BILL CHINERY: You know, my poor paying for me in the hospital is going to be expensive. And so that is really an issue that governments are going to have to tackle. And they're not doing a good job at it.
PETER HAYNES: Welcome to episode 53 of TD Securities podcast series Bid out, a market structure perspective from North of 49. I'm your host, Peter Haynes. And today, we're going to cross over to the other side of the balance sheet to discuss the evolution of liability-driven investing, or LDI for short, amongst pension funds. Joining us for this episode are two experts in the pension fund space.
First is Bill Chinery. Bill has had a long and distinguished career in finance. He started out as an actuary, and he moved into institutional client management at YMG and BlackRock before finishing up with a stint on the board of Ontario Teachers that just ended.
Also with us today is Frederic Kibrite, Vice President and Director of Asset Liability Portfolio Management for TD Asset Management based out of Montreal. Fred and Bill, thanks for joining me today.
BILL CHINERY: Thanks, Peter.
PETER HAYNES: Bill, I've got to ask you first. Now that you're no longer on the board of Ontario Teachers, what's keeping you busy? 'Cause you can no longer pester those folks in capital markets you probably drove crazy for the length of time you were on that board.
BILL CHINERY: Well, thanks, Peter, for inviting me. So I am keeping busy. I am on Industrial Alliance Financial's board. I am the Chair of the Toronto Firefighters Pension Plan. And lastly, I sit on a venture capital fund called Green Sky, which has a series of venture capital investments, which I enjoy actually the most of all. And I play with my grandkids, and I travel.
PETER HAYNES: And do you still drive the folks at Ontario Teachers crazy, or they don't have to take your calls anymore?
BILL CHINERY: They-- in fact, when I do try to talk to them, they kind of ignore me now because I have no say in what they're doing.
PETER HAYNES: Well, I don't know. I think they probably miss speaking to you. Everyone I know from that organization speaks fondly of their interactions with you. So let's just get started here.
But I do need to remind our audience that this podcast is for informational purposes. The views described in today's podcast are of the individuals and may or may not represent the views of their firm. And of course, the content of this podcast should not be relied upon as investment, tax, or other advice. I've said this a million times in these podcasts.
Nobody enjoys doing them more than I do because I learn so much from subject matter experts like the two of you. Now, my history with the liability side of the pension fund balance sheet goes back to a conference speech at the old Super Bowl of indexing in Arizona. It was probably around the early 2000s. It was post the tech bubble. And a gentleman by the name of Ron Ryan, who I guess is a well-known expert in the US, he was speaking to what is mostly an equity crowd about asset class returns and the impact of these returns on asset liability mismatches.
I think it was '95 that was his example. It was a year when equities were up significantly, like over 30%. But the bond market was also up close to 20%. I was thinking, what a great year for funds, until Ron explained what a bad year it was for pensions as their liabilities went up more than their assets by virtue of a lower discount factor. For me, this was a bit of a light bulb moment.
Now, Bill, I know I wasn't at the precipice moment for LDI and that the concept of asset liability matching went way back further. But it seemed to pick up steam in the early 2000s. What are the early iterations of LDI as you remember them, and how has LDI evolved in a general sense from the early days?
BILL CHINERY: So Peter, if you start pension plans in Canada, pretty well started in the '50s. So if you go back to the '50s, the only investment managers at that time were insurance companies. And insurance companies populated by actuaries all of a sudden came up with these deposit administration contracts. A deposit administration contract is like a long bond at a guaranteed interest, term of anywhere from 20 to 30 years, guaranteed principal. And an interesting aspect-- also guaranteed annuity purchase rates.
So effectively, the first pension plans in Canada were LDI'd. And when somebody retired, they bought annuities for the person. So for '50s, '60s, and '70s, that's exactly the start of LDI. So the '80s and '90s come along. '80s and '90s, all of a sudden, you have a higher risk premium. You have higher interest rates. And you also have the advent of the Jarislowsky Frasers of the world and the PH&Ns of the world.
So all of a sudden, this gets disconnected, and you create the famous 60/40 portfolio, 60% in equities and 40% in bonds. So you would think that those bonds, the 40% in bonds, would at least be LDI'd relative to the liabilities. But they weren't. They were invested relative to the universe of pension plans, much like you would have an equity fund against the TSX. Why is that? Because that's what everybody did.
And I would, as a consultant back then, I was trying to tell my clients, you know what, take those bonds, and at least immunize yourself against the liabilities. But they didn't do that because nobody else did that. If I did that and interest rates went up, I was going to underperform my peers. So that was kind of the disconnect for the '80s and '90s. '80s and '90s were gold for pension plans.
