Straight Talk with CIO Jill Pepall

How will the Investment Management Corporation of Ontario (IMCO) benefit the Plan going forward?

In today’s challenging investment environment, developing effective strategies to maximize returns is critical. IMCO provides OPB with immediate economies of scale and will enhance our ability to directly invest in a broader array of high-quality assets that we believe will deliver enhanced risk-adjusted returns. We expect that participation in IMCO will boost investment returns, and even a small increase could have a significant impact. For example, if OPB were able to increase its annual investment returns by 25 basis points (1/4 of 1%) above the Plan’s discount rate, this would add approximately $2.0 billion to the funded status of the Plan at the end of 15 years. In addition, through IMCO, OPB will benefit from:

• the ability to retain superior leadership and investment management talent.
• the incorporation of a more robust risk management and monitoring system into its investment decisions and processes.
• cost advantages from the continued internalization of investment expertise for selective public and new private markets investments.
• access to greater research capabilities.
• lower relative costs.

What will or will not change once IMCO is managing OPB’s investments?

First, let’s look at what stays the same. OPB will continue to own its assets and maintain control over the strategic asset mix of the Plan and the policies governing our investment strategies such as the Plan’s Statement of Investment Principles and Beliefs (SIP&B), Statement of Investment Policies and Procedures (SIP&P), and Strategic Asset Allocation. It is important for OPB to set its own SAA as it marries its asset strategy with the Plan’s pension liabilities, which will remain at OPB and be separate from those of WSIB and all other IMCO members.

Once IMCO is operational, it will be responsible for managing our assets and will become OPB’s sole and exclusive investment manager. As such, IMCO will be subject to the terms of an investment management agreement (IMA) and a service level agreement (SLA) between OPB and IMCO. The SLA will detail OPB’s expectations of IMCO in terms of governance, record-keeping, performance measurement and reporting capabilities, and compliance requirements. Also, OPB’s investment and investment finance staff will move from OPB to IMCO which means the Plan’s assets will be managed initially by the very same experts who are managing them currently.

Furthermore, OPB will have its own Head of Investments to oversee IMCO’s implementation of OPB’s SAA and to manage the relationship with IMCO.

What were some of our key successes in 2016?

2016 was a successful year for OPB. The Plan generated a solid return in an increasingly challenging environment. The strong performance of both Private and Public Markets contributed to an 8.1% return, which exceeded the Plan benchmark of 6.6% by 1.5%.

OPB made substantial headway with its Internalization Program in 2016, and now internally manages the money markets mandate, a passive fixed income mandate and several absolute return strategies. Other key successes in 2016 include enhancing performance and risk reporting, improving OPB’s ability to respond to market conditions and make timely investment decisions, and the hiring of a Director of Responsible Investing, improving OPB’s capacity to assess and mitigate long-term environmental, social and governance risk.

How does OPB use Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) to its advantage?

The SAA is the optimal asset mix that reflects the Plan’s long-term funding and cash flow needs. It is the most important factor in determining total returns of the Plan. Setting asset target allocations will remain an OPB responsibility once IMCO is operational and will be managed by the Head of Investments at OPB, supported by the investment professionals at IMCO.

TAA is a strategy used to enhance returns by altering the SAA over the short term to take advantage of financial market volatility. TAA can be used to preserve capital by reducing exposure to markets when a downturn is expected or by increasing exposure when it is expected that markets will perform well. This was the case in the last quarter of 2016 when the equity exposure of the Plan was increased to 5% overweight versus the SAA, in anticipation of stronger equity markets reflecting improved global growth. Once operational, IMCO will leverage TAA to effect short-term changes within the SAA guidelines as set by OPB.

How did the low level of interest rates impact the Plan’s return in 2016?

Low interest rates provide both opportunities and challenges for the Plan. On the upside, low interest rates provide an opportunity to increase capital deployment into certain types of private debt investments, allowing the Plan to enhance returns with only a minimal increase in risk. Additionally, lower interest rates allowed OPB to acquire high-quality real estate assets at very low financing rates, providing the opportunity for OPB to borrow funds at a low cost via bond issues. Both private debt and real estate assets provide attractive returns and ongoing predictable cash flow – which is very important to paying out pension benefits.

