Successful pension formula:

control cost and manage risk while spurring growth

Minimising risk and maximising return is often easier said than done in the pension fund industry. In this article, HOOPP President and CEO John Crocker describes how an integrated asset management software system supports the liability-driven investment model of the leading Canadian pension fund, which bases its success on non-traditional portfolio structures and alternative investment.

by John Crocker, President and CEO, HOOPP

In the harsher post financial crisis environment, increased market volatility, financial instability and regulatory change are impacting business risk, cost and growth respectively, and creating challenges as well as opportunities that are not necessarily always in equal measure. For the pension fund industry, the hallmarks of success will be flexibility in implementation and adaptability in operation of investment strategies. Aiming to maximise pension benefits, one of the main challenges will be choosing the right investment management system to successfully support investment strategies while minimising risk and controlling costs.

When looking for a new operational platform at the Healthcare of Ontario Pension Plan (HOOPP), the set of circumstances and challenges were much the same as in the rest of the industry – only the point of departure was different. Since its creation in 1960, HOOPP has developed into one of the leading pension funds in Canada. Serving as the main provider of pension services to the Ontario healthcare sector, HOOPP is not only structured differently compared with other Canadian pension funds but also has a unique way of delivering its services. In 1993, it went from being an employer-sponsored benefit scheme to becoming a jointly sponsored scheme, and is now the largest private pension fund in Canada with assets under management totalling around C$36 billion.

Also a little unusual is the fact that the fund’s Board of Trustees controls both the pension benefits and the pricing of these benefits. The Board of Trustees is made up equally of union representatives and hospital appointees. In the case of other pension funds, the actual pricing is negotiated separately in a different structure. The board is responsible for controlling both the investment and administrative aspects of the business, which helps provide a 360° perspective on all the key pension issues, including the assets managed by the fund and the liabilities underlying the pensions to be paid out in the future.

DEFINED BENEFIT PENSION PLAN

The HOOPP fund pays out a defined benefit pension and believes that this is the best type of pension for ensuring people obtain an adequate pension in retirement. The pension is calculated based on two elements: years of service and earnings. By comparison, defined contribution plans, on the other hand, do not provide a pension at all, but rather are a savings vehicle promoted by the banking industry and insurance companies to offload responsibility for retirement savings to the individual. Defined contribution plans do not have a savings target. Corporate entities like this approach because essentially they are transferring the risk of providing the pension from the company to the employee.

For their part, defined benefit pension funds have not traditionally allocated large resources to promoting the model. When a defined benefit pension plan is thoroughly examined, it is actually the most effective way of turning a dollar of earnings into a dollar of pension income. HOOPP’s cost of managing the fund is around 25 basis points; by contrast, the investment cost for many retail mutual funds is roughly 10 times that amount. So the fee impacts on individual savings over a 20-30 year period are huge.

HOOPP’s costs not only include incentives and direct compensation for professional investment management expertise but also include the cost of its investment management system, i.e. the IT platform on which operations are based. The approach to running this operation is fairly lean; the investment team has only around three dozen members. Overall, each of the fund’s investment professionals is responsible for around C$1 billion in assets.

LIABILITY-DRIVEN MODEL AS INVESTMENT APPROACH

For the past few years, the HOOPP fund has implemented a liability-driven investment (LDI) approach involving non-traditional portfolio structures and alternative investment strategies. The liabilities are modelled in terms of calculating what the cash flows look like, what interest-rate sensitivities are built into the liabilities, what inflation-rate sensitivities are involved, and also the demographic profile of our pension membership. Against this is placed what we term as a liability-hedge portfolio. One of the main parameters considered in this approach is interest rates: the lower they go, the more they drive up the liabilities – a 0.25 percentage point move in interest rates amounts to a difference of C$1-2 billion in shifting valuations.

The benefit of the liability-hedge portfolio is that most of the assets and liabilities move together so that if interest rates go up or down, the assets move accordingly and in tandem. This has been the central element of our fund’s new investment philosophy. On top of this, the fund has what we describe as a return-seeking portfolio, which includes data and risk overlays, hedges, alpha strategies, various equity-based strategies, private-equity instruments, cross-market arbitrage, etc. The fact that our pension fund made money while others lost money owed much to the success of this liability-driven investment model.

One of the main explanations why funds like HOOPP have fared better than many of their counterparts in recent times was an early decision to pursue a more actively managed approach to the investment portfolio. In the 1980s and ’90s, it was traditional for the North American pension fund industry to divide portfolios into an asset mix comprising 60% equities and 40% fixed income.

This approach worked fine coming out of the 1982 recession, but stopped working when the Internet bubble burst in 2001-02. In those two years combined, HOOPP lost a total fund value of around 10% when it was targeting an annual return of 7.75% in each of those years. Instead of making 15-15.5%, it lost 10% and was 25% down. That was basically the wakeup call needed to conclude that the fund had too much risk in its asset mix and in its investment approach.

MOVING INTO A NEW ASSET MIX

To correct this state of affairs, HOOPP’s Board of Trustees decided in the mid-2000s to move away from the traditional asset mix to an asset allocation of 46% in equities and 54% in fixed income. That strategy led to a key decision in the fourth quarter of 2007. We sold around C$6 billion worth of equities and moved that money mainly into the bond market. This move to reduce the assets in equities dampened volatility a little.
Then in the fourth quarter of 2008, the financial crisis erupted, the bankruptcies began to occur and the chaos became palpable. The payoff for our decision to reduce exposure to equities translated that year-end losses were limited to less than 12% of the fund’s value. Compared to this, the average pension fund account lost around 18% and some of the bigger funds lost as much as 20 to 30% or even more.

