OTPP Gains 14.3% in 2010 But Funding Challenges Persist

Via Pension Pulse.

On Tuesday, Ontario Teachers' Pension Plan (OTPP) announced, Teachers’ turns in 14.3% rate of return, net assets hit $107.5 billion, but funding challenges remain:

The
Ontario Teachers’ Pension Plan (Teachers') today announced that it
earned the largest value-add dollar amount in its history in 2010. It
ended the year with $13.3 billion in investment income, representing a
14.3% rate of return, which is $4 billion above its 9.8% benchmark.
Net assets totaled $107.5 billion as of December 31, 2010.

“Our
investment team remained true to our investment fundamentals, taking
appropriate risks to earn solid returns, while seeking the best
diversification to meet our plan’s long-term needs,” said Teachers’
President and CEO Jim Leech. “Our Member Services team also had an
exceptional year, scoring a 9-out-of-10 quality service rating from
members, second against its peers around the world, and meeting its cost
objectives.”

“Our employees
exceeded expectations this year, but the plan continues to face serious
funding challenges,” Mr. Leech noted. He explained that the plan is
facing systemic funding problems. “The root cause of the $17.2
billion preliminary funding shortfall is a combination of factors:
member longevity, retirement periods that exceed working years, low
real interest rates, which reflect lower economic growth going forward,
and the maturity of the plan, which now receives $1.8 billion less in
contributions than it pays out annually,” he said.

The fund’s asset mix was modified in 2010, reclassifying some assets and adjusting certain target allocations. Full details of the fund’s actual asset mix and the asset mix policy are available in the fund’s annual report.

The
fund’s equities portfolio holdings totaled $47.5 billion, compared to
$41.2 billion a year earlier. Fixed Income assets totaled $45.9 billion
at 2010 year-end, compared to $35.3 billion in 2009. The fund’s
allocation to commodities increased to 5% in 2010 from 2% in 2009 and
was valued at $5.2 billion at year-end compared to $1.9 billion in
2009.

A new asset classification, Real Assets, comprises real estate, infrastructure, and timberland investments. The
net value of the real estate portfolio totaled $16.9 billion at
year-end, compared to $14.2 billion in 2009. The infrastructure
portfolio grew to $7.1 billion in 2010 compared to $5.6 billion at 2009
year-end, while the timberland portfolio declined to $2.2 billion in
2010 from $2.3 billion at 2009 year-end.

The
plan’s sponsors, the Ontario Teachers’ Federation and the Ontario
government, must eliminate the preliminary shortfall and file a
balanced valuation in 2012 at the latest; they currently are studying
the merits of filing in 2011.

With $107.5 billion in assets as
of December 31, 2010, the Ontario Teachers' Pension Plan is the largest
single-profession pension plan in Canada. An independent organization,
it invests the pension fund's assets and administers the pensions of
295,000 active and retired teachers in Ontario. For more information
visit www.otpp.com.

Teachers' also posted their rates of return compared to benchmarks:

To understand the details behind the numbers, you need to go over OTPP's 2010 Annual Report.
There is an excellent discussion on the plan's funding approach and
funding challenges starting on page 12 (Teachers' is the best at
discussing this issue) which is a must read for all plan sponsors.
Unlike the Caisse and CPPIB, Ontario Teachers' and OMERS have to manage assets and liabilities (Caisse and CPPIB are fund managers, not pension plans).

For me, the interesting discussion starts on page 25, the section on managing investments. I quote the following:

To implement our strategy, we embrace a total-fund perspective that fully integrates the individual portfolios.
This way, we are able to take advantage of our expertise across the
Investment Division and its support groups and to diversify the risks
that the fund takes across many asset classes. Effective communication allows us to maximize the use of risk and capital across the total fund,
as we select diversified assets that have the best chance of providing
the investment returns needed to meet the plan’s long-term needs. We
also align our compensation practices with our long-term view. We
believe that our collaborative approach leads to better investment
decisions and the most efficient use of the plan’s resources.

The message to all other big funds? Break down the goddamn silos and make sure the message is loud and clear that it's the total fund's performance that really counts,
not just the individual portfolios. Senior pension officers have to be
compensated (at least 50% if not more of their bonus) based on total
fund performance, not just their individual portfolio's performance.

On risk management, I note the following (pages 25-26):

Our
risk management activities are focused on the ultimate risk facing the
plan – the risk that the plan’s assets will fall short of its
liabilities (the future benefits owed to members). We recognize that funding risk can come from assets or liabilities. The asset risk is obvious; investments can, and do, decline in value periodically. The biggest risk to plan assets is a decline in equity markets.

