Prolific pension plans extend global leadership
Well funded, world class, global scale, ambitious and innovative: Canada’s state pension plans and investment funds richly deserved being dubbed ‘Maple Revolutionaries’ by The Economist. Philip Moore reports on a C$1.1tr sector that has made the rest of the world envious of Canada.
Neil Petroff, executive vice president and chief executive officer at the Toronto-based Ontario Teachers’ Pension Plan (OTPP), says that in 2012 his investment team travelled a total of 12.5m miles. That, he adds, is the equivalent of going to the moon and back 26 times.
OTPP may not yet have explored investment opportunities on the moon, but it has done so more or less everywhere else. “We have investments on every continent except Antarctica,” says Petroff. “That calls for a lot of work and plenty of travel, but when you own an asset in Australia or Chile, you need to make sure it’s being well managed.”
Given that all Canada’s leading pension plans are prolific global travellers, it is fitting that the largest of them all — the Canada Pension Plan Investment Board (CPPIB) — was part of an investor group that bought a 65% stake in Skype from eBay in 2009. At the time, the investment in an apparently speculative internet company by a pension plan regarded as a conservative institution shocked onlookers. But when Microsoft made its $8.5bn bid for Skype two years later, it was estimated that CPPIB’s stake, originally acquired for $300m, was worth a little over $1bn.
So not only did the pension plan generate a $700m-plus windfall for Canadian workers. It also contributed to the growth of a company viewed as a godsend by millions of travellers, who are now able to connect with loved-ones by video from lonely hotel rooms on all corners of the planet.
It is forward-thinking investments in enterprises ranging from Skype and Formula One to countless airports and the world’s largest manufacturer of potty seats, that has enhanced Canada’s pension plans’ collective reputation as what The Economist has dubbed the “Maple Revolutionaries”. “We didn’t set out to be revolutionaries,” says OTPP’s Petroff. “We simply set out to run pension plans as viable businesses staffed by investment-centric people that would earn high risk-adjusted returns over the long term.”
That was back in 1990, when Ontario’s government set up Teachers’ to administer a pension plan that had existed since 1917. Before the establishment of OTPP, the government-sponsored plan had invested almost entirely in illiquid Province of Ontario debentures, with obvious implications for the fund’s performance. By the end of 2012, OTPP had net assets of $129.5bn invested across a highly diversified range of asset classes.
“We were the first Canadian pension fund to invest in real estate, the first direct investor in infrastructure, the first into timber and the first to invest in hedge funds,” says Petroff. “Today, all pension funds around the world will tell you they invest in real estate and hedge funds, but back then these were genuinely seen as being alternative asset classes.”
Global role model
The establishment of OTPP sparked a movement that has since evolved into one of the most successful pension plan systems in the world. While Canada’s economy, its credit rating and its banking industry have frequently been held up as role models for other developed countries in recent years, so too has its pension fund sector. According to a recent OECD report, having grown at 10.6% over the last 10 years (versus a global average of 6.4%), total Canadian pension fund assets are now estimated at C$1.1tr.
The OECD’s report notes that Canada’s funds now hold 5.6% of total pension assets in OECD countries of $20.1tr, which puts Canada in sixth place, behind the US, Japan, the UK, Australia and the Netherlands. In terms of the ratio of pension assets to GDP of 64%, Canada ranks eighth.
Critically, Canada’s pension funds are generally much more strongly funded than those in many other jurisdictions. According to an exhaustive study of 461 defined benefit (DB) pension plans in the US, Canada, Japan and Europe published by DBRS in July, the aggregate pension deficit is now “in the danger zone”. The entry point at which pension plans slip into this danger zone is defined by DBRS as a funded status of 80%, “below which the challenges associated with funding the deficit would become more formidable”.
Not so those in Canada. “DBRS has found that Canadian plans have a higher funded status than the US plans and other international plans in the sample set reviewed,” says the preamble to the 542-page report. “The aggregate funded status of Canadian plans is higher at 84.4%, which is safely above the 80% threshold. Only 12 [Canadian] plans were below 70%, and all were above the 55% funding level.” By contrast, says the DBRS analysis, some of the worst funded plans are now below 50% funded.
