Category: Pension Newsroom

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Last week, John Mauldin published an important comment, Angst in America, Part 3: Retiring Broke:

Today we continue looking at angst in America, the financial worries that so afflict us here in the world’s largest economy and by extension in much of the developed world. We may be the envy of the world in some ways, but we also have no shortage of stress. Today we’ll look at some data on retirement savings – or lack thereof.

Let’s start by backing up a little bit. I’m not the only one talking about financial anxiety. Last week I ran across a survey from NerdWallet on this very issue. They engaged the Harris Poll to ask 2,000 Americans of all ages about their biggest financial concerns. Here’s a chart showing the top worries (click on image).

The biggest worries are healthcare expenses, lack of emergency savings, and lack of retirement savings. Yet only 28% worry they lack retirement savings? Compare this with what we know about people’s actual savings, and that number is far too low.

We can see in another recent survey by GOBankingRates.com that more people should be worried about their retirement (click on image).

Here we see that 33% of Americans have no retirement savings at all; another 23% have less than $10,000; and a further 10% have less than $50,000. So that’s 66%, a full two-thirds of Americans, with either no savings at all or not enough to generate significant income. (If you have $50,000 and can pull out 4% a year without drawing down principal – which is hard to do – you’ll get something like $160 a month.)

The NerdWallet survey also shows that 13% have accumulated $300,000 or more in retirement savings. I am skeptical of that number, too, unless it includes the cash value of defined-benefit plans held by government employees. And for them that value is mostly an illusion; for many of them, their plans can’t possibly deliver anything near what the workers were promised. But that’s another subject.

How much do we Americans really have saved? A Motley Fool article last year, citing data from the Employee Benefit Research Institute, looked at actual Individual Retirement Account balances. As of year-end 2013, 20.6 million individuals held a total $2.46 trillion in IRA accounts. Some of those unique individuals are each other’s spouses, so the number of family units would be lower.

Do the math and we find that the average IRA holder’s balance was around $120,000 as of three years ago. But remember, the average IRA holder is not the average American. If only 20.6 million of us have IRAs, then over 300 million of us don’t have them. Some no doubt have other retirement vehicles, like 401(k)s. But this still suggests that a large plurality of Americans, and maybe a majority, have little or nothing saved for retirement. This shortfall is a problem, and not just for them.

Social Insecurity

It’s easy for those of us in the Protected Class to think the masses will be fine. They at least get Social Security and Medicare, enough to keep them out of poverty, right?

No, not right. We know this straight from the horse’s mouth, too. The Social Security Administration publishes a very handy annual “Fact Sheet.” As is the case with most bureaucracies, the SSA’s goal is partly to demonstrate how indispensable they are, but in the process they tell us a few things that should make us uncomfortable.

In 2017, the average monthly retiree benefit is $1,360. Multiply that by 12 months and divide by 52 40-hour weeks, and living off Social Security is equivalent to being a full-time worker who earns $7.85 an hour (and remember, this is the average; many people receive less). Social Security benefits are worth a little more than the same amount in wages, net of taxes, but they still aren’t much. Guesstimating the tax differential suggests an equivalent hourly wage of about $8.50 an hour.

Social Security’s fact sheet also says benefits represent about 34% of the elderly population’s income – but that number is heavily skewed in favor of the wealthy. Among retirees, 21% of married couples and 43% of unmarried persons rely on Social Security for 90% or more of their income.

Currently, 41.2 million retired workers and 3 million dependents receive Social Security benefits. So that means 15 million or more retirees must be living on an income that’s meager by any definition.

But at least they don’t have to worry about medical bills, you say; Medicare covers them all. Well, yes, it does cover them, but that’s not the same as covering their expenses. Copays and deductibles add up quickly unless you have supplemental insurance, which itself is expensive. Medicare recipients are responsible for 20% of hospital bills, and for these people even a short stay can wipe out months of income.

Forty-one percent of Americans have no savings at all. An article in Forbes cites data that shows that just 37% of Americans have savings to cover an emergency that costs over $500. And understand, that is not just medical emergencies. What happens when your car breaks down? You have to get it fixed because you have to get to work. Having extensive experience with my seven children (and now seven grandchildren!), I can tell you that emergency expenditures seem to be the norm, not the exception (at least in the Mauldin household). Now the kids are adults and trying to make it on their own, but there are still times when The Bank of Dad has to help out in emergencies.

The Social Security fact sheet has some other chilling numbers. It says 51% of the private workforce has no private pension coverage. Those are presumably people who work in small businesses or are self-employed or “gig” workers. Confirming NerdWallet’s figure, Social Security says 31% of workers report they and/or their spouses have no savings set aside specifically for retirement. Depending on the survey, another 10% have less than $10,000. It wouldn’t take very long to run through someone’s entire savings, given a significant hospital stay or illness.

Is Social Security sustainable? To listen to politicians, Social Security obligations will always be met. Then again, looking at the mathematics, at least for those just now approaching retirement age or younger cohorts, the reality may be different. By 2035, the number of Americans 65 and older will climb from about 48 million today to over 79 million. That’s the Baby Boomer impact. Currently there are 2.8 active workers for each Social Security beneficiary. It will be only 2.2 workers per beneficiary by 2035.

And just to throw a little more fuel onto your worry fire, that figure of 2.2 workers per beneficiary assumes that labor force participation rates between now and 2035 will be stable or improved from where we are today. But the chart from Larry Summers last week showed that there are now 10 million men in America between 24 and 54 who are not in the labor force. That number could rise to as high as 20% of the labor force by 2035. Take out another 10% of the labor force, and now there are fewer than 2 workers per Social Security beneficiary. That means each and every worker, from the lowest paid to the highest, must pick up the tab for roughly $7,000 per year of Social Security expenses through their contributions and taxes – before they start to pay for any other government services like healthcare or defense (not to mention interest on the national debt). John Lennon’s song lyric comes to mind: “You say you want a revolution?”

A few more uncomfortable statistics from the SSA:

Only 39% of Boomers have tried to figure out how much they need to have saved for retirement. Of those that have, a third did not include healthcare costs in their calculations. On average, Boomers estimate that healthcare will consume 23% of their income in retirement, compared to the 33% of income that those over 60 actually spend today. Fifty-nine percent of retirees expect Social Security be their major source of income, up from 42% five years ago. Divorce is becoming a major factor in retirement: 24% of divorced Boomers expect to be worse off in retirement than if they had not divorced. Roughly 16% of Americans are taking premature withdrawals from their retirement accounts, while 30% of Boomers have stopped contributing to their accounts.

A 2016 report from the Insured Retirement Institute is likewise sobering:

The real surprise is in Boomers’ expectations for the lifestyles they will lead in retirement. Despite being under-saved and largely lacking sources of lifetime income beyond Social Security, six in 10 Boomers believe their retirement income will cover basic expenses and a limited (38 percent) or extensive (22 percent) budget for leisure activities. Only 11 percent essentially expect a subsistence lifestyle, paying for basic needs and little else, while 19 percent worry they will not have enough money to meet even basic expenses for food, housing, and health care. For these Boomers, a long-term care event would be devastating and almost certainly require state care.  (IRI: “Boomer Expectations for Retirement 2016”)

Simply put, most Baby Boomers will be down to subsistence living by the time they are 80, living on Social Security and other government benefits, with help from any capable children (click on image).

The following graph puts the stark reality of Boomer retirement in perspective. There is a massive gap between what people expect to have during retirement and what they will actually have and be able to spend (click on image).

The surprising thing, at least to me, is that there isn’t more angst in America than what we currently see.

Why We Can’t Save

The basic facts that we just reviewed aren’t complicated, or even much disputed. Up until age 30 or so, it’s easy to think you will be young forever. Then reality sets in, and you know it’s time to grow up. Or at least that’s how it was for me – the line seems to be creeping higher.

Why, then, do so few people save anything for retirement? Can people really be that oblivious? Depressingly to some of us, the answer is yes. We all have many different needs competing for our attention. We have to prioritize, and long-term needs often get lower priority than whatever need is pressing in the here and now.

I recall a very depressing conversation I had with my fishing guide last year in Maine. He had had a job in one of the paper mills, but it had closed down. He had about $150,000 in his 401(k). He was taking out about $10,000 a year (and paying the penalty) just to survive. There were no other jobs in the area, other than what he could make from his work as a guide and from other part-time gigs, jobs all of his friends were competing for. I pointed out to him that by the time he was physically going to need to retire (as the work he was doing was pretty strenuous), if he kept hitting his 401(k), there would be nothing left. It was a very sobering conversation. Basically, he didn’t know what to do. Reality was that the expenses he faced simply to maintain his home and minimal lifestyle forced him to go to his savings.

Paraphrasing Spock, the needs of the present outweigh the needs of the future.

It’s also the case that stifling the temptation to indulge in short-term pleasures is an acquired skill. It doesn’t happen automatically. I think that skill comes mostly from seeing your own parents exercise fiscal discipline while you’re a child. Boomers who grew up in times of relative prosperity may not have felt the need to be frugal and may find it hard to do so.

Still, I think most adults know on some level that retirement won’t take care of itself. They know they should be saving; they know what will happen if they don’t; and yet many still don’t do it – or can’t. That’s why, to varying degrees, surveys show that people are worried about retirement. You don’t worry about something unless you know it is both important and problematic.

Is our national behavior really a surprise? Look at our diet and health indicators. As a nation, we eat too much and indulge in all kinds of unhealthy habits. If we can’t even take care of our bodies, then it figures that we’re not very good at financial planning, either. You’re probably an exception to that rule if you are reading this article, but the data shows that people like you are not the norm.

Having said all this, it is not necessarily true that financially unprepared people don’t want to prepare. As I said above, we all have priorities. Median household income in the US is less than $60,000. That’s not much for a young parent faced with expensive housing, food, medical expenses, childcare, transportation, and all the rest, not to mention taxes. The average family making $60,000 pays about $7000 in taxes to the federal government and more, perhaps a lot more, depending on the state they live in. And it’s not just taxes; there are fees for everything – drivers licenses, car tags, deposits for utilities, and so on. Not to mention the occasional ticket from the police for some infraction. To the extent that people save at all, it will be for their children’s college fund rather than their own retirement.

There’s a stereotype, not entirely imaginary, that some Americans have plenty of money but just choose to spend it frivolously. Such people do exist, and of course they’re responsible for their own decisions. But let’s not forget that we live in a consumerist culture filled with seductive marketers telling us to buy unnecessary things. Often, they succeed. You have every intention of saving some money at the end of the month, but something comes along that grabs your attention, and you absolutely must have it. Oh well, you can save a little more next month.

Note also: The fact that a person has little or no retirement savings now doesn’t mean the person never had any. People lose jobs. Bear markets happen. In both cases, whatever retirement savings you have will either lose value or go toward your here-and-now living expenses. Faced with foreclosure or other hardships, people will swallow hard and pay the tax penalty to get the cash. (See the story of my fishing guide above.)

Speaking at conferences and reading your feedback, I’ve noticed a little subculture emerging in the last decade. It’s composed of people who, ahead of the 2008 crisis, saved their money, invested properly, and generally made all the right moves. I mean intelligent, educated, well-paid people. Then the financial crisis hit, and their retirement savings went up in flames. Having lost half of their assets, many sold to preserve what they could – just in time to miss the recovery.

Did they make a mistake? Yes, obviously. Was it because they were dumb, selfish, or short-sighted? No, it was because they were human. The moves they made might have been right in other circumstances. Yet they ended up back at square one, having lost decades of hard work and financial progress, while the clock kept ticking. On paper, their situations look much like those of people of the same age who never saved anything, but they aren’t the same at all. I try to remember this before I assume things about people.

Hitting the Wall

Whatever the circumstances, millions of Americans are growing older and headed straight toward an unforgiving brick wall. They will reach their mid-sixties and find there is no pot of gold under the retirement rainbow. Social Security plus their own savings, if they have any, won’t be enough to finance the kind of leisurely golden years they saw their parents and grandparents enjoy.

In historical context, this reality shouldn’t surprise any of us. The idea of capping off your life with a decade or two of carefree living didn’t exist before the 20th century, unless you were of royal lineage. Everyone else worked as long as they were physically able and died soon after they weren’t. That’s what was normal for most of human history, and it still is in places we rarely see on TV.

If you aren’t worried about financing your retirement, you’re either very wealthy or very oblivious. You’re not oblivious if you’re one of my readers. So to the wealthy ones, congratulations. To everyone else… join the club. I know it may feel like you’re the only one worried about retiring, since you don’t get to look at your neighbor’s balance sheet, but you’re hardly alone.

Can you do anything about your situation? Maybe. Find ways to save a little money here and there, and it will add up. Having a small nest egg is better than having none at all. At some point, you will be glad you have it.

I’ve written before about the growing number of retirees who keep working right past 65 and even into their 70s. Twenty-five percent of Baby Boomers expect to work to at least 70 and beyond. If you ask them why, the answer is often that they enjoy their work and don’t want to stop. I’m sure that’s true for many. But I’d also bet many keep working out of necessity, no matter what they tell pollsters and friends.

I don’t see anything wrong with this. I will be 68 later this year, and I’m still working as hard as I ever did, maybe more so if you count the total hours. Then again, I’m fortunate to have work that I enjoy and that is not too physically strenuous (except for the travel, which is starting to be more of a challenge). I tend to spend my “leisure time” reading and researching rather than watching TV. Those factors, along with a pretty good diet and exercise program, augmented by some medical anti-aging breakthroughs that I think are coming quite soon, should hopefully enable me to stay productive for many more years. That’s a good thing (true confession here), because the lifestyle I currently enjoy would not be possible in a traditional retirement situation. I would certainly not be destitute, and no one would feel sorry for me, but I am about as happy as I’ve ever been with my current situation.

Action over Angst

Let’s be more specific. Say you’re 60 now and woefully unprepared to retire in five years. You lost your savings or never had any. What do you do? “Give up” is not the answer. It is entirely possible, even likely, that you’ll be physically able to work for another 20 years. That’s an entire career in and of itself. It doesn’t have to be decades of drudgery, if – here’s the key – you plan ahead.

Financial planning works best when you have a lot of lead time. Compound interest takes years to do its magic. Career planning is different. It works best when you can act immediately. Take a deliberate approach and you won’t have to settle for a low-paid service job. So, if you’re behind the retirement curve, here’s what to do.

• Figure out what kind of work fits your aptitudes and circumstances. It may be different from your previous career. That’s OK.
• Acquire any necessary education or credentials.
• Build experience and contacts in your chosen field before you actually enter it.
• Push the start button.

The people I know who have taken this approach all describe the same experience. Step 1 is a kind of attitude adjustment, at first painful but then exhilarating. Something clicks, and they suddenly have more “life” ahead of them. They stop thinking about the leisurely rounds of golf and vacations they will miss and instead look forward to their new “encore” career.

Of course, sooner or later you will still reach a point where your health makes work too difficult. But then again, maybe the medical miracles I see coming down the path in the near future will extend your work span along with your lifespan and health span. Work, if it’s something you enjoy, is not a burden; it’s a blessing.

Whatever you’ve done all your life, you have valuable experience and knowledge. You can apply it to a new career, build savings, and avoid boredom all at the same time. Action is the answer to angst.

