OPTrust Returns 5.3% in 2023

Benefits Canada reports OPTrust returns 5.3% in 2023, marks 15 consecutive years at 100% funded status:

On Tuesday, OPTrust released its results stating it is fully funded for 15th consecutive year:

OPTrust today released its 2023 Funded Status Report, People. Purpose. Pensions., which details the Plan's financial results and funded status. In 2023, OPTrust remained fully funded for the 15^th consecutive year and achieved a net investment return of 5.3 per cent. Over the past 10 years, the Plan's average net investment return is 7.2 per cent.

"At OPTrust, we have a clear purpose – to deliver peace of mind in retirement to our members," said Peter Lindley, President and CEO of OPTrust. "For the 15^th consecutive year, OPTrust is fully funded, and the people we serve can continue to rely on a secure, sustainable pension."

For OPTrust members, investment returns account for more than 70 per cent of the benefits they receive in retirement, with more than $1.3 billion in entitlements paid in 2023, benefiting communities across Ontario. OPTrust's Member-Driven Investing (MDI) strategy is designed to deliver the total return needed to keep the Plan sustainable over the long term, without taking excessive risk. OPTrust's average annual net investment return since inception is 7.9 per cent.

"Against a backdrop of volatile markets, global conflict, and an affordability crisis, stability and security are more important than ever,” said Lindley. "By striving to construct a portfolio that is resilient to a variety of economic environments, we remain focused on the long term and in a strong position to pay pensions today and decades into the future."

OPTrust's annual Responsible Investing Report has once again been integrated into the Funded Status Report. In 2023, OPTrust made significant progress implementing its enhanced climate change strategy, including calculating the first Total Portfolio carbon footprint, and announcing an interim portfolio decarbonization target of 30 per cent by 2030 in support of achieving a net-zero portfolio by 2050.

"OPTrust's climate change strategy is designed with one purpose in mind: to protect our pension promise over the long term," said Lindley. “With a recognition of the increasing urgency to act on sustainability issues, we are taking steps today to protect our members' pension security through a transitioning global economy."

In 2023, OPTrust welcomed five additional nonprofit organizations and nearly 1,000 new members to reach a total membership of over 4,200 in OPTrust Select. OPTrust also continued to provide an exceptional service experience to members who rated their service satisfaction as 8.7 out of 10. OPTrust was recognized among the top 10 pension plans for service by CEM Benchmarking Inc.'s global rankings.

OPTrust maintained the discount rate at 3.0 per cent, net of inflation. Additional information about OPTrust's 2023 strategy and results is available in People. Purpose. Pensions. at optrust.com.

ABOUT OPTRUST

With net assets of $25 billion, OPTrust invests and manages one of Canada's largest pension funds and administers the OPSEU Pension Plan (including OPTrust Select), a defined benefit plan with over 111,000 members. OPTrust was established to give plan members and the Government of Ontario an equal voice in the administration of the Plan and the investment of its assets through joint trusteeship. OPTrust is governed by a 10-member Board of Trustees, five of whom are appointed by OPSEU and five by the Government of Ontario.

Please take the time to read OPTrust's 2023 Funded Status Report here.

Earlier today, I discussed this report with CIO James Davis and want to thank him for taking the time to talk to me. I also want to thank Jason White for setting up the call and sending me the material beforehand.

Before I get to my interesting discussion with James, let me go over some items.

First, take the time to read the message from Chair Lindsey Burseze and Vice-Chair Richard Nesbitt:

Next, take a minute to read CEO Peter Lindley's message:

I note the following:

OPTrust’s climate change strategy is designed with one purpose in mind: to protect our pension promise over the long term. In December 2023, we released a one-year update to our enhanced climate change strategy, detailing the progress we have made since 2022 and the goals we have set to strengthen the fund’s resiliency to climate change. Some of the highlights include launching an innovative Climate Metric Framework, calculating our first Total Portfolio carbon footprint, and setting a goal to reduce our carbon footprint by 30 per cent by 2030.

Recognizing environmental, social and governance factors are increasingly important for our members and stakeholders, we moved away from publishing a standalone annual Responsible Investing Report last year and integrated that content within our 2022 Funded Status Report. We are taking that same approach this year to ensure members and stakeholders can easily view our responsible investing activities and better understand how we are incorporating these considerations into our investments.