...

The liability risk is less obvious but has a significant impact on the plan’s funding status. A 1% shift in the real interest rate assumption impacts projected liabilities by approximately $25 billion on a funding basis. Finally, increased life expectancy also augments pension costs.

On setting asset mix targets, OTPP published this comment (page 27):

During
the year, we reviewed and clarified our asset-mix policy by
reclassifying some assets and adjusting certain target allocations.
These changes were undertaken to enable us to make better asset-mix
decisions for the pension fund and to improve our reporting. For
example, absolute return strategies and money market securities were
previously reported in the fixed income asset class. These assets and
the performance associated with absolute return strategies are now
reported separately. The fixed income asset class now holds primarily
nominal bonds and RRBs. This allows us to more clearly report assets and performance.

On absolute returns strategies, OTPP explains (page 28):

We
employ absolute return strategies in a number of departments to enhance
the fund’s overall returns in an effort to meet the plan’s long-term
needs and minimize funding shortfalls. The goal of these absolute return
strategies is to generate positive returns that are uncorrelated to our
other asset classes.

Absolute
return strategies (which are managed internally) generally look to
capitalize on market inefficiencies and also include external hedge fund
assets that are managed to earn consistent, market neutral returns
while diversifying risk across multiple managers, strategies and styles.

Assets employed in absolute return strategies and external hedge funds totalled $11.4 billion at year end compared to $11.7 billion at December 31, 2009.
The change in the value of our hedge fund investments at year end
resulted from reducing our exposure to some of these investments, as well as the impact of the rising Canadian dollar, which affected valuations for U.S.-denominated hedge funds.

The
money market asset class provides funding for investments in other
asset classes, which is comparable to a treasury department in a
corporation. Derivative contracts and bond repurchase agreements have
played a large part in our investment program since the early 1990s. For
efficiency reasons, we often use derivatives to gain passive exposure
to global equity and commodity indices in lieu of buying the actual
securities. We also use bond repurchase agreements to fund
investments in other asset classes because it is cost effective and
allows us to retain our economic exposure to government bonds.

In terms of performance by asset classes, here are some bullet points:

• Canadian equities (both public and private)
  totalled $9.3 billion at year end compared to $8.4 billion at December
  31, 2009. They returned 14.6% compared to a benchmark return of 13.8%.
  On a four-year basis, these equities generated a 2.2% compound annual
  return, underperforming this category’s four-year benchmark by 1.0
  percentage point.
• Non-Canadian equities (both public and private)
  totalled $38.2 billion at year end compared to $32.8 billion at
  December 31, 2009. They returned 9.4% compared to a benchmark return of
  5.9%, or $1.0 billion above the benchmark in 2010. On a four-year basis,
  these equities generated a -1.3% compound annual return, outperforming
  this category’s four-year benchmark by 3.1 percentage points.
• Private equity investments (included in the above totals for Canadian and non-Canadian equities) totalled $12.0 billion at year end compared to $10.0 billion at December 31, 2009. Teachers’ Private Capital returned 19.0% compared to a benchmark return of 7.1%, or $1.1 billion above the benchmark.
  On a four-year basis, these assets generated a 2.6% compound annual
  return, outperforming this category’s four-year benchmark of -1.2%.
• Fixed
  income assets totalled $45.9 billion at year end compared to $35.3
  billion at December 31, 2009. They returned 9.9% compared to a benchmark
  return of 9.5%, or $0.1 billion above the benchmark for this asset
  category. On a four-year basis, these assets generated a 7.3% compound
  annual return, outperforming this category’s benchmark by 1.0%.
• The
  fund’s policy allocation to fixed income increased in 2010. RRBs were
  previously reported in another asset class. Holdings of government bonds
  – both nominal and RRBs – were increased by $14.9 billion at attractive
  prices. Nominal bonds went on to perform well as interest rates fell
  during the year. RRBs performed very well, which partially offset the impact of declining real interest rates on the plan’s pension liabilities. We have returned to reporting only traditional fixed income investments in this asset class. For clarity, we are now reporting absolute return strategies under a separate category.
• We
  invest in commodities, which typically mirror short-term changes in
  inflation, as a hedge against the cost of paying inflation-protected
  pensions. Investments in commodities totalled $5.2 billion at year end compared to $1.9 billion at December 31, 2009. The
  increase in the portfolio was due to a decision to raise the asset-mix
  target for commodities from 2% to 5% in 2010. The portfolio returned
  3.2% compared to a benchmark return of 3.3%. The one-year benchmark
  reflects the impact of the stronger Canadian dollar. On a four-year
  basis, these assets generated a -7.0% compound annual return, matching
  this category’s four-year benchmark.
• Investments
  in real assets – real estate, infrastructure and timberland – are good
  long-term investments for the pension plan because they provide returns
  that are linked to changes in inflation and act as a hedge against the
  cost of paying inflation-protected pensions. Over
  the past 10 years, these investments have played an increasingly
  important role in helping us to meet our performance objectives and
  minimize risk.
• Prior to 2010, these assets were held in
  our former inflation-sensitive category along with RRBs and commodities.
  RRBs are now included in the fixed income asset class and commodities
  were established as a separate asset class. Infrastructure and
  timberland, previously one portfolio, are now reported as separate
  portfolios. Accordingly, the assets and performance of each are reported
  separately.
• Real assets totalled $26.2 billion at year end. These assets returned 13.9% compared to the benchmark return of 5.5%, or $1.8 billion above the benchmark. On
  a four-year basis, real assets generated a 6.3% compound annual return,
  outperforming this category’s four-year benchmark by 1.0 percentage
  point.
• Real estate
  delivered strong performance on both an absolute and value-added basis.
  The net value of the real estate portfolio totalled $16.9 billion at
  year end compared to $14.2 billion at December 31, 2009. It returned 16.9% compared to a benchmark return of 7.7%, or $1.3 billion above the benchmark for this category.
  On a four-year basis, the real estate portfolio generated an 8.2%
  compound annual return, outperforming this category’s four-year
  benchmark by 1.2 percentage points.
• Infrastructure investments totalled $7.1 billion at year end compared to $5.6 billion at December 31, 2009. Infrastructure assets returned 13.0% compared to a benchmark return of 4.0%, or $0.6 billion above the benchmark. On a four-year basis, these assets generated a 2.8% compound annual return, matching this category’s four-year benchmark.
• Timberland investments totalled $2.2 billion at year end compared to $2.3 billion at December 31, 2009. These holdings returned -3.1% compared to a benchmark return of -0.2%, or $0.1 billion below the benchmark.
  Performance was affected by decreased U.S. demand stemming from the
  housing market slowdown. On a four-year basis, these assets generated a
  2.1% compound annual return, consistent with this category’s four-year
  benchmark.
  