A Few Final Thoughts

The reality is, my simple solution won’t work for most people. Given the data we have looked at, is it any wonder that more and more Americans are increasingly anxious? Especially Baby Boomers? They want change because they feel (correctly) that the country is headed in the wrong direction; and when someone says here’s an easy solution and blames all the problems on some other group or factor (whether it’s the rich or illegal immigrants or trade or bureaucracy or – pick a scapegoat), they are speaking directly to the anxieties people feel, and that message drives polls and elections.

Some see Trump as the culmination of this expression of anxiety. I think that’s a simplistic and wrong explanation. Trump is not the culmination; he is the harbinger of a coming age of increasing anxiety in response to an even more volatile economic, social, and political climate. We are one global recession away from being in the situation that Greece found itself five years ago: They were left with nothing but bad choices. If you think the stress level in America is high, visit Greece. Or any country in Southern Europe, for that matter.

When the average American or European or even Chinese thinks about retirement, there is angst, and the level of angst is increasing. Even though I can cite reams of data showing how the world is a better place to live than it was 100 or 50 or 20 or even 10 years ago, it’s your own personal situation that you are faced with. You don’t get to live the “average,” it’s-getting-better-for-everyone experience. And growing angst is driving political polarization in countries all around the world.

Republicans fantasize that we can go back to the ’80s and President Reagan and implement the same policies he did and get the same results. Democrats fantasize that if we could just tax the rich more, things would all work out. And I use the word fantasize because unrealistic fantasies riddle thinking on both sides. Reagan had a massive demographic wind at his back; and yes, the policies he chose to put in place were the right ones at the right time, but we are no longer living with those demographics or that debt situation. And taxing the “rich” in order to spend even more will only slow down growth and opportunity for ordinary people on the street.

The real solutions are going to require massive compromise on the part of both major parties in this country – which doesn’t seem to be in the cards. Which means we are going to keep bumbling down the same path until we find ourselves up to our eyeballs in a crisis, with no good choices.

Gentle reader, if you have been reading me over the years, you may have come to believe in the correctness of the statements I made in the previous paragraph. What I’m telling you is that it’s not the end of the world for you if you take control of your own future. You cannot let yourself be subject to the slings and arrows of outrageous fortune. Your own personal future can be one of relative comfort with the ability to help others. Which in the future is about as good as it’s going to get for the vast majority of us.

John Mauldin has analyzed in-depth what I’ve been warning of for years, namely, the United States of Pension Poverty is heading down the wrong road and millions are doomed as they succumb to pension poverty.

What about workplace pensions? Well, they barely exist any longer and the ones that do exist face all sorts of problems. I have discussed America’s crumbling pension future and why I openly worry that
collapsing US pensions will fuel a much bigger crisis down the road.

But this isn’t a US problem, it’s a global one. In the UK, one in five Brits have no pension savings and face retirement poverty. The situation in Canada isn’t any better where nearly half of working-age Canadians are not saving for retirement, which is why enhancing the CPP is so critically important.

Got that last part? Unlike John Mauldin who I met in Montreal years ago and respect a lot and even share some of his conservative economic views, I believe large, well-governed public defined-benefit plans are the ultimate solution to global retirement angst.

Whenever I read John’s long comments on the retirement crisis, I’m reminded of those Lifelock commercials where you see an armed guard say “I’m not a security guard, I only monitor security problems” or a dentist say “I’m not a dentist, I am a dental monitor, yup, you have a real bad cavity” as he walks away and does nothing.

You see what John doesn’t tell you is the brutal truth on defined-contribution plans is they are an abject failure, exacerbating pension poverty.

But Leo what if we all saved more and invested in a basket of low-cost ETFs, rebalanced our portfolios every year and invested more in dividend stocks? Wouldn’t we be better off?

Yes, no doubt about it, but the reality is people aren’t saving and even when they do, they end up getting gouged on fees over the long-term or simply don’t know how to build a proper retirement nest egg.

And even if the younger generation is increasingly investing in digital (robo-advisor) platforms, it still doesn’t match the benefits of having their retirement savings managed by a large, well-governed public pension fund which can diversify investment and longevity risk, lower costs and invest directly or indirectly with top managers across public and private markets all over the world.

That’s why I was pleased to read that US pensions are adopting the best practices of their Canadian counterparts, namely, cost mitigation, a well-diversified investment portfolio across several asset classes and geographies, and a large appetite for illiquid investments.

So if the Canadian pension model is the way to go and a bigger CPP makes sense for Canada, why aren’t other countries adopting this model, enhancing their social security system?

There are a lot of political and ideological reasons as to why other countries haven’t adopted the Canadian model, but that is slowly changing. I’ve said it before and I’ll say it again, an enhanced Social Security based on an enhanced Canada Pension Plan whose assets are managed at CPPIB makes logical sense as long as they get the governance right.

Why doesn’t John Mauldin talk about this solution? I don’t know, I suspect he doesn’t know enough about it and has an ideological aversion to any public fund even if it’s well-governed and offers the best solution over the long run to America’s growing retirement angst.

Corporate DB plans could soon be going on a bond buying spree, according to a report released on Friday by Morgan Stanley.

Years of steady stock gains have pushed many corporate DB plans close to 80 percent funding; when plans get to that funding level, it’s typical to ramp up bond holdings, according to the report.

High-grade, long-term corporate bonds are the most likely to be scooped up by these pension plans.

From Bloomberg:

The biggest gainers may be corporate bonds maturing in around 30 years. Longer-term corporate bonds have risen 1.9 percent this year, including interest payments, compared with around 1.6 percent for the broader investment-grade universe, according to Bloomberg Barclays indexes.

“Pension funds’ sweet spot is out at the long end of the curve,” said Vincent Murray, who heads U.S. fixed income syndicate at Mizuho Securities USA in New York. Investors in some deals he’s worked on this year have placed orders for five times as much 30-year debt as was for sale, he said. “We’ve seen good demand.”

[…]

For long-term corporate bonds, it’s unlikely that new-issue supply will be able to meet demand in the near term. Until supply catches up, yields — particularly on 30-year debt — will likely sink, according to Hans Mikkelsen, head of high-grade credit strategy at Bank of America Corp.

“Pensions have a natural bias toward buying long-duration bonds,” Mikkelsen said. “The initial move is going to be lower long-term yields, and selling equities.”

 

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

The California Public Employees’ Retirement System (CalPERS) put out a press release yesterday, Réal Desrochers Leaving Private Equity Program:

The California Public Employees’ Retirement System (CalPERS) said today that Réal Desrochers, managing investment director of the CalPERS Private Equity program, is leaving the pension fund to take a position with a large overseas bank.

Desrochers’ last day at CalPERS is Friday, April 7. Sarah Corr, an investment director in Private Equity, will become the interim head of the program.

Desrochers joined CalPERS in 2011 from the Saudi Arabian Investment Company, where he was chief investment officer. Prior to that, he spent 11 years managing the private equity portfolio at the California State Teachers’ Retirement System (CalSTRS).

“Réal’s leadership, professionalism, and integrity are unmatched,” said Henry Jones, chair of the CalPERS Investment Committee. “Private equity is integral to our long-term success, and Réal has been invaluable in helping ensure the long-term future of the CalPERS Fund. We wish him great success as he embarks on this next chapter in his outstanding career.”

Private Equity has been CalPERS’ best-performing asset class over the past 10 and 20 years, returning 9.9 percent and 11.2 percent respectively, as of January 31, 2017. Over the past five years it has returned 11.8 percent. Since its inception in 1990 through June 30, 2016, the program has generated $33.4 billion in profits for CalPERS.

“Réal has worked for years to reduce costs and increase transparency throughout the industry, and he leaves a legacy at CalPERS of working tirelessly on behalf of our members,” said Ted Eliopoulos, CalPERS chief investment officer. “Because of him, we’ve been able to streamline the number of managers we work with, while at the same time negotiating much more favorable terms with our business partners. Réal has also been instrumental in moving the private equity industry to become much more open by adopting a standardized approach to reporting fees.”

Eliopoulos said the Investment Office will continue to review possible new business models for the CalPERS Private Equity program.

“As I outlined to the CalPERS Board last year, we’re going to continue reducing the number of general partners we do business with, and we’re going to explore how the program might eventually be adjusted to increase alignment and drive down costs even further,” he said.

About 8.5 percent of the CalPERS fund, or about $26 billion, currently is invested in Private Equity.

For more than eight decades, CalPERS has built retirement and health security for state, school, and public agency members who invest their lifework in public service. Our pension fund serves more than 1.8 million members in the CalPERS retirement system and administers benefits for more than 1.4 million members and their families in our health program, making us the largest defined-benefit public pension in the U.S. CalPERS’ total fund market value currently stands at approximately $312 billion. For more information, visit www.calpers.ca.gov.

The last time I spoke with Réal Desrochers was after I critically examined the “private equity disaster” at CalPERS which another blog alluded to. This same blog keeps harping on CalPERS’s private equity program, suggesting they paid a consultant to whitewash private equity misconduct.

I think some blogs, just like many newspapers, post things for “shock and awe” purposes trying to garner ever more readers as they feed them a lot of garbage.

I’m all for transparency in private equity and other asset classes, but if you read some of the garbage out there, you’d think private equity is all a big fraud, the returns are all hyper-inflated, that pensions should shun this asset class because they can get similar returns with more liquidity investing in the stock market. This is all nonsense and pure fiction.

Don’t get me wrong, these are treacherous times for private equity, the influx of money coming into this asset class and lack of opportunities has led to diminished returns and there are legitimate concerns of misalignment of interests.

But there is no denying that private equity is one of the most important asset classes for all pensions and that if done properly, investing in a handful of top funds and getting co-investment and other direct investment opportunities to lower overall fees, then it’s a winning strategy. Just ask Canada’s mighty PE investors.

[Note: As part of my many links on the right-hand side, you will see links explaining various assets, including private equity in the assets section. I must admit, I don’t update these links often but I try to keep them up to date. I recommend you read a bit on the J-Curve and also go over this CalPERS’s workshop on private equity which was done in November, 2015.]

Anyway, after my conversation with Réal, I can’t say I am too surprised he is calling it quits. I think he told me he’s approaching 70 years old, and while he keeps in good shape, the job is grueling and requires a lot of travel, not to mention back-to-back meetings all day.

As I stated in my blog, when Réal arrived at CalPERS, its PE program was one giant PE benchmark because they pretty much invested with everyone. He had a tough job cleaning up that portfolio and getting the benchmark right. Moreover, there remain issues which CalPERS’s CIO Ted Eliopoulos alluded to, namely, they need to streamline it even more and ramp up co-investments to lower fees.

I wish Réal all the best in his new life after CalPERS. I think he will take some time to relax with his wife Jo and who knows, he might do some consulting work if he’s up to it.

Another big departure which did catch me by surprise yesterday was Roland Lescure, the CIO of the Caisse, who announced on LinkedIn that he is entering French politics (click on image):

I had a chance to meet Roland on a few occasions and he always left a good impression on me. The best way I can describe him is as a classy, smart and very nice French (from France) man.

In fact, he reminds me a lot of a friend and former colleague of mine from PSP, Frederic Lecoq, who is also from France but emigrated to Canada a long time ago (Roland should meet Fred who keeps me very informed on the French political scene).

Fred referred me to today’s article in La Presse which states Roland will be helping centrist Emmanuel Macron who along with far-right leader Marine Le Pen, still hold a firm lead over the pack in France’s presidential election (meanwhile, while scandal-hit conservative candidate Francois Fillon was holding on to third place, 65-year-old Jean-Luc Melenchon, a veteran far-left maverick, has moved up fast in the ratings). 

Fred also told me that Roland’s older brother is Pierre Lescure, a well-known French journalist and television executive. According to Fred: “Win or lose, Macron (who is just 39 and was virtually unknown a year ago) has a great political future in France and Roland will be instrumental in helping to guide him on economic and financial issues.”

The last time I saw Roland was when the prince of Bridgewater was in town and he was the moderator for the event. I covered that event in detail and it was thanks to Roland that I was able to attend for free. I wish him a lot of success with his political aspirations and truth be told, France and Europe needs someone with his experience, temperament and knowledge.

The Caisse put out this press release announcing Roland’s decision:

Caisse de dépôt et placement du Québec today announced that Roland Lescure has decided to leave his position as Chief Investment Officer to enter public and political life.

“I have spent the past seven years working in one of the best institutions in Canada. I worked with extraordinary people and helped build a world-class investment organisation whose success benefits all Quebecers. On the eve of the French elections, I have decided to enter public and political life because I want to play a quite active role at a crucial time for France and for Europe. Since la Caisse is apolitical and non-partisan, I will have more to say about the political commitment I am making tomorrow,” said Roland Lescure.

“From the moment Roland joined la Caisse in 2009, he has worked tirelessly to build what la Caisse is today. While building highly talented investment teams, Roland’s intellect and creativity have helped shape so many of the strategies we have pursued at la Caisse. And he has excelled at rallying his teams to deliver these strategies,” said Michael Sabia, president and CEO of la Caisse. “Over the past few months, Roland and I have discussed his involvement in public and political life, and the decision he is announcing today is a testimony to his values and who he is as a person. This kind of commitment is admirable and should inspire all of us. I am convinced that, whatever form it takes, Roland will make an important contribution to French politics and democracy,” added Mr. Sabia.

“On behalf of the Board, I would like to thank Roland for his exceptional work as an executive of la Caisse. Over the past seven years, the Board has benefited from the depth of his economic and financial expertise, the soundness of his judgment and his fundamental understanding of la Caisse’s mandate,” said Robert Tessier, chairman of the Board of la Caisse.

Given that Mr. Lescure is leaving la Caisse to enter public and political life, his departure will be effective on April 6, 2017.

An international recruitment process for the Chief Investment Officer position has been launched. In the interim, Michael Sabia, president and CEO of la Caisse, will take on Mr. Lescure’s responsibilities.

Now, who will replace Roland? That’s not a given. I can however think of a great internal candidate, Jean Michel, the Executive Vice-President, Depositors and Total Portfolio, who joined the Caisse last year after performing miracles as the head of Air Canada’s pension plan, bringing it back to fully funded status by implementing the same approach that has led to Ontario Teachers’ and HOOPP’s long-term success.

But there are great external candidates too, people like Neil Petroff, the former CIO of Teachers’, Leo de Bever, the former CEO of AIMCo, or Wayne Kozun, a former senior VP at Teachers’. And I’m sure there are a few other high profile candidates that I’m not aware of.

The problem is the job is in Montreal, you need to speak and write French, and truth be told, there are very few people who have the skill set, leadership, language skills, and political temperament for this coveted but highly demanding position which I believe oversees public and private markets (not sure of the exact responsibilities of the role in terms of private markets). Who knows, maybe Réal Desrochers or François Trahan will express an interest to come back to Montreal.

For now, Michael Sabia will assume the role of CIO, which is actually a good thing because it will allow him to detach from some of the more mundane tasks of his job to focus more on what is happening at various portfolios across public an private markets (maybe Michael can offer me a contract to help him in the interim as he searches for a new CIO).

