As a fresh-faced elementary school student in 1977, Aaron Bennett wasn’t quite in the target demographic for the freshly launched Benefits Canada magazine.
Still, Bennett — now the chief investment officer at Ontario’s University Pension Plan — has a pretty firm grasp on the concerns that would have occupied the minds of his predecessors as they leafed through that inaugural edition, since they bear a remarkable resemblance to the ones he’s currently facing. “History doesn’t necessarily repeat itself, but it often rhymes.”
Flashback to the 70s
For many in the investment industry, the recent spike in inflation brought back memories of the late 1970s — the last time serious doubts were expressed about central banks’ ability to keep rates under control as they spiralled towards double figures.
Read: How to prepare pension portfolios for persistently higher inflation: CPBI session
1977 — First edition of Benefits Canada rolls off the presses
1987 — Ontario’s Rowan Report recommends certain public sector pension funds be allowed to diversify their portfolios by investing in markets and operating as arm’s length entities independent of government
1990 — The Ontario Teachers’ is established following reform of Ontario’s Pension Benefits Act
1991 — The Foreign Property Rule is loosened for the first time since its introduction in 1971, allowing tax-deferred retirement plans to hold up to 20 per cent of their portfolio in foreign assets
1997 — The CPPIB is formed
2001 — The Foreign Property Rule cap is raised to 30 per cent of funds’ book value
2005 — The Foreign Property Rule is eliminated
2008 — The financial crisis spurs a liquidity squeeze, creating opportunities for Canadian pensions
2020 — The coronavirus pandemic shakes capital markets and sparks lockdowns globally
2020 — Eight of Canada’s largest pension plans — the AIMCo, the BCI, the Caisse, the CPPIB, the HOOPP, the Ontario Teachers’, the OMERS and PSP Investments — demand companies adhere to the Sustainability and Accounting Standards Board and the task force on climate-related financial disclosures framework when reporting ESG disclosures
Back then, investors also had to deal with a labour market revolution powered by advances in technology and education, just as members of the baby boomer generation began to establish themselves in C-suites across the country, as well as on shop floors.
These days, Canadian workplaces already shaken up by the mass retirement of workers from the very same generation have seen the coronavirus pandemic reset traditional norms regarding the office and remote working. In either era, Bennett says the disruption of large secular trends brought investment executives at Canada’s largest financial institutions to essentially the same conclusion. “The playbook that we used for the last 10 or 15 years maybe isn’t the right playbook for the next 10 or 15 years.”
But that may be where the parallels end, according to Yusuke Khan, Canada investments leader at Mercer, who explains that the complex combination of assets owned and controlled by today’s typical institutional investor would be unrecognizable to their forebears in the industry. “If you went back to the 70s or before, you would see much more conservative portfolios.”
Over time, pension plans in particular reduced their reliance on bonds, progressing gradually towards the 60/40 split with equities that became the gold standard for balanced portfolios with investors of various sizes, he adds.
Read: The pros and cons of opting for a 60/40 balanced portfolio strategy
Anyone who wanted to get more creative found their ambition constrained by regulations that limited investment beyond Canadian borders. The Foreign Property Rule, established under the Income Tax Act in 1971 to encourage the growth of Canadian capital markets, capped the proportion of foreign investments at 10 per cent of a registered retirement plan’s total assets.
The rule wasn’t loosened until 1991, when the limit on foreign assets began rising in a series of increments, topping out at 30 per cent in 2001, before its elimination altogether in 2005. In the meantime, a package of reforms to Ontario’s Pension Benefits Act cleared the way for the emergence of a Canadian model of pension plan management, characterized by massive jointly-sponsored plans — such as the Ontario Teachers’ Pension Plan and the OPSEU Pension Trust — operating independently and controlling their investment strategies in-house.
“From there, it has really been a quest for innovation and improvement both in expected returns and managing risks,” says Khan.
Following the Canada Pension Plan Investment Board’s formation in 1997, Ed Cass, its chief investment officer, says the end of the Foreign Property Rule was a “tremendously significant” moment in the development of the fund, coinciding as it did with the CPPIB’s shift from passive to active management.
Read: Head to head: Should pension plans be investing actively or passively?
“It allowed us to diversify geographically, which importantly helps insulate the fund against concentration risk in Canada. We now invest in all major asset classes worldwide to enhance long-term risk-adjusted returns through diversification and security selection, while building a highly resilient portfolio. By doing so, the fund benefits from positive global growth in the world’s largest investment markets and remains resilient during periods of slow growth within specific regions.”
Shift to alternative assets
In recent years, the search for yield in a low interest rate environment accelerated Canadian institutional investors’ shift towards alternative assets.
Indeed, between 1999 and 2019, the proportion of defined benefit pension funds’ real estate assets tripled from four per cent to 12 per cent, according to the Pension Investment Association of Canada’s annual asset mix survey, while the actual value of that property exploded over the same period, from $20 billion to almost $280 billion. More recent data from the PIAC suggested around a quarter of all Canadian DB assets fall into the broader alternative asset category, encompassing real estate, private equity and hedge funds, among other investments.
More than a third of the Colleges of Applied Arts and Technology pension plan’s assets are tied up in alternatives, including a small but growing allocation to agricultural investments, according to Asif Haque, the plan’s chief investment officer. “We believe they carry a return premium over public alternatives and we’re giving up liquidity to access these opportunities,” he says, noting his stance is aided by the longer-term investment horizon the CAAT pension plan works on.
Read: Canadian pensions have healthy liquidity despite alternative investments: report
“Canadian pension investors are in a very interesting position in being able to look through current volatility and find value where it exists,” he adds.
