Succeeding Claude Lamoureux is a daunting task. By every measure – service delivery, asset growth and deployment, staff development, corporate conduct and international acclaim – Claude oversaw the creation of a world-renowned organization. My job is to build upon his legacy and to responsibly manage all of these assets so they continue to serve future generations.
The theme of this year’s annual report – Keeping the promise. Facing the challenge. – reflects both Claude’s primary concern in recent years and mine as I look ahead. In 2008, management plans to work closely with the plan’s sponsors – the Ontario Teachers’ Federation (OTF) and the provincial government – to better position the plan to meet ongoing funding challenges.
Although the past year was a trying one for Canadian investors, I am pleased to report that the Teachers’ investment portfolio continued to grow, with $108.5 billion in net assets at December 31, 2007. The fund earned $4.7 billion in investment income despite the adverse impact on foreign investments of the rising Canadian dollar, negative impact on international credit markets of the subprime mortgage crisis in the U.S., and the collapse of Canada’s market for non-bank asset-backed commercial paper (ABCP).
Our investment professionals had not invested directly in the types of investments that gave rise to what is now known as the subprime crisis. However, we did have some indirect exposure to subprime-based assets through debt securities, which had subprime mortgage-backed securities as collateral, as well as a limited exposure to non-bank ABCP. In addition, we made investments in bank-sponsored ABCP and commercial mortgage-backed securities whose values and returns have been materially impacted by the global credit crisis. More broadly, the resulting market instability in the fourth quarter hurt the performance of all our public equities and fixed income portfolios.
Diversification has always been a hallmark of our investment program. The fund’s real estate, private equity and infrastructure assets, as well as tactical asset allocation and absolute return strategies, led the way in producing a 4.5% total fund return, beating the composite benchmark return of 2.3% for the eighth consecutive year. Despite outperforming our benchmark, poor market performance in general meant that our returns fell short of the amount required to match the growth of the plan’s liabilities.
Our Member Services division has again scored top marks in plan administration. Employees continued to deploy the technology that is essential for efficient, effective information processing and which allows our pension benefit specialists to put their knowledge and expertise to more valuable use in helping members understand their benefits. As you will read in Management’s Discussion and Analysis, Member Services has exciting plans to expand personal service in 2008.
Notwithstanding the fund’s 2007 investment growth, the preliminary funding valuation at January 1, 2008, shows a $12.7 billion shortfall between the plan’s assets and liabilities under the current Funding Management Policy. This is largely the result of the continuing challenge of managing a mature plan. The significance of being a “mature” pension plan is summed up in these three ratios:
•
Benefits paid to contributions received. The plan now pays $1.9 billion more in benefits annually than it receives in contributions. Projections indicate this gap will widen in the future.
•
Future contributions to total assets. In 1990, the present value of projected member and employer contributions equalled 42% of plan assets. Last year, they equalled only 26%.
•
Active members to pensioners. In 1990, there were four working teachers for each pensioner. Now there are 1.6, and in 10 years the ratio is expected to be 1.2 to 1.
The plan pays out more than it takes in from contributions. This means investment returns are that much more important. But seeking higher returns generally means taking on greater risk. As the fund grows, so does the impact of the periodic losses that are an inherent part of investing. A 5% loss on a $50 billion fund creates a $2.5 billion gap that must be covered. A 5% loss on a $100 billion fund creates a $5 billion gap. This difference would not matter if the plan’s active membership was growing at the same rate as the pension fund. But that is not the case.
As the pension fund has grown, total membership growth has flattened, and the percentage of retired members has risen steadily. Regular contributions totalled $1.3 billion in 1990, and net assets available for benefits totalled $20 billion at the end of the year. In 2007, contributions had increased only to $2.1 billion, while net assets available for benefits had grown to $108.5 billion. Pensioners do not make contributions and, by law, their benefits cannot be reduced. The same protection applies to benefits already earned by current teachers.
Put simply, a declining proportion of the plan’s members bear increasing responsibility for keeping it fully funded. All defined benefit pension plans worldwide face this challenge. Just as Teachers’ became an innovator in investment management and member service by necessity, we now need to help find innovative solutions to achieving intergenerational balance.
By September 30 of this year, it is expected that the sponsors will have filed a funding valuation that reflects their plans to address the issues raised by the shortfall. All of the parties involved in managing, overseeing and sponsoring the plan have worked together to address funding shortfall solutions. Each group involved deserves credit for doing what is best for all concerned – Ontario’s teachers and taxpayers.
As we continue to work together on these solutions, we now have better information than ever before, as a result of last year’s members’ survey report and the expert panel’s study on the plan’s assumptions. These reports and their conclusions provide excellent information for the plan sponsors to consider, as they offer an objective assessment of the strengths and weaknesses of the current Funding Management Policy and the views of those most affected by any potential change.
The outside experts suggested that more prudence be incorporated into the plan’s approach to setting demographic assumptions, especially in regard to mortality. There were a number of recommendations regarding how to deal with the maturity of the plan. A supplementary report on Risk-Sharing Arrangements (Among Members) in Eight Canadian Pension Plans is scheduled to be completed later this spring. We expect valuable insight from this report as the partners consider what options might be appropriate to allow the plan’s risk to be shared fairly among members. Respondents to the member survey indicated that, generally, they are willing to pay somewhat higher contributions to maintain current benefits, but are also open to a change in benefits – specifically conditional inflation protection – should future shortfalls necessitate change.
A renewed spirit of teamwork is underway and solid, objective information is available, giving the plan’s decision-makers an environment that is conducive to making changes that serve members now and in the future. Teachers’ management team stands ready to work with all concerned so that, together, those responsible for the plan can ensure fair and effective funding management for every member – including the young teachers of today and those to be hired in the future.
As Teachers’ and the plan sponsors arranged for an expert review of the plan’s funding assumptions, the Ontario government assembled another expert panel – the Arthurs Commission – to review the legislation that governs all defined benefit pension plans registered in this province. This is the first such review in a generation. Boldly titled “It’s Time to Retire the Current Pension System,” (65KB PDF) our submission calls for major changes, including regulatory recognition of the vast differences between private and public sector plans. This submission is available on our website.
The arrival of a new CEO always prompts questions about the management team – people with whom I have worked closely for six years and whom I respect. Yes, there will be changes in the years to come. There will be normal attrition as senior managers reach retirement age. It is quite possible that their successors are already here. Teachers’ has long been a learning organization offering opportunity for career development and advancement. That will continue on my watch and I trust that part of my legacy will be the development of a whole new generation of leaders.
We face another constant challenge: maintaining our edge as one of the world’s most innovative investors. Teachers’ had to be creative during the 1990s to quickly grow the pension fund. Now, in the 2000s, that resourcefulness must continue because conventional stock and bond markets cannot generate the returns we need at the level of risk we can prudently assume. While each innovation offers attractive gains at the outset, the rewards dwindle as other investors compete for smaller investments. The search for the next investment frontier is constant.
The same pursuit also continues to find value from existing investments and with it goes our ongoing commitment to good governance at the corporations in which we invest. As before, we will use our influence as a significant investor to seek fair and proper alignment of management’s interests with those of shareholders.
I have assumed my new role at Teachers’ during a period of dynamic and positive change. We have an opportunity to work with our partners to adopt industry-leading changes that will benefit our members for generations to come. This will all be driven by a talented and dedicated group of professionals whose first priority is always our members. You can understand why my guiding principle as CEO of this great, one-of-a-kind organization is: People. Execution. Results.
I look forward to reporting to you next year on our progress in keeping the pension promise and facing the challenges of a mature plan.
