 2017. This move added conservatism to the Plan’s funding valuation by calculating a higher liability value, which helps to protect the Plan from future market volatility.

More detailed information about OPTrust's 2018 strategy and results is available in Building for the Future.
Take the time to carefully read OPTrust's 2018 Funded Status Report here. I will be referring to tables and charts from this report below.

Earlier today, I had a chance to speak with Dani Goraichy, Vice President, Actuarial Services at OPTrust. I thank Claire Prashaw and Joe Vesci for setting this call up.

Dani is a sharp actuary and I enjoy talking to actuaries because they really understand plan design and asset liability matching.

He began by telling me the plan remains fully funded. You can see the funding highlights below (click on image):

Dani said there are two sources of income: investment returns and contributions. "The less need we have for investment returns, the less risk we have to take."

The goal is to keep the contribution rate as stable as possible all while maintaining a fully funded status.

I asked why the Plan's real discount rate, already the second lowest of Ontario's public plans (OTPP has the lowest), was lowered from 3.30% to 3.15% given it's a fully funded plan and he told me for two reasons:
  1. Stability of the contribution rate
  2. Intergenerational equity
"Having a surplus allows us to maintain the stability of the contribution rate and it minimizes generational inequities."

On page 33 of the 2018 Funded Status Report, you can see the membership statistics (click on image):

As you can see, OPTrust is a mature plan. Dani told me the ratio of active to inactive members is 1.2. The average age of members is 45 years old and of pensioners it's 71 years old.

You can also see the average salary in 2018 of active members is $63,195 and the average annual pension is $21,613. I like seeing these numbers because a) it shows you the pensions we are talking about are modest but very important to these members and b) more importantly, there are real people counting on these pensions or that will be counting on them.

In other words, a pension isn't just about investment returns or even asset liability management, it's about helping people retire with modest but safe and secure benefits.

All too often people forget behind each pension, there's a person, so I like OPTrust's table above, I'd actually put it at the beginning of each Funded Status Report, it provides an excellent snapshot of members and what these pensions mean to them.

Now, getting back to the discount rate, changes in the Plan’s actuarial assumptions can have a major impact on the projected cost of members’ and retirees’ pensions and the Plan’s funded status. This table from page 21 of the 2018 Funded Status Report shows the impact (in millions of dollars) of a 0.5% change in certain key assumptions on the Plan’s funded status (click on image):

As shown above, lowering the discount rate by 50 basis points has a huge impact the projected cost of members' and retirees' pensions.

I got into this interesting discussion with Dani on what Malcolm Hamilton told me last week, namely, all of Canada's large public sector pensions should be using the Government of Canada long bond yield to discount their liabilities.

I noted that OPTrust's CIO, James Davis, told me last week at the luncheon, while he understands Malcolm's position, if OPTrust did this, it would to double the contribution rate, which is crazy. James also told me: "Malcolm's proposal would effectively kill DB plans, this is what they did in the Netherlands and ruined a great system, forcing pensions to de-risk at the worst time and cutting benefits when they didn't really need to" (HOOPP's Jim Keohane agreed and said it's even worse than that as they used the 10-year swap rate to discount liabilities and it went to zero).

Dani noted another problem with Malcolm's proposal, namely, OPTrust has a lot of illiquid assets in infrastructure, real estate and private equity, so it doesn't make sense to use a very liquid Government of Canada bond yield to discount future liabilities.

He said it's probably more appropriate to use the Province of Ontario's long bond yield (roughly 80 basis points higher than the Government of Canada long bond yield) but that they are doing a lot more research on the appropriate discount rate and this is a more complex subject than most people think.

We then got into why OPTrust and OMERS are the only two major Ontario pension plans which have yet to adopt conditional inflation protection. Given the maturity of these plans, I'd think it's only logical and necessary to ensure long-term sustainability.

