Retirement (Special report): Pension funds - No gain, just pain

Canada’s biggest pension fund managers wanted big returns. The strategy has hurt.

Mary Lou LeRoy isn’t planning to retire any time soon. But as a regular contributor to the Canada Pension Plan, she’s outraged by the most recent results of the CPP Investment Board, the body that actively manages the CPP’s portfolio. “I think it is an absolute disgrace,” says LeRoy, 51, a Halifax entrepreneur, about the CPPIB’s negative rate of return of 18.6% for the fiscal year ended March 31. That amounted to a $17.2-billion decline in net assets. “Everything did not crash in one day,” says LeRoy. “It crashed over a period of six month, or so. When the house is on fire, you are supposed to leave, you do not wait until the house burns down to the ground.” LeRoy adds that she expected the fund managers to “switch the money around quickly to deal with the ebb and flow of the market.”

Sébastien, a 38-year-old Montreal professional has had some of his pension money invested by the Caisse de dépôt et placement du Québec since he started working 20 years ago. Like LeRoy, he is disillusioned with its performance. Last year, the Caisse had a negative return of 25%, and its net assets fell more than $35 billion. “They hired the wrong persons,” says Sébastien, who asked that his last name not be used, of former Caisse chief Henri-Paul Rousseau. (Rousseau resigned from the Caisse in May 2008 and was followed in quick succession by Richard Guay and Fernard Perreault; former BCE chief Michael Sabia replaced Perreault in March.) As for the $4 billion that the Caisse wrote off in 2008 because of a doomed investment in asset-backed commercial paper, “they just shouldn’t have taken on that much risk,” Sébastien complains.

And then there’s Kelly Alles. She’s a teacher with the Toronto District School Board who has been contributing to her pension for more than 21 years. The Ontario Teachers’ Pension Plan’s net assets were down more than $20 billion last year. Now, Alles hopes her retirement won’t suffer. She has always opted to contribute as much to her pension as permitted, because she doesn’t want to worry about money when she’s no longer working. A high return, she says, is great, “but when it comes right down to it, I’d rather have a lower guaranteed return.”

But Canada’s three largest pension portfolio managers don’t use a passive management style that guarantees returns. Instead, they actively diversify investments to beat (in theory) the returns of safe, income-bearing vehicles, such as government bonds and guaranteed investment certificates.

This strategy comes with a price: higher risk. That means there’s no guarantee the funds will even beat the paltry returns of bonds and GICs. And risk can lead to higher returns, but also big losses. The CPPIB, the OTPP and the Caisse collectively saw their net assets fall in one year from just over $385 billion to $313 billion, a drop of 19% — a decline roughly equivalent to the entire 2008 GDP of Croatia. The retirement savings of millions have been hammered. You just can’t help but wonder: instead of taking on so much risk, would these funds be better off taking a safer, more passive approach?

That’s not an option for the Ontario Teachers’ Pension Plan. “The fact of the matter is we have to take on risk to meet our pension promise,” says Jim Leech, head of the OTPP. The plan, Leech points out, will be in a tough position a decade from now, when every working teacher will be funding one retired one. (Compare that to the 1970s, when 10 teachers supported a retired teacher.) Leech needs high returns to meet plan obligations, and bond yields just won’t cut it, since they’re too low. Government of Canada 30-year-bonds, for example, had their lowest rate of return in at least 18 years in 2008, just 3.455% compared with a high of 10.326% in 1990.

And it’s not just bond yields that are likely to be low in coming years. Leech says the double-digit returns of the past decade “were unrealistic and unsustainable … those were the great windfalls.” A realistic rate of return, he now says, is closer to 4.5% to 5%. But even as the economy shows some signs of recovery, it’s not at all clear where markets are headed.

To deal with the uncertainty, the OTTP is using a defensive strategy. “We’re playing it like Bobby Orr,” says Leech. “When we see the net, we’ll hit it.” Even so, Leech adds that, going forward, managing pension funds will mean revisiting the money being paid out. One obligation changed last fall was the cost-of-living adjustment (COLA) for retirees. Pension contributions made from 2010 will be eligible for a COLA of 50% to 100% only if the OTPP has money. Pam Capling, a teacher near London with Ontario’s Thames Valley District School Board, is relieved she’s retiring next year, so she’ll be affected by the new rule for only a few months. But she is worried about younger teachers who will not have guaranteed COLA.

The new regime has caught others off guard. “That’s ugly news to me,” says Alles, who, at age 50, has no foreseeable plans to retire. “With costs going up, basic COLA is what I expect.” Alles, like many Canadians, was hard hit in her personal retirement savings because she loaded up on equities instead of assets with safer returns. “I had invested with high risk, hoping for high returns,” she says. “Instead, the opposite happened.”

All three of the large pension funds attributed their 2008 losses, at least in part, to the bad economy. But in interviews with Canadian Business, representatives of the CPPIB and OTPP insisted that, on a comparable basis, their results weren’t all that bad. “On a relative scale,” said Leech, “it wasn’t horrible.” As a result of the tough economic situation, he adds, the OTPP actually reduced risk from its portfolio; between 2008 and 2009, it dropped its equity holdings from 45% to 40%.

