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Background: OPTrust is in a Strong Funding Position"

posting date Posted: February 6 , 2006

February 6 , 2006

Some pension commentators have questioned the assumptions used by public sector pension plans to estimate whether they have enough assets to pay their pension obligations. It has even been suggested that Ontario workers and taxpayers will have to pay substantially higher contributions to cover large funding gaps. As it is, some plans have already increased their contribution rates and rolled back benefits.

OPTrust does not foresee any need to increase contribution rates before at least 2009. We have no plans to roll back benefits. Our plan is fully funded.

Not all pension plans are alike. They have different member demographics. They offer different pension entitlements that create different liability cost structures. They have different investment policies to match assets and liabilities.

For example, OPTrust has a lower ratio of retirees to active members than some other plans. Currently 2.2 members pay in for every retiree drawing benefits. This means we are better positioned to pay current pensions than a plan with fewer active members per retiree.

With 22,000 beneficiaries and 52,000 active members, our pensioner population is small. (OPTrust had no retirees when it was created 10 years ago). Our members are slightly younger than some other plans. An overall two-year age difference doesn’t seem like much, but it reduces liability costs over the long term. 

In the 1990s, pension surpluses were commonplace, driven by a booming stock market. Some plans responded by introducing permanent benefit improvements that are now creating funding stresses.

By contrast, the OPSEU sponsor introduced mostly temporary benefit improvements. Most important, they fully paid for them in advance with surpluses that had already arisen.

The secret of our funding success is that our sponsors acted responsibly by making prudent plan decisions and by setting aside surplus in the good years to cover funding deficiencies in the lean years. That’s why OPTrust is fully funded.

The attached article explains key assumptions we use in our funding valuation.  They are based on a great deal of research and analysis. They are realistic. And they are right for our plan. As a result, OPTrust members can be confident that their entitlements will be there for them when they retire.

How We Keep Your Pension Plan Fully Funded

Ontario pension plans are required by provincial legislation to conduct a valuation by independent actuaries of their assets and liabilities at least every three years. The purpose is to determine whether they have enough assets to pay all the pension benefits their members expect when they retire.

Assets are investments like stocks, bonds and real estate. Liabilities are benefit entitlements owed to plan members, with a small provision for administration expenses to pay those entitlements. If assets fall short of liabilities, a funding gap occurs. Pension plans must find ways to close that gap by changing their valuation assumptions, altering their benefit structures or increasing the contributions that workers and their employers pay into the plan. Avoiding contribution rate increases is a key funding objective and one that OPTrust has successfully achieved for the past 10 years.

Seeking the Right Asset/Liability Balance

We have adopted a liability-driven approach to investing. We start with the cost structure of future pension obligations. This cost structure is determined by making various demographic and economic assumptions. Two assumptions are expected changes in the future wage levels of plan members and their projected retirement ages. They are important because pension entitlements are based on wages and length of service. We also look at mortality rates to estimate how long members will live in retirement.

This type of information gives us an understanding of the present value of future pension obligations. What we really want to determine is the equilibrium between income flowing into the plan from investment assets and contributions and the income flowing out in benefit payments in the decades ahead.  Starting with liability costs helps to shape the mix of investment assets needed to generate sufficient investment income.

Two important assumptions we study on the asset side of the ledger are future expectations for inflation and investment returns.

The Influence of Inflation

Inflation influences both investment returns and wages. Higher inflation erodes asset values. It can also drive wage demands up as workers seek to maintain the purchasing power of their pay cheques. Higher wages increase the cost of pension liabilities since benefits are based on average salaries.

Inflation by itself is not necessarily bad. In a growing economy, investment returns and wage increases should exceed the rate of inflation over the long term.  Our most recent funding valuation anticipates such a scenario.

Deciding on the Long-term Rate of Return

One of the most complex assumptions concerns the expected rate of return on investments.

Most investments are highly unpredictable in the short term as they respond to both rational and irrational factors that may have nothing to do with the quality of the investment itself. Over the long term investments tend to behave in more predictable ways by filtering out psychological, political and economic factors of short-term duration. History can, in fact, provide an informed framework of what might happen in the future.

There are two definitions of investment returns. One is the nominal rate of return – the investment performance you read in the business pages or see on your mutual fund statement. The nominal rate includes the effect of inflation.  The other is the real rate of return. It excludes inflation. If the nominal rate of return is 7 percent and the inflation rate is 3 percent, the real rate of return is 4 percent (that is, the nominal rate minus the inflation rate).