If you look at Ontario Teachers, for instance, coming out of the '90s, 30% surplus, probably the highest surplus they ever had. And then, of course, you get the 2000s and 2010s where you get the dot-com bubble burst. And then 2006, 2007, 2008, you get the great financial crisis. So that decimated all those surpluses and brought the pension plans virtually unfunded across the world.
Now, LDI, you mentioned early 2000. Now, that's an interesting time because that's probably what you're referring to as the Boots moment. So Boots pension plan in the UK, LDI'd, their portfolio, they bought long bonds and gilts, long gilts I guess, to immunize their fund. So that was kind of the start of a lot of pension plans doing that.
Also at the same time, you've got a lot of these plans now are closed. If you look at the FTSE 100, the exchange in the US, the largest plans in the UK, none of them have DB plans that are open anymore. They're all closed. So those CFOs are looking to, at some point in time, immunize those plans. And we can talk a little bit more about that in a minute when we talk about what's happened in the UK.
PETER HAYNES: Well, Fred, UK is definitely going to be front and center in this discussion. Because the whole term LDI was really not well known outside of the asset management and pension space until really last summer where it made headlines in the UK. And that was because then UK Prime Minister Liz Truss announced tax cuts that did not have an offset in spending cuts. And the market punished the UK with a selloff in gilts, and ultimately Liz Truss lost her job. How did this translate into LDI taking center stage?
FRED KIBRITE: Yeah. It's a great question, Peter. And maybe the first interesting bit on LDI, and picking up on what Bill said, so LDI is really a term meaning liability-driven investment that's specific to the pension world. More generally in asset liability management, we refer to ALM, asset liability management. And I actually tracked down the term, was curious to know where it came from. And it originated back 161 years ago.
PETER HAYNES: LDI did?
FRED KIBRITE: ALM, the broader term, and from what is believed to be the first actual paper on asset liability management. And the paper actually laid out the general principles on investing for a general account for a life insurance company as Bill said. So I thought that was interesting. And what's even more interesting is that the actuary writing this paper was based in the UK and wrote that back in 1862. Anyways, I thought that was interesting for your audience.
PETER HAYNES: Do either of you guys know where the term LDI came from?
BILL CHINERY: I don't know the genesis of it, no, Peter. Sorry. It's been around forever.
PETER HAYNES: --a bit of an acronym that's almost got like a cachet to it. So but anyway, I'm interrupting here.
FRED KIBRITE: OK, so back to LDI in the UK, how this came about. So a bit of context maybe as to how pension plans are managed. So pension plan asset management is about managing the risks. There are a variety of risks. And manager of pension assets have really to balance those risks out to achieve the objectives.
So one of the main risks facing pension plan asset managers is the interest rate risk as we know as actuaries. The discount rate is driven by interest rates. And that's what's going to present value, all the future cash flows, all the promises that are made. So the goal of LDI is just to balance out all the risks that are within the plan with that interest rate risk, and acknowledging that you need a source of return with those return-seeking assets.
You cannot invest only in government bonds. You would not be able to achieve your long-term goals. So balancing this out, keeping return-seeking assets on the books, and wanting to hedge more interest rate risk, create positions that we call overlay, so leveraging up the bonds that you already own and buying more using repos or swaps to generate that additional protection against interest rate.
So that's the position that most UK plans were in when the event happened. And what triggered the crisis there was that as rate increased-- and rate increased substantially, 121 basis points over five days following that announcement by the government. So that generated losses on the bonds. And because when you're doing overlay structures, you have actually borrowed against those bonds, you are creating losses. So those losses need to be reimbursed, or we say post collateral for them, and that created pressure on selling bonds to be able to post that collateral.
Another manner to reduce the risk is actually to reduce your positions, your exposure. So you acknowledge that you need to reduce the interest rate exposure protection that you've built up so that if you, as a plan sponsor, wanted to execute those transactions, it meant selling more bonds. So in total, pressure on posting collateral, pressure on selling bonds to reduce the exposure. So that created an imbalance in the market. A lot of sellers, not a lot of buyers. And the government, in the end, had to step in to be the buyer of last resort of those bonds.
PETER HAYNES: And ultimately cost Liz Truss the prime minister position here given the fallout that came as a result of that. Now, Bill, what was curious, I think, to us that are one step removed from the world that both you and Fred live in is that you would think this issue that occurred with the pension funds in the UK would have cascaded to other places in the world. Why did that not happen?
BILL CHINERY: A variety of reasons. First of all, in the UK, as Fred said, they had leveraged these up. And they used overnight repo to fund them, OK? Overnight repo, the ones that are done in Canada that do use leverage and do this don't use overnight repo. They use a longer term funding structure that doesn't create as much of a problem.