That is all for today. I wish Réal Desrochers and Roland Lescure all the best in the next chapter of their life. Both of them have worked very hard at their respective organizations and contributed to their success and they should be proud of their accomplishments.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

On Tuesday, OMERS Private Equity announced it acquired Inmar:

OMERS Private Equity (“OPE”), the private equity arm of OMERS, the pension plan for municipal employees in Ontario, together with management, has agreed to acquire Inmar (“Inmar” or the “Company”) from ABRY Partners (“ABRY”). ABRY will continue to be a significant shareholder in the Company.

Founded in 1980 and headquartered in Winston-Salem, North Carolina, Inmar operates intelligent commerce networks, connecting offline and online transactions in real time for the world’s largest retailers, manufacturers and trading partners across multiple industries. Inmar’s customers rely on the Company to securely manage billions of dollars in transactions across its promotions, supply chain, and healthcare platforms. In addition, Inmar’s platforms generate meaningful data and enable the Company to provide clients with actionable analytics and insights to meet the evolving needs of shoppers, patients and businesses.

David Mounts, Chairman and CEO of Inmar, said, “We are excited to partner with OPE at this stage in Inmar’s evolution and equally excited to be continuing the strong relationship we have with ABRY who I have come to respect and appreciate deeply for their collaboration and knowledge.” Mr. Mounts continued, “OPE brings significant financial resources and experience in partnering with growing companies like Inmar. With OPE and ABRY behind us we will increase investment in technology and expand into new and emerging markets. Our partnership will position us to capitalize on our platform and set in motion the next phase of substantial growth.”

“We look forward to partnering with David and the entire management team to support the Company’s next phase of growth. Inmar is an excellent addition to our growing business services portfolio,” said Eric Haley, Managing Director at OPE. “Inmar’s focus on being a trusted intermediary for its customers has continued to impress us, and we believe the Company will continue to be a leader in the markets it serves.”

“The investment in Inmar is consistent with OPE’s strategy of acquiring industry leading companies with world class management. The Company has steadily grown beyond commerce and into analytics and engagement solutions, which is an area where we see great opportunity. Unlike traditional PE firms, OPE can hold investments for longer durations, and Inmar, like recent investments in DTI/Epiq and Forefront Dermatology, matches up well with our strategy of choosing assets that have excellent long-term fundamentals,” said Michael Graham, OPE Senior Managing Director and Head of North America.

OPE will support management to continue its impressive track record of profitable growth both organically and through strategic acquisitions.

This transaction is expected to close in the second quarter of 2017.

Weil Gotshal & Manges LLP is acting as legal counsel for OMERS Private Equity. Kirkland & Ellis is acting as legal counsel for ABRY Partners and Inmar. Wells Fargo Securities, LLC is acting as financial advisor to Inmar. Credit Suisse and Wells Fargo Securities, LLC are serving as joint lead arrangers and joint bookrunners for the credit facilities in support of the transaction.

About Inmar

Anyone who has redeemed a coupon, filled a prescription or returned a product, has touched Inmar. Inmar applies technology and data science to improve outcomes for consumers and those who serve them. As a trusted intermediary for over 35 years, the Company has unmatched access to billions of consumer and business transactions in real time. Inmar’s analytics, platforms and services enable engagement with shoppers and patients, and optimize results. To learn more about Inmar’s service offerings visit www.inmar.com

About OMERS Private Markets and OMERS Private Equity Inc.

OMERS Private Markets [OMERS Private Equity and Borealis Infrastructure] invests globally in private equity and infrastructure assets on behalf of OMERS, the pension plan for municipal employees in Ontario. OPE’s investment strategy includes active ownership of a portfolio of industry-leading businesses across North America and Europe. Investments are aimed at steady returns to help deliver strong and sustainable pensions to OMERS members. OPM has offices in Toronto, New York, London and Sydney. For more information, please visit www.omersprivatemarkets.com.

About OMERS

Founded in 1962, OMERS is one of Canada’s largest defined benefit pension plans, with more than CAD$85 billion in net assets, as at December 31, 2016. It invests and administers pensions for more than 470,000 members from municipalities, school boards, emergency services and local agencies across Ontario. OMERS has employees in Toronto and other major cities across North America, the U.K., Europe and Australia – originating and managing a diversified portfolio of investments in public markets, private equity, infrastructure and real estate. For more information, please visit www.omers.com.

Interestingly, there is nothing stated about ABRY Partners, the private equity fund that presented this opportunity to OPE:

Founded in 1989, ABRY Partners is one of the most experienced and successful media, communications, business and information services focused private equity investment firms in North America. We invest in high quality companies and partner with management to help build their businesses. Since its founding, ABRY has completed over $62 billion of leveraged transactions and other private equity, mezzanine or preferred equity placements, representing investments in over 550 properties.

ABRY maximizes the value of its investments by concentrating on certain industry sectors where we have substantial operating and investment experience. Because ABRY brings deep industry insight to the investment process, we are able to quickly understand key issues, accurately assess opportunity, value and risk, and bring relevant information to bear. Simply put, we partner with skilled executives and invest significant capital to help build stronger companies that become industry leaders.

As far as Inmar, you can learn more about this company here, but I like this overview:

“Anyone who has redeemed a coupon, filled a prescription or returned a product, has touched Inmar. We apply technology and data science to improve outcomes for consumers and those who serve them. As a trusted intermediary for over 35 years, we have unmatched access to billions of consumer and business transactions in real time. Our analytics, platforms and services enable engagement with shoppers and patients, and optimize results.“

Last week, I discussed how PSP and OTPP are investing data centers and stated that over the last five years, everything in the IT space is about the rise of data storage, data analytics and cloud computing.

Michael Graham, OPE Senior Managing Director and Head of North America, states something important in the press release:

“The investment in Inmar is consistent with OPE’s strategy of acquiring industry leading companies with world class management.  The Company has steadily grown beyond commerce and into analytics and engagement solutions, which is an area where we see great opportunity.  Unlike traditional PE firms, OPE can hold investments for longer durations, and Inmar, like recent investments in DTI/Epiq and Forefront Dermatology, matches up well with our strategy of choosing assets that have excellent long-term fundamentals.”

As Ron Mock, Ontario Teachers’ CEO, explained to me last week when I went over OTPP’s 2016 results, one form of direct investment comes when the life of a private equity fund comes to end (typically after four or five years), and in order to exit from an investment, the general partner (GP or private equity fund) will sell a stake to a limited partner (LP or investor) who knows the company well and can carry it on its books for a long time.

This is what happened in this deal. OPE likely bid on it and acquired a stake in Inmar. Details of the deal are not disclosed but as stated in the press release, it matches up well with OPE’s strategy of choosing assets that have excellent long-term fundamentals. Because OPE has a much longer investment horizon than a private equity fund, it can carry this investment for a lot longer.

What else has OMERS been up to lately? A couple of weeks ago, Simon Jessop of Reuters reported, OMERS, Kuwaiti investors take stake in U.K.’s Thames Water:

A consortium of Canadian and Kuwaiti investors has agreed to buy a minority stake in Britain’s Thames Water from funds managed by Macquarie, ending the Australian group’s 11-year investment in Britain’s largest water firm.

The deal is the latest high-profile acquisition of British infrastructure by overseas investors, as pension schemes, sovereign wealth funds and others look to tap into stable returns tough to find in other financial markets.

Canadian pension fund investor Borealis Infrastructure and the infrastructure investing arm of the Kuwait Investment Authority (KIA) are buying a 26 per cent stake in Kemble Water Holdings, the holding company of Thames Water.

Borealis, infrastructure investment manager for OMERS, the pension plan for Ontario’s municipal employees, and Wren House Infrastructure Management, the infrastructure arm of the KIA, said they had agreed to buy the stake from Macquarie Infrastructure & Real Assets.

No financial details were disclosed.

Thames Water is Britain’s largest water and wastewater services provider, with 15 million customers across London, the Thames Valley and surrounding areas. It supplies 2.6 billion liters of drinking water per day.

“The Consortium has met with Thames Water’s existing management team and… will support Thames Water’s ongoing 4.5 billion pound capital investment program – for the 2015 to 2020 regulatory period – the largest in the UK water industry,” Borealis and Wren House said in a joint statement.

Macquarie, in a separate statement, said its Macquarie European Infrastructure Fund 2, which held most of the stake, was divesting as it approaches maturity and the deal would end the group’s involvement with Thames Water.

During its tenure, Thames Water invested more than 11 billion pounds, or around 1 billion pounds a year, more than twice that invested during the five-year period before privatization in 1989, it said.

“Today, Thames Water is undoubtedly a better, stronger and more customer-focused business than that which we invested in back in 2006,” said Martin Stanley, global head of Macquarie Infrastructure and Real Assets.

You can read the press release on this deal on OMERS’s website here.

Gill Plimmer of the Financial Times provided more financial details in her article, Macquarie sells final stake in Thames Water for £1.35bn:

Macquarie, the Australian infrastructure bank, has sold its final stake in Britain’s biggest water supplier Thames Water for an estimated £1.35bn.

The infrastructure arms of the Canadian pension fund Omers and the Kuwait Investment Authority have bought the 26 per cent stake.

It highlights a growing appetite for shares in British utilities as they are increasingly seen as “prized assets” for investors because they deliver steady returns.

Borealis Infrastructure and Wren House, the infrastructure investing arms of Omers and KIA respectively, bought the stake in Kemble Water Holdings, the holding company of Thames Water.

Thames Water has a regulatory capital value of £11.9bn, providing about 2.6bn litres of tap water to about 9m customers per day in London and the Thames Valley region.

The financial details of the deal were not disclosed, but it is understood Macquarie has received about £1.35bn for the sale, which had been delayed from last year in part due to uncertainties over the impact of Brexit.

The timing of the sale — a decade after Macquarie bought Thames Water from RWE for £8bn — is driven by the 10-year life of most Macquarie funds.

Last week Fiera Infrastructure paid $149m for an additional 2.4 per cent stake in Thames Water, while in February Australian fund manager Hastings Fund Management bought a 50 per cent stake in South East Water for about £200m.

“The consortium has met with Thames Water’s existing management team and . . . will support Thames Water’s ongoing £4.5bn capital investment programme — for the 2015 to 2020 regulatory period — the largest in the UK water industry,” Borealis and Wren House said in a joint statement.

The sale comes as Thames Water is due to appear in court for sentencing this week after being warned that it could receive its “biggest fine in history”.

The company has admitted that it dumped millions of litres of sewage into the river Thames at six sites in Henley-on-Thames, Didcot, Little Marlow and Littlemore, killing fish and other wildlife.

Meanwhile, construction started at the end of last year on a £4.2bn, 16-mile “super-sewer” to prevent raw sewage overflowing into the Thames.

Thames Water and the government have set up Bazalgette Tunnel Limited, a separate company, that will own, manage and finance the project during construction. Thames Water has already raised customers’ water bills to help pay for the tunnel.

In addition to its stake in Thames Water, Macquarie-managed funds own stakes in three UK power stations, airports and Arqiva, the mobile and TV mast company.

It is also tipped to buy the Green Investment Bank, a government-owned bank that invests in renewable energy projects.

Last week, I covered why the Caisse is betting big on insurance and water, and as you can see, other large Canadian pensions are also investing in the water industry, especially in the UK where they have been investing in infrastructure for a very long time.

I’m sure a few other consortia made up of Canadian and foreign investors bid on this deal but in the end, OMERS Borealis and KIA’s Wren House Infrastructure Management got it.

Infrastructure investments are very attractive for pensions but it is a heavily regulated sector which is why this was one of the terms of the deal:

The Consortium will support Thames Water’s ongoing £4.5 billion capital investment programme – for the 2015 to 2020 regulatory period – the largest in the UK water industry.

Nevertheless, these assets are extremely long term in nature and typically offer decent yields in between stocks and bonds with no market volatility. This is why pensions with long investment horizons love them.

The problem is that competition for these infrastructure assets is fierce, so consortia typically have to outbid each other on pricey deals. In other words, for now, the real winner in this deal is Macquarie Infrastructure and Real Assets.

Still, Thames Water is a great infrastructure asset, one that OMERS’ Borealis Infrastructure can add to its existing portfolio of great assets.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Gary Marr of the National Post reports, New report suggests a ‘fully-funded’ expanded Canada Pension Plan might not be such a sure thing:

A new report that looks at the federal government’s blueprint for an expanded Canada Pension Plan warns the larger payouts are predicated on returns that may not materialize over the next 40-75 years.

The C.D. Howe Institute in a paper out Tuesday is calling on Ottawa to be more forthcoming about the potential investment risk for the plan, suggesting that over the next 40 years the expanded plan will achieve 90 per cent of targeted benefits only 54 per cent of the time based on the current return expectations.

“There are risks and we don’t know whether there (are) going to be enough assets and contributions in the fund to ‘fully fund’, as we normally understand it, (the CPP),” said Alexandre Laurin, one of two authors along with William Robson of a report titled Bigger CPP, Bigger Risks: What “Fully Funded” Expansion Means and Doesn’t Mean.

Currently, the C.D. Howe report says, participants pay 9.9 per cent per year on earnings covered by CPP and the benefit, after 40 years, equals 25 per cent of that covered amount.

Under the new plan, announced in June, the level of earnings being covered will increase: Participants are expected to pay an extra two per cent on currently covered earnings and eight per cent on the newly covered earnings. After contributing for 40 years, participants will receive benefits equal to 33.33 per cent of the higher earnings level.

While the government and other advocates of the expanded plan have used the term ‘fully funded’ to describe it, the C.D. Howe paper says there is a catch: they are not using that term to mean the plan has assets to cover the present value of benefits accrued to date.

The group maintains the rate of return assumed in projections for the base CPP and the expanded plan are “well above the current yields available on the kind of sovereign-quality Canadian debt that people might think appropriate” for the plan.

The authors go on to say the expanded CPP will “expose participants to more risk than they know” and say it is tough to assess the risk that returns will be too low to cover promised benefits.

The report says the chief actuary for the government has plotted a course for a return of 3.55 per cent in real (inflation adjusted) terms over 75 years. It noted the federal government’s real return bond currently yields 0.7 per cent.

“The return is very important because the new CPP is different than the old. CPP has to be funded through contributions and investment on the contributions so the investment income is important,” said Laurin, adding his group looked at reasonable risks that the fund could not meet its goals.

Over the next 75 years, the paper says the expanded CPP will see 65 per cent of targeted benefits covered 90 per cent of the time. That was based on the 3.55 per cent real rate of return which the chief actuary said would be established with an asset mix that included 37.5 per cent equities, 37.5 per cent fixed income securities and 25 per cent real asset.

“The base CPP, only a small portion is contingent on returns. Our annual contributions mostly cover the current benefits and it will be the same in the future,” said Laurin.

He says the bill that created the expanded CPP has issues that still need to be resolved, such as regulations as to what happens if there is a shortfall.

“There are really only two options (if the expanded CPP comes up short). Lower benefits if there is not enough investment return or higher contributions and the future generations will pay more than what they get which is already the case with the base CPP,” said Laurin, adding at the very least the government should make it clear an expanded CPP is contingent on financial returns.

Alexandra Macqueen of the Globe and Mail also reports, CPP changes could leave younger workers footing the bill, report says:

Policymakers may be misleading Canadians into thinking the expanded CPP is on firmer financial footing than it actually is, and if the plan’s investment returns stumble, younger workers may be at risk of footing the bill for older Canadians, says a report released Tuesday by the C.D. Howe Institute.

