The words "bold" and "pension fund" don't always go together easily. But Canadian public pension funds are once again employing bold strategies in a world in which interest rates have remained persistently low at the very moment that aging baby boomers are increasingly drawing down their retirement funds.
With traditionally safe pension investments such as bonds no longer yielding enough to cover obligations, a number of Canadian plans are intensifying leveraged strategies – approaches intended to squeeze more profit from their investments by doubling down with debt. They are mortgaging some of their swankiest skyscrapers and forming in-house hedge funds that invest in complex derivatives such as forwards, swaps and options, accepting more risk in an effort to keep their promises to retirees.
"We have to earn that return somehow," said Jim Keohane, chief executive of the Healthcare of Ontario Pension Plan (HOOPP), which has been among the most aggressive pursuing the new leveraged strategies. "If I don't do this, what am I going to do instead?"
It's not the first time the Canadian funds have pushed the envelope internationally. As early as the 1990s, some began establishing private equity arms to take active stakes in businesses, successfully competing with Wall Street giants for such assets as department stores, highways and, recently, pieces of GE Capital.
Today, at least seven of Canada's large pensions have "substantial" in-house hedge fund operations. By comparison, none do in the United States and only two do in Europe, according to data from the international pension fund consultancy CEM Benchmarking Inc. CEM, based in Toronto, declined to name the funds, but did say the five that have been at it the longest have beaten their benchmarks by an average of 0.9 per cent annually over the past five years while the 10 largest U.S. funds have managed no extra return.
"In a world where safe investments provide unacceptably low returns, they have to move farther out the risk spectrum to get the kinds of returns they need," said Malcolm Hamilton, a retired pension fund actuary who's now a senior fellow at the C.D. Howe Institute. "At the end of the day, you turn out being a hero or a goat, and there's not much room in between."
U.S. pension funds have generally addressed the same pressures by retaining the services of Wall Street hedge funds, CEM data show, but high fees can eat away at gains.
Unlike in Canada, where professional boards tend to oversee public funds, in the United States the responsibility lies with elected officials who are hesitant to approve the compensation needed to attract Wall Street talent, according to Tsvetan Beloreshki, a New York-based pension fund consultant at FTI Consulting.
Canada's public pensions, in contrast, have been poaching top talent off Wall Street for some time. The ranks at the Canada Pension Plan Investment Board, which manages the country's primary public retirement fund, includes veterans from hedge fund Golden Tree Asset Management and private equity giant Carlyle Group, as well as investment banks such as Morgan Stanley, JPMorgan Chase & Co. and Goldman Sachs Group Inc., according to the CPPIB website.
Don Raymond was recruited from Goldman Sachs to head up Canada Pension Plan Investment Board's public markets investments in 2001 and later began luring former colleagues from Wall Street as he set up an in-house hedge fund operation. At the time, leverage on CPPIB's balance sheet – measured as the difference between total assets and net assets – was less than 1 per cent. By 2011 it stood at 10 per cent and by the end of the fiscal year, it had grown to 22 per cent, according to publicly available data compiled by Bloomberg.
CPPIB, Canada's primary public retirement fund, returned 18.3 per cent its fiscal year ended March 31 and had $264.6-billion of assets under management.
"I wouldn't advise people to follow the Canadian path just because it seems easy; it's actually not," said Mr. Raymond, who departed last year for Alignvest Investment Management. "If things do go wrong in derivatives, they tend to happen a lot faster than unlevered portfolios. A derivative will magnify things."
Leverage at HOOPP now exceeds 100 per cent of its net assets, leading to a more than doubling of the total assets at its disposal to invest. Ontario Teachers' Pension Plan, Canada's third-largest, has leverage equal to half its net assets.
HOOPP earned 17.7 per cent in 2014, while Teachers returned 11.8 per cent. The S&P/TSX composite index returned 10.5 per cent in 2014, including dividends.
"Traditional skill sets in pension funds are much different than what we have," HOOPP's Mr. Keohane said. "A lot of what we do is more like what you would see in a hedge fund."
Asked about the leverage on its balance sheet, a spokesman for Teachers said derivatives are a better way to invest in certain assets. A spokesman for CPPIB said its leverage is a form of cash management that keeps the fund "nimble" and boosts returns.
In the case of HOOPP, Mr. Keohane said the fund needs to earn 3.4 per cent above inflation to cover its pension obligations, no small feat given 10-year Canadian government bonds yield half that, U.S. ones are at about 2.3 percent and yields on $1.9 trillion of European debt are actually below zero. "So what we're trying to do is find things that add incremental return with the least amount of risk," he said.
The fact derivatives, unlike equities, can eventually expire and provide a payout means that risks from leveraging can be contained by investors with the means to ride out any interim storms, Mr. Keohane said. "We have an advantage over hedge funds because we have a balance sheet they don't," he said. "Nobody's going to shake us out of a trade."
Yet that's precisely what happened in the financial crisis to Caisse de dépôt et placement du Québec, Canada's second-largest pension plan. The Caisse suffered a 25-per-cent loss in 2008 following a collapse in Canada's market for bonds backed by short-term corporate loans.
Those losses were compounded by leverage that had grown to 56 per cent of assets, according to Roland Lescure, the fund's current chief investment officer, who joined in a management shake-up made after the crisis.
"Suddenly, a book of derivatives that was not supposed to carry any directional risk started carrying some," he said. The Caisse has since brought its leverage down to about 20 per cent of assets, mostly mortgages on its properties.
Proponents of today's hedge fund strategies say the Caisse's 2008 failure didn't occur from using derivatives themselves, but from devoting too much money to a single market, which happened to freeze up.
C.D. Howe's Mr. Hamilton is understanding of the new strategies but, recalling the financial crisis, still uneasy. "I'm sure there are a lot of banks who thought they knew exactly what they were doing, and they had the risks all covered off – until they didn't."