HOOPP's CEO on Pension Delivery and More
Twenty years ago, Jim Keohane was brought into the Healthcare of Ontario Pension Plan to launch its derivatives program. Since then, he’s climbed his way to the role of president and chief investment officer, grown his reputation as a trailblazer in liability-driven investing and navigated the pension fund through the financial crisis with positive returns.Earlier today, I had a chance to speak with HOOPP's CEO Jim Keohane for a little over an hour. I want to thank him for taking the time to speak with me as this was another excellent conversation, one of many we have had over the last ten years.
“Prior to me being here, HOOPP had never done a derivative transaction so I was brought in for that reason,” he says. And now, the HOOPP is known around the world for its LDI strategy, which has derivatives at its core.
The LDI strategy began as a result of the technology meltdown of 2000- 2002, when the HOOPP quickly moved from surplus to deficit, says Keohane. “Effectively, our assets and liabilities moved in a different direction, so the liabilities went up and the assets went down, which is kind of the perfect storm, if you will, and we tried to think about ways that we could reduce that mismatch.”
The HOOPP’s previous derivatives transactions had allowed it to separate alpha and beta, using the arrangements to break a portfolio down to its component return streams, he says. “If you wanted to break down a portfolio into its component returns streams, you could think of it along the lines of the capital asset pricing model: risk-free, plus beta, plus alpha. Risk-free for us is long-term bonds, essentially. Beta is your exposure to risky asset classes, so you can get that through derivatives. So rather than actually physically being invested in equities, you can actually get that using equity index futures or options or swaps. And then alpha is any active management strategy.”
Typically, alpha is security selection, notes Keohane. However, a plan can use any absolute return strategy to substitute stock selection. This allowed the HOOPP to build its portfolio based on the building blocks as opposed to asset classes.
Most of the pension fund’s physical assets are in a liability-matching portfolio, with interest-rate sensitive and inflation-sensitive assets, such as real-return bonds, long-term bonds and real estate.
Then, as part of its return-seeking, the HOOPP layers on equity and credit exposure using derivatives, as well as internally executed absolute return strategies. The strategy also includes private equity.
The LDI approach allowed the plan to beat the financial crisis and produce a positive return for 2008 and 2009 combined, highlights Keohane.
Also, after looking at risk and stress testing, the HOOPP made a shift in 2007, moving 30 per cent of its money out of equities into long-term bonds and real return bonds. “We actually didn’t get very badly hurt because of that,” says Keohane. “And that actually benefited us quite a bit because being in a defensive position enabled us to buy long-term assets in 2008 at very attractive prices that benefited the fund for several years after that.”
A key differentiator to the plan’s approach is thinking about itself more as a pension delivery organization than an asset management organization, he notes. “And that sounds subtle, but it’s actually pretty profound because it refocuses you in terms of what you should be doing. It’s not just about beating markets, it’s about delivering on the pension promise.”
Keohane is set to retire from the HOOPP in March 2020.
We began by talking about the article above, focusing on HOOPP as a pension delivery organization. According to Jim, because HOOPP is a pension plan managing assets and liabilities, it has a more holistic view of what is at stake and its focus is entirely on matching assets liabilities.
It's an important distinction, HOOPP, OTPP, OMERS, OPTrust and CAAT Pension are pension plans that manage assets and liabilities whereas AIMCo, BCI, CPPIB, IMCO, the Caisse and PSP Investments are pension funds that are responsible for managing the assets of their members.
Jim was careful not to criticize these pension funds. "They are great organizations but their focus is entirely on managing assets whereas ours is on how to best match assets with liabilities. Their members take care of liabilities and pick an asset mix, we focus solely on matching assets with liabilities, we have a total view of the plan, it's not split in half. This helps focus out attention on the entire plan and this is why we call it a pension delivery organization."
We then moved into a discussion on HOOPP's total portfolio. I noted that Yaelle put up a chart in her article which showed HOOPP's allocation to Private Equity was only 5%. It seemed low to me so I asked Jim if the chart above is correct.
He said "no" because it doesn't reflect that HOOPP runs an expanded balance sheet, meaning it leverages its entire portfolio. "If you account for leverage, our allocation to Private Equity is anywhere between 10% to 15%. In terms of equity, it might be 5% but in the context of total balance sheet, it's much higher."