In fact, some of HOOPP’s total loss was artificial because we were obliged to adopt some mark-to-market accounting to record the loss. Subsequent events proved this move to be correct in the sense that the markdowns that were taken in 2008 returned to full-market value in 2009, allowing the fund to generate a return of well over 15% in that year. We were probably one of the few funds to report a positive return – albeit a small one – in the two-year period of 2008-09.

NEW ASSET MANAGEMENT SYSTEM FOR NEW ACTIVITIES

At the time when the fund was increasingly moving into the area of derivatives and other non-traditional portfolio compositions, we were using an old investment management system as our core operational platform. We found ourselves in a situation where, with business processes increasingly dominated by the use of derivatives, the software system was just not capable of keeping up with the growing complexity of portfolio structures and alternative investment vehicles. Consequently, we were ending up with hundreds of spreadsheets, controlling and risk-managing them, and involving time-consuming and costly workarounds. These error-prone manual processes were no longer acceptable, as in our business errors can translate into hundreds of millions of dollars.

It became increasingly apparent to us that the existing portfolio management and accounting system would not support the types of activities that we wished to undertake, both now and in the future. What was needed was a portfolio management and accounting system that could handle all of the various investment products and strategies that we needed to employ. In addition, that system needed to be flexible enough to absorb new products and strategies in the future and provide timely and adequate reporting and accounting to support investment decision-making.

HOOPP President and CEO John Crocker outlines how the support of non-traditional portfolio structures and alternative investment strategies applied by the Canadian pension fund requires an extremely robust and flexible investment management system infrastructure.

This imperative led us to start a search to replace our system with one geared towards reducing risk and enabling us to obtain more functionality in terms of the type of products our investment team generates. Following a rigorous selection process, the SimCorp Dimension investment management system was chosen because of its ability to provide a fully integrated, front-to-back office architecture with robust capabilities including derivatives management and accounting.

The support of diverse investment instruments and strategies requires an extremely robust and flexible investment management system infrastructure. Adopting the new system has allowed the investment team to engage in more and different types of transactions and really test the functionality of the asset management solution. With the new system in place and up and running, the year-end financial and accounting work proved also faster and more efficient, both for our internal personnel and the external auditors.

Running a very sophisticated portfolio made it a high priority to find and deploy a single solution that could support the operation. The investment management system serves as a primary means of processing every transaction on the books and is the system of record. It is able to support the complex derivatives book, all existing instruments as well as potential ones to come in the future. All instruments are processed through the system, including bonds, equities and derivatives. As such, it acts as the single, integrated system of choice to support the fund’s investment strategy.

Choosing the new software solution was a strategic decision to support the investment team, which manages all of the fund’s assets in-house. It would without a doubt have been extremely difficult for us to do this effectively without the power, functionality and flexibility of the new portfolio management software which has been absolutely mission-critical in terms of us being able to move forward. The highly integrated and automated investment workflow is anchored in an integrated platform, which allows us not only to reduce manual involvement but also to further increase the integration and automation of workflows.

MATCHING INVESTMENT MODEL AND SYSTEM

The implementation of an LDI strategy at HOOPP reflects success in every respect. The plan stands today in its strongest position ever: it has more assets under management and more members than at any time in its history. HOOPP is fully funded. By combining the right kind of investment model – in this case, a liability-driven investment model – with the right kind of investment management system – such as the one we have now – you have the makings of a great marriage. In a business partnership like this, there is every reason for us to believe that we can achieve the kind of competitive advantage that is needed to stay ahead in ensuring HOOPP can deliver on its pension payments for generations to come.

By way of summary, implementing the type of applied asset management software HOOPP has found with its current provider gives us a platform which enables us to mitigate operational and financial risk, while at one and the same time supporting and enabling our investment growth strategy.

Utilising this system, our investment team is able to respond more swiftly to changing market conditions and come up with fresh investment ideas, thereby creating a competitive advantage over other players in the same space. This gives HOOPP speed and flexibility and yet maintains a good risk-control culture.

Finally, our investment management platform also enables HOOPP to keep operations lean which in turn helps us to maintain a high degree of control over costs. These are all critical building blocks that combined, help us to ensure that our fees are kept to the minimum, and that the pension benefits are maximised.

John Crocker, CFA, has held the post of President and Chief Executive Officer at HOOPP since 2001. Joining HOOPP in 1998 as Chief Investment Officer, he had more than 30 years experience in the investment industry, having managed large funds in the insurance, trust, and banking industries. He reports directly to HOOPP’s Board of Trustees and is responsible for overall leadership and management of the organisation. He is also responsible for developing, implementing, and overseeing – in consultation with the board – performance measurement programmes, long-term strategies, and annual work plans to ensure the organisation meets the needs of plan beneficiaries. John Crocker is a member and former director of the Toronto Society of Financial Analysts, a member of the CFA Institute, and a member of the Pension Investment Association of Canada (PIAC). He holds a bachelor of commerce degree from McGill University and is a Chartered Financial Analyst (CFA).