Risks and Rebounds

We increased our inflation holdings by increasing our holdings of real-return bonds and real estate. We also increased the duration of our interest rate sensitivity by increasing the duration of our existing bond portfolio and significantly adding to our long bond position. And, to fund those other changes, we reduced our equity position. We took our public equities down to 30% of the total portfolio, and we put some hedges on our equity position as well. We also significantly reduced our exposure to credit.

We were well positioned for what happened, but it wasn’t intended to be a market timing change. It was driven more by focusing on proper risk management: trying to gauge that properly and get the right risk/return trade-off. That has obviously paid significant benefits over the past couple of years.

Has HOOPP’s investment strategy changed since then?
Not really. We’ve maintained the same asset mix. We’re [currently] going through an exercise to try to determine whether, given where we are today, we have enough return potential in the portfolio to maintain our funded status over a period of time. Right now, we’re slightly underfunded, so we’ll have to make that up.

It’s looking out into the future and understanding how much return potential is in the portfolio and [if] we can meet our objectives of staying fully funded. If not, we may change our asset mix. We’re trying to base things [on] our funded status as opposed to [on] market views.

Did pension funds assume too much risk?
I think some of the pension funds got into exotic trades that really didn’t belong in pension funds. The typical pension fund has a 60% equities, 40% bonds asset mix. That implies a rate of return that’s quite a bit higher than the actuarial assumption—so you don’t really need to take that much equity exposure to gain the [necessary] level of return.

Particularly in the corporate plans, there’s a mixed objective: if you can earn a higher rate of return, the sponsor doesn’t have to put up as much money. In the case of multi-employer pension plans such as ours, there is very little benefit to the employers if we were to dial up the risk in order to produce an exceptional rate of return.

If you read [about] previous crises going back several centuries, it’s typical for these types of declines to be preceded by very low interest rates, which encourages people to take excessive risk to try to earn a decent return. So what you saw was fairly typical. We generally tried to avoid doing that. We tried to be disciplined.

I think there was a lot more risk in some of the strategies that people were pursuing than they had perceived. And there was this reliance on VAR, which is not a particularly helpful tool for pension funds.

Why doesn’t VAR work for pension funds?
There are a lot of assumptions in the tool, and if you don’t understand what those assumptions are, you can get very misleading information.

I think the tool, in most cases, is really designed for banks and investment dealers [whose] definition of risk is essentially market risk. In our case, the definition of risk is quite different.

Risk, from our point of view, is anything that doesn’t match the liability stream. In other words, if you could construct a portfolio that perfectly matched your liabilities, then you would almost eliminate your risk. So the typical off-the-shelf VAR systems don’t measure our risk particularly well.

Is LDI a future trend?
I think it will be. There was a lot of talk about LDI after the 2000-2002 meltdown as well, but not a lot of people did [anything] about it.

If you have a 60/40 equity/bond asset mix, the way the actuaries do the calculation, they give you credit for earning the equity risk premium out into the future (which you haven’t really earned). So if you take your equity weighting down and put it more into bonds, it reduces your expected return [and] actually makes you more underfunded.

Right now, if we were to take our equity mix back up to, say, 50% from 30%, our actuary would probably say we’re fully funded again, even though nothing’s changed other than our asset mix. The expected return has gone up on a portfolio by increasing the equity, but the risk of the portfolio goes up materially as well.

I think funds have a lot of fear of using derivatives—but in fact, it’s really the only way to tackle the problem. You want to reduce the big risks—a decline in long-term interest rates, an unexpected increase in inflation and equity market risk—and redeploy that risk elsewhere. And the best way to do that is through non-traditional strategies such as long/ shorts, absolute return and derivative overlay. It requires a different view of how a portfolio should be constructed.

How have your plan members reacted to the economic uncertainty?
I think they have been very concerned, watching what went on over the last few months. But when they saw our results, there was a big sigh of relief.

Other funds are having discussions on how much to raise the price or cut the benefits. We’re still pretty close to fully funded, so there’s no real need to make any changes to prices or benefits at this time. We did have to make those types of decisions in the 2002/2003 framework, and it was a very painful exercise for the board, so they’re quite pleased not to have to go there again.

Has the economy changed the way HOOPP communicates with its plan members?
We did send out several communications during the market decline. We’ve probably communicated more frequently than we would normally do—just from the point of view of trying to make sure people understand that we’re still in pretty good shape. I don’t know if that’ll be a permanent change.

What is HOOPP’s greatest challenge?
The biggest challenge to HOOPP is that the hospital environment is changing and we are unsure how that will impact the fund longer term. As a multi-employer pension plan, HOOPP can be part of the solution because it allows employees to move between hospitals and community care facilities. The feedback we get from our members is that maintaining their membership in HOOPP is a very important factor in the decision.

Trying to get ourselves back to a fully funded status without taking on too much risk is also a challenge.