Dani told me OPSEU is a sponsor of HOOPP, OTPP, and CAAT Pension Plan, all of which have adopted conditional inflation protection (not guaranteed inflation protection like OPTrust and OMERS) but that OPTrust has not experienced a serious pension deficit that warranted such a shift.

All true but I told him I am a big believer in a shared risk model that adopts conditional inflation protection. In fact, HOOPP's Jim Keohane told me last week: "Even in a worst-case scenario, we calculate that completely cutting inflation protection for a brief period can improve the funded status by 20%."

Dani and I then discussed OPTrust's innovative new pension solution, OPTrust Select, an initiative which aims to provide a defined benefit solution for the broader public sector, charitable and not-for-profit industries.

He said it's going well but can't provide more information at this time. Also, he said while OPTrust Select will make the Plan younger, the drop in the discount rate is by far the most important thing to ensure the Plan's long-term sustainability (all you mature plans, if you really want to make your plans younger and more sustainable over the long run, adopt conditional inflation protection just like OTPP, HOOPP and CAAT).

Anyway, let me shift my attention to investments. Take the time to read this section carefully starting on page 22 of the 2018 Funded Status Report.

Some of the main points I noted:
  • Liquid asset internalization: we now manage over $10 billion of gross liquid assets internally — this has reduced costs, made us more agile, and allowed us to pursue more customized strategies. 
  • Illiquid asset rebalancing: we took advantage of favourable market conditions to realize gains on some illiquid assets, while taking a disciplined approach to new capital deployments.
Now, have a look at OPTrust's asset mix (click on image):

As you can see, 29% is in Alternative Public Market Strategies which didn't perform well last year, down over 5%:
Asset returns are composed of a risk-free rate, risk premia, and alpha components. We invest in customized, alternative public market strategies to access a broader and more diversified set of risk premia and alpha streams. These strategies are less correlated with traditional market returns and make our total fund portfolio more resilient to different economic and market environments. Alternative public market strategies generated a net return of -5.4% in 2018. Within this portfolio, alternative risk premia and multi-asset strategies struggled, consistent with weak returns delivered by market risk premia in 2018. Lower returns in these strategies were offset by positive returns from our pure alpha and insurance-linked securities strategies.
In English? The internal and mostly external absolute return strategies (ie. hedge funds) struggled last year and didn't deliver the alpha OPTrust was looking for.

Go back to read my comment from earlier this year, 2018's Hedge Fund Winners and Losers, you'll understand why it was a tough year for many hedge funds. Ray Dalio's Pure Alpha hedge fund returned 14.6% net of fees in 2018. But Dalio’s important All Weather Fund, in which he is heavily invested, was down by about 6%.

Still, Dalio earned an estimated $1 billion in 2018, all part of an elite club of the highest-earning hedge fund managers.

As far as multi-strategy funds, most struggled but Ken Griffin's Citadel and Izzy Englander's Millennium delivered great risk-adjusted results last year (there were a few others).