While there are more than 5,000 corporate pension schemes spread across Canada, the bulk of the industry’s assets are concentrated among a handful of super-large public plans, led by CPPIB, OTTP and the Ontario Municipal Employees Retirement System (Omers). According to the OECD, Canada has seven pension funds in the global top 100 and 19 in the top 300.
It is these largest plans that are generally regarded as providing a blueprint that other jurisdictions have increasingly looked to replicate. A recent report on the top 10 public plans, published by the Boston Consulting Group (BCG), says that these 10 “are consistently regarded as global leaders by their international peers in terms of their approach to governance and their investment policies, the scale of their assets and their solid performance”.
“This reputation has helped establish Canada as a centre of excellence for managers of quality, large-scale investments,” adds the BCG report.
The right influence
The plans themselves and Toronto-based bankers give a number of reasons for their success. The consensus is that the most important of these is the plans’ governance structure that ensures that they operate as commercial asset managers at arm’s length from the federal or provincial governments with the single objective of maximising returns.
In other words, the public plans observe an investment-only mandate, which ensures they are not influenced by any non-investment objectives related to areas such as social or economic development, or by a home bias. “The funds are entirely agnostic in their investment strategies, and are under no political pressure to invest in Canada or in any of the provinces,” says David Hay, vice chairman of CIBC World Markets in Toronto.
At CPPIB, which manages the assets of the Canadian Pension Plan, which is the mandatory pension plan for all Canadian workers created by an Act of Parliament in 1966, senior vice president and chief investment strategist Don Raymond emphasises how inviolable this code of governance is. “The CPPIB Act spells out our investment-only mandate very clearly, the fact that we’re not civil servants, and that our assets can’t be co-mingled with any other government assets,” says Raymond. “An indication of how the politicians of the day were thinking is that they made the Act very difficult to change. To ensure that future politicians could not use the plan’s assets for anything other than paying pensions, they made the Act more difficult to change than the Canadian Constitution.”
A governance code emphasising independence from government has had a number of important by-products which have kick-started a virtuous cycle at the funds. One of these, says Hay at CIBC, is that from the outset they have been able to attract professionals from the private sector to shape their management style and investment strategy.
When Gerald Bouey, former governor of the Bank of Canada, became the first chairman at Teachers’, one of the first things he did was hire Claude Lamoureux as its CEO. Lamoureux, who has spent the previous 25 years at Met Life of Canada, was recruited — according to OTPP — specifically to “run Teachers’ like a business”.
Sticky and secure
Applying a private sector management style to the public pension funds from their inception has been pivotal to ensuring that they have been able to attract and retain top quality investment professionals. So too has the predictability of the funds’ long term cashflows. “Part of the reason people are attracted to us is the fact that our capital is sticky,” says James Donegan, president and chief executive officer at Omers Capital Markets in Toronto. “The environment is very different to a hedge fund, where large investment losses can lead to withdrawals of capital that puts job security and possibly the business at risk.”
Being able to offer relative job security is an important consideration in a highly competitive but relatively restricted market for talent. So too is a compensation policy that allows the funds to compete with banks and other fund managers for the ablest people. “Our governance structure allows us to pay competitively,” says Donegan, adding that the low turnover rate in personnel at Omers is compelling evidence that the pay structure is appealing.
Donegan is echoed by Raymond at CPPIB, which has the added attraction of being one of the fastest growing pension funds in the world. According to projections made by Canada’s Chief Actuary, CPPIB’s assets will reach $275bn by 2020 and over $500bn by 2050, compared with $183.3bn at the end of 2012. “If your sole objective in life is to make as much money as is humanly possible, this is not the best place to work,” says Raymond. “But there is an element of self-selection in our recruitment policy, and we appeal to managers who value performance-based compensation twinned with the stability of our asset base. Knowing that the asset base is projected to double over the next decade or so is a huge competitive advantage for us.”
Another essential component of the public funds’ success has been their strategy of managing most of their assets in-house, rather than farming out mandates to external managers and paying overinflated fees for the privilege. “We’ve chosen to invest largely internally because we believe the cost of investing in external funds is too high,” says Petroff at Teachers’. “For example, investing in a typical private capital fund would probably cost us about 6% of our returns, whereas managing our exposure internally costs basis points.”
