As a fresh-faced elementary school student in 1977, Aaron Bennett wasn’t quite in the target demographic for the freshly launched Benefits Canada magazine.
Still, Bennett — now the chief investment officer at Ontario’s University Pension Plan — has a pretty firm grasp on the concerns that would have occupied the minds of his predecessors as they leafed through that inaugural edition, since they bear a remarkable resemblance to the ones he’s currently facing. “History doesn’t necessarily repeat itself, but it often rhymes.”
Flashback to the 70s
For many in the investment industry, the recent spike in inflation brought back memories of the late 1970s — the last time serious doubts were expressed about central banks’ ability to keep rates under control as they spiralled towards double figures.
Back then, investors also had to deal with a labour market revolution powered by advances in technology and education, just as members of the baby boomer generation began to establish themselves in C-suites across the country, as well as on shop floors.
These days, Canadian workplaces already shaken up by the mass retirement of workers from the very same generation have seen the coronavirus pandemic reset traditional norms regarding the office and remote working. In either era, Bennett says the disruption of large secular trends brought investment executives at Canada’s largest financial institutions to essentially the same conclusion. “The playbook that we used for the last 10 or 15 years maybe isn’t the right playbook for the next 10 or 15 years.”
But that may be where the parallels end, according to Yusuke Khan, Canada investments leader at Mercer, who explains that the complex combination of assets owned and controlled by today’s typical institutional investor would be unrecognizable to their forebears in the industry. “If you went back to the 70s or before, you would see much more conservative portfolios.”
Over time, pension plans in particular reduced their reliance on bonds, progressing gradually towards the 60/40 split with equities that became the gold standard for balanced portfolios with investors of various sizes, he adds.
Anyone who wanted to get more creative found their ambition constrained by regulations that limited investment beyond Canadian borders. The Foreign Property Rule, established under the Income Tax Act in 1971 to encourage the growth of Canadian capital markets, capped the proportion of foreign investments at 10 per cent of a registered retirement plan’s total assets.
The rule wasn’t loosened until 1991, when the limit on foreign assets began rising in a series of increments, topping out at 30 per cent in 2001, before its elimination altogether in 2005. In the meantime, a package of reforms to Ontario’s Pension Benefits Act cleared the way for the emergence of a Canadian model of pension plan management, characterized by massive jointly-sponsored plans — such as the Ontario Teachers’ Pension Plan and the OPSEU Pension Trust — operating independently and controlling their investment strategies in-house.
“From there, it has really been a quest for innovation and improvement both in expected returns and managing risks,” says Khan.
Following the Canada Pension Plan Investment Board’s formation in 1997, Ed Cass, its chief investment officer, says the end of the Foreign Property Rule was a “tremendously significant” moment in the development of the fund, coinciding as it did with the CPPIB’s shift from passive to active management.
“It allowed us to diversify geographically, which importantly helps insulate the fund against concentration risk in Canada. We now invest in all major asset classes worldwide to enhance long-term risk-adjusted returns through diversification and security selection, while building a highly resilient portfolio. By doing so, the fund benefits from positive global growth in the world’s largest investment markets and remains resilient during periods of slow growth within specific regions.”
Shift to alternative assets
In recent years, the search for yield in a low interest rate environment accelerated Canadian institutional investors’ shift towards alternative assets.
Indeed, between 1999 and 2019, the proportion of defined benefit pension funds’ real estate assets tripled from four per cent to 12 per cent, according to the Pension Investment Association of Canada’s annual asset mix survey, while the actual value of that property exploded over the same period, from $20 billion to almost $280 billion. More recent data from the PIAC suggested around a quarter of all Canadian DB assets fall into the broader alternative asset category, encompassing real estate, private equity and hedge funds, among other investments.
More than a third of the Colleges of Applied Arts and Technology pension plan’s assets are tied up in alternatives, including a small but growing allocation to agricultural investments, according to Asif Haque, the plan’s chief investment officer. “We believe they carry a return premium over public alternatives and we’re giving up liquidity to access these opportunities,” he says, noting his stance is aided by the longer-term investment horizon the CAAT pension plan works on.
“Canadian pension investors are in a very interesting position in being able to look through current volatility and find value where it exists,” he adds.
James Davis, chief investment officer at the OPTrust, expects the trend towards alternative assets to continue for the foreseeable future, thanks in part to the increased efficiency of public markets. “It’s much harder to add value than it was in 1977. As we head into the future, there’s going to be a lot more continued interest in alternative investing — infrastructure, real estate private equity — because of the diversification benefits of those assets. But probably equally as important is the value-creation potential that those assets provide . . . because of the depth of talent and the depth of relationships that are possible in an institutional investing framework.”
The Canadian pension model
In a 2020 study, Sebastien Betermier, associate professor of finance at McGill University, identified the steady stream of income and diversification that comes with real estate and infrastructure assets as a key plank of Canadian pension funds’ consistent outperformance of their global peers between 2004 and 2018.
