The CFA Institute Annual Conference is an unrivaled opportunity to access high-quality, unbiased educational content that equips investment professionals with the latest thinking on critical industry issues. The 71st CFA Institute Annual Conference will be held in Hong Kong on 13–16 May 2018.
What is the highly acclaimed Canadian public pension fund model, and can its methods be translated to other countries?
To address these questions, a panel of experts convened at the 69th CFA Institute Annual Conference in Montréal for an illuminating discussion. The participants were Ron Mock, president and CEO of the Ontario Teachers’ Pension Plan (Teachers’), which has C$171 billion in assets under management (AUM); Michael Sabia, president and CEO of Caisse de dépôt et placement du Québec, which has C$248 in AUM; Dana M. Muir, professor of business law at the University of Michigan’s Ross School of Business; and moderator Miville Tremblay, CFA, of the Bank of Canada.
So, what are the key characteristics of the Canadian model?
“I would say size, whilst important, doesn’t lead to an obvious advantage,” Mock explained. “What’s more important is clarity of purpose, what to focus on — paying pensions for generations to come — and governance.” To that end, Teachers’ set out to manage both the asset and liability sides of its plan’s balance sheet. The management of portfolio construction and security selection are the main points of emphasis on the asset side. On the liability side, the focus is the interest rate sensitivity of liabilities, aging demographics, and inflation protection.
At Caisse, Sabia highlighted the flexibility of the plan’s internal model of asset management. In common with other Canadian plans, 90% of assets are managed internally. At Caisse, this costs only C$0.38 per C$100 of assets per year. Internal management helps facilitate flexible and unique investment strategies. Caisse differentiates itself from other asset owners by acting as a business owner, developing partnerships, embodying patient capital, and investing in assets rooted in the real economy.
Canadian pension plan governance seems to facilitate investment flexibility. “Teachers’ has an independent professional board. That means we are independent of union politics,” Mock said. “Having that independence and running it like a business allows us to hire the right staff and build the right partnerships. Therein lies the secret sauce.” This approach enables Canadian pension plans to invest more directly than most other pension plans around the world.
Applying the Canadian Model Elsewhere
Wherever there is considerable union or political interference and no independent professional board — common circumstances in the United States and the United Kingdom — the Canadian approach would be impractical. The Canadian framework also means pension funds can invest in their own regions, which in other contexts would tend to invite political interventions. Sabia spoke passionately about how knowing more about the local economy than other investors gives Caisse a competitive advantage when making local investments.
Muir applauded the double-digit returns Teachers’ has earned in the last decade but expressed skepticism that the model could be easily imported to the United States. “Two points make it difficult for us [in the United States]: We have fewer than 20 public plans that have more than US$60 billion, so we need to work on scale if we are to import this model,” she said.
Secondly, on governance, “this model, in a US context, might ask more of a pension board than the US can deliver,” she said, pointing to what she sees as the greater social cohesion in Canada compared with the United States. “I fear that we are more prone to political meddling.” Paying market rates of compensation for staff, direct infrastructure, investment in local economies, and even asset allocation could be problematic for US imitators of the Canadian model.
Send Central Bankers to the Slammer?
One topic of contention was the influence of monetary policy. Tremblay read out the prevailing charge sheet against central bankers, accusing them of “killing all the returns from fixed income, making all other assets way too expensive, and keeping rates lower for longer and perhaps forever.” All this has certainly been a game changer for investors. But Sabia is unconvinced that central bankers warrant such condemnation. Unconventional monetary policy helped prevented an economic catastrophe, he said, and even though it has impacted the risk-free rate and caused investors to move into riskier assets, it has decisively driven innovation.
Over the last 30 years, fixed-income returns helped pension plans achieve returns in line with managing liabilities. “All that is over,” Sabia said. The future will involve less traditional fixed income, such as mid-market lending, sovereigns, and emerging market debt. Additionally, Caisse is looking at cash productive assets, such as leases, royalties, cell towers, and water systems. Faced with the impact of monetary policy, Caisse’s leadership is thinking differently about the future and considering investments in highly regulated infrastructure.
Mock explained that where Teachers’ uses derivatives, it is careful to mark to market on its balance sheet. Teachers’ has a potentially challenging mortality profile, with a membership that is educated, nonsmoking, 70% female, and long living — with over 130 centenarians. Marking these variables to market on its books has driven innovation in infrastructure and real estate.
Talent Development Fuels Innovation
Internal talent is another driver of the Canadian model, according to panelists. “Where normal market rates of return are going to be low for a long time in my view, what we have to lean on is the internal talent that has the capacity to add value,” Mock said. Teachers’ has created a global network of offices to facilitate this. This diversity is especially essential for the 28% of assets that these two large funds deploy in private equity, infrastructure, and real estate. Specialized teams are key. In its small hedge fund exposures, which are structured to maximize correlation benefits, Caisse has a full-time internal team vetting funds intensively, and it also uses hedge funds as a learning window on the latest innovations and techniques.
Caisse’s leadership tries to be creative in its investment entry points by buying distressed assets and considering greenfield developments. It also deploys innovative deal structures, intervenes in underlying investments to boost returns, and utilizes global partnerships. For example, Caisse recently acquired a large stake in Eurostar, the rail service linking London to Europe, and the transaction was facilitated by existing French partnerships.
“Operational excellence in the assets we are involved in is the enduring source of value creation, not financial engineering,” Sabia said. So, use of leverage is very limited, as is use of derivatives: 95% of derivatives use is focused on defensive currency and rates management. At Teachers’, risk and leverage are two different things, and leverage is used to control the portfolio and shift exposures around. “We are not shy about deploying derivatives,” Mock explained. But it is more circumspect about gearing exposures speculatively, and risk is not regarded as a VaR (value at risk) calculation. “Sector specialization is critical in risk management,” he said.
The panel concluded with the consensus that longer-term thinking is critical to success. The recent disaster at Valeant “is the poster child of what can happen when the focus of capital markets is on the short term,” according to Sabia.
Teachers’ likewise embraces the long-term view in constructing its compensation systems. As Mock said, “We avoid trying to dance around the noise that occurs from one quarter to the next.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Photo courtesy of W. Scott Mitchell