Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.
On Friday, I had a chance to talk to Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP). Before I get to to that discussion, you should all read an article Jim and Hugh O’Reilly, President and CEO of OpTrust, wrote for the Globe and Mail back in February, Looking for a better measure of a pension fund’s success:
The world of business is one where people like to quantify and measure things. This drive has led to the old saw: “If it can’t be measured, it can’t be managed,” and, like all sayings, it has its portion of truth. However, our desire to measure progress can also leave us vulnerable to certain pitfalls.
Too often, we head down the path of holding up metrics as accurate barometers of success because they represent things that are easy to understand, quantify and report. This then raises questions for any business. Are we are on the right track? Are we truly doing the right things for success, not just for this quarter or year, but for the long term? And, most important, are we measuring the right things?
For example, if you were in the business of cutting paths through a forest, you might take measurements of how straight your paths were and how quickly you were progressing. But those measurements would be completely meaningless if you were cutting a path through the wrong forest.
This is a bit of what goes on in the pension-fund industry. Many pension funds view themselves as asset managers, and their metrics for gauging success focus on how the asset side of their balance sheet has done in comparison with public market benchmarks. There is some validity to this approach at a micro level, but in terms of measuring organizational success, it is akin to measuring results in the wrong forest.
Canada’s large public-sector pension plans have garnered considerable acclaim as investors on the world stage. But it’s a misnomer to call us asset managers. We are pension-delivery organizations. The nature of the product we deliver to our members means our goals are fundamentally different from organizations that are simply looking to accumulate and grow capital. We are investing to deliver a specific outcome, which is to make the pension payments to our members that they are expecting.
Despite this, people inside and outside the industry have historically looked to a measure that is short-term, easy to report and easy to understand: annual investment returns.
Each year, when the results come out, people sift through the numbers like fortune tellers trying to discern the future from tea leaves. But it’s all sleight of hand, a showy distraction from the real action. Annual investment returns are just one part of the complex business of running a pension plan. Ultimately, to be successful in delivering pensions to our members, the assets have to outperform the liabilities (which are the current and future pension payments owed to our members). We measure this by looking at a plan’s funded ratio. If a plan’s current assets are equal or greater than the present value of current and future pension payments, it is fully funded and has achieved success.
Positive investment returns are generally a good indication of success, but not always. There are scenarios in which investment returns have been positive and the funded ratio has declined, and conversely times when investment returns are negative yet the funded ratio improved.
Our own industry has been as guilty as anyone else in trumpeting annual returns. In a world in which so many people are in a pension rat race to accumulate the biggest pot of money before they retire, it feels normal to celebrate when we’ve been able to make our assets perform faster, higher and stronger. However, if we are honest with ourselves, it’s not the business we’re in. Does this mean that returns don’t matter? Not at all. What it does mean is that as pension plans, our investment approach must be inextricably linked to the goal of keeping the plan fully funded.
Growing and maintaining our funding surplus over time to ensure we can deliver pension benefits to our members leads to very different decision-making, particularly when it comes to risk management, and the nature and mix of assets that we hold in the investment portfolio.
For members, the true value of a defined-benefit (DB) pension plan is certainty at a stage of life when there is little runway to accumulate more. Beyond the dollars that will one day be paid, we give members the confidence that they can count on their pension to be there when they retire and that their contributions will remain as stable as possible during their working years.
When creating certainty is the true goal, taking undue risk with members’ futures for the sake of a few hundred extra basis points in a given year makes no sense at all. That is why both of our organizations have adopted an approach that puts funding first, one in which we balance the need to generate returns with the need to effectively manage risk.
When viewed from this perspective, being good, better or best will not be assessed on the basis of a given year’s investment return. Instead, we will measure success by the plan’s funded status. This measure of success also means that plans will be focused on putting the interests of plan members first in the decision-making process. In so doing, we will be putting stock in another old saw: “If it isn’t measured, it doesn’t matter.”
This is a great article which nicely covers the importance of a pension plan’s funded status as the true measure of long-term success.
Interestingly, over the weekend, Suzanne Bishopric forwarded me a Vox Eu comment on measuring institutional investor performance which argues that the skill set of institutional investment officers is critically important in producing meaningful outperformance in private equity and that institutional investors could improve returns by paying their investment officers more, by letting them share the upside, and by monitoring them better.
No doubt, you need to pay your investment officers properly, especially in private markets like private equity, real estate, and infrastructure which require unique skills sets, but the message that Jim Keohane and Hugh O’Reilly are conveying is equally important, pensions need to focus first and foremost on their funded status, not taking huge risks to beat their policy portfolio benchmark.
The nuance here is that you can’t blindly compare the performance of one pension plan to another without first understanding how their liabilities are determined and what their funded status is.
For example, Ontario Teachers and HOOPP are widely regarded as two of the best pension plans in Canada, if not the world. They both use extremely low discount rates (HOOPP’s is 5.3% and Teachers’ is just below 5% because it’s a more mature plan and its members are older) to determine their liabilities, especially relative to US pensions which use expected returns of 7% or 8% to determine their liabilities (if US pensions used the discount rate HOOPP and Ontario Teachers use, they’d be insolvent).
