Do large public pension funds need more third-party investment reviews?

In May, the Canadian Union of Public Employees’ Ontario branch renewed calls for a third-party review of the OMERS’ investment strategies, returns and internal performance after the pension fund reported billions of dollars in losses for 2020.

Read: CUPE seeking third-party review of OMERS following 2020 investment losses

According to the OMERS’ 2020 annual report, its portfolio lost 2.7 per cent as a result of the pandemic. In particular, the report highlighted the impact of widespread lockdowns on its investments — such as retail properties and the transportation and entertainment sectors — which it said accounted for more than half of the shortfall. The OMERS’ endured further losses because of significant allocations to dividend-paying financial services and energy businesses, as well as a rebound in the Canadian dollar after it fell sharply at the start of the crisis.

A report from the union compared the OMERS’ 2020 performance to other large public sector pension funds. At 97 per cent, the OMERS maintained the same funded status as at Dec. 31, 2020, while the Healthcare of Ontario Pension Plan reached 119 per cent, followed by the Public Sector Pension Investment Board (111 per cent) and the Ontario Teachers’ Pension Plan (103 per cent). And in a chart comparing the 10-year annualized returns of eight of Canada’s largest pension funds in the decade leading up to the pandemic, the report found the OMERS was the lowest performing fund.

In a statement made alongside the report, George Cooke, chair of the board of directors at the OMERS Administration Corp., said an independent review isn’t warranted. “OMERS’ investment program is governed by an independent expert board, whose members have been nominated by our sponsors. The board continually and thoroughly reviews investment performance, independent of management, utilizing external experts where appropriate.

Read: OMERS’ portfolio lost 2.7 per cent, net of expenses, in 2020

“Following the 2020 results specifically, we undertook a thoughtful look at our investment strategy and past decisions with an open mind. We are confident in our strong new leadership team and have concluded that our current investment strategy is appropriate.”

Fred Hahn, president of CUPE Ontario, says the plan’s 2020 results do warrant an independent review, a measure the union called for earlier this spring. “[OMERS said] there’s no problem and they had a negative 2.7 per cent result in 2020, when every other comparable plan weathered the pandemic in a better way, as well as a 10-year comparison that shows at the bottom of the pack of all these plans. . . . This demonstrates there’s got to be a problem. If they’re not capable of identifying it, then someone from the outside needs to be engaged to do that.”

While Hahn says third-party reviews aren’t always necessary, he believes they’re essential if factors such as performance, returns and ethical investments are escaping a plan’s internal oversight. “How is the plan doing? Is it performing well? [First], are the investments generating the kind of resources necessary to not just pay the pension promise but to make the plan strong? Second, what manner of control or say do the sponsor organizations of the plan have in its investment strategy?

“Third, what’s the plan doing around how it’s investing money in relation to the change in the vantage point in terms of collective resources when it comes to pension plans? In other words, are we investing in the arms trade and things that are killing the planet or are we investing in sustainable mechanisms that help workers retire with a healthy retirement income while building capacity in our communities? If those things exist in a plan, I don’t think a third-party review is required at all. But when they don’t, it’s essential.”

The OMERS didn’t respond to Benefits Canada’s requests for comment.

Read: AIMCo calls reports of losses on volatility strategy ‘dramatically’ overstated

The OMERS wasn’t the only large public pension fund to experience a significant loss in 2020. The AIMCo posted a $2.1 billion loss through a volatility trading strategy, known as VOLTS, which began in 2013 and was expanded in January 2018 to include capped/uncapped variance swaps.

Amid the pandemic, the AIMCo’s board took steps to mitigate further losses by approving a plan to wind down and permanently close the strategy altogether. While the strategy would have been expected to generate some losses in periods of market volatility, the losses were far greater than expected, noted a report on the review. Although a legacy risk system was in place, it didn’t work well with non-linear returns like the volatility strategy, said the report.

“Oversight of AIMCo’s investment strategies and risk management is the responsibility of the board of directors,” it said. “The losses incurred by our clients as a result of the VOLTS strategy are wholly unacceptable. The board is determined that the lessons from this experience will improve AIMCo’s management processes, prevent any similar occurrences and, most importantly, strengthen the risk culture of AIMCo.”