Perhaps the area where Canadian pension plans are regarded as the most accomplished exponents of the direct investment model, however, is infrastructure. According to the OECD’s comparison of Canadian and Australian pension funds, the share of Canada’s institutional participation in infrastructure via direct investment (as opposed to via funds) is the highest in the world.
At Omers, which has the largest exposure to infrastructure among the public funds in terms of percentage allocations ($9.8bn, or 14.8% of assets), Donegan says that the emphasis on internal management of the plan’s net assets of $60.8bn (as of the end of December 2012) is one of the most important pillars of its governance model. “Our structure is the exact opposite from the US where pension plans are provided with a budget from the state treasury to manage their funds, whereas in Canada the funds themselves pay for the management,” he says.
The effectiveness of this model, he says, has led Omers to focus on increasing the internally-managed component of its assets. The plan ended 2012 with 88% of the portfolio managed in-house, compared with 74% five years ago. The long term goal, says Donegan, is to increase the share of the internally managed component of the portfolio to 95%.
The broad focus on internal rather than external management is clearly paying off in terms of overall cost savings. According to the BCG analysis, the average cost of managing assets at the top 10 Canadian funds is about 0.3% of assets. “This level is comparable to passive index exchange-traded funds (ETFs), much lower than the 1.5%-2.5% (or higher) charged by many other managed funds, and lower than the 0.3%-1% average for many other Canadian pension funds,” notes BCG. Its report attributes these minimal costs to the balance between internally and externally managed assets, which BCG puts at 80/20.
The public pension plans’ governance framework also gives them very considerable freedom and flexibility to formulate investment strategies and asset allocation models that aren’t restricted by pre-determined geographical parameters or ratings limits.
Indeed, the Canadian pension plans are probably even freer than a number of sovereign wealth funds, some of which are prevented from investing in their home market. As CPPIB’s Raymond says, Canada’s pension plans used to be subject to similar restrictions, and until 2005 were allowed to invest a maximum of 30% of their assets outside Canada. Today, they are free to invest where they choose, with CPPIB having increased its overseas exposure from 30% in 2005 to 63% today. Raymond explains that this growth in the international component of CPPIB’s portfolio has been important for several reasons.
“The first is the size and structure of the Canadian equity market, which accounts for about 2% of the global market and is very highly concentrated in a small number of sectors,” says Raymond. “There’s very little in industries like healthcare and technology, which restricts the diversification of Canadian equity portfolios.
“More specific to us,” he adds, “is that because we are the national pension fund, diversifying internationally means we rely less on the Canadian economy to fund future pensions.”
Another reason why international diversification has been especially important for Canadian pension funds is that their sheer scale means that opportunities in the domestic infrastructure sector have been limited. Like their Australian counterparts, Canadian pension funds are recognised as being among the most sophisticated infrastructure investors in the world.
Unlike the Australian funds, however, which have a roughly equal exposure to domestic and international infrastructure, Canada’s pension funds have a small exposure to the local market.
“We’re not averse to investing in Canadian infrastructure,” says Raymond. “In fact, our largest infrastructure investment, which is a 27% stake in the 407 toll road, is in Canada. But we need scale in our infrastructure investments, and social infrastructure assets such as $10m hospitals and schools — which is where much of the emphasis has been in Canada — don’t give us the scale we require.”
CPPIB’s target for infrastructure investments is in the range of $500m-$2bn equity participation per transaction, although it is able to invest up to $4bn in single investments.
More broadly, says Raymond, the flexibility and independence of CPPIB’s governance code has allowed the plan to maintain what he describes as a forward-thinking investment strategy. “We start with a reference portfolio which is 65% equities and 35% bonds, which reflects our risk appetite and satisfies our fiduciary mandate,” he says. “As of April 1, 2006, we’ve overlaid an active management approach where we aim to outperform the reference portfolio by diversifying into a wider range of asset classes and geographies.”
Raymond says that CPPIB has done so by applying what it calls a “Total Portfolio” approach. “This allows us to displace public equities and bonds with assets with similar risk characteristics but greater risk-adjusted return potential,” he explains. “If we buy an office building for $100m, for example, which we regard as riskier than bonds but less risky than equities, we would sell $60m of bonds and $40m of equities to finance the acquisition. We thereby maintain the overall risk profile of the fund and hopefully add value at the same time.”
