Will Leverage Save the Canada Model?

Gareth Gore of Thompson Reuter's International Financial Review reports that pension giants are adding leverage as 30-year-old Canadian model flounders:
In the late 1980s, the Ontario government set up a task force to tackle what it saw as a ticking financial time bomb. After decades of under-funding, it was worried that the pensions of teachers and other public servants might one day place an insurmountable burden on state finances. The pay-as-you-go model, with workers contributing just 1% of their salaries and the state filling any shortfalls, was seen as unsustainable.

The task force recommended a complete overhaul of the system, proposing that public-sector pensions be spun off and managed independently by teams of professional investors. Though controversial, in 1990 the state launched the first such fund – the Ontario Teachers’ Pension Plan – that rapidly became a template for other public-sector pension schemes not just in Ontario but across the whole of Canada.

The Canada model, as it is known, is widely seen as a huge success. Shrewd investment decisions haven’t just eliminated gaping deficits, but have also transformed the funds into powerful investors and major shareholders in companies such as Lyft, Tencent, Facebook and Nestle. The top 10 funds have quadrupled assets in just 15 years, and today manage more than C$1.5trn (US$1.1trn) for 25 million members.


But, after almost three decades of success, the Canadian model is showing signs of strain. Over the next few years, several funds are expected to fall back into deficit, with contributions insufficient to cover the growing number of pensioners who are on average living longer. The shift has prompted several funds to add a controversial new element to the tried-and-tested Canadian model: leverage.

Canada Pension Plan, by far the largest of the funds with more than 20 million members, is leading the charge. Since its first tentative step into the bond market with a C$1bn private placement in mid-2015, CPPIB – the fund’s investment arm – has become a regular issuer. Its pace of issuance has steadily picked up over the past few years, with the fund now having more than C$26bn of outstanding bonds. On Friday, it mandated banks for another deal - a 30-year in euros.

It’s a trend that is mirrored across the sector. OMERS, which manages the pensions of half a million public servants, librarians, police officers and fire fighters in Ontario, and OTPP have both set up bond issuance programmes, while three other funds have stepped up issuance. As a result, outstanding bonds issued by Canadian pension funds have more than trebled over the past three years to almost C$60bn.

“This is unique,” said Jason Mercer, who monitors the sector for ratings agency Moody’s, adding that it was rare to see pension funds taking on leverage. “The Canadians are really pioneers in this and the only ones doing it. A lot of the funds have already increased their investment horizon to look for other sources of outperformance, and leverage is the next step to magnify returns.”


Projections show why there is a pressure to lever up. Next year will be CPP’s last in surplus, with the number of people claiming pensions set to rise by two million over the next few years even as the number of contributors stays relatively flat. By 2030, its deficit is expected to be C$9bn a year. As a result, it will become increasingly reliant on returns from its investment pot to fill the gap.

The shift could hardly come at a worse time. After a decade of low rates, returns on many assets have fallen to record lows, making the industry annual target of generating 4% over inflation increasingly difficult, despite the move that many have made into alternative assets such as private equity, property and emerging markets.

“There’s no question about it, market conditions are challenging for long-term investors,” said Jonathan Simmons, CFO at OMERS, which issued its first bond – an upsized US$1.25bn five-year bond with a coupon of 2.5% – in April. “The Canadians have been active debt issuers for several years. Plans taking on prudent leverage is accepted in this market, and that’s what OMERS decided to do.”

It’s an optimisation strategy: we have an asset mix that is approved by our board … about half in alternative assets and half in traditional assets such as equities and bonds. We’ve been building that asset base now for more than 20 years. As we have reached our targets, we have the asset mix we want, and so the question is how we optimise. And adding a little bit of leverage is the next phase in that.”


Leverage isn’t restricted to bond issuance. Almost all the big pension funds have sizeable commercial paper programmes, with many also borrowing tens of billions of dollars via the repo markets. The Bank of Canada has in the past voiced concern about the rise in leverage – particularly given the big shift in the funds’ asset allocation to alternative, less-liquid assets, which on average make up about 40% of their portfolios.

“The trends toward more illiquid assets, combined with the greater use of short-term leverage through repo and derivatives markets may, if not properly managed, lead to a future vulnerability that could be tested during periods of financial market stress,” the central bank said in a 2016 report. It declined to comment on the rise in bond issuance when contacted by IFR.

According to Mercer, the shift towards bonds is positive in that it removes regular short-term refinancing risks that come with CP and repo financing. “Terming out the debt is a good thing,” he said. At the same time, many funds have been reducing their less-liquid Level 2 assets and investing in more liquid securities to better balance out their portfolios, which are heavily skewed towards the least-liquid Level 3 assets.

There are some concerns, however, that the rise in leverage could leave some funds exposed during the next market turndown. In 2008, many funds – then unleveraged – posted double-digit falls. At the same time, in some cases leverage will be used to dial up already leveraged investment strategies. Many funds are big equity investors in the leveraged buyout space.

Simmons believes that OMERS’ strategy remains prudent. It has a hard leverage limit of 10% of assets, which – compared to many other industries – is extremely low. It plans to use that space. “We’ll be moving towards it over the next few years as we continue to be active as issuers,” he said. “We think that 10% is very conservative, and so we want to use that limit – prudently – to improve our plan’s returns and asset mix.”
I've already discussed why Canada's pensions are piling on the leverage here and followed up with another comment on Canada's highly leveraged pensions here.

In February 2018, I looked into Canadian pensions cranking up the leverage and noted the following:
[...] it's definitely true that Canada's large pensions leverage up their portfolio and some do it  a lot more than others. It's not just about issuing debt, some pensions (like HOOPP and OTPP) use extensive bond repos to leverage up their fixed income portfolio or swapping into fixed income indexes to invest in hedge funds (portable alpha strategy).