Using the real rate of return makes sense because pension benefits are adjusted annually to protect them against inflation. We also need to adjust assets on the other side of the ledger to exclude inflation. The real rate of return does that.

The first step in determining the real rate of return is to look back and analyze up to 50 years of historical data, with more emphasis on the last 25 years. We review the returns for each major asset class like bonds and stocks in different geographic markets, such as Canada and the U.S.

Next we look forward by reviewing the consensus forecasts of more than 40 economists and investment portfolio managers at such organizations as banks and investment firms. What investment performance do they expect from each asset class over the long term?

We then establish a range of acceptable assumptions for each asset class and aggregate them according to our target asset mix – that is, how much we plan to invest in each asset class. 

Our Current Target Asset Mix

The following table summarizes the target asset mix we used in our most recent funding valuation. This is the investment portfolio that we believe best matches the cost structure of our liabilities.

Canadian equities

25.0%

U.S. equities

15.0%

Non-U.S. foreign equities

20.0%

Total equities

60.0%

Real estate

  9.5%

Real return bonds

  7.5%

Fixed income securities

23.0%

Totals

100.0%

Our target asset mix differed from other pension plans because we have a different cost structure and therefore a different income need. For example, we need less cash today to pay current pensions than some other plans; consequently, we can afford to assume a somewhat higher level of risk to earn better returns.

In recent years, we have begun to increase our investment in alternative assets, such as real estate, private equity and most recently infrastructure. These assets are appealing because they generate an income stream that can be a good match for paying pension benefits, much like an annuity. They also tend to be less volatile investments than publicly traded stocks and bonds. In addition, tangible assets like real estate and infrastructure are a good hedge against inflation. Real return bonds are a perfect inflation hedge, though they are currently in short supply. 

Furthermore, we can earn extra returns by actively managing an increasing portion of our asset mix, which we are starting to do.

What Our Research Shows

Over the past 25 years, our target asset mix would have yielded between 3 percent and 6 percent annually. Looking forward, it is expected to yield a real return of 4.9 percent. This forecast reflects a lowering of expectations among economists and investors. In 2000, for instance, the consensus real return for our target asset mix was 5.8 percent.  (The expected real rate of return for other public sector pension plans will be different because their target asset mix is different).

Merging the historical and projected rates of return suggests that our target asset mix should earn between 3 percent and 5.5 percent over the long term. Being cautious, we selected an assumed real rate of return just below the median at 4 percent.

Of course, this expected rate of return looks low compared with the 23.4 percent real return generated by the Canadian stock market in 2005 – and that followed two years of strong performance. But not all assets did as well. The U.S. stock market, for example, was fairly flat in 2005. Fixed income securities showed only modest gains. And who knows for sure how stock markets will do this year or next? Few anticipated the strong growth of Canadian equities between 2003 and 2005.

As short-term performance, either positive or negative, tends to get smoothed out over the longer term, our 4.0 percent real rate of return is both realistic and prudent in making our funding valuation.

The Impact of Interest Rates

Other economic factors can influence the future value of assets and liabilities. One of the most important is the level of interest rates.

Declining interest rates are good for fixed income assets like bonds because they drive prices, and thus asset values, higher. (The price of fixed income securities moves inversely to changes in interest rates). But declining interest rates can be devastating for pension liabilities. 

For example, when interest rates are around 5 percent, it takes about $350,000 to pay a lifetime pension of approximately $25,000 a year. (This assumes the full $350,000 in capital, plus interest earned on that capital, is paid out over the member’s retired lifetime). However, when interest rates fall to say 3 percent, roughly $500,000 is required to pay that same $25,000 annual pension.

This conceptual example illustrates the seesaw relationship between interest rates and the present value of accrued pension liabilities. When interest rates are low, today’s cost of future pension liabilities is higher. When interest rates are high, today’s cost of future pension liabilities is lower. A common rule of thumb is that a one percent decline in interest rates leads to a 10 percent increase in the present value of pension liabilities.

In recent years, interest rates have been unusually low by historical standards, increasing the value of future pension benefits. Should interest rates rise in the next few years, as is widely expected, the cost of pension liabilities will decline, bringing assets and liabilities into better balance.

Looking Ahead

Currently we are making our latest asset/liability study that should be completed in the spring of 2006. The study may persuade us to adjust our assumptions about long-term rates of return. Any adjustment, however, will be minor and will not jeopardize our commitment to avoiding contribution rate increases and maintaining current benefit entitlements for our members.