PE and the pension system

The impressive 2010 investment performance results posted by the Ontario Teachers' Pension Plan (OTPP) - one of the world's largest LPs - a month ago amount to an historically high value-added dollar amount. But the fact remains that this has had little effect on the fund's substantial liabilities overhang, which poses a thorny problem for OTPP senior management in future - with implications for their counterparts in many other major pension plans in the West.

As Jim Leech, OTPP president & CEO, put it in a recent statement:

"It's always difficult to explain that while we had phenomenal investment results last year our deficit appears to be the same."

The fund realized C$13.3 billion of investment income by December 31, 2010, or a 14.3% return.

Net assets were pegged at $107.5 billion. A year earlier, the comparable figure was $96.4 billion.

The fruit of 2010 tweaks?

OTPP undertook asset mix modifications in 2010, including a re-classification of some assets for more clarity in performance monitoring (among other reasons). It also adjusted various target allocations.

Under the macro numbers, the encapsulated results were as follows:

Equities (public and private) portfolio holdings totaled $47.5 billion, up from $41.2 billion a year earlier. Fixed income assets amounted to $45.9 billion compared to $35.3 billion in 2009.

Additionally, the commodities allocation rose to 5% from2%, a timely shift. The timberland portfolio dipped slightly, however, and was re-consigned to a new category, ‘Real Assets', where it has been regrouped with real estate and infrastructure.

These latter two portfolios rose, real estate to $16.9 billion from $14.2 billion in 2009. And infrastructure net value is now reported to be $7.1 billion as of the end of 2010 vs $5.6 billion a year earlier.

From an overall equities-returns-compared-to-benchmarks perspective, these stood at 10.4% vs a 7.5%. Within this, however, Canadian equities gained 14.6% compared to a 13.8% benchmark, while non-Canadian equities performance rise was pegged at 9.4% compared to its 5.9% benchmark.

Fixed income and commodities returns were about on par with their respective yearly benchmarks.

Private equity, a major driver

As to the impact the private equity portion had on overall equities performance, OTPP's 2010 Annual Report is succinct:

"In 2010 the PE portfolio generated the majority of the value-added performance in this (equities) asset class."

OTPP's private equity unit, Teachers' Private Capital's total investments stood at $12 billion in 2010, compared to $10 billion in 2009. Returns were reported to be 19% vs the benchmark 7.1%, or $1 billion over, and generated a 2.5% compound annual return, outperforming the category four-year benchmark of -1.2%.

These results were mostly due to improved company earnings and higher NAV for some portfolio companies. Teachers' Private Capital also added nine new direct investments, accounting for $919 million of change in portfolio size in 2010. As well the recovery seen in PE markets provided the opportunity for some advantageous exits.

Jane Rowe, senior vice-president, laid out Teachers' fundamental PE investment strategy for AVCJ:

"We operate on a three pillar approach. The first is our investment in funds, and that amounts to about half of the capital we have working today. We think of the funds business in terms of its capability to augment Ontario Teachers' global footprint as investors. We also look at them as a way to bolster our industry sector specialization groups."

Teachers' focuses primarily on funds that go out globally, that have a good track record and a real interest in partnering with them on future deals.

"The second pillar is co-investing with those funds or other sophisticated partners in the investment community; and the third is direct investing on our own account."

The latter two categories account for the remaining 50% of currently invested capital.

Their motivation goes beyond purely financial considerations of the moment, however. In terms of these co-investments and directs, the aim is to build them on six major industry sector specializations the fund has developed, namely financial services & healthcare; telecom, media, technology & energy services; and consumer, retail & industrial products. They endeavor to have teams that understand the industries that they operate in - or at least the most salient sectors thereof - and try to build that knowledge base in partnership with some of the funds they work with, she explains.

"We've consistently viewed funds as being part of our bench strength, because they've enabled us to learn to walk before having to run."

Teachers' has been engaged in private equity for 20 years, since 1992. And their signal achievement over that program lifespan has been IRRs of over 18.5% p.a., including through meltdowns like the tech bubble burst of 2001 and the more recent global financial crisis.

The Asian dimension

Their investment engagement with Asia began shortly after their PE program launch, in 1994.