“The Canadian funds did better not only when you looked at their overall risk-to-return ratio, but also in terms of asset-to-liability hedging. It was interesting to us, because typically the more you hedge, the more you have to bear costs on returns and that wasn’t the case here.”
In addition, Betermier and his co-authors found Canadian pension funds distinguished themselves from other large pension, corporate and sovereign wealth funds through their heavier use of in-house investment teams, allowing them to manage more than half of their own assets. The Canadian pension plans then compounded their savings by redeploying the extra funds internally, outspending comparable investors across asset classes.
In a follow-up study, Betermier and his colleagues looked at the extraordinary level of direct real estate investment by Canadian pensions plans, finding their transactions accounted for 60 per cent of the global deal volume involving retirement funds, despite representing just six per cent of all pension assets under management. “Here, the funds are doing it themselves,” he says. “They’re on the ground, building the projects themselves in Toronto, in Montreal and abroad.”
Using domestic data on LEED certification for new and retrofitted buildings, the authors also found Canadian pension funds are pursuing an impact strategy of greening urban properties. “There is this combination of value-added as well as a positive environmental impact,” says Betermier.
A rise in ESG investing
For the CPPIB, environmental, social and governance factors have become increasingly important, says Cass, ever since it began incorporating sustainability into investment decision-making over a decade ago.
“ESG is going to be an even bigger factor in the future. Investors will need to learn how to construct portfolios that both manage the risks, as well as access the opportunities that climate change, in particular, presents,” he says, pointing to the fund’s plan to boost investment in green and transition assets to at least $130 billion by 2030.
When it comes to ESG considerations, Canadian institutional investors are ahead of the game compared to their U.S. counterparts, says Marina Severinovsky, North American head of sustainability at Schroders. “It’s always a year after we’re having conversations with our Canadian clients that we’re having the same conversations with our U.S. clients.”
The 2022 edition of the firm’s annual institutional investor study backs up Severinovsky’s sentiments, with 88 per cent of Canadian respondents reporting they use ESG integration to invest sustainably, compared to a global average of 75 per cent.
She was also struck by the proportion of Canadian institutional investors that identified the positive societal and planetary impact as a driver of their sustainable investment strategy. The corresponding figure was 38 per cent for U.S. investors, who Severinovsky says tend to be more focused on performance.“Maybe what Canadian investors have figured out is that there is money to be made from solving the world’s big problems. It’s not mutually exclusive that you should want good returns and should also be able to address some of those challenges.”
There are still plenty of obstacles for institutional investors seeking to make the most of their sustainable investments, says Melanie Pickett, head of asset owners for the Americas at Northern Trust Corp. While a large proportion of public companies make some kind of ESG disclosure, the quality varies. “Private companies are much more inconsistent and there isn’t really a model that they’ve settled on,” she adds.
In late 2020, a number of Canada’s largest pension plans took matters into their own hands, demanding that companies adhere to the Sustainability and Accounting Standards Board and the task force on climate-related financial disclosures framework when reporting ESG disclosures.
But the issue isn’t unique to ESG disclosure, according to Pickett, who says data analytics capability will be crucial for institutional investors if they’re to thrive in the future, thanks to their increasingly sophisticated asset allocation strategies.
“They need a much more holistic view of exposure. For public assets, there is a lot of market data at hand, but with private investments, it’s a much more complex problem to solve. The underlying exposures are not as transparent.”
Whatever the coming decades bring, Bennett says he’s focused on his job and relishing the challenge. “I don’t spend a lot of time predicting the future, I just try and build resilient portfolios. Volatility is something to keep an eye on, but these are also opportunities — potentially career-making opportunities. My concern . . . over the next several years is to capitalize on some of these opportunities, to bring new tools to bear, to get people engaged and to make investments in areas that are seeing this level of change.”
I read this comment earlier and there's a lot of good material covered here.
First, I agree with CPP Investments' CIO Ed Cass, the end of the Foreign Property Rule in 2005 was a “tremendously significant” moment in the development of the fund, coinciding with its shift from passive to active management:
“It allowed us to diversify geographically, which importantly helps insulate the fund against concentration risk in Canada. We now invest in all major asset classes worldwide to enhance long-term risk-adjusted returns through diversification and security selection, while building a highly resilient portfolio. By doing so, the fund benefits from positive global growth in the world’s largest investment markets and remains resilient during periods of slow growth within specific regions.”
It allowed all of Canada's large pension investment managers to expand geographically which they continue to do, now focusing on expanding their reach in the APAC region.
I also agree with Ed that ESG factors are increasingly important and even though they've been incorporating them for a long time, they are now shifting to look at risks and opportunities:
“ESG is going to be an even bigger factor in the future. Investors will need to learn how to construct portfolios that both manage the risks, as well as access the opportunities that climate change, in particular, presents,” he says, pointing to the fund’s plan to boost investment in green and transition assets to at least $130 billion by 2030.
