Background

Ontario Teachers' Pension Plan (OTPP) is the pension plan for the teachers in the Ontario province of Canada. It was founded in 1990. Its assets under management amount to CAD$190 billion (equivalent of US$147 billion) in December 2017.¹ It is built on four pillars: a clear mission, a strong and independent governance, the vision to manage the fund like a company and the policy to hire and retain top talent.

In practice, there are a number of key characteristics that to a large extent describe both Ontario Teachers' and more generically a number of other large Canadian pension plans:

• A return orientation, with emphasis on generating high and sustainable returns;
• Active investing with an entrepreneurial mind-set;
• A tendency to internalize the investments;
• A large of allocation to private assets (more than 40%).

Ontario Teachers' is a defined benefit plan. It aims to index its pensions. In recent years, flexibility in the indexation, conditional indexation, has been introduced as a way to cope with the reduced flexibility of the fund because of its increasing maturity. A sign of this increasing maturity is that net pension payments of the fund already exceed the premiums with almost a factor of 2:1. As compared to the start of the fund in 1990, the ratio of active members vs. pensioners has shrunk from 4:1 to 1:1 and the expected years on pension increased from 25 to 32. This puts much pressure on the return-generating capacity of the plan.

The challenge

Two challenges are central to Ontario Teachers': creating and maintaining a strong board, and generating the strong investment returns they need to maintain the pension promise.

The board has 11 members who are appointed by the sponsors of the fund, the Ontario Teachers Federation and the government of the Ontario Province. The board oversees the management of the fund, for which Chief Executive Officer (CEO) Ron Mock is responsible. Importantly, board members have strong professional backgrounds in finance and governance. Typically, they come from accounting, actuarial sciences, banking, the corporate sector, economics, education, and investment management. The investment committee consists of all the board members, thereby emphasizing the enormous interest Teachers' attaches to the investment part of the fund.

The process

In terms of delegation by the board to the management, the plan adopted the “OneTeachers Strategy”² in 2017. The core of this is that the board specifies a long-term return target, which fits the pension promise and is realistic. This target stands at around a 4% real return. This is the objective the investment management organization adopts. It has to be realized on a four-year rolling horizon within a risk budget. Importantly, the OneTeachers' Strategy specifies an absolute, and not a benchmark relative investment goal. In this way, the fund is agnostic about whether the return comes from harvesting from benchmarks (beta) or from benchmark-relative performance (alpha). This is a crucial part in the delegation process by the board: it creates enormous degrees of freedom and, therefore, responsibility for the management team. At the same time, this means that the board investment committee has to be highly qualified in order to be able to judge and support the management team and the investment strategy. This is all the more true in a bad period, when it would be easy for the board to blame the management and create an unsafe environment in which it would be difficult to stay the course for the long term.

As said, internalization of the investment management is an important ingredient of the approach of Teachers'—both because of cost reduction reasons, especially in the private assets, and of the possibility to closely control the quality. Some 80% of the portfolio is managed internally. The choice for internal or external management is made within the investment organization. External management predominantly exists in hedge funds, public equities, and private equity funds.³ In private equity, partnerships are the way to get access to markets in a high quality way where Teachers' does not have the network or the know-how to invest directly. Teachers' has these so called “strategic relationships” with many of the leading global private equity firms. In addition, in public equity markets they partner up for the longer with high added value external managers. There is even a specific department for searching and managing partnerships.

The core contributor to the long-term success of the Teachers' is their large and extremely successful allocation to private assets, predominantly real estate, infrastructure, and private equity. In order to be successful on the ground, especially in private assets, Teachers' has opened offices in London and Hong Kong, so as to build strategic relationships and identify investment opportunities.

The outcome

To zoom in on private equity, the Private Capital Group invests directly in private companies, either on its own, with partners, or indirectly through private equity funds. The group generates added value to the companies in the portfolio—and thereby to the plan—by helping with their long-term strategic planning, the creation of high-performing management teams and boards, and the creation of strong governance. Over the 25 years up to 2016 this has resulted in annual returns of 20%, net of all costs of the private equity investments.

Lessons for Achieving Investment Excellence

• In order to run a pension plan as an entrepreneurial company, you need strong governance and a board that has all the relevant competences and experience.
• The investment management organization at Teachers' has many degrees of freedom. This creates both opportunity as to where the returns go, and a potential risk of too many responsibilities being delegated by the board. Every fund should make its own care judgment here. Key ingredients for this judgment are: the quality of the investment management organization, the quality of the board, and the strength of the governance arrangements.
• Not many pension funds around the world have the governance budget, the desire, or the capabilities to build an investment operation as strong as Teachers'. Building this capability is a multi-decade process in which there will be both successes and failures. Therefore, if a board wants to go in this direction, it has to be prepared to stay the course.