"Today, as regards our exposure in the region, the reality is that we partner with 4-5 regional funds, and look to invest into those funds - and sometimes co-invest with them. They are really our partners in Asia. Plus, on the rest of our funds book, we have a number of global funds that also happen to have offices in that part of the world. Again, we're always looking for ways to expand our global footprint," she told AVCJ.

In short, Teachers' sees Asia as both an area in which they've been invested for some time, and one that continues to be an important place for them to be invested in. But they emphasize they are not newcomers.

"Basically, we're committed," Rowe notes. "I just got back from there two weeks ago, and will return in June and September."

The liability overhang

Nevertheless, she acknowledges that regardless of the upside, OTPP as a whole has a $1.8 billion shortfall between what they pay out in benefits vs what they receive in contributions. But this must be viewed in the context of the fund having $107.5 billion in assets, half of which are liquid whether in equities or fixed income. The longer term, mostly illiquid private equity private equity investment model is very much the exception.

But, she says emphatically, they are not challenged with liquidity issues.

"What we do have is shifting dynamics."

Fund CEO Jim Leech offers an analogy to better understand this; filling a glass of water at a tap. Both member contributions and investment returns are the water. The problem is that the glass keeps getting bigger. So the level of water within it stays the same.

"When we say the liabilities are continuing to grow, it's just simple math. Ten years ago, people lived about 20 years after retirement on average. Today, it's more like 30 years. And the prognosis is that they'll live even longer in the years ahead. Which means we have to make investment decisions to support this trend, and that's quite difficult."

His colleague Malcolm Hamilton, the Plan Actuary, adds some telling detail.

Maturity in pension plans is just a way of indicating that they, like the aging people they support, get old.

"In 1991, we had large numbers of teachers educating baby boomers: the ratio was one retired teacher for every four working in the classroom. So contributions easily exceeded benefits paid. Today it's about 1.5 teachers working for each retired beneficiary.

"Also back then even safe investments offered good returns, bearing in mind however that the pension fund today is about 10x payroll as compared to 3x payroll. Benefits are about 2x contributions per annum.

"But at the point of maturity the plan can't afford to take as much risk. Nevertheless we find ourselves in an investment environment where safe investments produce dismal results. So we have to take risks knowing that our ability to deal with the consequences is not what it was."

That would seem likely to author change in terms of GP/LP relationships, perhaps driving an increased appetite for alternatives on the one hand, but with smaller amounts to invest. It's mostly conjecture at this point, but it's food for thought.

OTPP is not precisely typical as a pension fund, mostly because ‘typical' is hard-to-impossible to define. But the horns of Teachers' dilemma do seem a little more pointed.

One the one hand, Hamilton notes, they tend to get better investment results than many, if not most, other pension plans. But they also seem to face more daunting challenges. Why?

One variable concerns what the plan contributors actually do for a living. Not surprisingly much of a pension plan's status quo has to do with the flow of contributions, and the prospects of same going forward.

Hamilton compares Ontario Teachers with other big plans in the province, specifically the hospital workers. With the large baby boomer numbers in schools now long passed, it's only logical that the number of teachers hired will also shrink. But the boomer population is only beginning to approach intensive medical care needs en masse, so hospital worker numbers are likely to rise.

This means, as one consequence, that HOOPP (the hospital workers' pension plan) can afford to take the risks that Teachers could 20 years ago. And the same probably applies to another huge Ontario-based LP, OMERS.

Another big determinant in terms of investment performance these days is low interest rates. Simply put, it takes much more investment over a significantly broader horizon of risk - given that low growth has some connectivity with low interest rates long maintained - to deliver the same investment returns.

No one at OTPP suggests that they will be able to earn their way out of the shortfall. Rather partner/sponsors will have to adjust contribution rates or benefits packages to bring the fund back into balance. And that will ultimately be decided by the contributors themselves.

But the point is, from a PE fund point of view, that the long-established GP/LP relationship norms are likely to come under new and stronger pressures in the coming years, and that this will not just be a knock-on effect of the recent GFC. That's suggested by the fact that OTPP is not unusually disadvantaged by this newly emerging situation; more like a leading edge.

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• Topics
• North America
• Financials
• National Pension Service (Korea)