Some of
my comments on OTPP's 2010 investment performance. First, the bulk of
the value added came from private markets: private equity, real estate
and infrastructure. These asset classes trounced their benchmarks in
2010, which tells me the benchmarks are not properly reflecting the
risks they're taking (note: I
was asked to write a piece on pension fund benchmarks for a major
publication where I will clarify this topic in great detail).

Second, while I applaud Teachers' asset mix modifications which enable
them to make better decisions for the pension fund and improve their
reporting, I think it's only fair to clearly report the performance of public equities as well (you have to deduce it).

Third, and somewhat odd, Teachers' states that absolute return
strategies and money market securities were previously reported in the
fixed income asset class "but are now reported separately" and yet I
couldn't find details on the benchmark or performance of this portfolio
which represents a sizable chunk of assets (assets employed in absolute
return strategies and external hedge funds totalled $11.4 billion at year end).
I'm obviously missing something here but Teachers' has to do a better
job reporting on these investments, separating out the performance of
internal alpha vs. external absolute return strategies.

In terms of executive compensation, you can click on the table below for details (page 67):

Finally, Tara Perkins of the Globe and Mail reports, Teachers prepares to tackle funding shortfall:

The sponsors of the Ontario Teachers’ Pension Plan
are considering taking early action, such as boosting contributions or
cutting benefits, to tackle a growing shortfall in funding.

The
gap between the pension fund’s assets and the amount of benefits it has
promised to pay in coming decades will be almost impossible to
eliminate through investment returns alone, a fact made clear Tuesday
when the plan reported its 2010 results.

Although
Teachers’ investment portfolio posted record income above its target
benchmarks during the year, that wasn’t enough to stop its funding
deficit from growing to $17.2-billion from $17.1-billion, as
liabilities outpaced assets.

Now the fund’s investment
professionals are in a bind. “Just at a time when we need greater
returns, we can’t take the risk to do it,” said Teachers chief executive
officer Jim Leech.

While unsettled financial markets are
compounding the fund’s headaches, its biggest problem is demographics.
And the issues it is grappling with are ones that many other pension
funds around the world will soon find themselves facing as well, Mr.
Leech said.

“This is a plan that is
maturing. We’ve been saying that for a decade, and now we’re seeing it
in front of our eyes,” he told reporters at a press conference in
Toronto.

