Perfect timing

The Healthcare of Ontario Pension Plan (HOOPP) is like the ant in Aesop’s fable “The Ant and the Grasshopper.” While others were enjoying market returns, HOOPP was preparing for the future. After years of strong financial markets, HOOPP’s investment team, led by Jim Keohane, decided to pull $6 billion out of equities to prepare for a potential market downturn. When shortly after that move in 2007 the figurative winter hit, HOOPP was one of the few pension plans to report positive results for the two-year period of 2008/09. The plan’s 15.2% return in 2009 more than offset the 12.0% loss of 2008. Many other plans were left out in the cold—much like Aesop’s grasshopper.

While the brunt of the downturn is now in the past, the consequences are not over. Large DB plans such as HOOPP have new challenges to face. In addition to nagging European market risks and the U.S. fiscal cliff, the driving concern is continued low interest rates, which threaten investment returns and pension promises. Having learned valuable lessons in the early 2000s, HOOPP is managing this long financial winter by remaining conservative—focusing on its own weaknesses, applying a liability-driven investment (LDI) strategy and carefully considering fresh opportunities.

HOOPP today
HOOPP has more than $40 billion in assets, with more than 270,000 members and pensioners. In 2011, the fund saw a return of 12.2%.

Today, Keohane is HOOPP’s CEO, the position he stepped into in January 2012 after 14 years with the plan. He is credited with playing a key role in the adoption of the LDI strategy, which enabled HOOPP to maintain its fully funded status through levels of market uncertainty not seen in decades.

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.

An enviable position
So how did Keohane’s team transform HOOPP? The philosophy behind the changes began decades ago when he and the investment team were juggling with the foreign property rule (FPR) in the 1990s. “We were only allowed to put 30% in foreign markets. It made it difficult to diversify risk in the portfolio,” he recalls. Motivated by a desire to remove this risk, Keohane developed the plan’s first deriva-

tives program to diversify the portfolio without breaking any investment regulations. “It also increased our returns, because Canadian products were overpriced since everyone had to own them.”

When the FPR was lifted in 2005, Keohane began looking for other weak spots in the portfolio. It didn’t take long to notice the plan’s overexposure to Nortel stock. “Nortel represented 40% of the TSX index, and, because it was such
a huge component of the index, it was hard not to own. It was a concentration risk,” he says, especially because, at the time, external managers did much of the portfolio management. To compensate, his team created hedging positions around the stock for every manager. The plan would buy a put option, which would allow the plan to sell the stock when the price dropped by, say, 5%, while also selling a call option to sell the stock if it rose by 20%. “Essentially, we could limit our downside risk by giving away the upside above a 20% return.” This strategy saved HOOPP from taking a major loss when Nortel fell from grace.

These two successful risk management exercises had Keohane thinking deeply about the pension’s liabilities. But before changes could be made, the 2002 tech bubble burst. “We went from a surplus in 2000 to a deficit position very quickly. Equities fell dramatically, and interest rates fell at the same time, which inflated liabilities. There was way more risk in the portfolio than we had expected,” he says. “We would have thought equity risks were our biggest concern, but it turned out to be a decline in long-term interest rates.” It was time to pay attention to the plan’s liabilities.

The switch to LDI
With the new 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 the $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.”

Staying the course
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.”

Leigh Doyle is a freelance writer based in Toronto.

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