In 2015, Ontario Teachers returned 13% as growth in its private market assets really kicked in while HOOPP which is more heavily weighted in fixed income than all of its larger Canadian peers only gained 5.1% last year.
A novice might look at the huge outperformance of Ontario Teachers as proof that it’s a better managed plan than HOOPP but this is committing a fatal error, looking first at performance, ignoring the funded status.
Well, it turns out that HOOPP’s funded position improved last year as it stood at 122%, compared to 115% in 2014, placing it in the top position of DB plans when you use funded status as the only real measure of success (less contribution risk relative to other DB plans). And unlike others, HOOPP manages almost all its assets internally and has the lowest operating costs in the pension industry (it’s 30 basis points).
Now, to be fair, Ontario Teachers’ is a much larger pension plan and it too is now fully funded and does a lot of the things HOOPP does in terms of internal absolute return arbitrage strategies and using leverage wisely to juice its returns, but the point I’m making is if you’re looking at the health of a plan, you should focus on funded status, not just performance.
Yes, the two go hand in hand as a pension that consistently underperforms its benchmark will also experience big deficits but it’s not true that a pension plan that consistently outperforms its benchmark will enjoy fully or super-funded status.
Why? Because as I keep hammering on my blog, pensions are all about managing assets AND liabilities. If you’re only looking at the asset side of the balance sheet without understanding what’s driving liabilities, your plan runs the risk of being underfunded no matter how well it performs.
Now, to be fair, I should also point out that unlike Ontario Teachers and HOOPP, most of Canada’s large pension funds (like bcIMC, the Caisse, CPPIB and PSP) are NOT pension plans mnaging assets and liabilities. They are pension funds managing assets to beat their actuarial target rate of return which is set by their stakeholders who know their liabilities.
Also, unlike many other pension plans, HOOPP, Ontario Teachers and a few other Ontario pensions (like OpTrust and CAAT) have adopted a risk-sharing model which basically states the members and the plan sponsor share the risk of the plan if a deficit occurs. This effectively means that when a deficit persists, members can face a hike in contributions or a reduction in benefits.
It’s also important to understand that HOOPP didn’t achieve its super-funded status fortuitously. It went though a deep reflection after the tech crash when it was underfunded and Jim Keohane who was then the CIO went to Denmark to understand how ATP was closely managing its assets and liabilities.
That was a huge moment for Jim Keohane and former CEO John Crocker because the entire culture and focus at HOOPP shifted to managing assets and liabilities a lot more closely. That effectively meant HOOPP started immunizing its portfolio, hedging interest rate risk, long before other DB pensions even thought of it and increased its allocation to fixed income assets, effectively derisking its plan and managing its assets and liabilities more closely.
[Note: In a phone conversation, Leo de Bever, AIMCo’s former CEO, told me that “HOOPP started hedging interest rate risk long before others, including Ontario Teachers.” He also told me at one point, Teachers’ had 25% allocated to real return bonds.]
The timing of that decision proved to be critical as HOOPP now enjoys a funded status that most other DB pension plans can only dream of. I wish my father and his physician friends had access to a HOOPP long ago because that would have made their retirement a lot smoother.
[Note: HOOPP is a private plan which manages pensions of Ontario’s healthcare workers but not Ontario physicians. I’m sure if doctors in Ontario had a choice they too would prefer to fork over their retirement savings to HOOPP than some mutual fund in their RRSP and enjoy a real DB, not DC pension.]
The above rant that was my preamble to my conversation with Jim Keohane on Friday. I also got to LinkIn to Hugh O’Reilly and exchanged messages with him but I will have to cover changes at OpTrust another day when I talk with him and his CIO, James Davis.
I’ve said it before and I’ll say it again, Jim Keohane is one of the smartest and nicest pension fund leaders I’ve ever had the pleasure of meeting. They’re all nice but Jim really takes the time to talk to me and explain things in clear terms. I am very fortunate to have access to him and others when covering pensions and investments.
So what did we talk about? We covered a lot of topics which I will summarize below. Please take the time to read his insights and any errors are entirely mine and will be edited if needed (I will ask Jim to review my entire comment):
- On Fed policy and buying bonds with negative yields: Jim thinks the Fed is in a bad corner and needs to raise rates in order to have ammunition to combat the next recession. He didn’t say whether he thinks the Fed will raise in September or December but he did say with rates at zero, policy will be more constrained when the next crisis hits. More importantly, he told me that HOOPP will never buy bonds with negative yields. “It just doesn’t make sense. Many institutions are forced to which distorts the market but if you think about it, why buy a bond where you know with certainty you’re payoff is negative?” (Leo de Bever thinks the return on risk in bonds will be low to negative in the coming years).
