Pension giants add leverage as 30-year-old Canadian model flounders

IFR 2291 6 July to 12 July 2019
7 min read
Gareth Gore

In the late 1980s, the Ontario government set up a task force to tackle what it saw as a ticking financial time bomb. After decades of under-funding, it was worried that the pensions of teachers and other public servants might one day place an insurmountable burden on state finances. The pay-as-you-go model, with workers contributing just 1% of their salaries and the state filling any shortfalls, was seen as unsustainable.

The task force recommended a complete overhaul of the system, proposing that public-sector pensions be spun off and managed independently by teams of professional investors. Though controversial, in 1990 the state launched the first such fund – the Ontario Teachers’ Pension Plan – that rapidly became a template for other public-sector pension schemes not just in Ontario but across the whole of Canada.

The Canada model, as it is known, is widely seen as a huge success. Shrewd investment decisions haven’t just eliminated gaping deficits, but have also transformed the funds into powerful investors and major shareholders in companies such as Lyft, Tencent, Facebook and Nestle. The top 10 funds have quadrupled assets in just 15 years, and today manage more than C$1.5trn (US$1.1trn) for 25 million members.


But, after almost three decades of success, the Canadian model is showing signs of strain. Over the next few years, several funds are expected to fall back into deficit, with contributions insufficient to cover the growing number of pensioners who are on average living longer. The shift has prompted several funds to add a controversial new element to the tried-and-tested Canadian model: leverage.

Canada Pension Plan, by far the largest of the funds with more than 20 million members, is leading the charge. Since its first tentative step into the bond market with a C$1bn private placement in mid-2015, CPPIB – the fund’s investment arm – has become a regular issuer. Its pace of issuance has steadily picked up over the past few years, with the fund now having more than C$26bn of outstanding bonds. On Friday, it mandated banks for another deal - a 30-year in euros.

It’s a trend that is mirrored across the sector. OMERS, which manages the pensions of half a million public servants, librarians, police officers and fire fighters in Ontario, and OTPP have both set up bond issuance programmes, while three other funds have stepped up issuance. As a result, outstanding bonds issued by Canadian pension funds have more than trebled over the past three years to almost C$60bn.

“This is unique,” said Jason Mercer, who monitors the sector for ratings agency Moody’s, adding that it was rare to see pension funds taking on leverage. “The Canadians are really pioneers in this and the only ones doing it. A lot of the funds have already increased their investment horizon to look for other sources of outperformance, and leverage is the next step to magnify returns.”


Projections show why there is a pressure to lever up. Next year will be CPP’s last in surplus, with the number of people claiming pensions set to rise by two million over the next few years even as the number of contributors stays relatively flat. By 2030, its deficit is expected to be C$9bn a year. As a result, it will become increasingly reliant on returns from its investment pot to fill the gap.

The shift could hardly come at a worse time. After a decade of low rates, returns on many assets have fallen to record lows, making the industry annual target of generating 4% over inflation increasingly difficult, despite the move that many have made into alternative assets such as private equity, property and emerging markets.

“There’s no question about it, market conditions are challenging for long-term investors,” said Jonathan Simmons, CFO at OMERS, which issued its first bond – an upsized US$1.25bn five-year bond with a coupon of 2.5% – in April. “The Canadians have been active debt issuers for several years. Plans taking on prudent leverage is accepted in this market, and that’s what OMERS decided to do.”

“It’s an optimisation strategy: we have an asset mix that is approved by our board … about half in alternative assets and half in traditional assets such as equities and bonds. We’ve been building that asset base now for more than 20 years. As we have reached our targets, we have the asset mix we want, and so the question is how we optimise. And adding a little bit of leverage is the next phase in that.”


Leverage isn’t restricted to bond issuance. Almost all the big pension funds have sizeable commercial paper programmes, with many also borrowing tens of billions of dollars via the repo markets. The Bank of Canada has in the past voiced concern about the rise in leverage – particularly given the big shift in the funds’ asset allocation to alternative, less-liquid assets, which on average make up about 40% of their portfolios.

“The trends toward more illiquid assets, combined with the greater use of short-term leverage through repo and derivatives markets may, if not properly managed, lead to a future vulnerability that could be tested during periods of financial market stress,” the central bank said in a 2016 report. It declined to comment on the rise in bond issuance when contacted by IFR.

According to Mercer, the shift towards bonds is positive in that it removes regular short-term refinancing risks that come with CP and repo financing. “Terming out the debt is a good thing,” he said. At the same time, many funds have been reducing their less-liquid Level 2 assets and investing in more liquid securities to better balance out their portfolios, which are heavily skewed towards the least-liquid Level 3 assets.

There are some concerns, however, that the rise in leverage could leave some funds exposed during the next market turndown. In 2008, many funds – then unleveraged – posted double-digit falls. At the same time, in some cases leverage will be used to dial up already leveraged investment strategies. Many funds are big equity investors in the leveraged buyout space.

Simmons believes that OMERS’ strategy remains prudent. It has a hard leverage limit of 10% of assets, which – compared to many other industries – is extremely low. It plans to use that space. “We’ll be moving towards it over the next few years as we continue to be active as issuers,” he said. “We think that 10% is very conservative, and so we want to use that limit – prudently – to improve our plan’s returns and asset mix.”