A new World Bank report showcases the features of the Canadian pension model that have made it the poster child for good design. Through case studies, it gives practical lessons for building world-class pension organisations and acts as a guide for emerging economies seeking to deliver their own retirement security.
Not so long ago, Canadian public pension funds invested predominantly in domestic government bonds, lacked independent governance and were administered in an outdated, error-prone fashion, the World Bank report states.
Today, the country’s top 10 public pension funds manage more than $1.2 trillion in assets, employ thousands of highly qualified professionals, and compete for investment opportunities around the globe.
The report commissioned by The World Bank and written by Common Wealth, The Evolution of the Canadian Pension Model , charts the transformation of the sector by profiling Alberta Investment Management Corporation (AIMCo), the Caisse de dépôt et placement du Québec (CDPQ), the Healthcare of Ontario Pension Plan (HOOPP) and OPTrust.
Its aim is to act as a guide for emerging economies seeking retirement security. The report also urges Canadian funds to collaborate with emerging economies via exchange programs, secondments and capacity building ventures, to help develop these pension sectors.
The importance of governance
The Canadian model, which has long been held up as an exemplar of good pension design, is a balance of strong collaboration between diverse stakeholders and robust independent governance, the report states.
Funds are structured as high-performing entities that are both transparent and accountable.
“Establishing a track record of independent decision-making early in the life of the organisation is important,” the report advises. “The board, and especially the chair, should be willing to push back against potential infringements on the organisation’s independence.”
At the core of the Ontario Teachers’ Pension Plan is “a strong, independent board that ensures Ontario Teachers’ is run like a business”. It’s a phrase from the fund’s founding chief executive, Claude Lamoureux, and remains embedded in OTPP’s self-description, the report notes.
Another way of expressing the concept is the idea that the funds exist at arm’s length from both government and the sponsoring organisations, including labour unions and employers.
This independence lets the funds prioritise “doing the right thing in the long term, over doing the comfortable thing in the short term,” the report states.
Internal asset management
Canadian funds tend to manage the majority of their assets in-house. Roughly three-quarters of the assets of the top 10 Canadian pension funds are internally managed, across a range of asset classes.
But there hasn’t been uniformity in the way this has been achieved. In some cases, in-house teams have been built from the ground up, as with Ontario Municipal Employees Retirement System’s infrastructure subsidiary, OMERS Infrastructure. Sometimes, they have been acquired, as with OTPP’s entry into direct real estate through the acquisition of Cadillac Fairview.
While funds have had different approaches to building teams, many of them began the move to internal management with liquid assets such as public equities, then moved to in-house, direct investment in alternative classes later. But the C$19 billion ($15 billion) OPTrust took the opposite approach, building in-house capability in private markets first and moving to in-house management of public-market investments more recently.
Canadian funds have also used co-investment to enter, and develop expertise in, new asset classes like infrastructure, real estate, and private equity. Much of the co-investment is with other pension funds, in a collaborative approach OPTrust chief executive Hugh O’Reilly calls an “ecosystem”, the report states.
Co-investment allows funds to share risk and lower due diligence costs by working together to scrutinise potential opportunities. In 2012, Canadian pension funds including CPPIB, AIMCo, OTPP, and CDPQ led a consortium of investors that acquired TMX Group Inc., which owns the Toronto Stock Exchange.
Focus on the talent
Today, Canada’s pension funds recruit globally and provide competitive, performance-based compensation to attract top-notch personnel; however, these funds began with small internal teams. They have grown over the years, by attracting qualified professionals and developing internal talent.
Jean Michel, executive vice-president, depositors and total portfolio, at CDPQ, credits talent and independent governance with the organisation’s success over the years.
“When hiring for a new position,” Michel says, “we adopt the mentality of ‘Who’s the best person in the world?’ We want to compete with the best globally.”
In an alternative approach, Edmonton, Alberta-based AIMCo has focused on building a farm team of local talent.
The organisation is not in a financial centre like Toronto; this way it can still ensure the next generation of leadership is in place.
“We have a strong internship program,” C$100 billion ($78 billion) AIMCo chief investment officer Dale MacMaster says. “We build talent from the bottom up. It can be difficult to recruit people, but once they join, they don’t leave, unlike the ‘revolving door’ phenomenon [in bigger financial centres]. Older workers are willing to come back from overseas. In terms of recruitment, you need to be creative, but you can be successful.”
Canada’s pension funds aren’t subject to public-sector compensation limits; exemption from such rules is often part of the founding legislation for these organisations. Compensation typically involves a significant performance-based component, tied to factors such as investment value added, member satisfaction or funded status, the report states.
Diversification and comparative advantage
In the mid 1980s, Canada’s largest pension funds invested most of their assets in local government debt. Today, these funds have large overseas allocations, in equity and real estate especially. Roughly one-third of the portfolios of the top 10 Canadian public pension funds are in alternative asset classes, the report states.
Canada’s pension funds also understand their comparative advantage when it comes to investing. Their strategies include playing to their ability to invest long-term and working with expert partners.
“You can’t be world-class at everything,” AIMCo chief executive Kevin Uebelein says. “You need to be thoughtful about determining the functional areas in which you are truly outstanding.”
The chief executive of the C$70 billion ($54 billion) HOOPP, Jim Keohane, says the fund takes its comparative advantage seriously.