The other thing is the gilt market is very illiquid. It is not a very liquid market relative to, say, treasuries or even Canadian bonds. And as a result, when there's a whole bunch of sellers and no buyers, that just creates as a lopsided market. So those are two of the reasons.
The other reason is it's very-- a lot of plans in the UK are doing this, were doing this. They were underfund. They created this leverage structure. Then they took the rest of the assets and created return-seeking assets, which the others didn't do. They haven't done as much of that in other countries.
So it was, again, herd mentality. I'm going to do this if my other competitor does this. And then all of a sudden, it blows up.
PETER HAYNES: Well, that's an early lesson in this podcast that I've now heard two or three times and perhaps will hear it again. One of the problems that I see in the case of the UK is, first of all, I understand that the corporations in the UK are very, very sensitive to their pension fund exposure and would love to annuitize if they could. They have to mark their gains and losses from their pension fund on their income statement, and this really does preclude these funds from what might otherwise be better asset mix decisions for the long term.
Earlier this week, a think tank operated by former prime Minister Tony Blair in the UK suggested that the country's pension protection fund could be utilized as a consolidator of sorts for corporate pension funds. The think tank believes that corporate pensions in the UK, if freed from the risk of underperformance and subsequent income hits, could add risk that makes long-term sense through a centrally managed super fund or super funds that would have some responsibility to invest some of the assets back in the UK equity market. This proposal has some legs with the Sunak government in place today. And it's despite the fact that the solution that they're coming up with here is coming from across the political aisle. What's your thought on first blush, Bill?
BILL CHINERY: I'm not a big believer in governments interfering in these things. If you look at Ontario Teachers, you look at CPP, they've firewalled themselves from governments. I mean, effectively they can do whatever they want without very much interference by the governments. All you need to do is look south of the border to see how governments interfere with pension plans. If you look at CalPERS and CalSTRS, they're the worst governed organizations in the world. You have all sorts of--
PETER HAYNES: What do you mean by that, if I can just ask?
BILL CHINERY: So their board-- their board, the people that oversee it, are all ex officio members of the government. So right away, the state of California, all these people are sitting on this board. And instead of thinking of the beneficiaries of the trust, they're thinking of political issues and all sorts of other issues. They're 60% funded, 65% funded, and that's with discount rates that aren't realistic. They don't pay their people very well. They can't make more than a certain level of government employee.
I mean, once you have this type of structure, you're going to underperform. And they have underperformed, and they are underfunded. And that's when governments interfere with plan.
Now, IMCO is a good example of where that's kind of working, like you've said. So IMCO was created, and anybody who goes into IMCO gets a benefit on solvency issues. Now, I don't want to get into complicated solvency issues. But if you're willing to concede into this bigger pot, the government gives you a break on funding. And so something like that. But IMCO still is a bit firewalled from the government.
So you've got to keep government employees and government officials off these boards and then set it up so that it can work. So maybe an IMCO type of arrangement could work. But just forcing people into a plan where government people are going to oversee it is wrong.
PETER HAYNES: And it's corporations we're talking about, not public pensions. So that makes it even more complicated.
BILL CHINERY: A little bit, yeah, correct.
PETER HAYNES: So Fred, how much time have you spent with pension funds that you speak to talking them off the ledge after this UK LDI near catastrophe?
FRED KIBRITE: Yeah, absolutely. Clients were reaching out for sure. The first thing we want to tell them is this wasn't an event that would cause contagion to Canada and to our business here, so making that distinction that Bill was describing.
And we had basically four points here. Making the distinction between the two countries. More mature market in the UK, so more one-sided pressure. Leverage levels were sometimes a bit higher than what we would see here in Canada with some controls lacking. There was this issue, it is called clean versus dirty CSA. It's a very technical term, but CSA is an acronym for what is called a credit support annex. It defines the relationship or the engagement versus a counterparty and what kind of collateral can be posted.
And now, the UK market wanted to do good and force participants to generate cash in order to post with the counterparty. So cash is more liquid. That's the number one instrument.
PETER HAYNES: So they wouldn't let them post the government bonds. They forced them to liquidate the government bonds and post cash.
FRED KIBRITE: Exactly, and post cash. So that generated more selling pressure and makes a difference. In Canada, here we're still allowing for mostly the posting of actual securities.
And finally, it was a politically-driven event. And let's not forget that. Markets don't like surprises. And what caused all this in the UK as a starting point, it was this political event. So that's the first answers we provided to our client.
The second was about our own internal controls on our funds, our pool funds, and our segregated mandates. We do manage pool funds on behalf of smaller clients, and we do have segregated mandates with overlays for our larger clients.