Personally, I prefer this approach than issuing the Responsible Investing Report at a different time, just issue it at the same time with your annual results but I would have liked a video presentation on this going over highlights (I should consult pensions on how to improve transparency and communications).

In terms of the Plan's funding, I note the following:

Under OPTrust Select, on an annual basis at the discretion of the Board, pensions that are being paid may be granted COLA, and active members may be granted accrued benefit upgrades to adjust for inflation.

The investment environment is more uncertain than normal due to monetary policy tightening,  geopolitical risk events, and changes in fiscal policy impacting economic growth and asset pricing in unpredictable ways which can put pressure on the Plan’s funded status.

The demographics of the Plan are challenging because the proportion of inactive members relative to active contributing members remains high. This situation means funding risk is borne by a smaller group of contributing members, which constrains the amount of investment risk the Plan can bear.

There are several methods to help maintain the funded status: our Member-Driven Investing (MDI) strategy, the risk tolerance specified in our Risk Appetite Statement and our funding tools. As Plan challenges continue, the tools at our disposal are applied differently over time. This includes the way we use risk within the MDI strategy. Plan sustainability is directly influenced by how we manage challenges and the amount of risk we are willing to assume. For instance, the discount rate includes a margin to protect the Plan from future adverse events. The margin in our discount rate remains strong at the end of 2023. Yield levels remain higher than during the pandemic, which has reduced the downward pressure on the discount rate used to value the Plan’s obligations.

We try to foresee upcoming challenges that could potentially affect the Plan’s sustainability. We perform projections under varying economic environments, such as high inflation and low economic growth, or market collapses and rebounds, to help prepare for outcomes that may affect the level of future contributions and/or benefits.

I would also recommend you read the 2023 Responsible Investing Report embedded in the Funded Status Report and I note the following on climate strategy which I discussed briefly with James:

Lastly, it is worth noting that OPTrust invests primarily in Canada (35%) and the United States (46%):

And like Maple Eight larger peers, the bulk of the investments (71%) are managed internally to make sure they keep costs low:

Alright, those are the preliminaries, let me get to my discussion with James.

Discussion With OPTrust CIO James Davis

Earlier this afternoon, I had a chance to discuss OPTrust's 2023 Funded Status Report with CIO James Davis.

James is a supper nice guy, a veteran who used to work in Barb Zvan's portfolio construction team at OTPP before joining OPTrust as CIO.

He knows Michael Wissell well and like Michael, he's very sharp and an independent thinker.

I began by asking him him to give me an overview of OPTrust's results last year:

Sure, the first thing I would tell you and you know this, our main benchmark, our north star, the one thing we focus most on is our funded status and we remain fully funded for 15 years in a row.

At the end of 2015, we put in place a new member driven investment strategy which is very focused on the funded status. We only take the risk we need to take to pay pensions, we are not looking to make outsized returns by taking unnecessary risks.

So that necessitates relatively strong bond exposure because we want to hedge some of these liabilities.

Our strategy in terms of value creation is focused more on public markets than it is on private markets. That's somewhat uncharacteristic of the Canadian Model as many of our peers have more public equity exposure than we do. 

James told me total equities -- public and private -- made up 30% of the portfolio and their private equity exposure has increased through their MDI strategy over the last number of years (in 2015, they had a public equity allocation of roughly 30%, now it's 10-11% and the rest is PE).

He added:

What this means is in a year like 2023 when public equities are doing very well, we are not going to have a strong return, but over the long run our value creation in private equity will work in our favor. So over the long term, we prefer to have more in private markets like infrastructure, real estate and private equity.

I noted that right now, OPTrust and Teachers' have the lowest allocation to public equities (10%) and that is done purposely to mitigate downside risks (but you also miss upside risk like n 2023).

James also told me the approach in PE is still mid-market and they do not have venture in private equity noting this however:

We do have a very small sleeve where we pursue smaller opportunities where we think there may be growth potential. If you look at our portfolio, you'll see something called "other" and we had quite a significant positive rate-of-return in 2023 but it's a very small allocation. There we will look at smaller opportunities that are venture or something in the climate space like climate tech or financial innovation. More recently, we did a very small deal in AI so we can learn more about that space.