As a group, teachers have been at the forefront of a
number of major demographic and lifestyle shifts; a slew of them were
hired to educate the baby boomers, meaning that the profession over all
skews older than most. In addition, teachers in general tended to quit
smoking and adopt better eating and exercise habits earlier than other
workers, Mr. Leech said.

As a result they are living longer,
even while retiring earlier. And the profession has more women than
most, adding to the longer lifespan.

On
average, Teachers’ members now draw a pension for 30 years, after
working 26 years. In 1990, on average, they received benefits for 25
years after working 29 years. About 45,000 Ontario teachers who are
members of the plan are expected to retire over the next decade.

Those
trends, coupled with losses stemming from the financial crisis, have
created a problem that needs to be addressed quickly. While the pension
plan is solid and could pay benefits for years to come even with no
changes, its sponsors – the Ontario Teachers’ Federation and the
provincial government – must come up with a plan to ensure there will be
money to pay pensions to the province’s young teachers decades from
now.

“The investment department did
exceptionally well, but we are still saddled with a $17-billion
deficit,” said Mr. Leech, whose total compensation amounted to
$3.9-million in 2010, up from $2.3-million a year earlier.

The
plan’s sponsors are required to make a filing with regulators by 2012
demonstrating how they will bring the plan into balance. Since 2005,
they have taken actions to shore up the plan, including special
contribution increases, but it has become clear that this is not a
short-term situation.

Having spent the better part of two years
thinking about the issue, the sponsors are now considering making that
filing this year, ahead of schedule, a move that would give it a jump
start on tackling the problem. No decision has been made yet, and to
make a filing this year, the sponsors would have to do so by September.

Along
with demographics, a good portion of the pension plan’s problems
relate to trouble in the economy and financial markets. The fund posted
a $19.03-billion investment loss in 2008, and low interest rates are
continuing to cause headaches.

A 1-per-cent change in the plan’s
real interest-rate assumption has about a $25-billion impact on its
funding valuation. It takes $900,000 in assets to finance a typical
$40,000 pension when real interest rates are 1.5 per cent, compared
with $735,000 when they are 3 per cent.

Shortfalls are causing
more pain for young teachers because there are fewer working teachers
paying into the plan and more retired teachers drawing benefits than in
the past. That means Teachers’ investment team can’t take large risks.
The percentage of its assets in equities, a relatively riskier asset,
dropped to 45 per cent in 2010, from 61 per cent in 1994.

The
pension plan’s assets now stand at $107.5-billion, below the peak of
$108.6-billion in 2007. The plan took in $2.7-billion in contributions
last year while paying $4.5-billion in benefits, leaving a gap of
$1.8-billion that is projected to grow in coming years.

You can watch Jim Leech, President and CEO of OTPP, discuss the 2010 annual results at the bottom of the press release
(they should post these videos on YouTube with an embed code). I thank
Deborah Allen, Director, Communications and Media Relations at OTPP for
letting me know when the results would be made available. Any errors,
omissions or points of contention in this blog post will be corrected as
soon as OTPP gets back to me with a written response which I will
gladly publish in an update at the end of this comment.

Below, Malcolm Buchanan, retired General Director of OSSTF, is
interviewed at the Congress of Union Retirees of Canada Convention in
Ottawa on the pension crisis by Ish Theilheimer of Straight Goods News,
October 7, 2009 (HT:Gary).

Comments

[Winisk]

No comments?  That is odd.  I appreciate the summary.  I know many teachers that are quick to say how great OTPP is.  After all that's what they are being told so it has to be true right.  I keep asking them why it is underfunded even after the longterm good performance of the investments.  I remind them how it's expected to do if we get into another tailspin in the markets.  I remind them how much more they have had to contribute to keep it funded and that was before the 2008 crash.  I love teasing them.  They are so sure of themselves.  I love the term 'mature' to describe the Ponzi when it becomes difficult to maintain. 

[Leo Kolivakis]

Amazing, not even one comment on this post! I guess people were speechless!

[Deep]

Leo you are a pension expert, my finace is a teacher in toronto, just started 2 years ago, will her pension be safe 25 years from now, me and her are both 31, and i have to start planning.

[Winisk]

No one, not even Leo, can see into the future that far.   They (pension experts) can tell you what you want to hear but that will depend on how accurate their assumptions are.  Many pensions still assume 7-8% return.  Sound reasonable to you?  This much is certain.  Her contributions will go up.  Her benefits will go down.  She won't be able to retire as early as hoped.  And inflation will erode the value of her benefits.  That is if it lasts that long.