Neither their governance framework nor their innovative investment style, however, has made them capable of the sort of alchemy that would have been needed to insulate Canada’s pension plans from the impact of severe market dislocations. In terms of performance there have been some gruesome years. None more so than 2008, which was especially grim for Teachers’, which saw its total assets tumble from a previous record of $108.5bn at the end of 2007 to $87.4bn 12 months later. While few investors anywhere came away from 2008 unscathed, Teachers’ investment return was minus 18% compared with a fall in its composite benchmark of 9.6%.
Over the longer term, however, the performance of Canada’s leading pension plans has generated demonstrable added value for their members, generally making quick work of recovering from the trauma of 2008. According to data published by the Toronto-based CEM Benchmarking, in 2011 Teachers’ absolute and value-added returns were the highest among its peers globally, for example. In 2012, it delivered a 13% return, generating $2bn above its benchmark.
Among the other largest Toronto-based plans, Omers has posted average annual investment returns in the four years since the crisis of 8.9%, and over the last decade of 8.24%. CPPIB, meanwhile, generated a 10.1% return in fiscal 2013, bringing its 10 year annualised rate of return to 7.4%.
As CIBC’s Hay says, however, assessing the relative performance of Canada’s largest public pension plans is like comparing apples and oranges because each have very different pay-out profiles which has a direct impact on their growth rate and scale. CPPIB, for example, is an accreting fund which will be collecting excess contributions until 2021. Longer term, it will see its total assets grow more than five-fold between now and 2050.
Growth is of course beneficial in that it allows CPPIB to adopt a very long term investment strategy, constructed around the mantra that it aims to deliver performance for its members not over a quarter of a year, but over a quarter of a century. As Raymond says, because the plan is still seeing net inflows, short term price declines need not be detrimental to long term performance. “We focus a lot on markets like Brazil, India and China, all of which have been under pressure in recent months,” he says. “But that’s not necessarily a bad thing because it allows us to buy at lower prices. Market dislocations can provide opportunities because when others are fleeing for the exits, we can be building long term positions.”
True enough, although growth will also bring challenges, reducing the share of the portfolio that can be managed actively and potentially making some publicly traded markets too small and illiquid for CPPIB.
Others are in a very different position. Teachers’, for example, is a mature fund, meaning it has a declining number of active members contributing to the asset pot. In a speech delivered in April, president and CEO Jim Leech said that 2,800 of the plan’s members were aged over 90 and 107 were over 100.
As a mature fund, Teachers’ faces a very different fundamental challenge from CPPIB, as Petroff explains. “We have an annual payroll to retired teachers of about $4.9bn and we only receive contributions of about $2.9bn — $1bn split equally from the government and $1bn from the teachers themselves,” he says. “So unlike a plan like CPPIB, we start every year knowing we’re going to be down by about $2bn. That means we need to be careful about the risk we take.”
This perhaps explains why Teachers’ makes very active use of derivatives to hedge its interest rate exposure, and why it has historically had a weighting of 45% equities in its portfolio, which is lower than other pension plans. It has indicated recently, however, that it will now be looking to increase its exposure to emerging markets in general and emerging market equities in particular. At the end of 2012, Teachers’ had lifted the net share of equities in its portfolio to 47%.
As well as influencing the pension plans’ investment philosophies, their relative scale and growth rate also informs their approach to asset-gathering. While the last thing CPPIB needs is to turbocharge its already very rapid expansion by adding external assets, for a number of other funds the emphasis is on growth. Since 2009, for example, Omers — which had an actuarial deficit of $9.9bn at the end of 2012 — has been permitted to manage third-party assets on behalf of smaller Canadian pension funds.
“We’ve been very deliberate about finding strategic partners, which we have done by establishing innovative capital-raising initiatives,” says Donegan. “One of these is the Global Strategic Investment Alliance (GSIA), where we have co-invested in infrastructure alongside a number of strategic Japanese investors.”
“One of the attractions of acquiring third-party capital is that investment returns can be enhanced if we can buy bigger assets,” he explains. “If you can write a cheque for a billion dollars rather than chase assets worth $100m or $200m, competition tends to be less intense.”