To be fair to Yaelle Gang who I have met and writes great comments for the Canadian Investment Review, she probably wasn't aware of HOOPP's expanded balance sheet based on the sophisticated use of leverage and what it means in terms of its actual exposure to various asset classes.
I pressed Jim hard on HOOPP's use of leverage, asking him what is the maximum and what it's based on. He told me that leverage limits are "based on risk" and it has gone "as high as 2 to 1", most notably in 2007 when HOOPP shifted out of equities into long-term bonds and real return bonds.
He told me that HOOPP's expanded balance sheet currently stands at $150 billion based on assets of $92 billion, so it's pretty levered.
Jim told me a lot of the leverage HOOPP takes is based on its extensive fixed income portfolio, engaging in bond repos, and "it is seasonal" meaning there are periods where they take assets from banks and use bonds as collateral.
You'll notice in the asset mix pie chart above, 55% is in government bonds, but Jim told me on an expanded balance sheet basis, "it's closer to 70%".
Our conversation then moved into government bonds and what he thinks of the prevalence of negative-yielding sovereign bonds in Europe why some of the world's best pensions in The Netherlands and Denmark are starting to worry.
Jim reiterated something he told me a long time ago, namely, "HOOPP will never buy negative-yielding bonds, they are guaranteed to lose you money if you hold them to maturity."
I asked him why so many of these European pensions that also practice LDI keep buying negative-yielding bonds and he said he's not sure if these bonds were bought a while ago when they were yielding positive yields and are now yielding negative yields.
I told him you can still buy negative-yielding bonds and make a lot of of money on capital appreciation but he said that is a "greater fool's game" and it doesn't make sense from a liability-hedging perspective to buy negative-yielding bonds. "Once bonds yield zero percent, there is no reason to hold them, there is no interest rate protection, you can't discount negative rates for liabilities once you pass zero, that's it."
So, that brought on my next few questions. I asked him what will HOOPP do if negative interest rates hit Canada and the US? Jim told me for one, they will shorten duration considerably as the front end of the curve will presumably still yield positive.
But apart from that, they will continue looking at interesting projects in Real Estate and even Infrastructure where HOOPP is lagging its larger peers and is still grappling on how to best approach this asset class given most of the prized assets are "selling at nosebleed valuations" if they are for sale.
My sources also told me that HOOPP is looking at hedge funds so I asked him about that. Jim told me that they are invested in one or two hedge funds looking at transitioning risks or getting into scale in some strategy but that this represents "a very small part of the total portfolio."
He said negative rates “are forcing pensions out on the risk curve” and that could be problematic for underfunded pensions. I agreed and brought up a recent study by the Boston Fed on this topic and stated every asset class is overvalued now, including private equity where secondaries are no longer selling at a discount.
I also told him that central banks are forcing investors out on the risk curve and mentioned this chart that Mohamed El-Erian posted on LinkedIn:
On LinkedIn, I wryly quipped:"Wake me up when the Fed's balance sheet surpasses all other central banks combined, then the fun begins."
I asked Jim whether or not we are in a "bubble in bonds" and what that means for investors. I told him I read a couple of comments recently, one from Louis-Vincent Gave, CEO and co-founder of Gavekal Research, on why the bond market is the biggest bubble of our lifetime, and another from BCA Research's Chief Global Investment Strategist, Peter Berezin, saying"owning bonds will be quite painful".
To my surprise, Jim agreed, stating the bond market right now is "already pricing in deflation" and if something changes, many investors will be caught off guard. He said "inflation expectations are way off the mark" and he thinks breakevens on real return bonds (RRBs) are quite good right now and it's a good time to buy.
He talked about how Ray Dalio wrote a paper on paradigm shifts going on every ten years and he thinks Trump's tariffs are already inflationary and if labor unions start gaining more power, real wages will rise and you can easily see a spike in inflation (and rates).
I was a bit perplexed because I'm a deflationista and believe there are serious structural factors weighing inflation expectations down. You can read Lacy Hunt and Van Hoisington's latest Quarterly Economic Review and Outlook here to see why long bond yields are likely headed lower.
But I also stated back in August that bond market jitters are overdone and absent real deflation, it was hard to justify rates on the 10-year US Treasury note near 1%.
Anyway, Jim is right, if rates do start creeping up because US inflation starts creeping up, a lot of investors dead set on deflation will get burned badly.