In June, 2016, the federal and provincial finance ministers announced they’d reached a deal to expand the Canada Pension Plan to replace more of the income Canadians earn during their working years.

Under the revamped CPP, working Canadians would contribute 1 per cent more than current rates for the “base” CPP benefit and an additional 4 per cent on newly-covered earnings above that amount. Employers would be required to match these increased contributions.

While the current CPP is designed to cover up to 25 per cent of the average industrial wage, the expanded CPP – or “CPP2” – would cover up to 33.33 per cent of the higher covered earnings amount.

The importance of investment returns to plan success

The problem, say the authors of the C.D. Howe Institute’s report, William Robson and Alexandre Laurin, is that federal and provincial policymakers have described the CPP enhancements as “fully funded,” but what this means in the context of CPP is not what most Canadians might think.

In the context of a defined benefit pension plan, a “fully funded” plan has assets sufficient to cover the present value of benefits earned by plan participants to date. In the context of the CPP, however, “fully funded” means the plan’s investment returns are expected to offset the need for contribution increases as the number of contributors (working Canadians) falls in the coming decades, relative to the number of retired Canadians receiving CPP income.

Canada’s Chief Actuary has calculated that CPP2 will be able to pay the projected increased benefits from the higher increased contribution rates so long as the Canada Pension Plan Investment Board (CPPIB) is able to earn a 75-year average rate of return of 3.41 per cent, after investment management expenses.

If this assumed rate turns out to be too low, retirees could expect higher benefits or lower premiums (or both). Alternately, if this rate of return is not attained in reality, the C.D Howe report, entitled “Bigger CPP, Bigger Risks: What ‘Fully Funded’ Expansion Means and Doesn’t Mean,” says Canadians may end up with lower-than-expected benefits or higher-than-expected costs.

Who foots the bill for shortfalls?

Achieving the projected long-term rate of return requires “a fair amount of investment risk and uncertainty,” said Mr. Robson and Mr. Laurin. In addition, they believe that low-risk, relatively secure assets – such as long-term government bonds – are not producing a rate of return that is close to the 3.41 per cent CPP minimum.

For example, they pointed to the rate of return for a federal long-term, real-return bond, which is currently yielding 0.7 per cent. “If the CPPIB were to invest in such an asset [to produce the required investment returns], and its yield stayed at that level,” the authors said, the contribution rates on CPP2 would need to more than double, or promised benefits would need to fall by more than half.

The CPP legislation provides that contributions can be increased in the future, if the provinces consent. Rate increases, however, are limited to not more than two-tenths of a per cent per year, which might not be sufficient to cover shortfalls, and if the provinces and the federal government cannot agree on contribution rate hikes, the rules about changes to benefit levels and contribution rates (which themselves will also be subject to provincial consent) have not yet been written.

A call for increased transparency

For the report’s authors, the problems stemming from the increased investment risk embodied in the enhanced CPP are twofold: first, the plan might not hit its return targets and secondly, if the targets are not met, the actions policymakers can take to rectify any shortfalls are not yet set, which means younger working Canadians could be on the hook.

The bottom line? For the authors, CPP needs more transparency regarding its risk exposure – which its participants will bear the brunt of – and how the plan will respond if things don’t work out as expected.

“In fairness, if the investments do better than expected, the current generation might end up paying for benefits enjoyed by future generations,” said Joe Nunes, an independent actuary and president of Oakville, Ont.-based Actuarial Solutions Inc. “Then again, if the investments do well, I am sure there will be political pressure to improve benefits as soon as possible, again pushing the risk of insufficient assets to a future generation.”

The C.D. Howe report recommends that the provinces and Ottawa consider developing safeguards to protect against CPP2 increasing contributions from (younger) working Canadians to cover shortfalls for older (retired) Canadians if the realized investment returns from the CPPIB don’t meet the minimum required threshold rates.

One option would be to adopt a “target benefit” model, in which benefits above a target amount (for example, 80 per cent of the base benefit) are protected, but benefits above this basic amount are allowed to adjust downwards in the event of a plan shortfall.

“The starting place for this discussion,” said Mr. Robson and Mr. Laurin, “needs to be understanding among the officials and interested Canadians that, in an uncertain world, even the Canada Pension Plan makes no guarantees,” as neither the base CPP nor CPP2 are, or will be, “fully funded.”

You can read a summary and the full C.D. Howe report, Bigger CPP, Bigger Risks: What “Fully Funded” Expansion Means and Doesn’t Mean, by clicking here.

Now, before I share my opinions, let me be upfront and tell you I actually like the C.D. Howe Institute and don’t find it as ideologically warped as the Fraser Institute.

I also like Bill Robson, its President and CEO, who I have met at pension conferences in Montreal and Toronto. Bill is a smart and sensible guy and he and his co-author Alexandre Laurin have written a decent report highlighting some important issues on the expanded CPP.

Still, I wish these “think tanks” would be more upfront on who exactly funds them and why they perceive expanded CPP to be such a threat (ie. Canada’s large financial services companies who know they cannot compete with Canada’s large, well-governed defined-benefit plans).

From a policy perspective, there’s no doubt Bill Robson understands the intricacies of expanding the CPP extremely well. But from an investment and actuarial perspective, neither he nor Alexandre Laurin are authorities on how Canada’s large pensions take calculated risks across public and private markets all over the world to achieve their long-term actuarial target real rate of return.

Now, it’s true that the Canada Pension Plan (CPP) is not a “fully funded” plan like Ontario Teachers’, HOOPP, OPTrust or OMERS. Instead, the CPP is a partially funded plan:

Beginning in the 1980s, the CPP’s financial sustainability became a key issue due to a convergence of factors, including increases in the life expectancy of the Canadian population, and a large, aging baby boom demographic that would soon be retiring (meaning more people would be drawing on the retirement system and fewer would be contributing). Accordingly, the concern was for the long-term viability of the CPP and its ability to provide meaningful benefits in the future.

While this issue was recognized in the 1980s, little action was taken due to a lack of political will. It wasn’t until 1998 that the federal government and the provinces agreed to make substantial reforms to the program to address the issue of its sustainability. Under the reforms, CPP contributions by employers and employees were significantly increased to provide a stronger revenue base. Additionally, the Canada Pension Plan Investment Board was established to invest those funds that were collected but not immediately required (for payout of benefits).

As a result of these reforms, the CPP moved away from a “pay-as-you-go” basis, where contributions were set at a level that would accommodate pension payouts and provide a contingency fund of two years’ worth of benefits for all eligible Canadians. (Under the previous system, any surplus was automatically loaned to the provinces.) Under the new reforms, the CPP moved to a “partially funded” model, accumulating a larger fund of approximately five years’ worth of benefits. In turn, these monies are subsequently invested more broadly by the Canada Pension Plan Board to achieve a better rate of return ― meaning that the funds are not simply sitting “parked” somewhere, but are accruing value.

These reforms significantly improved the financial sustainability of the CPP, such that in 2007, the federal Office of the Chief Actuary released a report on the CPP, which concluded the CPP will be financially sound over a 75-year period. It also found that between 2007 and 2019, CPP contributions will be more than sufficient to cover benefits. After 2019, a portion of the CPP’s investment income will be needed to make up the difference between contributions and expenditures. That said, the economic recession of 2008-09 did impact the CPP. In February 2009, the CPP Investment Board reported a decline in the fund, of $13.8 billion for the nine-month period ending December 31, 2008 (CPPIB, February 2009). By September 2009, however, the board had reported a sharp increase in the fund’s value, which regained the value it lost during the recession (CPPIB, November 2009).

Being partially funded effectively means that CPPIB can take more risks than these other large pension plans because it’s not managing assets and liabilities very closely.

Still, CPPIB is very risk conscious and it has plenty of assets to meet its actuarial obligations:

In the most recent triennial review released in September 2016, the Chief Actuary of Canada reaffirmed that, as at December 31, 2015, the CPP remains sustainable at the current contribution rate of 9.9% throughout the forward-looking 75-year period covered by his report. The Chief Actuary’s projections are based on the assumption that the Fund’s prospective real rate of return, which takes into account the impact of inflation, will average 3.9% over 75 years. CPPIB’s 10-year annualized net nominal rate of return of 7.3%, or 5.6% on a net real rate of return basis, was comfortably above the Chief Actuary’s assumption over this same period. These figures are reported net of all CPPIB costs to be consistent with the Chief Actuary’s approach.

The Chief Actuary’s report also indicates that CPP contributions are expected to exceed annual benefit payments until 2021, after which a small portion of the investment income from CPPIB will be needed to help pay pensions.

“Over the period of his latest report, the Chief Actuary confirmed that the Fund’s performance is well ahead of projections as investment income was 248% higher than anticipated. The Fund’s investment returns have made a favourable impact and contributed to the lowering of the minimum contribution rate required to help keep the CPP sustainable over the long term,” added Mr. Machin.

So, after reading this, you have to wonder, why all the fuss about expanding the CPP? I happen to think it’s a great thing for Canadians and the Canadian economy over the long run as it ensures more people will escape pension poverty and live off a solid retirement well into their golden years.

I’m also at a loss as to this passage from the National Post article:

“The C.D. Howe Institute in a paper out Tuesday is calling on Ottawa to be more forthcoming about the potential investment risk for the plan, suggesting that over the next 40 years the expanded plan will achieve 90 per cent of targeted benefits only 54 per cent of the time based on the current return expectations.”

I don’t know where they pulled these figures from and as for Ottawa being more forthcoming about the potential investment risk for the plan, maybe Canada’s banks and mutual fund companies should be more forthcoming on the fees they charge on their mediocre funds (it’s coming with CRM2) and be brutally honest on how DC plans expose millions to pension poverty.

Over the weekend, John Mauldin posted a great comment, Angst in America, Part 3: Retiring Broke, which is a must read for all of you. In the UK, one in five Brits have no pension savings and face retirement poverty. The situation in Canada isn’t any better where nearly half of working-age Canadians are not saving for retirement, which is why enhancing the CPP is so critically important.

Sure, we can discuss whether a 3.55% actuarial real rate of return target is realistic over the next 75 years, or whether we need to introduce more risk-sharing in a “fully funded” Canada Pension Plan so if there is a persistent shortfall, benefits need to be cut or contributions raised, but it’s too early to worry about these issues and they certainly shouldn’t be used as an excuse to question the expansion of the CPP, which is good pension and economic policy, period.

We have the best defined-benefit pension plans in world in Canada. Instead of acknowledging this and building on their success, some think tanks are criticizing them and question their long-term sustainability without highlighting their success or the abject failure of the private sector’s solutions to our ongoing retirement crisis.

Anyways, don’t get me started, I like Bill Robson and have nothing against the C.D. Howe Institute, and while this report raises a few valid concerns, it also perpetuates myths that CPPIB will not be able to deliver over the long run, exposing the CPP to serious funding risks.

I simply don’t buy this and neither does Bernard Dussault, Canada’s former Chief Actuary, who will share his thoughts later today in an update to this post (you can click on the pig at the top of this blog to reload the page and get the latest updates).

Update: Bernard Dussault, Canada’s former Chief Actuary, shared these insights with me on this new C.D. Howe report (added emphasis is mine):

I am not inclined to agree whatsoever with the main conclusions of the C.D. Howe report. Here is why.

The C.D. Howe report claims, without really substantiating it, that “… the rate of return assumed in projections for the base CPP and the expanded plan are “well above the current yields available on the kind of sovereign-quality Canadian debt that people might think appropriate” for the plan.”

Despite the investment losses incurred by the CPP fund in 2008, at the time of the largest economic downturn since the 1929 crash, the CPP has since rapidly recovered from those losses in such a way that the average real rate of return on the CPP fund over the last 10 years exceeds the one (4%) assumed in CPP actuarial reports since the 1998 CPP reform.

In other words, CPP statutory actuarial projections have so far always proven to be reliable. I have yet not seen any evidence that the pension investment landscape has been subject pursuant to the 2008 economic downturn to any structural change that should cause a material decrease in the expected average long term economic growth.

Therefore I tend to give to the Chief Actuary’s following conclusion (last paragraph on page 9 of 28th CPP actuarial report) more credit than to the conclusions in the C.D. Howe report.

This report confirms that if the Canada Pension Plan is amended as per Part 1of Bill C-26, a legislated first additional contribution rate of 2.0% for the year 2023 and thereafter, and a legislated second additional contribution rate of 8.0% for the year 2024 and thereafter, result in projected contributions and investment income that are sufficient to fully pay the projected expenditures of the additional Plan over the long term.

I thank Bernard for sharing his wise insights with my readers and I agree with his and the current Chief Actuary’s conclusion.

Texas officials, both in the statehouse and in Dallas’ mayoral office, are weighing how to address the severe underfunding of the city’s public safety pension system.

So far, it seems the only thing they can agree on is that the latest proposed bill – one that suggests increasing city contributions and giving more board positions to city employees, among other things — stinks.

From the Dallas Observer:

As amended by the committee, [Texas State Representative Dan] Flynn’s bill would take control of the Dallas Police and Fire Pension System’s board out of the hands of the city and hand it to retired police and firefighters. As written by Flynn, the bill would’ve given city employees a clear majority of spots on the board. The committee version of the bill gives the city five seats, police and firefighters five seats and allocates one seat on the board to be chosen by consent of both groups.

[Dallas Mayor] Rawlings said that taking control of the fund away from the city will make it vulnerable to the types of risky investing that have led to the current threats against the DPFP’s solvency.

[…]

The mayors also criticized the financial component of Flynn’s bill, which would require the city to make escalating payments to help the fund based on proposed new officer hires by the Dallas Police Department, regardless of whether or not the department actually hires the new officers, eventually increasing the city’s annual contribution from 27.5 percent of DPFP members’ annual salaries to 34.5 percent. Rawlings called the bill a “taxpayer bailout” of the fund.

The bill is still a ways away from getting a vote in the Texas House.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Matt Scuffham of Reuters reports, Canada’s CPPIB pension fund concerned over rising protectionism:

The Canada Pension Plan Investment Board, one of the world’s biggest investors, is concerned about the rise of protectionist trade policies, its chief executive told business leaders in Toronto on Friday.

The CPPIB, which manages Canada’s national pension fund and invests on behalf of 20 million Canadians, has become one of the world’s biggest global infrastructure and real estate investors as it seeks to diversify from public equity and fixed income markets.

Chief Executive Mark Machin told the Toronto Region Board of Trade that the pension fund had benefited from globalization and would suffer from policies that make international trade more difficult.

“We worry about it,” Machin said. “Our investment strategy benefits from open markets. Open markets for investment, open markets for trade, open markets for people and impediments to that are not helpful.”

U.S. President Donald Trump is planning to reform a trading agreement between the United States, Mexico and Canada while Britain has voted to leave the European Union and candidates with sceptial views of free trade are running in elections in France and Germany in 2017.

“You can understand some of the concerns that have led to these policies. Not everybody has been a beneficiary of globalization,” said Machin. “Ultimately I hope that pragmatism will reign in the end and we won’t see too profound an impact, whether it’s in Europe or North America, of these policies.”

At the end of 2016, CPPIB had only 13 percent of its assets of over C$300 billion ($226 billion) invested in Canada.

About 44 percent of the investments were in the United States, with about 19 percent in Europe, around 19 percent in the Asia-Pacifc, and about 5 percent in South America and other regions.