On the downside, it is generally harder to earn high investment returns in a low-interest-rate environment over the long term. In 2016, the bond market in Canada returned only 1.7% as indicated by the FTSE TMX Universe Bond Index. Despite the challenges that low interest rates present for investment returns, OPB’s fixed income portfolio earned 4.2% in 2016. OPB was able to generate better returns by diversifying strategies and overweighting credit exposure (which returned 9.8%) versus government bonds (which returned 0.9%) and adding to Private Debt (which returned 9.0%).

In addition, OPB’s TAA strategy as it relates to fixed income helped preserve capital and enhance the return of the Total Fund. Capital was preserved by investing in bonds that have a shorter yield to maturity and thus tend to retain their value better when interest rates move up. The Total Plan return benefited from the decision to underweight the lower-yielding fixed income asset class and overweight the higher-return equity asset class.

What are the benefits of increasing our exposure to private markets?

Given OPB’s long-term investment horizon, investing in private markets is a sensible way to enhance returns while adding diversification away from public markets. Private market investing provides a greater degree of transparency and access to the underlying investments’ management teams, as well as increased governance and influence which creates the potential for generating higher overall returns. OPB has been very successful in implementing the private markets’ infrastructure and private equity investment strategies since they were introduced to the SAA in 2011. We’ve been able to generate positive returns in those portfolios since day one by strategically investing in secondary funds and co-investing directly with partners.

How does the Internalization Program help position OPB for future success?

Implementing and supporting further internal asset management allowed OPB to agilely respond to market movements and opportunities and to cost-effectively generate incremental risk-adjusted returns. At IMCO, former OPB investment staff will continue to develop the Internalization Program by investigating, evaluating and implementing additional internal investment mandates that provide value-added portfolio management, while lowering costs over the longer term and providing greater control and transparency to IMCO’s members.

What were your key challenges in 2016?

Economic and geopolitical factors in 2016 created one of the most challenging investment climates since the global financial crisis eight years ago. This investment environment was characterized by several key themes:

• Volatility of financial markets in response to Brexit/U.S. election;
• Low-interest-rate environment;
• Competition for private markets assets; and
• Rise of populism, which can mean real change for which the outcome and consequences to financial assets is very uncertain.

We managed the investment portfolio successfully through these challenges. I am very proud of the team’s performance in the face of these headwinds.

What is the investment approach to ensure the long-term sustainability of the Plan?

The most critical step to ensuring the long-term sustainability of the Plan is the alignment between our pension obligations and our assets. The purpose of the triennial asset/liability (A/L) study is to determine if our assets are a good match for our liabilities based on up-to-date actuarial data. It is an opportunity to adjust the Strategic Asset Allocation, if needed, as market and economic conditions change. OPB initiated an asset/liability (A/L) study in 2016, which was completed in early 2017. We adjusted our SAA modestly to ensure the Plan is well positioned in advance of the operational launch of IMCO.

What is your 2017 investment outlook?

After years of quantitative easing and increasing monetary stimulus to encourage economic growth, central banks globally are starting to ease up on that strategy. Global economic growth is accelerating, signs of inflation are re-emerging and risk assets (equity and credit markets) are at the higher end of historical valuations. It is no wonder that central banks are making monetary accommodation decreasingly available – from the European Central Bank that has held stimulus flat for over a year, to the U.S. and China where the respective central banks have started to raise interest rates. In the U.S., consumer confidence is at a cycle peak, unemployment is at a cycle trough and, with the Trump presidency promising significant fiscal stimulus, public equity markets have surpassed all-time highs.

Strengthening global growth should continue to be positive for equity markets for the near term. This environment, however, is less attractive for fixed income markets due to the prospects of rising interest rates to curtail inflation.

While the investment environment will remain challenging, it will also provide investment opportunities. OPB is well positioned to manage through these challenges, and, more importantly, we have the strategies and expertise needed to generate value-added results in today’s investment climate.

Jill Pepall
EVP & Chief Investment Officer