Institutional investors in the Benefits Canada era by the numbers
7.6% — Canada’s annualized inflation rate as for July 2022, according to Statistics Canada
8% — Canada’s inflation rate in 1977, according to the OECD
10% — The cap on foreign property as a proportion of total retirement plan assets between 1971 and 1991
$12.3BN — The value of real estate held by Canadian pension funds in 1999 or 4% of their total holdings, according to the PIAC
$278.5BN — The value of real estate held by Canadian pension funds in 2019 or 12% of their total holdings, according to the PIAC
88% — The proportion of Canadian institutional investors that use ESG integration to invest sustainably, compared with a global average of 75%, according to a Schroders survey
James Davis, chief investment officer at the OPTrust, expects the trend towards alternative assets to continue for the foreseeable future, thanks in part to the increased efficiency of public markets. “It’s much harder to add value than it was in 1977. As we head into the future, there’s going to be a lot more continued interest in alternative investing — infrastructure, real estate private equity — because of the diversification benefits of those assets. But probably equally as important is the value-creation potential that those assets provide . . . because of the depth of talent and the depth of relationships that are possible in an institutional investing framework.”
The Canadian pension model
In a 2020 study, Sebastien Betermier, associate professor of finance at McGill University, identified the steady stream of income and diversification that comes with real estate and infrastructure assets as a key plank of Canadian pension funds’ consistent outperformance of their global peers between 2004 and 2018.
“The Canadian funds did better not only when you looked at their overall risk-to-return ratio, but also in terms of asset-to-liability hedging. It was interesting to us, because typically the more you hedge, the more you have to bear costs on returns and that wasn’t the case here.”
In addition, Betermier and his co-authors found Canadian pension funds distinguished themselves from other large pension, corporate and sovereign wealth funds through their heavier use of in-house investment teams, allowing them to manage more than half of their own assets. The Canadian pension plans then compounded their savings by redeploying the extra funds internally, outspending comparable investors across asset classes.
Read: CPPIB doubling-down on Korean industrial real estate, Caisse developing Brazilian rental properties
In a follow-up study, Betermier and his colleagues looked at the extraordinary level of direct real estate investment by Canadian pensions plans, finding their transactions accounted for 60 per cent of the global deal volume involving retirement funds, despite representing just six per cent of all pension assets under management. “Here, the funds are doing it themselves,” he says. “They’re on the ground, building the projects themselves in Toronto, in Montreal and abroad.”
Using domestic data on LEED certification for new and retrofitted buildings, the authors also found Canadian pension funds are pursuing an impact strategy of greening urban properties. “There is this combination of value-added as well as a positive environmental impact,” says Betermier.
A rise in ESG investing
For the CPPIB, environmental, social and governance factors have become increasingly important, says Cass, ever since it began incorporating sustainability into investment decision-making over a decade ago.
“ESG is going to be an even bigger factor in the future. Investors will need to learn how to construct portfolios that both manage the risks, as well as access the opportunities that climate change, in particular, presents,” he says, pointing to the fund’s plan to boost investment in green and transition assets to at least $130 billion by 2030.
When it comes to ESG considerations, Canadian institutional investors are ahead of the game compared to their U.S. counterparts, says Marina Severinovsky, North American head of sustainability at Schroders. “It’s always a year after we’re having conversations with our Canadian clients that we’re having the same conversations with our U.S. clients.”
Read: Canadian institutional investors more likely to integrate ESG than global peers: survey
The 2022 edition of the firm’s annual institutional investor study backs up Severinovsky’s sentiments, with 88 per cent of Canadian respondents reporting they use ESG integration to invest sustainably, compared to a global average of 75 per cent.
• Legislative changes in the 1980s and 1990s set up a golden age for Canadian pensions in which they transformed their structures and made their marks on the world stage as sophisticated asset owners.
• The case for alternative assets recently received a boost as market volatility, workplace disruption and higher inflation signalled the start of a new era for institutional investors, but new investment strategies may be required to meet these challenges.
• Following their relatively recent emergence, ESG factors will play an increasingly important role in institutional investors’ portfolio construction.
She was also struck by the proportion of Canadian institutional investors that identified the positive societal and planetary impact as a driver of their sustainable investment strategy. The corresponding figure was 38 per cent for U.S. investors, who Severinovsky says tend to be more focused on performance. “Maybe what Canadian investors have figured out is that there is money to be made from solving the world’s big problems. It’s not mutually exclusive that you should want good returns and should also be able to address some of those challenges.”
There are still plenty of obstacles for institutional investors seeking to make the most of their sustainable investments, says Melanie Pickett, head of asset owners for the Americas at Northern Trust Corp. While a large proportion of public companies make some kind of ESG disclosure, the quality varies. “Private companies are much more inconsistent and there isn’t really a model that they’ve settled on,” she adds.
In late 2020, a number of Canada’s largest pension plans took matters into their own hands, demanding that companies adhere to the Sustainability and Accounting Standards Board and the task force on climate-related financial disclosures framework when reporting ESG disclosures.
But the issue isn’t unique to ESG disclosure, according to Pickett, who says data analytics capability will be crucial for institutional investors if they’re to thrive in the future, thanks to their increasingly sophisticated asset allocation strategies.
Read: How are pension plan sponsors approaching investments in 2022?
“They need a much more holistic view of exposure. For public assets, there is a lot of market data at hand, but with private investments, it’s a much more complex problem to solve. The underlying exposures are not as transparent.”
Whatever the coming decades bring, Bennett says he’s focused on his job and relishing the challenge. “I don’t spend a lot of time predicting the future, I just try and build resilient portfolios. Volatility is something to keep an eye on, but these are also opportunities — potentially career-making opportunities. My concern . . . over the next several years is to capitalize on some of these opportunities, to bring new tools to bear, to get people engaged and to make investments in areas that are seeing this level of change.”
Michael McKiernan is a freelance writer.