- On real estate over fixed income: That discussion led to an interesting discussion on bonds. I told him that I view bonds as the ultimate diversifier in a deflationary world and can’t take seriously all this talk of a bubble in bonds or cracks in the bond market. Jim explained to me it’s not a matter of bubbles in the bond market, which he doesn’t believe in either, but rather long term investing. “Why hold bonds over the next 15 years? Bonds are a hedge against a decline in rates but rates have already declined significantly.”Okay, fair enough but if not bonds, then what? He told me he prefers real estate with cap rates at 5-6% over bonds over the next 15 years. “Even if you take a big 20% hit on asset values, you will still come out of ahead just on the differential of rates” (I thought to myself true provided of course we are not entering a prolonged period of debt deflation).
- On the risk of deflation or inflation: Jim didn’t tell me whether he thinks deflation will prevail over inflation but he did tell me that real return bonds are very cheap. “The breakeven trade (spread between nominal and real return bond yield) is at historically cheap levels. Market is calling for long term inflation of 1.3% and bonds are pricing in a depression” (all true but I wouldn’t ignore the bond market’s ominous warning).
- On HOOPP’s real estate investments: We talked about Brexit and how cheap the pound is which makes it cheaper for Canada’s large pensions to invest in the UK. Jim told me that HOOPP invested in UK real estate which is basically a large warehouse and port for technology driven firms like Amazon. “You have them in North America but not in Europe and these are great projects with solid tenants. We are even building one for BM in Sweden.”
- Of course, I had to ask why wouldn’t an Amazon or other tech giants invest its mountain of cash in such real estate projects? Jim told me it’s all about return on investment: “Why tie up their capital in a project yielding 6% or 7% per year when they can earn 12% focusing on other projects? The same goes for banks, why buy real estate when they can put your capital at work and earn more elsewhere?” Excellent point.
- On the benefits of greenfield real estate: In December, HOOPP will be moving from 1 Toronto Street to 1 York Street. The new offices will be just a few blocks from its current location. What is interesting about this building is that it was a greenfield project. In fact, 1 York Street is a new 800,000 square foot, 35-storey, LEED Platinum office development in Toronto’s South Core which already has solid tenants. Jim told me “the cost of construction is cheaper than buying a building and even though it took five years to build, it’s well worth it.” He added: “New buildings are significantly more energy efficient which means HOOPP will collect more rent per square foot and the tenants will benefit from less common costs.” Still, he admitted “there is a big time lag in greenfield real estate projects and it takes expertise to do it right.”
- On Vancouver real estate: Jim told me that article about Canadian pensions unloading Vancouver real estate was way overdone and misleading. “Yes we sold one project but are building an ever bigger project a few blocks down which will be a shopping center with condos. No reporter bothered to contact us so we can explain our real estate projects in Vancouver.”
- On pricey infrastructure: I noted that HOOPP is a “big laggard” in terms of infrastructure relative to its larger Canadian peers but this didn’t seem to phase Jim one bit. “If you look at OMERS Borealis, they have a great infrastructure portfolio but they were first movers. That is great for their members but they haven’t done as many big infrastructure investments in the last few years because deals are a lot pricier as competition is fierce.” I asked whether he still thought pensions are taking on too much illiquidity risk and he said “yes, no doubt about it.”
- On the stock market: We talked about stocks and sectors. Jim told me he thinks many banks are cheap, “selling at book value” and that they are still positive on the energy sector. Given my views on deflation (terrible for financials) and the US dollar, I bit my tongue but also understand his long term view.
- On emerging markets: Jim told me that emerging markets are “ok from a price perspective but vulnerable if global liquidity is weak.” Again, given my views on the US dollar and deflation, I would steer clear of emerging markets until a much better buying opportunity presents itself, say if anothert EM crisis erupts.
- On the big risks that keep him up at night: He told me: “With low rates, there’s a lot of risk out there. Valuations are stretched and there’s nothing cheap out there.
- On HOOPP’s S&P volatility trade: In 2012, HOOPP gained a whopping 17% as everything kicked in, including their liability driven investments and long term option strategy which was basically selling 10-year vol when the S&P was at 1000. I asked him if they are buying long term vol at these levels but he told me “it’s priced high”. He also made an excellent point that “10-year vol swaps are NOT 10-year vol options” and “many investors entering these 10-year vol swap trades are going to get killed.”
Finally, it is worth noting that HOOPP is on track for another stellar year, which doesn’t surprise me as I stated this on my blog a couple of months ago. Given their high allocation to fixed income (44%), it’s not surprising that they will deliver outstanding results (bonds are performing well so far this year).
And what if the bond market cracks and rates shoot up? Jim had an answer for that too: “It’s all about assets vs liabilities. If rates go up, our liabilities will decline significantly, so even if we get hit on fixed income, we will still maintain our fully-funded status.”
Smart guy, real smart and super nice. Jim Keohane reminds me a lot of Ron Mock, another nice guy who really knows his stuff. It’s hardly surprising these two pension plans are the envy of the world.
On that note, please forgive my tardy comment, I’ve been battling an ear infection (swimmer’s ear is very painful) and have been visiting our super hospital frequently (looks like antibiotics are kicking in). If there are any errors or additional information, I will edit this comment.
Once again, I thank Jim Keohane for graciously offering his time and wise insights. There are many reasons why HOOPP is one of the best pension plans in the world, and if you ask me, the number one reason is its amazing leader.