Although CPPIB has grown to be one of the world’s biggest infrastructure investors with assets worth C$27.6 billion, it has a relatively modest stake in infrastructure projects in its own country.

Machin said he hoped plans by Canada’s Liberal government to set up an infrastructure bank to facilitate private financing for projects could lead to opportunities to invest in more large-scale projects in Canada.

“We’re hoping that the initiatives the federal government is taking will lead to a better flow of sizeable opportunities,” he said. “We focus on markets where there’s a consistent flow of projects that are investable by institutional money. Canada’s not had too many of those.”

According to Barbara Shecter of the National Post, CPPIB is most interested in airports:

The Canada Pension Plan Investment Board will consider bidding on Canada’s major airports if they’re put on the auction block by the federal government.

“We would look at it — absolutely,” Mark Machin, who took over as CPPIB’s chief executive in June, told the Financial Post on Friday after his first major public address. “We know airports, we like airports, we’d be interested if something happened.”

There has been speculation that the Liberal government is looking to collect billions of dollars by selling off some of the country’s large airports including Pearson International Airport in Toronto.

The Ontario Teachers’ Pension Plan owns stakes in three airports in the UK, including London City Airport, and CPPIB teamed up with a partner in Chile a couple of years ago in an unsuccessful bid for one of the South American country’s large airports.

In the interview with the Post following his speech to a business crowd at the Toronto Region Board of Trade, Machin expressed confidence in Ottawa’s planned Infrastructure Bank, through which the government hopes to combine billions of dollars in public and private money in large-scale projects that will create jobs and stimulate the economy. Ottawa hopes Canadian pensions that invest in infrastructure around the world including toll roads, shipping ports, and airports will be key participants.

“The intent is terrific… I think it’ll come,” Machin said, adding that it will take some time to turn the strategy into a large-scale institution with a systemic approach to infrastructure and a pipeline of deals.

Projects, however, will have to meet certain criteria including scale and an acceptable risk-adjusted return to draw interest from large institutional players such as pensions.

“Canada’s not had a lot of those,” Machin said, though he noted that CPPIB’s largest infrastructure investment is in the 407 highway near Toronto.

Machin said it is a good sign that the government has tapped former Ontario Teachers’ Pension Plan CEO Jim Leech as an adviser for the infrastructure bank, adding that this should ensure its development incorporates the needs of global institutional investors. Smaller projects could be packaged together to reach size requirements, Machin suggested, and there might be ways to structure operations to provide sufficient returns for institutional capital.

“I hope it will get off the ground soon — you can’t create a large institution overnight,” he said.

Machin said CPPIB is continuing to scour the globe for investments, including looking in China, India, and the United Kingdom, where the economy has so far shown little impact as Britain works its way toward an exit from the European Union.

At the conclusion of his speech in Toronto, he told the business crowd he hopes pragmatism prevails over protectionist policies emerging in the United States and Europe.

“CPPIB has been a huge beneficiary of globalization,” he said, adding that while he understands the urge of some countries to protect their citizens and economies, he also recognizes the benefits of open borders and open trade.

What else did Mark Machin discuss? John Gray of BNN reports that he warned investors to expect lower returns:

Canadian investors should lower their expectations for outsized market returns, warns the head of Canada’s largest pension fund.

Stocks, real estate and other global assets are fully valued and are will likely see more modest returns for the time being, Mark Machin, CEO of the Canada Pension Plan Investment Board (CPPIB) told BNN in an interview.

“Most asset prices are quite rich around the world so we are going to be careful and cautious about where we invest,” he said. “It also means that expectations about returns from relatively full value are going to be lower for a period of time.”

CPPIB manages more than $298 billion in assets on behalf of the Canadian Pension Plan. The fund reported a net investment return of about 6.9 per cent in December.

The fund is looking to increase its investment return by looking for more alternative investments, he said. “We find opportunities by looking at other asset classes, other strategies, other geographies, and not following the crowd into really crowded trades,” he said.

Machin’s comments come just two days after the Ontario Teachers’ Pension Plan (OTPP) reported a rate of return of 4.2 per cent, down from 13 per cent in the same period in 2015. The fund cited unfavorable currency movements as one of the primary sources of weakness.

CPPIB’s long investment horizon makes hedging Canadian currency risk impractical, says Machin. The CPPIB also has a diversified portfolio of global investments that also act as a natural currency hedge, he says.

Last week, I went over Ontario Teachers’ 2016 results and discussed the impact of currency swings on the Fund’s overall results.

I had a chance to talk to OTPP’s President and CEO, Ron Mock, yesterday and we went over the 2016 results. I asked him plenty of questions and he was kind enough to answer them all and cover a lot of material.

I began with the most obvious, the impact of currency swings which is front and center in the news articles and in the Annual Report (click on image):

By now, everyone in the world knows Brexit hit Teachers’ results last year and if their investment staff didn’t partially (50%) hedge the Fund’s exposure to the Pound Sterling prior to the Brexit vote, the results would have been even worse.

As stated in the press release, Teachers has investments in 37 global currencies and in more than 50 countries. In those local currencies, the return on our investments was 7.2%. Converting the return on those investments back into Canadian dollars, the currency in which pensions are paid, had a -2.8% impact on the Plan’s total-fund rate of return. By contrast, currency gains added 8.3% in 2015.

Ron told me that in terms of asset returns, 2016 was actually better than the previous year, but when you factored in currency swings, it really detracted from the performance.

Like CPPIB, Ontario Teachers’ typically doesn’t hedge currencies. This means in years where the euro, yen, pound, and US dollar are up relative to the Canadian dollar, they enjoy currency gains but in years where the CAD is doing relatively better, they take a hit on currencies.

What else did I discuss? The new federal infrastructure bank:

[…] on the newly created $35-billion Canada Infrastructure Bank, Bill Curry of the Globe and Mail reports that Ottawa just hired Metrolinx CEO, Bruce McCuaig, to advise it. Mr. McCuaig will be joining Jim Leech, the former CEO of Ontario Teachers’, who was tapped last month to get this new federal infrastructure bank up and running.

I don’t know but Ron Mock is right, considerable work needs to be done to get better alignment of interests and the bigger, more ambitious infrastructure projects take years to set up and complete.

In the meantime, I agree with those who think Ottawa’s plan to sell airports needs to take off right now — while the market is still hot. This is something that I’m sure Ontario Teachers’ and other large Canadian pensions would invest in and help transform our airports into world class airports.

In fact, just yesterday Ron Mock told BNN that Canadians will be slow to adapt to the concept of privately-owned airports, but will eventually understand their benefit.

I briefly discussed this new federal infrastructure bank with someone over the weekend who told me “it looks like they’re going to set it up in Toronto by the looks of the people that are working on it.”

I told him that would a shame because Montreal has great infrastructure expertise and the city desperately needs a new federal organization like this one.

He told me “regardless of where its headquarters will be, they need to get the governance and compensation right or else it’s going nowhere.”

Jim Leech knows all this which is why I know he’s working hard to set it up right. Canada’s large pensions are counting on him to lay the proper foundations for this organization.

I also had a chance to relay this CNBC clip on how some new infrastructure projects can be privately financed, using REITs as a model to Andrew Claerhout who leads Ontario Teachers’ Infrastructure & Natural Resources Group. Andrew shared these thoughts with me:

Raising funds from retail investors through a REIT or REIT-like structure is an interesting thought, but it fails to deal with the fundamental issue which is a lack of investable opportunities (and not a lack of capital).

During the interview, Scott failed to directly answer the question of where the funding would come from: government or tolls.

If from government through an availability payment, then there’s already a large investor universe focused on traditional PPPs and, as we have discussed before, these types of deals cater much more to lenders and construction companies than equity investors, as the equity cheques involved are typically very, very small relative to the total cost of the project.

If from tolls, then these are the exactly the types of assets large institutional investors such as Teachers’ focus on and want to see more of.

In both cases, no more capital is needed and so although the idea is interesting, I doubt it would result in any further infrastructure being built.

Another friend of mine who is an infrastructure expert at the Caisse shared Andrew’s sentiments and said that the problem isn’t lack of capital, it’s lack of investable opportunities and investors can already invest in infrastructure in public markets, “it’s called Brookfield.”

Back to Mark Machin’s comments above. CPPIB isn’t the only big pension fund worried about protectionism. On Friday, I discussed why the Caisse invested in insurance and water, buying USI Insurance with its private equity partner, KKR, for $4.3 billion:

The deal is the latest in a string of mergers in the insurance market, which has not grown quickly enough to support smaller brokerages.

“It’s a sector we like,” Caisse Chief Investment Officer Roland Lescure said in an interview. “It’s quite defensive, it has high cash-flow generation, and it’s a growing sector where there is consolidation taking place.”

The Caisse, Canada’s second-largest public pension plan, is buying businesses to help it diversify from public equity and fixed income markets.

The pension fund, which has net assets of more than C$270 billion ($202 billion), wants to have 30 percent to 35 percent of its investments in areas such as private equity, infrastructure and real estate in the next four to five years, compared with 28 percent currently.

“At a time when there are lots of fears and questions on the potential protectionism and border adjustment tax,” Lescure said, “being exposed to small and medium companies is a safer way of exposing yourself to the U.S. economy.”

Now, I highly doubt the Trump Administration will go ahead with nonsensical protectionist policies but you never know exactly what this administration will do in terms of trade.

I think it’s fair to assume powerful CEOs of multinational corporations are warning the administration not to pursue such disastrous trade policies and Trump being a businessman, will listen to their concerns.

As far as expecting lower returns ahead, I’ve been warning of this for a long time. Ron Mock also warned of this as have Michael Sabia and André Bourbonnais.

Interestingly, over the weekend, Bryce Cowen of Knowledge Leaders Capital put out a nice comment, Stock/Bond Ratio Back at 2007 Peak:

As 1Q17 finishes with a gain in the books, the stock to bond performance ratio has also broken to a new cycle high, elevating to levels not seen since mid-2007. Our measure of the stock to bond ratio measures the total return of the S&P 500 relative to that of the JPM 10 year treasury total return index. When the blue line rises, stocks are outperforming bonds, and vice versa (click on image).

While a rising stock to bond ratio isn’t all that surprising, especially in a bull market, the recent acceleration is not commonplace. Over the last two quarters stocks have outperformed bonds by 31%, which is highest level since 2011. Only in 1999 did stocks outperform bonds by a wider wide margin over a two quarter period (click on image).

So what does this simple chart tell us? Over short periods of time, the relative performance of stocks and bonds fluctuates around around a mean of about zero. When stocks outperform bonds by a large amount over a short period, that period of outperformance reverts back towards zero, either through time or performance. While we can’t possibly predict the performance of either stocks or bonds, what we can fairly confidently deduce is that further stock strength relative to bonds is unlikely over the coming months.

Now, I always warn my readers that “markets can stay irrational longer than you can stay solvent,” which is a quote often attributed to Keynes but it comes from Gary Shilling.

In my opinion, there is still a lot of juice in the system to drive risk assets higher but I have warned my readers that the Trump rally won’t go on forever, regardless of the proposed tax cuts and plans to revamp US infrastructure.

This is why I’ve been telling people to ignore the reflation chimera and bond bears that are getting slaughtered and keep buying the dips on US long bonds (TLT) to sleep well at night because if we get any negative surprises in the second half of the year, long bonds will rally a lot further (click on image):

It’s also worth remembering that CPPIB is a large pension fund with a great liquidity profile, so in a bear market, it typically outperforms because its fund managers are able to capitalize on public and private market dislocations across the world. The same goes for all of Canada’s large pensions, but CPPIB and PSP have the added advantage of great liquidity that others don’t have.

Let me end by plugging the market research at Cornerstone Macro. François Trahan and Michael Kantrowitz sent out a great report this morning, Addressing Most Popular Questions While On The Road, which I highly recommend my institutional readers all read.

In fact, if you’re not subscribed to the market research at Cornerstone Macro, I highly recommend you do so. François Trahan and Michael Kantrowitz regularly put out great reports covering market trends in detail (I covered François’s CFA luncheon in Montreal here).

Again, given my views on the reflation chimera and a potential US dollar crisis despite the recent selloff, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE) and Financial (XLF) shares.

The only sector I like and trade now, and it’s very volatile, is biotech (XBI) but technology (XLK) is also doing well, for now. As I stated above, if you want to sleep well, buy US long bonds (TLT) and thank me later this year.

I foresee very choppy markets in Q2 but the risks of a reversal are high, so be prepared for a downturn. Of course, if we have a melt-up like 1999-2000, stocks are heading higher, but the risks of a bigger downturn down the road will be magnified (who knows, we shall see).

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

I wasn’t going to blog today but I realize that I’ve been slacking on my coverage of the Caisse. Two weeks ago, Devin Banerjee, Scott Deveau, and Frederic Tomesco of Bloomberg reported, Caisse Joins KKR in $4.3 Billion Deal for Onex’s USI Insurance:

KKR & Co. and Caisse de Depot et Placement du Quebec agreed to buy Onex Corp.’s USI Insurance Services for about $2 billion as the acquirers partner to make long-dated private equity investments.

KKR and CDPQ, Canada’s second-largest pension fund manager, will have equal ownership in the Valhalla, New York-based insurance broker, according to a statement Friday. The deal values USI at $4.3 billion including debt.

The acquirers also said they’ve established a partnership to make core private equity investments, or deals for stable companies they can hold for longer than the typical three- to five-year period in leveraged buyouts.

Private equity firms have long favored deals in insurance services, where capital expenditures and debt levels are typically low and cash flow is steady. KKR and CDPQ outbid others including buyout firms Carlyle Group LP and CVC Capital Partners for USI, according to people with knowledge of the process. Blackstone Group LP agreed last month to buy human-resources and benefits-administration platforms from broker Aon Plc for as much as $4.8 billion.

“Insurance is a defensive sector that generates a lot of cash and is relatively resilient to economic slowdowns and recessions,” Roland Lescure, CDPQ’s chief investment officer, said in a phone interview Friday. “The good thing about being a broker is that you are only an intermediary and you are not exposed to asset risk.”

Longer Ownership

KKR’s new partnership with CDPQ to make longer-hold investments reflects a wave of similar strategies by peers seeking to benefit from holdings that grow steadily and produce stable cash. Blackstone struck its first such deal in January, acquiring music-rights company SESAC Holdings, and Carlyle and CVC also have funds to make core private equity investments.

KKR co-founder Henry Kravis has lamented in the past that typical buyout fund structures don’t allow for longer ownership, calling Warren Buffett’s long-duration capabilities in Berkshire Hathaway Inc. “the perfect private equity model.”

“The goal is to look for longer-term, defensive deals — deals for which we are prepared to accept a little bit less leverage, a little bit smaller returns, because there is less risk and a greater resilience to economic slowdowns,” Lescure said of the strategy with New York-based KKR. “There’s no defined time horizon. Yes, it’s probable that in five, seven or 10 years we will decide to sell this business and move on. But neither KKR nor we have the obligation to sell.”

Onex, Canada’s largest buyout firm, agreed to buy USI from a fund run by Goldman Sachs Group Inc. in 2012, in a transaction valued at $2.3 billion. USI has since made more than 30 acquisitions to increase its network across the U.S., according to data compiled by Bloomberg. Onex and partners made a $610 million equity investment in the initial deal, which is now valued at 3.4 times that amount, the firm said in a separate statement Friday.