But whatever the case, it's critically important to understand two things:

  1. Canada's large pensions have the governance to hire very talented individuals who understand derivatives and how to engage in very sophisticated trades that may seem risky to an outsider but in reality is an efficient and conservative use of capital
  2. Canada's large pensions have a successful long-term track record, they're fully-funded which allows them to get a AAA credit rating from the rating agencies to go out and issue debt to invest across public and private markets all over the world. Again, this is an efficient use of capital, much like a corporation that issues debt to invest in new plant equipment. 
I think it's critically important to keep these two points in mind when it comes to Canada's pensions leveraging up their portfolio. They're doing so because a) they have the balance sheet and long-term track record to do so and b) they know what they're doing and investing wisely and c) their interests are perfectly aligned with those of their members.

It's also worth noting that when structured carefully and intelligently, increasing leverage can reduce the overall risk of the portfolio (think about risk parity strategy done internally).

The only criticism I have when it comes to using leverage is that Canada's pension overlords get compensated extremely well which is fine given their long-term success and expertise, but at one point leverage has to be factored into the equation when it comes to benchmarks and compensation.
Some might rightly argue the intelligent use of leverage merits higher compensation and I would agree with them, but there still should be some recognition that leverage has helped juice returns and maybe Canada's large pensions should start reporting unlevered vs levered returns (after all, it's part of active management).

In April 2018, I looked into how leverage is the key to meeting Canada's pension promise. Again, I explained a lot of misconceptions regarding the use of leverage and what risks it exposes a pension plan to. I also went over a CAPSA communiqué reviewing the use leverage at pension plans.

Leverage is one of the topics that most people just don't get, especially when it comes to Canada's large pensions. With interest rates at historic lows, in my opinion, it would be highly irresponsible if Canada's large pensions weren't issuing some debt to take advantage of investment opportunities in public and private markets all over the world.

Remember, we are talking about giant pension funds with a very long investment horizon running very sophisticated operations.

Now, the article above is very sloppy and is full of misinformation. The Canada Model isn't "floundering" nor is leverage the key to extending its success.

The cornerstone of The Canada Model is great governance which separates the management of large public pensions from governments. This allows these large pensions to attract and retain very talented people who can add value across public and private markets all over the world.

Admittedly, the bulk of the value add over the long run has come from private markets -- private equity, real estate, and infrastructure -- and that makes sense since by their very nature private markets are less efficient than public markets so there are more inefficiencies to exploit.

Leverage is just another tool to help Canadian pension funds reduce overall risk and take advantage of dislocations in markets. Used wisely, it can greatly enhance risk-adjusted returns.

The article above states over the next few years several plans will run into deficit, including the Canada Pension Plan.

Total nonsense! CPPIB's five-year real rate of return, which adjusts for inflation, was 8.9% as of March 31 while the 10-year real rate of return was 9.2%. Those returns are well ahead of what the Chief Actuary of Canada has determined to be necessary to sustain the Canada Pension Plan to at least 2090.

Other pension plans like HOOPP, OTPP, OMERS, OPTrust, are fully funded and some have huge surpluses. Even if they experience a rough patch and get into a deficit, it's not leverage that will save them but rather their shared risk model which incorporates conditional inflation protection (at least for HOOPP and OTPP which have conditional inflation protection).

What else irks me about the article above? He states CPPIB's pace of issuance has steadily picked up over the past few years, with the fund now having more than C$26bn of outstanding bonds.

So what? It manages over $400 billion in assets, so that $26 billion represents less than 10% of the total Fund (he
puts up a chart of debt issuance by year instead of debt issuance as a percentage of total assets every year). CPPIB should be issuing bonds at these historic low rates to invest in green projects and other private markets all over the world where it can earn a lot higher returns over the long run.

I have spoken with CPPIB's CEO Mark Machin on the use of leverage and he told me "it's modest" and "under no circumstance would it jeopardize CPPIB's AAA rating."

Also, I recently discussed why CalPERS is considering to leverage up its portfolio. CalPERS's CIO Ben Meng is smart enough to realize he doesn't want to get caught in another 2008 scenario where they are forced to sell equities at the bottom to make their capital calls to private equity and real estate funds.

I also mentioned Wisconsin's big public pension cheese basically adopted Bridgewater's all-weather approach which is one of the reasons why it's one of the few fully funded US public pension plans (the main reason is it adopted a shared risk model).

Lastly, many consultants in Europe are telling their pension clients to embrace leverage and complexity but many plans there lack the governance model of Canadian plans to do so.

Below, Mark Machin, CEO of Canada Pension Plan Investment Board, says the fund is a "substantial" investor in China's Alibaba. It is also watching the trend of the rising middle class in India and China, he says (April 2019).

Update: Jim Leech, OTPP's former CEO and co-author of The Third Rail, shared this with me after reading this comment:
Reuters writer is mixing up “in deficit” (a measure of a fund’s sustainability where liabilities exceed assets) and “mature” (where benefits paid exceed contributions received).

There is a big difference.

None of the Canadian plans are forecast to be in deficit - but they are maturing (Teachers’ for example has been “mature” for close to 15 years - but it is not in deficit)

Granted, as a plan matures, investment risk must be reduced as recovery from a large loss is more difficult. Prudent leverage (eg issuing bonds priced off the fund’s credit rating as opposed to mortgages priced off individual real estate projects; leveraging real rate bond portfolios, etc) and reducing equity exposure are two ways to reducing risk that the “Canadians” have employed.
I thank Jim for sharing his wise insights with my readers on this important and misunderstood topic.