Pension Plan Debt Issuance in Canada
On June 21st, 2017 AIMCo joined the list of pension funds issuing debt by launching its initial debt offering, a AAA rated C$400M 7-year note priced at 2.266%. This report analyzes the key trends and reasons for why large pension funds in Canada are starting to issue more and more debt.
Overview
Historically, Canadian pension plans have issued very limited debt, which has been restricted to short-term borrowing such as commercial papers and lines of credit. A new trend of long-term debt issuance has been emerging, with the Canadian Pension Plan Investment Board (CPPIB) and Alberta Investment Management Corporation (AIMCo) issuing their inaugural bonds in 2015 and 2017, respectively. This report aims to uncover why Canadian pension plans have begun issuing long- term debt and how it impacts institutional investors. Key factors examined are:
- Burden of Defined Benefit plans on employers
- Decreasing ratio of active contributors to retirees
- Demand from investors for high quality fixed income securities
- Low interest rate environment
- Increased pressure to generate additional investment returns
The top 10 pension funds in Canada managed over $1.3 trillion dollars as of December 31, 2016(1). This represents 35% of all Canadian retirement assets and 80% of public pension plan assets.
(1) Year-end dates for CPPIB, PSP and bcIMC are on March 31, 2017.
Types of Pension Plans in Canada
There are two main employer-administered pension funds in Canada: Defined Benefit (DB) plans, where retirees receive a set monthly income for life, and Defined Contribution (DC) plans where retirees receive a variable monthly income dependent on how much they contributed to the pension plan and how this money was invested. Investment risk for a DB plan is placed on the employer whereas for DC plans the onus is on the employees.
While some employers have eliminated pension plans altogether, many have restructured their plans from DB to DC in order to cut costs and minimize future liabilities. Research in Chart 1 shows total Canadian registered pension plan membership, plotted as a percentage of employment:
Due to drastic cost-cutting measures, employer-administered DB plans have fallen steadily since the 1980s, while DC plan membership has nearly tripled.
Defined Benefit Plans
Looking solely at DB plans (Chart 2) , another interesting trend can be observed. Although the overall DB plan membership rate is decreasing, when looking at just the public sector group, DB plan membership rate is actually increasing. Thus, most of the decline in DB plan membership can be attributed to the private sector. One possible explanation is that public sector employers still needs to keep up with the tradition of DB pension plan benefits in order to attract new talent to the firm.
For the largest Canadian public pension funds - whose primary donors are public sector employees - this indicates there has been an increase in new DB plan memberships. Research has shown that DB plans tend to reduce employment turnover in order to maximize their future pension wealth.
Indeed, Chart 3 shows that 44% aged 35-44 with over 15 years experience at a firm has a DB plan and similarly 52% aged 45-54 with over 15 years tenure at a firm is covered under a DB plan. The corresponding numbers for those with less than five years of tenure were 19% and 18% respectively.
These differences in coverage rates by DB plans across tenure do not merely reflect an age effect. In fact, the likelihood of belonging to a DB plan rises with time spent with the employer regardless of age.
Changing Demographics
Compounding to the trend of more boomers becoming pensioners is the fact that not enough new members are joining the public sector to match the amount leaving, and therefore not contributing enough new money into the fund to maintain healthy ratios. As a majority of the pension plan’s income is from working members’ salaries, this creates a significant decline in the ratio of working members to retired members. Chart 4 shows the current active member to retired member ratio of various pension funds.
When combined with the general trend of increasing life expectancy, this suggests pension plans will have an increased future liability, and as a result, pension fund managers have increased pressure to generate additional returns. With this increased pressure, adding leverage becomes a more attractive option for fund managers.
Changing Demographics
Chart 5: Statistics on Retired Teachers in Ontario
| Year | Avg. Starting Pension | Working: Retired Ratio | Expected Years on Pension | Avg. Retirement Age |
|---|---|---|---|---|
| 1954 | $1,600 | 11.0 : 1 | 18 | 62 |
| 1976 | $7,800 | 6.6:1 | 22 | 61 |
| 1984 | $19,100 | 4.5:1 | 23 | 60 |
| 2001 | $34,800 | 1.9:1 | 29 | 55 |
| 2008 | $41,200 | 1.6:1 | 30 | 58 |
| 2012 | $43,400 | 1.5:1 | 31 | 58 |
| 2016 | $45,000 | 1.3:1 | 31 | 59 |
Source: OTPP Annual Reports
Taking a closer look at demographic trends experienced by OTPP (Chart 5), we see pensioners on average are living longer, receiving higher salaries, and retiring earlier while there are fewer new pensioners supporting them.