KKR has a long history in the business too, leading an investor group that bought a predecessor to Willis Group Holdings Ltd. and then took the broker public in 2001. Former Willis Chief Executive Officer Joe Plumeri was hired by KKR as an adviser in 2013 to help find new deals.

USI, founded in 1994, now has more than $1 billion in annual revenue and 4,400 employees in 140 offices across the U.S., according to its website. It offers a portfolio of diversified insurance and financial services to its customers.

Sweta Singh and Matt Scuffham of Reuters reported on a major deal, KKR, Canada’s Caisse to buy U.S. insurance broker USI:

Private equity firm KKR & Co LP (KKR) and Canadian pension fund Caisse de dépôt et placement du Québec announced plans on Friday to buy USI Insurance Services from Onex Corp (ONEX.TO) for $4.3 billion, including debt.

The deal is the latest in a string of mergers in the insurance market, which has not grown quickly enough to support smaller brokerages.

“It’s a sector we like,” Caisse Chief Investment Officer Roland Lescure said in an interview. “It’s quite defensive, it has high cash-flow generation, and it’s a growing sector where there is consolidation taking place.”

The Caisse, Canada’s second-largest public pension plan, is buying businesses to help it diversify from public equity and fixed income markets.

The pension fund, which has net assets of more than C$270 billion ($202 billion), wants to have 30 percent to 35 percent of its investments in areas such as private equity, infrastructure and real estate in the next four to five years, compared with 28 percent currently.

“At a time when there are lots of fears and questions on the potential protectionism and border adjustment tax,” Lescure said, “being exposed to small and medium companies is a safer way of exposing yourself to the U.S. economy.”

Valhalla, New York-based USI had net debt of about $1.82 billion as of Dec. 31 and generated 2016 earnings of $353 million before interest, taxes, depreciation and amortization.

USI provides insurance and employee benefit-related products to smaller U.S. companies. Its staff of 4,400 operates from 140 offices throughout the United States.

Canadian private equity firm Onex bought USI in December 2012 for $2.3 billion from Goldman Sachs Group Inc’s private equity arm, funding $702 million of that through equity and borrowing the rest, with debt placed on the company.

The biggest deal in the insurance brokerage sector last year was the merger of Willis Group Holdings and Towers Watson. It created Willis Towers Watson Plc, a company with a $17 billion market capitalization.

USI has been active in buying small regional rivals. It has been trying to beef up USI One Advantage, an interactive platform that helps it share information with sales consultants sitting in offices around the United States.

KKR and the Caisse said they expected the deal to close by the end of the second quarter.

Canadian Underwriter also reports, Caisse de dépôt et placement du Québec to buy stake in commercial brokerage USI from Onex:

Toronto-based Onex Corp. is selling its stake in one of the world’s largest commercial brokerages, USI Insurance Services LLC, to Caisse de dépôt et placement du Québec and other buyers.

Valhalla, N.Y.-based USI placed 11th worldwide in an earlier ranking by Finaccord Ltd., of commercial brokerages. USI has 140 offices in the United States, placing coverage for property, liability, auto, excess and environmental, among others.

Montreal-based Caisse de dépôt et placement du Québec manages funds, mainly for pension and insurance plans.

Onex said Friday that Onex and its affiliates agreed to sell USI to an affiliate of New York-based private equity firm Kohlberg Kravis Roberts and Co. LP and Caisse de dépôt et placement du Québec “for an enterprise value of $4.3 billion.” The sale, which is subject to regulatory approval and other conditions, is expected to close in Q2. In its Q4 2016 financial report, Onex said it owned 89% of USI.

KKR and CDPQ will be “partners with equal ownership” of USI, CDPQ stated.

New York City-based KKR said Friday that “KKR and CDPQ, along with USI employees,” agreed to jointly acquire USI.

“CDPQ and KKR are co-leading this investment and leveraging their respective expertise in the sector to support USI’s world-class management as it pursues its strategic plan for long-term growth,” stated Christian Puscasiu, co-head, direct investments, private equity at CDPQ, in a release. “USI operates in a resilient sector characterized by stable, long-term returns and serves small and medium-sized businesses, which are the cornerstone of the U.S. economy.”

Upon completion of the transaction, the Onex Group will have received proceeds of approximately (US) $2.1 billion, including a prior distribution of $181 million in 2015,” Onex said March 17 in a release.

In a 2014 report- Global Insurance Broking: A Strategic Review of the World’s Top 150 Commercial Non-Life Insurance Brokers – London-based Finaccord ranked the top 150 brokers by estimates of commercial non-life broking revenues in 2013. USI placed 11th. Finaccord’s estimates excluded revenues from personal lines, employee benefits, wholesale insurance and reinsurance. The top three were Aon, Marsh and Willis. Eight brokerages based in Canada made the top 150. Chicago-based Hub International Ltd. – whose Canadian operations include HKMB Hub and Totten Insurance Group – placed seventh.

Other firms in which Onex has an equity investment include claims services firm York Risk Services Group of Parsippany, N.J. and Toronto-based electronics equipment maker Celestica, which was spun off from IBM Corp. in 1996.

Onex was founded in 1983 by Gerry Schwartz, currently chairman, president and CEO.

Onex made a killing off this deal, buying USI from Goldman Sachs for $2.3 billion in December 2012 and selling it to the Caisse and KKR for $4.3 billion in a little over four years.

So, what is this major deal all about? It’s a large co-investment where KKR sourced the deal and presented a great opportunity to the Caisse to buy a growing US insurance broker which provides insurance and employee benefit-related products to smaller US companies.

Remember, fund investments and co-investments are an integral part of investing in private equity at Canada’s mighty PE investors. They invest in funds where they pay the big fees (typically 2 & 20) and then get to co-invest alongside them on bigger deals where they pay little or no fees (the bulk of their direct investments in private equity come from co-investments).

In order to do this properly, they need to 1) select the right private equity partners where they get solid alignment of interests and 2) hire smart people in private equity who can quickly analyze co-investments to limit turnaround time and act quickly when great opportunities present themselves.

Now, as far as this deal goes, the Caisse’s CIO Roland Lescure nailed it: “It’s a sector we like. It’s quite defensive, it has high cash-flow generation, and it’s a growing sector where there is consolidation taking place.”

What else? Interest rates are at historic lows and insurance companies have been struggling to generate revenues in this low rate environment. The ones that are growing, like USI, are growing through acquisition and when rates finally start creeping up, they will be well placed to generate even more revenues.

For the Caisse, this is a long-term investment which fits into its investment philosophy of investing in solid cash flow businesses across public and private markets.

What else has the Caisse been investing in lately? Earlier this month, Barbara Shecter of the National Post reported, Caisse de dépôt pumps US$700 million into GE water venture:

The Caisse de dépôt et placement du Québec is investing US$700 million for a 30 per cent stake in General Electric’s Water & Process Technologies business.

The Quebec pension giant is teaming up on the transaction with Paris-based sustainable resource management company SUEZ, which will contribute its existing industrial water business to GE Water and will own 70 per cent of the combined water treatment operation.

The transaction values the GE Water, which provides equipment, chemicals and services for the treatment of water and wastewater in 130 countries, at US$3.4 billion.

The Caisse is seeking to increase its exposure to the water sector and executives view Wednesday’s investment as a key part of that strategy to help create generate long-term returns.

“Operating in a core industry, GE Water has built a premier business with recurring revenues and a high-quality and diversified customer base,” Caisse chief executive Michael Sabia said in statement.

“This investment is therefore highly aligned with CDPQ’s long-term vision of increasing its emphasis on stable assets anchored in the real economy, alongside a world-class operator such as SUEZ.”

In a statement, the Caisse and SUEZ said growing water scarcity and the impact of global warming on the water cycle are expected to keep long-term demand strong for water treatment equipment, chemicals and services.

In addition, increasing global concerns related to industrial wastewater and its impact on the environment will make advanced treatment of water “an absolute necessity,” they said.

Water treatment plants are a big business and this deal will provide the Caisse solid returns over the long term.

You might be asking yourself what’s the link between the insurance business and water treatment business. For the Caisse, it all comes down to finding stable, growing businesses with recurring revenues to pay for their members’ long-dated liabilities.

And the Caisse’s CEO Michael Sabia has publicly warned of market complacency, so you know they are preparing for the next downturn and these private investments with stable revenues (yields) figure prominently into their overall defensive strategy.

The same goes for the rel estate investments where the Caisse and CPPIB recently teamed up to invest in Asian logistical warehouses, a great long-term deal for Canada’s largest pension funds.

Lastly, CBC News reported this week, Cost of Montreal’s light-rail train project rises by $500M:

The cost of a long-awaited Montreal light-rail commuter train line is going up by half a billion dollars.

CDPQ Infra, the subsidiary of the Caisse de dépôt et placement du Québec overseeing the project, presented an update Tuesday on the work done so far.

The project, which would link downtown Montreal with the South Shore and West Island, was initially pegged at $5.5 billion. Now it’s at $6 billion.

Quebec’s pension fund, the Caisse de dépôt et placement du Québec, is funding the project and has committed $3 billion to building the 67-kilometre light-rail transit system (LRT).

Michael Sabia, the head of the Caisse de Depot, said he isn’t worried about costs getting out of hand.

“It’s deliberate decision-making. It’s not costs just rising out of neglect or mismanagement — not at all,” Sabia said.

Those decisions include adding three new stations in Montreal and adding more cars to take the pressure off the Metro’s Orange line.

Sabia doesn’t believe the heftier price tag will affect ongoing funding negotiations with the federal government.

A good investment, environmental group says

Environmental group Équiterre considers the additional costs to be a good investment.

“There’s been a lack of investment in public transportation for years, so to see money being put into transportation for a project that has great impacts, we see it in a positive light,” said Colleen Thorpe, Équiterre’s director of education programs.

Deal with agricultural groups

The groups says it’s also pleased an agreement was struck to limit urban sprawl and protect farmland around the site of the South Shore station.

The consortium behind Montreal’s planned light rail project announced an agreement with local agricultural groups and municipalities to promote the use of agricultural land.

CDPQ Infra said the partnership will mean the creation of an agricultural land trust and, eventually, a park aimed at promoting the use of agricultural land.

“Through this agreement, we are laying the groundwork for a unique initiative to promote the use of the agricultural land located around the South Shore terminal station,” said Macky Tall, president of CDPQ Infra.

The consortium has been criticized by some environmental groups for failing to protect agricultural land.

The first trains are expected to run by the end of 2020.

Critics abound on Montreal’s light-rail transit system but as I already covered here, the public doesn’t have a full understanding of who these critics are and why they’re desperately trying to torpedo this project.

Moreover, I will state this one last time, greenfield projects of this scale and magnitude are always going to run into problems and cost overruns but I’d rather have the professionals at CDPQ Infra managing this project than some government bureaucrats awarding contracts to various construction companies (the Caisse assumes the risk of these cost overruns, not the Quebec government, so it’s in their best interest to try to minimize them as much as possible).

Again, the people working on this project are first-rate world class professionals who know what they’re doing and will deliver a great product on time and on budget. Sabia isn’t worried about costs getting out of hand and neither am I (keep in mind this project is Michael Sabia’s baby, he isn’t micromanaging it but he’s definitely present and takes an active part in the decision making).

That wraps up my overview of the Caisse’s Q1 activity. Below, Bloomberg’s Scott Deveau reports on the Caisse and KKR’s $4.3 billion deal to buy USI from Onex. I am glad private equity has discovered Warren Buffett and this this is a great deal for KKR and the Caisse.

Reporter Ed Mendel covered the California capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com.

Using new power for the first time, the CalSTRS board is expected to increase the state contribution to the teacher pension fund this week, a response to new forecasts of lower investment earnings and longer retiree life spans.

The new forecasts adopted in February increased the funding shortfall. But actuaries still expect CalSTRS to stay on a long path to full funding, thanks to a long-delayed record rate increase in 2014 that will more than double school district pension costs by 2020.

At a media briefing last week, an actuary said one of the factors maintaining a projection of full funding by 2046, despite the larger shortfall from the new forecasts, is new but tightly limited rate-setting power given CalSTRS as part of the funding package three years ago.

“We still think that probability is greater than 50 percent,” said David Lamoureux, CalSTRS deputy chief actuary. A new annual risk report issued last November, before the new forecasts, put the probability of reaching full funding in three decades at 60 percent.

The big risk for public pension funds like the California State Teachers Retirement System is that investment earnings, expected to pay nearly two-thirds of future pensions, will fall below the forecast in the long run, creating massive debt or “unfunded liability.”

California public pension funds originally were limited to bonds with predictable earnings, limiting the risk of major long-term losses. But voters approved initiatives in 1966 and 1984 that now allow any “prudent” investment.

Much of the pension money was shifted into stocks and other higher-yielding but risky investments. Reaching “full funding” when stock markets boomed was used as a rationale (see previous post) for increasing pensions and cutting employer contributions.

But “full funding” is based on earnings forecasts for stocks and other risky investments. Since CalSTRS, like CalPERS, cut contributions and raised pensions when fully funded around 2000, the stock market has fallen, crashed and then rebounded to all-time highs.

A report by Milliman consulting actuaries in 2013 said if CalSTRS were still operating under its 1990 structure, without the changes made around 2000, pensions would have been 88 percent funded instead of 67 percent.

Now a new actuarial report prepared for the board this week said CalSTRS funding is 63.7 percent with an unfunded liability of $96.7 billion as of last June 30, compared to 68 percent funded and a $76.2 billion unfunded liability the previous year.

The new report is based on an earnings forecast lowered from 7.5 to 7.25 percent. The forecast will be lowered again to 7 percent next year. Using current data, funding would drop to 61.8 percent and the unfunded liability would increase to $105.1 billion.

A four-decade history of CalSTRS funding in the new actuarial report shows the funding level or ratio increased each year from 1975, when it was only 29 percent, to 1999 when it remained at 104 percent before peaking in 2000 at 110 percent.

The string of steady increases continued through a major transition when legislation in 1982 gave CalSTRS management of its investment fund, which previously was managed by the larger California Public Employees Retirement System.

The history also shows how the downward zig-zag of CalSTRS funding since the peak in 2000 is the result of rapidly growing future pension costs outpacing the modest gains from contributions and investment earnings.

The actuarial assets increased by more than half, growing from $102 billion in 2000 to $170 billion in 2016. The actuarial obligation for future pensions nearly tripled, growing from $93 billion in 2000 to $267 billion in 2016.

The table showing the history of CalSTRS funding does not include a large and unusual inflation-protection side fund, valued at $12.8 billion last June. In the latest report, the fund had a surplus of $5.6 billion as of June 30, 2015.

Most pension funding is based on projections of money received in the future. But the CalSTRS Supplemental Benefit Maintenance Account is expected to have enough money on hand to keep pensions at 85 percent of original purchasing power through June 30, 1989.

The account is funded by a vested annual payment from the state of 2.5 percent of teacher pay ($607 million last fiscal year) and a rare fixed investment return equal to the CalSTRS earnings forecast, whether actual earnings are above or below the target.

The table shows that since the stock market crash in 2008 the CalSTRS pension fund grew from $155.2 billion to $170 billion last fiscal year. The inflation-protection account more than doubled, growing from $5.3 billion in 2008 to $12.8 billion last fiscal year.