Don Raymond, the CPPIB’s senior vice-president of public market investments, says his organization will continue with equity holdings of 65%, despite its recent negative returns. That’s because he believes equities will outperform in the long term. Raymond dismisses suggestions that a guaranteed investment certificate would have easily beat the CPPIB’s four-year annual average return of 1.42%. “In retrospect, you can invariably always find something that will generate better returns,” he says. And he denies that by moving away from traditional bonds and stocks, the big pension funds are taking on too much risk. “This is a plan that is sustainable over the long-run,” Raymond adds. “There is no risk to Canadians.”

Although the OTPP did suffer losses from less conventional investments, such as hedge funds and credit products, Leech also defends its risk model; one of the top lessons learned last year, he says, is that, overall, it is working. Things could be better, he concedes, and that’s why the risk model will now include more testing of different scenarios. At the Caisse, the explanation for last year’s performance is more muted, since it isn’t granting interviews under newly appointed CEO Sabia, who took the job of getting the plan back on track. What it has at least acknowledged in writing is a mistake in its investment choices. “The ABCP [asset-backed commercial paper] episode is without a doubt a difficult page in the Caisse’s history,” former CEO Perreault said in a February release. (Worldwide investments in ABCP, of course, were one of the triggers for the global liquidity crisis.) “In hindsight we placed too much confidence in these securities,” Perreault acknowledged. “[I]t was a mistake to accumulate so much ABCP.”

Ordinary pension holders may find themselves wondering why a pension fund that manages the retirement savings of millions of everyday Canadians would invest in something as toxic as asset-backed commercial paper. But the Caisse isn’t alone in choosing to park money in complex instruments. The CPPIB has invested in swaps, futures and equity contracts, while the OTPP has invested in hedge funds, derivatives and billions in liabilities tied to securities sold under an agreement to repurchase. Heck, it even made a failed bid for Sabia’s former company, BCE Inc. Over the years, the financial statements of these three organizations have contained more and more different types of investments. Indeed, they’re arguably starting to resemble hedge funds themselves, with their seemingly complex investment strategies aimed at higher returns.

And that has some people worried. “These aren’t regular financial institutions who should be taking on a lot of risk for any kind of return,” says Sébastien, who lost 40% of his own personal retirement savings last year. “Of course, if we had a bang-on year, I wouldn’t be complaining. But less risk is what we need.” Sébastien notes that the big pension funds are supposed to protect the interests of many different Canadians, from professionals to blue-collar workers. “No one asks if we’re OK with this amount of risk being undertaken.”

We decided to compare Government of Canada bond yields to the long-term annual rates of return of the CPPIB, OTPP and the Caisse. And guess what we found? The bonds outperformed the pension funds, despite their active-management styles. “The implication for portfolio management is it isn’t worth the time and effort if you can get a similar or better return investing in risk-free government bonds,” says John Stephenson, senior vice-president and portfolio manager at First Asset Funds Inc. in Toronto. “Presumably, these portfolios are being dragged down by last year’s performance. However, they are barely keeping ahead of inflation, I suspect, and [are] not earning a strong enough return from equities, real estate or corporate bonds.”

Our analysis of long-term annual rates of return could be criticized for being too simple. For one thing, the CPPIB receives billions every year from plan contributors. It couldn’t invest all of the money at once and wait around for a decade. So we decided to look at what the annualized rate of return would have been if the net assets received each year since 1999 were invested in government bonds. In this scenario, the CPPIB actually did outperform the bonds, but not by much. Its return was 4.3% compared with a modelled bond return of 3.74%. But keep in mind that was just using a regular Government of Canada bond. Investment experts almost certainly could have found a combination of bonds and other risk-free investments that could come close to, or surpass, the 4.3% return.

Raymond says the economic maelstrom has left a talented pool of financial and investment experts looking for work. And that could be a boon for the CPPIB, since it expects to double its size in the next eight years. But maybe the dismal performance of fiscal 2009 shouldn’t be reversed by hiring more investment professionals to take on more risk. Instead, pension managers might want to lower risk by putting significantly more into fixed instruments. Canada’s chief actuary says the CPPIB needs an average annual rate of return of 4.2% to meet its long-term pension obligations over a 75-year period. Once the bulk of its $105.5 billion in net assets under management is invested in guaranteed investments — the current government 10-year yield is 3.437% — the board can play with a smaller portion of money to achieve higher returns and fulfil its active management mandate effectively.

Of course, it will have to scrutinize its investment philosophy. Fully 259 Canadian mutual funds outperformed the CPPIB’s average annual rate of return over the past 10 years. Are there lessons here? Of course, lowering the risk could spell lower returns. And that would mean the CPP may have to mimic the OTPP, and institute a potentially smaller payout for people like Alles, LeRoy and Sébastien. “Yes, with a lower level of risk, I’m aware of the lower level of profits,” says Sébastien. “But isn’t it better to make 5% than lose 25%?”