Art by Vivienne Flesher
CIO: The Healthcare of Ontario Pension Plan (HOOPP) moved in the direction of de-risking and liability-driven investing (LDI) more than a decade ago. And I think it’s safe to say the strategy has paid off—and then some. But I sense that you’re not done…
Jim Keohane: Not yet. Our LDI approach has been an evolution—not a revolution. It began in 2003 and it’s still ongoing. We have made various small steps over a long period of time, instead of as one big bang.
Many people think LDI is just putting their money in bonds, when it’s actually a very dynamic process. We believe de-risking focuses on different drivers of the portfolio. HOOPP’s LDI strategy is far from being autopilot. It is not a passive approach at all, but a very active one. As markets change, we have to continue to adjust the portfolio. The holdings we currently have are changing as we speak—it’s far from a static strategy.
CIO: Let’s backtrack a bit. Could you walk me through this decade-long LDI plan? How did the thought process of shifting the focus to liabilities begin? And more importantly, why is it important to consciously make this change?
Keohane: In 1999, we found ourselves with a surplus from our traditional 60/40 portfolios in the ’90s—until the tech collapse that brought us to a deficit. This pushed us to do some soul searching. Was our portfolio in the right position? How do we go through another crisis without such drawdowns?
After a deep internal look into our balance sheets, we found a great mismatch in assets and liabilities. We were overexposed to equities and underexposed to fixed income in an environment in which equities were running off while bonds were rallying.
Albert Einstein said the definition of insanity is doing the same thing over and over again and expecting different results. Every time we went through a crisis or market downturn, we wondered why we experienced the same drawdowns: Insanity. At the time, we needed to earn about 6% for the funded status to stay the same. But if you have a big drawdown on the assets, that means you don’t have enough assets to meet liabilities. It then becomes a slippery slope—the lower funded you are, the higher return you need. We then decided losing can become more damaging than gaining can be beneficial.
Once you have made that mental shift, you then need to think about ways to have more interest-rate sensitivity in your portfolio. I believe interest-rate risk, inflation exposure, and equity-market risks are the most dominant risks to look out for.
CIO: Now that the fundamental philosophy has been put in place, what about the implementation process? I suspect a big change such as this was difficult to get the investment committee or board to initially stomach.
Keohane: Our process began with modeling work, which revealed the best way to implement this was to create a two-structure portfolio: a liability-hedging one and a return-seeking one. We then decided we needed to use derivatives to support this structure. The complexity of derivatives required us to put in place not only the expertise within our teams, but also the control environments and monitoring systems. Further asset-liability modeling brought us to a five-year business plan to get us from a 60/40 portfolio to the LDI one. This was 2005. We then switched out our core portfolio management accounting system to one that would accommodate alternative portfolios.
And you’re right. The board approved the strategic plan, but the most challenging part was to get people to understand and appreciate the risk drivers. We also say that our fund is a pension-plan delivery organization rather than an asset manager: We seek to deliver the promises we made instead of beating markets.
CIO: Now I think it’s appropriate to mention here that HOOPP isn’t your traditional public fund. What makes it different and how does this uniqueness—and the distinctive governance model—play into the transition from a 60/40 portfolio to LDI?
Keohane: HOOPP is in fact different from many of our peer funds in that we are a private trust that was created through an agreement between the employer and the four founding unions. Legally, we operate under trust law, and as such under our governance structure, the board is responsible for overseeing all aspects of the HOOPP plan and trust—and has a fiduciary duty to act in the best interest of the members.
This differs from our sister funds—such as the Ontario Teachers’ Pension Plan and the Ontario Municipal Employees Retirement System—which are statutory plans created through provincial legislation. And they operate under corporate law.
Our ownership structure is more like a mutual insurance company and as such, our members’ pensions are only backed by the assets of the fund. HOOPP pensions are not an obligation of the Ontario government.
This is perhaps why it was easier for us to focus on the liabilities when we did—looking through the lens of our members to determine what is in their best interest.
CIO: Let’s get into the weeds of the two-part portfolio laid out in the 2005 strategic plan. How does the balance of the liability-hedging and return-seeking aspects help hit your return target—and keep the funded status high?
Keohane: Our liability-hedging portfolio contains most of our physical assets. We use physical bonds to create interest-rate hedge. About 70% of our physical assets are in nominal bonds, 12.5% in real return bonds—a sort of Canadian TIPS (Treasury Inflation-Protected Securities)—and 12.5% in real estate to hedge against inflation. It’s the least risky portfolio we could have to meet our obligations, and our expected return is 4%.
The return-seeking portfolio is largely derivatives based—the only physical asset is the private equity portfolio of about 5% of the total. We get our public equities exposure through index derivatives and swaps (nearly 29% notionally in equity swaps and global futures). Ten percent of this portfolio is in credit overlay. We also implemented a long-term options strategy as well as an absolute-
return strategy that’s essentially hedge funds managed internally. All these components help us maintain a low exposure to equities. In aggregate, they produce enough returns but keep equity risk down so we can earn 150 to 200 basis points to our 4% return from the liability-hedging portfolio.
CIO: This was all built in-house, right?
Keohane: Yes. We have the scale to do it—not to mention it’s cheaper for us to work on it in-house. It also allows us to focus on us and our very specific needs, rather than depending on third-party specialists.
CIO: This brings us to HOOPP’s incredibly high 122% funded status. This is unheard of in the US, and even among Dutch pension funds, which are also pioneers and innovators in LDI. What’s your secret sauce other than the intricate LDI plan we just talked about?
Keohane: I think it comes back to our fundamental idea of delivering pension promises instead of acting as an asset manager. Start with the right focus and the right definition of risk. Pension management is not about beating the S&P 500, even though that’s how people and managers evaluate performance. It’s also important to maintain purchasing power of your assets—be able to buy long-term assets at attractive prices. This can allow you to meet your obligations and liabilities with a much lower asset base.
CIO: One of the biggest concerns in de-risking is longevity risk. What is HOOPP’s stance on it—and how are you hedged?
Keohane: We assume that longevity is going to improve—and we’ve already built this view into our models. Because the risk is already factored in, we don’t expect any large actuarial losses from mortality improvements.
CIO: If you’re not finished with LDI yet, what’s next for HOOPP?
Keohane: We are a high-growth organization and managing this growth will be our challenge going forward. It’s really about augmenting our growth appropriately to ensure we are delivering solid returns to our members over a long period of time.