During the same period, the number of CalSTRS retirees receiving the inflation-protection payments dropped from 89,412 receiving $348 million in 2008 to 47,764 receiving $172 million last fiscal year.

In the latest biennial report for the fiscal year ending June 30, 2015, Milliman actuaries projected that if inflation remained at 3 percent, the account could keep pensions at 85 percent of original purchasing power forever or at 91 percent through June 30, 1989.

But if inflation remained at 3.75 percent, Milliman projected the account would be empty in 40 years. CalSTRS members do not receive Social Security, and their annual 2 percent cost-of-living adjustment is based on the original pension amount, not compounding.

Will the big surplus in the inflation-protection account become a target as school budgets continue to be squeezed by the doubling of CalSTRS rates for teachers, in addition to the doubling of CalPERS rates for non-teaching employees?

The state withheld payment to the account in 2003 to help close a budget gap. An appeals court ruled in 2007 that the account must be repaid $500 million, citing a law (AB 1102 in 1998) that made the state contribution, 2.5 percent of pay, a vested right.

Why the law made the contribution a vested right, but not 85 percent of orginal purchasing power, is unclear. (See previous post) Perhaps the intent was to create a fund surplus large enough to allow an increase in purchasing power protection.

The Supplemental Benefit Maintenance Account began with legislation in 1989 that restored 68.2 percent of original purchasing power. Later legislation moved the purchasing power to 75 percent in 1997, 80 percent in 2001, and 85 percent in 2008.

There apparently has been no study or analysis of whether the CalSTRS inflation-protection program is cost efficient or wasteful. CalPERS, for example, provides inflation protection through its overall employer-employee contribution rate.

The new risk report issued last November said the inflation-protection account is expected to grow from the current 6.4 percent of combined CalSTRS investments to nearly 15 percent in 30 years.

The growth will create “increased volatility” or larger swings in investment returns and the need for contribution increases, said the report. The CalSTRS board, with its limited power, will have more difficulty setting contribution rates that ensure full funding if long-term returns fall short.

The funding legislation in 2014 authorized CalSTRS to raise state rates by up to 0.5 percent a year, reaching a maximum of 23.8 percent of pay before the legislation expires in 2046.

This week, the CalSTRS board is expected to use the power for the first time, raising the current state rate of 8.8 percent of pay by 0.5 percent. The increase is included in the $2.8 billion payment to CalSTRS in Gov. Brown’s proposed state budget.

The funding legislation will more than double CalSTRS rates paid by school districts, up from 8.25 percent of pay to 19.1 percent by 2020. After that, CalSTRS can raise school district rates to no more than 20.5 percent.

Reform legislation giving teachers hired after Jan. 1, 2013, lower pensions requires them to pay half the “normal cost” of pensions earned during a year, excluding debt or unfunded liability from previous years that can be a much larger amount.

The CalSTRS board previously was expected to raise the rate for new teachers by 1 percent of pay in July, up from the current 9.21 percent of pay. Now the increase is not expected until next year, actuaries said last week.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Matt Scuffham of Reuters reports, Ontario Teachers’ Pension Plan sees lower 2016 rate of return:

The Ontario Teachers’ Pension Plan’s rate of return dropped to 4.2 percent last year from 13 percent in 2015, the fund said on Wednesday, citing unfavorable currency movements.

The results still exceeded a benchmark target of 3.5 percent for the fund, Canada’s third-biggest public pension plan.

The plan, which administers pensions for 316,000 working and retired teachers in Canada’s most populous province, said its net assets grew to C$175.6 billion at the end of 2016 from C$171.4 billion a year earlier.

The fund, which has investments in more than 50 countries, said currency movements had a negative impact of 280 basis points on its rate of return in 2016, compared with an 830-basis-point positive effect in 2015.

Ontario Teachers’ said it was 105 percent funded as of Jan. 1, meaning it had a surplus of assets with which to meet its future pension obligations. This was the fourth year it has posted a surplus after a decade of recording annual deficits.

Chief Executive Officer Ron Mock said the fund had achieved that despite major challenges in the global economy.

“Being focused on the long-term, we continue to believe having a highly diversified portfolio is the best way to pay pensions and minimize funding volatility over time,” he said.

“Last year big swings in global currencies had an impact on the short-term value of Plan assets,” he added.

Ontario Teachers’ pioneered a move by Canadian pension funds in the 1990s to invest directly in private companies, infrastructure and real estate internationally as an alternative to Canadian equities and government bonds.

No doubt, currency swings were a big factor behind Ontario Teachers’ 2016 results. Scott Deveau of Bloomberg reports, Ontario Teachers’ Posts Worst Return Since 2008 on Pound’s Drop:

The Ontario Teachers’ Pension Plan posted its worst annual return since 2008 after the plunge in the British pound and other currency moves curbed investment gains.

The 4.2 percent gain for 2016 was down from 13 percent in 2015, and trailed the fund’s average annual return of 10 percent since it was founded in 1990. It was the worst performance since the financial crisis.

Ontario Teachers’ blamed the lower returns on currency moves, after the Canadian dollar gained last year against the U.S. dollar, British pound and other currencies. The loonie added 3 percent against the U.S. dollar and 23 percent against the pound, according to Bloomberg data.

“The big mover last year was the British pound,” said Bjarne Graven Larsen, Ontario Teachers’ chief investment officer. “Usually we do not hedge in general. But we felt that before the referendum in the U.K. that it was a significant risk so we decided to hedge 50 percent of our significant position in the British pound.”

The pension fund manager, which has investments in 37 global currencies, said its returns were 7.2 percent in local currency terms, before converting to Canadian dollars. The currency swings lowered returns by 2.8 percent, compared with currency gains of 8.3 percent in 2015.

“If you look at currency in the last three years, it has actually benefited us,” Larsen said. “We don’t as a general rule hedge. We know that some years we benefit from it, some years it actually gives us a loss.”

He said the fund’s exposure to the U.S. dollar also eroded returns because more of its assets are based there.

“It might be a battle between the British pound and the U.S. dollar. A larger position in the U.S. dollar but a smaller appreciation,” he said.

Fund Returns

While the pension fund manager said it beat its benchmark return of 3.5 percent, the gains were less than the 7.6 percent return for the Caisse de depot et placement du Quebec and the 10 percent net return reported by the Ontario Municipal Employees Retirement System.

Ron Mock, Ontario Teachers’ chief executive officer, said in a year marred by market volatility, low rates, geopolitical uncertainty and the unexpected Brexit vote, the return of 4.2 percent last year wasn’t bad.

“We do think that the return environment going forward is not going to be the 10 or 12 percents we’ve witnessed over the last eight years,” Mock told reporters in Toronto Wednesday.

“We see it as a pretty solid result and most importantly a pretty solid funding position we find ourselves in,” he said, noting the plan has been fully funded for four years straight.

Fewer Currencies

As part of a broader shuffling of its portfolio, Ontario Teachers’ reduced the amount of its assets in foreign currencies to 40 percent from 60 percent of the portfolio.

“Currency, in all of the pension plans I know of, is a big issue,” Larsen said. “Some hedge. Some don’t. Half of the time, you regret your policy and half of the time you’re happy about it. There’s no easy answer.”

Ontario Teachers’ said its net assets grew 2.5 percent to C$175.6 billion ($130 billion) as of Dec. 31 from C$171.4 billion in 2015.

The fund said the total value of its public and private equity investments were C$66 billion at year-end, down almost 15 percent from C$77.5 billion a year earlier. The fund said the decline was part of an effort to reduce the risk in its portfolio by lowering its exposure to equities and increasing its focus on fixed income.

To that end, the fixed-income portfolio increased to C$75.2 billion at year-end, up nearly 9 percent from C$69.1 billion the year before. The bond portfolio returned 0.8 percent.

Larsen said the portfolio was too “equity-centric” prior to that shift.

“We want more diversification in the portfolio. We want less equity risk factor. But then we’re actually buying other things that will actually yield returns. So, we’re buying more credit and we’re buying other things,” he said. “It’s still the same expected return we’re going for and better diversification.”

What else is Teachers doing? Andrew Willis of the Globe and Mail reports, Ontario Teachers Pension Plan favours minds over machines:

In an era when an increasing number of investors are embracing passive investments such as index funds, the Ontario Teachers’ Pension Plan is putting its faith in its people by allocating more capital to active investment strategies.

Teachers announced on Wednesday it earned a 4.2-per-cent return in 2016, performance that ranked behind peers but exceeded its benchmark and left the $175.6-billion plan with an $11.5-billion surplus.

Last year, Canadian pension plans averaged a 6.8-per-cent return, up from 5.4 per cent in 2015, according to survey from Royal Bank of Canada. Teachers’ 4.2-per-cent return exceeded the 3.5-per-cent performance of its benchmark. Over the past five years, Teachers posted a 10.5-per-cent annual return, and over 10 years, gains averaged 7.3 per cent.

Teachers chief investment officer Bjarne Graven Larsen said in a news conference on Wednesday the fund turned in “solid returns,” with short-term performance reflecting a $4.5-billion negative impact from swings in currency markets last year. Gains on currency moves added 8.3 per cent to performance in 2015, when the fund was up by 13 per cent.

Approximately 60 per cent of the Teachers portfolio is invested in non-Canadian dollar assets, and the fund invests in 37 different currencies.

To reduce risk and increase future returns, Teachers chief executive Ron Mock said the fund decreased the amount of capital it allocates to passive investments in stocks and bonds, shifting the portfolio to sectors in which the fund has in-house expertise, such as real estate, private equity and larger equity ownership in select companies. Mr. Mock said the fund’s “secret sauce” is the internal investment acumen built up over 25 years of investing.

New York-based BlackRock Inc., the world’s largest asset manager, made headlines this week by announcing plans to replace actively managed mutual funds with passive vehicles that rely on computer-driven stock picks. Mr. Graven Larsen said that while Teachers also makes use of cutting-edge technology in the investment process, the fund is increasing its focus on active management.

Mr. Mock warned that investors should not expect the 10-per-cent-plus annual returns turned in by equity markets during bull markets. He said if the fund can consistently generate 4-per-cent “real returns,” after inflation, “we will be pretty happy.”

Teachers has significant investments in Britain and Mr. Mock said the fund plans to continue investing in the region in the wake of Britain’s decision to leave the European Union, because of the country’s attractive regulatory regime and solid economic fundamentals.

As CEO at one of Canada’s largest pension plans, Mr. Mock said he is in regular contact with the federal government over the Liberals’ plans to invest in infrastructure. Former Teachers CEO Jim Leech was recently named a special adviser to the planned Canada Infrastructure Bank.

Mr. Mock said that while Teachers supports the infrastructure bank concept, considerable work needs to be done to align the relationship between private investors and federal, provincial and municipal governments before the fund commits capital. He said that while there are a handful of large Canadian infrastructure initiatives that could be launched within the next year, experience in Australia and Britain shows it can take a decade to get significant projects planned, funded and permitted, in order to start construction.

The Teachers fund has 318,000 active and retired members, including 142 pensioners who are over the age of 100.

By the way, on the newly created $35-billion Canada Infrastructure Bank, Bill Curry of the Globe and Mail reports that Ottawa just hired Metrolinx CEO, Bruce McCuaig, to advise it. Mr. McCuaig will be joining Jim Leech, the former CEO of Ontario Teachers’, who was tapped last month to get this new federal infrastructure bank up and running.

I don’t know but Ron Mock is right, considerable work needs to be done to get better alignment of interests and the bigger, more ambitious infrastructure projects take years to set up and complete.

In the meantime, I agree with those who think Ottawa’s plan to sell airports needs to take off right now — while the market is still hot. This is something that I’m sure Ontario Teachers’ and other large Canadian pensions would invest in and help transform our airports into world class airports.

In fact, just yesterday Ron Mock told BNN that Canadians will be slow to adapt to the concept of privately-owned airports, but will eventually understand their benefit.

As far as the UK, Barbara Shecter of the National Post reports, Ontario Teachers’ Pension Plan dealmakers won’t ‘head for the hills’ as Brexit takes shape:

The Ontario Teachers’ Pension Plan is continuing to hunt for deals in United Kingdom, even as concrete steps were taken Wednesday to extricate the Britain from the European Union.

“We’re not heading for the hills by any stretch of the imagination,” chief executive Ron Mock said at a media briefing Wednesday, shortly after news broke that Britain sent a letter to the European Union that marks a significant step in its move to exit the economic partnership.

The historic breakup has not led to any bargains so far, according to chief investment officer Bjarne Graven Larsen, who noted that while currency fluctuations can sometimes make assets look cheaper, “the pricing of assets in the UK continues to go up.”

Mock said there is likely to be a period of uncertainty, but added that the pension managers are hopeful about the long-term prospects for Britain and the European Union.

The Ontario Teachers’ Pension Plan posted a 4.2 per cent return in fiscal 2016 after accounting for swings in British pound and U.S. dollar. Despite the negative impact of currency fluctuations, the plan exceeded its benchmark return of 3.5 per cent and remained fully funded for its fourth consecutive year, Teachers’ revealed Wednesday.

Net assets rose by $4.2 billion from the previous year to $175.6 billion. Beating the benchmark translated to a “value add” of $1.3 billion, the pension manager said in a statement Wednesday.

“I’m very pleased that Ontario Teachers’ remained fully funded for the fourth year in a row despite major challenges in the global economy,” said Mock, who noted that big swings in global currencies had an impact on the short-term value of the pension plan’s assets.

The fund invests in more than 50 countries with 37 global currencies, and the return on those investments in local currency was 7.2 per cent. Converting those gains back into Canadian dollars has a negative impact of 2.8 per cent. In 2015, currency gains added 8.3 per cent to returns.

At a media briefing Wednesday morning, executives told media the currency impact in 2016 would have been worse if the fund manager, which invests and administers the pensions of Ontario’s 318,000 active and retired teachers, had not hedged about half its exposure to the British pound before the surprising outcome of the Brexit vote.

While currency exposure has helped Teachers’ in the past, Mock and Graven Larsen said the exposed portion of the portfolio is being reduced to around 40 per cent from 60 per cent through a combination of asset allocation, hedging and balance sheet management.

The Ontario Teachers’ Pension Plan, which invests in stocks, bonds and real assets including real estate and infrastructure assets, has posted an average annualized return of 10.1 per cent since its inception in 1990. The five-year return is 10.5 per cent and ten-year return is 7.3 per cent. The plan was 105 per cent funded as of January 1, 2017.

More than three-quarters of the funding of members’ pensions has come from total investment income since 1990, with the remainder coming from member and government contributions.

“We make investments to pay pensions for generations,” said Graven Larsen. “Stable returns and capital preservation are essential to our ability to deliver retirement security to our members.”

Last year, Teachers’ began implementing a new strategy aimed at better integrating its asset selection approach and risk management processes. There are three strategic areas of focus: total-fund returns, value-add above benchmark returns, and volatility management.

The fund’s real assets group, which includes real estate and infrastructure, had total assets of $44.3 billion at year-end, compared to $40.6 billion a year earlier. The real estate portfolio, managed by subsidiary Cadillac Fairview, totalled $26.5 billion in net assets at year-end and returned 7.7 per cent, exceeding the 7.4 per cent benchmark. The infrastructure portfolio had $17.8 billion in assets at year-end, up from $15.7 billion a year earlier.