In order to make up for this gap, pension plans must somehow generate additional cash flows to both support the monthly payouts as well as invest in more assets in order to generate higher returns for the future. Combined with other factors, this all leads to an increased need to issue debt.
Success of the Canadian Model
Despite the fact that DB pl ans are bec oming ever so unpopular among employers, Canadian pension plans have managed to do quite well in terms of returns when compared to peers in other countries. Chart 6 shows the 5-year annualized returns for top 10 pension plans in the country versus the S&P TSX Total Returns Index.
Nearly all of the funds have managed to generate close to 10% returns annually, which is quite impressive considering the minimal amount of risk taken to achieve that. This has led to pension fund managers from around the world looking into the causes for such success and even coined the term “Canadian Model” when referring to optimal pension plan investment strategies.
Success of the Canadian Model
One major contributor for such success of the “Canadian Model” can be attributed to the early adoption of investments in alternative asset classes, namely, private equity. OTPP led the change on that in the late 1990’s and the results today can speak for itself. Chart 7 shows the amount of PE assets each fund currently holds as a percentage of total net assets. In order to fund more PE acquisitions and maintain the high returns, pension plans are more inclined to issue long-term debt securities.
Some other factors that led to the success of the “Canadian Model” can be attributed to:
- Becoming more of an active investor rather than passive investing; by improving the operations of a company via board seats rather just focusing on returns
- Gaining in-house investment management expertise to save on external management fees and attracting better talent to build competent deal teams
- Consolidation of smaller pension funds/plans for better bargaining power internationally and ability to fund larger direct investment opportunities
(1) PE Assets includes investments in Real Estate, Infrastructure and Natural Resources; both directly and through externally managed funds
Debt Issuances
With all of the aforementioned reasons, it is no wonder pension plans have started to issue long- term debt. One major factor contributing to this is the low interest rate environment in the post dot com boom and post mortgage crisis. Looking at the timeline below, we can see that’s exactly where these funds made their initial debt offerings, with OTPP take the lead in late 2001.
(1) First issuances of long-term bonds, not including commercial papers or other short term financing instruments
Debt Issuances
Fast forward to today, the Chart 8 shows the total amount of debt from pension funds that is outstanding today. This is not representative of all debt that has been issued to date as some may have been already redeemed by the issuing entity or matured.
Generally, t he am ount issued correlates t o the asset size of each fund. There are still two funds on our list that have yet to issue: HOOPP and OPTrust. Perhaps with the beginning of a rising rate environment or a large LBO opportunity, they might join the other funds in the near future by issuing debt for the first time.
Fintech Tools to Monitor Future Activity
Capital markets fintech platform Overbond offers issuers a suite of Corporate Bond Intelligence (COBI) tools. One of them is an automated, machine learning pricing tool that can help treasury managers evaluate funding costs and determine the optimal time to issue. Combined with other analysis and visualization tools debt maturities, credit curves and more, this can give issuers an edge over their peers when it comes down to a new bond issuance or reopening.
Another feature is COBI Opportunities, which leverages big data technology and machine learning to provide automatic investment ideas by predicting potential new issues which are curated for a particular investor. Users will be able to input their investment preferences in pension plan debt and follow these issuers’ activities on the platform.
Conclusions
Key reason for why pension plans are starting to issue more debt have been discussed in the report. Below is a summary of our findings and conclusions:
- Defined Benefits (DB) pension plans in Canada have become increasingly burdensome for employers tofund. In order to cut cost, many DB plans in the private sector have been eliminated, however within the public sector DB plans are still the norm
- Pension fund managers therefore must find ways to overcome a steep decline in the ratio of active members to retired by increasing investment returns via leverage
- On the demand side for pension plan debt, investors are also extremely receptive of any new issues due to the consistent high annual returns generated by these plans and a high investment grade rating
- The low interest rate environment in both the early and late 2000s and has also encouraged fund managers to issue as they can now secure even better rates than traditional mortgage loans
- 8 of the 10 biggest public pension funds in Canada has begun issuing long-term debt since 2001. Cumulatively they current have over C$31.9B debt outstanding or 2.5% of combined net assets
- For investors that would like to take advantage of this trend, they can use Overbond to monitor pension plan issuance activity, receive curated investment ideas and pricing prediction on potential new issuances
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