So if hedge funds didn't deliver the requisite alpha, where did most of the alpha come from? Where else? Private markets which make up roughly 36% of the asset mix. Here are some highlights that caught my eye:
  • Real Estate: Real estate markets were characterized by strong fundamentals and ample access to capital in 2018, but the cycle is maturing and expected returns have moderated. Against this backdrop, we focused on building portfolio resilience through market cycles. We committed to 10 new investments totalling $435 million in 2018, nine in North America and one in Scandinavia. These investments were sourced through existing partners, reflecting our ability to access compelling opportunities through our network of trusted partner relationships. New commitments were partially offset by $258 million of selective realizations. The real estate portfolio generated a net return of 7.6% in 2018.
  • Infrastructure: Asset valuations have remained elevated in a record year for fundraising within the infrastructure asset class. While this environment created good selling opportunities in the portfolio in 2017, the heightened competition from increasing capital inflows has meant there was better value in 2018 in smaller scale opportunities and establishing platforms to pursue them. We executed on six new transactions totaling $569 million, reflecting the value of our flexible and partner-driven approach in a challenging market. The infrastructure portfolio was able to generate a net return of 9.9% in 2018.
  • Private Equity: Our private equity strategy, which includes private credit, long term equities and buyout investments, allows us to identify a broad range of investment opportunities and execute upon those which offer the most attractive risk-adjusted returns. In 2018, we committed to 10 new investments totalling $434 million and funding ongoing growth and expansion initiatives in various portfolio companies. As in 2017, we were able to capitalize on the strong market conditions by selling our equity ownership stakes in certain portfolio companies that had achieved their value-creation plans while retaining minority positions, where practicable, to continue to participate in future growth potential. The private equity portfolio generated a net return of 15.7% for the year.
What else caught my eye? The contribution from passive currency exposure was 1% for the total fund:
  • Currency overlay and other: The remainder of the total fund return is comprised of our foreign currency exposures, overlay portfolio activity, credit, gold, cash and money market, and other capital markets activities. Among these exposures, currency and overlay portfolio activities made the largest contributions to total fund returns at 0.9% and -0.7% respectively. We hedge most of our foreign currency exposures, as fluctuations in exchange rates can significantly impact the volatility of a global investment portfolio. However, we do maintain some exposure to currencies that can act as a safe haven in times of stress and a small amount of emerging market currencies. The positive return contribution from currency in 2018 reflected a weakening of the Canadian dollar against the foreign currencies we hold. Negative return contributions from the overlay portfolio mostly reflected currency hedges to bring down our total fund foreign currency exposures and positions undertaken to diversify our total fund risk-mitigation strategy. Other items in this category made only marginal contributions to total fund returns.
Now, OPTrust partially hedges currency risk but stated another way, if the currency swung the other way, OPTrust's entire gain for 2018 (1%) would have been wiped out. It's also worth noting that active currency overlay detracted from the fund's performance (-0.7%) which proves my point, it's very hard to make money in active currency overlay.

It also proves that IMCO's Jean Michel is on the right track with his view that he needs to build a strong currency department (please read my last comment going over CFA Toronto's annual spring pension conference for details).

What else did I notice from the discussion on investments in OPTrust's 2018 Funded Status Report? There is no discussion on benchmarks used to benchmark public and private markets and added value over benchmarks.

To be fair, I didn't get a chance to talk to OPTrust's CIO James Davis today about this report and didn't raise this issue with Dani, but I have a feeling it's because they want the focus to be on the Plan's funded status, not its investment gains relative to benchmarks (all part of changing the conversation to focus on what matters most).

Still, benchmarks are used to evaluate long-term and short-term performance, and it's long-term performance which determines compensation (click on image):

Obviously, OPTrust is delivering the added value over the long run but I would have liked to have seen more transparency on benchmarks for each asset class and the added value over the benchmark results.

Nevertheless, there is a full discussion on governance and accountability starting on page 34 of the Report which is worth reading in detail.

Again, take the time to read  OPTrust's 2018 Funded Status Report, it is excellent and offers a lot more information on all investment and non-investment activities that took place last year, including a great discussion on Responsible Investing.

Lastly, let me address another issue. Hugh O’Reilly recently resigned as President and CEO of OPTrust.

I heard a few things about this while I was in Toronto last week. One person who isn't related to the organization told me: "OPTrust has had a hard time keeping its CEOs around, Hugh was actually there the longest. Before him, Bill Hatanaka lasted less than one year, and before him, Stephen Griggs, left in 2012 after about a year on the job and he sued the organization."

I don't know what exactly is going on but all I can say is there's no doubt in my mind OPTrust lost a great CEO and that Hugh O'Reilly did wonders while at OPTrust raising the organization's profile. In fact, Dani Goraichy told me flat out: "that's an understatement."

So let me end this comment with a tribute to Hugh O’Reilly. Since there are no video clips available going over 2018's Funded Status Report, I  decided to embed an older one where Hugh explained why they are changing the conversation. Good luck, Hugh, hope you're well.