“We don’t believe that we can outsmart people,” Keohane says. “We look to our comparative advantage – what can we do well that other people can’t or are unwilling to do?”
These advantages can appear in very particular areas; for example, OPTrust has developed an edge in midmarket infrastructure by often competing effectively for smaller deals that may not be of interest to larger funds.
Despite the funds’ similarities, there are also marked differences that emerging pension sectors should be mindful of, the report states. While each of the funds employs a highly diversified portfolio, for example, their approaches to asset allocation and portfolio construction vary.
HOOPP’s portfolio is more heavily weighted to fixed income. CDPQ and OPTrust are putting increasing emphasis on emerging markets. AIMCo and HOOPP have kept their efforts largely in developed markets. CDPQ, AIMCo, and OPTrust have invested significantly in infrastructure but HOOPP has stayed away from it, although it does make some direct investments in real estate and private equity.
CDPQ and AIMCo are focused on asset management, whereas HOOPP and OPTrust serve as integrated pension delivery organisations, managing both the assets and the liability side of the balance sheet.
The organisations also differ in their mandates. HOOPP’s and OPTrust’s investment goals focus on paying pensions or liability management but CDPQ has a dual investment mandate: it seeks both to maximise return on capital and to contribute to the province of Québec’s economic development.
Since the financial crisis, HOOPP, OPTrust, CDPQ and AIMCo have put greater emphasis on risk and liabilities. For example, HOOPP has identified three main risks: equity risk, inflation risk, and interest-rate risk. Managing these threats to the plan’s funded status has become the basis of a revamped strategy that focuses on increasing the interest-rate and inflation sensitivity and reducing the plan’s sensitivity to equity markets. OPTrust has recently begun to shift to a similar approach, which it calls member-driven investment.
“Risk has become much more integrated into our investment process,” CDPQ’s Michel says. “The chief risk officer is at the same level as the chief investment officer in the investment decision-making process.”
Like all funds around the world, Canada’s face challenges ahead. Lower expected returns and interest rates will make it more difficult to meet pension promises sustainably.
This ‘low for longer’ environment is leading funds to seek new investment strategies for achieving the required risk-adjusted returns, bringing additional complexity as they expand into new geographies and asset classes, and compete globally for attractive investment opportunities.
Staying focused on comparative advantage and seeking partnerships will be paramount, the report states.
Canadian public pension fund profiles
Assets under management at AIMCo are roughly $100 billion and the fund has had an annualised return since inception, in 2008, of 8.6 per cent; since 2009, $49 billion of AIMCo’s growth can be attributed to its net investment returns, $4.2 billion of which was value added over and above relevant benchmarks. Nearly a quarter of the portfolio is allocated to illiquid markets, including infrastructure, private equity, and real estate. Chief executive Uebelein links successful asset management to five key prerequisites: people and tools; low cost; appropriate risk taking; stable/ patient capital; and proper incentives.
CDPQ has $271 billion ($211 billion) in assets under management and a five-year return of 10.2 per cent. It is unique among Canadian pension funds for its dual mandate: to maximise returns and contribute to Québec’s economic development.
The initial investing approach at CDPQ was focused entirely on bonds. The fund started to invest in public equities in 1967 and created a private equity portfolio in 1971. Through the 1970s and 1980s, it continued to diversify, entering global equity and real-estate markets. In the 1990s, it went into real estate and began boosting the equity allocation from 40 per cent to 70 per cent of assets. In the late 1990s, CDPQ became one of the first Canadian pension funds to invest in infrastructure.
Macky Tall, CDPQ’s executive vice-president of infrastructure and chief executive of CDPQ Infra, offers the following advice to emerging-economy pension funds looking to invest in infrastructure: develop strong in-house teams; find partners with strong local and sector knowledge; take a long-term macroeconomic perspective on the countries where you invest; and ensure there is a stable and transparent framework for private investment.
The fund has assets of $70.4 billion ($54.7 billion) and a 10-year return of 9.08 per cent. It is 122 per cent funded. The HOOPP fund has been divided into two separate branches: a “return-seeking” portfolio and a “liability hedge” portfolio. The return-seeking arm is largely derivatives based; it comprises public equities, private equity, corporate credit, a long-term option strategy, and a variety of other strategies.
The liability-hedge portfolio includes short-term assets, nominal bonds, real-return bonds, and real estate. HOOPP’s journey towards a liability-driven approach began at the time of the dot-com crash of the early 2000s.
“We went from a big surplus to being materially underfunded in less than two years,” said chief executive Keohane, who led HOOPP’s transition to LDI. “Both sides of our balance sheet moved against us – equities crashed and interest rates dropped. We realised the disconnect between our assets and liabilities was one of the biggest risks to the plan.”
OPTrust is the 14th-largest pension fund in Canada, with assets under management of $15 billion. It has a 10-year return of 6.2 per cent and a funded status of 110 per cent. Its alternatives allocation is large, at 38 per cent of assets. In 2015, OPTrust adopted a new investment strategy framework called member-driven investing (MDI). As chief executive O’Reilly explains, the aim is “to change the conversation” away from a narrow focus on returns to an emphasis on pension certainty, contribution stability, and sustainability for plan members.
O’Reilly says this is a fundamental shift, from asset manager to effective “pension management organisation”. Portfolio construction under MDI means a desirable mix of beta exposures. To this, OPTrust seeks to add alpha by using its differentiated skills and relationships to take advantage of market inefficiencies.