He said HOOPP is very cautious right now, focusing on liquidity risk because "they want to be buyers, not sellers, in a market downturn".
We then moved our discussion to pension policy. HOOPP recently warned of Canadian retirement anxiety and Jim said it's becoming challenging for anyone worried about retirement as longevity risks rise, rates hit ultra low levels and markets become more volatile.
"Even small pension plans are finding it hard to cope in this environment which is why we want to see more HOOPP-like structures to expand coverage to more Canadians looking to retire in dignity and security."
Interestingly, I asked Jim why HOOPP isn't following CAAT Pension and OPTrust to provide a defined-benefit solution for more Canadians looking to retire in dignity and security and he told me that HOOPP is a private trust and it would not benefit its members to do these sort of initiatives.
Still, with over 550 member organizations, only 400 of which are hospitals, HOOPP already does a lot covering the retirement needs of those working in Ontario's healthcare sector.
Jim also enlightened me that some doctors in Ontario are members of HOOPP by virtue of working in a member organization but most aren't because they have set up personal corporations to get tax advantages. "This way they can take their family to Florida and claim some expenses if they give a talk but if they knew all the advantages of being with HOOPP, they would opt for that."
I told him the Ontario Medical Association has just announced the creation of the Advantages Retirement Plan™, a first-of-its-kind group income plan specifically designed to help medical professionals begin reserving their retirement at any stage of their career. If they were smart, they would have approached HOOPP to handle the retirement needs of Ontario's physicians.
We had a lengthy discussion on the benefits of defined benefit plans. I mentioned a recent post of mine on the failure of the corporate DB plan model and he told me there are clear synergies from pooling investment and longevity risks.
He said the problem us the lifespan of a pension plan is longer than the lifespan of a corporation, meaning liabilities go way beyond the lifespan of a company which can go bankrupt and gave me the example of Sears Canada whose pensioners reached a settlement late last year after they were denied priority over the company’s other creditors.
In terms of the Mercer report on global pension systems which I covered yesterday, he said Canada lags behind others because we don't have the coverage other countries have (ie. we don't cover enough citizens properly when it comes to pensions, even with enhanced CPP).
He spoke about Australia saying he will meet representatives tomorrow from Australia superannuation funds and told me they do a great job covering all their citizens with pensions that are portable from one employer to another.
I replied: "Yeah but they aren't defined-benefit plans, they're defined-contribution plans". Jim agreed but he said in Australia, they recognize this weakness and are moving toward target benefit plans and are interested in a HOOPP-like structure.
Perhaps the most important message Jim Keohane wants to get out is the value of a good pension. Take the time to read this report by downloading it here.
Below, you can read the Executive Summary:
Retirement is one of life’s biggest expenses. Yet while there has been vigorous debate about whether Canadians are saving enough for retirement, there has been much less discussion of how they are saving. Given stagnating income and strained household budgets, now is an important time to examine how best to achieve value for money in retirement savings. This study compares the efficiency of a variety of approaches to retirement, from a typical individual approach to a large-scale “Canada model” pension plan, as well as a variety of models in between.Again, take the time to read the full report here, it is excellent.
The value for money in a retirement arrangement can be measured by the efficiency with which today’s savings generates tomorrow’s retirement income. In other words, how much does a person need to save, over a lifetime, to meet their retirement goals? This is influenced by saving behaviour, investment returns, and the ability to manage the post-retirement or “decumulation” phase in an efficient manner.
A review of evidence from both academic and industry literature reveals that good pensions create value for money for Canadians through five key value drivers:
The lifetime financial effect of combining these five value drivers can be dramatic. By participating in a top-performing pension plan—a plan with Canada-model characteristics, including independent fiduciary governance as well as scale, internal investment management, and risk pooling—a representative worker could achieve the same level of retirement security for a lifetime cost of nearly four times less than if they took a typical individual approach. This amounts to a lifetime savings of roughly $890,000.
- Saving
- Fees and costs
- Investment discipline
- Fiduciary governance
- Risk pooling
The largest savings comes from risk pooling ($397,000), fees and costs ($275,000), and investment discipline ($116,000). From a retirement “bang for buck” perspective, for each dollar contributed, the retirement income from a Canada-model pension is $5.32 versus $1.70 from a typical individual approach.