Read: AIMCo board undertaking third-party review of volatility trading strategy

As a result of the review, the AIMCO’s board adopted several recommended changes. These include the broadening of its risk framework to deepen the description of risk appetite and tolerance, as well as the implementation of revised investment approval thresholds relating to any investment strategy or product using over-the-counter options, swaps or other derivatives, with the exception of cases in which derivatives are used only for hedging risks inherent in an investment strategy.

In addition, the AIMCo’s board said its human resources and compensation committee would continue its redesign initiatives to push risk and investment managements’ further integration, including provisions for their compensation to be meaningfully linked to both teams’ degree of improved collaboration. The board also asked the chief executive officer to revise the AIMCo’s talent management strategy, organizational design and management succession plan.

“No matter how carefully designed a set of prescriptive rules are, a so-minded individual or group can usually find a way to circumvent such rules,” said the report. “Consequentially, the most important changes emerging from the board’s review are actually not process changes at all, but rather changes to the culture in which the rules are to be embedded.

Read: AIMCo’s board makes recommendation after reviewing strategy that lost $2.1 billion

“With the oversight of the board, senior management will continue to move AIMCo’s culture toward a more collaborative environment among risk and investment professionals. These changes are not so easily affected and will require strong focus and leadership from the board and senior management, as well as continuous evaluation against clear, predetermined benchmarks.”

In an emailed statement to Benefits Canada, the AIMCo declined to provide further comment.

While the losses from the AIMCo’s volatility strategy were significant, the results were highly irregular, says Kendra Kaake, director of investment strategy at SEI Investments Canada Co. “[The losses aren’t] something you’d see ubiquitously across all of the large plans. It really depends on the specifics of the situation. This isn’t anything common or a trend among plan sponsors in Canada.”

Regarding duty of care, she says while the members of a plan’s investment committee aren’t presumed to be all things to the organization, there’s an expectation they obtain the proper information regarding investment decisions.

Read: UAPP withdrawing $2.7BN public equities portfolio from AIMCo

“It’s all about the long term and sustainability of the enterprise — Do you have clear investment goals? A suitable allocation using broadly diversified investments? Generally, it means having an obligation to behave in good faith and with good judgment [and] to rely in good faith on the advice provided by experts.

“The larger the pension fund, the more likely you’re going to have more mandates and more specialized mandates. You’re likelier to have more boutique firms and specialty asset classes like real estate, infrastructure, private equity and private debt. These things require more expertise and it may require consultants that have bigger research teams. . . . When we’re talking about those large plan sponsors, you have to think of those strategies in relation to the total portfolio, as opposed to silos. You have to focus on the broader picture.”

Colin Ripsman, president of Elegant Investment Solutions Inc., says while Canada’s large public pension plans have ample in-house expertise, a third-party review can help guard against factors such as regulatory compliance risk and fiduciary risk.

“The regulators want to make sure you’re making reasonable decisions [and] considering the right things. But a large part of it as well is controlling that fiduciary risk, making sure you have a third party you can look to and say, ‘We thought this was the right thing, but we can point to a third party who looked at all these different things and this was their recommendation.’ If you have regulators look at the arrangement or have members challenge that arrangement, using that third party is a real benefit in defending those decisions. That ties into reputational risk as well. [Large plans] have these capabilities in-house, but there might be a benefit to separating themselves by having a third-party view.”

Read: Nova Scotia Teachers’ underperforms benchmark in 2020, facing independent review

While the pandemic was a unique and unanticipated event, it’s pushing pension plans to more closely review factors they wouldn’t have previously considered as potential areas of risk, says Tyler Smith, vice-president of actuarial and investment consulting at People Corp. While significant reform to how investments are reviewed isn’t necessary, there’s always room for improvement as evidenced by the results of 2020, he adds.

“I’m not sure if those returns are something we can expect to see again. There was a really good amount of due diligence and review, so the losses we saw in 2020 were simply a factor of what happened in the environment. It’s opened the eyes of a lot of those organizations to review the more esoteric or asymmetric risks out there.

“It’s not always easy to find correlations when a global pandemic happens and what that means for the different asset classes. It was a unique year and it gave the industry a chance
to adjust its thinking a little.”

Blake Wolfe is an associate editor at Benefits Canada.