In managing a pension plan, every basis point of investment return and expense ratio and every unit of risk matter. While that has always been true, it hasn’t been as imperative as it will be going forward. In the environment of high returns of the past 25 years, a quarter of a per cent here or there didn’t make the difference between achieving a pension plan’s required rate of return or not. Over the next 25 years, it may.
Economic and capital market conditions are such that it’s difficult to envision a scenario that produces returns from investment-grade fixed income above low-single digits or from developed market public equities above mid-single digits. Institutional-quality real estate seems to be at its full value after a terrific run of more than 20 years, with running yield also likely to be in the mid-single digits and limited prospects for much capital appreciation.
The effort to generate return will continue to push institutional investors to tilt their allocations further toward assets with higher expected returns, such as private equity, infrastructure and developing market equities, as well as the use of more leverage and hedging strategies. While those strategies may increase expected return, they’ll also tend to increase a plan’s expense ratio and risk profile.
I’m painting a difficult, not a dire, future. It may be that the future return environment is less difficult than I’ve outlined, but at the Ontario Pension Board, we feel the need to prepare for, and make the changes to, successfully manage that scenario. The organization’s performance over its first 25 years has been solid in terms of return, risk management and cost-efficiency. It has long managed a plan with the type of demographic maturity most other public sector plans have only recently begun to grapple with. That meant risk and expense management featured as prominently as return seeking.
As the public service pension plan has grown past $20 billion, the Ontario Pension Board has successfully increased its real estate investments, moved into private equity and infrastructure, built a position in developing markets and begun to use leverage and hedging programs. We’ve enhanced our risk management systems and capability to keep pace with our growth. Those efforts have confirmed our approach and opened us up to new opportunities, both in terms of investments and further enhanced risk management. Our expense ratio has risen but it remains low. We want to keep it that way.
In short, as we grew, we began to really see the potential for additional scale to assist us in achieving our return, risk management and expense management objectives. While bigger isn’t necessarily better, our experience has convinced us it can be.
The government of Ontario’s decision in the late 1980s to reform the management of public sector pensions — to create independent, expert plan administrators — has proven very successful. We believe that pooling asset portfolios of small- and mid-sized broader public sector organizations can prove equally successful.
The impact of a few basis points of incremental net return can be significant. For example, for the $23-billion public service pension plan administered by the Ontario Pension Board, a 25-basis point shift in average annual net investment return over 15 years can translate into a $2-billion delta in the going-concern funded status. The board believes it’s reasonable to expect that asset pooling can generate an incremental net investment return of 0.25 to 0.50 per cent per year, compared to what it can can on its own.
Why? The reasons include access to a broader range of potential investments and the ability to drive better deal terms; the ability to create a centre of investment excellence, rather than diluting each other’s teams in the competition for talent; an ability to cost-effectively invest directly in private markets; an ability to build better risk systems and teams; and economies of scale.
Those factors have led us to partner with the Workplace Safety and Insurance Board and the government of Ontario to create the Investment Management Corp. of Ontario and to participate in it as one of two founding clients and members of the fledgling organization.
The corporation is the culmination of five years of effort and collaboration. As part of the process, several critical success factors for the design and implementation of asset pooling are now in place:
- The corporation must be independent of any one client and the government and not an agency of it;
- It must have an expert board without any overlapping membership with the boards of clients;
- Its clients must also be members, with governance rights and influence;
- The clients and members must appoint a majority of the members of the board;
- Clients must retain control over the asset mix and the corporation must be able to manage assets as specified in the investment management agreements;
- Clients must retain ownership of their assets and must not be exposed to the liabilities of other clients;
- The corporation must be not for profit and charges to members must be on a cost-recovery basis;
- Its design must encourage participation by other Ontario broader public sector entities; and
- Participation must be voluntary.
With the WSIB and the Ontario Pension Board as the initial clients, the corporation will have immediate scale at more than $50 billion in assets under management. The work to get it operational is well underway and we expect it will commence operations in the first half of 2017. Once it’s up and running, other broader public sector organizations with potential combined assets of between $25 and $50 billion can choose to join.
To support the corporation’s success, the Ontario Pension Board and WSIB will each maintain internal investment talent dedicated to working with it.
All of those involved recognize that bigger isn-t necessarily better, as incremental net returns won’t automatically flow from asset pooling. We do, however, believe bigger can be better if properly structured, implemented and governed.
Mark Fuller is the chief executive officer and president of the Ontario Pension Board.