So returns there are volatile, they were solid last year but the goal there is to gain exposure into things we otherwise wouldn't gain exposure to.

Our private equity portfolio is more conventional. It is mid-market and we do try to invest in sectors that are less economically sensitive and that has served us well over time. Sandra (Bosela) has done an amazing job and our longer term performance in private equity is quite spectacular.Looking at the 4-year period, PE has delivered over 18% annualized, so it's been a great contributor o the overall portfolio. 

Infrastructure has been another great asset class, not as strong in 2023 because interest rates have gone higher, so the cost of capital has gone up and that asset class is not immune to that. So the strong performance we had in infrastructure over a 4-year period is over 13%. In 2023, it was 2.7% but if you look at 2021, our infrastructure portfolio delivered 33%.

So we know looking at any single year return of any asset class is meaningless, we focus on the longer term but the value creation opportunities in private equity, infrastructure and real estate are quite phenomenal.

I'll comment briefly on real estate because there we had a negative rate-of-return, -1.9%, but if you look at it over a 4-year period, it's 7.8%. And since inception in 2004, returns close to 9% peer annum.

Here I interjected noting the -1.9% in real estate last year is actually quite good relative to the larger peers which lost 6-8% in that asset class last year. I asked James is that due to sector diversification and he replied:

The strategy for us is we try to stay in strong geographies where there are strong growth and income opportunities. The other thing we have done -- and this is quite deliberate over the past several years, going back pre-Covid -- is to reduce our exposure to office and retail and grow our exposure into multi-residential and industrial. We have about a half of market weight in the office sector but where are office buildings are, we are focusing on class A office buildings . 

We also have a significant exposure to development real estate, that's an important part of our strategy. The cities we focus on -- Toronto, Vancouver, Seattle, San Jose and other areas in the West Coast US. We have exposure to other eareas of Canada, of course, limited exposure to Europe. We are focused on big cities where there are high growth opportunities, focusing on high quality buildings.

Where there are challenges and you probably heard this from some of our peers is inflation is something you can hit with real estate but you have to think of that in the long run. In the short run, it can be very problematic not only because it pushes interest rates higher which pushes cap rates higher but also on the development side of real estate, it costs you more to build a building because price of materials go up, the price of labor (wages) goes up, so that makes it more problematic.

And of course when you have an asset class that is in distress, it starts to snowball. So the one thing I can tell you is we have been actively refinancing properties. We did 15 mortgage renewals in this past year and all have been successful. We have more to do but we have not had any problems because the majority of our properties are in Canada, and we've got great relationships with those institutions that are financing us.That has made financing a lot easier for us but I know for some others, it hasn't been as smooth, financing has been more problematic.

I then shifted my attention to private debt and asked James if they have a sleeve there. He replied:

Good question, we do not have an allocation to private debt. The way I structured our portfolio, I want the deal teams in private markets to vet and invest across the capital stack. So about 18% of our real estate exposure is in real estate debt. We do have some exposure there and the team feels there are good opportunities in that space now.

But we don't have a core allocation to private credit like some of our peers do. 

We do have some exposure in our Credit sleeve which primarily all passive but we don't have an allocation to private debt and I would prefer the deal teams to do it on an opportunistic basis.

I mentioned that while Michael Wissell remains somewhat constructive on private debt, Jo Taylor thinks we are at the mid to end stage of the cycle and returns gong forward will not be as good in private debt and credit in general.

James told me "when everyone is talking about a new asset class -- and I've seen this in quite a few conferences where everyone is talking about private credit -- that's generally the time to start to worry."

I told him I completely agree and remember back in 2005, I attended a commodities conference in London where brokers from Goldman and Barclays were trying to persuade me that PSP should invest in commodities, and I ended up making the opposite recommendation thinking we were close to the top (we were).

