In 2016, Ontario Teachers’ Pension Plan (OTPP) paid staff more than C$360 million ($276 million) in compensation. This is a huge figure in anyone’s world. But when it comes to salaries, the OTPP story is one of value, not absolute figures, and it’s a good case study for investors looking at their own compensation structures.
OTPP has the advantage of being a relatively new organisation, at least compared with some pension funds globally, such as the largest fund in the US, California Public Employees’ Retirement System (CalPERS), which is more than 85 years old. The benefit of this youth is a clean sheet of paper to design an organisation that can be fit-for-purpose and capitalise on governance best practice.
Since it was formed in 1990, OTPP has maintained many of the elements that are now known as the “Canadian model”, which have been identified as tenets of good organisational design and investment practice. These include independence, strong governance, direct investing with world-class teams and the ability to attract and retain talent.
Many other funds have grown up with more complexity, legacy issues – and in some areas naivety around these tenets – than the slick operations of OTPP.
The fund argues that its people are its edge and that only through hiring and remunerating good investment professionals has it been able to implement the ideology that has made it so successful – innovation, low cost and good, consistent returns. Paying good people good money is, and should be, a key part of an organisation that has 80 per cent of its assets managed in-house.
OTPP is 105 per cent funded and has C$180 billion ($138 billion) in assets. It employs 1100 people in its offices in Toronto, London and Hong Kong, and another 1500 in its real-estate subsidiary, Cadillac Fairview.
Its investment strategy is built on innovation and a bedrock of strict risk management, with a large allocation to private assets managed directly (65 per cent of the portfolio is in natural resources, real estate, infrastructure and private capital).
Investments have been the most significant contributor to the success of the fund’s mission. Since 1990, 78 per cent of the pension funding has come from investments, 12 per cent from government and employer contributions, and 10 per cent from member contributions.
Over the last 10 years, OTPP has returned 7.3 per cent against a benchmark of 6.3 per cent. Since inception, it has posted an annualised return of 10.1 per cent.
In contrast, the average 10-year investment returns for US state pension plans to June 30, 2016, was 5.7 per cent. The best-performing state plan returned 7.1 per cent over that decade.
The role of salaries and incentives
Consistent with the fact the vast majority of assets are managed in-house, salaries dominate investment expenses. In 2016, salaries to staff made up 64 per cent of investment expenses at OTPP – C$290.1 million of a total expense of C$451.2 million, its annual report states. (Note: the 2017 OTPP annual report will come out in April).
OTPP paid a further C$33.1 million in compensation to key personnel, including the chief executive, chief investment officer and critical investment staff.
In total, that’s C$323.2 million ($247.5 million) in salaries, benefits and incentives.
To put this in perspective, CalPERS spent only $69 million on investment salaries in 2017, about 20 per cent what OTPP paid.
Comparisons are always fraught, but in trying to uncover value for money, it’s worth exploring the differences between these two funds a little further.
The $345 billion CalPERS, which admittedly has a very different governance structure, including a lay-person board and a government-imposed cap on salaries, has the vast majority of its private equity and real assets managed externally and does not have anywhere near the proportion of direct or private assets that OTPP does. CalPERS has only 20 per cent of its portfolio in private equity and real assets, compared with OTPP’s 65 per cent.
In 2017, total investment expenses for CalPERS were $871.3 million. So while internal staff were paid $69 million, CalPERS spent a whopping $598.8 million on external investment managers and a further $6.6 million on consultants’ fees.
To be fair, CalPERS has been on a cost-cutting exercise for some years now, and in the last four years has reduced its external manager fees from more than $1.34 billion in 2014. But the point remains; on every measure, OTPP outflanks CalPERS, despite its exorbitant staff compensation bill.
CalPERS’ total costs are much higher than OTPP’s, CalPERS is only 68.3 per cent funded, and its 10-year return is an annualised 4.4 per cent versus 7.3 per cent for OTPP.
In 2016, the chair of OTPP, Jean Turmel, received C$170,000 in compensation. In the same year, CIO Bjarne Graven Larsen received C$3,153,728 and CEO Ron Mock earned total compensation of C$4,087,974, making him the highest-paid executive in pension management globally (at least based on what can be gleaned from publicly available information).
But it’s the way OTPP structures its salaries, including strict benchmarking and design principles, that make this an interesting story.
OTPP is fully aware that to attract and retain the talent needed to run its portfolio, it must compete with fund managers, banks and insurance companies within Canada and, for some jobs, globally. So it explicitly makes its salaries competitive with those organisations.
Salaries are made up of a base, an annual incentive plan (AIP), a deferred incentive plan and a long-term incentive plan (LTIP).
The mix of fixed and variable compensation varies by role, with the more senior leaders having a higher percentage of variable pay; for example, for the CEO and CIO, the mix is LTIP (37.5 per cent), AIP (37.5 per cent) and base salary (25 per cent).
Each employee’s incentive pay is designed around the risk budget and the board approves the active risk allocations, which in turn establish expected annual dollar value-added performance goals each year. There are other design rules, too, like an upper limit on annual payments and clawback provisions for wrongdoing.
Depending on the job function, the annual incentive plan (AIP) for executives is a combination of: fund performance, division performance, four-year total fund performance, four-year investment department performance, and individual performance.
Further demonstrating that the incentive scheme aims to align employees with the total plan, staff can choose to allocate all or part of their AIP to a total fund plan, a private capital plan, or a combination of the two, for up to two years.
The deferred amount will increase, or decrease, by the actual rates of return of the plan.
So, similar to how investment management firms align staff with their investment decisions, employees of OTPP can allocate their own pay to the fund. Note again, the fund’s performance since 1990 has been 10.1 per cent, annualised.
The fund’s LTIP is designed to reward employees for delivering total fund net value-added and positive actual returns, net of costs over the long term.
Each year, a small percentage of the year’s total net value added forms an LTIP pool, which is allocated to individuals’ notional accounts.
Individual LTIP accounts are adjusted annually, based on the total fund’s actual rate of return; then, each year, active employees are paid 25 per cent of their individual account balance as LTIP.
Of CEO Mock’s total compensation of C$4,087,974 in 2016, for example, the largest component was the long-term incentive payment of C$2,208,000.
At the beginning of 2016, Mock’s notional account balance was C$7,237,730. The account earned 4.24 per cent, consistent with the total fund performance that year. So Mock was paid C$2,208,000 from this account and so was left with a balance of C$6,623,805.
Mock’s pension value increased by C$771,600 in 2016 and at the end of the year he had a balance of C$5,946,300. This will give him an estimated annual pension benefit at age 65 of C$387,800.
There’s no question the staff at OTPP are paid handsomely, but the incentive structure that has them rewarded through, and invested in, the total fund is a sophisticated alignment of interests.
This has produced stellar investment returns, reduced costs and sustained good performance. But the model’s success can also be expressed in another measure of value.
In 2016, the average starting pension for an OTPP member was C$45,000, this is a significant improvement from when the fund started, in 1990, when the average starting pension for a teacher in Ontario was C$29,000. After all, it’s what goes back to the members that matters.