In my last comment, I went over a discussion I had with Jamie Gray-Donald, Senior Vice President, Sustainability & Environmental, Health & Safety at QuadReal, BCI's real estate subsidiary.
Jamie explained the difference between green-certified buildings and net-zero buildings and why the the wave of the future is that buildings will be required to go beyond LEED and shift to a net-zero standard.
When CIOs talk about "building a highly resilient portfolio," they need to start thinking ahead to know where the puck is heading in all asset classes.
There's been a lot of criticism on ESG, some of it merited in public market funds which were accused of greenwashing their investments, but as far as Canada's large pension investment managers, responsible investing is embedded in their investment approach and they are looking at the risks and opportunities of climate change.
The part of the comment I didn't like is that ESG data is easier to get in public assets and much harder in private assets.
I would argue that ESG data in private markets is easier to get because our large pensions and their strategic partners have more pull on private companies when they acquire them.
There are tremendous efforts going on right now across public and private markets to get better disclosure and standardize the data.
All this to say, the shift into private markets doesn't just add diversification benefits and return premiums, it also allows for a deeper value creation plan which incorporates ESG factors more easily, something OPTrust's CIO James Davis refers to when he states this:
“It’s much harder to add value than it was in 1977. As we head into the future, there’s going to be a lot more continued interest in alternative investing — infrastructure, real estate private equity — because of the diversification benefits of those assets. But probably equally as important is the value-creation potential that those assets provide . . . because of the depth of talent and the depth of relationships that are possible in an institutional investing framework.”
He's spot on, these strategic relationships are critical and they will be more critical over the next decade.
As far as alternatives, CAAT Pension Pan's CIO Asif Haque explains why more than a third of the of the pension plan’s assets are tied up there, including a small but growing allocation to agricultural investments:
“We believe they carry a return premium over public alternatives and we’re giving up liquidity to access these opportunities,” he says, noting his stance is aided by the longer-term investment horizon the CAAT pension plan works on.
CAAT Pension Plan is fully funded so giving up some liquidity to access opportunities in illiquid alternatives makes sense. Their approach is also critical, co-investing with strategic partners to lower fee drag.
In fact, I'd argue that the success of Canada's large pension investment managers comes from their governance model which allows them to hire talented people to manage more assets internally.
They still need strategic partners, especially when investing abroad, but if they attract the right people, they can lower fees and add meaningful value-add over the long run.
That brings me to the long run and what the next 10 to 15 years have in store for institutional investors.
UPP's CIO Aaron Bennett states the disruption of large secular trends brought investment executives at Canada’s largest financial institutions to the same conclusion as the late 70s: “The playbook that we used for the last 10 or 15 years maybe isn’t the right playbook for the next 10 or 15 years.”
Aaron, however, isn't trying to predict the future, as he explains:
“I don’t spend a lot of time predicting the future, I just try and build resilient portfolios. Volatility is something to keep an eye on, but these are also opportunities — potentially career-making opportunities. My concern . . . over the next several years is to capitalize on some of these opportunities, to bring new tools to bear, to get people engaged and to make investments in areas that are seeing this level of change.”
Well, he has a nice opportunity at UPP to slowly construct a well diversified portfolio across public and private markets and he has a strong team and CEO backing him up.
As far as what the future holds, it's unclear whether we are headed for a stagflationary crisis unlike anything we've ever seen or a potentially painful period of global deflation.
The macro backdrop is as bad as it gets. Add heightened geopolitical risks in that mixture and anything can happen over the next two years, let alone the next decade.
This is why it's important to maintain the long view which is what Canada's large pension investment managers are doing, capitalizing on opportunities as they present themselves across public and private markets all over the world.
In my opinion, we aren't headed back to the 70s. The world is much better now, just look at the proportion of women working today versus then and the amount of technological disruption going on.
But if policymakers aren't careful, it can potentially be a lot worse.
There are still a lot of structural problems plaguing the global economy, rising inequality and sovereign debt just to name a few.
The shift to a green economy is welcome but it will take time and it won't be linear.
Volatility will be part of markets, it always is, but now more than ever, Canada's large pension investment managers need to maintain their long view and find the right opportunities as they present themselves.
This is what they are doing, looking to expand their portfolios geographically and future-proof them against changes coming from regulations and consumer/ corporate demand, and find opportunities in climate change while recognizing the risks.
Below, the IMF’s October 2022 World Economic Outlook examines two economic forces that could impact inflation going forward. One chapter looks at wage dynamics post-COVID-19, wage-price spiral risks, and how policymakers can respond. Another chapter investigates the potential near-term effects of critical climate policies on inflation and economic activity and how they can be best designed.
After briefly summarizing the chapters, the IMF authors discuss their findings with PIIE senior fellows Olivier Blanchard and Pinelopi Koujianou Goldberg. A Q&A with the audience follows.