The total value of the plan’s public and private equity investments dropped to $66 billion at the end of 2016 from $77.5 billion a year earlier. Teachers’ said the reduction was partly due to a strategic decision to reduce total portfolio risk by lowering exposure to equities and increasing exposure to fixed income securities. The investment return in the equities portfolio was 4.8 per cent, compared to the benchmark of 4.9 per cent.

The pension plan missed the benchmark return in two areas: private capital and fixed income. Private Capital investments totalled $26.6 billion at year-end, a decrease from $28.4 billion a year earlier, while the investment return was 4.3 per cent compared to the benchmark of 5.4 per cent.

Fixed Income had $75.2 billion in assets at year-end, compared to $69.1 billion at the end of December 2015. The one-year return of 0.8 per cent was slightly below the benchmark return of one per cent.

Meanwhile, natural resources investments posted a one-year return of 8.3 per cent, above the benchmark of 6.7 per cent. The investments totalled $10.5 billion at year-end, compared to $10.2 billion a year earlier.

OTPP put out a press release, Ontario Teachers’ is fully funded for fourth consecutive year:

Ontario Teachers’ Pension Plan (Ontario Teachers’) today announced it was 105% funded as of January 1, 2017, its fourth consecutive year of being fully funded. Net assets rose by $4.2 billion year-over-year in 2016 to $175.6 billion. The total-fund rate of return of 4.2% exceeded the benchmark of 3.5%, resulting in $1.3 billion in value-add.

“I’m very pleased that Ontario Teachers’ remained fully funded for the fourth year in a row despite major challenges in the global economy,” said Ron Mock, President and Chief Executive Officer. “Being focused on the long-term, we continue to believe having a highly-diversified portfolio is the best way to pay pensions and minimize funding volatility over time. Last year big swings in global currencies had an impact on the short-term value of Plan assets.”

Ontario Teachers’ has investments in 37 global currencies and in more than 50 countries. In those local currencies, the return on our investments was 7.2%. Converting the return on those investments back into Canadian dollars, the currency in which pensions are paid, had a -2.8% impact on the Plan’s total-fund rate of return. By contrast, currency gains added 8.3% in 2015.

Since its inception in 1990, Ontario Teachers’ has achieved an average, annualized return of 10.1%. The five and ten year returns are 10.5% and 7.3% respectively. Total investment income since 1990 has accounted for more than three-quarters of the funding of members’ pensions, with the remainder coming from member and government contributions.

“We make investments to pay pensions for generations. Stable returns and capital preservation are essential to our ability to deliver retirement security to our members,” said Chief Investment Officer Bjarne Graven Larsen. “Our philosophy is that we will perform better than average by having a deep understanding of what is going on in the world rather than trying to make bold forecasts.”

In 2016, Ontario Teachers’ began implementing a new strategy aimed at better integrating its accomplished bottom-up approach to asset selection with a well-established top-down risk management process. The strategy focuses on three pillars: total-fund returns, value-add (above benchmark) returns, and volatility management.

Ontario Teachers’ continues to show strong performance in pension services, according to two independent, annual studies. The plan’s Quality Service Index (QSI), which measures members’ service satisfaction, was 9.1 out of 10 in 2016, and the plan was ranked second, by CEM Benchmarking Inc., for pension service in its peer group and internationally.

2016 investment return highlights by asset class

The total value of the plan’s public and private equity investments totaled $66.0 billion at year-end, compared with $77.5 billion at December 31, 2015. The reduction from the previous year was partly due to a strategic decision to reduce total portfolio risk by lowering exposure to equities and increasing exposure to fixed income securities. The investment return in the equities portfolio was 4.8%, in-line with a benchmark of 4.9%.

Private Capital investments totaled $26.6 billion at year-end, a slight decrease from $28.4 billion a year earlier. Private Capital’s investment return was 4.3%, compared to the 5.4% benchmark.

Fixed Income had $75.2 billion in assets at year-end, compared to $69.1 billion at December 31, 2015. The one-year return of 0.8% was slightly below the benchmark return of 1.0%.

Real assets, a group that consists of real estate and infrastructure, had total assets of $44.3 billion at year-end, compared to $40.6 billion a year earlier. The real estate portfolio, managed by the plan’s subsidiary Cadillac Fairview, totaled $26.5 billion in net assets at year-end and returned 7.7%, exceeding the 7.4% benchmark. The infrastructure portfolio had $17.8 billion in assets at year-end, up from $15.7 billion a year earlier. New investments and higher valuations for existing assets were partly offset by the impact of a stronger Canadian dollar. Infrastructure assets delivered a one-year return of 1.4%, outperforming the benchmark return of -2.3% (As country benchmarks are assigned to each asset class, conversion back to Canadian dollars results in a negative benchmark).

Natural Resources investments were $10.5 billion at year-end, compared to $10.2 billion at December 31, 2015. The one-year return of 8.3% was above the benchmark return of 6.7%.

About Ontario Teachers’

The Ontario Teachers’ Pension Plan (Ontario Teachers’) is Canada’s largest single-profession pension plan, with $175.6 billion in net assets at December 31, 2016. It holds a diverse global portfolio of assets, approximately 80% of which is managed in-house, and has earned an average annualized rate of return of 10.1% since the plan’s founding in 1990. Ontario Teachers’ is an independent organization headquartered in Toronto. Its Asia-Pacific region office is located in Hong Kong and its Europe, Middle East & Africa region office is in London. The defined-benefit plan, which is fully funded, invests and administers the pensions of the province of Ontario’s 318,000 active and retired teachers. For more information, visit otpp.com and follow us on Twitter @OtppInfo.

Attachments:

Net Assets graph

Preliminary Funding Valuation graph

Currency Impact on Total Fund Return graph

Net Investments and Rates of Return by Asset Class chart

Link to 2016 Annual Report

Benchmarks Used to Measure Fund Performance

I am glad Teachers provided links to everything I need to cover its 2016 results. Before getting started, I highly recommend you read the Report to Members, the Report from the Chair, and this Report on Investments.

I also highly recommend you read OTPP’s 2016 Annual Report and at least take the time to read the Report from the CEO (page 3), Management’s Discussion & Analysis on subsequent pages and the Report from the CIO (on page 12).

I had a chance to talk to OTPP’s President and CEO, Ron Mock, yesterday and we went over the 2016 results. I asked him plenty of questions and he was kind enough to answer them all and cover a lot of material.

I began with the most obvious, the impact of currency swings which is front and center in the news articles and in the Annual Report (click on image):

By now, everyone in the world knows Brexit hit Teachers’ results last year and if their investment staff didn’t partially (50%) hedge the Fund’s exposure to the Pound Sterling prior to the Brexit vote, the results would have been even worse.

As stated in the press release, Teachers has investments in 37 global currencies and in more than 50 countries. In those local currencies, the return on our investments was 7.2%. Converting the return on those investments back into Canadian dollars, the currency in which pensions are paid, had a -2.8% impact on the Plan’s total-fund rate of return. By contrast, currency gains added 8.3% in 2015.

Ron told me that in terms of asset returns, 2016 was actually better than the previous year, but when you factored in currency swings, it really detracted from the performance.

Like CPPIB, Ontario Teachers’ typically doesn’t hedge currencies. This means in years where the euro, yen, pound, and US dollar are up relative to the Canadian dollar, they enjoy currency gains but in years where the CAD is doing relatively better, they take a hit on currencies.

The chart below shows OTPP’s currency exposure by country (click on image):

As you can see, the biggest exposure is to the US dollar ($49.6 B) which I recently discussed and stated that I’m still long despite the recent selloff, followed by the euro ($7.8 B) and then the Pound Sterling ($4.5 B).

UK investments are significant for Teachers, especially in private markets like infrastructure where they hold major stakes in airports and other investments in that country. This is why exactly one year ago, Ontario Teachers’ was assessing Brexit risk very closely.

Now, after the fact, anyone could say they should have fully hedged the risk of a yes vote for Brexit and they would have looked like superstars, but that vote was very close and it was a stunner. Thank goodness they partially hedged their currency exposure but even that decision wasn’t a given.

Anyway, Ron told me that Teachers’ implemented a new strategy focusing on three pillars: total-fund returns, value-add (above benchmark) returns, and volatility management.

That last component — volatility management — was to ensure they can maintain the funded status or reduce the volatility of the funded status as much as possible. This new strategy has all sorts of implications in terms of investments, including currency exposures which they decided to limit to 40% from 60% of the portfolio through a combination of asset allocation, hedging and balance sheet management.

Why not fully hedge currency exposure just like HOOPP and OMERS do which is one big reason they both outperformed Teachers’ last year? The way Ron explained it is fully hedging currency exposure adds costs and it could have serious implications on liquidity needs in the short run.

I take a more intuitive approach when thinking of currencies. I believe the US economy will continue to dominate the global economy for many more years which is why I want to be long US dollars over the long run. Moreover, I think the Canadian economy is going to run into all sorts of problems in the next few years so if you ask my opinion, Canadian pensions are better off not fully hedging their currency exposure.

Can there be unexpected negative surprises? Sure, the eurozone might blow up sending the euro even lower, but I think the best way to play currencies is not to hedge or hedge partially like Teachers did when there is significant event risk.

Anyway, if I had to bet, I’d bet Teachers, CPPIB and I believe now PSP will gain from currency exposure this year as they all don’t hedge for the most part.

The important thing to note is big currency swings matter a lot to Canadian pensions that don’t fully hedge currency exposure and they add or detract from net results (I wish every Canadian pension fund had a dedicated section on currency hedging and exposure in their respective annual report).

What else did Ron and I discuss? Compensation. In particular, Ron told me the new strategy had implications on compensation so he enlisted the help of the top investments officers at OTPP to draft and discuss it and then they did a survey to see if the rest of the investment staff were on board.

Ron told me everyone overwhelmingly agreed with the three pillars of the new strategy and the new compensation system, which sort of surprised me somewhat because I told him “there are always egos at pension funds who want their compensation based primarily on individual targets.”

He told me it all stems from the plan’s mission statement and that every employee at OTPP signed off on five core values of the organization, “humility being the first one.”

So, what does this mean in practice and how does it change investment decisions in the short and long run? Ron told me that compensation “has to align with the mission statement” and it was lower last year “because value-add was lower”.

And as you can see from the table below, he wasn’t kidding, apart from Bjarne Graven Larsen who is the new CIO and holds the top investment job at OTPP, all other senior executives including Ron saw their total compensation go down in 2016 (click on image):

Moreover, from now on every investment decision will take into account total fund volatility targets. “You might not see a significant change in a month, but over the next few years, it will represent a significant change,” Ron said.

Are you confused? Well let me clarify. Ron agrees with Jim Keohane and Hugh O’Reilly, the best measure of a pension plan’s success is its funded status, so even if they return double digit gains, add value over a benchmark, it’s meaningless if the pension plan’s funded status deteriorates and that should be reflected in their compensation.

Remember something I keep harping on, pensions are all about managing assets AND liabilities. If rates sink to new secular lows and liabilities skyrocket, it doesn’t matter if pension assets gain, in that scenario, the increase in liabilities will more than swamp any increase in assets, so the funded status will necessarily deteriorate.

Interestingly, Ron told me OTPP was implementing something akin to Bridgewater’s All-Weather approach looking at how their total portfolio would do under various growth/inflation scenarios. He said they were exposed to the “low growth/ high inflation” scenario which was the main reason they decided to reduce their equity exposure and increase their exposure to real assets.

At this point I had to bite my tongue because I’m a well-known delfationista who thinks we have yet to see secular lows on US long bond yields but I trust the folks at Teachers have done their homework and they know which economic scenario their Fund is most exposed to (to be fair, Ron put it this way: “We realized we are under-invested for this scenario”).

Anyway, the critical thing to remember is the new system is looking to reduce risk while obtaining the required rate of return and everyone at Teachers is on board. “It has unleashed a level of innovation and horizontal communication to better structure all our portfolios, placing the plan’s mission statement front and center.” (I am paraphrasing a bit here but that’s what he told me)

In terms of private markets, I asked him if it’s getting tougher to find opportunities. He said yes but they have expert partners that can assist them in finding great opportunities and better managing companies and other investments like airports where one of their consultants was the previous CEO of Heathrow airport for many years.

He agreed with me that most of the direct investments at Canada’s mighty PE investors come from co-investments and said it would be “naive” to think you can go it alone in private equity. I stated it would also be against the best interests of the plan’s beneficiaries and he agreed.

But one thing he said that I learned from is that when a private equity fund wraps up and it comes to the end of its life, quite often the private equity partner will go to Teachers and ask it if it wants to bid on a portfolio company as part of its exit strategy. Ron told me since they sit on the board and know the company well, if they like it, they will bid on it to own it directly after the fund wraps up.

And on co-investments, Teachers typically is the lead investor, does most of the due diligence and knows the deals very well, often presenting opportunities to other LPs who are part of the syndicate on the deal. Interestingly, he added that it’s a mutually beneficial partnership with all their general partners across many asset classes including private equity: “Sometimes they come to us with deals, sometimes we go to them with deals.”

He added: “This is why it’s critical to select the right partners who have the right culture and alignment of interests.”

For example, in my last comment going over why PSP is investing in data centers,  I mentioned Ontario Teachers’ acquisition of Compass Datacenters, a wholesale data center developer it acquired in partnership with RedBird Capital Partners.

On private debt, he told me that “Teachers isn’t there yet” doing some fund deals in private equity but if they were to significantly increase this activity they would opt for the same approach of CPPIB and PSP, namely, find the right talent, seed them with a platform where they own 100% of the assets.

Ron gave me a good example of how Teachers selects its private deals, citing its acquisition of OGF, France’s leading funeral home company. “It has 45% of the market, is very well positioned, and we are contributing to its long-term success with our own value creation plan.”

By the way, they do this for every private market investment, implement a value creation plan and then routinely benchmark themselves against it. Ron was adamant about one thing: “Long gone are the days of financial engineering, either you roll up your sleeves and drive EBITDA growth by increasing operational efficiency, or forget making money in private equity.”

This is the philosophy that permeates every private market activity, including infrastructure where they have a team of engineers with airport and other expertise at their disposal and renewables where they invested with PSP in major sustainable investments, and recently announced a clean energy partnership with Anbaric, a leader in the development of clean energy transmission and microgrid projects.

That’s why I was laughing when I read last night that students, teachers, and climate activists are continuing to pressure the Ontario Teachers’ Pension Plan to immediately stop investing in the destruction of their future by divesting from fossil fuels.

Apart from being ignorant of Teachers’ commitment to renewable energy, it shows that a few plan members don’t understand the plan’s mission statement and why it’s virtually impossible to divest from fossil fuels (not to mention it’s not in their best interests).

Anyway, I’ve covered a lot, I am really tired (exhausted) so I am going to wrap it up here. I think you should all take the time to carefully read OTPP’s 2016 Annual Report and this Report on Investments.

Let me end by thanking Ron Mock for taking the time to speak with me, I know he’s a very busy man but I always enjoy our conversations and still firmly believe Ontario Teachers’ is very lucky he’s at the helm of this venerable organization. If there are any mistakes or things that need editing, I will ask Ron and his senior staff to get back to me and I will edit this comment.