With more than $40 billion in assets and 270,000 members and pensioners, the Healthcare of Ontario Pension Plan (HOOPP) saw a return of 12.2% in 2011. The organization has also maintained its fully funded status through levels of market uncertainty not seen in decades. How has HOOPP managed? By focusing on its own weaknesses, applying a liability-driven investment (LDI) strategy and carefully considering fresh opportunities.
Jim Keohane, HOOPP’s CEO, is credited with playing a key role in the adoption of the LDI strategy. The plan—which nabbed the No. 5 spot in Benefits Canada’s 2012 Top 100 Pension Funds—is also fully funded.
“This means, we have sufficient resources to pay every pension owed to the membership—not just now but into the future,” Keohane says. And, taking into account the smoothing reserve, HOOPP has a small surplus, he adds. A smoothing reserve comprises investment earnings set aside to subsidize years of low or negative returns.
HOOPP started to consider the LDI strategy after the 2002 tech bubble burst, when the organization discovered that despite efforts to mitigate equity risk, interest rates were another significant issue.
With those risks uncovered, Keohane pushed for HOOPP to embrace an LDI strategy. He began by engaging the plan’s board of trustees. “We asked, ‘How much risk is too much?’ But it was much more difficult than I expected to get people to quantify what risk is,” he says.
The board settled on a simple principle: it didn’t want to raise the price of the plan or reduce the benefits. “We knew how much money we could stand to lose before we were in that position, so it gave us a high-level idea of [the board’s] risk tolerance.”
Next, HOOPP stress tested its portfolio. “We were in a good funded position but learned there was way too much risk. We were taking on more than we needed,” he says, referring to the plan’s overexposure to equity.
In addition, HOOPP acknowledged the need to address interest rate and inflation risks. “The initial benefit payment is influenced by wage inflation, so inflation has a big influence on what the liabilities end up being.”
The whole exercise took about a year, and the final decision was a $6-billion move out of equities. That money was redeployed into long-term bonds, real return bonds and real estate. This move fundamentally changed the plan’s asset mix, from 60%/40% fixed income/equities to 46%/54%. “Our goal was to increase the interest rate sensitivity risk and reduce equity risk,” says Keohane. “If we hadn’t made that change, we would probably be in an underfunded position.”
LDI informs real estate, bonds
Now the liability-matching strategy makes up 95% of HOOPP’s assets in two categories: inflation-sensitive assets, such as real estate (12.5%) and real return bonds (12.5%), and interest rate-sensitive assets, such as long-term bonds (70%).
The problem is, the LDI strategy doesn’t earn enough to fund the plan in the current environment, says Keohane. HOOPP needs to earn a return of 6.5% to stay funded, and the liability-matching portfolio currently brings in about 4%. “As long-term interest rates decline, that gap gets wider. How do we bridge that without adding undue risk?”
Keohane and his team are already using equity investment strategies to ensure they hit their return goal in the coming years. “We sell long-term options against the S&P 500 because investors are paying a lot for options to hedge variable annuities.”
Even though it seems this financial winter of low interest rates could last years, HOOPP’s LDI strategy and keen sense of opportunity in the equity market leave it well positioned in these uncertain times. Keohane himself remains optimistic. “It’s not to say equity prices can’t go down, but I believe we’re coming to the end of the secular bear market we have been in since 2001. I’m expecting a long run in a bull market, but that may not happen in the short term.