We then discussed fixed income where I told him HOOPP CIO Michael Wissell told me they used volatility in bond markets last year to significantly increase their exposure to real return bonds (mostly TIPS). I asked James if they did the same thing:

Short answer is no. Our liabilities are nominal although they are inflation indexed, but the way we do the discount rate, it's a nominal discount rate. So we hold nominal bonds to deal with interest rate sensitivities to plan liabilities but I look at inflation hedging more from my real estate and infrastructure portfolio. We also have a small allocation to comorbidities which is actively managed. We are looking at alternative ways in managing inflation exposure. It's obviously become something which is more front and center in the last few years.

I don't know if it will be problematic in the next few years but there's more potential now than a decade ago.We are looking at different ways to hedge inflation but we are not sure the mismatch between Canadian and US inflation and whether TIPS would be the best way to hedge inflation. We have held TIPS in the past but it's not a core part of our liability hedging portfolio.

That's not to say TIPS won't be part of our inflation hedge going forward, we are looking at this and inflation swaps to mitigate inflation exposure. But what's most important to us is we do this in a cost effective way and keep our eye on the long term. 

What most concerns me about inflation isn't the impact on liabilities but the impact on assets. So, I want to make sure our assets are resilient to an inflationary environment. I do think in the long run, equities, especially private equity, infrastructure and real estate can give us that kind of hedging and also offer us value creation, and that's where I struggle with TIPS, I don't know how to create value with TIPS.

I shifted the discussion to private equity where I noted the cost of financing and higher labor costs have hit margins and the returns of larger peers and asked him if absolute return strategies hedge against inflation. James replied:

Again, we try to look at the portfolio in a holistic way, each sleeve, each line item has a specific purpose. I tend not to look at absolute return strategies as an inflation hedge and the reason is that the risk-free rate has gone up and that concerns me because if I'm looking at the performance of funds of funds, am I collecting a high enough risk premium over cash if the risk free is 5%?

So again, where do I get the best opportunities for value creation, it's in private equity. It's not just about the the asset class itself, it's how you run the businesses, how you select the sectors you want to be in. We do look for businesses where there are opportunities to pass through costs and recoup them in revenues so we get less margin compression. We found over the years the services sector tends to be the area we are most comfortable in and tends to have those characteristics, more than the manufacturing sector.

So if you look at our private equity portfolio, we are more focused on services than industrial or manufacturing. That has more of an inflation hedging characteristic

But even public equities over the long run are a good long term hedge against inflation.

When I look at the portfolio over the long run, I think we are resilient. Our overall MDI strategy is all about resilience, it's about being able to weather any macroeconomic environment. The most challenging one is a stagflationary one and that's what has been scary over the last few years, it felt stagflationary. Hopefully that's behind us but it's a bit early to draw conclusions.

Indeed, a sustained stagflationary environment like in the 70s, early 80s is the worst outcome for pensions but so is a severe and prolonged deflationary shock (think a decade of Covid). 

The one good thing now is central banks have raised rates significantly and they are much more measured in cutting them, fearing a reemergence of inflation.

James noted there's a lot of room to cut rates now which is a good thing because rates are high, "so if we do see an economic slowdown and inflation isn't a problem, they have the ammunition to significantly reduce the cost of capital."

Lastly, James noted on their climate strategy, they have done significant work to measure emissions across public and private assets. He said they're really trying to understand the risks and opportunities of climate change and they put in place metrics to measure carbon exposure, working with tier investment partners and portfolios companies to try to get more insight in private markets where they have a high exposure.

They are holding their private companies and partners to account and helping them understand their exposure to carbon and it's a work in progress but they are closer to achieving their interim goal of reducing their exposure by 30% by 2030.

They are also doing climate scenario analysis to measure the risks to their portfolio but at the end of the day, it's all about ensuring the Plan remains sustainable.

Finally, James wanted to give a shout-out to his "amazing team" and he's very proud of the leadership and culture which maintains and enhances the focus on a total portfolio approach which is instrumental to their MDI strategy. 

Alright, these comments take forever to write, I need to figure out ways to upload my interviews on YouTube and save me a ton of time but writing them out helps me appreciate the nuances and different approaches at Canada's venerable pension plans and funds.

Also, as I customarily do, here is the executive compensation at OPTrust but private market officials are not there (they should be!!):

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