Although these numbers may seem high, they are arguably calculated on a conservative basis and are directionally consistent with findings from a recent study of the Australian superannuation system.
This efficiency advantage does not depend on where the contribution comes from, whether from the individual, their employer, or the government.
Pensions are often identified with cost. This research shows that a better way to characterize pensions, especially if they are well governed and managed, is as efficient vehicles to pay for something expensive: retirement. In an era of government fiscal restraint and tight household budgets, it is especially critical that policymakers continue to support existing high-quality pension plans, of which Canada has some of the best regarded and most efficient in the world.
To take the opposite tack and move towards more individualized approaches to retirement would be to compromise value for money and efficiency. This would ultimately cost Canadians as savers, retirees, and taxpayers, and it would undermine a critical social and economic asset.
Policymakers should also encourage existing workplace retirement plan providers to adopt more of the characteristics of a good pension for their plans, including mandatory or automatic saving, lower costs, fiduciary governance, and risk pooling, especially during the post-retirement phase.
Unfortunately, outside the public sector, the past several decades have seen a trend away from pensions, resulting in a quiet but steady shift from collective to individualized approaches to retirement. Defined benefit pensions now cover only 10% of private sector workers—about a third of the coverage of the late 1970s—and overall workplace pension plan coverage has also declined. There is a growing number of uncovered workers who are disproportionately likely to be financially vulnerable Canadians, including lower-income people, women outside the public sector, young people, and new Canadians.
Economic and labour market trends, including automation, the rise of “nonstandard” work, and decreasing company longevity, suggest that, barring some intervention, this shift from collective to individualized retirement saving is likely to continue, if not accelerate. This will make retirement less efficient and thereby costlier for individuals, employers, and government.
In addition to continued support for good pensions, expanding access to pensions and other more collective retirement arrangements is a worthy goal for policymakers and other stakeholders that are concerned with the financial security of Canadians and their ability to make ends meet efficiently. Policymakers and other retirement system stakeholders, including employers, unions, associations, and private providers, could help more Canadians access a pension or other collective retirement plan by extending the reach of existing plans or by creating new plans to serve uncovered workers,
including the growing portion of the workforce that is considered nonstandard.
A key focus of such efforts should be on the five value drivers identified in this report: saving, fees and costs, investment discipline, fiduciary governance, and risk pooling. Pursuing quality coverage expansion will be challenging, but unlike in other developed countries, Canada is in a strong position: we already have examples of well-regarded efficient pensions in the public sector, institutions whose principles and key features can be applied to build or improve collective retirement arrangements for other parts of the economy.
Jim told me that overall society will be better off with more large, well-governed defined-benefit plans as the "system will be more efficient and the outcomes will be better.”
I couldn't agree more, large, well governed defined benefit plans are the best and most efficient way to deliver the pension promise, they lead to better outcomes and are far less costly than relying on the social welfare system to meet the retirement needs of your working population.
He said that placing the retirement onus entirely on individuals to save and make the right investment decisions is a recipe for disaster because individuals tend to make the "wrong decisions at the wrong time" and even people who are savvy investors can "fall ill with dementia" which will incapacitate them to manage their portfolio properly.
I told him that Biogen just announced it is filing for FDA approval of its failed Alzheimer’s disease drug aducanumab after factoring in data generated after the cutoff for the interim assessment. I said if successful -- and that is a big "if" -- this will be a game changer and lower the cost of long-term cares, increase lifespans and improve the quality of life for many elderly patients and their families.
Jim rightly noted that it will extend longevity risk and the cost of retirement for individuals, thus making his case for more HOOPP-like DB pensions.
I want to once again thank Jim Keohane for taking the time to talk to me earlier today. I love talking to HOOPP's smartest guy in the room and told him I hope he didn't take my comment on HOOPP exploiting the danish tax system to heart.
Jim said "no" and he told me he isn't able to talk now but once the case is settled, he will present the facts "and you'll be more sympathetic with HOOPP's point on the matter."
Below, a Canadian Club clip from November 2017 featuring Jim Keohane, Hugh O’Reilly, Kim Thomassin and Kevin Uebelein moderated by Terrie O'Leary. Listen carefully to all of them, especially to Jim (minute 25) discussing HOOPP's pension delivery management. Great discussion.
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